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A currency board provides for strict conformity between hard currency reserves and the amount of national currency issued by the Central Bank (i.e. the wide monetary base, which equals cash in circulation + commercial bank obligatory reserves + amount in correspondent accounts at the Central Bank). Growing confidence in the national currency as a result of its complete convertibility into hard currency at a fixed exchange rate is usually the most positive outcome of a currency board.

The major negative effect of a currency board is the Central Bank’s inability to conduct an independent monetary policy. The main obstacles to its introduction include the huge volume of inter-enterprise debt and barter, as well as the fact that Russia is not a small open economy, for which the introduction of a currency board has traditionally been most appropriate.

In addition to Chernomyrdin’s plan, other scenarios are also possible. The most radical one provides for tight government control over the exchange rate and prices. Elements of tighter centralized control are contained in his proposed plan, in particular the introduction of a state monopoly on the sale of alcohol. Interestingly, another element of such a strategy - full government control over export revenues - has not been mentioned. In any event, all scenarios seem to suggest a transition from a market-oriented model to a mixed economy with tighter government control.
 

Last week, trading in US dollars resumed on MICEX, electronic fixing procedures were introduced, and a single market rate began to be quoted. On September 4, the dollar rate was 16.99 rubles/dollar and on September 7, 18.9 rubles/dollar. Higher rates (about 20 rubles/dollar) were observed during trading on the SELT system, in which the Central Bank participated only minimally. In light of this, investment in foreign currency is currently extremely lucrative. Last week, such operations yielded a profit of no less than 2500%.
 

The question of private individual bank deposits is yet to be resolved. The State Duma’s “Law on Guarantees for Citizen Deposits and Ensuring Stability” forbids the conversion of deposits into another currency without the depositor’s permission. This may slightly decrease the outflow of funds from the banking system and reduce tension on the foreign exchange market.

The practically uncontrolled growth in prices and the dollar rate against the background of decreasing gold and foreign exchange reserves (which amounted to $12.7 billion at the beginning of September) makes it necessary to implement emergency measures. One way to stabilize the situation is the introduction of a currency board. The media has already reported (although not officially confirmed) that Victor Chernomyrdin will take cues from the Argentinean experience when pursuing his economic policy. If so, the implementation of an anti-crisis program will be accompanied by a ban on the Central Bank to print money not backed by gold and foreign exchange reserves. This means that given the existing monetary base and gold and foreign exchange reserves (at the beginning of September), the dollar rate must be fixed at 12.5 rubles/dollar, or 13.5 rubles/dollar if the wide monetary base is taken into account. Such rates are much lower than the current official exchange rate (18.9 rubles/dollar).
 
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Three weeks have already passed since the GKO/OFZ market was frozen. Over that time, the Ministry of Finance made no redemption payments and no secondary trading was conducted on MICEX. Commercial banks (which are major holders of government securities accounting for a significant portion of their assets) were bound to fulfill all their obligations to individual depositors and legal entities. The proposed GKO/OFZ debt restructuring scheme (which has yet to be approved by the government) cannot help banks resolve their current liquidity problems. The Central Bank refuses to lend to banks against securities whose future value is unknown. Instead, the Central Bank offered its own securities. Unfortunately, it failed to sell these two-week bonds last week. Acceptable yields for banks participating in the auction ranged from 200% to more than 1000% per year, while yields offered by the Central Bank during a secondary trading session ranged from 60-80% per year.

At the same time, the cost of state debt redemption fluctuated significantly. When the debt was frozen, the monetary authorities explained their action by saying that they had no resources for its servicing. The ruble devaluation over the past two weeks led to a significant increase in prices. Therefore, debt servicing is now two to three times less costly for the government. Furthermore, price growth makes a monetary emission inevitable. Under such conditions it would be a logical step to go ahead and fulfill obligations to government securities holders (it would also be possible to redeem “short” GKOs before maturity because bank portfolios containing GKOs to be redeemed before the end of the year amount to less than 50 billion rubles). Financially, such measures could help normalize the situation in the banking sector. Strategically, such actions could be even more important. Over the past two years Russia has tried to create the image of a reliable borrower. As part of this, Russia assumed the Soviet Union’s and czarist Russia’s debt obligations. A decision not to pay GKO/OFZ holders would prove that all these efforts were in vain, whereas normal repayments would salvage the possibility of future foreign investment.

Returning to the GKO/OFZ market, one should note that even in the event of government securities redemption, the question of further movement of these funds will automatically arise. It seems likely that certain limits on the conversion of these funds into foreign currency will be imposed upon Russia’s banks. This in its turn implies the imposition of limits on banks’ foreign currency-denominated liabilities, including individual deposits. In our opinion, such measures will be needed to prevent limitless growth of the exchange rate and inflation.

The probability today that GKOs and OFZs will be unfrozen is rather high. At the same time, it is clear that the proposed scheme, as well as any other schemes, will be worked out only following the approval of a new Prime Minister.

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Domestic political and economic developments failed to provoke any changes on the MinFin market. In actuality, the market is non-existent. Indicative price quotations range from 5 to 27 points, corresponding to yields at maturity amounting from 44% to 1100% per year in US dollars. Traders’ worries that the government’s default on ruble-denominated securities will lead to a similar scenario in the market for foreign currency-denominated securities sent the MinFin market into a coma. According to independent analyst estimates, Russia’s debts due before the end of 1998 now amount to $6 billion. Of this, more than $950 million is in the form of interest on Eurobonds and restructured debt to the London Club of creditors. Because foreign exchange reserves are limited (Russia’s reserves amounted to $12.7 billion on August 28, 1998), payment of such a large amount will be a difficult task. This is particularly so considering the acute contradictions between the IMF and Russia’s government regarding the disbursement of the second tranche of the IMF’s stabilization loan. This significantly increases the risk of default on MinFin bonds and effectively makes this instrument a pariah on the international capital market. It’s no wonder that according to Standard & Poor’s, Russian securities have the lowest credit rating in the world.
 

A sharp decline in MinFin prices caused market capitalization to fall to $3.2 billion, from $18.3 billion at the end of July 1998. Moreover, one can safely assume that the situation on the MinFin market will not change in the near future. It may even worsen slightly if Russia defaults on any of its foreign loans. If this happens, purchase prices will no longer be quoted. The market’s response to the formation of a new government is likely to be delayed until it produces a realistic economic plan.

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Analysts who twelve months ago predicted the rapid growth of Russia’s equity market can hardly be accused of non-professionalism. It is also wrong to say that experienced businessmen who took their advice and invested in Russia’s equity market had no intuition.

In the middle of 1997, the international financial community was rather enthusiastic about the International Finance Corporation’s preparation to include Russian shares in the calculation of its stock market index, known as the IFC Investable. The expectation of this inclusion prompted growth on Russia’s equity market for several months. On November 3, 1997 Russian shares accounted for nearly 5.6% of the total emerging markets capitalization included in the calculation of this index, a share much larger than initially expected. It put Russia in sixth place following other emerging markets, such as South Africa, Mexico, Brazil, Malaysia and Taiwan. It also meant that from that moment onward, investment funds operating with emerging markets (whose total capital amounted to several billion dollars) would invest at least 5.6% of their funds in Russian corporate shares. According to Vedi analyst estimates, at that time foreign investments in Russian shares amounted to between $6 and $7 billion.
 

Russian share prices have declined by more than 90% since then. On September 4, 1998, Russia’s major stock-market index (the RTS index) declined to 60 points, compared to 570 points in August 1997. Last week alone Russian share prices decreased by 8%. Shares in the world’s largest gas producer Gazprom, which cost $1.5 to $2 a year ago, now cost less than 8 cents. Shares in Russia’s monopoly electricity supplier UESR (in which non-residents invested 20 to 30 cents per share) now cost only 2 to 3 cents. LUKoil shares cost $3.50 (compared to $20 in 1997), Mosenergo shares cost 1.4 cents ($1.34 in 1997), and Rostelekom shares cost 60 cents ($3.1). Equity market liquidity indicators (trading volumes and the average market spread between purchase and selling prices) show that there is no interest whatsoever in Russian shares despite their meager prices. The volume of trading on RTS amounted to about $1.5 million last week, compared to $120 to $130 million a year ago. The average market spread grew to 800%, compared to 4-5% last year.

Russian and Western financial institutions are now frantically trying to restore or at least maintain the existing structure of Russia’s financial market. Current proposals range from offering apologies to investors and returning their money to applying the Argentinean model in an effort to stabilize Russia’s economy.

Under such conditions, it is senseless to rely on Western aid. Russia will be associated with default for a long time. Foreign investors whose interests clashed with Russian realities will undoubtedly be more cautious and as a result, Russia’s equity market will develop at a much slower pace.

The 1998 average market value of MinFin bonds, Eurobonds, and rescheduled debt to the London Club of creditors.

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