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One question is whether all the major causes of Russia’s financial crisis have been eliminated. Some of the major destabilizing factors included fundamental problems, such as an unfavorable macroeconomic background, a budgetary crisis, and a decrease in exports. However psychological factors, which determine the behavior of investors, also played an important role (e.g. rumors regarding a sudden ruble devaluation, the Ministry of Finance’s inability to fulfill all or some of its obligations, and the possibility of a banking crisis). Although new foreign borrowing will help calm investors for some time, Russia’s macroeconomic indicators are unlikely to improve next year.

How the stabilization funds will be used is another important question. Redemption of domestic debt at the expense of foreign debt will prevent the situation in the financial sector from deteriorating. However, it will be impossible to improve Russia’s economic and financial situation without improving tax collection, reducing inter-enterprise debt, and boosting investment and foreign trade. Perhaps the largest problem is that Russia has no overall strategy for overcoming its economic depression. New foreign borrowing will allow the government to smooth over some social problems and maintain relatively low interest rates for some time, but if the government fails to follow through on serious economic reform during this brief breathing space, another financial crisis is likely to begin by the end of the year.
 
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Yields on government securities decreased sharply last week. On Monday, July 13, yields on government securities amounted to 120% per year due to a complete absence of demand. The next day, yields decreased by 50% to less than 60% per year. Two major factors led to an increase in investor interest for government securities. One of them was undoubtedly the agreement between Russia and the IMF and World Bank regarding the amount and terms of a large stabilization loan package. The results of Anatoly Chubais’ negotiations exceeded investors’ expectations both in terms of the amount and the conditions attached to the loan. Naturally, this helped bring down yields on government securities. Another factor prompting GKO purchases last week was the announcement of Russia’s plans to convert outstanding GKOs into dollar-denominated Eurobonds.
 

This conversion will make it possible for the Ministry of Finance to reduce the cost of short-term domestic debt servicing. For their part, investors will be able to acquire foreign-currency denominated securities and thus avoid the risk of a sudden ruble devaluation. Some investors still believe that this risk is significant and continue to show interest in new securities denominated in foreign currency. Given a favorable situation on Russia’s financial market, a decrease in the number of outstanding GKOs will cause an increase in demand for liquid, short-term securities and a subsequent decrease in yields.

Thus, last week’s rapid decrease in yields was explained by 1) the provision of a loan that will enable the Ministry of Finance to minimize the issue of new securities and 2) the announcement of the GKO-Eurobond conversion scheme, which will reduce the number of outstanding GKOs on the market. Moreover, growth in securities prices continued the entire week (excluding July 17) despite the fact that there was no significant inflow of new funds into the market. This reflected expectations that a successful implementation of these plans would prompt an inflow of funds into the GKO/OFZ market, thereby keeping yields low. Further developments on the government securities market will be determined by how reality matches up to these expectations.

Three events are highly likely; the conversion will take place, the total amount of converted securities will be two to three times the established minimum, and the Ministry of Finance will reduce the issue of new securities. Will that be enough to convince financial institutions to proceed with new investment in Russian securities with yields amounting to 30-40% per year? There is no doubt that yields are likely to decrease further over the next few weeks, but much uncertainty remains regarding long-term market developments. Granted, the Central Bank’s reserves will increase, making it possible to maintain low growth of the dollar rate. However the threat of a new financial crisis will linger if no serious macroeconomic changes take place soon. It may therefore be difficult to keep yields on government securities low for very long.
 
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The announcement that the IMF, the World Bank, and Japan’s Export-Import Bank agreed to provide $14.8 billion in financial aid to Russia in 1998 (in all, Russia will receive more than $22.6 billion through 1999) was the main factor determining the situation on the MinFin market last week. This decision to provide such a large amount had a favorable effect upon all segments of Russia’s financial market, in particular the MinFin market.
 

In the second half of the period under review, a downward price adjustment occurred on the MinFin market due to profit taking after a period of significant price growth . For the week, MinFin bonds earned a return ranging from 212% to 552% per year in US dollars.

The partial exchange of outstanding GKOs for Eurobonds planned for next week is another important factor that will influence the situation on the MinFin market. It is expected that the total amount of this conversion will be no less than $2 billion. Moreover, Eurobonds worth up to $500 million may be sold for cash. Seven and twenty-year Eurobonds are expected to be issued with a minimum spread of 837.5 basis points compared to US T-bills. The exact parameters of the issue remain unknown. However most observers believe that yields on these Eurobonds (if they are placed) will amount to about 15% per year in US dollars (slightly above market yields). Taking into account investor interest in such instruments, one can assume that yields will decrease to the average market level by the end of July.

Next week, the situation on the MinFin market will be determined by the following two factors: the parameters of the new Eurobond issue and the results of Anatoly Chubais’ meeting with the IMF’s Board of Directors. For the week, MinFin prices will likely increase by 0.3-1.0 percentage point.
 
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News regarding the provision of $22.6 billion in additional financial aid (including $14.8 billion to be provided in 1998 alone) had a favorable effect upon the foreign exchange market. The probability of a sharp ruble devaluation decreased significantly. The speed with which the decision was made and the size of the package (compared to the initially discussed amount of $10 to $15 billion) also played an important role.
 

Since the probability of a sudden ruble devaluation has decreased, futures market participants began speculating on a fall. As a result, prices for futures contracts traded on MICEX and CME decreased by 10-15% last week, while prices for December contracts returned within the boundaries of the Central Bank’s three-year exchange rate corridor (5.25-7.25 rubles/dollar).

The dollar rate decreased by about 0.35% (from 6.2310 to 6.2090 rubles/dollar) on MICEX last week, while the official rate grew by 0.11% (or 6% per year) to 6.2190 rubles/dollar. Despite a decrease in interest for foreign currency, the Central Bank continued to implement its policy of a gradual increase in the dollar rate.

The provision of a stabilization loan alone will not help resolve Russia’s foreign exchange crisis. The recent decision to convert Russia’s domestic debt into foreign debt will help to stabilize the situation only in the short term. An extension of the debt’s term and a reduction in debt servicing costs are undoubtedly positive factors. However if a financial crisis occurs again, its consequences will be much more serious because Russia will have a significantly larger foreign debt by that time.

The situation on Russia’s financial market remains uncertain. Most market participants have assumed a wait-and-see attitude. Moreover, it is impossible to give an unequivocal evaluation of the results of the forthcoming GKO-Eurobond conversion auction. On one hand, significant interest in these new Eurobonds will reduce demand for foreign currency over the remaining months of the year and show that investors remain confident in Russian financial instruments. On the other hand, the withdrawal of funds from the government securities market by a majority of investors will be a sign that the threat of a ruble devaluation remains.
 
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Trading on Russia’s equity market increased in volume in the middle of the Summer. This was largely due to the announcement on Monday, July 13, that international financial institutions would provide a new stabilization loan package for Russia. The total amount to be provided in support of the Russian government’s anti-crisis program is greater than almost anyone expected. In total, the package provides for $22.6 billion in stabilization funding. The IMF will provide $15.1 billion, the World Bank’s untied medium-term loan will amount to $6 billion, and Japan will provide the remaining $1.5 billion.
 

 

The greatest increase in share prices (almost 17%) occurred on July 14. On that day, prices for some shares (particularly MGTS and the St. Petersburg Telephone Network) increased by 25-50%. The rapid growth in share prices increased the probability of an equally rapid decline, particularly in the event of aggressive sales of shares whose prices had risen significantly. To prevent this decline, regulatory authorities were forced to intervene and suspend trading on major trading floors (RTS, MICEX, and MSE) several times.

Share prices stopped increasing on Thursday, July 16. A downward price adjustment (-5%) occurred that day after a period of rapid price growth. An upward trend developed again at the end of the week (+6.6%) with the average share price level increasing by 43.4% during the period of price growth (July 7-9).

Despite last week’s favorable developments on the equity market, Vedi experts remained skeptical regarding the existing situation due to the peculiarities of the current market situation. In particular, the increase in share prices was not the result of real investment. Indeed, despite the very low share price level (now 50% lower than at the beginning of 1998 and equal to the level during the second half of 1996), there were no large purchases of Russian shares last week. This was confirmed by relatively low daily trading volumes, which amounted to $56 million.

Moreover, there are still no grounds to support the argument that company shares have become more liquid. The average spread between the purchase and selling prices still exceeds 200%, while blue chip shares still account for the vast majority of transactions (90-95% of the total volume). Thus, it is logical to assume that this increase in share prices was artificial, prompted by the activities of short-term investors who wanted to compensate for losses incurred during Russia’s prolonged financial crisis.

In our opinion, the potentially favorable results of the GKO-Eurobond conversion scheme to be announced on July 20 are also only conditional indicators. A large amount of converted debt may either show that non-residents began to show more confidence in the Russian government due to decreased investment risks, or alternatively that non-residents still feared a sudden ruble devaluation and wanted to withdraw funds from ruble-denominated financial instruments.

Share prices are likely to continue to increase next week, provided that the Eurobond issue is placed successfully and the first tranche of the IMF’s stabilization loan ($5.7 billion) is disbursed on-time. However, the amount of funds available will hardly be adequate for supporting share prices at a high level. New large investments will be needed for real market stabilization. According to our estimates, these investments must amount to $2.5-$3 billion.
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