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The onset of the 2008-2009 crisis followed a similar pattern (see Fig. 7). The factors contributing to the collapse of the Russian stock market were identical to those present in and included a drop in metal prices starting from May 2007 and in oil prices starting from July 2008, the withdrawal of foreign capital and growing risks against the background of an expected ruble devaluation. As a result, the stock market fell starting from June 2008, experiencing a real collapse in August of that year. However, on this occasion the crisis was countered by active crisis management government policies in the financial sector that were made possible by the foreign exchange reserves that had reached nearly 600 billion dollars.

Source: RTS and IMF data.

Fig. 7. Dynamics of the RTS index, Brent oil prices, and the ruble-US Dollar exchange rate (January 2007 = 100%) Given the decreasing raw material export revenues and the flight of short-term capital, a ruble devaluation was inevitable. However, as distinct from the events of ten years previously, the government did not delay tackling the issue until the last possible moment, initiating a devaluation starting from September 2008. Most importantly, the chosen method was of gradual rather than abrupt devaluation. This had several positive consequences in the financial sector. Banks and heavily indebted industrial companies received an opportunity to gradually restructure their foreign currency-denominated assets and borrowings from foreign creditors without resorting to a default on such borrowings. The general public was able to convert part of its ruble savings into foreign currency assets, avoiding the shock inherent in the sudden loss of savings in the national currency. However, a downside of the gradual devaluation was evident in the significant loss of foreign exchange reserves and their redistribu RUSSIAN ECONOMY IN trends and outlooks tion in the hands of a limited number of banking and industrial interests. Along with the gradual devaluation, the government made available significant debt financing to banks and to a number of key industrial enterprises, enabling them not only to avoid insolvency but also to prevent the transfer of significant equity stakes into the hands of foreign collateralised creditors. Thus the stock market collapse in 2008-early 2009 did not result in a systemic financial crisis. It should also be noted that unlike the first financial crisis where the drop in oil prices had continued for nearly two years, the 2008-2009 crisis, notwithstanding its global reach, saw oil prices dropping only slightly more than half a year, which is another reason why the duration of the current financial crisis is less than that of the 1997-1998 crisis.

Differences in the extent of the ruble devaluation during the two crises in question have resulted in the different recovery trends for the RTS and MICEX indices. MICEX stock portfolios are valued in rubles while RTS stock portfolios are valued in US Dollars, and as a result of this distinction, the MICEX index recovered faster than the RTS index notwithstanding the five-fold devaluation of the ruble1 (see Fig. 8). The MICEX index had recovered to its precrisis peak by May 1999, a mere eight months after hitting bottom during the crisis, whereas the RTS index recovery took 59 months from the crisis low point.

Source: RTS, MICEX Stock Exchange, the Bank of Russia.

Fig. 8. Trends in the US Dollar exchange rate, RTS index, and MICEX index during the 1997-1998 crisis (July 1997 = 100%) The maximum extent of ruble devaluation during the 2008-2009 crisis equalled 50% (see Fig. 9) and was followed by the strengthening of the national currency. For this reason, the RTS and MICEX indices recovered at similar rates in the past months, with the MICEX index holding only a slight advantage in terms of recovery speed. By the end of 2009, the RTS in From 1998 to Section Monetary and Budgetary Spheres dex had reached 58.7% of its pre-crisis peak registered in May 2008, while the MICEX index had reached 71.2% of its pre-crisis peak.

Source: RTS, MICEX Stock Exchange, the Bank of Russia.

Fig. 9. Trends in the US Dollar exchange rate, RTS index, and MICEX index during the crisis from May 2008 to December 2009 (May 2008 = 100%) 2.4.3. Government crisis mitigation support measures in the financial markets Support to the financial system was the core element of the government crisis mitigation policies in 2008-2009. It is difficult to estimate the total amount of funding received by financial institutions due to the numerous instruments of support. Several of these instruments were based on lending principles or were offered indirectly. There is insufficient information transparency regarding the implementation of funding decisions for financial sector support.

Due to these factors, the estimates of the total cost of crisis mitigation measures in the financial sector vary. On September 17, 2009, Reuters that quoted the Russian President Expert Department in stating that the total amount of financial support to companies, banks and individuals, considering the repayment of unsecured loans and the remittance of Ministry of Finance deposits, stood at RUR 7.4 trillion, or 240 billion dollars. The World Bank estimates the total amount of crisis mitigation measures financed from the state budget and aimed at supporting the Russian financial sector in 2008-2009 at RUR 1.4 trillion1.

World Bank report on the Russian economy No. 18, March 20089, page 15. Published at www.worldbank.org.ru RUSSIAN ECONOMY IN trends and outlooks Government equity injections in bank capital From the beginning of the crisis, the state demonstrated its readiness to take the most decisive measures to support the banking sector, including direct equity injections in the statutory capital of financial institutions, granting subordinated loans, as well as long-term targeted deposits. The principal instruments of such support are shown in Table 2 and amount to a total of RUR 2.8 trillion.

Table Key measures for strengthening the capital of financial institutions in 2008Measure Amount, RUR billion Equity injection into Vnesheconombank to support the financial system Subordinated loan to Vnesheconombank to support the stock market Long-term deposit for the purposes of foreign debt repayment by Russian companies and banks Funds granted to the Housing Mortgage Lending Agency to support mortgage financing Funds granted to the Deposit Insurance Agency for bank restructuring Long term subordinated loans to banks for improving their capital adequacy Equity injection into Rosselhozbank Total Other measures created the conditions for strengthening bank revenue bases by mobilising loan funds from the Bank of Russia, the state budget, government corporations, and private deposits. Related measures included the gradual devaluation of the ruble that enabled banks to redress the imbalance between their foreign currency denominated assets and liabilities. The decisions to lower mandatory reserve levels and the introduction of guarantees for private deposits in an amount up to RUR 700,000 at a given bank significantly contributed to improving bank stability.

Devaluation of the ruble and the currency gap in bank assets and liabilities Foreign exchange reserves amounting to nearly RUR 600 billion at the beginning of the crisis enabled the government to prevent the spread of the crisis in the financial sector and in the lending market. Prior to the 2008-2009 crisis, similarly to the previous Russian crisis, the speculative carry trading strategies, when banks actively borrowed foreign currency funds in sophisticated international markets at low interest rates and then invested these funds in high yield ruble assets, were the main driver of bank growth. Prior to the 1998 crisis such assets were represented by short-term government bills (GKO), while prior to August 2008 they consisted of consumer loans, ruble-denominated corporate bonds, and loans to large corporates1.

Martin Gilman, who worked as an IMF liaison with Russian authorities in the late 1990s, describes the business strategies of Russian banks on the eve of the 1998 crisis as follows:

they sought to take advantage of the exchange rate stability and make money using a seemarry trading strategies, their rationale and the related risks in the Russian financial markets were analysed in our earlier publications.// The Russian economy in 2008: trends and prospects, Issue No. 30, oscow, IEPP, 2009, pages 524534; The crisis economy in modern-day Russia: trends and prospects/ .bramov, .pevalova, .stafieva et al; edited by .. Gaidar, oscow, Prospekt, 2010, pages 524534.

Section Monetary and Budgetary Spheres ingly failsafe mechanism: taking cheap dollar borrowings, buying high yield government bills, buying dollars again with the ruble proceeds when the bills matured, and pocketing the difference. For more cautious non-resident investors who wanted extra insurance for their ruble-denominated investments in GKO bills, they entered into forward contracts to purchase dollars.Carry trading strategies are high-risk in nature: in case of devaluation of the national currency, the ruble-denominated assets of speculative traders immediately lose value while their foreign currency-denominated borrowings from non-residents become unserviceable. The bank is caught in the liquidity gap or becomes insolvent. According to IMF experts, the high involvement of emerging market banks in carry trading to fund the growth of consumer loans is one of the principal financial markets risks in these countries2.

Watching the rapidly growing gaps in recent years between bank foreign currency denominated assets and their liabilities to non-residents prior to a financial crisis (see Fig. 10), one might wonder at the obvious disregard by the Central Bank of Russia of such core banking sector risks.

Source: Calculations based on Bank of Russia data.

Fig. 10. The positive (+) and negative () currency gap in bank assets and liabilities (percentage share relative to bank assets(liabilities)) The extent of bank involvement in carry trading strategies is clearly shown by the negative and positive currency gaps, i.e. the value of their foreign currency denominated assets compared to the value of non-resident claims on such banks as a percentage of total bank assets.

In 1997, prior to the 1998 banking crisis, borrowings from non-residents exceeded banking assets by 5% of the total asset value of the banking system. The threefold devaluation of the ruble resulted in widespread bank insolvency. The balance was restored by bankrupting the top private Russian banks and by freezing (i.e. defaulting on) bank borrowings from non . , / . . .. .: , 2009. . 223.

IMF. Global Financial Stability Report. Financial Market Turbulence: Causes, Consequences, and Policies.

September 2007. P. 2225.

RUSSIAN ECONOMY IN trends and outlooks residents that the government was compelled to legalise by issuing a moratorium upon the repayment of bank obligations to non-residents. As a result, the balance between foreign currency denominated bank assets and liabilities was restored, and in 1998 the cumulative foreign currency gap in the banking system amounted to only 1% of total banking sector assets.

However the international reputation of the national banking system was damaged for many years to come.

Prior to the 2008-2009 crisis, as of August 1, 2008, the currency gap between bank assets and liabilities amounted to 10.7% of the total banking sector assets, twice exceeding the level that preceded the August 1998 crisis. The period from early 2004 up through July 2008 saw the peak of carry trading strategies at Russian banks. The devaluation of the ruble starting from late 2008 that resulted to in a 50% drop in the value of the national currency (see Fig. 9), would have undoubtedly led to a repeat scenario of the 1998 banking system collapse if not for state support to banks. The provision of lending by the Bank of Russia and government regulators, as well as the gradual ruble devaluation policy, gave the banks the time and resources necessary to redress the balance between their foreign currency denominated assets and liabilities.

To minimize the time needed to close this currency gap, the Bank of Russia adjusted the mandatory reserve requirements for bank borrowings from non-resident banks and for other foreign currency denominated liabilities from pre crisis levels of 5.5% and 5.0% respectively of the total value of liabilities to 8.5% and 6.0% respectively for the period from September to September 17, 20081. Banks were compelled to partially repay foreign debts and convert ruble denominated assets into foreign currency. As a result, by the end of 2008, the currency cap that had previously amounted to RUR 2.4 trillion was largely closed, and as of January 1, 2010, the currency gap between bank assets and non-resident claims amounted to 3.1% of the total banking system assets. Our estimates put the effect of this measure on the Russian banking system at RUR 3.3 trillion (see Table 3).

All this was only made possible by the unprecedented government financial support to banks and key real sector companies. The scale of government support is evidenced by the decrease of Russias foreign exchange reserves from August 2008 to February 2009, as shown in Fig. 1.

However, starting from the second half of September 2008, these ratios began to decline to amount to only 2.5% each at the end of 2009.

Section Monetary and Budgetary Spheres Source: Bank of Russia and the Russian Ministry of Finance.

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