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Last week, uncertainty regarding a new financial aid package had an effect not only on market participants, but also on Russia’s monetary authorities. The majority of investors expected that the Central Bank would raise the refinancing rate to a level which would push interest rates to a maximum. However the Central Bank did not raise the refinancing rate despite the fact that GKO/OFZ yields exceeded this rate by 30% to 70%. Instead, the Central Bank ceased to provide Lombard loans at a fixed rate and introduced auctions at which such loans were provided for terms of up to 7 days on a competitive basis. This showed that the Central Bank recognized that the refinancing rate no longer affected market rates. It also indicated that the Central Bank had tightened monetary policy (through agreements to provide loans at rates acceptable to leading banks) in order to impede speculation by market participants.

The situation on the foreign exchange market was also problematic. On the interbank currency market, the dollar rate exceeded the upper boundary of the Central Bank’s exchange rate corridor three times over a five-day period. Forward contract prices showed that traders expected a 50-percent annual devaluation of the ruble. The Central Bank’s gold and foreign exchange reserves decreased to between $13 to $14 billion as a result of measures aimed at fulfilling demand for foreign currency. The foreign exchange market now awaits a ruble devaluation. The only question is when and to what degree. However neither the Central Bank nor the Ministry of Finance provided any comments regarding the situation on the financial market. Under conditions of uncertainty, market participants preferred to speculate on a fall.

According to Vedi experts, the Central Bank’s current stance confirms that it is revising its monetary policy. The targets, measures, and tools envisioned in this policy will depend on the terms of financial aid to be provided by the IMF and leading foreign banks. However this new policy is unlikely to be revealed next week because it must first be tied to the government’s fiscal policy and approved by international financial organizations.

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The situation on the GKO/OFZ market continued to deteriorate rapidly in the period under review. The average amount of funds reserved by investors for government securities purchases was 1 billion rubles, compared to a 3-billion-ruble average since the start of the year. The Ministry of Finance’s large redemption payments (a little less than 5 billion rubles) on Wednesday, July 8 led to an increase in the amount reserved in the trading system to only 2.8 billion rubles. By Friday, the amount of funds in the trading system decreased again to 1 billion rubles. Moreover, most of the funds received by investors after the redemption of securities was spent on foreign currency.
 

The almost total lack of interest in government securities accounted for very low demand. For example, new securities issues amounted to 7 billion rubles, but investors were willing to buy only 2.7-billion rubles worth of government paper, or only 40% of the issue. This amount was the lowest since the beginning of the year. The issuer’s redemption payments taken from its reserve fund amounted to about 5 billion rubles. As a result, the Ministry of Finance’s negative net revenues on the GKO/OFZ market grew to 27 billion rubles since the start of the year.

By the end of the week, yields on government securities grew to 130% per year, compared to 90% per year a week before. Information that talks centered around a new stabilization loan were proceeding successfully failed to improve the situation. Minimal purchases of government securities halted the growth in yields for only a short time.

The overall situation on the GKO/OFZ market is approaching a critical stage. Over each of the next three weeks, the Ministry of Finance will have to pay 9 billion rubles to holders of redeemed bonds. Large redemption payments traditionally have a negative effect on investor sentiment.
 

In light of this, the situation on the GKO/OFZ market is unlikely to improve next week. Investors will treat with caution any information regarding a stabilization loan for Russia. It is unlikely that investors holding large GKO/OFZ portfolios will begin making large purchases of government securities, and many will likely decide to take profits. In light of this, only a large inflow of foreign investor funds will help reduce yields on government securities. In our opinion, the probability of such an inflow is rather low. As a result, yields on government securities are likely to exceed 150% per year after the next government securities auction.

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Last week’s MinFin market can be divided into two parts according to the direction of price movements. At the beginning of the period under review, a downward trend dominated due to negative information released during that period (such as newspaper reports regarding the rumored illness of President Yeltsin) and unfavorable conditions on other segments of Russia’s financial market. These factors accounted for an increase in yields on the third MinFin issue (the “shortest” issue) to 20% per year in US dollars. According to market participants, a significant decrease in MinFin prices (provoked by negative news) was the result of a number of large Western market participants significantly reducing the share of MinFin bonds in their investment portfolios. This was largely due to the fact that Russian securities became less attractive to investors, who activated a stop-loss mechanism.
 

The downward trend reversed in the second half of the week. According to analysts, Anatoly Chubais’ announcement that negotiations with the IMF and the World Bank were proceeding successfully and might be completed by the middle of July was a main factor in the reversal of this downward trend (the IMF’s share of the aid package is expected to amount to 40%). News regarding the forthcoming arrival of funds improved the situation on the MinFin market, causing prices to increase by 0.2 percentage points over the last two working days of the week. For the week, yields on buy-and-hold investments in MinFin bonds amounted to -10 to -61% per year in US dollars.

Next week, the situation on the MinFin market will be determined by news regarding a new financial aid package. In our opinion, it is possible that MinFin prices will increase on average by 0.5 - 0.8 percentage points.

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Continued political and economic instability in Russia, along with delays in negotiations with international financial organizations negatively impacted the foreign exchange market last week. Demand for US dollars (which began to grow at the beginning of July) caused the dollar rate to exceed the upper boundary of the Central Bank’s daily exchange rate corridor several times last week. It also compelled the Central Bank to increase its intervention on the foreign exchange market, which amounted to no less than $1-$1.5 billion last week.
 

Growing interest in foreign currency was not tempered even by a strong demand for ruble funds (last week, the total amount of commercial bank funds deposited in correspondent accounts with the Central Bank fluctuated between 10 and 13 billion rubles). Under such conditions many investors preferred to sell their government securities, and there was no increase in dollar sales.

News regarding a broad agreement with the IMF released at the beginning of last week was the only favorable news in the period under review. Unfortunately it did not dispel market uncertainty. The amount of the loan and the schedule of its disbursement remain unknown, and negotiation delays reduce potential positive effects. Market participants already base their forecasts on the assumption that financial aid will be provided to Russia.

Changes in the Central Bank’s policy helped restrict demand for foreign currency. Although the Central Bank did not change its refinancing and Lombard rates, it did cease to provide Lombard loans at fixed interest rates. It also reduced the terms of Lombard loans provided at weekly auctions from 21-30 to 1-7 days and reduced limits on foreign exchange transactions with commercial banks by 20%.

Despite the Central Bank’s measures, stabilization of the dollar rate on July 9 could be regarded only as a brief exchange rate adjustment. On Friday, demand for dollars again grew due to the withdrawal of funds from the GKO/OFZ market. As a result, dollars were purchased and sold at rates beyond the Central Bank’s daily exchange rate corridor.

A new phase of foreign exchange destabilization raised expectations of a faster ruble devaluation. Prices for futures contracts traded on MICEX were based on expectations of a 70-percent annual ruble devaluation, while prices for futures contracts traded on the CME were based on expectations of an 85-percent annual ruble devaluation. Current futures contract prices have reached a maximum level for the current crisis period.

To stabilize the situation on the foreign exchange market, the Central Bank will have to implement urgent measures over the next few days. However, further tightening of monetary policy may worsen the situation in the banking sector. Russia’s gold and foreign exchange reserves have decreased significantly. According to Vedi estimates, they decreased from $15.1 billion on July 3 to $13-13.5 billion at the end of the week under review, with the Central Bank’s foreign exchange reserves amounting to $7.5-8 billion. It should be remembered that the Central Bank spent about $6 billion on interventions on the foreign exchange market to overcome the Autumn 1997 crisis. Today, non-resident investors hold $15 to $20 billion in Russian government securities.

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The fulfillment of foreign investor buy orders for Gazprom shares (some of these orders exceeded $1 million) accounted for a 12-percent increase in prices (to 2.45 rubles) on July 3, a day after the July 2 trading session when Gazprom share prices declined by 10%. The volume of trading in Gazprom shares nearly doubled to 75 million rubles that day.
 

Strong demand for shares in Russia’s monopoly gas supplier along with very high yields on government securities (123% per year in rubles) created favorable conditions for investment portfolio restructuring by Russian finance companies. This was particularly true for those planning to increase their share of investments in the least risky financial instruments (GKOs and OFZs). The implementation of these short-term strategies accounted for a decrease in Gazprom share prices at the beginning of the period under review (July 6-10). The average selling price for Gazprom shares amounted to 2.28 rubles on Monday, July 6. On July 7, it fell below a critical level to 2.099 rubles. As a result, the yield on short-term investments in Gazprom shares (shares bought on July 2 and sold on July 3 or 4) amounted to 10% to 40% per year in US dollars. Evidently, most of this money was earned by Russian finance companies. Inactive trading on the following days (when trading volumes on the Moscow Stock Exchange decreased by nearly 50% to 30 million rubles) showed that non-residents made primarily long-term equity investments in the belief that share prices would begin to increase over the next twelve to eighteen months.

Buying shares in one of the largest companies (according to capitalization, Gazprom is now the #1 ranked company among all share issuers in emerging markets) at $0.33 per share is an excellent opportunity for investors. However Gazprom regards such share prices as unjustified, and therefore its management plans to raise funds on international markets through the sale of shares to strategic investors (such as Italy’s ENI and Royal/Dutch Shell) rather than through offerings on the open market. Selling $2 billion worth of shares will make it possible for Gazprom to pay its debt to the federal budget and to prevent the erosion of its charter capital and further depreciation of the company’s shares.

The situation on the market for shares in other companies developed according a scenario that became traditional during the third (May) phase of Russia’s economic crisis. Share price movements followed a three-phase cycle consisting of a decline in share prices, a period of depression, and then a rise. The first and the second phases lasted for most of the period under review due to a shortage of investment resources and the absence of incentives. Moreover declines were deep, while rises were insignificant. Transaction volumes were also rather low on the organized market, amounting last week to $101.9 million. Russian share prices now decline at a rate of 5-10% a week. Last week, they declined by 5.3%.

The situation on the equity market will be determined by two major factors in the second half of July. One will be yields on securities that provide alternative investment opportunities, while the other will be the IMF’s decision regarding a stabilization loan. Vedi experts believe that developments will follow a pessimistic scenario. By the autumn of 1998 the RTS index will decline to 100 points. Accordingly, capital withdrawals from the equity market will amount to $1-1.5 billion from July through August.
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