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
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
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
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
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
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
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
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.
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
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
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.
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
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.