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A crisis situation has also arisen on the currency market, where high demand for foreign currency exists side by side with an almost complete lack of supply. Official commentary places blame for this situation on commercial banks. However in retrospect this appears rather naive, for the following reason. On July 1, 1998 private individual foreign currency deposits amounted to $6 billion. In the coming days the public will attempt to withdraw from deposit accounts no less than $4 billion. Therefore the demand for foreign currency on MICEX and the interbank market is entirely understandable and is unlikely to decline.

Last week’s events left the commercial banking system on the verge of disaster, and Russia’s economy was pushed to the brink of hyperinflation. Analysts are trying to compare Russian data to that of various crisis-stricken emerging markets (such as Indonesia, South Korea, or Mexico), and the government is trying to put together a working stabilization program. In the current situation this might mean a shift to a new economic model, more centralized and less market-oriented.

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Presently, there is virtually no currency market in Russia due to the lack of trading on MICEX and extremely low liquidity on the interbank segment. The results of last week’s trading on MICEX were rather historic, and are worth examining a second time.
 

• August 24: During the course of trade on MICEX the dollar rate was fixed at a level of 7.14 rubles/dollar (+1.9%).
• August 25: The dollar’s market rate amounted to 7.86 rubles/dollar (+9.16%). Trade was halted twice by the Central Bank after falls of 5% and 9.9% respectively.
• August 26: The stoppage of trade following a 5% fall in the ruble exchange rate to 8.26 rubles/dollar resulted in the cancellation of the day’s trading results.
• August 27: Dollar trade on MICEX opened with quotes of 8.2-9.5 rubles/dollar, and the spread between supply and demand for US dollars amounted to about $290 million. As a result of this situation the Central Bank decided to temporarily postpone trade, leaving the market without a daily fixing.
• August 28: Ruble-foreign currency trade on MICEX did not occur.

Acting as the only seller of foreign currency, the Central Bank once again depleted its gold and foreign currency reserves: if according to official data reserves amounted to $13.4 billion on August 21 (including $8 billion in cash) then according to VEDI experts as of August 26 they shrank to $12.5 billion (including $7-7.5 billion in cash). Therefore the low level of reserve assets foreshadowed a change in policy; the Central Bank decided to halt market intervention, resulting in an unofficial dollar rate via the MICEXSELT system of between 12-13 rubles/dollar.

In light of this uncertainty, the condition of Russia’s banking system is in serious danger. If balanced profits over the first 7 months amounted to less than 1 billion rubles, then net profits (allowing for depreciation) amounted to minus 4.5 billion rubles.

This situation is exacerbated by the possibility of greater losses as a result of a further rise in the ruble exchange rate (for example, as of July 1 the difference between currency liabilities attracted by banks and distributed currency assets amounted to about 17.5 billion rubles, or $2.8 billion). If this large imbalance between ruble and currency portions of banking balances continues (a recent Central Bank decision limits the purchase of foreign currency by commercial banks for personal use), then a rise in the dollar rate of 1% will lead to a rise in expenditures by credit organizations of 175 million rubles. For example, in the event of a 10% devaluation, balanced banking system profits will fall to zero. A fixing of the exchange rate higher than 7.15 rubles/dollar will lead to working losses for 1998 among most commercial banks.

A sharp rise in the ruble exchange rate will lead to a significant decrease in proprietary funds among credit organizations; a fixed exchange rate of 9.5 rubles/dollar will lead to a fall of 7-7.5%, and a rise in the dollar rate higher than 12 rubles/dollar will lead to a fall of at least 13%.

However as was mentioned previously, ruble devaluation will have a serious impact upon commercial banks, although measures intended to support ruble stability might lead to much more serious consequences, including the total liquidation of Russia’s banking system.

In these circumstances the Central Bank should either release or fix the dollar rate. In case of the latter, a number of measures would follow including the freezing of funds located in private investments and deposit accounts, the limitation of access to foreign currency, and the imposition of mandatory 100% sales of export revenues among others.

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It is likely that in the course of restructuring, investors will be assessed taxes. However funds reinvested in new paper will be free from taxation.

The remaining 95% of debt will automatically be converted into new security issues. The conversion period runs until September 26. In the course of restructuring the GKO/OFZ market, investors may exchange 20% of their paper for new securities denominated in US dollars with a 5% yearly coupon and maturation in 2006. The remaining debt will be converted in equal proportions into ruble securities with maturation after 3, 4, and 5 years with coupon payments of 20-30% interest. The owners of government securities can also obtain Sberbank deposit certificates issued with the same conditions.

The option to convert GKOs into deposit certificates most likely supplements the plan to transfer public deposits from commercial banks to Sberbank. This makes possible a plan to transfer public deposits and at the same time redeem deposit certificates (further accounting will take place between the Ministry of Finance and Sberbank). However there has been no official commentary regarding this possibility.

The announced exchange of government securities does not cover obligations belonging to private individuals. Their obligations will be fulfilled on time (the overall volume of private investment in government securities is valued at 2 billion rubles, or less than 1% of the total debt). The long-term restructuring of government securities located in the Central Bank’s portfolio will be treated separately. According to nominal value, the volume of GKO/OFZs in the Central Bank’s portfolio amounts to about 130 billion rubles (including coupon payments). An additional 50 billion rubles will go toward redemption of securities not traded on the market.

All purchase and sale operations involving converted securities will be suspended until their redemption date. Additionally, the Ministry of Finance has the right to impose limits on the trading of new government securities issues on the secondary market.

As a result of the exchange, the nominal debt volume will decrease purely as a result of the 5% cash payment for immediate redemption, as well as for the 20% conversion of ruble obligations into foreign currency-denominated securities. Additionally, according to the precise parameters of the new debt, we must subtract the Central Bank’s share (about 28%) from the old debt. Taking these suggestions into consideration, the new debt may amount to 217 billion rubles, and including coupon payments, 420 million rubles. The structure of the new debt (not including paper belonging to the Central Bank) will be roughly according to the following: a little more than 40% of the paper will be located in non-resident portfolios, a bit less (36%) will belong to Sberbank (growth in its share may occur as a result of the deposit certificate plan), and the remaining 20% will belong to commercial banks and legal entities. According to preliminary analysis, the average term of aggregate debt may rise from 452 days to 3.5 years.

In the event of a conversion of 20% of GKOs into foreign currency-denominated securities, the volume of foreign debt will rise by about $3.5 billion, and the size of yearly coupon payments will amount to about $170 million.

It is presently rather difficult to speak in terms of a secondary market. First of all, its creation presupposes certain limitations of which nothing concrete is yet known. Secondly, the establishment of the parameters of these new securities reflects a clearly non-market orientation. In the course of secondary trading, these securities will fall considerably in value. Moreover, in the complete absence of demand, the number of investors wishing to sell them at any price will be rather large.

An alternative means of creating a secondary market has been suggested through the Central Bank’s plan to issue “short” obligations (a complete analogue to GKOs, but this time the Central Bank is the issuer) for the support of banking system liquidity. The first auction of 1 billion rubles worth of these new securities (which will trade on MICEX) is planned for September 2. The maximum volume of this market (i.e. the maximum volume of paper that may circulate on the market at any one time) is limited to 10 billion rubles, and the maximum term of circulation is limited to 3 months.

These new securities may only be purchased by credit organizations with a Central Bank license. For banks, these securities may also serve as deposits for the reception of Central Bank credits. In this sense, the Central Bank is counting on the possibility that the purchase of these new GKOs will be more preferable for banks than the purchase of foreign currency. In our opinion, such a plan to bring the banking system out of the current crisis appears to be very reasonable. Moreover, one may conclude from this that the preservation of a functioning banking system is a Central Bank priority. Unless some political decision fundamentally alters the entire financial system, the creation of such a market may be the first step toward normalization of the situation.

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The fall in the capitalization level of Russia’s equity market over the past five days is estimated to be over 18%. The naming of Victor Chernomyrdin as acting Prime Minister passed through the market rather quickly. Over two trading sessions, the market grew by 8%, and Gazprom shares in particular by 58%. In the middle of the week, following the announcement of the details regarding the internal debt conversion and the subsequent sharp devaluation of the ruble, a flight out of Russian equity instruments ensued. Between August 26 and 28 the fall in prices for the most prominent national companies amounted to 25%. On August 27 the equity market registered a new historical low (since the creation of an “organized” equity market) as represented by an RTS index of 63.2 points.

Massive sales of internationally traded securities led to a 7% fall in the value of ADR/GDRs (-30% since August 17 alone).

Indicators of equity market activity (the volume of trade and the average market spread) point to a global decrease in market liquidity. The weekly trading volume decreased in relation to the previous month’s average by a factor of three, to $26 million ($5.2 million/day). The second indicator (average market spread) tripled to a level of 500-600%; for the most liquid assets this indicator reached 35%. Market participants’ imposition of limits on most counteragents (on average each market participant has three) sharply reduced both the possibility of arbitrage and the speculative attractiveness of the equity market as a whole.

In this sense, the modern corporate securities market closely resembles the equity market circa 1995, in terms of price levels, trade volumes, and the number of liquid instruments and primary export-oriented branches (oil, gas). Frankly speaking, a return to a starting position was officially registered on August 28 by the National Association of Equity Market Participants following their announcement of the creation (beginning September 1, 1998) of an institute of primary market participants and a registry of these participants’ securities.

In accordance with the changes in trade rules (entering into force September 1, 1998), primary participants must place limits on each other of $200 thousand. Primary participants must support two-way quotes and minimum trade lot size (no less than $30 thousand for liquid securities and $10 thousand for all others). The list of equity shares belonging to primary dealers includes shares that comprise at least 1% of overall trade volume over the previous three months. The list of new primary participants includes Alfa Capital, Credit Suisse First Boston, Brunswick Warburg, United Financial Group, Regent European Securities, Rinaco Plus, and Troika Dialog. The list of securities traded by primary dealers includes Unified Energy Systems (ordinary and preferred), Lukoil, Mosenergo, Surgutneftegaz (ordinary and preferred), Rostelekom, Irkutskenergo, Tatneft, and Sberbank.

The creation of an institute of primary dealers implies an attempt to create a new equity market identical to the old one. Shares reacted favorably to this news; prices rose on Friday, August 28 by more than 5%.

However this initiative is likely to end in failure. After all, the equity market in 1995 was created on the basis of functioning banking system flows and rising industrial equity liquidity (the spread for the most attractive securities on RTS at the beginning of September 1995 amounted to 8% and at the end of August 1998 to 35%). Moreover a dependable class of investors ready to put their savings into Russian securities was already forming. The institute of primary dealers was originally intended for the most part to insure the risk of non-fulfillment of obligations to equity brokers.

Today, a totally different situation has developed on the equity market. What is lacking is not mutual trust among professional market participants, but a normal “circulatory” system (i.e. commercial banks, which assure monetary payments). Will this new financial institute function at all on the wreckage of the old banking system?

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