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• The financial crisis that hit Russia from April through June led to a worsening of the country’s macroeconomic indicators. If interest rates, and particularly yields on government securities decrease to 30-35% by the end of 1998, Russia’s 1998 GDP will decline by just 0.5%. On the other hand, if interest rates stay at about 50%, the decline will be more significant, by about 1.5%.
• For the first time since December 1996, Russia’s industrial output in May decreased by 2.1% compared to the same period the previous year. In 1998, Russia’s industrial output will decline by up to 2%.
• From January through May 1998, real disposable personal income decreased by 7.9%. Personal income continues to decline and income inequality continues to grow.
• From January through April 1998, an increase in imports by 4.4% accompanied by a decline in exports by 7.5% resulted in a significant reduction in Russia’s trade balance, which amounted to $0.1 billion in April. Russia’s trade balance was positive ($2.4 billion) from January through April 1998, compared to $8.4 billion in the same period last year.

Major factors underlying instability in Russia’s economy include 1) the absence of real GDP growth, 2) the government’s failure to meet budget revenue targets, 3) the ongoing payment crisis, and 4) the worsening of the situation on international commodity and financial markets.

The absence of real growth in production and continued financial instability led to an increase in government spending and a decrease in revenues. Russia was quickly approaching a point at which default and a ruble devaluation were almost inevitable. Having realized the grave consequences for the economy of a massive ruble devaluation (as well as the inadequacy of government finances and the lack of economic incentives for boosting production), the government worked out a list of emergency measures. These measures were aimed at stemming the crisis and formed the basis of what became known as the government’s anti-crisis program. However the government first had to normalize the situation on Russia’s financial market. Only than could fundamental changes in the tax system and overall economic policy occur. To achieve this, a $10-15 billion long-term loan from international organizations was necessary.

Russia’s real GDP increased by 0.2% in April 1998 and decreased by 1.2% in May. From January through May 1998, Russia’s GDP decreased by 0.2% compared to the same period in 1997. In money terms, it amounted to 978.3 billion rubles during that period.

An analysis of the major elements underlying GDP use shows that demand for consumer goods continued to grow from January through May 1998. During that period, turnover amounted to 103.1% of the corresponding figure for the same period last year. At the same time, the decline in investment remained significant. Fixed capital investment decreased by 6.2% compared to 1997. The trade balance in commodities also decreased significantly (by $8.2 billion from January through April 1997), to $2.4 billion over the first four months of 1998.

GDP deflators remain low, and since January 1998 have been significantly lower than consumer price indices. For instance, the May 1998 deflator was 101.1% compared to May 1997, while the consumer price index rose to 107.5%. If the GDP deflator stays at its current level until the end of the year, Russia’s actual GDP measured in current prices will be much lower than that forecasted (amounting to about 2,630 billion rubles, while the official figure used for the preparation of the budget is 2,840 billion rubles).

The forecast regarding real GDP for 1998 will depend on whether financial stabilization will be achieved. If interest rates and particularly yields on government securities decrease to 30-35% by the end of 1998, Russia’s 1998 GDP will decline by about 0.5% compared to 1997. If interest rates stay at about 50%, the decline will be more significant, by about 1.5%.
 

Industry. From January through May 1998, Russia’s industrial output amounted to 650 billion rubles, a 0.6% increase over the same period last year. In May 1998 (and for the first time since December 1996), Russia’s industrial output decreased by 2.1% compared to the same period last year.

Industrial output is steadily declining in those sectors where output grew in 1997. These include the fuel industry, ferrous metallurgy, and the chemical/petrochemical industries. Over the first five months of 1998, industrial output in these sectors decreased by 1.8%, 1.7% and 3.8% respectively.

From January through May, the greatest increase in production occurred in the microbiological (12.8%), medical equipment (10.6%) and printing (8.7%) industries. The output in non-ferrous metallurgy increased by 7.1% over the first five months of 1998. However it decreased by 0.8% in April-May.

Investment. Fixed capital investment amounted to 114.5 billion rubles from January through May 1998, a 6.2% decline compared to the same period last year. The reason for this decline is the same: a shortage of capital among enterprises in the real sector and a reduction in government financing of investment programs.
 

According to the Federal Treasury, the consolidated budget deficit amounted to 33.1 billion rubles (or 4.3% of GDP) from January through April 1998.

According to the State Tax Service, the State Customs Committee, and the Federal Treasury, about 43.2 billion rubles in tax revenues (21.0% of GDP) was transferred to the consolidated budget in May 1998, a 16% decrease compared to May 1997 (offsets at the federal level excluded). Tax revenues decreased due to a decrease in tax collection at both federal and local levels.
 

 

Federal budget. According to preliminary data, federal budget expenditures amounted to 144 billion rubles (or 14.7% of GDP) from January through May 1998.

Spending on state debt servicing amounted to 52.1 billion rubles (or 5.3% of GDP and 36.2% of total spending) over the first five months of 1998. Spending was especially high in May (13.8 billion rubles, or 6.7% of GDP) due to servicing of the foreign debt ($1.3 billion).

Federal budget revenues amounted to 105.6 billion rubles, or 10.8% of GDP over the first five months of 1998, a 5-percent increase over 1997.

From January through May 1998, tax revenues amounted to 86.2 billion rubles (8.8% of GDP), a 3% increase over the same period in 1997 (75.6 billion rubles, or 8.0% of GDP).
 

Federal Budget Deficit. According to the Federal Treasury, the budget deficit calculated on a cash basis amounted to 36.0 billion rubles (3.7% of GDP) over the first five months of 1998. From January through May, budget revenues exceeded current spending. This resulted in a primary budget surplus of 13.4 billion rubles, or 1.4% of GDP.

Financing of the Budget Deficit According to IMF Standards. According to preliminary estimates, over the first five months of 1998 the federal budget deficit calculated on a cash basis in accordance with IMF standards amounted to 44.6 billion rubles, or 4.6% of GDP.

A sharp rise in yields on government securities (provoked by the development of Russia’s financial crisis) occurred in May. For this reason, borrowing on the domestic financial market was only carried out to refinance this debt. In May, the government had to spend 6.0 billion rubles of budgetary funds to repay the debt to GKO/OFZ holders. In all, net borrowing in May turned out to be smaller than spending on debt servicing. This gave rise to a primary surplus amounting to 1.5% of GDP (7.2 billion rubles, or 0.7% of GDP over the first five months).
 

Russia’s gross international reserves (GIR) decreased by approximately $2 billion beginning in April and amounted to $14.6 billion at the end of May. This caused net international reserves (NIR) to decrease from $1.4 billion in March to only $58 million in May. This decrease was largely due to spending on foreign debt servicing as well as the Central Bank’s intervention on the foreign exchange market to support the ruble.

Russia’s net domestic assets (NDA) grew by 6.7% in May compared to April. Moreover, all NDA components grew during that period. After a reduction in NIR and an increase in NDA in May, the share of NIR in the monetary base shrank to almost nothing. As a result, domestic assets began to account for most of the monetary base.

Required reserves grew from 25.7 billion rubles in April to 25.8 billion rubles in May, reflecting a slight increase in deposits. The required reserve deposit ratio was practically unchanged from March 1998 (after minimum reserve requirements were raised to 11%). This ratio amounted to 11.0% in May.

Money velocity decreased from 6.7 in April to 6.3 in May. From January through May 1998, average money velocity decreased by 11.3%, compared to the analogous period last year. This decrease was another indication of a liquidity crisis.

The Central Bank raised the refinancing rate twice in May 1998, from 30% to 50% per year on May 19 and then to 150% per year on May 27. The raising of the refinancing rate to the shocking level of 150% stopped speculation on the government securities market and led to a slight decrease in GKO yields. The Central Bank reduced the refinancing rate to 60% on June 5 after a period of relative stabilization. This level however proved to be too low and did not reflect the real level of country risk in Russian investments. Further growth in GKO yields and pressure on the foreign exchange market compelled the Central Bank on June 26 to raise the refinancing rate once again, to 80%.

Inflation. Consumer prices grew by 4.0% over the first five months of 1998. In May 1998, prices grew by 7.5% compared to May 1997. Food prices grew by 5.0%, manufactured goods prices grew by 1.3%, and service prices grew by 6.1%.

From January through May 1998, producer prices grew by 0.5%. Prices for means of production increased by 1.8%, while consumer goods prices increased by 2.3%. Prices for dual use products decreased by 0.9%. The most noticeable decrease in producer prices occurred in the oil industry (11.1% since the start of the year).
 

 

Total wage arrears amounted to 66.9 billion rubles as of June 1. Total wage arrears due to the absence of budget financing at all levels amounted to 11.0 billion rubles, or 16.4% of the total amount.

In May, 1.6% of total personal income was saved in the form of bank deposits and securities investments, compared to 4.3% in May. This decrease was explained by a decline in general income level. The share of income kept at home in the form of cash also decreased, from 4.7% in April to 0.6% in May. The share of income spent on goods and services increased to 77.5% in May (from 71.6% in April) while the share of income spent on foreign currency grew from 13.0% in April to 14.1% in May. Bank deposits grew by 2.2% in May to 165.8 billion rubles. In real terms, bank deposits grew by 1.7%.
 

 

Trade balance. Russian exports to the “far abroad” and CIS countries continued to decrease from January through May 1998. Hopes that a decrease in Russian exports to the “far abroad” would be compensated by an increase in exports to CIS countries (due to the abolition of VAT on imports from Russia to Ukraine) were disappointed. The difficult economic situation in Ukraine (which grew worse due to the international financial crisis) does not provide grounds to believe that effective demand for Russian goods will increase. Nonetheless, the share of Russian exports to CIS countries as a percentage of total exports grew from January through April 1998 compared to the same period in 1997. A sharp decrease in prices for oil exported to countries outside the CIS was partly compensated by an increase in deliveries to the “far abroad” and the CIS.

Imports from non-CIS countries continued to increase, while imports from CIS countries decreased (compared to January through March 1997). Unfortunately, a decrease in the share of machinery and equipment as a percentage of total imports from the “far abroad” shows that investment activity in the domestic economy has decreased. Clearly, this sharp deterioration in Russia’s trade balance compelled exporters to cut allocations for the modernization and expansion of production.

An increase in imports accompanied by a decrease in exports resulted in a significant deterioration in Russia’s balance of trade in goods, which amounted to almost zero in April. Russia’s overall trade balance was positive ($2.4 billion) from January through April 1998, compared to $8.4 billion in the same period last year. Total exports amounted to $23.3 billion (down 7.5%), while total imports amounted to $20.9 billion (up 4.4%).

From January through May 1998, Russia’s trade with countries outside the CIS amounted to $33.2 billion, an 8.8% decrease compared to the same period in 1997. Exports amounted to $17.6 billion (down 19.5%) and imports amounted to $15.6 billion (up 7.4%).

Over the first five months of the year, Russia’s trade with CIS countries amounted to $11.0 billion (exports amounted to $5.7 billion and imports to $5.3 billion). During that period, Russia’s trade with CIS countries decreased by 3.6% compared to the same period in 1997. Moreover, exports and imports decreased in almost equal proportions.
 

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According to preliminary estimates, Russia’s balance of payments deficit will amount to $22-29 billion in 1998, depending on the rate of capital outflow (including net purchases of foreign currency by ordinary Russians, non-transfer of export revenue into Russia, and errors and omissions). The balance of payments deficit is determined by a negative balance in Russia’s current and capital operations with the outside world (excepting operations with international reserves, new foreign borrowing, growth in overdue debt, and postponement of foreign debt repayments). In 1997, this deficit amounted to $16.8 billion (with an overall positive current account balance of $3.3 billion) but was easily covered by loans from international financial institutions (about $7.5 billion), Eurobond issues ($4.5 billion), and the restructuring of Russia’s sovereign debt to the London Club of creditors. This resulted in an increase in foreign reserves by $1.8 billion.

The growth of the trade deficit in 1998 was explained by a decline in exports, growth in imports, an increase in interest payments to non-residents, and a decrease in the inflow of foreign capital into the private sector. According to preliminary estimates, exports will decrease by 3.5% in 1998 due to a decline in international prices for crude oil and refined products, which are Russia’s major exports. An increase in imports is determined by an increase in demand for goods that are not produced by domestic manufacturers. However, the rate of import growth slowed to 2.5% in 1998, compared to 5.8% in 1997. An increase in interest payments to non-residents and a decrease in capital inflow into the private sector was caused by an increase in interest rates provoked by the ongoing financial crisis. As a result, Russia’s current account balance is expected to be negative in 1998 (-$5 billion). The rate of capital outflow from Russia will depend on the government’s economic policy, tightening of control over the transfer of foreign currency out of Russia, and the expectations of ordinary Russians regarding a ruble devaluation. Capital outflow from Russia will probably decrease by $5-10 billion in 1998, provided that the illegal transfer of foreign currency from Russia decreases or remains at the 1997 level.

The balance-of-payments deficit means that the outflow of liquid foreign assets from Russia exceeds the inflow (excluding government funds raised through foreign borrowing). Consequently, pressure on the exchange rate will increase if the government fails to attract adequate foreign financing. When government policy aims at restricting growth in the exchange rate, this can lead to a decrease in international reserves and/or a ruble devaluation.

In 1998, sources for financing the balance of payments deficit will include federal borrowing ($6.3 billion) and local and federal Eurobond issues ($6.8 billion). In all, $13 billion can be raised from these sources. If reserves amount to the level at the beginning of the year ($18 billion), an additional $9-16 billion will be necessary. A $10-15 billion long-term loan can help reduce pressure on the balance of payments and maintain adequate reserves. However the main purposes of this loan are to dispel fears of a ruble devaluation, reduce the outflow of capital, and help stimulate the inflow of foreign capital into the GKO/OFZ market. Such a loan will be needed to finance the balance of payments, to maintain ruble stability, and prevent an economic crisis entailing a massive ruble devaluation, a jump in inflation, and a sharp increase in the cost of foreign debt servicing.

If the loan is received, it will become necessary to consider the government’s long-term financial prospects. If the loan money is spent on covering the deficit, it will help resolve balance of payments problems this year only. In order to improve Russia’s macroeconomic situation, the funds must be used in the best possible way. Russia’s trade balance is not expected to improve significantly in 1999, and capital outflow is not expected to decrease. It is possible that imports will decrease slightly due to an increase in import taxes. However the IMF is highly unlikely to approve of this. Therefore the receipt of a loan package can only be regarded a last opportunity to resolve Russia’s major economic problems and boost economic growth. The funds received should be used as follows: 1) a reduction in domestic debt leading to a reduction in interest rates leading to an increase in production, 2) an increase in long-term direct foreign investment, 3) a reduction in the deficit through an increase in tax collection, and 4) control over the growth of foreign debt in the private sector and Russia’s regions.

The borrowed funds must first be used for the repayment of domestic debt (redemption of GKOs on the secondary market before maturity). First of all, this will prove quite profitable for the budget due to low government securities prices. Second, it will reduce the Ministry of Finance’s dependence upon borrowing on the GKO/OFZ market and will make it possible to reduce the threat of speculative attacks. It will also help to reduce interest rates. Russia’s budget has no capacity to ensure servicing of such expensive loans for a very long time. Moreover, the very high cost of loans resulting from high yields on government securities will lead to a decline in capital investment. Conversion of the foreign debt will cause the money supply to grow. Given the shrinking of the government securities market and the inadequate increase in demand for funds (investment in the real sector is unlikely to increase right away), demand for foreign currency will increase. Under such conditions, it would be appropriate for the Central Bank to sell part of its GKO/OFZ portfolio.

The government still has the opportunity to improve the situation by reducing the budget deficit. Monetary measures can no longer be used. The government can only slightly loosen its monetary policy or switch to a non-market distribution of financial flows. As has already been mentioned, the receipt of a stabilization loan will make it possible to resolve some budgetary problems. The problem of the budget deficit is in many respects separate from the problem of the balance of payments deficit. A balance of payments crisis can occur even in the presence of a balanced budget or a small budget deficit (see Indonesia or Chile). However, neither a reduction in debt nor economic growth will be possible without an increase in tax collection and a reduction of the budget deficit. Moreover, fiscal measures may not only have a long-term effect (a reduction in debt), they also have a short-term effect (such as an improvement in the psychological outlook on the part of foreign investors). Such an effect might prove to be significant.

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The crisis that struck Russia’s financial market in May 1998 posed a serious threat to the stability and reliability of the banking system. In light of the fact that investments account for the greatest percentage of lending institutions’ revenues (40% as of June 1, 1998), a rapid decline in government securities prices and a crash in the equity market would have a direct effect on lending institutions’ profitability.

A fivefold increase in the refinancing rate (from 30% to 150%) and a new level of GKO yields led to a rapid devaluation of banking investment portfolios. At best (if securities are held until maturity), banking losses will be manageable, in effect amounting to “lost profit” (albeit rather significant lost profit). Primary dealers on the GKO/OFZ market who must quote securities prices at auction will incur real losses.

Corporate securities portfolios are currently depreciating even faster. In May alone, equity market capitalization decreased by 40%. At present, the equity market is practically illiquid. The only exception is comprised of no more than ten Russian blue chips, whose share prices are steadily declining and have already dropped to a level last seen two years ago.

Banking Assets	Banking Liabilities

At the same time, banks were unable to exploit the opportunity to buy GKOs at unusually low prices. The raising of the Lombard and refinancing rates to 150% made it impossible for them to borrow funds. This also paralyzed the interbank market and caused serious liquidity problems. Under conditions of financial instability, most banks preferred to refrain from lending ruble funds. This caused lending rates to increase to 180-220% per year. Lending was carried out by only four or five leading banks that have a mutual guarantee system in case of emergency. Most banks refrained from lending due to the fear of mutual default. Thus, an acute shortage of funds was the result of banks’ refusal to lend to each other rather then the result of a decrease in the amount of money in circulation. However a significant shortage of available funds on the market and significant changes in liquidity could cause serious problems for many banks. The situation became even worse at the end of the month, when banks had to prepare their balance sheets.

On May 29, the Central Bank was forced to suspend the acceptance of deposits with fixed interest rates. This measure was aimed at preventing an additional incentive for a reduction in interbank lending.

A 150% rate makes Lombard lending practically senseless. At the same time, a number of Russian banks that received Lombard loans from the Central Bank some time earlier had to refinance these loans at new rates. Under conditions of a decrease in interbank lending, banks that encounter liquidity problems will have to compensate for a shortage of funds through the sale of government and corporate securities. However by doing so they will incur huge losses.

General instability on Russia’s financial market is worsened by growing expectations of a ruble devaluation. Russian banks are sensitive to changes in the foreign exchange market. Therefore, a ruble devaluation would mean huge losses for the banking system. First of all, foreign currency-denominated loans account for a significant percentage of banks’ loan portfolios. A sharp decline in the ruble would mean a greater debt burden for the borrower and consequently a decrease in the quality of the loan portfolio. Secondly, banks’ dependence on external sources of finance (including Eurobonds and syndicated loans from Western banks) has recently grown significantly. Russian banks’ total debt to syndicated loan providers with maturation over the next three months now amounts to $660 million.

The significant foreign debt held by Russian banks is an additional source of instability. The largest borrowers that must repay debts in July and August include Inkombank, Menatep, and Rossiisky Kredit. It is highly probable that some banks will be unable to refinance their debts due to foreign investors’ fears regarding Russia’s continuing financial crisis. Moreover, if only one medium-sized bank collapses, the banking system as a whole will face a crisis of confidence. Of course, the Central Bank will be able to prevent the collapse of a large bank unable to reschedule its credit. This however will lead to a reduction in the Central Bank’s reserves and worsen the overall investment climate.

The overall health of the banking system will be determined by Russia’s economic crisis. The stabilization of Russia’s financial market will lead to stabilization of the banking system. If the IMF provides a stabilization loan to Russia, the probability of banks being able to refinance their loans will increase significantly.

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