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On Friday, the draft emergency budget for the 4^th quarter of 1998 was published (it appears as though the newspaper Kommersant, where the plan was published, is becoming a public platform for the airing of official documents). This document was astonishing because it showed that documents that contradict each other are periodically being released from the Ministry of Finance. This plan admits the unreality of the current 1998 budget and the related worsening of the situation surrounding tax collection (as opposed to Mikhail Zadornov, former member of the Kiryenko government, who pointed to a noticeable rise is tax revenues following the passage of the economic and financial stabilization program). It also makes reference to the necessity of minimizing budgetary expenditures. At the same time it notes that the actions of the government and Central Bank should be focused on the minimization of inflation insofar as “the rise of inflation and the related indexing of wages, pensions, and other payments in the budgetary sphere will lead a strengthening of the budgetary imbalance and a hyper-inflationary spiral”.

We would note that inflation and accelerated ruble depreciation raises budgetary revenues, both nominal and real. On the other hand, in this situation real budgetary expenditures are declining and will become more balanced (taking into account current indebtedness, one cannot even begin to speak of the indexing of wages). This result will be achieved by lowering the public’s and government enterprises’ real incomes. This situation is complicated by the implementation of expenditures connected with the servicing of Russia’s external debt. Given a rising exchange rate, more and more funds become necessary. However it appears as though the government, as it did in previous years, intends to decide this problem via external credits. If they are not received, the government intends to announce a restructuring of its foreign debt (i.e. default).

Therefore, the emergency 4^th quarter budget indicates that by the end of the year the government intends to correct its finances and pay off all its wage arrears. This will be accomplished at the expense of the population, enterprises, commercial banks, and foreign investors. However this would also allow the government to fulfill at least one task- the normalization of the banking system. Unfortunately tax collection will be lower than even the most pessimistic forecasts.
 
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Several expert forecasts regarding the fixing of an exchange rate lower than the market rate during special trading sessions on MICEX turned out to be inaccurate. The rate for “today’s” dollar on October 6 was fixed at a level of around 16 rubles/dollar. Meanwhile the danger of a difference between the dollar rate during special sessions and that during regular sessions is starting to become clear. On October 6 the difference between the ruble exchange rate for today and that for tomorrow amounted to about 0.5%, but by the end of the week it amounted to almost 2%.

The results of the first special sessions were virtually unchanged from those on MICEX previously. Trade volume over the first three days amounted to a bit less than $200 million (about $62 million/day, with an average trade volume for last month of an even $65 million).
 

During the past week a change in the relationship between supply and demand for foreign currency occurred on the cash segment, exemplified by slightly more active purchases of US dollars by the Russian public.

The rate of the official dollar rate’s growth during the period under review slowed somewhat; over the past week it even declined by 0.8% and on October 10 was fixed at a level of 15.84 rubles/dollar. Since the beginning of the year the ruble exchange rate has risen by 165.8%, and the emergency 4th quarter budget for 1998 envisions yearly growth rate at between 235% and 370% (an optimistic government scenario envisions a rise in the dollar rate to 20 rubles/dollar by the end of the year, and according to a pessimistic scenario, to 28 rubles/dollar).

Although there is currently no hint that the government is considering the notion of a currency board regime, rumors occasionally creep into the mass media regarding the potential use of this model as a possible means of Russia overcoming the current economic crisis. For example, at the beginning of October the increased level of the country’s gold and foreign exchange reserves (estimated on October 2 at $12.8 billion) allowed the Central Bank to fix the ruble exchange rate at a level slightly above 15 rubles/dollar).

Next week will most likely not see any significant changes on the currency market. On the eve of the accounting date for forward contracts for a majority of participants on the Russian market, a high dollar rate would be disadvantageous. The likelihood of a repeat of the September scenario is high; insignificant growth (or even decline, as occurred a month ago) of the exchange rate before the 15th of the month, and accelerated growth following October 15.

In the near term the Central Bank’s currency policy may proceed in different directions. As has been noted, the market is currently witnessing growth in the difference between the “commercial” ruble exchange rate (fixed during special sessions) and the market rate. Given this upward trend the Central Bank may either 1) permit a rise in the commercial rate, 2) support the market rate through intervention (particularly since the basic supply of foreign currency is formed during special sessions), or 3) tolerate further growth in this difference and proceed with arbitrage operations.
 
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Despite the fact that the final GKO/OFZ restructuring plan has not yet been presented, the 4th quarter emergency budget for 1998 includes several figures related to the servicing of domestic debt. Above all, the volume of funds to be paid on frozen GKOs amounts to 12 billion rubles, which is even less than envisioned in the first restructuring scheme. The plan also notes the necessity of redeeming obligations (i.e. offering more advantageous conditions compared to other investors) belonging to pension funds and insurance companies that were forced to purchase state securities. Non-residents will be offered the option of exchanging their frozen debt (85 billion rubles worth) for currency-denominated obligations. If this option is not chosen, non-residents will not be able to convert funds received from GKO redemption into currency for a period of six months.

Russian investors and commercial banks in particular (which for over two months have been deprived of a liquid and dependable ruble instrument, such as the old GKO/OFZ) are gradually becoming acclimated to the new OBR market. Last week the volume of operations with this instrument grew significantly. Over the course of the week, turnover amounted to more than 600 million rubles compared to less than 100 million rubles the week before. However this large volume was mainly the result of Central Bank secondary market placements and early OBR redemption, with an overall volume of about 416 million rubles. As a result of these operations the volume of OBR debt rose to 1.96 billion rubles at nominal.
 

During the past week a relatively significant fall in OBR interest rates occurred; at the end of the week, average-weighted yields amounted to slightly more than 60% compared to 76% the week before. In our opinion there are several objective reasons for these positive changes. First, the imposition of limits on the purchase of currency by commercial banks raised the potential volume of funds that might by directed toward the OBR market. Second, having estimated that the likelihood of significant growth in the exchange rate before October 15 is not very high, market participants may choose to invest free resources in ruble instruments during this period. And third, it is highly likely that the Central Bank is currently placing some of its paper by purchasing GKOs from banks, which thereby raises the attractiveness of OBRs.

The future situation on the OBR market will depend upon the ruble exchange rate and the degree of the Central Bank’s activity during the exchange of GKOs for its own paper (if indeed this takes place). An increased devaluation rate will sharply lower the attractiveness of OBRs. According to budgetary calculations for the 4th quarter of 1998, the ruble exchange rate at the end of the year may amount to 20 rubles/dollar (optimistic variant) or 28 rubles/dollar (pessimistic variant). Interest rates for ruble instruments should be at a corresponding level of 120% or 360% respectively (or somewhat lower, given the placement of “short” paper). This will hardly satisfy the Central Bank. A different path of market development would involve the Central Bank’s offer of resources for banks to acquire OBRs. In this case, it would be possible to maintain current interest rate levels.
 
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The basic topic of discussion in Russian financial circles last week was the problem of the relationship between Russia and large international financial organizations. A Russian delegation was invited to the 53rd annual meeting of the IMF and World Bank, which occurred in Washington between October 6-9. Attention was mostly focused upon the question of how to overcome the world financial crisis. A leitmotif of this discussion was the problem of how to avoid the collapse of Latin American financial markets, a traditional object of investment on the part of many American and Western European companies. However Russia’s difficult economic situation was not discussed separately at this meeting.

The purpose of Finance Minister Mikhail Zadornov’s and Central Bank chairman Victor Gerashchenko’s visit to Washington was to negotiate with the management of the IMF and World Bank regarding the approval of the next credit tranche. The crisis of Russia’s financial-economic system and the lack of a unified government program to tackle it forced the Russian representatives to lower their requested amount of aid from $6 billion to $2.5 billion. According to media reports, this money will be used directly to repay Russia’s foreign debt (i.e. in practical terms the Russian government will not be in charge of these funds).

Nonetheless even the reception of this amount of credit will only slightly lower the probability of Russia’s default on its external debt in 1999. If the IMF and World Bank refuse to approve credits this year, the Russian government intends to use the Central Bank’s gold and foreign currency reserves for external debt payments. By the end of 1998, budget funds amounting to $3.2 billion are to be used for this purpose. According to analysts, the future possibility of Russia servicing its external debt (payments on Russian foreign currency-denominated securities will amount to almost $5 billion in 1999 alone) will directly depend upon the form and character of economic reform pursued by the new government.
 

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The unexpected rise in the securities quotations for Gazprom resulted in corresponding spontaneous growth in shares for other industrial enterprises. Basic investor demand was centered on shares in companies with branches similar to those of Gazprom; over the course of three days the shares for UES Russia grew by almost 20%, for LUKoil by 25%, for Mosenergo by 96%, and for Tatneft by 50%.
 

This upward trend on MSE’s equity segment turned out to end as swiftly as it began. On Thursday, October 8, Gazprom’s share price plummeted by 22% and during Friday’s trade by an additional 18%. During the middle of trade on October 9, deals involving shares of this gas company were completed on virtually the same terms as they were the previous week, 69 kopecks, or 4.4 cents (the closing price on this day was 92 kopecks). Likewise, as a result of the fall in the value of Gazprom paper, share prices for the above-mentioned companies also fell. However, their dynamic at the end of the week showed more inertia than at the beginning. The 4% fall in the RTS equity index on Thursday, October 8 was compensated by an almost equal rise during the week’s last trading session on Friday. In total for the week, market price growth moved into positive territory, amounting to +9%.

Market participants identified the reason behind this rise in share prices as an agreement between the government and Gazprom’s management providing for a widening of the mutual payments (and/or barter) scheme governing debts for gas deliveries to budgetary enterprises and Gazprom’s tax payments to budgets at various levels. In our opinion, successful lobbying of the new government by this gas monopoly was not a factor underlying this sudden swing in the equity market.

In our opinion, these sudden changes in the price indicators for Gazprom were the result of its attempt to exert artificial pressure on the market for its equity assets, assuring itself of the possibility of independently determining its value. This suggestion appears rather likely on the eve of an auction to sell a 5% (or perhaps 15%) government stake in the company’s shares at the end of 1998. This is particularly so if Gazprom is forced to attract investors alone, since similar capabilities on the federal level (i.e. on the part of the Russian government) are currently lacking. Unfortunately, we were unable to receive some sort of confirmation or denial from Gazprom’s management regarding this possible active corporate intervention. However we leave open the possibility that this indeed occurred. In this context one can suggest two possible versions of what occurred on this equity segment:
 

1. The first suggests that Gazprom (as the largest operator) made a “show of strength” via the intensive purchase of shares at the beginning of the week and a sharp liquidation of its position on Thursday-Friday. As the results show, at current price levels the simultaneous purchase of 35 million shares over the course of three days can raise the share price by 75%. This amount of shares represents 0.15% of the overall amount issued by Gazprom. Therefore on the eve of auction negotiations, Gazprom can easily raise the value of its sale assets several times. By the way, if such a “rehearsal” indeed occurred, then the company realized considerable profits- 2000% interest denominated in US dollars.

2. The second version suggests the following: Gazprom’s equity market policy reflects a medium or long-term character (i.e. Gazprom bought up its shares over the course of the entire week, created a heightened demand on the eve of the auction and simultaneously increased its own equity portfolio). In this case it must be noted that as an investor Gazprom did not take a loss. For the week, at a share price 30% higher than nominal, Gazprom managed to purchase more than 65 million of its own shares, or 0.27% of its overall equity assets.

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