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The second program is filled with pessimistic macroeconomic forecasts, unclear goals, and a lack of resources for their achievement. For example, the plan suggests no significant monetary emission and to keep the rise in prices by January to a minimum. To fight renewed inflation the plan calls for a confiscatory restructuring of the GKO market, the lowering of social expenditures, the restoration of cooperation with the IMF, and the continuation of privatization.

According to what VEDI experts know of the first plan, it was put together several years ago with the goal of supporting Russian enterprises and is filled with a number of measures intended to overcome the current financial crisis. In part, the plan mentions the wholly justified suggestion to admit the mistaken nature of the August 17 governmental decisions and to restore secondary trade and payments relating to state securities. According to this document, a monetary emission (necessary to liquidate budgetary wage and pension arrears as well as to overcome the banking liquidity crisis) may occur via the provision of direct Central Bank credits to the Ministry of Finance or through the Central Bank’s purchase of GKO/OFZs on the secondary market.

The authors of the first program have over the past several years supported the view that the monetarization of the economy would lead to a revival of economic activity. However the events of the last few months have significantly complicated the realization of this plan due to 1) the changed structure of the money supply, 2) the public’s penchant for savings, 3) the rise in inflationary expectations,  and most importantly 4) the severe problem of the ruble exchange rate (more precisely how to contain its growth). With this in mind the plan also contains a large section dedicated to changes in currency regulation and the strengthening of currency control.

Nonetheless, the fact remains that there are only two ways in which events may develop. Either international financial organizations will continue to provide credits in current or even greater volumes, or centralizing measures will be applied to limit demand for foreign currency. There is reason to suggest that the choice of scenarios will be in favor of the IMF in so far as the Russian government lacks a similar choice.
 
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During all of last week the dollar rate fluctuated within a very narrow range of 15.5-16.2 rubles/dollar. Similar stability on the currency market last week was achieved as a result of the mid-September stimulation of exporter currency revenue sales (which even allowed the Central Bank to replenish its foreign exchange reserves, from $12 billion on September 18 to $12.4 billion on September 25). This stability was also the result of the actions of the Central Bank and the total uncertainty regarding the government’s chosen economic course.

Based upon the recently published anti-crisis program, the regulation of Russia’s currency market through market mechanisms is currently practically impossible. It has been suggested that either the ruble exchange rate be fixed, or that non-market mechanisms be employed up to and including a ban on the free circulation of US dollars within Russia.
 

Last week’s decision to introduce different exchange rates within Russia exemplifies this shift away from market regulation of the currency market (particularly the announcement of special trading sessions on MICEX beginning October 6). It should be remembered that at the end of September the Central Bank approved a regulation (No. 57, as of September 28, 1998) “Regarding the rules and conditions of US dollar-ruble trade during special trading sessions on the interbank currency market”. According to this document the fixing of a “commercial rate” will occur based upon the conversion of funds received as a result of foreign trade activity. The supply of US dollars (currently the only foreign currency to be traded during these sessions) will be formed as a result of the obligatory sale of a portion of exporter revenues. US dollars will also be sold through authorized banks in their name or via client orders. Unlike the supply of foreign currency, demand will be strictly limited during these new trading sessions. Aside from the purchase of US dollars for import contracts, commercial banks will have the right to obtain foreign currency to fulfill client orders through operations that do not fall under the debt moratorium (including the paying of dividends or other interest relating to shares and portions of fixed investment, or the redemption of financial credits provided with a guaranty from foreign governmental organizations that insure export credits). Otherwise, during these sessions authorized banks will be allowed to purchase US dollars to make foreign currency payments to private individual accounts opened in these banks.

Most likely, these sessions will occur under the direct control of the Central Bank, which will intervene to compensate for any imbalance between supply and demand. In this respect one can already speak of the beginning of a fundamental change in the Central Bank’s currency policy. What will be the next decision by the Central Bank’s management? Will it be the next step on the path to limiting the free circulation of foreign currency within Russia?

One might answer these questions by examining the complex discussion of several points of the “official” program. “The purchase of foreign currency from the public will occur without limit at the cashier’s offices and exchange points of credit organizations”. Nothing here is said regarding the sale of foreign currency to the public through commercial bank exchange points. Moreover, one must consider the rumors (subsequently denied) that began on October 1 regarding the President’s support for an idea put forth by Sverdlovsk Governor Eduard Rossel to band the free circulation of US dollars within Russia. This is all somewhat alarming; it is possible that as a result of the implementation of a “command-administrative” policy, the ruble exchange rate will be fixed at between 9-10 rubles/dollar, which would correspond to the “first scenario” of Victor Gerashchenko’s plan (see “Kommersant-daily”, No. 178, September 25, 1998).

However one would hope that the new Russian government will continue the “path of reform” despite the cost of a further rise in the ruble exchange rate (inevitable following the freezing of state securities and the restoration of Russia’s payments system).
 
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Last week, hope appeared for holders of state securities (frozen for more than 1.5 months) in the form of the restoration of a functioning GKO/OFZ market (mentioned in a published plan of immediate measures to overcome the financial crisis). Despite the fact that the government considers the published program to be merely one of many possible variations, and that most of its points were sharply criticized by the government itself, in part (particularly concerning the restructuring of domestic debt) the program may well be implemented.

Measures suggested in this document include a repeal of the decisions taken on August 17, although such an intention is not stated explicitly. Nonetheless, the restoration of secondary GKO/OFZ trade is suggested in order to raise banking system liquidity. Moreover, the Ministry of Finance is instructed to purchase securities on the secondary market with funds transferred from the Central Bank (i.e. a targeted emission). Similar actions appear entirely logical and necessary provided that the government makes a preliminary admission that the decisions of August 17 were illegal.
 

If this happens (i.e. if the program actually suggests the repeal of previous decisions and the restoration of the GKO/OFZ market in its pre-August 17 form), one can begin speaking of the maintenance of equal rights for both residents and non-residents, an equality that foreign investors insist upon. Additional possibilities available to several groups of investors (for example insurance companies or industrial enterprises) as a result of this suggested scheme should not be a source of alarm for non-residents; even before August 17 foreign investors were limited with regard to their operations with state securities, particularly their inability to engage in repo operations.

Another scenario regarding the GKO/OFZ market flows from potential budgetary legislation for the 4th quarter, which was presented to the IMF last weekend. This envisions an 85 billion ruble decrease in debt to non-resident GKO/OFZ holders (i.e. the portion of their debt falling under the restructuring scheme) and a corresponding increase in foreign debt by exchanging GKOs for currency obligations. There is no further clarity regarding domestic investors.

In any event, the likelihood of a restoration of a functioning GKO/OFZ market grew significantly over the past week. As a result, changes on the currency market introduced by the Central Bank (part of the plan to limit currency purchases by commercial banks) allows one to suggest that it will be impossible to direct funds received from the redemption of GKO/OFZs in full measure to the currency market. Undoubtedly however, a portion will be converted into US dollars. Another means of investing these funds is via Central Bank obligations (OBRs).  This market is currently in a formative stage. On September 30 (i.e. one month following the announcement of the issue of OBRs) the Central Bank managed to place an issue at a primary auction (previously these securities were only placed on the secondary market or exchanged for GKOs). The volume of the issue was about 20 million rubles, almost totally compensating the issuer for the cost of redeeming 5th series obligations that day. The volume of trade on the secondary market currently amounts to about 10 million rubles, and averaged-weighted interest rates are between 75-80%.

The prospect of growth for the securities market (with either the Central Bank or Ministry of Finance as issuer) currently depends entirely upon the government’s monetary-credit policy. When the reference points regarding a large-scale emission or a rise in prices are uncertain, it is hardly possible to evaluate the attractiveness of purchasing securities, even if investor confidence in ruble assets were to be restored.
 
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The most noteworthy event last week with the potential to influence the condition of the world’s emerging markets (including Russia) was the September 29 decision by the US Federal Reserve’s Open Market Committee (FOMC) to lower a basic short-term interest rate (the Federal Funds Rate) by 25 basis points, from 5.5% to 5.25%, and to leave the discount rate unchanged (5%). However a majority of market participants expressed disappointment with the FOMC’s decision, having earlier suggested that this basic credit rate sould be lowered by at least 50 basis points. A great majority of world equity indexes fell as a result, and prices grew for the state debt securities of industrialized countries (interest on US 30-year Treasury bills fell to a record low of less than 5%).

Therefore, the FOMCs decision to lower this interest rate failed to alter the direction of international investment flows resulting from the world economic crisis. Due to investment losses in emerging markets and world equity markets, the currently preferred instruments of financial investment remain the debt obligations of leading world powers.

At the same time, analysts see a clear justification for this “modest” lowering of rates by the FOMC as a direct result of the US economy’s 1998 macroeconomic indicators. For example, growth in average income reached its highest level in 10 years, 1998 unemployment was the lowest in the past 30 years, and year-on-year growth in GDP for the first half of 1998 was over 3%. Given these conditions a further lowering of interest rates might lead to an overheating of the economy and form the basis of an economic-financial imbalance. Nonetheless, judging by the mood of prominent investors in US business circles, one should not exclude the possibility that a policy of lower interest rates will continue until the end of 1998.

On October 3 the IMF’s board of directors began its yearly meeting and discussed its lending policy with regard to Russia. Depending on its decision, the prospects for the development of Russia’s economy until the end of 1998 will assume greater or lesser clarity. However a majority of observers believe that over the next two months the chances of an inflow of IMF credits into Russia are slim.

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Unfortunately, our hope that the inherent potential of Russia’s equity market would be at least partly realized was misplaced. Current trade in blue chip Russian companies has been reduced to the display of indicative quotations and appears as nothing more than a business computer game. The management efforts of national issuers (intended to support the market liquidity of their corresponding shares) deserve respect, but given conditions of general economic chaos they cannot lead to an improvement in the market situation. The programs presented for public judgment entitled the “Program of immediate measures to lead the economy out of financial-banking crisis” (created on the initiative of a group of Russian academics and supported by First Deputy Prime Minister Yury Maslyukov) and the “Anti-crisis program of action” presented by the well-known economists Yegor Gaidar, M. Dmitriyev, V. Mao, A. Ulyukaev, Yakov Urinson, and Yevgeny Yasin unfortunately completely ignore the laws and specifics of the development of an equity market. This development has two foundations, the role of foreign investors regarding investment in Russia’s fuel and energy complex and their investment goals. The liquidation of offshore companies and offshore zones within Russia, the tightening of rules governing the circulation of foreign currency within Russia, the raising of the tax burden upon oil and gas companies- all of these neutralize activity upon which investment in Russian shares might be based.

The corporate securities market, previously seen as an independent and self-regulating financial structure, is today in need of governmental support. This might take the form of a stimulation of portfolio investment flows via a total repeal of taxes on profits from equity operations, liberalization of the servicing of equity turnover denominated in foreign currency, the unfreezing of investment projects (including expensive ones such as production sharing agreements) which in some fashion are connected to participation with the fixed capital of Russian companies, etc. Given a lack of these or other emergency measures the very existence of the equity market is useless and the servicing of its infrastructure exceedingly expensive.

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