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Section 1

The Crisis of the Russian Financial System:Key Factors, Economic
Policies and Initial Results

The year 1998was marked in Russia by adramatic aggravation of a crisis that hit its economy, politics and socialsphere. It had been brewing over a long period and assumed an explicit andunambiguous dimension in August. The underlying causes of the crisis were stillthere after August, although their economic and political forms were nowslightly modified. Finally, the August crisis remains a key factor for Russianeconomic and political development in the current year, 1999.

1.1. Evolution of the Russian financialcrisis in 1997-19981

The crisis evolved in four major phases:November to December 1997; January 1998; February to April 1998; May to August1998. Throughout the period under review risks associated with doing businessin Russia were assessed as growing steadily worse. We are referring to risksrelated to currency convertibility, changes in the credit ratings of thecountry and its domestic counterparties, loss of prestige, changes in the taxsystem that were not investor-friendly, and a negative transformation of thelegal environment. Moreover, actual developments followed the worst possiblepattern.

A benign situation on the Russian financialmarkets in September 1997 (with weighted average yields on the GKO-OFZ marketdown to 20 per cent per annum and the RTS-1index at about 500points) made itpossible for Boris Yeltsin to declare that from 1999onwards Russia would nolonger need any financial programs from the IMF. (His statement was also meantto prepare the ground for redenomination of the ruble.) At the same timeAnatoly Chubais’sacknowledgment as the world’s best minister of finance in 1997 boosted the prestige of theRussian government and sent a clear message to Western investors that itsmarket reform policy was sustainable in the context of overall stability inRussia.

Hence, even in the early autumn of 1997 theRussian economy followed a generally positive market pattern. However,financial stabilization and an explosion of Russian financial markets developedagainst a backdrop of fundamental economic challenges: a fiscal crisis, adramatic worsening of the balance of payments and an increasingly unstablebanking system. There was a serious concern over the ratio of short-termgovernment debt to nonresidents and the external reserves of the Central Bank.In the wake of a political scandal over a July 1997tender for a block ofshares in Joint Stock Company Svyazinvest the investors had to downgrade theirassessment of Russian political stability and the potential of the youngreformers’team.

On 27October 1997, the Dow Jones IndustrialAverage index fell by a record 554points, which signaled the beginning of afinancial crisis in Russia. It eventually destroyed all themacroeconomic results achieved by 1997 and entailed a change in the course ofeconomic transformation. Obviously, the acute global financial crisis which hitthe developed markets and sent prices downwards on a number of emergingmarkets, was just one factor triggering off a series of destructive processesin Russia.

As early as the first week of the crisisweighted average yields on the government debt market rose from 22 per cent to28 per cent per annum. There was a dramatic increase in auction sales, with amore than twofold weekly growth of the secondary market, and a concurrent heavydrop in Russian Eurobond quotations.

The RF Central Bank had to choose between abad and a very bad option. Its first option was to protect the ruble against abig devaluation by increasing interest rates on the government debt market. Itssecond option was to keep interest rates at a relatively low level through openmarket transactions. Regrettably, in November 1997 the Central Bank chose thelatter option and increased its GKO holding.

It was not until 11November 1997 that theCentral Bank increased its refinancing rate - from 21 per cent to 28 per cent– which was clearlynot enough to maintain an equilibrium on the government debt market. Itsinterventions on the GKO market helped the Bank of Russia to prevent ratesrising above 30 per cent until the last week in November. Nevertheless, asnonresidents who had sold their government bond holdings developed a bigappetite for foreign exchange, the Central Bank's gold and forex reservesdeclined at a fast pace, which jeopardized the stability of its exchange ratepolicy. During November its external reserves plummeted from $22.9billion to$16.8billion. The November loss of reserves resulted in a sharp increase inthe ratio of short-term debt to international reserves - from 1.9to2.7.

The policy just described appears to be amistake largely responsible for the further development of the crisis. Insteadof supporting low interest rates on the GKO-OFZ market, the Bank of Russiashould have allowed them to grow until a market equilibrium was reached.Moreover, it should not have permitted a complete liberalization of thedomestic debt market for nonresidents as of 1January 1998; more specifically,it should not have cancelled a guaranteed level of bond yields and a restrictedtimeframe for profit repatriation. Had there been a timely and significant risein the refinancing rate and an appropriate growth of interest rates ongovernment securities, attacks on the Russian ruble might have been far lessaggressive.

The policy of higher interest rates couldhave been complemented with higher rates of ruble depreciation. Even thoughthis would have signaled to the investors that there was a higher risk ofdevaluation, it could have helped stabilize the currency market given anadequate level of external reserves and a predictable behavior of the exchangerate. Such policies could have been implemented by establishing a more narrowcurrency band with a higher slope. However, the Central Bank failed to takeadvantage of a possible acceleration in ruble depreciation as it announced, on10November 1997,its exchange rate policy targets for 1998-2000, providing fora wider currency band. The announcement sent a negative signal to the markets,showing that the RF Central Bank was committed to maintaining a low rate ofruble depreciation via foreign currency interventions, which was bound toincrease exchange rate risks.

Apparently, the alternative measures justdescribed (higher interest rates coupled with higher rates of rubledepreciation) would have had a controversial impact on the financial situation.Some of the investors would have thought that high interest rates would beenough to offset higher risks. The more conservative investors would havecontinued to export their capital out of Russia. Nevertheless, the most likelyresult of this policy would have been the emergence of a new equilibrium on theRussian financial markets against the background of a moderate decline inexternal reserves.

While the Central Bank was pursuing aninappropriate policy the government did not have any meaningful program forreducing government expenditures and the size of the fiscal deficit. Anotherfactor responsible for a deteriorated financial situation was the governmentreshuffle at the end of November 1997. The reshuffle meant a final abandonmentof the program of the 'young reformers'' government. Investors no longerbelieved in the executive authorities’ ability to pursue a sound andconsistent financial policy.

In the last week of November 1997, theCentral Bank, which had lost over a quarter of its international reserves, gaveup its efforts to maintain low interest rates and quit the GKO-OFZ market.Weighted average yields on government debt soared to 40 per cent perannum.

The end of 1997 and the start of 1998 weremarked by a growing crisis in Southeast Asia. In this context major investmentfunds chose to redistrubute their investment quotas among various countries andequity markets saw yet another fall in stock prices while GKO and OFZ yieldsincreased.

In January 1998, quotations for Russiansecurities plummeted down to nearly 30 per cent. The overall decline of theRTS-1index between 6October 1997 and end-January 1998 was 50.9 per cent. Thefall in quotations for Russian corporate stock was tantamount to aself-supporting process. Having received clients’ orders for selling sizeableblocks of their shares, investment companies anticipated a heavy drop in thelevel of market support and were themselves eager to sell their liquid shares,thereby aggravating the market crisis.

An outflow of portfolio investments fromRussia stepped up pressure on the ruble so that at the beginning of the yearthe official exchange rate of the US dollar grew at a fast pace and forwardquotations increased. The Central Bank’s attempts in January to boost therates of ruble depreciation provoked a dramatic rise in GKO interest rates. Themarket extrapolated the faster growth of the exchange rate to a broader contextand responded by a hike in interest rates to offset a drop in foreigncurrency-denominated yields. The market reaction confirmed that it is generallyalmost impossible to attempt devaluation in the context of a confidence crisis,short government debt, a high share of nonresidents on the market and lowforeign exchange reserves.

The latter half of January was marked byrenewed political complications. A substantial reallocation of powers occurredwithin the government: Chubais's terms of reference were curtailed to economicssince the financial sphere became Victor Chernomyrdin’s domain. Boris Nemtsov lostcontrol over the fuel and energy complex. The weakening of thereformers’ positionsresulted in even lower investor expectations.

A period of relative stabilization set in onthe markets between February and April 1998. Such positive trends were largelydue to a series of steps taken by the President and the government, steps thatclarified the immediate prospects for economic policy. More specifically, thePresident advocated a tighter fiscal policy and called for achieving a primarysurplus of the federal budget already in 1998. Following a series ofreshuffles, the government formulated 12Key Social and Economic PolicyMeasures. The document made all members of the government and presidentialadministration officials personally responsible for implementing specificmeasures to promote a sound budget, normalize the wage arrears situation,etc.

Meanwhile, some other developments occurredwhich sent positive signals to the investors. Thus, in February the IMF decidedto extend a three-year credit to Russia for another year. Michel Camdessus gaveit to understand that Russia would get another $700million tranche of thecredit and that, subject to compliance with all the arrangements, it would bereceiving loans until 2000. On February 24, Russia and the UK reached acomplete agreement on the terms of Russian debt restructuring within theframework of the Paris Club.

On 10March 1998, Fitch IBCA rating agency,in spite of all the ups and downs of the Russian financial markets, confirmedRussia’s long-termcredit rating for foreign currency-denominated borrowings at BB+ and left itsshort-term rating at the same level. On the following day, however, Moody'srating agency downgraded Russia’s credit rating for foreign currency-denominated external debt fromBa2to Ba3 and for foreign currency-denominated bank deposits, toB1.

On 23March 1998, the Russian Cabinet ofMinisters resigned on the President's order, with Sergei Kiriyenko appointed asacting Prime Minister. The financial markets’ short-term reaction to thegovernment reshuffle was quite positive. Later on, however, economic agentslost their bearings in the political uncertainty that followed, due to afive-week lag before Kiriyenko’s final confirmation as Chairman of the Government.

The newly formed government focussed onbudget recovery as the thrust of its economic policy. An analysis of the fiscalpolicy pursued by the Kiriyenko government in the spring and early summer of1998 shows that it succeeded in preventing a further aggravation of thecrisis.

The tax collection record for the firstquarter of 1998 proved to be slightly better than in 1997. At the same timethe execution of the expenditure side of both the federal and the consolidatedbudgets in the early half of 1998 was radically different from the previousyear. Practically all items in both budgets other than government debt serviceand government administration expenditures were slashed. The federalbudget’s defensespending in the first half of 1998 was cut down by approximately 1-1.5 percent of GDP as against the previous year’s level.

A reconstructed budget of Russia’s enlarged government (includingextrabudgetary funds) in the first half of 1998shows that tax receipts fell inthe first half of 1998 as against 1997 (from 32.6 per cent of GDP to 30.7 percent). There was an even more significant change in total revenues - 36.5 percent of GDP as against 33.4 per cent of GDP. A greater decline in consolidatedbudget expenditure (from 43.2 per cent of GDP to 38.5 per cent of GDP) reducedthe deficit of the consolidated budget by 1.6 per cent of GDP.

The final phase of the Russian financialcrisis developed as follows: There was a buildup of political instability andhigher pressure on foreign exchange reserves in a setting of strainedgovernment finances, short domestic debt, a large share of internationalinvestors and an emerging banking crisis. Under such circumstances there is ahigh probability of problems getting even worse even though the government maybe pursuing a correct and consistent policy aimed at a sound budget, compliancewith investors’rights, etc. Objectively speaking, market reaction is asymmetrical: anyeconomic policy error or bad news entails serious adverse effects while theright steps fail to elicit a positive response from the markets.

In mid-May (right after theCabinet’sconfirmation) there was a sharp drop in quotations for government securities.Secondary market trade increased, the RTS-1 stock index fell by 40 per cent andthe ruble exchange rate came under heavier pressure. During May the foreignexchange reserves went down by $1.4billion (nearly 10 per cent).

The State Duma passed a law (eventuallysigned by the President) on special management of federal government-ownedshares in RAO Unified Energy Systems of Russia and other joint stock utilities.The law breached owners’ rights by restricting quotas for international investors (to nomore than 25 per cent of total stock).

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