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On one hand, the negative macroeconomic background will remain unchanged or even strengthen due to seasonal factors. Industrial production will not increase, personal income will decrease, and budget revenues will remain low. On the other, a number of factors will cause yields on government securities to increase and share prices to decrease. The disbursement of the stabilization loan will significantly reduce the risk of a sharp ruble devaluation, but the growth in the dollar rate will accelerate. The GKO/OFZ market will shrink following the exchange of government securities for Eurobonds. Other conditions being equal, this will cause GKO/OFZ prices to increase. An overall decrease in yields will provoke an increase in prices for corporate securities.

The above factors act in different directions. The cumulative effect will depend on the government’s stabilization measures. At present, they can hardly be considered as having already been effective. Hence, our outlook for next week is negative.

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Last week confirmed that Russia’s financial crisis (particularly on the foreign exchange market) is not yet over. External factors (including difficulties in receiving IMF loan payments in a timely fashion and the worsening situation on international markets) as well as domestic factors (negative assessments of government measures and growing social tension) continued to influence exchange rate movements.

Positive news announced at the beginning of last week (the IMF Board of Directors’ decision to approve the stabilization loan and the successful GKO-Eurobond exchange) was followed by a decrease in the dollar rate to the lower boundary of the Central Bank’s daily exchange rate corridor. However market activity remained low, with market participants expressing different views regarding future developments. Most assumed a wait-and-see position.
 

The situation changed by the middle of the week. Demand for foreign currency began to grow. By the end of the week, the dollar rate exceeded the upper boundary of the Central Bank’s exchange rate corridor (6.27 rubles/dollar). New rumors regarding a ruble devaluation and news that Russia’s major oil and gas companies strongly disapproved of the government’s policy accounted for growing investor interest in foreign currency. The fact that there were no large foreign currency sales on behalf of clients helped maintain this interest.

The reduction of the refinancing rate on July 24 was viewed by market participants as an ill-timed and unaccountable measure. It failed to raise optimism among market participants due to the existing situation on the foreign exchange market. Demand for foreign currency was rather high and continued to grow throughout the entire trading day.

High demand for US dollars resulted in an increase in the dollar rate by nearly 1% (51% per year) during the week. The Central Bank continued to implement a strategy aimed at a gradual increase in the dollar rate. During the week, the official rate was raised by only 0.11% (or 5.4% per year), but the interval for daily exchange rate fluctuation increased from 1.2% to 1.44%.

Deterioration of the situation on the financial market had an immediate effect on futures contract prices. The rate of ruble devaluation on which futures contract prices were based grew to 43-50% per year.

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The rapid decrease in yields on government securities in the middle of July (which was the market’s response to the receipt of stabilization loans) proved to be a brief respite. GKO/OFZ yields decreased from 120% to 60% per year, but then rose to 80% per year at the end of the week. Investor uncertainty regarding future trends on the GKO/OFZ market was felt the entire week.

The results of the auction to exchange GKOs for Eurobonds were announced on July 21. This new Eurobond issue amounted to $6.4 billion, with a yield amounting to 15% per year in US dollars. January 27, 1999 was fixed as the last day of redemption for those GKOs eligible to be exchanged for Eurobonds, while the total value of exchanged GKOs amounted to 27.5 billion rubles. In light of the fact that the Ministry of Finance has to pay nearly 150 billion rubles to securities holders by the end of 1998, it is clear that the exchange of securities only minimally reduced the burden of ruble debt servicing. Although the share of non-resident security holders decreased significantly, it is quite possible that demand for foreign currency from Russian market participants will increase.

Despite the large amount of funds left in the trading system, the only noticeable demand was for “short” securities, whose yields decreased to 25% per year by the end of last week. With redemption payments amounting to 9 billion rubles, demand for the new issue of coupon bonds amounted to less than 8 billion rubles. Without raising yields significantly, the Ministry of Finance managed to place just 3 billion rubles’ worth of new bonds.

Information regarding the Central Bank’s net position following the July 16 trading session (published on July 23) failed to produce optimism among market participants. The Ministry of Finance’s additional placements that day were almost fully compensated by securities purchases by the Central Bank. This resulted in no real demand for securities and, consequently, no potential for further reduction in yields.

The monetary authorities’ attempt to influence the market by reducing the refinancing rate had no noticeable effect. Although it is possible that there were some good reasons for implementing this measure, it has recently proved ineffective in preventing the growth of GKO/OFZ yields.

A sharp decrease in yields on government securities in the middle of July was prompted by investors’ positive expectations regarding the inflow of new investment resources into the market. The absence of such an inflow provoked a significant increase in yields last week. The possibility that this trend will reverse in the near future will depend entirely on the inflow of new funds into the GKO/OFZ market. It will hardly be possible to reduce yields through a reduction in total debt. Moreover, although the Ministry of Finance has declared an intention to reduce domestic borrowing, it has also already announced a new government securities issue worth 13 billion rubles (including the issue of new “documentary” GKOs) next week. Growing foreign debt and high interest rates will further impede foreign investment in GKOs and OFZs.
 

 

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The results of the Ministry of Finance’s GKO-Eurobond exchange auction were the determining factor on the MinFin market in the first half of last week.

The total amount of the two Eurobond issues was $6 billion, with maturities in 2005 and 2018. Of this amount, $500 million worth of Eurobonds with maturities in 2018 was sold for cash. The spread as compared to US T-bills was 940 basis points. The average weighted yield amounted to about 15% in US dollars. Such yields are higher that those on other outstanding Eurobonds. Market participants regarded the results of this exchange as favorable. Most believed that the issue was a success for the Russian government. As a result of this mood, prices for Russian foreign debt securities increased in the first half of last week. In particular, prices for new securities increased on average by 2.7 percentage points.
 

However, the upward trend on the MinFin market reversed in the second half of the week. Observers believe that this was due to the worsening of the situation on international financial markets, which was provoked by a number of factors. These include the news regarding Moody’s possible downgrading of Japan’s credit rating and testimony by Alan Greenspan (Chairman of the US Federal Reserve System) in which he referred to the lingering threat of inflation and the bleak prospect for further growth in America’s stock markets. The negative effect of these factors manifested in a more than 2-percent decrease in the DJIA index on July 24. Similar price movements were observed in other emerging markets, particularly the MinFin market. As a result, MinFin prices leveled off at the beginning of the week. For the week, buy-and-hold investments in MinFin bonds earned a return ranging from -42% to -354% per year in US dollars, depending on the issue.

In our opinion, MinFin prices will probably adjust upwards at the beginning of next week following a decline in the middle of July. However, they will continue to fluctuate in the near future and no particular trend will dominate.

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Last week, the RTS index needed to rise by another 3.5% to reach the psychologically important level of 200 points, but it failed to do so. Having increased by 43% over the six preceding days, it stopped at 193 points on Monday, July 20 as the result of market participants waiting for more information.
 

The developments that followed confirmed Vedi analysts’ most pessimistic forecast. The absence of positive news had a depressing effect on holders of equity investment portfolios, whose value had nearly doubled. News regarding the exchange of “short” GKO’s for Eurobonds and the IMF’s approval of the stabilization loan package seem to have been received negatively by the market. The growing probability of a rapid decline in share prices, along with the recent rapid increase in share prices, compelled market participants to reject medium-term strategies aimed at maintaining existing portfolio structures in expectation of financial stabilization. Instead, market participants began to implement short-term strategies aimed at profit-taking that would partially compensate for losses incurred since October 1997.

The latter strategy was generally dominant. On the first day of its implementation (July 21) share prices decreased by 5%. Over the next two days, they decreased by 6.6% and 7%, respectively. As a result of this three-day decline in share prices, the prices for the most liquid shares (particularly those for Rostelekom and UESR) decreased by 11-22%. Share prices for Gazprom decreased by 16% over the same period. At the beginning of the week, only a small fraction of securities was sold, those being shares purchased due to expectations of steady growth in share prices. On the third day of decline, even long-term investors lost patience and began massive sales (a threefold increase in daily trading volumes on MSE confirms this). As a result, prices for shares in Gazprom declined by 11%, to 2.4 rubles per share. The decline in share prices slowed on Friday (-3%), which is traditional for the end of the week. However, market participants’ expectations regarding the prospects for Russia’s equity market remained unchanged.

Vedi analyst forecasts regarding the situation on the equity market over the next two weeks also remain unchanged. The current volume of investment in Russian corporate shares is inadequate to maintain share prices at current levels. Share prices will continue to decline steadily over the next few days. The scale of this decline will depend on the attractiveness of investment in lower-risk ruble and foreign currency-denominated securities backed by government guarantees.

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