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The macroeconomic background is currently rather negative, but it is not worse than half a year ago. The budgetary crisis as a result of low tax collection continues. However this problem developed a long time ago and is unlikely to be resolved in the medium term. At the same time, the instability of the state debt market has debilitating effects on both the financial and real sectors. The risks of a large-scale attack on the ruble and a liquidity crisis in the banking system are high, while high interest rates make lending to the industrial sector impossible.

The current level of yields on government securities cannot be regarded as the equilibrium level. According to the State Statistics Committee (Goskomstat), Russia’s prices did not change during the first week of June. They are expected to increase by 8-10% by the end of the year. Thus, yields on government securities exceed 50% in real terms, an extremely high level. Moreover, due to the January and May crises the Ministry of Finance’s interest payments grew by more than 16 billion rubles (more than $2.5 billion).

Under such conditions, further growth in state debt and additional inflationary pressure are inevitable. If the monetary authorities do not implement well-considered and coordinated measures in the near future to normalize the situation on the GKO market and reduce yields on government securities, the ruble exchange rate  and the entire banking system will be destabilized by the middle of the Summer.

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However, the primary trading session ended poorly for the issuer. The secondary trading session also ended poorly for those market participants who bought new securities. Demand for securities was low and the issuer was forced to raise yields. Nonetheless the issuer failed to raise the amount needed to refinance maturing debt. For the week, the issuer’s net loss (with all placements and redemptions taken into account) amounted to 2.5 billion rubles.

Securities prices declined on Thursday, June 11 against the background of a significant amount of funds (about 4 billion rubles) reserved in the trading system. The hope that the Central Bank would participate in secondary trading sessions failed to materialize. Rather, the monetary authorities continued to implement a policy aimed at preventing ruble devaluation and refrained from large-scale operations on the open market.
 

In light of the situation at the end of the period under review, the prognosis regarding developments on the GKO/OFZ market is rather pessimistic. Next week, the Ministry of Finance will have to redeem more than 9 billion rubles in maturing debt. The previous week showed that even weak market support by either the Central Bank or foreign investors was enough to cause steady growth in securities prices. Today, nobody can count on such support and a steady reduction in yields is highly unlikely in the near future. In our opinion the market will likely remain volatile and the corridor for yield fluctuations will be between 40% and 60% per year. If yields exceed 60% per year they will undergo correction, but only if such deviations do not exceed 65% per year and last no longer than 1 or 2 days. Otherwise, the market will again be panic-stricken and yields will increase significantly.

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These factors prompted an increase in demand for foreign currency.  At the end of the week, the dollar rate amounted to 6.215-6.22 rubles to the dollar. Futures contract prices adjusted accordingly. On June 11, December contracts were concluded on  MICEX at more than 7.4 rubles to the dollar  (based on a 40-percent ruble devaluation by the end of the year).

Major factors that will affect the foreign exchange market in the near future will include the approach of the settlement date for futures/forward contracts, developments on other financial markets (particularly the GKO/OFZ and equity markets), and the general information background. These factors will have a strong effect on the foreign exchange market.

In view of existing price levels, the execution of futures contracts by Russian operators is unlikely to cause serious problems. This year, contracts have been concluded at prices not lower than 6.21-6.25 rubles to the dollar. Moreover, during that period Russian market participants frequently speculated on a fall in order to increase the profitability of futures transactions. This caused the exchange rate to decrease,  at least on MICEX. On the other hand, a decision by foreign investors to withdraw funds from the Russian market may cause demand for foreign currency to increase. In this scenario, the Central Bank will be forced to resume intervention on the foreign exchange market.

Developments on the GKO/OFZ market will also have a strong effect on exchange rate movements. If yields on government securities continue to increase, traders will again encounter liquidity problems. In this scenario, the supply of foreign currency will increase, causing the dollar rate to fall to the lower limit of the daily exchange rate corridor. At the same time, a further development of the crisis will lead to losses and cause market participants to begin to withdraw  funds from the system. This will lead to an increase in demand for foreign currency.

In any case, a continuation of the crisis on the GKO/OFZ market will lead to an increase in demand for foreign currency either in the near future or later on (due to a future increase in yields). In view of this, stabilization of the foreign exchange market will be impossible without normalization of the situation on the GKO/OFZ market. This is especially so in light of the fact that a decrease in the Central Bank’s foreign exchange reserves will not permit an increase in interest payments to foreign investors.

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The first set of factors was related to the announcement by IMF representative S. Fisher, who was quoted as saying that Russia was not in need of additional financial aid (G7 Deputy Finance Ministers expressed similar opinions during the recent G7 summit). This announcement had a decidedly negative effect on MinFin market participants, most of whom believe that a failure by the international community to provide additional aid may lead to another financial crisis. Such expectations were raised by the downgrading of Russia’s long-term credit rating by the international rating agency Standard & Poor’s.
 

Also last week, Boris Yeltsin signed a decree restricting the rights of Russia’s regions to issue Eurobonds or float international loans. The decree also gave borrowing by the federal government precedence over borrowing by local governments. This decree was clearly justified from the federal government’s standpoint. Russia’s difficult financial situation combined with a shortage of investment resources oriented toward Russia make the establishment of control over borrowing on international capital markets a necessity. However this restriction of local administrative rights (especially in view of recent “rural” bond redemption problems) may make Russian provinces less attractive to investors.

The situation on the MinFin market is likely to remain unstable next week. MinFin prices are likely to fluctuate, but it is also possible that they will increase by 0.3-0.5 percentage points.

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In the next two weeks, non-residents are likely to continue to restructure their investment portfolios in order to get rid of Russian shares. Since there is no demand for such securities, they will either be “frozen” in portfolios of large Russian investment companies or repurchased by the investment sub-divisions of respective issuers, such as NIKoil and LUKoil-Reserv-Invest.

Unless the imposition of limits on foreign purchases of Russian shares is recognized as being counterproductive, the situation on the secondary market will be characterized by infrequent transactions of shares in five or six blue chips by the beginning of the second half of the year. In accordance with the parameters of a pessimistic scenario (in which the RTS and MT indices decrease to 100 points by the beginning of Autumn), share prices will continue to decline by 5-7% per week during the next few weeks.
 
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