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The structure of personal spending changed. Spending on goods and services as a proportion of total spending increased, while savings decreased. However the trend toward an increase in savings kept in deposits and invested securities as well as a decrease in purchases of foreign currency visible at the beginning of 1998 reversed at the end of the first half of the year. Despite high deposit rates offered by commercial banks, bank deposits grew less attractive to ordinary Russians due to rumors regarding a possible ruble devaluation as well as the unsteady position of a number of large banks. Consequently, foreign currency became more attractive.

If instability on Russia’s financial market continues, demand for foreign currency among ordinary Russians will increase significantly, making it more difficult for the Central Bank to control the exchange rate.
 

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The dollar rate exceeded the upper boundary of the Central Bank’s daily exchange rate corridor practically all of last week. To stabilize the situation, the Central Bank was forced to intervene on the foreign exchange market. According to Vedi analyst estimates, Central Bank interventions amounted to at least $1 to $1.5 billion last week.

Changes in futures contract prices had almost no effect upon demand for foreign currency on the spot market. Futures contract prices were practically unchanged last week. However they did decrease a little on MICEX during the early part of last week.

The dollar rate on the exchange grew by 0.21% (10.8% per year) last week. On the interbank market it grew even less (5-8% per year) because its growth was restricted by the upper boundary of the Central Bank’s daily exchange rate corridor.

Last week, the Central Bank allowed the official exchange rate to grow a bit faster. During that period, it grew by 0.0035 points, compared to 0.003 points a week earlier. If the exchange rate continues to grow at this rate until the end of the year, the dollar rate will increase to 6.65-6.70 rubles/dollar by the end of the year (11.5-12% annual growth). One question arises at this point- will the dollar rate begin to grow faster in the near future? The answer will depend upon measures the Central Bank implements over the next few days. If the dollar rate increases by .0085 points each day, it will rise to the upper limit (7.15 rubles to the dollar) by the end of 1998. Such growth corresponds to 20% annual growth in the exchange rate.

It is already possible to speak about a gradual devaluation of the national currency. Allowing the dollar rate to rise to 6.6 rubles to the dollar by the beginning of 1999 means an 11-percent annual growth in the exchange rate. However, it was proclaimed at the beginning of the year that the dollar rate will not rise higher than 6.2-6.3 rubles to the dollar (a less than 6-percent annual growth) by the end of the year.

When analyzing developments on the foreign exchange market over the next few days, we would point out that the situation is unlikely to improve significantly.  On the interbank market, growth in the dollar rate will be restricted by the upper boundary of the daily exchange rate corridor coupled with Central Bank intervention. A slight decrease in demand for US dollars will probably occur periodically.
 

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Yields on government securities once again increased significantly last week. Government securities prices increased slightly only on the eve of redemption payments due to expectations of an inflow of funds. Moreover these payments were made using budgetary funds following the cancellation of new placements. When it became clear that funds received following redemption payments would be withdrawn from the market, yields on government securities began to rise sharply. By the end of the week, yields on “long” securities reached 100% per year.
 

It should be pointed out that despite a reduction in overall domestic debt, foreign investors’ share of the domestic debt market is growing. Over the last few months, it exceeded 30%. During the $6.4 billion exchange of GKOs for Eurobonds, non-residents acquired only 60% of these newly-issued securities, while Russian investors (primarily the Savings Bank of the Russian Federation, or Sberbank) acquired the rest. This shows that in fact Russian investors are the ones who are leaving the market (the Central Bank’s share of the market practically remained unchanged).

At the same time, the Ministry of Finance (which assessed the prospect for developments on the GKO/OFZ market together with the IMF) believes that the Central Bank will increase its GKO/OFZ portfolio by 7 billion rubles by the end of the year. Sberbank will reinvest all the funds received following redemption. Other commercial banks will reduce their presence on the market in the third quarter, but will resume purchases of government securities in the fourth quarter. Non-resident participation in the market will decrease steadily, according to our forecasts.

The accuracy of these assessments as well as the Central Bank’s position regarding open market operations will become known relatively soon. The situation on the GKO/OFZ market is unlikely to change significantly next week. It is highly probable that next week’s developments will follow last week’s scenario. The market will wait for the results of the next government securities auction to be announced. Yields will probably decrease slightly if the auction is cancelled. This however will be the result of short-term speculation on a fall rather than an optimistic mood among market participants.
 

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Another circumstance that provoked a decrease in MinFin prices was the announcement that Russia would probably encounter difficulties in obtaining the World Bank’s structural adjustment loan. However this information was only partially confirmed. The World Bank’s Board of Directors nonetheless approved the $1.5-billion loan to Russia. Of this amount, $300 million was to be disbursed immediately. One of the main conditions for the disbursal of the rest of the amount was the reorganization of Russia’s natural gas monopoly Gazprom, which would make it possible for independent gas producers to gain access to Russian pipelines. Observers characterized this demand as having had a negative effect on the market. For the week, yields on buy-and-hold investments in MinFin bonds amounted on average to -410% per year in US dollars.

The Russian government’s approval of a limit on Russia’s 1998 foreign borrowing (through Eurobond issues) was another noteworthy event last week. The approved limit for 1998 amounted to $14 billion. As a result, the government received the right to issue another $2.7 billion-worth of Eurobonds in 1998. This will likely help reduce tension on Russia’s financial markets. However, taking into account the statements of various government officials, one may assume that Russia’s new Eurobond issue will occur no sooner than October.

No favorable changes are expected to occur on the MinFin market next week. Market participants will be rather inactive, while MinFin prices are unlikely to change significantly.

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On Tuesday, August 4 the DJIA index fell more than 299 points (-3.41%) to a level of 8,487.3. This was the third most significant decline of the DJIA index in its history (the all-time record decline occurred on October 19, 1987, when the DJIA index declined by 22.7%. On October 28, 1997, the capitalization of America’s stock market decreased by more than 7%). A decline in the DJIA index comparable with last week’s decline occurred almost exactly a year ago, on August 15, 1997, when the DJIA index dropped by 3.1%. A fall in share prices on the world’s major stock markets led to panic among equity market participants in other countries. However, as in August 1997 its effect on Russia’s market was relatively insignificant. Upon receipt of the news, Russian share prices decreased by only 4%.

The reasons that prevented a Russian equity market collapse were different in both cases. Optimistic forecasts regarding the future of Russia’s equity market made during a period of relative economic and political stability prevented a collapse in 1997. In 1998, the Russian equity market did not collapse because of the very low share price level, which was comparable to that of May 1996 (140-150 points). Low market liquidity also had an effect (in early August, the average daily transaction volume on RTS decreased to $13 million, and the average market spread grew to 230%).

The potential consequences of the government’s implementation of decisions proclaimed in the “Letter on the Development Policy in Order to Raise the Third Loan for the Restructuring of the Russian Economy” were negatively received by equity market participants (this $1.5-billion loan is part of a $22.6 billion aid package provided to Russia by international financial institutions). This letter includes the government’s decision to restructure Gazprom by January 1, 1999. This measure is in line with the World Bank’s requirement to establish Gazprom’s gas transportation subdivisions as separate entities. It can be expected that the second, seemingly innocuous step - the issue of a legal document on the reorganization of Gazprom’s transportation subdivision into an independent entity - will mean the effective liquidation of the company’s monopoly in gas supply within Russia.

The letter also contains a promise to restructure Russia’s state property through the sale of stakes in 24 Russian companies in Russia and abroad. These companies include a number of strategically-important companies, such as Rosneft, Svyazinvest, LUKoil, Slavneft, UESR, ONACO, and others. This sale will have significant consequences because it will result in the sale of a significant part of Russia’s assets for next to nothing in order to raise immediate revenues. It will also result in erosion on the secondary market and a decrease in market capitalization.

Largely due to this factor, the majority of Russian share prices decreased by 2.2% on Friday, August 7, while prices for Gazprom shares decreased by 3.6% to 2.12 rubles per share. For the week, Russian share prices declined by 11.2%.

As a rule, a budgetary crisis hits Russia at the end of each year. As a result, macroeconomic trends relating to Russia’s financial system become rather negative. The downgrading of Russia’s rating for long-term foreign borrowing from BB to BB- by the international rating agency Fitch IBCA and expected controversy between the government and State Duma during budget negotiation for 1999 show that the above factors may have a serious effect upon Russia’s equity market this year. Worries among equity market participants will cause Russian share prices to decline further in accordance with Vedi analysts’ pessimistic forecast.