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Fig. 300 28 30 8 9 1998 1999 2000 2001 2002 2003 2004 2005 2006 2007 2008 , Private Sector debt and government financial reserves growth Private sector debt Gold and foreign currency reserves, including Stabilization Fund Fig. 6000 (1- 1996 . = 100%) 3000 0 2 Energy sources and monetary reserves growth in Russia (I Quarter of 1996 = 100% Monetary instrument M2 Foreign currency reserves Oil prices growth Gas prices growth Source: estimates as per IMF financial statistics.

Galati G., Heath A., McGuire P. Evidence of carry trade activity. BIS Quarterly Review, September 2007, pp.28-29.

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= 100%) , % 2, , 1996-QQQQQQQQQQQQQQQQQQQQQQQQQTo implement carry trading strategy, three preconditions are required: the downgrading of credit currency, low interest rates in the country where the credit is taken, and the availability of liquidity and relatively stable foreign exchange market and financial assets denominated in national currency.

There were exactly such preconditions in Russia in late 2003-s (see Fig. 2). During that period a moderate growth in the world prices for oil and gas was replaced by explicit growth by exponential trend.

The inflow of the U.S. oil dollars and gas Euro to Russia has inspired accelerated growth of gold and foreign currency reserves and monetary supply. Ruble has been on the road to long-term strengthening.

Fig. 3 shows how, starting from the end of 2003, ruble was strengthening against the U.S. dollar and Japanese yen. If the Japanese yen exchange rate to ruble at the end of the fourth quarter of 1999 is taken for 100 per cent, then by the fourth quarter of 2003 the Japanese yen has strengthened against Russian ruble by 8.9 per cent, whereas later, till the second quarter of 2008, it has downgraded by p.p., to 89,9 per cent. Since 2004, the USD exchange rate to RUR was volatile, but it has also declined by 12,5 p.p. At the same time, in Fig. 3 one can see that throughout the period under review, the cost of credit resources in RUR in the domestic market was substantially higher than the cost of borrowings in the American and Japanese markets. Therefore, by the end of 2003, there were rather favorable preconditions in Russia for implementation of carry trading strategy. It should be also mentioned, that at the same time, Russia has been granted investment credit rating by international rating agencies, thereby strengthening foreign investors confidence in investing to the country.

Fig. , 130 112,108,9 100,100 90 89,70 100 , Interest rates and dynamics exchange rates in USA, Japan, Russian national currencies Foreign currency exchange rates (4th Quarter of 1999 = 100%) Period of RUR strengthening against USD and JPY Source: estimates as per IMF financial data statistics.

All this has led to growing popularity of the strategy carry trading in the Russian stock market, which, in our view, has resulted in a rapid liquidity growth of the Russian financial market since the end of 2003 through the third quarter of 2007. This strategy has started to exhaust itself since the second half of 2007, as the crisis of confidence in global financial markets started to expand due to the problems of unsecured mortgage commitments. These problems have led to the development of confidence crisis. It became increasingly difficult to attract foreign credits, and even impossible from second half of 2008.

The main promoters of the strategy carry trading in the Russian financial market were commercial banks and foreign hedge funds. It is difficult to assess the proportion of funding sources involved through strategy, in the total value of ruble-denominated bonds and equities. For example, according (4.1999 . = 100%) , % (.) QQQQQQQQQQQQQQQQQQto the estimates of Greenwich Associates, the hedge funds share, in the volume of trades in bonds of issuers from countries with emerging economies in 2006 made 45 per cent53.

The effect of carry trading in different segments of the Russian financial market can be assessed by analyzing the changes that occur in the liquidity of the market since 2004, when Russia began to apply this strategy and since August 2007, when Russian companies and banks began to experience serious difficulties in attracting borrowed resources.

Fig. 4 shows the state of bank liquidity (banks' balances in correspondent accounts and deposits with the Bank of Russia), as well as the volume of placement of the ruble-denominated corporate bonds and the secondary stock market thereof. During the period 2001-2003 the market for corporate bonds and the amount of bank liquidity grew rather moderately in linear trend. Starting from through July 2007 balances of banks in the Central Bank started to grow more rapidly and their volume has significantly increased. Following the banking liquidity, the rapid growth of the rubledenominated bonds. Herewith, faster growth rates were noted in the secondary market of these financial instruments trades as compared with placement of those financial instruments. This happened due to the fact that corporate bonds traded through repo transactions, which are similar to credits against collateral securities became one of the major mechanisms of inter-bank crediting. The sharp decline in bank liquidity started in August 2007, but then it has led to a slowdown in growth only in primary market of corporate bonds. Their secondary market has become more volatile, however, it continued to increase, reflecting its growing popularity as a mechanism to supply liquidity to the interbank market. All those three stages in the evolution of the corporate bond market and bank liquidity coincide with the stages of the development of carry trading strategy. Rapid growth of liquidity and the bond market from 2004 to July 2007 coincided with the active use of carry trading strategies by the Russian banks and foreign hedge funds.

Fig. 1 800 000 1 2001-2008 .

1 600 000 1 1 400 000 1 1 200 000 1 1 000 000 1 800 000 600 000 400 000 200 000 - Transactions with corporate bonds and bank liquidity in 2001 Bonds transactions, RUR, mln Secondary placements Placements Bank liquidity Growing liquidity zone Moderate liquidity zone Bank liquidity, RUR bln Source: as per Bank of Russia and MICEX FB data Major results are published in The Wall Street Journal 30 2007 . . . OECD. Financial Markets Trends, Volume 2007/1, 92, .42.

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In Fig. 5 there presented the correlation of bank liquidity with the market rates of interest on interbank loans. The interest rates on interbank credits for a period from two to seven and eight to thirty days, published by the Bank of Russia were used as correlation indicators. During the period of moderate liquidity in 2001-2003 the interbank credit rates on the market were high and very volatile. They have reached 15-20 per cent per annum, ranging from 3 per cent to 25 per cent. The inflow of liquidity in the period from 2004 to the first half of 2007 has provoked a decline in interbank credit rates to 4-per cent per annum, as well as reduction of their volatility. The liquidity of the banking crisis during that period in May-June 2004 was rather high due to the crisis of confidence, provoked by reckless statements of the Bank of Russia about claims, made against a number of commercial banks. Since the second half of 2007, with the growth of global financial crisis and difficulty in obtaining cheap credits in foreign financial markets, the rates in the interbank credit market started to grow, as well as their volatility. Thus, the volume and volatility of market interbank credit rates, as well as bank liquidity were changing synchronously with the activity of carry trading strategy.

Fig. 1 400 25, 2001-2008 .

1 20, 1 15,10,5,0 0, 2 7 . 8 30 .

Average monthly indicators of bank liquidity and interbank credit market rates in 2001 - Liquidity indicators, RUR bln Moderate liquidity zone Growing liquidity zone Financial crisis expansion Source: Bank of Russia data.

Fig. 6 shows the correlation of interest rates in the interbank credit market with the mechanism of direct repo, used by the Bank of Russia. During the growing liquidity the Bank of Russia has been able to manage the excessive interest rate growth in the interbank credit market rather effectively, providing short-term loans to banks in the form of direct repo transactions with the government, corporate and regional bonds. Since the second half of 2007, the CB continued to use the mechanism of direct repo rather actively, though it was possible to restrain the excessive growth of interbank credit rates at the expense of far larger infusions of credit resources.

Therefore, one can see on the example of the market of corporate bonds, bank liquidity, interest rates, MICEX market, that the application of carry trading strategy by the banks and hedge funds has coincided in time with the rapid growth of the banks balances, the volume of placements and turnover in the secondary market of ruble-denominated bonds, reduction of the level and volatility of market rates in MICEX. By contrast, the growing difficulty in application carry trading strategy since the second half of 2007 was accompanied by the decline in bank liquidity, bond market, but the growing volatility of the interbank credit rates. Rapid growth of the stock market was also noted in , % , . .

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2004 - the first half of 2007, that is, in the period of active application of carry trading strategy.

Rapid growth of foreign debt of Russian companies and banks also took place in 2004-2007. All this suggests that the strategy of carry trading played a crucial role in accelerating the growth of the Russian stock market in 2000-s, and a subsequent downfall in the stock market, slowing economic growth and rising risk of defaults in the market of corporate and regional bonds are based on difficulties with this strategy implementation in the second half of 2007.

Fig. 21 2003-2008 .

16 11 6 1 -4 2 7 . Implementation of direct repo mechanism for bank liquidity management in 2003 % per annum Growing liquidity period Financial crisis expansion RUR bln Balances in the Central Bank accounts MICES credit interest rates for 2-7 days Direct repo Credit interest rates on direct repo transactions Source: Bank of Russia data.

What are the risks in carry trading strategy In the banking system, it leads to the accumulation of the imbalance between foreign currency assets and liabilities of banks, and in the substantial excess of foreign currency liabilities over available foreign currency assets. This is the major risk factor of liquidity crisis in banking system. According to IMF experts, involvement of the banks from developing countries in carry trading for funding the increasing volume of credits, provided to the population, is one of the main risks in financial markets of those countries54.

As shown in Fig. 7, in 1997, in anticipation of the August crisis, the amount of excessive foreign currency liabilities of the banks foreign currency assets amounted to 5 per cent of the total value of the banks assets. Ignoring the risks of liquidity loss and foreign currency risks, large banks attracted enormous loans from foreign lenders under futures contracts. After the RUR devaluation in August 1998, the majority of those banks were unable to repay the liabilities to foreign creditors, and then to the Russian creditors. The decision taken in August 1998 by the monetary authorities of Russia, temporary forbidding the banks to repay foreign debts, looks very disputable until now. This did not affect the course of the banking crisis, but has led to inefficient usage of those funds, aimed at the support of IMF. Global Financial Stability Report. Financial Market Turbulence: Causes, Consequences, and Policies.

September 2007, pp.22-25.

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