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In May Sergei Dubinin addressed a meeting ofthe government with a warning about an impending crisis in the financial systemand a catastrophic buildup in government debt. His statement produced a shockmade worse by a lack of transparent statistics with regard to monetary andcurrency policies.

An early warning sign of an imminent bankingcrisis was the introduction of external management at bank, which hadreceived substantial loans from Western banks.

The cancellation of a sale of Rosneft asannounced onMay 26 (due to a fall in its market stock value) deprived thebudget of $2.1billion, which sent a negative signal to theinvestors.

The government’s response to a growing crisis inthe Russian financial markets was too slow, which made the crisis even worse.It was not until the end of May that the newly formed Kiriyenko governmentbegan to develop anti-crisis measures. A series of statements was issuedbetween May 17 and 19: by the government (on its commitment to a policy aimedat macroeconomic stability), the Central Bank (on the immutability of itscurrency policy and inadmissibility of monetary financing of the budget), theMinistry of Finance (on an austerity plan for budget expenditure), and theFederal Securities Commission (on securing investors’ rights).

OnMay 29, the government issued a statementon immediate measures to stabilize the financial market and on fiscal policy in1998. A few days after his Cabinet appointment Boris Fyodorov outlined majorways of improving tax collection in Russia. Financial markets began to showsome degree of optimism after Chubais paid a visit to Washington, D.C. betweenMay 29 and 30, to discuss the problem of a large financial aid package forRussia. In the first week of June yields on government debt dropped to 51 percent and in the second week, to 46 per cent.

Nevertheless, investor confidence was waningin the absence of consistent anti-crisis actions by the government. The Junesituation was made worse by the slow pace of the Russian government’s talks with the IMF on thedisbursement of a large aid package.

A massive flight of investors' funds fromfinancial markets led to yet another increase in the GKO interest rate to 50per cent in the latter half of June. The stock index went down by 20 per centduring the month of June. All this put much more pressure on the ruble exchangerate and forced the Central Bank to carry out large-scale interventions on thecurrency market.

In spite of an unfavorable situation, onJune10, Russia floated five-year bonds for the amount of $1.25billion at the rateof 11.75 per cent. OnJune 24, a new $2.5billion loan was floated at as highas 12.75 per cent. The high cost of borrowing sent a negative signal to theinvestors and reduced quotations for other negotiable Eurobonds.

OnJune 17, Boris Yeltsin appointed AnatolyChubais a special presidential representative (with vice premier status) forliaison with international financial institutions – a positive move in the eyes ofthe players on the Russian financial markets. OnJune 23, the IMF Board ofDirectors approved the disbursement of another $670million tranche of itsRussian credit. Moreover, the IMF issued a statement in support of the Russiangovernment's measures to prop up its national currency and avoid a majordevaluation.

During June 1998, the government was busydeveloping anti-crisis program measures, notably a planned reduction in gasprices and electricity tariff rates, amendments to tax legislation (VAT to becharged at shipment, introduction of a flat income tax scale, a lower rate ofprofit tax, higher rates of excise taxes and duties, a limited number ofenterprises’settlement accounts, introduction of a sales tax, etc.), and sellinggovernment-owned stakes in major Russian corporations (in particular, five percent of the shares in RAO Gazprom and the government stake in Joint StockCompany Svyazinvest). Sergei Kiriyenko submitted a package of anti-crisis billsin installments for consideration by the State Duma early in July of1998.

At the time, weighted average yields on thegovernment securities market amounted to 126 per cent per annum. On 8July1998, the RF Ministry of Finance canceled auction bids for GKOs and OFZs.OnJuly 13, the Russian government announced its intention to offer the GKOholders an option of converting them into medium- or long-termdollar-denominated bonds, to be redeemed in 2005 and 2018, respectively. Thesituation turned for the better after an announcement on 13July 1998,that theIMF, the World Bank and the Japanese government would give Russia $22.6billionin financial aid, of which $5.6billion was to be disbursed right after ameeting of the IMF Board of Directors. Between July 13and 19, weighted averageyields on GKOs dropped to 53 per cent. The RTS-1index went up to 34 per centduring the same week. The next GKO auction scheduled forJuly 15 never tookplace, however, and government debt was serviced at the expense of the federalbudget. OnJuly 20, an announcement was made that one-year governmentsecurities would not be issued any longer.

The State Duma voted down many of the billsin the anti-crisis package proposed by the government in June-July 1998. Aspassage of those bills was part and parcel of the Russian commitment to the IMFand a condition for the provision of financial support, the size of the aidmight be expected to decrease. Nevertheless, as a result ofChubais’s talkswith the IMF top management the first tranche was cut down by areasonable amount - from $5.6billion to $4.8billion. OnJuly 21, the IMFpassed a resolution on disbursing a new aid package to Russia.

Notwithstanding the reduced size of the firsttranche, the financial markets’ response was positive. Yields on government debt went down to 45per cent. Further developments, therefore, largely depended on whether themarket would receive clear signals from the Russian leaders as to their furthermeasures to normalize the situation. The government did not take any steps,however, to show that it had a coherent plan of action.

The Russian government interpreted atemporary stabilization of the market after July 20 as a sustainable trend, andit was not until the following week that a meeting was arranged, onJuly 27,between the Prime Minister and a number of key investors to explain thegovernment’s plan ofaction with respect to government debt repayment and service in the nearfuture. The government failed to produce any convincing proof, however, thatRussia would be able to meet its commitments before the end of 1998 based onavailable data on tax revenue and increased international reserves.

In addition to the increasingly more obviouspolitical weakness of the government, which failed to push the package of billsagreed with the IMF through the State Duma, mention should be made of severaladditional factors which had by early August caused a downturn in the overallsituation and led to an uncontrollable chain of furtherdevelopments.

Firstly, we are referring to a slump on theinternational financial markets. Secondly, there was a seasonal drop in theproportion of risk assets in the portfolios of key institutionalinvestors – a commonoccurrence shortly before summer vacations. A serious aggravation of thebanking crisis was another major factor provoked by a worsened situation on thefinancial markets in the context of a tight monetary policy pursued in thefirst half of 1998. An acute liquidity crisis occurred in the banking systemlargely due to decreased quotations for Russian government securitiesdenominated in foreign currencies. As they served as collateral for loansgranted by foreign banks to their Russian counterparts, the latter wererequested to increase their margin calls. To meet these requirements banksbegan selling their portfolios of GKOs and OFZs and corporate shares with aview to converting the proceeds into foreign exchange. Such moves by the banksmade the financial markets even more nervous, including the market for Russianpaper denominated in foreign currencies. The first two banks to default ontheir debts to international lending institutions were SBS-Agro andImperial.

The above factors combined to produce aserious deterioration in the financial situation in the period between the IMFloan disbursement date and early August. Yields on government debt jumped to 56per cent and the stock market was falling at accelerated rates. The RTS-1Indexplunged by nearly 30 per cent between the disbursement of the IMF stabilizationloan andAugust 17. International reserves were plummeting at a fast rate: from$19.5billion as atJuly 23 to $18.4billion as atJuly 31 to $16.3billion asat August 7.

To sum up our analysis of developmentsleading up to the climax of the crisis, it is worth noting that, along with itsunderlying causes listed above, there were two other major factors responsiblefor Russia’s failureto avoid ruble devaluation in August, namely, a lack of support for thegovernment’santi-crisis program from the State Duma and insufficient aid from the IMF. Thesituation might have been reversed by the G-7 countries’ aid to the tune of $10 billion to$15billion. Under the prevailing political situation, however, it would havebeen unrealistic to expect such help. A devaluation of the ruble was the onlyfeasible option.

The government's plan as announced on August17provided for three sets of measures: introducing a floating exchange ratefor the ruble with its devaluation to roughly Rb9 per dollar by the end of theyear; introducing a three-month moratorium on repayment of Russianbanks’ external debt;a compulsory GKO-OFZ debt restructuring scheme.

On 15-16August, the government's plan wasagreed with the IMF. The program announced onAugust 17did not include adomestic government debt restructuring scheme and elicited a negative responsefrom the financial markets. The stock market plunged by a further 29 per centin just a week. A restructuring scheme was finally published by the governmentwith a one-week delay. The amount of frozen domestic sovereign debt totaledRb265.3billion ($42.2billion at the exchange rate as of 14August 1998). Whatremained in circulation were the OFZs totaling Rb75billion and maturing in2000-2001.

The Kiriyenko government’s program was never implemented asoriginally announced. OnAugust 23, the Kiriyenko Cabinet resigned and VictorChernomyrdin was appointed acting Prime Minister. This decision had someserious economic and political implications. Firstly, the resignation and thestatements about a change in economic policy virtually canceled outRussia’s arrangementswith the IMF in respect of both an enlarged lending facility program anda stabilization loan (with due regard to the IMF-backed measures as announcedonAugust 17). Secondly, the political crisis introduced much more uncertaintyto economic policy.

The above factors generated a new wave ofpanic on financial and commodities markets. OnAugust 26, the RF Central Bank,having spent considerable reserves to prop up the ruble at lowrates vis-à-vis the dollar, suspended trade at the Moscow Interbank Currency Exchange(MICEX) for an indefinite period in an effort to preserve its gold and forexreserves. Regional currency exchanges had to suspend their trade as ofAugust28. Further on, the Central Bank was no longer able to prevent the ruble fromfalling due to its depleted forex reserves ($12.46billion as atSeptember1).

September 1998 witnessed a furtheraggravation of an economic and financial crisis arising from the devaluation ofthe ruble and eroded confidence in the Russian national currency. A devaluationof the ruble by two-thirds and a skyrocketing velocity of money accounted for arapid rise in consumer prices. In August prices rose by 3.7 per cent and inSeptember, by 38.4 per cent.

Eventually, the rate of inflation slowed downconcurrently with a depreciation of the US dollar. This was largely due to themonetary policy pursued by the RF Central Bank. There was practically no changein base money in August despite the fact that the Bank of Russia then spent5.95billion US dollars out of its gold and foreign exchange reserves.Apparently, forex interventions were sterilized as a result of open marketoperations with government debt and the disbursement of stabilization loans tocommercial banks.

During September base money increased by 9.5per cent against the background of dramatically decreased rates of shrinkage ofexternal reserves. At the same time, the inflationary effects of currency issuewere largely offset by a decrease of the monetary multiplier due to thewithdrawal of household deposits from commercial banks.

In the absence of a market for domesticpublic borrowing the only indicator of interest rates on Russian debt was nowthe market for foreign-currency denominated domestic bonds (OVVZs) andEurobonds. Quotations for third-tranche OVVZs (maturing in 1998) plunged to 40per cent of their face value as compared to 90 per cent as of early Augustwhile the prices of the other OVVZ tranches plummeted down to 10 per cent oftheir face value. The Eurobonds were rated at 20 per cent to 30 per cent oftheir face value (as against 70 per cent to 85 per cent before thecrisis).

September 1998 saw marked fluctuations in thedollar exchange rate in the Electronic Lot Trading System (commonly known asSELT, to use the Russian acronym). As atAugust 31, for example, the exchangerate was Rb7.905 to the dollar whereas onSeptember 9, it was as high asRb20.825. The need to reduce exchange losses on forward contracts due inmid-September accounted for a subsequent drop in the dollar exchange rate toRb8.67for the dollar. After the rate was fixed at this level on 15September1998, it soared again to Rb16 per dollar. During September the US dollar ratewent up by 102.4 per cent.

Following the August drop in quotations,Russian stock prices declined at a slightly slower pace in September 1998. InAugust the RTS-1index dropped by 56.2 per cent whereas in September it wentdown by 33.2 per cent. Since the start of 1998 the RTS-1index had dropped by89 per cent and since the beginning of October 1997, by 92.3 percent.

Data on the interbank ruble loan market showsthat that overnight lending rates as of mid-September reached 450 per cent perannum and interest rates on three-day loans, 130 per cent p.a. High earningsfrom foreign exchange operations ensured repayment of such loans. The Septembervolume of transactions plunged to one-tenth of the August volume.

1.2.Principal Factors Behind the 1998Financial Crisis

1.2.1.Fiscal Deficit and GovernmentDebt

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