The first ten months of 1997 showed that Russia’s inflation had slowed during that period. In certain months prices even decreased. Annualized yields on government securities decreased from 34% to 17%. The ruble rate grew only by 5.88%, while the Central Bank’s foreign currency reserves grew by 62.5%.
However, success of the financial stabilization policy was achieved mainly due to a significant volume of foreign investments, both loans from international financial organizations and also funds placed on Russian capital markets. In total the inflow was over $30 bln. Financial stabilization achieved with the help of «external» funds was accompanied by a number of negative trends, including the following:
 

• Despite a decrease in interest rates, there was no increase in lending to the real sector and no increase in investment. On the contrary, in 1997 fixed investment decreased by 6%;
• The structure of the government securities market changed and became more heavily weighted by non-residents. Foreign investors’ share of the government securities market increased from 16% on January 1, 1997 to 31% on October 25, 1997. This increased the dependence of the GKO/OFZ market on external factors (conjuncture);
• Owing to a decrease in yields on investments in GKO and OFZ, many Russian commercial banks reduced their investments in GKO and OFZ and began to invest more in municipal bonds, corporate securities, promissory notes and other more risky and less liquid instruments. This increased the probability of a crisis in a number of banks or the entire banking system;
• The growth of the Central Bank’s foreign currency reserves with a relatively stable GKO/OFZ portfolio was accompanied by a significant ruble emission. Moreover, the share of the most liquid components of the money supply (cash in circulation and enterprises current accounts) did not decrease. On the contrary, they grew slightly, making the achieved financial stabilization more vulnerable;
• Reduction of the yields on GKO reached the minimum acceptable level for both Russian and foreign investors.

Source: EU VEDI, Central Bank of Russia

On the other hand, in October 1997 yields on investments in GKO and OFZ held to maturity were acceptable only to large domestic operators, who regarded investments in government securities as safe investments with a high level of liquidity.

The amount of funds available to the government debt market decreased simultaneously with a decrease in yields of government securities. Commercial banks had to cut interest rates on household and enterprise deposits which led to a decrease in the total sum of deposits and, consequently, lowered probability of banks maintaining state securities portfolios without change. The desire to remain on the list of primary dealers and to earn additional profits from the sale of government securities to foreign investors was an additional stimulus for banks to hold government securities in their portfolio. Nonetheless, the transfer of funds from the government securities market to other segments of the Russian financial market became a visible trend by the middle of 1997.

Thus, on the eve of financial crisis in the world financial markets the stability of Russia’s financial system was based on a stable inflow of funds from foreign investors who expected relatively low yields and risks and on an increase in the share of such capital on the financial markets. At the same time, the structure of the money supply and commercial banks’ investment portfolio showed an increase in the probability of higher rates of inflation and a liquidity crisis in the banking sector. The existing negative trends could be worsened by negative external factors. Indeed, the crisis on the international financial markets that occurred during the last months of 1997 proved to be such a catalyst.

While the equity market responded to this crisis only by a significant fall in prices, the situation unfolding on the foreign exchange and government securities markets threatened to undermine the whole Russian financial system. Stability could be achieved only after the international financial market conditions improve. In this context, the stability should be understand as the end of an intensive capital outflow from the Russian financial markets.

In any case, the main characteristics of various segments of the Russian markets such as yields and investor type, will be different from those initially expected. This in turn will define possible scenarios for the former development of the Russian financial system in 1998.

The evaluation of the effect of the world financial crisis on the Russian financial market and also the possibility of the realization of the various scenarios in 1998 can be made only after an analysis of the development of various segments of the Russian financial market in 1997 right up to the beginning of the international financial crisis.

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GKO/OFZ Market

Despite the fact that the first GKO auction was held in May 1993, foreign investors received official permission to participate in this segment of the financial markets only in February 1996. Initially, non-residents could invest in government securities only using «I» accounts and only at primary auctions and could not participate in the secondary trading. Between February and June 1996, an insignificant amount of about 12 trillion rubles was invested in government securities.

In August 1996, after the presidential election, foreign access to the government securities market was significantly liberalized and was achieved through «S» accounts. Foreign investors received the right to participate both in primary auctions and secondary trading. Simultaneously, the Central Bank offered non-residents to lock in yields on government securities by entering forward contracts for purchasing foreign currency.

In 1996, non-residents invested $9.1 bln in Russian state securities, including $5.6 bln invested through «S» accounts and $3.5 bln invested through the so called «shadow scheldues». Due to a further liberalization of foreign access to this market, which resulted in a decrease of the share of obligatory forward contracts with the Central Bank and the shortening of notice time prior to repatriation of profits from operations with GKO, foreign investors began predominantly using «S» accounts.

  GKO/OFZ Investor Structure
Source: EU VEDI

The continuous increase of the share of foreign financial resources on the government debt market made it possible for the monetary authorities to reduce yields on government securities to 17%–18% (in ruble terms). Given the stability of the exchange rate, the yields on GKO/OFZ were 9%–11% in foreign currency (for those investors did not enter into forward contracts). By late October 1997, the share of foreign capital on the government debt market exceeded 30%.
  Average Weighted Yield on GKO’s and OFZs at Maturity and Average Duration
Source: EU VEDI


The government task of lowering yields on government securities seemed to be realistic. The Central Bank held 27% of outstanding GKO/OFZ and Sberbank, controlled by the government, held 29%. Moreover, the Government financial program for 1997–1998 included not just continuation of a decline in inflation but also the continuation of the downward trend in yields on government securities (in ruble terms, to 14% by the end of 1997 and 11% by the end of 1998). Simultaneously, the share of foreign investors on the government debt market was expected to increase to 50% of total market volume.

However, in October and November 1997, a wave of relative decline hit the international capital markets. The withdrawal of funds by non-residents from Russian government and corporate markets resulted in huge sales which naturally led to sharp decreases in prices. To prevent a rapid growth of yields on government securities, the Central Bank began to increase its GKO/OFZ portfolio. As a result, at the end of the year the Central Bank held 40% of the GKO/OFZ outstanding of all issued securities by face value and around 26% of the amount circulated in the market. In total in 1997, foreign investment in the GKO/OFZ market increased by $10.3 bln while during the period from January 1 — November 1  $12–$13 bln. Thus, the outflow of capital from the GKO/OFZ market during November–December was about $2–$2.5 bln.
 

Non-resident and Central Bank GKO/OFZ Portfolio (face value)

Source: EU VEDI, Central Bank of Russia


The development of the GKO/OFZ market in 1998 will largely depend on the volume of inflow of foreign capital. The draft of State 1998 budget was based on the assumption that yields on government securities would decrease to 14% while the share of non-residents on the government securities market would increase to 50%.

However, already by the end of the year, because of the growth of GKO yields and due to the change in the primary auctions (hoping to retain investors short term GKO/OFZ were placed) by the end of 1997 corrections to the 1998 budget expenditures (related to domestic debt servicing) were made. That is, already at the end of 1997, it became clear that the development of the GKO/OFZ market in 1998 would develop differently than planned and could be one of the two following scenarios.


Scenario 1 –
Based on foreigh investments
According to this scenario, the inflow of foreign capital to the Russia will resume in early 1998. During the first half of the year, the volume of foreign capital will regain its end of October 1997 level. The Central Bank’s foreign exchange reserves will grow by $5–$7 bln and accordingly its government securities portfolio will decrease by a corresponding amount.

Simultaneously, the yields on GKO will decrease to 21–24% in ruble terms and 17–20% in US dollars. Domestic inflow to the market will also increase as Russian investors will be able to earn additional profits with a steady growth in GKO prices (reduction of yields).

Beginning with in the second quarter of 1998, foreign capital share will increase and reach up to 40% by the year end. Yields will decrease to 15–17% in ruble terms and 12%–15% in US dollars (assuming planned appreciation of the exchange rate).

Let us remember that on January 1, 1998, non-resident’s portfolio of government securities was about $18 bln (face value), or 27.5% of the total government domestic debt. According to forecasts of Vedi experts, by the end of 1998 with the yield on GKO/OFZ decreasing from 35% to 15–17% the size of the debt will increase from 384.9 to 491 trillion rubles, or by 27.6%. If non-residents portion increase to 40% by the end of 1998 their portfolio will amount to about $32 bln. In order to achieve this, approximately $9 bln in foreign investment must enter Russia. Non-residents’ interest income from the GKO/OFZ market will amount to more than $5 bln in 1998.


Scenario 2 –
Based on domestic investments
This scenario assumes that in 1998 there will be no significant foreign capital inflow. The probability of this scenario is relatively low. However it may become more realistic with manifestations of an increase in political instability, changes in economic policy and also crises in international financial markets. In such situations, the Government will have to attract domestic financial resources to the market. As a result of the above circumstances, yields on GKO in the first half of 1998 will remain at 30–35% and the structure of the market unchanged.

In turn, the high yields on government securities and the significant share of GKO/OFZ held by the Central Bank will lead to higher inflation and a need to increase deposit rates. Accordingly, yields on GKO/OFZ will increase to 40%–50%. An insignificant decrease in yields on government securities will be possible only in the fall of 1998 as a result of anti-inflation measures. By the end of the year, yields on GKO/OFZ will be 30–40%.
 
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Foreigh Exchange Market

In 1997 the foreign exchange policy was determined by the main goals of the monetary program formed in 1996. In particular, in 1997, the Central Bank of the Russian Federation continued to implement measures intended to smooth the fluctuations and maintain the predictability of the exchange rate. Exchange rate movements were kept in a pre-set range (the «ruble corridor»). By the end of the year, the ruble/dollar exchange rate could be no more than 6350 and no less than 5780. At the beginning of 1997 the official rate was 5,560 rubles to the US dollar and the maximum decline by year end shouldn’t have been more than 14%, the minimum devaluation less than 3.4% during 1997. Stability of the real exchange rate (that is adjusted for inflation in Russia and the United States) was proclaimed to be of primary importance. At the start of 1997, the Central Bank’s foreign exchange reserves amounted to $11.2 bln.

In early 1997, the situation on the foreign exchange market was rather unstable. A number of seasonal factors, such as an increase in household income and a growth of money supply in December 1996, influenced it. Demand for foreign currency exceeded supply. In order to prevent exchange rate from falling, the Central Bank actively intervened (about $2 bln) in the foreign exchange market.
 

Central Bank Foreign Currency Interventions on Exchanges and in the Interbank Market (- purchase, + sale) and the Monthly Devaluation Rate
 
Source: EU VEDI
 
However, the situation changed in February 1997. At that time, large foreign loans and investments were made and the supply of foreign currency began to exceed demand for it from Russian economic agents. In 1997, capital inflow was intensively increasing from foreign numerous sources (loans from international financial institutions, issues of Eurobonds, non-residents’ investments in government securities and others). Under such conditions, the Central Bank’s main task became slowing down the strengthening of the ruble and keeping the exchange rate within the ruble corridor, that is to restrict the real exchange rate growth.
  Foreign Lending and Portfolio Investment in Russia (Net, million USD)    
   Source: EU VEDI
 
The demand for foreign currency was mostly formed by households (who used hard currency as savings or for transaction purposes in the «shadow» economy) and was formed both its traditional demand and an increase in appetite for foreign currency. According to the Central Bank, the first three quarters of 1997 households’ net purchases of foreign currency amounted to $22.7 bln. Households kept more than 90% of their gross savings in hard currency.

During the second half of 1997, demand for foreign currency both from households and non-residents grew due to an increase in inflationary expectations. This, together with a higher demand on the part of non-residents, led to a decrease of the Central Bank’s foreign exchange reserves. In November 1997, there in fact was a crisis on the foreign exchange market which was similar to the crisis in late 1994 («Black Tuesday») when the ruble collapsed against the dollar. (A currency crisis is defined as either a sharp depreciation of the national currency or a major decline of the Central Bank’s foreign exchange reserves or both tendencies).

This conclusion can be made from the fact that in November 1997, despite a slight change in the exchange rate, the Central Bank’s international reserves decreased significantly. The Central Bank tried to prevent the sharp depreciation in order to: 1) reduce exchange rate risks for foreign investors operating in Russia and 2) increase the probability of new foreign investment. The last factor was (and still is) especially important because of a continuously high demand for foreign currency from households and a low level of international reserves. Without new foreign investment the control over the exchange rate is impossible.
 

Foreign Exchange Index (index of the growth of the exchange rate and the Central bank’s foreign currency reserves)  
        Source: EU VEDI
 
The main goal of exchange rate policy in 1998 is to maintain the ruble exchange rate at the average level of 6.1 to the USD, focusing on new capital inflow and reducing the exchange rate risks for foreign investors and to provide foreign investment inflow. According to an optimistic scenario, about $30 bln in loans from international financial organizations and investments (direct and portfolio) will inflow to the Russian financial markets. In this case, the exchange rate will be 6.2 rubles to the dollar at the end of 1998, while the Central Bank’s foreign exchange reserves will increase by $3–$5 bln.

The pessimistic scenario assume that not more than $20 bln will reach the country in 1998. Under such conditions, demand for hard currency from Russian economic agents will match or slightly exceed the supply. This will increase the probability of ruble devaluation and a reduction in foreign currency reserves.

However, the main threats to the declared exchange rate control policy are a low level of foreign currency reserves and a strong probability of the level of inflation increasing during the first half of 1998. If the above mentioned factors will happen, the average exchange rate will probably be higher than the planned rate. This, in turn, will cause an uncertainty of the Central Bank’s exchange rate policy for 1999–2000.
 
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Equity Market

Summing up the results of the previous year, most analysts agree that 1997 had been lost by the Russian equity market. Capitalization and price indicators of this segment of the financial markets decreased to the start-of-the-year level. During the last months of the year the dominant trend was based on the restructuring of foreign investment portfolio with a reduction of investments in Russian equities.

At the same time, despite the end-of-the-year downturn, 1997 was useful in that it crystallized trends of the rapidly developing Russian equity market. The depth of the investment potential of domestic companies, the leading role of foreign capital in the formation of the market of these stocks and also the intensity of improvements in the market infrastructure became clearly visible in 1997.
 

RTS Index  
Source: EU VEDI
 
A significant reduction of political and economic investment risks in late 1996 were followed by a significant increase in investments in early 1997. During the first two months of 1997, investments in domestic equities were about $1.6 bln, 4 times greater than during the comparable period of 1996. During this period, investment was focused on Russian blue chips (oil, gas and telecommunications companies). As a result of active purchases of Russian equities, their price level increased by about 60%. From January till February 1997 capitalization of the equity market grew from $35–$40 bln to $50–$60 bln.

The sales of the most liquid shares by non-residents intensified during March and April 1997, because of an increase in political risks caused by a conflict between the Government and major monopolies and the continuous confrontation between the Central Bank and the Federal Commission for Securities. In the first two months of 1997 foreign investors sold $1.1 bln worth of shares, which led to RTS price index declined by 17%. The capital of domestic investor was characterized by low mobility during that period.

According to Vedi estimates, only 8% to 12% of Russian equities are currently traded in the market place. An inflow of $1 bln into the corporate securities market will increases market capitalization by $9–$12 bln.

New investments on the corporate securities market resumed in May through early August 1997. This was due to a number of reasons, including the absence of political upheavals, a reduction in yields on alternative financial instruments and growing attractiveness of Russian corporate securities in several segments due to efforts made by production managers. According to expert estimates, the principal sources of new investment were Western investment funds. Domestic investment accounted for 25% to 30% of total investments.

During this period, as a result of increased investment, the following changes on the corporate securities market took place:
 

• Total investments is estimated to have been $3.9–$4.1 bln during these three months. The amount of funds monthly invested in Russian equities grew up to $1.8–$2 bln;
• The average price level of domestic shares grew by 100% (by 200% since the beginning of the year);
• The number of companies whose shares were regarded as liquid grew to 250;
• Capitalization of the stock market grew four times between January through August 1997 to $100–$120 bln.
During the second half of October, after the period of growth, a traditional price correction took place and after it a global drop on the market. The culmination was registered on October 28, when a 14% decline of the Hang Seng stock market index (Hong Kong), a 7% of the DJIA index drop (the third greatest decline since the establishment of the American stock market in 1896) and a significant decline in share prices on the European markets caused panic among Russian stock market participants.

On October 28, the RTS index of the Russian companies declined by nearly 20%. The crisis of the international financial system was not overcome by early November. The international financial system was hardly stable at that time. As a result of a tendency towards redistribution of non-residents’ investment resources from the emerging markets to fixed-income securities of the most developed countries (especially US Treasury bills), in November and early December market capitalization decreased by another 23%, compared to the closing level of the October 28 trading session. According to expert estimates, about $5 bln was withdrawn from the market as a result of the sale of Russian securities during the time of the crisis (October through early December 1997).

Thus, according to Vedi estimates, at the end of 1997, foreign investment in Russian equities did not exceed $5 bln. The maximum level of foreign investment in Russian equity market was registered in July and August 1997 and was about $9 bln.

In all, foreign investors transferred $2.2–$2.5 bln to the Russian equity market in 1997. The maximum growth of investments ($5–$6 bln) was observed during the first half of 1997.

Investments in Russian Equities, billion dollars*

 
Source: EU VEDI
* - Possible discrepancies between figures in the text and in the table are due to the fact that figures in the text are as of particular dates while figures in the table are as of the end of each month


According to Vedi estimates, in 1998, the situation on the Russian corporate securities market is likely to develop in accordance with one of the following three scenarios.

The major factor behind these three scenarios is the state of the international financial system. It was assumed that market capitalization amounted to $70–$75 bln on December 29, 1997, while investments into equity amounted to $7.3 bln.

According to an optimistic scenario (Scenario 1), Russian stock-market capitalization will amount to $160 bln by the end of 1998, while the RTS index will reach up to 800–830 points. According to the multiplication rule ($1 bln of investment increases capitalization by $9–$12 bln), expected investments in Russian shares will be $8–$9 bln, including $6–$7 bln of foreign investments. In this scenario, the multiplication coefficient may change. It will decrease in the case of an increase in the number of shares trading on the market, that is the same amount of investment will result in a smaller growth in capitalization. Consequently, the forecasted indicators may change with either an increase (investment) or a decrease (capitalization).

Scenario 1 will also occur if investments which had been made in May through October 1997, in anticipation of inclusion of Russia in the IFC index were long -term investments and the share of Russian equities held by investment portfolio, up to 5.6%, will result from new investment. An increase in this share from 1.5% ($4–$5 bln) to 5.6% ($15–$16 bln) will increase the capitalization of the equity market to $150–$160 bln.

According to the moderate scenario (Scenario 2), which is equivalent to a volume investment in equities), Russian stock market capitalization will reach $130 bln by the end of 1998, while the RTS index will increase to 630–650 points. New investments will amount to $5.5–$6 bln, of which $4 to $4.2 bln will be foreign investments. In this case, the multiplication coefficient will change insignificantly, because Russian companies will hardly be interested in the issue of new shares. In addition, it is assumed that part of the investments made in the middle of 1997, in anticipation of the inclusion of Russian companies shares into the IFC index, was made by speculative investors planning to sell their shares once the market «heats up».

According to a pessimistic scenario (Scenario 3), market capitalization will reach $100 bln by the end of 1998, while the RTS index will increase to 500–550 points. New investments will amount to $2.5–$3 bln, including $1.8–$2.1 bln of foreign investments. The multiplication coefficient will likely increase because only liquid shares will be traded on the market. This scenario assumes that the investment potential of foreign investment funds had been fully realized before the international financial crisis (November 3) in anticipation of an IFC decision. In view of this, the maximum that can be expected by those interested in the Russian equity market, is the return of the same amount of investments which was withdrawn from the stock market during the crisis (that is $2–$3 bln).
 
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Conclusions
• 1. The crisis on the international capital markets had a significant effect on the situation on the Russian financial markets and eliminated the monetary authority efforts to reduce interest rates. At the end of 1997, major market indicators, such as yields on government securities, the Central Bank’s international reserves and prices of most liquid corporate securities were thrown back to December 1996 levels.
• 2. The crisis on the international stock markets had a negative effect on the Russian financial system as a whole. The main factors of the crisis were the stop of new capital inflow and also internal economic factors. The withdrawal of foreign capital from the Russian financial markets was hardly as great as initially expected. Nonetheless, under the structural changes and low yields on GKO the withdrawal of a small amount of funds had a multiplication effect. The crisis became stronger owing to inflationary expectations from Russian economic agents. Commercial banks converted their assets into hard currency, while households’ demand for cash foreign currency increased significantly.
• 3. In 1998, negative trends visible on the financial markets create additional uncertainty for Russian economic development. Major macroeconomic indicators for 1998 were calculated in the middle of 1997 and were based on the assumption that foreign investments would increase. As a result of changes in the situation on the financial market, the government expenditures on public debt service were revised. High interest rates reduced the probability of an increase in investments and made forecasts for inflation level of 5%–8% doubtful.
• 4. The primary goal of the exchange rate policy in 1998 will include the support of the average exchange rate at 6.1 rubles to the dollar, expecting foreign capital inflow and a reduction of exchange rate risks for foreign investors. The necessary precondition for it is the inflow of at least $25 bln of foreign investment. A low level of foreign exchange reserves and a probability of an increase in inflation in the first half of 1998 are major factors threatening to upset this policy. These factors increase the probability of the exchange rate depreciation above the planned level that will create additional uncertainty in 1999–2000.
• 5. The GKO/OFZ market may develop in accordance with two scenarios. According to the first scenario, the inflow of foreign capital will resume and the yields on GKO/OFZ will decrease to 21%–24% by the end of the first half of 1998. By the start of 1999, the yields on GKO/OFZ will amount to 15% to 17%. Non-residents will hold about 40% of the government debt market.
• The probability of realization of the second scenario, which will make it necessary for the government to attract domestic resources, will depend on the level of political instability and changes in economic policy, as well as the crises on the international markets. In this case, yields on investments will amount to 40% to 50% during 1998 and decrease to 30% to 40% by the end of the year.
• 6. The situation on the equity market will be rather unstable during 1998. It will depend on the inflow of foreign investments. An upward trend is the most probable and share prices (RTS index) are likely to increase by 30% (a pessimistic scenario) or by 100% and more (an optimistic scenario). The inflow of foreign investments will amount to $2 or $6–$7 bln.



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