The many challenges presented by market building are at the heart of public debate not only in Russia, but in the EU as well. The EU started its effort almost fifty years ago and is now in the process of completing a Single Market which encompasses 25 countries. Russia began its market building efforts much more recently and its endeavor is mainly concentrated on the domestic scene. Although at different stages, both the EU and Russia are, in a way, transition economies. Moreover, both face, in addition to the building of a market within their own borders, the challenge of connecting with each other through appropriate cooperative arrangements and consistent with established international standards.

Against this background, the Eurosystem [that comprises the Frankfurt-based European Central Bank (ECB) and the national central banks of the 11 euro-area countries – Ed.] and the Bank of Russia launched a major cooperative project in the field of banking supervision almost one year ago. Under the auspices of the European Union, the ECB, nine euro-area central banks and three EU supervisory authorities are now sharing with the Bank of Russia their experience in promoting and maintaining a stable financial system. All of the participants of this cooperative effort are well aware that the ultimate goal of their project is to improve the functioning of the economy.

When discussing experiences in market building, one occasionally hears the complaint that progress is too slow. For example, concerns have been raised that Russia is backtracking from its path of reform in favor of the strong influence of the state. At the same time, the EU is occasionally portrayed as “an overly bureaucratized organization which has lost its dynamism.” Some observers have also expressed their disappointment about EU-Russia relations since the signing of the Partnership and Cooperation Agreement.

In spite of the small grain of truth these criticisms may contain, they reflect the naive assumption that market building is a simple undertaking. This assumption is plainly wrong. Market building is a difficult process which inherently takes time. Indeed, the experience of more than thirty years in Europe provides enough proof of this. And yet, despite the challenges it is currently facing, the European experience suggests that – against all odds – goals can be achieved, which at the start were seen by many as illusory. Thus, I am deeply convinced that any difficulties or even setbacks should not lead to deviations from the main path toward the objective, since any detour is almost bound to lead to a dead end.

PRINCIPLES OF BUILDING DOMESTIC MARKETS

In the last two decades, Russia and the EU engaged in unprecedented market building projects. In 1986, the EU decided to complete the Single Market, while in 1992, Russia, which had been operating for more than seventy years under the principles of central planning, began transforming itself into a market economy. A widely shared assessment of both projects seems to be that much has been achieved, but more needs to be done.

Why does market building take so much time and why is it so difficult? Of course, political constraints play an important role. The building of markets represents such a fundamental change that political obstacles challenge the implementation of almost each step of this process since there are always groups and coalitions interested in retaining the status quo. To meet these challenges, a strong civil society is needed, where different and opposing interests engage in open public discourse. From the political point of view, this means being ready to take steps that may be unpopular in the short run, but serve long-term goals. It also means delegating the implementation of this project to sound and independent institutions. From the economic point of view, this is most relevant with regard to the interest of consumers whose interests are usually sacrificed for the interests of the producers.

However, it cannot be denied that market building is not only made difficult by its opponents, it is inherently difficult. Both history and theory indicate that Adam Smith’s famous ‘invisible hand’ produces the wonder of enhancing ‘the wealth of nations’ only when the spontaneous actions of individuals – each pursuing their own interests – are channelled and framed by the Rule of Law. Moreover, markets are not always perfect. Financial markets are a prime example, since it is prone to instabilities and crises. Imperfections and failures, although often linked to the interference of the public realm, are primarily caused by external factors and incomplete information. This leads to situations where the actions of individuals seeking to maximize their own benefits may be detrimental to others. Economists refer to this behavior as ‘moral hazard.’ For example, undercapitalized banks have an incentive to engage in risky investments, while the depositors, as opposed to the owners, carry most of the losses in case of failure. Banking supervision aims at countering this moral hazard through minimum capital requirements and by providing banks with incentives to invest funds in a prudent manner.

That markets may not work, or may not work efficiently, implies that a market economy needs a legal and institutional framework, as well as other forms of public action. In practice, there is a multitude of markets of different reach, complexity, vulnerability, and quality. The grocery trade, for example, is local and much less vulnerable to sudden disruptions than national or international financial markets. Any regulatory framework and public intervention must be able to recognize this multiplicity and diversity and be tailored to the specificities of sectors, goods and services. In general, public policies should always keep two objectives in mind. First, they should account for the risks associated with deficiencies and failures. Second, they should allow as much as possible for spontaneous actions by individuals creating, maintaining and organizing their businesses. This means that the regulatory framework must be aware that an economy has a policy and a market, and that the two must work in a harmonious relationship.

The legal and institutional framework is an essential part of market building. In analytical terms, the institutional framework is a means to lower transaction costs and facilitate exchange by providing participants the assurance that a strong third party will enforce the contracts. When such a framework is lacking or inadequate, not only is efficiency much lower, as the experience of informal sectors in many countries suggests, but greed and ambition often degenerate into disorder, mistrust and deception. It is undeniable that, in order to function effectively, market economies need the Rule of Law and a strong set of public arrangements.

Under normal circumstances – that is, when the economy is functioning on an orderly course – the policies and the market move together in a balanced way. The peculiarity inherent to any economic transition, not only in Russia, but in the EU as well, is that in order to reach an orderly course a difficult regime change is required.
There is no universally acceptable and proven blueprint for such a change, since the development of norms and regulations is only effective if it reflects the peculiarities of the economic and social structure of the respective countries. This is why the creation of a single market in Europe has been such an enormous task. Almost all of the national legislation regarding economic matters had to be re-written. This was only possible by limiting the sovereignty of member states with regard to the management of the economy. Indeed, the creation of the European single market required a move from unanimous to majority decision-making, introduced by the so-called Single European Act of 1986.

Although the development of new laws is a challenge in itself, even more difficult is the development of the proper institutions responsible for enforcing and implementing these laws, monitoring their compliance and sanctioning infringements.

In order for institutions operating in a market economy to function effectively, credibility is a key prerequisite. This also applies to local administrations which register and license new businesses.

Building and maintaining the credibility of a public institution is a difficult undertaking and contains several dimensions. One is the legal framework itself, which must provide the institution with the necessary and appropriate means to achieve the goals it has been created to achieve. Other dimensions relate to transparency and accountability, communication, functions and structures. Ultimately, credibility is time-dependent, as it is the track record itself which speaks for a given institution and determines its rating among the economic agents and society at large. Bureaucratic red tape, lack of transparency and corruption are the main reasons why institutions occasionally hamper the very process they were created to foster.

GLOBAL MARKET BUILDING

Not surprisingly, at the global level is where the establishment of a harmonious relation between the market and economic policy is most arduous. At the same time, an agreed set of standards and regulations is more needed globally than domestically, since information among the international economic agents is likely to be more incomplete than in a domestic setting. Different habits, business cultures, languages, legal and institutional frameworks pose additional hurdles to the exchange of goods and services. Even after all formal obstacles are abolished (for example, customs duties), it is still possible to observe a “home bias” since information asymmetries tend to grow with geographic distance.

Over the years, the global exchange of goods and services has been growing very rapidly in spite of persistently inadequate economic policies. In terms of world GDP, international trade rose from about 30 percent in 1990 to more than 42 percent in 2003. Similar trends are observed with regard to international capital markets, foreign direct investment, and migration.

The legal and institutional framework for international transactions has evolved over the years in a positive manner although it is still far less developed than in any domestic system. In the field of trade, the World Trade Organization provides legal ground-rules for international commerce. In the field of finance, cooperation is on a more informal basis, with sectoral committees, such as the Basel Committee for Banking Supervision (BCBS), or the Committee on Payments and Settlement Systems (CPSS), setting standards which are adopted worldwide and monitored by the International Monetary Fund. The OECD sets principles on corporate governance. Accounting principles are set by the International Accounting Standards Board.  The Financial Stability Forum oversees and coordinates activities related to financial stability. Independent of their form and status, the standards, rules and regulations adopted through these forums have an impact on a country’s international profile since de facto compliance are key elements for having full access to the global economy. This is why Russia would benefit from becoming fully compliant with these international standards.

Market building takes more time and produces softer results across countries than within countries. It is most difficult on a global scale, which is comprised of over 180 sovereign countries. Regional integration and cooperation (inside the Commonwealth of Independent States, for example, or the European Union) lie between the domestic and global activities. Such cooperation often helps increase the efficiency of the market economy in the fields of trade, finance and investment, to an extent that the global economy will perhaps reach only in a distant future. Indeed, interdependence advances faster regionally than globally. For example, the most productive model for trade integration is built on two variables: the economic size of the trading partners and the distance between them.

Similar observations can be made for the internationalization of production and finance. Moreover, geographical proximity often goes hand in hand not only with close mutual interests, but also with a shared political and cultural heritage. This is reflected in more comparable institutions and norms which facilitate the regulatory convergence and the establishment of common institutions. Thus, cooperative arrangements between neighboring countries, which are not only consistent with, but even conducive to integration into the global economy, are likely to have a bigger impact on the region’s output and welfare than similar arrangements with geographically distant countries.

EU–RUSSIA RELATIONS

Russia has for many years been the EU’s fifth largest trading partner, accounting for roughly 5 percent of its overall trade. This trading relationship, however, is more important for Russia, since more than 50 percent of its overall trade is with the enlarged EU. Reflecting the comparative advantages, about 70 percent of total Russian exports to the EU are energy-related, while approximately 50 percent of Russia’s total energy exports go to the EU. As one would expect, EU exports to Russia are more diversified, with machinery topping the list and accounting for little more than 20 percent of the EU’s exports to Russia, followed by electronic equipment with 12 percent. Any other product category is in the single digit level.

Financial links are also well established, as the EU accounts for the largest share of the accumulated foreign investment in Russia. Loans, the major source of foreign capital flows to the Russian Federation, are predominantly granted by European banks which hold – among BIS reporting banks – almost 90 percent of the Federation’s outstanding bank debt. By contrast, foreign direct investment by EU companies is still low, although it has been on the rise, mainly in the retail, banking and automobile industries. This indicates that European companies increasingly perceive Russia as a large market for EU goods and services, which has become more attractive in the last five years due to its consistent  growth.

Europe and Russia are two economic spaces which are bound by history and geography. Furthermore, many links exist in education and culture. Today, EU-Russia relations are based on the Partnership and Cooperation Agreement which – among other things – sets the goal of strengthening commercial and economic ties with a view toward establishing a EU-Russia free trade area. Both sides agree that stronger links should be established between the EU and Russia than those embodied in internationally agreed standards and forms of cooperation. More than ten years have passed since the PCA was signed, and I regret that there has been less progress than was originally anticipated.

For progress to be achieved, vision, steadiness, and realism are all required in equal proportion. Vision is necessary to provide direction and ensure that relations between the partners are not derailed by occasional “micro-conflicts,” as President Putin has recently called them. The goal of establishing a Common European Economic Space between Russia and the EU encompassing almost 600 million people represents such a vision. Moving together toward this goal requires the convergence in legal issues.

Steadiness is needed to take concrete steps wherever it is possible. The EU-Russian agreement on the Russian Federation’s accession to the World Trade Organization has been one such step, and is important because WTO membership will foster Russia’s transparency, predictability, and tariff reductions.
Finally, realism is required to accept compromises in areas where – at the current stage – interests are too diverse for an agreement to be possible. Again, WTO negotiations between the EU and Russia provide a useful example. Initially, the issues of reform and pricing in the energy sector were a major hurdle, but eventually an agreement was found and Russian energy prices to industrial users are to be doubled between now and 2010.

MONETARY ASPECTS

Money is perhaps the very essence of any exchange economy; to provide a stable currency is the key contribution of any central bank. Tidy government finances, moderate wage allowances, and a sound financial sector are of crucial importance. This is why so much emphasis was put on stabilization policies when the centrally planned economies started the process of market building. Privatization, price liberalization and improved governance have been critically important, but their beneficiary effects could only be felt in an environment of monetary stability. Western Europe faced similar challenges: price stability and the independence of the European Central Bank were the focus of an intensive debate concerning the design of the Monetary Union.

Progress in monetary stability has been remarkable in both Russia and the EU for the last fifteen years. In Russia, inflation has dropped from about 100 percent to almost single-digit levels; the exchange rate has been largely stable. Furthermore, interest rates have declined to their lowest levels since the beginning of the transition, while the government budget has been running surpluses. In the European Union, monetary tensions, high inflation in some countries, exchange rate crises and macroeconomic imbalances have been removed in the run up to  the euro and have not resurfaced since. The euro area is an area of stable prices and low levels of long-term interest rates.

Exchange rate stability has a positive impact on trade relations between currency areas, suggesting that sharp fluctuations should be avoided. On the other hand, a stringent exchange rate commitment may run counter to domestic objectives and a fix may conflict with the needs of economic adjustment. In a world that operates by the high mobility of capital, both a commitment and a fix are hard to sustain anyway. Indeed, this was the reason behind the collapse of fixed exchange rates in 1973 that led to the introduction of floating major currencies.

The euro is one such floating currency; this is rather obvious since the euro area is a rather closed economy. Moreover, euro area trade is geographically diversified, with the United States, Europe’s first trading partner, accounting for less than 15 percent. Foreign debt of residents in the euro area is mainly euro-denominated, while these individuals hold virtually no foreign currency in the euro area banks.

The case with Russia is different. Indeed, for most of the post-Soviet period Russia has anchored its currency to the U.S. dollar, and there are several reasons for this. The most important is that natural resources – traded in the global arena, where prices are quoted, and payments invoiced, in U.S. dollars – are Russia’s main export item. Russia’s financial links with the global economy are primarily based on the U.S. dollar, while most of Russia’s international debt is denominated in U.S. dollars. Finally, foreign banknotes and foreign exchange deposits are mainly held in U.S. dollars.

Thus, while the geographical structure of Russian foreign trade has a European (i.e. euro) bias, the anchor currency remains the U.S. dollar. It follows that the competitiveness of the Russian economy is, to a certain extent, influenced by fluctuations in the euro-dollar exchange rate. Assuming that linkages between the EU and Russia will strengthen in the near and medium term, this currency mismatch may further increase.

To account for this, the Bank of Russia has adjusted its exchange rate policies over the last two years. It is now placing more emphasis on the ruble’s real exchange rate, which also reflects changes in the euro-dollar exchange rate. Moreover, there has been a gradual increase of euro-denominated assets in Russia’s foreign exchange reserves.

There have been repeated calls for the further diversification of  invoicing and settlement currencies in EU-Russian trade in favor of the euro. This primarily involves the energy trade. Against this background, it is no surprise that the possibility of invoicing energy exports from Russia to Europe in euros has been the main issue in the debate on monetary and financial aspects of EU-Russian relations. In any case, the choice of invoicing and settlement currency is an issue dealt with in private contracts. Authorities should not interfere in this.

Invoicing energy in euros would raise challenging questions. The functioning of standardized global markets, such as the energy market, is closely related to the choice of currency. Economic analysis suggests that network externalities lead to the use of only one currency. A partial switch could make markets less transparent, less fluid and less efficient. On the other hand, considering that more than 50 percent of Russia’s total trade is with the EU, Russia may find it increasingly less beneficial to make its competitiveness dependent on fluctuations in the euro-dollar exchange rate. This is all the more relevant given the dominant role of natural resources in Russia’s export structure and the authorities’ aims to diversify export and production structures.

 In late May of this year, the central banks of Europe and Russia met for their first High-Level Joint Seminar  in Helsinki. Monetary and exchange rate policies, trade and financial links between the two economies and developments in their domestic banking sectors were given much attention. Together with the TACIS project in the field of banking supervision, this dialog reflects the conviction that cooperation between our institutions is necessary in order to meet the monetary challenges of the emerging regional and global markets.

At the same time, one has to keep in mind that monetary aspects represent only one dimension of market building. Progress is needed in the design of many different segments of the economy, from energy to finance, from labor to international trade. Only by implementing reforms and building appropriate structures, can we alleviate concern about the inertia of reform, insufficient diversification or lack of dynamism.

Market building is a difficult process and requires time. However, given its great potential in raising living standards and creating wealth for our citizens, the EU and Russia have much to gain if they take the right course. This applies to our efforts domestically, as well as on a regional and international level.