The Russian Public Debt and Financial Meltdowns

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The Russian Public Debt and Financial Meltdowns Andrey Vavilov

The Russian Public Debt and Financial Meltdowns

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The Russian Public Debt and Financial Meltdowns Andrey Vavilov

© Andrey Vavilov 2010 All rights reserved. No reproduction, copy or transmission of this publication may be made without written permission. No portion of this publication may be reproduced, copied or transmitted save with written permission or in accordance with the provisions of the Copyright, Designs and Patents Act 1988, or under the terms of any licence permitting limited copying issued by the Copyright Licensing Agency, Saffron House, 6–10 Kirby Street, London EC1N 8TS. Any person who does any unauthorized act in relation to this publication may be liable to criminal prosecution and civil claims for damages. The author has asserted his right to be identified as the author of this work in accordance with the Copyright, Designs and Patents Act 1988. First published 2010 by PALGRAVE MACMILLAN Palgrave Macmillan in the UK is an imprint of Macmillan Publishers Limited, registered in England, company number 785998, of Houndmills, Basingstoke, Hampshire RG21 6XS. Palgrave Macmillan in the US is a division of St Martin’s Press LLC, 175 Fifth Avenue, New York, NY 10010. Palgrave Macmillan is the global academic imprint of the above companies and has companies and representatives throughout the world. Palgrave® and Macmillan® are registered trademarks in the United States, the United Kingdom, Europe and other countries. ISBN 978–0–230–24893–9

hardback

This book is printed on paper suitable for recycling and made from fully managed and sustained forest sources. Logging, pulping and manufacturing processes are expected to conform to the environmental regulations of the country of origin. A catalogue record for this book is available from the British Library. A catalog record for this book is available from the Library of Congress. 10 9 8 7 6 5 4 3 2 1 19 18 17 16 15 14 13 12 11 10 Printed and bound in Great Britain by CPI Antony Rowe, Chippenham and Eastbourne

Contents List of Figures, Tables, and Boxes

vii

Acknowledgements

xi

Introduction

1

1 The External Debt Crisis of the 1990s

11

Introduction

11

1.1 The Soviet debt

12

1.2 The Russian debt: beginning of management

25

1.3 External debt and macroeconomic policy

40

2 The Domestic Financial System and Inflation

50

Introduction

50

2.1 The origination of financial markets

51

2.2 Macroeconomic stabilization and public debt

69

2.3 The fragile banking system

78

3 Virtual Economy and Fiscal Crisis

87

Introduction

87

3.1 Virtual economy

88

3.2 Fiscal crisis

100

4 The Risks of Domestic Debt Expansion

121

Introduction

121

4.1 Dynamics of public debt in 1995–98

122

4.2 Domination of short-term debt

128

4.3 Opening the domestic debt market

132

Appendix A4.1

140

Appendix A4.2

142

5 The Causes of the Russian Financial Crisis of 1998 Introduction

144 144

v

vi

Contents

5.1 A brief history of the Russian crisis

145

5.2 The fundamental factors of the crisis

151

5.3 The Central Bank policy

157

6 The Debt Crisis and Default

164

Introduction

164

6.1 Failure to normalize the state budget

164

6.2 Belated debt management

167

6.3 17 August – the debt default

171

6.4 A post-crisis inflation trade-off

178

Appendix A6.1: A model of banks supporting devaluation

182

7 Recovery After the Crisis

187

Introduction

187

7.1 The results of the ruble devaluation

187

7.2 Fiscal discipline, consolidation and the end of financial chaos

194

7.3 The debt burden easing after the default

203

7.4 Conclusion

207

Appendix A7.1: Restructuring of obligations to the London Club

209

8 Yet Another Crisis, 2008–2009

213

Introduction

213

8.1 Two crises: how much in common?

214

8.2 Anti-crisis policy

226

8.3 Impact of the crisis

233

8.4 What is next?

235

Notes

237

References

256

Index

262

List of Figures, Tables and Boxes Figures

I.1

The real oil price, 1979–2008 ($/barrel)

1.1

The Soviet external debt and the oil price, 1970–93

14

1.2

Russia’s external debt payments and debt increase in the 1990s ($ billion)

38

Inflation rate and the consolidated budget deficits in the 1990s

43

IMF credits to the Russian government in 1992–98 ($ billion)

44

2.1

The CPI inflation and the nominal exchange rate in 1992

52

2.2

Refinance rate and inflation in 1992–94 (per cent per month)

57

2.3

Inflation and the ruble-to-dollar exchange rate in 1993–95

59

2.4

Foreign currency exchange regimes and inflation, 1995–97

73

3.1

Dynamics of arrears in 1992–98 (per cent of GDP)

89

3.2

One-dimensional model of transition

94

3.3

Two-dimensional model of transition

96

3.4

Federal tax arrears and tax revenue in cash (percentage of GDP)

104

4.1

Domestic debt in 1994–97 in GKO-OFZ (trillion rubles)

124

4.2

Dynamic of real debt in market instruments (trillion rubles, base December 1993)

125

4.3

Real annual GKO-OFZ yields (per cent)

127

4.4

The ratio of gross debt expenditure to budget revenue

127

5.1

The timeline of main crisis events

146

5.2

Real GKO yields and real ruble effective exchange rate in 1995–98

152

Oil price and RTS index

156

1.3 1.4

5.3

vii

4

viii

List of Figures, Tables and Boxes

5.4

Fundamental causes of the Russian crisis

157

5.5

The refinancing rate and the average GKO-OFZ yield in 1997–98 (per cent per year)

161

Official foreign currency reserves and net domestic assets ($ billion)

162

6.1

The nominal ruble exchange rate in 1998–99 (rubles/$)

179

6.2

Monthly inflation and the ruble devaluation in 1998–99

180

5.6

A6.1 Zero-devaluation equilibrium

185

A6.2 Two equilibria under dollarization

185

7.1

The dynamics of exports and imports of Russian goods ($ billion)

189

7.2

The price of oil ($/barrel)

189

7.3

Trends in GDP and industrial production (billion rubles)

192

7.4

The dynamics of compensation and productivity, 1997 = 100

193

7.5

UES OF RUSSIA income structure (per cent)

195

7.6

Money supply and reserve requirement movements

201

7.7

Banking assets and equity movements (percentage of GDP)

202

7.8

Corporate loans and government bonds (percentage of assets)

202

The dynamics of returns of government bonds in 1996–2001 (per cent per annum)

204

8.1

Russian Stock Market vs. MCSI World, 2000–2009 (in logs)

221

8.2

Budget surplus/deficit in Russia, 2005–2009 (per cent of GDP)

228

7.9

Tables 1.1

Oil production by the USSR in 1988–91 (million tonnes)

16

1.2

Nominal wage growth and consolidated state budget deficit in the USSR in the period of Perestroika, 1985–91

17

The number of banks in the USSR in 1988–90 (end of period)

18

Russian external debt ($ billion, end of period)

36

1.3 1.4

List of Figures, Tables and Boxes ix

1.5

Dynamic and structure of new Russian debt in the 1990s ($ billion, end of period)

37

1.6

Sovereign debts owed to the Russian Federation by the end of 1991 ($ billion)

38

1.7

Russian Eurobond issues in the 1990s

48

2.1

Annual growth rates of nominal and real macroeconomic indicators in 1992–97 (per cent)

53

Russian domestic debt in securities in 1993–96 (end of year, percentage of GDP)

68

2.2 2.3

Characteristics of domestic public debt in securities in 1994–98

75

2.4

Federal budget of Russia in 1995–98 (percentage of GDP)

77

2.5

Russian banking system under market transformations

80

3.1

Size and structure of arrears in the first quarter of 1998

90

3.2

Tax revenues of consolidated budget in 1992–98 (per cent of GDP)

103

3.3

Federal budget 1993–97 as approved and executed, three items: total spending, total income, budget deficit (IMF definition) all as a percentage of GDP

107

3.4

Results of the ‘loans-for-shares’ deal

115

4.1

Russian public debt in the 1990s

123

4.2

Russian external debt in the middle of 1990s ($ billion)

124

4.3

Domestic debt of the federal government (end of period, percentage of GDP)

125

Share of foreign currency bank credits (per cent, beginning of period)

137

5.1

Indicators of monetary policy in 1996–1998 (end of period)

159

6.1

Federal budget performance in the first half year in 1997 and 1998 (percentage of GDP)

165

6.2

Value of maturing GKO and OFZs, June–December 1998

168

6.3

Growth rates of monetary policy indicators after August 1998 (per cent)

180

7.1

The rate of growth of industrial production (per cent)

192

7.2

Cash and non-cash payment transactions between large companies

194

4.4

x

List of Figures, Tables and Boxes

7.3

The share of payment offsetting (per cent)

196

7.4

The dynamics of tax revenues in the consolidated budget (per cent)

197

7.5

Sources of financing of the budget deficit

198

7.6

The debt burden on the Russian economy before and after the crisis (per cent)

204

A7.1 Initial data (per cent)

210

Boxes 1.1

The ‘Noga Saga’

23

1.2

The US Debt and Alexander Hamilton

28

1.3

The Problem of Mutual Debts Evaluation

34

2.1

Financial Pyramid MMM

61

2.2

The Voucher Privatization in Russia

64

3.1

Peculiarities of the Budget Process in Russia

108

3.2

Incentive Games in the Virtual Economy

113

6.1

A Calendar Effect of Vacations as a Predictor of Crises in Russia

173

6.2

The Argentine Debt Default and Swaps

175

7.1

Measures to Tackle the Crisis

200

8.1

Spurious Russian Market: All Shades of Grey

221

Acknowledgements Many colleagues have provided comments and suggestions for improving this book. A special thanks goes to Georgiy Trofimov, who provided invaluable assistance in improving the book’s content. Also I would like to thank Alexey Pomanskiy, Galina Kovalishina and Vladimir Kreyndel of the Institute for Financial Studies and Dr Barry W. Ickes of the Penn State University for their participation in the discussions and extremely helpful comments. Andrey Vavilov

xi

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Introduction

Great social revolutions are inspired by big ideas, implemented by enthusiasts of these ideas, fostered by big finance, and may be spontaneously affected by unforeseen eventualities. To some extent this is true with regard to the Russian capitalist revolution that began in 1991 and continued throughout the final decade of the twentieth century. It was a materialization of the basic idea to transform radically the decaying communist system into a modern market economy that would be able to survive and develop in the post-industrial world. The idea was not new at that time because the unprecedented economic transformations had already been occurring in Eastern European and some developing countries and had proved to be pretty successful in many cases. The processes of economic liberalization began around the world in the 1980s and led to tectonic changes that would have certainly affected the former Soviet Union. Fortunately, the last Soviet leaders, headed by Mikhail Gorbachev, were prudent enough to reject any new radical communist experiments and even tried to modernize, albeit unsuccessfully, the communist system. The author of this book is part of a generation of young economists brought up under the intellectual influence of the liberal ideas of that epoch. Twenty years ago all of us were very enthusiastic about the beginning of radical market reforms in Russia. Some got a lucky and rare chance to implement these big ideas in practice when the new post-communist Russia was born as a sovereign state in 1991. This book presents a participant’s observations and thoughts in hindsight about the revolutionary events that occurred during the last decade of the past century. The book presents a history of Russian finances that played a very important role in the Russia’s transition from communism to capitalism. Usually financial issues remain in the shadow of historical 1

2


events or personalities. They are typically neglected by historians who are reluctant to pay much attention to the dull matters of debts and credits. But in the case of Russia these issues were paramount because the attempts at economic transformation were very closely interrelated with the resolution of a cornerstone problem of public debt. This problem arose in the late 1980s and mirrored the serious economic troubles of the Soviet Union that were hidden for many years by official statistics. The excess and rapid build up of external debt obligations by the USSR alongside ineffective attempts to introduce semi-market reforms eventually caused the Soviet debt crisis and led to the insolvency of the state. There is no coincidence in the fact that the bankruptcy of the Soviet Union in December of 1991 occurred simultaneously with its disintegration. The history of the Soviet debt crisis and default is a story of the agony and death of the Soviet Empire. The subsequent history of new Russian debt origination, accumulation, and a new crisis, which is the principal subject of this book, is essentially a more intriguing story of the successes and failures behind Russia’s transition to markets. Market reforms started in Russia in the aftermath of the Soviet bankruptcy and in a political situation of considerable complexity. The new Russian government headed by Yegor Gaidar was formed by the first Russian president, Boris Yeltsin, at the peak of his charisma, as a team to conduct some radical economic reforms. Being widely perceived as a team of ‘whipping boys’, it had to fulfill three concrete tasks. First, the government of reformers had to undertake urgent measures to pull the country out of a deep economic crisis and to prevent a widespread social catastrophe. Second, it had to launch the great capitalist revolution in Russia, something that the previous liberal reformers in tsarist Russia (the predecessor of the USSR), such as Peter Stolypin, had failed to accomplish eighty years earlier. Third, the government of post-Soviet young reformers had to solve the Soviet debt problem in a civilized manner. These three tasks were mutually interrelated. The economic crisis could be resolved only on the basis of a market that was yet to be created. In introducing its reforms the Russian government needed political support from the governments of developed countries that were official creditors of the Soviet Union. At the same time the success of reforms was the only way for the Russian government to become eventually solvent so that it could pay back Soviet debts. The solution of the debt problem was, thus, a necessary condition for overcoming the economic crisis under which the Russian Federation was born as a new political entity.

Introduction 3

Negotiations around the Soviet debt restructuring, hence, became the key strategic issue for the Russian authorities. The recognition and restructuring of this debt made possible a civilized solution of the sovereign debt problem, for the first time since the Bolshevik revolution and Russia’s sovereign debt default in 1917. Russia assumed responsibility for the Soviet Union’ foreign debt in full, although this implied a very high additional financial burden for the newly created state. But, on the other hand, the debt assumption opened new options for Russia to enter the global capital markets several years later. Another strategic reason for the Soviet debt assumption was maintaining the status of a nuclear superpower (infirm but still alive) that Russia inherited from the USSR as its legal successor. Of course, leaving these strategic considerations aside, a more rational choice might have been instead to issue new debt at the beginning of the transition to facilitate this process and to smooth out household consumption. Successful reforms would, after all, lead to higher future incomes, so it would be sensible to finance some of the painful reforms from richer future generations. But as the successor to the bankrupted Soviet Union, the Russian Federation could not borrow any more before the resolution of the Soviet debt problem. This vicious circle made the whole situation relating to the external financing of Russian reforms very difficult. Another problem was that the Russian economy proved to be heavily exposed to fluctuations in the price of oil. ‘Her majesty, the oil price’ dictated the course of the most important events in Russia’s history of the last four decades, since the large Siberian stocks of oil were opened for exploitation. Figure I.1 depicts the dynamic of the real oil price for the thirty-year period 1979–2008. The price jump at the beginning of the 1980s ensured large export revenues but weakened the Soviet rulers’ incentives to make reforms. The first attempts to modernize the socialist system were initiated by Mikhail Gorbachev after the dramatic drop in the oil price in 1986 which turned out to be strong enough to cause the Soviet economy to fall first into crisis and then to collapse. The attempt to introduce semi-market reforms was in fact a ‘false start’, but the Soviet Union received huge volumes of foreign credits, as a seemingly upward price reversal manifested in 1989–90 (as seen in Figure I.1). But when the true market reforms started in 1992, the oil price began to fall again. A period of radical market transformations in the period 1992–99 thus coincided with a period of very low oil prices. Its drop fostered the initiation of radical reforms in Russia but at the same time made it very difficult to implement these reforms. As seen from Figure I.1, the minimal level of the oil price was reached in 1998,

4

The Russian Public Debt and Financial Meltdowns 100 90 80 70 60 50 40 30 20 10 0

79 981 983 985 987 989 991 993 995 997 999 001 003 005 007 2 2 1 2 2 1 1 1 1 1 1 1 1 1

19

Figure I.1 The real oil price, 1979–2008 ($/barrel) Source: The Federal Reserve System, the International Energy Agency.

a year of the Russian financial collapse that had a shocking effect on the global financial system. Although the Russian government agreed to assume the debt obligations of the Soviet Union in 1992, it was able to reduce the debt burden temporarily as a result of its negotiations with the clubs of foreign creditors and G7 governments. Russia received a seven-year breathing space to bring about its capitalist revolution. This book contains a participant’s personal view, with hindsight, of the political and economic processes in Russia that, being coupled with very unfavourable oil price movements during that period, led this revolution to the financial crisis and a new debt default in 1998. This book focuses on the problems and obstacles to the reform of the Russian economy with a special emphasis on state debt policy. This was the field of my personal activity as a member of the first and second cabinets that implemented radical reforms. When the state debt policy was designed initially, my colleagues and I shared the optimism that the debt burden would be eroded by economic growth that would be generated sooner or later by the market economy. We overemphasized the word ‘sooner’ and underestimated the difficulties that Russia would have faced in the transition to the market economy. One could not foresee the size of the forthcoming economic decline in the 1990s that was devastating for the Russian economy.1

Introduction 5

It was completely disorganized at the very beginning of market reforms, and, as I have mentioned, the main task of the reforming team was to prevent a catastrophe, rather than to transform deliberately the economy into a well-designed model. Of course, a programme of reforms had been prepared according to the standard logic of economic liberalizations and approved by international experts. But the programme could not envisage all the scenarios of transition and, in particular, it ignored a number of important features that were specific to the Russian economy. There was no theory of the transition to the market applicable to any country (since there was no reason to elaborate such a theory earlier). The experience of East European countries, on which the Russian reformers placed too much initial reliance, turned out to be not particularly useful. For reasons that I will discuss in this book, the economic transformation in Russia differed drastically from any earlier experience of other countries. It had often happened in Russian history that policy measures designed initially as benevolent, turned out to have unforeseen consequences. The post-communist reforms were a good illustration of this regularity, and reformers in Russia faced an immense gap between desires and possibilities. They could not prevent, for example, huge budget deficits and persistent three-digit annual inflation, the widespread non-payment crisis, the chronic fiscal crisis, a huge polarization of incomes and horrifying poverty, and the rise of extremely sharp social problems. The market economy institutions developed slowly, while important structural reforms were incomplete and inconsistent or delayed indefinitely. The economy suffered from a lack of transparency in nearly every sphere, and this made it difficult to attract foreign investment in the production sector. The rule of law, respect for ownership rights, the creation of a good investment climate, and the building of a trustworthy reputation by the state, remained empty slogans that were used for political demagogy and manipulations. One crucial difference is that Russia had experienced the planned economy for a much longer time and in greater depth than the East European post-communist countries. Three generations of Russians did not know about the market economy, while people familiar with capitalism were still alive in Poland, Hungary, the Czech Republic and other countries, where old traditions of individual activity and responsibility had not been forgotten completely. Even though the Russians were unaware of capitalism, many of them were enthusiastic about new opportunities for self-actualization and enrichment that appeared as

6


the reforms began. Unfortunately, very soon these hopes turned out to be vain for the majority of people that could not find their place in the new environment and reach success. But their failure to adapt to emerging markets was not their fault because this environment was very chaotic. In my opinion, the unintentional results of Russia’s market transition were caused not by people’s mentality, but rather by the burdensome legacy from the Soviet era. The Russian economy inherited a huge monetary overhang, implying that the economic liberalization had to begin from a tremendous inflation outburst. This was a shock for both domestic producers and households. The inherited economic structure was inefficient – due to arbitrary administrative decisions adopted previously in the command economy – and needed to be transformed dramatically. But the costs to the Russian economy of such structural adjustments were extremely high. On the one hand, the majority of domestic producers were used to the paternalism of the state and could not survive in the market – their cost structures were just not viable. On the other hand, the state could not permit the majority of enterprises be closed at one instant.2 It would be hardly possible to build a new economy on ruins of the old one in the absence of new investment and knowledge. An acceptable strategy was therefore to search for compromises that were, of course, in conflict with the radical approach that the reformers had initially tried to implement. Thus, the Russian government was trying to pursue conflicting goals and, at the same time, was faced by severe political constraints. The most serious problem was that the state had to maintain its social expenditures and obligations which were too high for an economy in deep distress. In relative terms these obligations were similar to those typical for the developed European economies. The state also continued to support inefficient production enterprises. The burdensome Soviet legacy, the unfavourable terms of trade, and the excess state obligations made inevitable huge budget deficits and emission of money or debt. As is made clear by from the title of this book, the public debt policy of Russia in the 1990s is the main theme of our analysis. I try to understand the dualistic features of the debt in the Russian transition. Even though the external Soviet debt was a burden for the economy, its assumption furthered the integration of Russia into the global financial system. As a result of the resolution of the debt problem, Russia received sovereign ratings in 1996 and entered the Eurobond market. The external debt that Russia committed to service and pay back was a discipline

Introduction 7

device for economic policy making at home. The Russian financial system was dependent on external debt, but this circumstance deterred pro-inflationary political forces and compensated for the lack of political support to market reforms. In particular, the International Monetary Fund had some political influence on domestic financial policy and thereby contributed to the macroeconomic stabilization of 1995–96. This stabilization was a hard-won victory because inflation was reduced at the cost of creating a whole set of new macroeconomic and financial risks. The monetization of budget deficits that had been the policy of ‘choice’ was replaced by domestic debt issues which were ruble-denominated, short-term, and high-yield. This kind of stabilization was a compromise solution justified by the absence of any other scheme to combat inflation, by the lack of credibility of state policy, and by the chronic fiscal crisis. There was also some optimism that somehow growth would accelerate enough so that the debt dynamics would not worsen (a sufficiently optimistic scenario always exists to justify any policy ex ante). The growth in domestic debt, however, created additional refinancing risks and increased the threat of a budget crisis in the near term as a result of the high costs of debt service. In contrast to the external debt which was managed in cooperation with the international financial organizations, the domestic debt was under the full discretion of national authorities and was therefore a source of many risks. On the one hand, the opening up of the domestic debt market was a breakthrough in the organization of securities exchange in Russia. It contributed to the emergence and development of domestic financial markets on a modern basis. The Russian Ministry of Finance that took control of this process was the main generator of financial development during that period. On the other hand, an opportunity to cover budget deficits by borrowing in rubles had perverse effects on the incentives of policy makers. Domestic debt was viewed as an unlimited and easy source of funds for the state budget, and the problem of a sustained budget deficit seemed to be solved easily. This political myopia manifested itself sharply during the second presidential election campaign in 1996 when the domestic debt was used to finance additional largescale expenditures of the state budget. A comprehensive fiscal reform was delayed, although, in my view, it could hardly have been implemented during the 1990s. The obstacles to such reform were fundamental, and this was a deep-rooted problem which was also a consequence of the Soviet legacy. The government formally abolished subsidies to privatized production enterprises but continued to support them implicitly. As a result, the government

8


was heavily involved in the economy-wide non-payment crisis, and a significant part of the state’s financial flows relied increasingly on barter schemes and monetary surrogates. This was the most essential feature of the Russian fiscal crisis that the authorities could not deal with. The risks of domestic debt proliferation were aggravated after the opening of the domestic debt market for non-residents in 1996. This was a good idea in principle, but its realization essentially neglected the fragility of the domestic financial system. Financial liberalization prompted hot money inflows that made it urgent to improve risk management by the state. On the contrary, the ruble exchange rate regime and the scheme of hedging of non-residents’ ruble holdings introduced by the Russian Central Bank led to outrageous currency risk mismanagement. The extreme weakness of the Russian banking system was another fundamental factor of Russia’s financial fragility. Domestic financial markets could not eliminate or diversify away the excess financial risks. Though the Russian government entered the Eurobond market in 1996, it did not manage to rationalize its public debt structure. The authorities misused the new opportunities opened by financial liberalization and only aggravated all kinds of financial risks. The financial crisis of 1998 with its sharp ruble devaluation and the default on domestic debt was the culminating point of this reckless policy. A large part of this book is devoted to a description of the Russian financial crisis. I consider this to be a cornerstone event in recent Russian history which resulted from many previous mistakes and omissions and which has had a major impact on the subsequent economic and political development of the country. The genesis of this crisis is traced back to the previous Soviet debt default, and then through the period of market transformation in 1992–97. I pay special attention to the fundamental factors that the Russian authorities could have had very little impact on even if they had acted prudently in all circumstances. I also emphasize the key policy mistakes, first of all, the lack of risk management and debt management, and the failures of monetary policy.3 The Russian capitalist revolution began with the radical economic liberalization in January 1992 and was finished with the radical resolution of the financial crisis in August 1998. Was this attempt to build Russian capitalism in several years a failure? I think not. The Great French Revolution of 1789–94 was in my view not a failure, although it flooded France with blood and eventually brought Napoleon Bonaparte to power. Even more so, the Russian capitalist revolution was not a failure. Russia avoided a civil war and the blood that would be associated with

Introduction 9

it, as a possible scenario in the early 1990s. The government of reformers prevented famine and social cataclysms that were very well familiar to Russia in its previous history of the twentieth century. The economic transformations that were very hard to implement in Russia and that were indeed several times on the brink of failure, ultimately bore fruit. It turned out that after the crisis of 1998 Russian people were living in a country that was quite different to the one it had been a decade earlier. The market economy has been created, and as a result of this Russia experienced spectacular economic growth in the period 2000–08. Of course, it was driven by even more spectacular oil price growth, but even this type of quasi-exogenous economic growth would have been impossible in the command economy. This was the first occasion, after many decades of dominating economic absurdity, that market forces had been in action and benefited the majority of the population. Most important is that Russia today has a perspective of further development which the communist system did not have in principle. The civilized solution of the external debt problem in the 1990s stimulated the economic integration of Russia with the developed world. Many new developments occurred, including the creation of a legal basis for markets, the market economy infrastructure and institutions, the modern systems of learning for professional market participants. All of these building blocks of the modern market economy demonstrated the ability to work and develop after the crisis. It is worth noting that in the 1990s economic policy making was a much harder task than it is today. The problems that policy makers faced in the 1990s were, in my view, much more difficult than those to be encountered today, even despite the global crisis that is seriously affecting the Russian economy. If, for example, the oil price was $25 per barrel in the first half of 1998 instead of $10 per barrel, Russia could, most likely, have avoided default. If, on the contrary, the oil price had fallen in 2008 to $25 per barrel, it would be a catastrophe for the Russian economy and financial system despite tremendous financial reserves accumulated by the state in the current decade.4 Financial management in the low-oil-price regime required much greater effort, professionalism, smarts, and enthusiasm of policy makers than is required when oil prices are very high. The current generation of policy makers has been spoiled by such prices and firmly shielded from the bad surprises by the huge financial reserves of the state. I am not sure that under tougher circumstances this generation would be able to act as selflessly as our generation did.

10


The book attempts to make this experience comprehensible, being based on both a description of recent Russian history and some personal reminiscences about the transition to the market. Nevertheless, it is neither a historical book, nor a political memoir; rather, it is an attempt to provide an assessment of economic policy in hindsight. I have tried to make such an assessment both from the view of an insider – a policy maker involved in making macroeconomic policy – and from the view of an outside observer of the course of events. During the historical period described in this book I occupied both roles. I was an insider during the ‘breakthrough period’ of the capitalist revolution 1992–97 and became an outsider a year before the financial crisis of 1998. Needless to say, there is no shortage of studies of this crisis, so the question may be asked: why is another one needed? Many of these studies were completed just after the 1998 default and thus lack some historical perspective. Moreover, many of these studies are most focused on casting blame. This book, on the other hand, offers a more comprehensive picture with the advantage of perspective gained from the decade since the crisis. And rather than search for who to blame, this book focuses on the key aspect of debt management as the central theme to understanding the crisis. The grim decennial anniversary of 2008 provided another reason to write this book, as the deterioration of understanding of the real causes of Russian crisis demonstrated by both domestic and international public became apparent. The book is structured as follows. Chapter 1 provides an account of external debt management in Russia in the 1990s which created a basis for integration into the world economy. Chapter 2 examines the interaction of the newly established financial markets and banking system, and also the link to the inflation-taming policy. Chapter 3 characterizes the specific concept of the virtual economy in the application to the problem of budget arrears and, more broadly, to the problem of the chronic fiscal crisis. Chapter 4 presents a road map to understand the development of public debt management in Russia. Chapter 5 contains a thorough account of the causes of the devastating Russian financial crisis of 1998. Next, Chapter 6 provides a description of how the crisis actually unfolded, and Chapter 7 explains how Russia recovered from the consequences of the crisis. Finally, Chapter 8 compares the situation and development in Russia during the current world crisis with the responses to the previous crisis.

1 The External Debt Crisis of the 1990s

Introduction Russian external debt has played a very important role in its recent history. At the beginning of the 1990s the Soviet Union found itself in a severe debt crisis that caused the bankruptcy of the state and the collapse of its planned economy. To a large extent the external debt crisis was caused by strategic mistakes made by the Soviet authorities over the course of the previous two decades. This crisis dictated the course of economic development of Russia in the 1990s and the current decade. The debt burden was unbearable for the country in deep distress, and a rescheduling of debt was inevitable as the only possible and civilized way to solve the problem. When the market reforms began in 1992, the external debt became the subject of comprehensive negotiations with western governments. The process was aimed, above all, at achieving support for market reforms in the new Russia. It was the first time in Russian history that top officials had negotiated with foreign partners about the key issues concerning development of the national economy. Negotiations on debt restructuring continued for several years and brought significant results in 1996. They allowed the Russian Federation to define its status as a legal successor of the Soviet Union. Russia remained a superpower, in particular, because it voluntarily assumed all of the obligations of the former USSR. As a byproduct of successful debt negotiations, Russia received sovereign credit ratings that opened the doors to the world of global finances. This chapter concerns the issues of external debt management of the 1990s that, in my view, provided a foundation for Russia’s integration with the world economy and for the creation of modern market institutions at home. The theme is of particular interest to me because of 11

12


my personal involvement in resolving the debt problems. During five years, in 1992–97, I participated in the negotiations with the Paris and London Clubs of creditors, the International Monetary Fund and the World Bank, regular G7 ministers’ meetings and so on. I was lucky to get acquainted with famous economists like Stanley Fischer, Lawrence Summers, Michel Camdessus, Robert Rubin and many others that were involved in the process. They sympathized with Russia and its reforms and put in a lot of effort to assist Russian authorities with building new market institutions. My contacts with such persons were very useful and provided a good opportunity of getting good advices and learning much about the ways of economic and financial policy making. As a key Russian policy maker in the 1990s, I was seeking to introduce a new style of work for the financial authorities based on the open economy ideology and giving a priority to market instruments. Negotiations about external debt were the first steps in the organization of public debt management and the creation of financial markets at home. Debt servicing was an effective discipline device for the fiscal and monetary authorities, for whom the IMF was an economic supervisor for several years. For various reasons discussed in subsequent chapters of this book, the economic performance of the past decade was controversial. But there is no doubt that the economic and financial system of modern Russia was created in those years on absolutely new principles.

1.1 The Soviet debt For many years the Soviet government had no foreign debt burden. All obligations of the Russian Empire to foreign countries were repudiated immediately following the socialist revolution of 1917.1 Subsequently, under the regime of ‘classical socialism’, there was no need for external borrowing. The Soviet economy was close to autarkic and, presumably, self-sufficient in terms of the development of its domestic resource base. Foreign trade and currency flows were insignificant and subject to centralized government control. The dominant feature of this economy was a permanent shortage with hidden inflation and budget deficits. For several decades, the Soviet authorities could use various direct and indirect channels to extract incomes and property from citizens for the needs of the state and had no need to secure external funds. The predecessors of Mikhail Gorbachev were not inclined to take international financial obligations that would imply any kind of dependence from foreign governments or international financial organizations.2

The External Debt Crisis of the 1990s 13

1.1.1 Petrodollars and the foreign debt For this reason, the USSR had virtually no foreign debts until the second half of the 1970s. Foreign trade was balanced since the government made import purchases in strict correspondence with concurrent export revenues. But the ‘mature socialism’ of the 1970s became a period of rapid growth in consumption, both public and private, not least in connection with the discovery of new colossal oil and gas fields in West Siberia in the 1960s. World oil prices were at high levels that allowed the planning authorities to import large amounts of equipment and consumer goods. The arms race and the inherent inefficiency of the planned economy placed obstacles in the way of the rapid increase in living standards for the mass of the population. But being obliged to fulfill at least some of the populist promises and slogans concerning the welfare of citizens (for example, an abstract ‘communism’ to be built by 1980 or a more concrete ‘separate apartment for every family’ after the same year), the authorities began to borrow abroad. They based on optimistic expectation of further oil price increase in the long term after a series of hikes in oil prices in the middle of the 1970s and the beginning of the 1980s. As a result, the external debt increased more than 15 times, from $1.8 billion to $29 billion, in the 15 years from 1971 to 1985. At that time the Soviet Union was considered by foreign creditors to be a first-class borrower (corresponding to AAA sovereign credit ratings). This reputation was gained by the centralized control over export revenues and currency flows and the tradition of stern financial discipline maintained over many years. But the expectations of increasing oil prices proved wrong, as became obvious in the middle of the 1980s, after the dramatic fall in the world oil price, shown in Figure 1.1. The state revenue from raw materials exports also declined, but the economy remained technologically dependent on imported goods. Production decisions in the planned economy were based on fixed natural proportions that were typically irrelevant and non-responsive to changes in relative prices. The living standards of Soviet citizens did indeed improve in the 1970s, and their new consumer habits made it almost impossible to introduce drastic restrictions on consumption imports (the ‘mature socialism’ leaders were reluctant to reduce consumption levels). In addition, financial decisions under the planned economy were predetermined entirely by detailed natural plans adopted by the Central Planning Committee (Gosplan). The latter followed a bureaucratic routine of one-year planning that had nothing to do with sophisticated matters of intertemporal choice under uncertainty. A new convenient

14

The Russian Public Debt and Financial Meltdowns 120

35

100

30 25

80

20

60

15

40

10

20

5

0

0

70

19

19

72

19

74

19

76

19

78

80

19

External debt, $ billion

19

82

84

19

19

86

19

88

90

19

92

19

US crude oil price, $/barrel

Figure 1.1 The Soviet external debt and the oil price, 1970–93 Sources: Russian Ministry of Finance, Energy Information Administration USA.

way of solving the problem of chronic shortages through external financial sources of imports was discovered, but the underlying risks were ignored completely. Thus, as a result of the rigidities of the planned economy, the desire of the population for higher living standards, and the myopia of financial decision makers, the Soviet Union chose to embark on large-scale borrowings, and the external public debt had reached about $32 billion by the mid-1980s. Western banks were eager to provide loans that were considered to be riskless, especially against expected cash flows of oil and natural gas export revenues. But the true external debt burden of the Soviet economy was unknown because of statistical data imperfections resulting from price distortions in the planned economy and the peculiarities of national accounting in the USSR. The indirect estimates of Soviet GDP were typically upward-biased, implying that the estimates of debtto-GDP ratio were downwards biased, as Boris Kheifetz (2002, p. 113) pointed out, although, admittedly, any estimates of Soviet GDP and the economy potential on the PPP basis could hardly be correct. In addition, both official and commercial lenders of the Soviet Union disregarded the underlying systemic and political risks and neglected the possibility of sovereign debt default. Actually, the centralized planned system could have collapsed as early as the end of the 1970s, if the new stocks of energy resources in West Siberia had not been discovered and utilized. This ‘manna from heaven’ gifted 15 years of life to the socialist system, while the generous external debt financing of the 1980s helped to continue its agony for several more years.


1.1.2 The debt addiction The tendency of debt accumulation changed as the domestic and foreign policy of the Soviet Union was modified in the second half of the 1980s. At this time Mikhail Gorbachev was engaged in the policy of Perestroika – an attempt to modernize socialism that ultimately failed but led to a dramatic increase in budget expenses. For instance, the ‘economy acceleration’ programme, proposed by the Nikolai Ryzhkov government in 1986, was based on the idea of large-scale centralized investment in the machinery industries. Additional state funds were required to deal with the extraordinary consequences of the Chernobyl catastrophe in 1986 and the Spitak earthquake in 1987. The resolution of numerous social and ethnic conflicts that emerged after 1987 also required considerable government expenditure. The anti-alcohol campaign launched in the same year undermined an important source of tax revenues since the official sales of alcohol were essentially reduced (and, as a result, the illegal production of surrogate alcohol increased sharply). The Soviet leaders could easily increase overseas borrowing, thanks to the sympathies of the western political leaders for Mikhail Gorbachev and the democratic tendencies in the USSR under his governance. But as it turned out, the political sympathies to Perestroika resulted in the doubling of the Soviet sovereign debt during in the five-year period 1986–90, from $31.4 to $62.5 billion (see Figure 1.1). These new borrowings were financed both by the governments and the private banks of developed countries. In our view, two fundamental factors were decisive in bringing about the expansion of the state’s uncontrolled external debt. First, the world oil price nearly halved in 1986–87, from US$25 to US$13 per barrel (Figure 1.1), and oil production in the USSR fell during the subsequent four years by 17.4 per cent, as seen in Table 1.1. At the same time the productivity of the existing oil fields was decreasing, while the opening of new fields became more costly. The fixed investment required for the creation of new oil capacities increased on average by 80 per cent over the period 1986–90, while total investment in oil industry grew by only 28 per cent in the same period (Gaidar 2006, p. 287). This led to a dramatic reduction in the level of exports and state budget revenues. In 1988 the total volume of Soviet exports reduced by 46 per cent as compared to the plan target level (Gaidar, 2006, p. 264). The export of oil halved in 1990–91, from 124 to 61 million tonnes. By the beginning of the 1990s the state’s falling oil revenues were spent

16


Table 1.1 Oil production by the USSR in 1988–91 (million tonnes) Year

1988

1989

1990

1991

Oil production % of change

624.3 0.0

607.2 ⫺2.7

570.0 ⫺6.1

515.8 ⫺9.5

Source: Gaidar (2006, p. 281).

primarily to service Russia’s external debt (Gaidar, 2006, p. 264). Despite the decline in the level of imports, the foreign trade deficit increased twice during the three years of Perestroika 1986–88, and tenfold during the 12-year period 1976–88. Second, the reduction of exports coincided with the awkward attempts to transform the system of centralized planning undertaken since 1987. The communist authorities tried to return to the semimarket reforms that were introduced in the 1960s but ended for ideological reasons in the 1970s. During that period (the ‘golden era’ of mature socialism) the Soviet economy did not face a problem of shortages that was as severe as it became in the middle of the 1980s. The time for experiments in the style of Yugoslavia or Hungary had been missed because of the macroeconomic imbalances accumulated during the two decades. An attempt to introduce some elements of the Chinese model into the Soviet economy was also unsuccessful: the majority of the population had been accustomed the paternalism of the state and did not have strong incentives to pursue individual activities. The key problem with making semi-market reforms was that the partial weakening of administrative control was in conflict with the partial freedom given to state enterprises in 1987. The price structure was subjected to extreme distortions because of state controls, and prices typically did not convey true information about the level of market demand.3 Another serious problem was the wrong managerial incentives of state enterprises. They benefited from the removal of administrative pressure and the newly emerged opportunities for choice by increasing, initially, the nominal wages of employees at the expense of the state in a financial irresponsible manner. As Anders Åslund (1995, p. 48) remarked, ‘The paramount problem was that wages rose more than twice as fast as they had previously. As a consequence, enterprise taxes declined and the budget deficit expanded’ (see Table 1.2). The managers of state-owned firms tried to ‘sit on two chairs’ by selling outputs and inventories at market prices while purchasing intermediates at fixed prices through channels of administrative supply.4 New cooperatives


Table 1.2 Nominal wage growth and consolidated state budget deficit in the USSR in the period of Perestroika, 1985–91 Year Nominal wage growth (%) Budget deficit (% of GDP)

1985

1986

1987

1988

1989

1990

1991

⫺

2.9

3.7

8.3

9.4

14.2

70.0

1.8

5.7

6.4

9.2

8.6

4.1

21.6

Source: Åslund (1995, pp. 47–8).

that appeared as a result of the law adopted in 1988 typically served as a bridge between the planned system and the new market segments of the economy. State enterprises established affiliated cooperatives and could effectively exploit the deficiencies of both systems. This kind of behaviour was a typical product of Gorbachev’s partial reforms that gave rise to rapid inflation under total shortage that were mutually reinforcing. The velocity of money was increasing with shortages, while precautionary purchases of storable goods were spurred by accelerating inflation. Nominal wage increase was a consequence of the partial freedom granted to enterprises and was eventually financed by the state. It hence generated budget deficits, as Table 1.2 demonstrates, that resulted in the type of open and uncontrolled inflation which had previously been hidden by shortages of goods. In part, inflation was accelerated through the mediation of commercial banks that began to emerge in 1988 from branches of the state monopoly bank Gosbank or as new financial institutions. By the beginning of the 1990s the number of commercial banks had grown rapidly, as seen in Table 1.3, but without adequate professional learning to banking by bank managers and under very weak regulation.5 The authorities, nevertheless, believed that the new banking sector would become a locomotive of the market economy and desired to give it the ‘green light’. But the true goals and services of early commercial banks were very far from these optimistic hopes. Banks broke a distinction between cash and non-cash money that had been a cornerstone of monetary control in the command economy. Wages to workers were paid in cash (nalichnyye), while payments between enterprises were made in non-cash (beznalichnyye). This system allowed the monetary authority to balance, in principle, aggregate wage payments with aggregate consumer demand and, thus, to maintain control over consumer price inflation. But commercial banks had the opportunity to transform the non-cash accounts of enterprises into cash and, in fact, were established in many cases simply for this purpose. These

18


Table 1.3 The number of banks in the USSR in 1988–90 (end of period) Year The number of banks

1988

1989

1990

43

224

1357

Source: Gaidar (2006, p. 278).

operations were widespread and masked under credit supply to the real sector. As a result, the monetary authority began to lose control over cash in circulation that it had been able, more or less effectively, to exercise previously. Gosbank tried to avoid the monetary loosening generated by the new banking sector and to constrain its overly rapid expansion using administrative measures. But this contradicted the Soviet law on banking adopted in 1988 which was based on lax regulatory rules and, in particular, weak capital requirements. This law aimed to facilitate new entry in banking and, in my view, was too liberal for the economy that made only first steps in transition to the market. Under these circumstances the state could not prevent the partial loss of foreign currency control and allocation that occurred in the late 1980s. Before Gorbachev’s attempts to introduce market reforms, the export revenues of all Soviet enterprises were transferred to the government. It allocated foreign currency to industrial and trade ministries that purchased producer and consumer goods abroad. When new cooperatives and private commercial banks appeared in 1988, the currency regulation weakened considerably. But even this bounded financial independence of enterprises, commercial banks, and regional powers caused the destruction of centralized financial controls and a dramatic reduction in the level of export revenues that had during earlier periods accumulated at the centre. The loopholes in financial legislation provided banks with an opportunity to generate cash flows, resulting in the uncontrollable growth of fiat money in the economy. In this situation the permission of foreign currency circulation led to the emergency of the foreign currency ‘black holes’. As a result, by the end of 1991 the newborn foreign currency market of Russia was engulfed in a profound crisis. At the same time the geography of external borrowing by the state was widening noticeably beyond the traditional loans obtained from developed countries. The new official creditors were now represented by the oil-producing and new industrial economies such as Kuwait,


Saudi Arabia, the UAE, and South Korea. A large amount of the new Soviet debt was also created through the help of the former socialist countries, including Comecon countries,6 Yugoslavia, and China. The latter case deserves attention. The original debts of the USSR to the Comecon countries amounted to $24 billion, roughly one-third of total Soviet foreign debt by the end of the 1980s. The emergence of these obligations provides a good illustration of the workings of some loopholes in the poorly managed system of currency controls. The new rules allowed joint enterprises to convert the ruble revenues from imports into the so-called ‘transferable rubles’. Initially, these rubles were used as pure accounting units in trade between the USSR and the Comecon countries and were not supposed to be a means of exchange. It is important to note that under the command economy these countries, typically, exchanged the lower-quality goods they produced for oil and gas imported from the USSR (they exported higher-quality goods to western countries in exchange for superior imports). Trade with the socialist economies of East Europe was of no benefit to the Soviet economy – it exchanged severely underpriced basic resources for overpriced manufacturing of inferior quality. This trade was, to a large extent, constructed for artificial political reasons and shrank by around 80 per cent after the introduction of foreign trade liberalization in 1991–92. But earlier, during Gorbachev’s reforms, imports from the Comecon countries were increasing because of highly profitable re-export to the USSR of trade items such as computers and office equipment.7 In addition, because of the weakened financial regulations, many trading firms applied schemes based on false import contracts with no delivery of goods used to withdraw cash from bank accounts. Under such circumstances the Soviet authorities made a mistake by giving the transferable rubles an artificial status of hard currency with a fixed one-to-one exchange rate with the dollar. The Soviet financial system thereby insured the currency and inflation risks of trading operations with the lower-quality trade partners of the Soviet Union. Adverse managerial incentives could be one of the factors behind such ‘generosity’ on the part of the state, although a more likely reason lay in the widespread incompetence of the financial decision makers in the planned economy. Obligations in transferable rubles were presented for payment after the Comecon fell apart8 and thus increased the sovereign debt of Russia. As a posterior expertise of the Comecon and other Soviet debts by the Russian Ministry of Finance revealed in 1992, its considerable part originated due to poorly designed experiments by the Soviet government in making semi-market reforms.9

20


Generally, by the end of the 1980s, the planned system in the Soviet Union had been de facto destroyed. It had moved from the inefficient but somewhat ordered and viable routines of short-term planning to the chaotic ‘spur of the moment’ style of decision making. The main task of the authorities became the urgent closing of numerous financial gaps. Commands were given to obtain any credits on any terms, and the issues of alternative costs were not discussed. 1.1.3 The first debt crisis onset The first difficulties in debt servicing were manifested in 1989 when domestic borrowers began suspending payments for import contracts. Although the government still continued to service external debt, trade credits were not repaid in time by Vneshekonombank that emerged from a department of Gosbank specialized in foreign payments operations related both to trade and the state debt management (this bank later received the status of a government agency for external debt management). The state was a recipient of all foreign credits, and the suspension of payments in trade was a negative signal, raising the issue of state credibility. The majority of foreign banks stopped providing loans to the Soviet government for both import purchases and foreign debt refinancing. The banks required additional official guarantees and suggested that they should resort to the governments of developed countries to make new borrowing (Gaidar 2006, p. 267). The latter conditioned the granting of new credits on domestic and foreign policy issues, including the need for radical market reforms in the USSR and concessions in disarmament and Soviet control over East Europe. These strategic issues became a subject of debt negotiations with the foreign governments that took the role of ‘creditors of last resort’ for the bankrupting Soviet Empire. The Soviet authorities were neither prepared to begin the radical market reforms, nor had they any consistent strategy to solve the urgent problems of foreign payments. They recognized the seriousness of the problem, but this circumstance aggravated the situation in relation to external debt. In July 1990 Mikhail Gorbachev hinted publicly about the need to restructure the state’s external debts, and this was perceived by creditors and financial markets as an additional negative signal (Gaidar 2006, p. 268). Taking into account the long tradition of deep secrecy in Soviet policy making, an official recognition of severe problems with foreign debt was seen as clear evidence of very big troubles. The fundamental cause of the foreign debt crisis that began in 1990 was the chronic economic crisis of the centralized planned economy.


Although it was hidden under official statistics, it clearly manifested from the middle of the 1980s through strengthening shortages and rising black market prices. The bust occurred in 1990, when the Soviet GDP declined by 4 per cent. When the Soviet Union collapsed in the last quarter of 1991, the chronic economic crisis was transformed into a full-scale economic disaster. The fall in industrial production in 1991 was catastrophic – 21 per cent, with GDP falling by 11 per cent. The ruble inflation was accelerating: nominal household incomes increased in that year by 300 per cent, although the CPI growth rate was ‘only’ 160 per cent since retail prices were still under state control. The money overhang ran alongside the debt overhang. In two preceding years, 1990–91, the volume of external debt increased by 26 per cent – by $8.6 billion in 1990 and $12.4 billion in 1991. To a large extent, the total financial collapse was a byproduct of the total collapse of the state. In this situation the external debt default was inevitable, as a result of the balance of payments crisis and the huge state budget deficit. A large fraction of budget incomes had to be spent on debt servicing and high interest payments (under annual interest rates of 8 per cent on average). The complete fulfillment of debt obligations would require $15–17 billion per year or roughly 40–50 per cent of expected budget incomes. But the latter continued to be squeezed because of the disorganization in finance, and the economy approached a situation of debt overhang. The main trouble for the monetary authorities was the loss of control over export revenue flows and the absence of a legal foreign currency market. The Soviet government had no other choice but to continue external borrowing at an increasing pace. But now the main task was not to solve numerous current problems in the governance of the centralized economy, but rather to evade the total economic and financial collapse. The situation became extremely dangerous because of the threat of social unrest in many cities. The market economy mechanisms were only emerging (the ‘invisible hand’ was either absent or too weak as yet to fulfill its work), while the administrative system of consumer goods production and allocation had been destroyed completely. The delivery of food was a supreme policy issue: the threat of famine became real during that period, especially in the larger cities. Russian history had provided an important lesson: the abovementioned revolution of 1917 was triggered initially by short interruptions of food delivery to Petrograd, at that time the capital of Russia. Similarly, at the beginning of the 1990s the opportunity to borrow abroad became, essentially, a matter of national survival. With the free access to foreign markets

22


for goods that Russia was enjoying by that time, the crucial issue was fundraising to make the necessary purchases of foodstuffs. Under many credit agreements signed in the crisis period of 1990–91, direct deliveries of goods were carried out, of which about 80 per cent was grain. Naturally, creditors who did not receive current payments refused to carry out their obligations with regard to the supply of goods. Since the problem of foodstuffs was perceived at that moment as being highly urgent, obligations to the USA, the main supplier of grain and cheap food,10 were met in full. According to the USA’s Jones’s Act,11 the delivery of goods by credit line to another country had to be suspended if interest payments were not made in a timely fashion. Such a priority of payments that the Russian government adhered to left practically nothing for its official creditors in Western Europe, principally Germany. The latter held 45 per cent of Russian debt under the Paris Club agreement,12 but had strong political motivations – the unification of the state and the withdrawal of Soviet troops – for making generous concessions in negotiations around Soviet debts to German government, firms and banks. Commercial credits to the Soviet government were linked to contracted imports and financed by the first-class banks abroad due to the guarantees provided by the Soviet government. For instance, in 1991 65 per cent of such loans provided by German banks and 80 per cent of those by English banks were guaranteed by the German and UK governments, respectively (Kheifetz 2002, p. 139). The Soviet government also provided guarantees to foreign banks supplying non-commercial loans that supposedly had to cover the balance of payments deficits. Unlike commercial loans, these were not monitored by the foreign banks and remained under the discretion of the Soviet authorities. In fact, many of these credits were misused and disappeared in the period of the Soviet Union disintegration, 1990–91. Note that commercial credits to the USSR allowed many western firms to make some large-scale clearances of excessive inventories. Quality controls on behalf of the Soviet customs service were practically absent. Not surprisingly, a large fraction of imported goods were of low quality and overpriced. Foreign producers used exclusive opportunities to make extra profits without essential risks. Trading firms engaged in this kind of business made widespread use of opportunities to make extremely profitable arbitrage on price gaps. As was mentioned previously, the domestic prices of tradable goods in the Soviet economy were many times below the world level. In addition to all these opportunities for a ‘free lunch’ a large number of fraudulent deals were contracted under provisions that gave the


right to counterparties of the Soviet Ministry of Finance to conduct accounting. The former abused their opportunities to artificially build up financial claims that were presented later to the Russian government. One of the best-known examples of such dubious business is the notorious ‘Noga case’ originated in 1990 and whose repercussions still reverberate in Russia (Box 1.1). This case became a symbol of disorder in commercial and financial relations between the Soviet/Russian authorities and international business at a period of dramatic political and economic transformations.13

BOX 1.1 The ‘Noga Saga’ The Swiss firm Noga (Noga d’Importation et d’Exportation SA) headed by Nessim Gaon was engaged in international trade and financial operations. At the beginning of the market reforms in Russia Gaon tried to establish a long-term partnership between the new Russian government that came to power in 1990 and the Swiss banks. Gaon organized a syndicated credit line worth $420 million to finance the subsidizing of Russian agriculture programme Urojai-90 (Harvest-90) and also imports of foods, electronics, construction materials, chemicals, and so on, in exchange for oil products. This deal was essentially a non-transparent barter scheme relying on non-market relative prices. As was typical for such contracts, imported goods to Russia were overpriced, while oil products exported by Russia were severely underpriced. The expected profit rates of trading firms for such deals were normally hundreds of per cent per annum in dollar terms. Although Russia delivered its oil products in advance, imports by Noga were in many cases delayed or not delivered at all. For this reason the Russian government decided to reject the continuation of the deal. This was in the Summer of 1992 when many similar barter agreements inherited from the USSR were cancelled or renegotiated on a market basis. Importantly, from the middle of 1992 the Russian government began to apply the market exchange rate of the ruble in all export and import operations implying the need for the renegotiation of barter contracts. However, the specific problem with Noga lay not only in the very vague contractual terms, but also in the absence of any interbank agreement (Vneshekonombank did not participate initially in this deal as a financial intermediary). The Russian government thus assumed the full financial responsibility for the deal, implying a possible loss of sovereign immunity.

24


I had to cope with the Noga deal in my work in the Russian Ministry of Finance. Nessim Gaon claimed $800 million as compensation for the lost opportunities. Such a large amount of Russia’s engagement with one small firm aroused my suspicion and I decided to check the Noga claims carefully. Since bank documentation was not available for us, an international audit company was hired by the Ministry of Finance to check the legal validity of these claims. As independent auditing confirmed, Russia did not have debts to Noga because it delivered oil products in advance of contracted imports, and by the beginning of 1993 Noga was actually a net debtor of the Russian government. In 1994 Noga applied to the Stockholm arbitrage which recognized only $23 million of its claims. Meanwhile Russia revealed counter-claims to Noga worth $30 million that were also verified by the international trial. As a result, by the beginning of 1997 Noga and the Russian Ministry of Finance were close to settlement and mutual debts offset. But just at this moment I resigned the Ministry of Finance office. Unfortunately, my successors could not complete this deal at the very final stage because of the lack of experience and incentives. They were merely engaged in the domestic policy issues such as the division of national property among the oligarchs (to be discussed below in Chapter 3). If the Russian authorities had completed the Noga deal in a timely fashion, it would not have had serious consequences. For three years Gaon did not protest the arbitrage decisions because the Russian counter-claims were well-founded. But in 2000, as it became clear that Russia had suspended its actions indefinitely, Gaon renewed his legal proceedings. This time Noga gained for the simple reason that no Russian official found time to defend Russia’s interests in the international trial. To enforce the Russian government to pay, overseas Russian assets were seized on several occasions, as, for instance, the sailing research ship Sedov in Brest, France in 2000, and the foreign bank accounts of 70 Russian organizations. Similarly, in order to evade the arrest, Russian military aircraft had to leave France 2001. A collection of 54 Russian paintings from the Pushkin Museum, Moscow being exhibited in Switzerland in 2005 were also seized and later returned to Russia after the great scandal. Noga even threatened to arrest the Russian president’s airplane. In 2006 the debts of Noga to the western banks were purchased by an intermediary, but in 2008 Noga began to make new financial claims against the Russian government. It appears likely that the Noga Saga will go on!


Meanwhile the official financial reserves were dwindling. Foreign currency reserves fell from $15.3 billion in 1988 to $7.6 billion at the beginning of 1991. The state sold the official stock of gold: $2.7 billion in 1990 and $3.8 billion in 1991. Ultimately, this stock dwindled away to nearly nothing: in January 2002 only 200 tonnes remained. The date of the first debt default in the history of new Russia is 19 November 1991, when Vneshekonombank ceased its payments without any official announcement. The obligations of this bank were transformed later into the sovereign debt of Russia which grew by $4 billion (corresponding to unpaid trade contracts) and by nearly $8 billion (corresponding to blocked accounts). The status of Vneshekonombank as a government agency (similar to the status of Fanny Mac and Freddie Mae in the USA) guaranteed, formally, sovereign immunity. Nevertheless, the ending of payments to commercial creditors of the state was, de facto, the state default. To protect the Soviet foreign assets inherited by Russia from the claims of foreign creditors, a state-owned Vneshtorgbank was established as a bridge-bank with no debts. In addition to recognition of the Soviet debts, Vneshekonombank issued special instruments, quasiEurobonds, in the period 1988–90 worth about $3 billion that were not traded in the open market. Foreign currency long-term bonds of a nominal amount of about $13 billion were issued by Vneshekonombank in 1993 and 1996 to securitize its obligations. These bonds (OVGVZ) fell into the category of domestic debt papers since the major part of initial creditors were domestic firms and organizations.

1.2 The Russian debt: beginning of management By the end of 1991 the USSR had thus become bankrupt and disappeared as a political entity. The Russian Federation, its successor, automatically found itself in a state of external debt default. In a literal sense the defaulted Soviet debt turned out to be an ‘original sin’ of the newly born state. The ‘expiation’ of this sin became an urgent problem of the Russian Ministry of Finance after the beginning of radical market reforms in January 1992. At this time the volume of Soviet foreign debt amounted to $85 billion. Its rapid growth at the end of the 1980s and the beginning of the 1990s resulted from the crisis of the planned economy and a series of chaotic and wrong decisions adopted to postpone the economic collapse and prevent the bankruptcy of the state. These decisions were essentially ineffective and served only to aggravate the problem of excess debt burden in the economy. The Soviet external debt inherited

26


by New Russia consisted, first, of $38.5 billion owed by the USSR to the Paris Club of official creditors, second, of $22.5 billion debt to foreign commercial banks – members of the London Club of private creditors, and, third, of about $24 billion recognized as debts to the former Comecon and other socialist countries. Because of the chaotic borrowing decisions taken during the late Soviet period, the proportion of short-term debt with a maturity of two years or less in the overall volume of debt was quite high – nearly 20 per cent. The fulfillment of the initial payment schedule had to be carried out in the first half of the 1990s, but this was above the country’s financial capabilities. For instance, foreign debt service and interest payments during the three-year period 1992–94 were $18 billion per annum on average, according to the initial schedule. This was twice as high as the actual external debt service in the second half of the 1980s which had been $8.5 billion per annum on average. 1.2.1 Strategic choices Such an extra debt burden would be unbearable for any economy in deep economic and political distress. During that period a fall in Russian export revenue continued, undermining the state budget. It was clear that in the economic situation in which New Russia found itself the accumulated external debt obligations could not be repaid. Strategic decisions on this subject had to be adopted by the new Russian government, and the alternatives for making the strategic choice were fairly clear. (A) Russia takes full or partial responsibility. The original accord between the former Soviet republics – the CIS (Commonwealth of Independent States) countries – provided for joint responsibility for foreign debts and the proportionate distribution of foreign assets. The shares of republics in debt-assets were supposed to be corresponding to their fractions in foreign trade, output and population size. The share of the Russian Federation, calculated as 61.3 per cent, was fixed in the initial agreement on debt recognition and servicing, proposed by the finance ministers of G7 and signed on 4 December 1991 in Moscow. But this agreement turned out to be ineffective from the very beginning. Despite joint responsibility for Soviet debts recognized formally by all participants, only the Russian Federation agreed to make payments. The reason was that the principle of joint responsibility meant that if one side rejected to pay, others took its obligation. All the CIS countries but Russia preferred to be free-riders and the latter had to take the role of a sole legal successor of the USSR with respect to all debts and assets. Of course, these countries did not decline to take responsibility for debt


service directly. Instead, their representatives simply demonstrated their unwillingness to take any debt obligations in the process of multilateral negotiations on the Soviet debt with the Paris and London clubs. In fact, the former Soviet republics were reluctant to deal with these Clubs, as soon as the issue of debt payments was touched on in negotiations. For example, I remember Boris Sobolev, then deputy finance minister of Ukraine, who was very enthusiastic in expressing his opinion in general discussions of sharing responsibility for the Soviet debt among all CIS countries. Yet usually he disappeared or at best pretended not to be concerned with the issue each time it came to the necessity for Ukraine to repay its debts. In addition, it would be hard to implement any joint responsibility agreement. It was absolutely unclear how to divide between the republics’ debts owed to different countries and of different terms, priorities and other quality characteristics. The question of the benefits and costs of transferring the Soviet Union’s debts and assets to Russia virtually did not arise at that time (although it was actively debated later in political and economic circles). It is important to note that Russia accepted full responsibility for debts on its own, with no hard pressure by creditors and G7 governments. As a result, it became the only counterparty of the creditors: from April 1993 it established a bilateral framework for negotiations with the Paris Club. Obviously, the exclusion of other former Soviet republics from negotiations greatly simplified the process of searching for a mutually beneficial and comprehensive agreement on Soviet debts. (B) Russia claims forgiveness of debt or takes tough commitments. Another dilemma was to restructure the whole debt or to try to agree with creditors about partial forgiveness. The Russian government chose the first strategy, although the experience of forgiveness of Polish foreign debts (touched on in what follows) could justify the second strategy. However, most of the Russian reformers were optimistic about the expected effects of shock therapy in Russia. They believed that comprehensive economic liberalization and tight monetary policy would bear fruit within a year or two. The subsequent beginning of sustainable levels of growth would provide an automatic reduction of the debt burden. Unfortunately, this scenario did not materialize, mostly because of the anti-reformist political pressure in Russia and the specificity of the inherited economic structure.14 The true burden of the external debt on the Russian economy was undervalued by the reformers. They did not anticipate that the market transformations would be so painful and the contraction of the economy would be so deep and long. Nevertheless, if the strategy of

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writing-off debts was chosen, other CIS countries would require the renegotiation on shares in Soviet foreign assets. If Russia’s debt burden was relaxed, its sovereign rights on foreign assets should be reduced correspondingly, but the criteria of such correspondence were vague. The choice of debt forgiveness would also imply a very different framework for negotiations of Russia with G7 governments, international financial organizations, and creditors’ clubs. The partial forgiveness of debts would leave less chance of improving sovereign credit ratings and obtaining access to the world’s capital markets. Russia would face more obstacles in the new borrowing in the 1990s. As turned out several years later, the access to foreign liquidity turned out to be important in the macroeconomic situation of the 1990s. There were also global policy issues that motivated the decision to repay all debts: the status of Russia as a successor of the USSR and a potential superpower, the perspective of membership in the G8, the relations with other international institutions, and some others. It is notable that the very fact that the external debt problem emerged as the Russian Federation appeared as a new sovereign entity suggests an interesting analogy with the early history of the USA (Box 1.2). In 1992 Russia’s post-Soviet political system was not as much influenced by its strategic choice on debt, but Russia’s international status and internal economic policy certainly were.

BOX 1.2 The US Debt and Alexander Hamilton Following the Revolutionary War of 1775–82 the debt burden was unsustainable for the North American states. The new Constitution adopted in 1787 shifted power to the federal government which assumed the debt obligations of states in exchange for the right to collect taxes (import duties and alcohol excises), introduced the ‘hard’ bimetallic dollar in species, and rejected from the possibility of inflating or defaulting on the debt. By taking these measures the federal government committed to debt funding through current and future taxes. This firm solution of the debt problem not only improved the credibility of government obligations and stabilized domestic prices, but also shaped the political system of the newborn United States. It was a tribute to the efforts of Alexander Hamilton. He was a brilliant person. At the age of 21, he had been a captain in the Revolutionary War and became an aide of George Washington.


After the war Hamilton made a political career as a prominent advocate of the federalist Constitution. During his tenure as treasury secretary in the first government of the United States in 1790–95 Hamilton completely reorganized American finances and established new institutions to facilitate pro-competitive financial, trade, and industrial policies. This activity contributed to the sustainable and impressive growth of the US economy that began in the 1790s. The key task solved by Hamilton as a treasury secretary was the reduction of the public debt burden through well-organized debt management. The first federal government inherited huge public debt amounted to $75 million – or roughly 32 per cent of aggregate output in 1790. Financial resources were not enough to service this debt in full, partly because the US economy of the post-war 1780s suffered from a stagnation of trade and a dearth of liquidity. Hamilton, nevertheless, insisted on paying off all of the wartime obligations – some $11.7 million – to European creditors, mainly through new borrowing abroad. A strong commitment to disciplined foreign debt service attracted new foreign loans (to a large extent from Holland) that fuelled private and public investment growth at home and even made it possible to fund the purchase of Louisiana in 1804 (Wright 2008, p. 131). But the domestic debt remained in sheer disarray: it consisted of various kinds of Revolutionary War certificates issued by the Continental Congress worth $40.4 million and also of states’ obligations to a total of $25 million. The markets for these instruments were thin, desultory, non-transparent, and of low liquidity. The new federal government issued new bonds of higher quality and liquidity, but at notably lower interest rates which were to be exchanged on the market basis for the old ones. This debt swap was very successful: it reduced domestic debt service, benefited debt-holders because of improved debt servicing, and encouraged the development of home markets for government and corporate securities, foreign exchange, commercial papers, and private insurance. Hamilton was a master of the art of political compromise. He suggested to his political opponents Thomas Jefferson and James Madison (both from Virginia) that the American capital should be moved to the Potomac in exchange for their support in the Congress for his programme of redeeming the public debt in full. Jefferson and Madison insisted initially on the redemption at face value only

30


for the initial holders of war certificates, that is, the soldiers of the Revolutionary War, and not to pay in full to other debt-holders who could buy their certificates very cheaply. Hamilton, however, cared about the federal state’s reputation as a reliable borrower. This political deal established the federal financial system and ensured that Hamilton’s other plans would be approved by the Congress. To implement the state’s financial policy Hamilton also founded the National Bank of the United States with the federal state’s stake 20 per cent and the Sinking Fund. These institutions became prototypes of the modern central banks and debt management agencies. They supported trade in debt instruments through open market operations, smoothed the tax revenues of the federal government, and provided liquidity to the financial system. The National Bank became a lender of last resort when prevented the propagation of financial crisis after the stock market crash and the liquidity shocks of early 1792 (Wright 2008, p. 157). The Sinking Fund used excess tax incomes to support the domestic debt market, thus making it cheaper to carry out new borrowing abroad. The sound and systemic financial policy favoured the US economic growth and led to a substantial reduction of the public debt burden from 32 per cent of GDP in 1790 to 15 per cent in 1800, and 6 per cent in 1810. Alexander Hamilton’s political career ended tragically in July 1804. He was killed in a duel with vice-president Aaron Burr, demagogue, populist, and scandal-monger. Hamilton had deliberately fired his shot away from Burr, following his moral and religious principles (as clear from his last letter written the night before the duel). As an architect of public finances in the United States, Hamilton formulated the basic principles of public debt management, including, for instance, the distinction between funded and unfunded debt: ‘The proper funding of the present debt will render it a national blessing. … The creation of debt should always be accompanied with the means of extinguishment’ (Wright 2008, p. 134). He believed that there existed a tipping point beyond which the expansion of national debt would be economically and politically deleterious: ‘Where this critical point is cannot be pronounced; but it is impossible to believe that there is not such a point’ (Wright, 2008, p. 142).


The Russian Federation had to take full responsibility for the Soviet debt as a condition of maintaining its geopolitical status. Another issue was building a good reputation as a sovereign borrower as a precondition for the creation by the state of sound guarantees of property rights for foreign investors. A good attitude of foreign investors to Russia was, in turn, viewed as a prerequisite for the successful transition to the market and sustainable economic growth. The new Russian government wanted to distance itself from any kind of the Bolsheviks’ solution of the sovereign debt problem that had occurred seventy years before.15 But this choice was in a sense paradoxical because, from a purely economic point of view, market transition would require new borrowing at the very beginning to make it easier to overcome an inevitable economic decline. For many reasons the market reforms in Russia turned out to have devastating effects on the economy which fell almost by half during the 1990s. The main factor behind this catastrophic fall of production was the extremely distorted Russian economy structure (discussed further in Chapter 3), the absence of market institutions, the lack of market economy knowledge and habits among the Russian population, the socio-political tensions and instability, and the local civil conflicts of the 1990s. The key external factor that was also unfavourable for Russia was the fall in the oil price during this decade, below the initial expectations based on a long-term trend. In hindsight, Russia should have borrowed more as it began its transition to market, but, in my view, it would hardly have been possible to use additional external funds in an efficient manner. Optimal borrowing by a state should always be constrained by the ability of state officials to make competent and efficient decisions. This issue was – and still is – the key limiting factor for the creative activity of the Russian government. 1.2.2 Negotiations… The USSR did not have relations with the Paris and London Clubs of creditors, and neither did it carry on talks with the G7 members about the insolvency problems. Soviet borrowings were based on bilateral agreements until the external debt default and the country collapse happened in 1991. From 1992 these Clubs, the G7 ministers of finance and central bankers, and the international financial organizations became the main counterparties of the Russian government in its external economic relations. The procedure of multilateral talks was initiated by the Russian authorities who were seeking to find a compromise solution but lacked significant experience in these kinds of negotiations. The difficulty was not only in the total volume of debt that Russia

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had inherited, but in a huge number (many thousands) of specific and knotted accounting problems requiring thorough expertise. But the key and most urgent problem in 1992–93 was insolvency: Russia was unable to make even interest payments on the main part of Soviet debts, because the average interest rate 7–8 per cent per annum was too high for the state budget. The principal debt could be restructured according to the standard rules, but the rescheduling of interest payments required special agreements based on regular meetings with their creditors. For this reason every three months, the delegation of the Russian Federation held talks with the Paris Club members in Paris. It attempted to explain the essential meaning of cardinal transformations taking place in Russia and to demonstrate its insolvency and the actual needs in additional external funds. In the hope that the debt crisis would be resolved in the future, the creditors announced at every meeting that they granted the Russian Federation another three-month respite, while the Russian Federation pledged to do all it could to repay the debt most fully and correctly. Political support of this process was reached on G7 annual meetings. Then the Russian programme of economic reforms and debt restructuring received approval from the IMF and quarterly negotiations with the Paris and London Clubs took place. This was not only a formal routine: the Russian delegation had to demonstrate that the government would have really been able to obtain opportunities to repay debts in the future. We had to present a programme of economic reforms to be realized. Admittedly, during this period Russia made significant advances in reforming the economy in a number of directions. The International Monetary Fund (IMF) was the main arbiter and provided expertise on the programmes. The G7 also adopted the package of financial aid for every year. In my view, these relationships with international institutions were fruitful and mutually beneficial. Developed countries requirements on the pace of liberal reforms coincided with our own view on strategy of reforming the economy. Negotiations with the London Club of creditors headed by Deutsche Bank usually took place in Frankfurt. In discussing the terms of restructuring debts to this Club, questions arose in relation to the legal responsibility of the debtor. Creditors insisted that the debts be recognized as sovereign obligations of the Russian Federation, which would equate them to Eurobonds, and Russia, quite reasonably, refused to comply. Following nearly two years of negotiations, a legal solution was finally found – the Russian Federation did not sacrifice


its immunity. Incidentally, after the 1998 financial crisis (discussed in what follows), this status provided legal grounds to interpret the suspension of payments on the London Club debt as a decision made by Vneshekonombank, rather than the Russian Federation. Before the reaching of the comprehensive agreement, payments were made more or less evenly to all official and commercial creditors with the exception of the previously mentioned preferential foodstuff credits received from the USA. The debt to the Paris Club also had a certain priority relative to the London Club obligations for the simple reason that the former represented official creditors and negotiations with its members had occurred at an earlier stage. A certain political pressure exerted by these members also had some effect, resulting in the division of annual payments between the Paris and London Clubs as 2:1 in favour of the former, albeit the basic proportion of debt obligations was roughly 5:4. Admittedly, the process of debt servicing by Russia was not chaotic during this period. For example, decisions on which external debts should be repaid were adopted regularly by the Ministry of Finance. Each month I summoned to my office Yuri Poletayev, the head of Vneshtorgbank, who brought a draft of the current debt service schedule. Since he shared a typical banker’s opinion that every debtor should be treated equally, payments in his version of the schedule were rationed evenly among countries-creditors. Priorities among these countries were unimportant for him, and on each occasion I had to select a priority among countries myself by taking into account, for example, the abovementioned Jones’s Act. In a way, the Russian Ministry of Finance, as a key economic decision maker, replaced the Soviet Gosplan, and I bore responsibility for issues such as foodstuff imports from the USA to Russia. Some issues discussed at the regular Paris Club meetings were very controversial and required a search for compromise. The Paris Club turned out to be involved in setting complex issues of mutual debts recognition between Russia and the former Comecon members and other allies of the USSR (Box 1.3). Another difficult problem was that the exchange rate of the transferable ruble was set at the non-market value. Nobody could suggest any definite and satisfactory solution to the problem of the Soviet ruble exchange rate determination from the retrospective of several decades. The essence of a compromise was that Russia gained in terms of a higher valuation of its foreign credits to the former allies, but lost due to a higher value of debt owed to the former Comecon countries (worth $24 billion). As a result, the net financial position of the Russian Federation improved, but the actual debt burden increased by several billion dollars.

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BOX 1.3 The Problem of Mutual Debts Evaluation The Soviet Union exported food, equipment, chemicals, raw materials, and defence technology worth many billions of dollars to allied countries. In many cases these exports were politically motivated and accepted by the ruling regimes in these countries as a form of friendly support, a kind of gift for their loyalty to Moscow. But there was no formal recognition by the Soviet Union that these exports were really gifts to the loyal regimes. The problem was that such trade relations were based primarily on informal personal promises underlying contracts worth hundreds of million of dollars. Typically, barter exchange between the USSR and the allies was not confirmed through formal trade and credit agreements, and even lacked any proper legal and bank documentation. In some cases the only documents confirming multi-million bilateral deals were protocols of bilateral negotiations and written orders by the chairman of a Council of Ministers or a foreign trade minister. These orders were of the highest command power in the planned economy, but lacked sufficient legal power to constitute any formal recognition of debt obligations to the Soviet Union following its collapse. Not surprisingly, some countries-debtors were reluctant to recognize the existence of sovereign debt in respect of any such trade. The Eastern European countries also had debts for physical assets such as oil and gas transportation infrastructure built by the Soviet Union in these countries. In contrast to many kinds of barter imports from the Comecon countries, these assets were really valuable and, more importantly, durable. Oil and gas pipelines are still in use, being the backbone of the energy infrastructure of the entire region. Yet the former Comecon countries tried to use the lack of legal implementation in bilateral contracts to renege on their debt repayment or even debt acknowledgement to Russia as a legal successor of the Soviet Union. They actively questioned the fidelity of credit arrangements and have managed to make their doubts clear to the Paris Club. The key problem for the Paris Club negotiations that occurred in the 1990s in relation to these mutual debts was that the Soviet investments were made in barter exchange at non-market prices. Typically, physical assets built by the USSR were priced in Soviet rubles and were strongly undervalued in dollar terms. On the other


hand, the use of the transferable ruble fixed at a one-to-one rate to the dollar led to a strong overvaluation of imports to the USSR. All of its former trading partners benefited from making claims to Russia for their imports according to the nominal contract terms, except for Germany. Germany wrote off the major part of the former East Germany’s claims as a gesture of goodwill for the reunification. But Poland, Hungary, and several other countries, however, stood firm on the debt issue and discussed any variants of rescheduling only reluctantly. Russia, in turn, claimed recognition of the former USSR allies’ debts at least on the basis of the book value of physical investments (although this was far below any fair valuation). It was still very difficult to present these claims because even when credit agreements existed, they were created by Vneshekonombank afterwards. It had fulfilled thorough work to restore and put order in debt claims by Russia on the basis of available contracting documents of the Soviet government. One matter of controversy was the difference in methodology of accounting that implied huge differences in debt assessments by Russia and the Paris Club members. The evaluation of foreign debts to Russia varied much more than the estimates of the Russian debts that were better documented and, hence, much easier for posterior assessment. At the end of 1991 the Russian Ministry of Finance estimated the total nominal value of inherited sovereign debts to the USSR at $145.2 billion. The IMF/Paris Club’s estimate was only around half this figure, $73.4 billion, since it was based on the downward-biased assessments of countries-debtors.

Another source of controversy was to be found in the indefinite status of short-term commercial loans that remained for a while on the balance sheets of the former Soviet enterprises and banks. The claimants had changed in many cases, and the volume of accumulated debts and penalties on interest and principal payments were questionable. Western banks insisted on the recognition of all Soviet commercial loans as official Russian debt, and the estimates of this debt varied between $4 and $12 billion. The controversy lay in the accounting methods that were applied by the Ministry of Finance and the foreign creditors. The issue of commercial loans determination remained unresolved until the restructuring and securitization of London Club debts in 2001.

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1.2.3 … and their results (A) External debt was rescheduled. As a result of negotiations the Russian Federation, as the legal successor to the Soviet Union, had to pay only $1.7 billion in 1992 and $2.5 billion in 1993, or 13.5 per cent of its initial debt payment obligations. Russia thus received breathing space for several years during its transition to a market economy. Afterwards, the annual debt payments were increasing, but not as rapidly as was prescribed under the initial schedule. On average, the amount of annual external debt payments did not exceed 25 per cent of the initial schedule in 1992–99. The residual debt burden was thereby shifted to the next decade, and the authorities received carte blanche to stabilize the economy and introduce their market reforms. Table 1.4 demonstrates the dynamics of inherited Soviet debt, new Russian debt, and the total external debt service costs in the 1990s. The external debt burden was in fact not so hard: it did not exceed 0.7 per cent of GDP on average until the financial crisis of 1998. Clearly the easing of the debt burden was a very important precondition for the Russian economy’s transition to a market economy, and this issue was one of the key points in our negotiations. Initially only current payments were rescheduled on an annual basis. In parallel to these more or less routine procedures, the preparation of a comprehensive agreement with the Paris Club members was proceeding through lengthy bilateral negotiations with governments-members. The agreement in relation to the Paris Club debt restructuring was signed in April 1996 and covered 82 per cent of total external government debt, amounting by that time to around $38 billion. It concerned the debt service falling due between January 1996 and March 1999 and embraced virtually all the debts rescheduled in the previous agreements. The average period to maturity of restructured debt obligations was in excess of 20 years. Another comprehensive agreement with the London

Table 1.4 Russian external debt ($ billion, end of period) Year

1992

1993

1994

1995

1996

1997

1998

The USSR debt 104.9 The Russian debt 2.8 Debt service costs, 0.7 % of GDP

103.7 8.6 0.3

108.6 11.3 0.5

103.0 17.4 0.9

100.8 27.7 0.9

97.8 35.6 0.7

95.0 53.9 1.2

Source: Russian Ministry of Finance.


Club of banks on a 23-year debt repayment of $33 billion was signed in December 1997. The principal debt of $22 billion was restructured as debt instruments called PRINs, while the unpaid interest capitalized had to be discharged through the issuing of another instrument, called IANs. As a result of these agreements, Russia obtained a five-year grace period, and, most importantly, the period for the major payments of Soviet debt were shifted to the next decade. (B) Important channels of external financing were created. Subsequently, operations with Soviet debt were limited to a series of successive restructuring measures. But the need for external financial resources remained, and Russia had to continue borrowing (Table 1.5). Initially, two kinds of loans were used: first, those from international financial organizations – the World Bank, the International Monetary Fund, and the European Bank for Reconstruction and Development; second, official credits on bilateral basis to finance imports of foodstuffs and equipment. However, as early as 1993 Russia had virtually stopped buying foodstuffs through the use of these credits; the annual volume of machinery and equipment purchases financed with such loans fell to $0.5–1 billion. In connection with this, the government external debt policy focused solely on the loans from the IMF and the World Bank. (C) Russia achieved the status of a creditor nation. As a result of the recognition and evaluation of the Soviet credits to former allies and other countries, the Paris Club recognized Russia as a creditor nation. This enhanced opportunities to manage Russia’s foreign assets, although some of these were either illiquid or very low in value. This

Table 1.5 Dynamic and structure of new Russian debt in the 1990s ($ billion, end of period) Years Total debt IFO* Paris Club London Club Eurobonds OVGVZ** CBR***

1993

1994

1995

1996

1997

1998

1999

8.6 3.5 5.0 0.1

11.3 5.4 5.9 0

17.4 11.4 6.0 0

27.7 15.3 7.8 0.1 1.0 3.5

35.6 18.7 7.6 1.3 4.5 3.5

53.9 22.2 9.7 0.2 16.0 3.5 2.3

54.5 19.4 9.5 0.11 15.6 3.5 6.4

Sources: Russian Ministry of Finance, Kheifetz 2002, p. 95. * International financial organizations: IMF, WB, EBRR; ** New Vneshekonombank foreign currency bonds issues were added in 1996 to external debt; *** Currency credits to the government for external debt repayment after 1998.

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The Russian Public Debt and Financial Meltdowns 25 20 15 10 5 0 ⫺5

1993

1994

1995

1996

1997

1998

1999

2000

⫺10 ⫺15 Debt payments

Debt increase

Figure 1.2 Russia’s external debt payments and debt increase in the 1990s ($ billion) Source: Russian Ministry of Finance.

Table 1.6 Sovereign debts owed to the Russian Federation by the end of 1991 ($ billion) Country

Cuba

Mongolia

Vietnam

India

Syria

Others

Volume

28.3

17.8

16.8

16.3

11.7

54.3

Source: Kheifetz (2002, p. 153).

problem concerned primarily the sovereign debts of underdeveloped former Soviet allies (given in Table 1.6 according to the assessment by the Russian authorities). The total number of sovereign debtors to Russia exceeded 50 countries, of which 13 owed 88 per cent of total debt, and the five countries mentioned in Table 1.6. owed 63 per cent of debt. The sovereign debts of countries like Ethiopia and Sudan were quoted at 1–2 cents per dollars, and debts of Afghanistan, Mali, Somali and Kampuchea had zero price (Kheifetz, 2001, p. 154). The membership of Russia in the Paris Club simplified negotiations and agreements with other members of the Club on the basis of standard mechanisms for debt negotiations. The procedures of settlement with debtors were initialized and a large spectrum of foreign assets was involved in the sphere of market exchange. This would be problematic on a bilateral basis, because in some cases the extent of debts to Russia were questioned by countries-debtors (Box 1.3), and the settlement


process required the use of international facilities. One has to acknowledge the importance of Russia’s decision to join this Paris Club in solving all of these problems. Absent the official creditor status, even the miserable repayment after the end of the process of rescheduling would be impossible. More importantly, Russia got a chance to become a global creditor nation in the next decade, when huge official foreign reserves of more than half a trillion dollars were accumulated and the National Sovereign Fund was created in 2007. (D) Russia received acceptable sovereign ratings. The external debts restructuring allowed the world’s leading credit rating agencies to give Russia sovereign credit ratings in October 1996. The new ratings were stable and firmly belonged to BB category: BB⫺ by Standard & Poor’s, Ba2 by Moody’s, and BB⫹ by Fitch IBCA. These assessments were based on the recognition of moderate country risks that were acceptable for financial investors operating in the emerging markets. One immediate consequence of rating conferment was the first successful issue of Russian Eurobonds in November 1996. The federal government received a valuable opportunity for public debt management using international market instruments. Moreover, the leading Russian banks could also achieve credit ratings and begin borrowing from abroad. Local governments of some advanced Russia’s regions and the largest cities also entered the foreign financial markets by issuing Eurobonds. These developments marked the de facto financial integration of the Russian economy with the global financial system. In hindsight it seems surprising how difficult it was to persuade the Russian authorities of the need to secure sovereign credit ratings for Russia. When I initiated this idea, it received support from the prime minister Viktor Chernomyrdin and leading economic reformer Anatoly Chubais. For a long time, however, the latter could not understand why indeed Russia needed sovereign ratings, and I had to explain to him the potential benefits for the Russian economy. The top officials were not very enthusiastic at being involved in the rating process and, especially, of having personal conversations with the rating agencies representatives. I remember the case when a Fitch IBCA expert posed Viktor Chernomyrdin a ‘delicate’ question: ‘What will happen with Russia if Boris Yeltsin dies?’ This was just before Yeltsin’s heart operation in 1996, and the question was quite a reasonable one. Viktor Chernomyrdin answered correctly that in such circumstances policy making would proceed according to the Russian Constitution, but following this interview he was angry at me for a while. Russia’s top officials became aware of the importance of sovereign credit ratings a bit later, when Russia began to receive foreign investments.

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(E) Institutions of debt management were established. These institutions are of central importance for any modern system of government finance. They could not emerge in a planned economy that was largely isolated from the world’s financial markets. Debt management based on market principles was an effective disciplining device. Obeying international rules required a certain transparency and responsibility on the part of the Russian authorities, thus introducing some order in the process of decision making. Cooperation with the world’s financial organizations and institutions allowed the authorities to improve the methodology of macroeconomic and statistical analysis, to use modern techniques, expertise and consultations. These processes had a positive effect on the domestic financial policy making framework and stimulated the creation and development of a comprehensive debt management system. Finally, the beginning of Russia’s integration with the international financial community acted as a catalyst for the development of domestic financial markets.

1.3 External debt and macroeconomic policy Debt policy in the USSR and Russia was shaped largely by the force of circumstances, above all political ones. The Soviet authorities were forced to build up external debt because they were unable to balance the budget and avoid the rapid monetization of the budget deficit. The Soviet debt crisis and the external debt default became inevitable because of the fall in the world oil price and foreign trade deficits, the failure of semi-market reforms, and the loss of financial control by the state. Its bankruptcy left no other choice for Russia but to launch radical market reforms in 1992. These reforms began with an acknowledgement of the external debt obligations of the Soviet Union. When Poland, at that time the benchmark case for Russia, had begun its reforms two and half years earlier, it received essential support from the world’s financial institutions. In particular, foreign debts were forgiven, and the stabilization fund to defend the zloty was created.16 Partly for this reason Polish shock therapy was successful and bore fruit within two years. As was mentioned above, the decision by Russia to take all Soviet debts instead of claiming debt forgiveness was justified by strategic and political motives. In a sense, it shaped the pattern of financial development of Russia during the 1990s. 1.3.1 External debt as a disciplinary device Initially, the Russian reformers thought that economic liberalization would stimulate economic growth that would – sooner or later – reduce


the initial debt burden. The idea was to restructure the external debt and repay it when the economy switched to the regime of steady growth. The optimistic beliefs that this would occur in two–three years, as had happened in Poland, turned out to be wrong.17 The Russian economy began to grow after only seven years, after the financial crisis of 1998, because of the devaluation of the ruble and the upsurge in oil prices. Instead, the market transformations caused a reduction of nearly onehalf in Russian GDP,18 implying that the external debt burden on the economy increased more than twice (because of Russia’s new debts). This burden per se was an obstacle to attract foreign investment and stimulate domestic private investment. One could judge a posteriori that the economy was being pushed artificially into a new debt trap. Not surprisingly, the decision in relation to debt acknowledgement was criticized by many opponents of the market reforms in Russia. One positive side of all these troubles was that the Russian financial authorities had no choice other than to negotiate with foreign creditors on the restructuring of the Soviet debt. They received thereby a strong stimulus to continue their market reforms despite the resistance of various lobbying groups at home. The key intermediary role in these negotiations was played by the International Monetary Fund. The Russian Federation became a member of the Fund on 1 July 1992 and just over a month later, on 5 August 1992, received the first credit line worth $1 billion. One has to admit that the Fund acted quickly taking into account the extreme need of Russia in external financing. As was mentioned above, although Russia inherited the whole of the Soviet debt, it could not service it during the first years of reforms. Each time a decision to postpone debt payments was adopted it was made contingent on the IMF’s approval of reforms and efforts by authorities to stabilize the economy. The agreement with the IMF of these annual programmes was a basic requirement for making regular agreements with its official and private creditors. This routine made it possible to eventually establish a full-scale restructuring of debts to the Paris and London clubs. The external debt was thus not only a burdensome Soviet legacy. At the beginning of the 1990s it was a strategic tool for reorganizing the macroeconomic policy framework on a market basis and with a strong priority being given to long-term financial planning. The Soviet-style financial managers were unfamiliar with this approach because they were trained on the administrative methods of control and the dominance of short-term planning in the natural form which finance was

42


subordinated to. The adoption of the new approach to financial management required effort and time. From the very beginning financial policy making had to be adapted to an open rather than a closed economy, which essentially the Soviet planned system had been for many decades. The emphasis in this work was made on the balance of payments calculations as a basic tool for financial planning. At the beginning of reforms the staff at the Central Bank of Russia (CBR) did not have enough professional experience as a result of their earlier activity in Soviet Gosbank, and the Russian Ministry of Finance staff had to rely on its own efforts and also on the assistance of the IMF’s staff in Moscow. Utilizing various balance of payments scenarios my colleagues and I made projections of the current account and evaluated the needs for external financing over the next few years. Analytical work of this sort could reveal Russia’s actual needs in new borrowing and was very important for our negotiations on debt restructuring with the creditors’ clubs. To improve the capacity of the Russian staff, the IMF organized regular training courses which were very effective. Our colleagues from the Ministry of Finance and the CBR very quickly learned about international accounting standards and other modern techniques. In addition, a new generation of high-skilled analysts became trained on modern ground in Russia. When I organized the Economic Expert Group in the Ministry of Finance in 1994, it was initially headed by highly qualified foreign experts in macroeconomics. But soon it became possible to invite talented Russian graduates from NES (The New Economic School, Moscow) which was established on the basis of CEMI (The Central Economic-Mathematical Institute of the Russian Academy of Sciences) in 1992, and where students with a very good mathematical background were taught by professors from western universities. Up to the present day NES is the most advanced economic school in Russia. For example, Arkadiy Dvorkovitch graduated from this school and was the head of the Economic Expert Group for several years. Today he is the chief economic adviser to the Russian president Dmitriy Medvedev. Foreign debt servicing was so important in this period that it formed a framework for fiscal and monetary policy making. Our work on debt policy was conducted in close cooperation with the IMF and made it possible to tame the inflationary demands of various interest groups. It is important to note that the Russian government was (and still is) politically heterogeneous. At that time it included both the liberal ‘financial’ block and the conservative ‘industrial’ block that resisted reforms and put pro-inflationary pressure on the government. In effect, the IMF was able to influence the budget process and monetary policy and provided thereby support to the financial block (initially the Ministry of Finance)


in its political confrontations with the industrial block. For this reason in the 1990s the external financing was an important inflation-deterring factor that had a substantial influence on the conduct of domestic economic policy. The most important effect was the conditionality of the IMF loans on the annual programmes of macroeconomic and structural reforms and, importantly, on the actual results of these reforms. At the beginning of our negotiations on debt restructuring and new loans provision these effects were negligible, since the attempts of Russian authorities to curb inflation in the period 1992–94 had been half-hearted. Nevertheless, the inflation rate was reduced from 25 per cent a month at the end of 1992 to 1.5 per cent a month by the end of 1995 (we will discuss the Russian macroeconomic stabilization in Chapter 2). Importantly, the style and preferences of monetary and fiscal authorities were changing, and the contribution of the IMF to improving monetary and fiscal discipline during these years was very significant. External debt agreements effectively constrained the opportunities of the Central Bank to inflate, which was the main macroeconomic problem until 1995–96. In addition, the foreign debt served as a commitment device through the increased expected costs of inflation surprises. This ultimately made the Russian authorities less inclined to resort to budget monetization or ruble devaluation as macroeconomic policy tools.

30

1400

25

1200 1000

20

800 15 600 10

400

5

200

0

0 1992 1993 1994 1995 1996 1997 1998 1999 2000 Consolidated budget deficit, % of GDP

CPI annual growth, %

Figure 1.3 Inflation rate and the consolidated budget deficits in the 1990s Source: Goskomstat, the Russian Ministry of Finance.

44


It should be emphasized that in the 1990s the IMF had the tools to have a strategic effect on the economic policy course in Russia. As a result of the relatively small size of the Russian economy and the lack of financial resources of the state,19 even hundreds of million of dollars were enough to close the serious budget gaps. The total amount of IMF credits disbursed to Russia in the 1990s was $20.5 billion (15.6 billion SDR, the IMF currency unit); the flow of annual payments is depicted in Figure 1.4. These credits were either short- or medium-term in nature, with typical durations of either 2–3 or 5–7 years, but were not subject to restructuring. Financial support by the IMF was significant and constituted nearly 36 per cent of the total Russian debt accumulated in the 1990s (as should also be clear from Table 1.5). The IMF had therefore enough power to implement a ‘carrot-and stick’ approach to policy. Sometimes it did indeed work as a stick: for example, Russia was granted only 68 per cent of a total credit line amounting to $30 billion. The ‘stick’ was also applied strictly to Russian policy makers at the height of the financial crisis of 1998, as will be discussed in Chapters 5 and 6 of this book. The IMF loans were most effective as a tool to support the attempts to achieve macroeconomic stabilization. The first credit tranche to Russia of 1992 and the so-called ‘system transformation’ credit lines of 1993–94 were designed to prevent a new unfolding of an inflation spiral. A stand-by $6.3 billion credit line was approved in April 1995 to implement a full-scale stabilization programme. This credit line was

7 6 5 4 3 2 1 0 1992

1993

1994

1995

1996

1997

1998

Figure 1.4 IMF credits to the Russian government in 1992–98 ($ billion) Source: Russian Ministry of Finance.


supposed to finance the federal budget deficit and served as a financial reserve for the case of the balance of payments deterioration. The results of the stand-by programme were very successful: Russia made notable progress in suppressing inflation (as will be shown in Chapter 2). A tight monetary policy framework was created through the monthly monitoring by the IMF and the fruitful integration of efforts by the Finance Ministry and the Central Bank. But the next credit line granted by the Extended Fund Facilities agreement in March 1996 turned out controversial, as, for instance, Stanley Fischer (2001) later recognized. The political situation after Boris Yeltsin’s re-election in 1996 was very uncertain and fragile, because of his illness and the weakness, and as a result of the extreme populism of the State Duma (the Lower House of Russian Parliament established in December 1993). The fiscal policy relaxed in 1996–97 making macroeconomic stabilization to a large extent meaningless. The IMF’s position was precautious, but it took the risk and decided to give a chance to a new command of ‘young reformers’ that occupied the government positions in 1997, even though it failed ultimately. In general, the influence of the IMF credits on domestic policy making was a positive one. But in my view, the Fund’s main contribution was in the transfer of qualifications, professionalism, methodology and the experience of macroeconomic stabilizations and liberal reforms. The IMF mission in Russia facilitated the spread of international standards of accounting, assisted in methodology of the budget process rationalization, provided regular high-level analysis of macroeconomic situations and expertise about the key problems faced by the economic authorities. On the one hand, the IMF’s assistance was enormously helpful in defence of the Ministry of Finance’s position in our negotiations with the Paris Club or G7 meetings. On the other hand, the pressure exerted by external financing and the IMF position constrained the pro-inflation activity of political populists and crowds of lobbyists like the so-called ‘red directors’ – the influential top managers of the industrial ‘dinosaurs’, as the large, inefficient Soviet-style enterprises were called. Unfortunately, the IMF was also heavily involved in domestic policy issues, including, for example, the complex problems of reforming natural monopolies. Structural reforms of this kind were very hard to implement and were in fact far beyond the competence of the Fund. This activity diverted efforts thus unwittingly furthering the influence of anti-reform interest groups on economic policy. The ordinary IMF staff members usually spent months in Russia and put a lot of effort into understanding in some depth the specificity of Russian transition

46


before making practical recommendations to the Russian authorities. This thorough and useful work contrasted with the activity of some top officials from the creditor countries who visited Moscow or participated in the Paris Club negotiations. In my view, their vision of the Russian economy lacked proper comprehension and was sometimes superficial, probably, because they did not have much time to go deep into details. Instead they preferred to repeat like a mantra the common sense assertions from elementary textbooks that the state budget should be balanced, the Central Bank should not inflate, the government should service its debt, and so on. For example, the key message by Jean-Claude Trichet, at that time a highranking official in the Paris Club, was that Russia had to service its debts completely, according to the initial schedule. This was in 1992, when Russia simply did not have enough foreign reserves to make full payments, and the Russian delegation did not want to take unrealizable commitments. But in Trichet’s view, the Russians disagreed with his requirement simply because they did not understand elementary matters such as the difference between interest and principal. Many times and for many hours my colleagues and I listened patiently to lectures on basic economics but, nevertheless, maintained our position. This was our main task in negotiations on external debt, and our ‘teachers’ were sometimes dissatisfied about their communications with such ‘slow-learning students’. Sometimes the Fund made simple mistakes because of their overreliance on the application of abstract theoretical principles. Of course, some textbook recommendations, such as price liberalization, were relatively successful, but some did not work at all. Two of the Fund’s suggestions had negative consequences for the Russian economy and deserve a mention. The first was the strong recommendation in 1992 that the former Soviet republics should unify their currencies. This idea was based on the optimal currency zone theory underlying European monetary integration, and on historical examples such as the disintegration of the Austro-Hungarian Empire in 1918. However, the political and economic situation in the CIS countries was very different. The Russian Ministry of Finance tried to raise objections against the Fund’s recommendation to unify currencies. As a compromise solution, it was decided to create the so-called ‘ruble zone’. The CIS countries had already established their own currencies, but, as members of the ruble zone, claimed provision of technical credits from the Russian Central Bank to meet credit expansion by their own national Central Banks. Because of the free-rider motive, the ruble zone was easily transformed into an ‘inflationary currency zone’ where all countries-recipients of technical credits benefited


from inflating at the expense of Russia. Actually, the latter subsidized the former Soviet republics by sharing seigniorage income. This system was abolished in August 1993, but for a whole year the technical credits were a channel of cross-country inflation spillover to Russia. The second questionable IMF recommendation was to abolish oil export tariffs in 1995 in order to eliminate trade barriers and tax distortions. This measure resulted in a drastic reduction of budget revenues at a time when a fiscal crisis had become the key issue for Russian authorities. The export of oil and gas is inelastic and limited by pipeline capacity, and the effects of export tax reduction on the supply were weak. Commodity export taxation is market distorting, but it was desirable as a second-best solution. It could effectively substitute for the rent taxation that was essentially ignored in the 1990s, because of the lobbying activities of the major oil-producing companies.20 The IMF unwittingly supported them by pressuring the government against oil export taxation. The government conceded but had to restore it in a couple of years. In the next decade the commodity export taxes became an important mean of oil rent collection by the state and a source of the federal budget surpluses. 1.3.2 Market-based debt management The external debt negotiations of the 1990s brought about some elementary order in the financial policy of Russia and created the prerequisites for systematic debt management by the state. The main problem was that the government still lacked standard market tools and had to initiate the development of a modern domestic financial system. A broader vision on active debt management was that it could be a framework for organization of a modern-style system of government finance. As the negotiations with creditors were close to the successful finale, a search for the solution to this problem became the main strategic task for the Ministry of Finance and for me as a deputy minister responsible for financial policy making. The next concrete step after rescheduling the Soviet debts and obtaining the sovereign ratings in 1996 was to organize external debt management on a long-term basis with the use of liquid and transparent market instruments. A starting point for the fulfillment of this task was the first Eurobond issue at the end of that year with a nominal volume of $1 billion. This was a pilot project implemented very successfully and perceived by the financial community in Russia and abroad as a real breakthrough. Nobody expected the initial bond price be so high, 100.5 per cent under a coupon rate of 9.25 per cent, as demonstrated in Table 1.7.

48


By comparison, at that time the real returns on domestic government papers were above 30 per cent per annum. The Eurobond yields exceeded interest rates on the IMF loans by two or three basis points, but the former did not require non-market negotiations and reflected positive public anticipations of economic performance in Russia. The subsequent three issues of Eurobonds in 1997 were also successful, with the third one issued at a higher coupon rate – 10 per cent – because of the beginning of the Asian crisis in June 1997. The total volume of these three issues was not so big, roughly $4.5 billion. But, in my view, the Eurobond market entry should have launched a long-term programme of Russian debt securitization and the creation of debt management based on market instruments. The main issue of public debt management to be put forward was the optimization of the volume of debt, maturity and currency structure, and risk profile. This should become the principal subject of financial policy. New debt issues had to be used to smooth tax distortions over time. For example, the tax burden on the Russian economy had to be increased dramatically in 1995–96 in order to sustain the macroeconomic stabilization (Fischer 2000). This would require a radical fiscal reform that it would have been virtually impossible to implement at this time. A new debt issue could mitigate the additional fiscal burden or compensate for the absence or failure of fiscal reform. As is known from the theory of optimal dynamic taxation,21 the debt structure matters under uncertainty related to primary budget incomes,

Table 1.7 Russian Eurobond issues in the 1990s Date of issue 21.11.96 13.03.97 19.06.97 24.03.98 30.04.98 10.06.98 24.06.98 24.07.98 24.07.98

Date of Duration, redemption years 27.11.01 25.03.04 26.06.07 31.03.05 21.04.03 10.06.03 24.06.28 24.07.05 24.07.18

5 7 10 7 5 5 30 7 20

Volume, billion $1 2 DM $2** 1.25DM 750IL*** $1.25 $2.5 $2.97 $3.47

Coupon Spread, Initial rate, % base points* price, % 9.25 9 10 9.375 9 11.75 12.75 8.75 11

345 370 365 475 435 650 753 940 940

101.3 101.8 99.2 101.4 99.7 98.8 98.4 73.8 73.9

Sources: The Russian Ministry of Finance; Kheifetz (2002). * Yield spread to government papers of the corresponding country and similar duration. ** The additional tranche $400 million was issued on 23.10.97. *** Italian lire.


expenditures, and the costs of debt servicing. In the 1990s the Russian financial authorities had to cope with a variety of currency, interest rate and rollover risks. When the fraction of short-term debt became too high and the potential threat of debt runs became a greater problem, the government had to focus on the term structure and try to lengthen radically the time to the maturity of obligations. Because of the limited demand of investors for ruble instruments, the available solution was the further extension of Eurobond issues in the second half of the 1990s. As will be shown further below, the government had this option at the beginning of 1997, but focused instead on hopeless attempts to increase duration of the ruble debt papers. When the Russian government entered the international financial markets, the portfolio of its obligations was exposed to systemic risks (described below in Chapter 4) that should also be dealt with actively. In my view, the measures of early crisis prevention, which were discussed intensively after the Asian and Russian crises of 1997–98, could have been installed into the system of debt risk management as an operating block related to rare or tail risk events. In the middle of the 1990s the Russian financial system became much too exposed to the external risks due to domestic debt expansion and capital inflows. The worst crisis scenarios were ignored by the monetary authorities, but one such scenario did emerge in 1998. The establishment of effective debt management based on a bundle of market instruments and financial engineering was supposed to be my urgent task as deputy Minister of Finance in the pre-crisis year 1997. Unfortunately, the creation of this system was blocked for a year, after I left the Ministry in March 1997. The active policy of debt management was reanimated only in Summer 1998, when the threat of financial catastrophe became obvious to the Russian authorities. The whole year was lost and the tardy attempts to govern the currency risks and change the term structure of debt proved to be awkward and unsuccessful. A large-scale securitization of commercial debts was postponed for several years and realized only under the London Club debts restructuring in 2000.

2 The Domestic Financial System and Inflation

Introduction In addition to the external debt obligations, Russia inherited from the USSR a huge money overhang caused by the hidden budget deficits accumulated over many years. This overhang transformed hidden inflation (manifested in chronic shortages, long queues, and price growth in the non-official segments of the economy) into explicit price growth and yielded a tremendous outburst of inflation, once prices were liberalized in January 1992. The Russian reformers applied shock therapy based on the Polish experience of economic liberalization and macroeconomic stabilization. They intended to tighten monetary policy to suppress inflation by means of a nominal anchor and then to create conditions for stable economic growth. This programme worked effectively in the East European economies where macroeconomic stabilizations normally required two or three years. Unfortunately, the attempt to curb postliberalization inflation in Russia was very short, and, because of the strong pro-inflatonary political pressure, the authorities began the monetization of huge budget deficits. The result of monetary expansion was real money squeezing that generated the problem of non-payments, an incurable disease of the Russian economy in the 1990s. As will be shown in this chapter, the Russian financial markets that originated in conditions of high inflation were chaotic and unregulated with neither an appropriate legal base, nor adequate market institutions and infrastructure. Ordinary people were, nevertheless, enthusiastic about searching for new financial investment opportunities, partially because high inflation eroded savings in rubles. But, as a rule, they had no experience and knowledge about underlying risks and incurred high losses from unfortunate financial investment. The authorities did not 50

The Domestic Financial System and Inflation 51

pay enough attention to organization of informational support and warning of population about fraudulent financial schemes. In this situation the urgent task was the creation of civilized financial markets that began with the launch of the domestic debt market in 1993. It was a real breakthrough that made possible the introduction of modern technology in financial exchange. Opening of the market for government securities, without doubt, made a significant positive contribution to the development of the Russian financial system (but was made later a scapegoat for the Russia’s financial troubles of 1998). The banking system proved to be dominant over the emerging domestic financial markets. It grew very rapidly under high inflation, but remained inherently very weak. The most dangerous aspect of the banking system’s fragility was its symbiosis with government finance that ensured high levels of profits. Bank managers typically ignored the essential risks and were typically unprepared to reversals in external factors. Banking practice was designed to exploit high inflation and could not adjust to abrupt changes in the monetary policy regime. The first banking crisis, which occurred as a result of the macroeconomic stabilization of 1995, was an early warning of future financial disasters, but did not lead to essential improvements in the quality of the Russian banking system.

2.1 The origination of financial markets The radical market transformation of the Russian economy began on 2 January 1992 with the radical liberalization of domestic and foreign trade. The first team of reformers was headed by Yegor Gaidar who was the acting prime minister at the time. The programme of reforms was based on a package of measures designed to be implemented over a period of two–three years. Price liberalization was the first step in the ‘shock therapy’ programme tested earlier in Poland. The second step, as initially designed, was to conduct a policy of monetary stabilization. The government attempted to impose money control in the first quarter of 1992 which continued until May of that year. This was a short period of relatively tight monetary and fiscal policy required to curb price growth after price liberalization. If consistent, this strategy would be able to suppress inflation within several months. Unfortunately, essential corrections to the initial programme had already been put in place just six months after the launch of reforms. The shock therapy policy in Russia failed at the very beginning, because of the strong political resistance and an economic structure that was not suited to radical reforms.

52


2.1.1 Inflation spiral The CPI jumped by 250 per cent in January 1992 as a result of the monetary overhang accumulated under the previous Soviet financial system and continued to grow at double-digit monthly rates subsequently. Price liberalization embraced all goods apart from energy resources, grain, and the main foodstuffs. The regulated prices were increased between three and five times in 1992 (domestic oil and gas prices more than six times), but still remained some two or three times below the world levels. The initial price shock was very strong, but it could have been temporary, as is shown by the reduction of the inflation rate in the first half of 1992 (Figure 2.1). However, in June 1992 the Central Bank of Russia weakened money control and began its expansion of credit. The average monthly growth rate of money supply M2 was 11 per cent in January–May but had increased to 27 per cent a month in June–December 1992. The CBR thus abolished the monetary stabilization programme which was part and parcel of the policy of economic liberalization. The initial explosion of inflation was an inevitable but temporary consequence of monetary overhang, but the Central Bank chose to switch to a highinflation regime. At the same time it abolished multiple non-market exchange rates and unified the exchange rate that became convertible

45

700

40

600

35

500

30 25

400

20

300

15

200

10

100

0

0

Fe

b92 M ar -9 2 Ap r-9 2 M ay -9 2 Ju n92 Ju l-9 2 Au g92 Se p92 O ct -9 2 N ov -9 2 D ec -9 2 Ja n93

5

Monthly inflation,% per month Nominal ruble exchange rate, rubles to dollar Figure 2.1 The CPI inflation and the nominal exchange rate in 1992 Sources: The Central Bank of Russia; Goskomstat.


on current account. The CBR adopted a regime of managed floating: there was no reason to apply nominal anchor in any form under high inflation. Figure 2.1 illustrates the close correspondence between the ruble exchange rate depreciation and inflation acceleration in the second half of this year. Since June 1992 the official exchange rate of the ruble had been determined on the market basis at Moscow Currency Exchange (MICEX) under the provision of compulsory sales of 50 per cent of export revenues used for currency interventions. The inflationary policy adopted by the CBR was simplistic in the sense that it consisted essentially of two kinds of decisions: first, on the volume of credits to the state and the economy (through the monetization of the state budget deficit and non-budget transfers) and, second, on the ruble-todollar official exchange rate determination.1 In July 1992 the newly appointed chairman of the CBR, Viktor Gerashchenko, announced a radical decision to support the production sector of the economy with massive centralized credits. Gerashchenko was the last head of Soviet Gosbank and had a great deal of experience about the technical issues of banking. But he ignored some important macroeconomic issues and suggested an inflationary way of solving sharp financial problems that Russian enterprises faced as a result of price liberalization. Very soon the monetary authority slid into an inflation spiral: once it began to inflate, it found it difficult to stop. As a result, the regime of three-digit annual inflation persisted during the first half of the 1990s, as demonstrated in Table 2.1. There were several key reasons for the CBR’s initiation of the inflation spiral: the rescue of productive enterprises, the poor system of payments, social tensions and political constraints, and the attempts by

Table 2.1 Annual growth rates of nominal and real macroeconomic indicators in 1992–97 (per cent) Year M2 CPI The dollar-to-ruble exchange rate Real M2 Real ruble exchange rate GDP

1992

1993

1994

1995

1996

1997

668 1260 162

509 940 198

300 315 189

128 131 28.9

45 21.8 19.8

29 11 7.2

– 44 419

– 41 249

–3.6 43.6

–1.3 79.2

19 1.7

16.2 3.5

–12.7

–4.1

–3.6

1.4

–14.5

–8.7

Sources: CBR, Goskomstat, the author’s calculation.

54


the Russian authorities to prevent the disintegration of the post-Soviet ‘economic space’. In my view the rescue of enterprises was the main reason for the credit expansion that began in June 1992. The price liberalization and the opening up to foreign trade caused relative price changes, revealing that many domestic producers were unprofitable and were incapable of surviving under strong market pressures. The working capital of enterprises was dramatically reduced by the inflation shock, and most of them had no facilities to deal with high inflation. Many became indebted and could not obtain short-term credits from commercial banks. The latter typically declined to supply credits to the real sector because of the increased credit risks and the lack of information about borrowers’ assets. In this situation banks reasonably preferred to channel the ruble liquidity to foreign currency speculation that guaranteed high profits. Enterprises faced a sharp credit crunch, and the CBR tried to cope with it through further credit expansion and by using administrative measures. For instance, it obliged commercial banks to open credit lines to debtor industrial enterprises that were equivalent to one-third of total inter-enterprise debt (or 6 per cent of annual GDP as it stood on 1 July 1992). In addition, the working capital of distressed enterprises was indexed and financed through the issuing of extra money. In 1992 the total magnitude of this indexation was equivalent to 5.6 per cent of annual GDP. The inflationary monetary policy was ineffective for many reasons and, partially, because of the bottleneck effects of the new payments system. Settlement in the Soviet economy was centralized and occurred simultaneously for all firms regardless of their profitability because netting of mutual debts was covered by Gosbank. The new system was mediated by independent banks but it was underdeveloped and too sluggish for the regime of high inflation. In the absence of financial reserves interbank settlements had to occur sequentially (each transaction had to be settled before the next one in line is executed) with long time lags (Ickes and Ryterman 1992, p. 342). Electronic correspondence did not exist at that time and banks used the public mail to send paper documentation. The Central Bank created a network of 1,400 cashsettlement centres, but this led to spread of banks’ scarce financial reserves over various centres (Ickes and Ryterman, 1992, p. 343). The Central Bank also enforced the introduction of correspondent accounts to facilitate the interbank transfer of payments but with little effect on the speed of settlement. The problem was that banks benefited from high inflation and had strong incentives to delay payments for weeks


or even months. For this reason many transactions occurred beyond the banking system in cash or through barter. To some extent the so-called ‘grey’ sector of the Russian economy relying on cash and barter transactions flourished in the 1990s because of this problem. The payments system found itself in gridlock: monetary expansion accelerated inflation which in turn caused a non-payment crisis in the economy. It began in 1992 and continued for nearly a decade (we will discuss this in the next chapter). But at the beginning of the high-inflation period non-payments were usually associated with sharp shortages of cash. The credit expansion outstripped the cash supply by the Central Bank, while printing new banknotes of higher denomination required some time. This problem was technical in its nature but had dangerous social consequences. Enterprises could not pay wages in cash to workers thus strengthening political pressure by red directors to further monetary expansion. The problem of cash shortages aggravated by the end of 1992 because huge flows of ruble cash were transferred to other former Soviet republics. Though they introduced national currencies in June 1992, the ruble still remained the main method of payment. The idea of currency union was still valid and the ruble zone was supported by the abovementioned technical credits supplied to the CIS countries by the CBR. This was a large-scale seigniorage sharing justified by the desire to prevent the economic disintegration of the former USSR and to maintain traditional trade links between former Soviet enterprises located in different republics. The ruble currency zone was subsidized through the CBR’s credits at 9.3 per cent of Russian GDP in 1992, according to the IMF estimate2 (Åslund 1995, p. 126). In fact, the support of traditional trading links with the CIS countries through technical credits was the form of indirect support of Russian enterprises that supplied goods to these countries. The Soviet economy was low-monetized because money did not play the crucial role. On the contrary, the demonetization of the Russian economy was caused by the nominal monetary expansion, although the issue of money holding became crucial for economic agents. Largescale centralized credits to the economies of Russia and CIS countries were designed primarily to offset the losses of Russian enterprises caused by the initial inflation shock. But inflationary policy had the opposite effect through its further eroding of domestic producers’ financial assets. Table 2.1 demonstrates that the real money stock in the Russian economy contracted by 44 per cent in 1992 and 41 per cent in 1993 – that is, by two-thirds in just two years. Clearly, the real effects of accelerated

56


inflation on the demonetization of the economy and domestic production were catastrophic. Through a policy of money creation the Central Bank attempted to support domestic producers in the seemingly easiest way but actually substantially worsened their financial position.3 As a result, the monetary authority fell into a trap when the continuation of inflationary financing of the economy was required to prevent the entire collapse of production. 2.1.2 Failure to combat inflation The Soviet economy had collapsed in part because it had been heavily subsidized by the state, and also because of its excessive social obligations. The transition to market did not reduce this legacy of Russia but created the additional quasi-fiscal burden to support the non-competitive industries. The inflationary redistribution of income to which the authorities resorted was non-transparent, extremely distorting and outrageously inefficient. The scale of state subsidies to the economy in transition threatened the course of market transformations and eventually made the whole idea of market reforms in Russia meaningless. According to the IMF data, in 1992 the total volume of budget and quasi-budget subsidies was 29 per cent of GDP, and the volume of centralized credits to enterprises was 23 per cent of GDP (Vasiliev et al. 2003). The inflationary subsidization of the economy generated seigniorage of tremendous size estimated by Oding and Vasiliev (2003) as 43 per cent of GDP in 1992 (while the magnitude of national income redistribution was 76 per cent of GDP).4 Such a big volume of seigniorage obtained in the first year of market reforms reflects the effect of nonbudget financial operations of the government and, more importantly, the low elasticity of money demand with respect to expected inflation that was the case after price liberalization. Economic agents were typically unprepared to adapt rapidly to a high-inflation regime (from the previously dominant regime of permanent shortages) and could not anticipate adequately the true losses from inflation. They therefore held excessive nominal ruble balances instead of converting all financial wealth into dollars as a reliable way of defending it from inflation. Monetary expansion that began in Summer 1992 had detrimental financial consequences and extremely distorting real effects. The centralized credits were supplied to the government and the industries at significantly negative real interest rates. The interest payments by enterprises were thus heavily subsidized by the government which, in turn, received seigniorage income from the Central Bank. Figure 2.2 depicts the inflation rate and the Central Bank refinance rate which is

The Domestic Financial System and Inflation 57 30 25 20 15 10 5

Ap

r-9

2 Ju l-9 2 O ct -9 2 Ja n93 Ap r-9 3 Ju l-9 3 O ct -9 3 Ja n94 Ap r-9 4 Ju l-9 4 O ct -9 4 Ja n95

0

Monthly inflation

Refinancing rate per month

Figure 2.2 Refinance rate and inflation in 1992–94 (per cent per month) Sources: CBR, Goskomstat.

a non-working policy indicator that sometimes considerably exceeded the actual CBR lending rates. As an example, the refinance rate was 80 per cent per annum (5 per cent per month) between August 1992 and May 1993, while the CPI inflation rate during this period was nearly 800 per cent per annum (or 20 per cent per month on average as seen from Figure 2.2). Typically, only a minor part of inflation was covered by lending rates. The uncontrolled reallocation of financial resources at negative interest rates reinforced rent-seeking behaviour in different forms, mainly as a struggle for a share of the ‘pie’ of state funds. Among the most notorious examples were agriculture and import subsidies, the provision of goods to Arctic territories, and credits to facilitate the conversion of the militaryindustrial complex enterprises. In many such cases the government had no possibilities to control the way in which the money was used by beneficiaries that could easily misappropriate the state funds. Typically, the winners in this struggle for the state financial pie were the managers of large enterprises, industrial vested interests, and politically influential regional authorities. The social sectors (education, science, culture, utilities and others) were surely the losers, as along with the wide groups of population that relied on the state budget (civil servants, pensioners, students, teachers, scientists, military men and so on) or were incapable of adapting quickly to the new rules of the game that were obscure to the majority of population at the beginning of the reforms.

58


By the end of 1992 it became clear to the Russian reformers that they faced substantial obstacles in their fight against inflation. Yegor Gaidar and his team were forced to resign in December 1992 because of the severe anti-reformist political pressure exerted by the Supreme Soviet of the Russian Federation (the legislative power inherited from the USSR and dissolved in October 1993). The new prime minister, Viktor Chernomyrdin, was an experienced Soviet top manager, the former minister of the gas industry and the founder of Gazprom. Unlike many of his colleagues he was able to learn and adjust policy making to market reforms.5 Being a master of compromises, and an essential feature of the Russian political framework, Chernomyrdin managed to remain prime minister for a record period – for more than five years in the period 1992–98. This period, called ‘Chernomyrdin’s epoch’, was a paradoxical time of revolutionary changes in the Russian economy and society occurring under a moderate-conservative political regime. The macroeconomic situation was very difficult in 1993 because of a political confrontation between President Boris Yeltsin and the populist Supreme Soviet, at that time the two centres of political power. This conflict of powers was conditioned by the controversies in the old constitution of the Russian Federation that had been inherited from Soviet times and exploited by politically ambitious populists. The situation of political power indeterminacy contributed to the rapid escalation of social and other obligations by the state. The Central Bank continued to inflate with the excuse of providing urgent help to domestic producers but also being involved in the political struggle on the side of the Supreme Soviet. The CBR financed 64 per cent of the federal budget deficit in 1993, as compared to only 35–40 per cent in 1992 (Sinelnikov and Trofimov 1998c, p. 210). In this situation the Ministry of Finance made an attempt to bring about some financial stabilization by taking the initiative of tightening fiscal policy. It restricted control over budget expenditures and abolished some items – for instance, import subsidies to enterprises. A monetary programme that was adopted initially in March 1993 was essentially an agreement between the fiscal and monetary authorities, approved by the IMF, on tightening control over budget expenses and money supply. The Central Bank, nevertheless, continued to inflate regardless of the adopted monetary programme commitments. The attempt to achieve macroeconomic stabilization in 1993 was unsuccessful, essentially because of the Central Bank’s involvement in political confrontations and its alliance with the pro-inflationary political forces. These forces had taken shape after the failure of shock


therapy and became sufficiently strong to organize political resistance to market reforms. Therefore the actions of the monetary authority were controversial. In the second half of 1993 the CBR raised the refinance rates on several occasions (see Figure 2.2), but continued the rapid accumulation of net domestic assets. The attempt at monetary reform announced in July 1993 was designed as a surprise exchange of old ruble banknotes for new ones to stop the cash inflows of rubles from the CIS countries. This measure buried the ruble zone but provoked panic among the Russian population who disposed of the rubles. A combination of foreign trade liberalization and fiscal tightening with an inflationary monetary policy was a new shock to the real economy. The abolition of centralized imports improved Russia’s current account, but inflation caused a very strong real appreciation of the ruble, 3.5 times during 1993, as seen from Table 2.1. The reason was a temporary nominal exchange rate stabilization that occurred while inflation remained in monthly double digits, as evident from Figure 2.3. This situation was very painful for domestic producers of tradables that had to compete with importers. The new wave of monetary expansion aggravated the problem of inter-enterprise non-payments that undermined the tax base, thus ‘sowing’ the seeds for a chronic fiscal crisis in the 1990s. Notably,

30

4500 4000

25

3500

20

3000 2500

15

2000

10

1500 1000

5

500 0 M

Ja

n93 ar -9 M 3 ay -9 Ju 3 l-9 Se 3 p9 N 3 ov -9 Ja 3 n9 M 4 ar -9 M 4 ay -9 Ju 4 l-9 Se 4 p9 N 4 ov -9 Ja 4 n95

0

Monthly inflation, % per month Nominal exchange rate, rubles to dollar Figure 2.3 Inflation and the ruble-to-dollar exchange rate in 1993–95 Sources: CBR, Goskomstat.

60


the basic reason for the fiscal woes of the Russian economy was that the production sector rather than the household sector was (and still remains today) the primary source of tax revenues of the government. The former is politically dominant too, and is favoured by the state in an inefficient way. In spite of all of these inconsistencies, the attempts to tighten fiscal policy by the Ministry of Finance were at least partially successful. The federal budget deficit was reduced to 4.8 per cent of GDP in the first half of 1993 – this was, in fact, quite a moderate level for a high-inflation economy. The fiscal authority tried to resist the monetary expansion by the CBR and also the strong political pressure exerted by the legislative power. For instance, in the second half of 1993 it voted for the revision of the state budget with a colossal budget deficit of 22 per cent of GDP. The inconsistency of macroeconomic policy was the fundamental problem for the Russian economy in the 1990s. As we will see below, the configuration of monetary and fiscal policies changed radically over the course of a couple of years, after the next attempt at stabilization in 1995. But the authorities then changed their roles: the Central Bank stopped inflating while the Ministry of Finance was forced to relax its fiscal policy and increase budget deficits. 2.1.3 Financial landscape In 1993 there was a dramatic increase in the real rates of return to ruble assets. The reason was that, as we have noted, the nominal ruble exchange rate stabilized for the five-month period in April–August, while monthly inflation rates remained above 20 per cent. During the whole year the ruble appreciated 3.5 times in real terms (see Table 2.1). Foreign currency speculation became unprofitable for a while, pushing up demand for the ruble assets that could at least partially compensate for losses through inflation. Another reason for this change of attitude was the resolution of a very dangerous political crisis caused by the struggle between the President and the State Duma. It continued for several months and turned into a dramatic civil conflict in October 1993. This crisis ended with adoption of a new constitution that endowed President with the main power. Russia got a new political system and a two-year period of political stability. But the majority of ruble instruments supplied at that time to the market were very poor in quality. The most striking example was the segment of financial pyramids that emerged in 1993 because of the lack of legislation and the low level of financial knowledge among the Russian population. Several financial companies organized large-scale


Ponzi games with self-quotations and real returns of more than 15–20 per cent per week. These companies, the most famous and aggressive one of which was MMM, used the mass media and involved many millions of people in financial gambling. The comprehensive law on securities had not yet been adopted, and the government had no effective legislative tools to prevent the spread of pyramids. I myself tried several times to signal to policy makers and the general public that this was an extremely dangerous process that threatened social and political stability. Only in August 1994, when the MMM founder was officially accused of disobeying the tax law, did this pyramid crash (see Box 2.1). Millions of people incurred losses, but the number of pyramid victims would have been much larger if the MMM and similar schemes had not been eliminated.

BOX 2.1 Financial Pyramid MMM The MMM pyramid was founded by Sergey Mavrodi, a mathematician, who had been engaged in computer imports. It was based on the selfquotation principle with share prices doubling every month and real returns of 16–17 per cent a week. On 1 February 1994 MMM made the first issue of one million ‘shares’. An aggressive large-scale advertising campaign through TV and retail trading was organized, ensuring the widespread public distribution of information and a high demand for these assets. Transaction costs were negligible because the shares were payable to the bearer and could circulate without registration (MMM even refused to quote the registered shares). The scheme became very popular since many people believed Mavrodi’s propaganda. To bring an end to this activity the Ministry of Finance as a financial regulator forbade the second issue of MMM shares. To obviate this restriction, Mavrodi issued certificates on shares, the so-called MMM tickets, since this was not restricted by any rules. There was no formal cause to stop the pyramid’s activity, and many other pyramids emerged, involving more and more people. It seemed that most of the top politicians and state officials in Russia ignored this activity and the possible perils for the economy and society. As was hinted at in the mass media, some of them were, possibly, involved in the scheme. In any case, they did not want to take personal responsibility for the possible consequences of the bubble crash and preferred to stay aside.

62


The cabinet members, nevertheless, became very anxious since the growth of MMM and other pyramids seriously threatened social stability. Being obliged to cope with this problem, I decided that the best solution would be to take immediately the radical measures and pierce this and other bubbles. In the attack against pyramid-makers I used their main weapon, the mass media, and made several public interviews persuading people to get rid of the MMM papers as soon as possible. I also organized a press conference in the Ministry of Finance in the middle of June 1994, to which Sergey Mavrodi was invited. He did not attend, thus demonstrating his unwillingness to disclose information and his reluctance to open discussions. The last opportunity was to accuse Mavrodi of disobeying the tax law which was a fair charge. He was arrested, and the MMM head office was stormed by the special police force. On 4 August 1994 the pyramid crashed: its shares dropped more than 100 times during the day. Mavrodi did not feel embarrassed and promised investors to compensate their losses by organizing a new Ponzi game with a fourfold price growth per month this time. People believed him again despite the crash and many even stood in long lines to use the chance and buy the new and old issues of MMM papers ‘very cheaply’. The end of MMM was very sad for 10–15 million shareholders who lost money and tragic for 50 people who committed suicide. Many investors anticipated extremely high real returns with no risks and sold all their wealth, including apartments, to buy the MMM shares. Sergey Mavrodi blamed the Ministry of Finance for all of the problems and even began an election campaign for the State Duma, running under the banner of being a ‘defender of shareholders’ rights’. During the campaign Mavrodi issued new tickets with a nominal value of 20 rubles (less than 1 US cent) and spread them free among voters. Following his election he never made any appearance in the Duma. Rather, he moved to the USA where he established a new pyramid called ‘Stock Generation’ that operated through the Internet. At that time this scheme was innovative, and the US Security Exchange Commission (SEC) had the same problem as the Russian Ministry of Finance: Mavrodi did not obey formally the American laws and represented this scheme simply as Internet gambling. But he cheated hundreds of thousands of people in USA, Great Britain, Canada and other countries. By appealing to the circuit court the SEC won, and Stock Generation was closed down. Mavrodi had to return to Russia, where he was accused of fraudulence and arrested. He and his company became a symbol of Russian financial jungles of the first half of the 1990s.


It is noteworthy that similar financial games in other countries caused political and social catastrophes – as occurred, for example, in Albania in 1996–97. The scale of Albanian pyramids was unprecedented relative to the size of the economy: the nominal value of the pyramid liabilities reached almost half of the country’s GDP. About two-thirds of Albanian citizens invested and became losers. When the schemes collapsed, the mass riots caused the fall of the government. The country descended into anarchy and a near civil war in which nearly 2,000 people were killed (Jarvis, 2000). The recent crash of the Madoff pyramid in the USA was not as politically explosive against a background of the global financial crisis, but it did demonstrate that large-scale Ponzi schemes can be operated over a very long period even on very well-developed financial markets. The Madoff case resulted in $17 billion of losses being incurred by three million investors (with a total of $50 billion involved in the scheme). The main reason why this pyramid survived for nearly 30 years was that the annual yields were stable and quite moderate, 10–15 per cent, and therefore did not arouse suspicion. Bernard Madoff, one of the founders of NASDAQ, had a very good reputation which was used to make his business non-transparent. Returning to the Russian financial markets at the beginning of the 1990s, it should be noted that investment risks were also high for another financial instrument that was very popular at that period – privatization vouchers. These were options that gave people the right to participate in a large-scale non-money privatization that was conducted in the period 1992–94. The strategic goal of the reformers was to privatize the economy and the immediate task of the privatization program was to arrange the rapid distribution of nearly 30 per cent of state property in production assets free of charge to all Russian citizens. The scheme was implemented by Anatoly Chubais, at that time the chief of the Federal Property Management Committee. On the one hand, every citizen was endowed formally with an equal share in privatized property and received a voucher entitling her or him with this right. In October 1992 roughly 151 million vouchers were issued at a nominal price of 10 thousand rubles, or $25 according to the current ruble exchange rate (see Box 2.2). The nominal voucher price was derived from the valuation of Soviet production assets conducted in 1990, totalling 4.3 trillion rubles or $4.3 billion according to the ruble exchange rate in the middle of 1993. At the same time, each privatized enterprise had to offer at least 29 per cent of its shares in voucher auctions. The shares were exchanged for vouchers according to a proportion of shares and vouchers supplied to the auction.

64


BOX 2.2 The Voucher Privatization in Russia The key idea of the non-money privatization was to allocate each Russian citizen an equal share of state property and then to allow them to exchange these shares for equities in specific enterprises. The proportions of exchange were supposed to be defined on the market base but in a peculiar way, irrespective of any money pricing of the underlying production assets. The nominal valuation of each voucher – at 10 thousand rubles or $25 – was an arbitrary and populist decision pushed forward by the Supreme Soviet (a political predecessor of the State Duma) that supported the idea of involving large groups of the population in voucher exchange. The valuation of national property though vouchers led to a severe undervaluation of production assets in money terms, especially for the tradable goods sectors. Enterprises subject to privatization could select among three models of privatization regarding 71 per cent of shares that were not supplied to voucher auctions and could be partially distributed among employees. The first model allowed 25 per cent of non-voting shares to be acquired free of charge by employees; the second model allowed the same for 51 per cent of the voting shares; the third model permitted the purchase by managers of 20 per cent voting shares at very low fixed prices. The first model was selected by 24 per cent of the privatized enterprises and the second one by 75 per cent. The second model was the most popular because its greatest beneficiaries were corporate insiders. The third model was selected by only 1 per cent of enterprises since it required formal agreements between managers and employees and was costly for the former. After corporate managers and employees had received their shares, outside investors could exchange their vouchers for the residual 29 per cent through non-money auctions. Transaction and information fixed costs were usually too high for the majority of ordinary citizens to participate in these auctions. As a rule, people did not understand the whole meaning of the large-scale privatization scheme and did not account for the expected costs and benefits of investment. Because of the relatively large fixed costs, the whole deal proved to be profitable only for the holders of large stocks of vouchers who were initially endowed with big volumes of capital that the absolute majority of Russian people did not have.


For this reason 62 million, nearly half of the 126 million Russian citizens that had received cheap vouchers, sold them to financial intermediaries. Another 26 million lost their vouchers by investing them in fraudulent companies that typically mimicked mutual funds and eventually went bankrupt. The remaining 38 million was represented by corporate employees and outside investors who received roughly one-third of national property. But within this group ordinary workers obtained only negligible amounts, because corporate managers usually forced them to sell their shares cheaply. Thus, as a result of the voucher privatization, a significant part of valuable production assets was eventually divided between corporate managers and a minority of active outside investors who benefited most of all from this privatization. Significantly, the new owners of these enterprises were not burdened with foreign commercial loans that had been made earlier. These loans had been guaranteed by the Soviet state and were eventually added to the external debt recognized by Russia. Vouchers did not provide ownership to the mass of the Russian population, as it was promised initially by the organizers of the voucher privatization. Instead, privatized property was typically concentrated in hands of ‘red directors’ and only rarely fell into the hands of outside investors. The state did not rid itself of the burden of subsidizing the production sector since ineffective privatized enterprises were subsidized implicitly (as will be shown in Chapter 3). In my view, this privatization was justified simply by the political motives of keeping the balance of interests in the society and preventing dangerous social and political tensions that could have arisen in the event of an abrupt reallocation of ownership rights. These processes occurred subsequently, but more spontaneously, locally and gradually. The year and a half between the issue of vouchers and the conducting of auctions (mostly in the first half of 1994) was a period during which vouchers could be traded. There was no organized exchange at the time, but the over-the-counter market for vouchers was very active. In a sense, this was a prototype of the stock market that emerged for the first time since the total nationalization of enterprises following the Bolshevik Revolution of 1917. The voucher market was represented by speculators and investors. The former benefited from short-term price fluctuations and ignored the fundamental value of vouchers in terms

66


of underlying shares, while the latter accumulated vouchers simply in order to take part in the auctions and acquire the shares. When the trade in vouchers began in October 1992, they were priced according to a nominal value of $25. Within six months the market price had dropped to $4–5 because many average Russians had very little faith in the system and disposed of these vouchers. Subsequently, the voucher price was rising steadily, reaching $20–25 by the end of the period of non-money privatization. Speculation on the upward trend turned out to be a highly profitable and low-risk business that guaranteed annual dollar returns of up to 400–500 per cent. The risks for outside investors were both different in nature and much higher than the risks for enterprise managers that purchased vouchers from their workers. The outside investment risks were characterized by the extremely high variation in auction share prices across regions (for example, Gazprom auction price varied between 50 and 2,000 shares per voucher). For many Russians financial pyramids and vouchers were the first experience of the emerging domestic financial markets. The financial landscape of Russia was also represented outwardly by flourishing commercial banks. In 1993 they substantially increased the supply of shortterm ruble deposits with interest rates that were high enough to cover inflation. The main risk in holding ruble deposits was insufficient information about the situation of banks (credit risks) and the lack of trust in commercial banks. People remembered the last Soviet monetary reform of 1991 that had made instant losers of millions of deposit-holders of the State Saving Bank, Sberbank. However, because of the lack of financial markets and instruments (apart from pyramids and vouchers) many potential investors had no choice but to hold their money in banks. We will consider some issues of the early Russian banking development at the end of this chapter. 2.1.4 Opening of GKO trade The growth of financial pyramids in 1993–94 demonstrated an urgent need for the creation of civilized financial markets in Russia. For seven decades citizens were not engaged in financial activity in the true meaning of this notion, and the culture of investment under uncertainty had yet to be developed. People could continue to learn on their own experience only if the civilized markets were opened and the modern intermediary institutions were established. The federal authorities thus had to build a large-scale centralized system of financial trade. The Ministry of Finance and the Central Bank began to fulfill this work by organizing the domestic debt market.


This was the best choice because the government had to replace the money emission as the main source of budget deficit financing. As a result of the high inflation the government was unable to borrow long-term in rubles. A new financial instrument GKO (Gosudarstvennye Kaznacheiskie Obligatzii, the State Treasury Notes), zero-coupon three-month government bill, was a version of the US treasury bills. The first issue of GKO occurred on 18 May 1993 on the Moscow Interbank Market for Currency Exchange (MICEX). The introduction of this instrument allowed the fiscal and monetary authorities to achieve three goals. First, the extent of federal budget deficit monetization and, correspondingly, the volume of direct Central Bank credits to the government could be reduced. Second, a very important and convenient tool was created for control over the money supply through open market operations. Third, the financial system received a new liquid, high-quality instrument with minimal technical and information risks (at the end there was a big credit risk produced by the wrong macroeconomic policy, not by the instrument per se). The creation of this financial product was the result of a year-long collaboration of the Russian fiscal and monetary authorities with the best financial market experts from the USA. Note that after the debt default in August 1998 (discussed in Chapter 6 of this book) the very notion of GKO became notorious for those who were unfamiliar with details of the origination of domestic financial markets. The launching of the trade in GKO meant not only the opening of a new financial market, but also the creation of an innovative financial infrastructure. The introduction of GKO was a real breakthrough in the technology of financial trading based on the essentially new microstructure organized at MICEX. It included continuous two-side auctions, electronic trade and settlement, the automatic clearing of orders, and remote trading. The system of trade permitted a complete cycle of transaction, including registration and the depositing of securities. This led to relatively low transaction costs, transparency and a negligible risk of non-payments. Noteworthy, the rapid time for transactions was a very unusual feature for a Russian economy that had historically suffered from a problem relating to arrears. A typical transaction required weeks or even months because of the delays in payments. Under conditions of two-digit monthly inflation this was a very important advantage of the GKO market since it eliminated the inflation risks of trade. As a result of these innovations and advantages, the GKO market became very popular among participants on the financial markets. A liquid and transparent secondary GKO market created a wide range

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of new investment opportunities. Trade volumes increased exponentially in 1993–95, because of high demand for investment. The issue of domestic debt provided true financial assets to a public that was starved of investment opportunities and had almost lost trust in the financial markets as a result of the fallout from a number of fraudulent schemes. Because of its highly liquid nature, the GKO served as collateral for credits and contributed to the development of Russian banking. The Ministry of Finance gradually increased the duration and diversity of debt market instruments: a 6-month GKO was issued in 1994 and a fixed-coupon one-year OFZ (Obligatsii Federalnogo Zaima, the Federal Debt Obligations) was first issued in June 1995. Meanwhile, the number of debt issuers widened: in a couple of years the domestic debt market already included the segment of regional and corporate obligations. The GKO trade also stimulated the development of the stock market (after the adoption of the law on securities in 1995) and generated a spectrum of derivatives such as GKO futures and REPO contracts. Unfortunately, at that time the corporate paper market was too thin and risky for mass household investment. In September 1995 the ruble-denominated state saving coupon bonds OGSZ (Obligatsii Federalnogo Sberegatelnogo Zaima) were issued and circulated in traditional paper form. They were linked to the GKO-OFZ market and allowed households to invest in government papers as an alternative to ruble deposits in banks. In spite of all these innovations, the Russian financial system still lacked a diversity of instrument opportunities. The latter were limited because insecure property rights discouraged investment in the real sector of domestic economy, while capital controls prohibited investment in foreign assets. In respect of domestic debt, the main problem for the government was high real interest rates under short maturities that implied a high debt burden for the budget over both the short and medium term. Initial 3-month GKO issues were supplemented with

Table 2.2 of GDP)

Russian domestic debt in securities in 1993–96 (end of year, percentage

Years

1993

1994

1995

1996

GKO OFZ OVVZ Securitized CBR credits Total debt in securities

0.11 0 5.7 0 5.8

1.7 0 4.4 3.1 9.2

4.0 0.7 2.2 1.5 8.4

9.0 1.5 2.7 1.3 14.5

Sources: OECD Economic Survey, Russian Federation, 1997, p. 82.


the 6-month treasury notes and one-year bonds without any serious problems. But as a result of high inflation, uncertainty, and the lack of credibility, a further lengthening of the GKO-OFZ duration required excessive interest payments. Efforts and time were also required for inflation to be suppressed and stabilized at predictable and moderate annual rates.

2.2 Macroeconomic stabilization and public debt At the same time that the GKO market was opened, the political and economic situation in Russia became unfavourable for accelerating market reforms. In December 1993 Vladimir Zhirinovsky and his ultranationalist party won the parliamentary election by making populist promises. Fiscal policy tightening in the second half of 1993 was, perhaps, one of the reasons for that routing of the democratic forces. Partly for this reason, Chernomyrdin’s government preferred not to take risks and tried to conduct a policy of ‘moderate’ inflation in 1994. This policy proved to be expansionary in both the fiscal and monetary spheres, and the macroeconomic stabilization was postponed for a year. As a result of the increasing pressure by the industrial and agriculture lobbyists, the Central Bank enhanced credits to the government. It made especially large money injections into the budget and the real economy in Summer 1994. Among the main (and most notorious) channels for this budget ‘drainage’ were the previously mentioned programme involving delivery of goods to Arctic territories, agricultural subsidies, and also tax and tariff preferences for the special interest groups closely linked to big businesses and privileged associations (for example, sportsmen and the Afghan war veterans). In 1994 the Central Bank focused on exchange rate control and allowed the gradual nominal appreciation of dollar to ruble with a stable rate of 1–1.5 per cent per week. The goal of this simple policy rule was that there should be a stabilization of the real ruble exchange rate. This policy failed because inflation followed the money supply rather than the nominal exchange rate and increased by 314 per cent in 1994. Inflation moved far ahead of the exchange rate (Table 2.1) and, as a result, the ruble appreciated in real terms by 43.6 per cent with no stabilization effect on inflation and real output. The inflation rate in the first half of 1994 was lower than expected, as seen in Figure 2.3, and the inflation problem was given much less priority.6 There was a loosening of fiscal and monetary policy, and by the end of the year inflation had begun to accelerate. In the fourth

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quarter it had reached 462 per cent in annual terms, whereas it had only been 98 per cent in the third quarter. As it turned out, the real economic situation in 1994 was catastrophic: GDP fell by 12.7 per cent and industrial output by 21 per cent. To some extent, this drop in production was caused by the lagged effect of the tightening of fiscal policy and the structural changes in the economy that occurred in 1993. Nevertheless, the signs of deepening crisis became evident in the second half of 1994, and the system of macroeconomic governance proved absolutely helpless in all respects. 2.2.1 Monetary tightening The main reason for this failure was that monetary policy had been inflationary during the previous years of reforms. Persistent threedigit inflation was one of the key obstacles to economic stabilization and growth. The Russian authorities had to make the ultimate choice between two alternatives: to cease collaboration with the IMF and negotiations with the Paris and London Clubs on the restructuring of external debt, or to make an attempt to achieve radical financial stabilization. The first option would mean the failure of reforms and, possibly, the return to one or another form of command economy. Under some pressure from the IMF the second alternative was chosen. An important decision to put an end to inflationary financing of the state budget was taken at the special cabinet meeting that took place on 9 October 1994 at Viktor Chernomyrdin’s dacha in Sochi. Coincidentally, two days after, on the so-called ‘Black Tuesday’ of 11 October the dollar-to-ruble exchange rate jumped by 39 per cent, from 2,833 to 3,926 rubles/$, causing panic purchases of dollars among the population.7 The following day the status quo on the foreign exchange was restored when the exchange rate recovered, but the heads of both the Ministry of Finance and the Central Bank lost their posts.8 This episode is curious because the drastic ruble devaluation and possible currency crisis were not prevented, but were abolished ex post after the tough administrative measures. In fact, the Central Bank would have benefited from a pre-emptive ruble devaluation in preparing the stabilization attempt. The devaluation surprise could increase demand for the rubles and allow the accumulation of sufficient foreign reserves to fix the exchange rate subsequently over a sufficiently long period of time. Actually, the ruble devaluation was postponed until the official launch of monetary stabilization in the first quarter of 1995 (the official government and CBR announcement took place on 9 March).


The CBR began tightening the money supply without making any announcement in the last quarter of 1994, soon after Black Tuesday. Initially, it had a very low level of foreign reserves and had to cope with the persistent expectations of devaluation following the events of ‘Black Tuesday’. Under such circumstances the CBR allowed a gradual ruble devaluation as seen in Figure 2.4. During the first quarter of 1995 the nominal exchange rate of the ruble depreciated by 28 per cent (equivalently, the ruble-to-dollar rate increased by 38 per cent, from 3,550 to 4,900 rubles/$). During this period the CBR followed a risky policy with the ruble exchange rate because of the small amount of official currency reserves it held. These would be exhausted under a coordinated speculative attack of banks on the ruble. The situation was similar to what occurred three years before, in July 1992, when the ruble exchange rate was allowed to float for the first time and the ruble fell to a third of its earlier level against the dollar. As I remember, the public mood was generally pessimistic after ‘Black Tuesday’. The chiefs of both the Central Bank and the Ministry of Finance were dismissed, and top officials were typically reluctant to take responsibility for firm actions. It was a feeling of a new catastrophe coming with no chance of preventing the economic collapse that would have meant the entire failure of market reforms in Russia. The situation of 1991 could repeat, but now with much more dangerous consequences for the country. Meanwhile the course of domestic and foreign policy of Boris Yeltsin had changed, as the first war in Chechnya began in December 1994. As a result, Yeltsin lost the political support of Russian liberals who found themselves in longstanding opposition to the ‘ruling regime’. The attitude of western politicians to Russia also worsened, and new international financial aid was under question. It was, nevertheless, necessary to do our best to undertake a new attempt at macroeconomic stabilization. Tatyana Paramonova, who became the acting chairman of the Central Bank after Victor Gerashchenko’s resignation, worked hard and thoroughly, literally days and nights, on the 1995 monetary programme. Meanwhile I began negotiations with the IMF on a stand-by credit to support the new stabilization attempt. In spite of the seeming hopelessness of the whole situation, we joined our efforts to elaborate every detail in the new monetary agreement. The fiscal and monetary authorities coordinated their actions to impose control over the money supply and to reduce the state budget deficit. These measures had been partly realized in advance, before the stand-by credit was approved by the IMF in February 1995. It is important to emphasize that this success resulted from the efficient collaboration by the Central Bank and the Ministry of Finance.

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Fortunately, by the end of the first quarter of 1995 the CBR had averted the crisis despite the depletion of the official reserves to just $0.8 billion. Foreign currency speculators also perhaps lacked sufficient ruble liquidity due to the pre-emptive tightening of the money supply, and could not repeat their attacks. Furthermore, the demand for ruble liquidity usually increases by the end of each quarter for making regular tax payments and other purposes, thus forcing banks to sell dollars. The sharp devaluation of the ruble was avoided, and the monetary stabilization programme of 1995 had been started successfully. The goal of this programme was to reduce the federal budget deficit from 11 per cent in 1994 to 6 per cent in 1995, and the M2 growth rate from 195 per cent to 65 per cent (Oding and Vasiliev 2003). The target inflation level was set at 1 per cent per month. As I have mentioned, the programme was supported by the $6 billion IMF stand-by credit line to enforce the anti-inflationary policy. Each month the Central Bank imposed tight controls over the net domestic assets monitored by the IMF. The fiscal policy was also tightened and contributed to the combating of inflation. The federal budget deficit was reduced to 4.6 per cent of GDP in 1995 as a result of the dramatic reduction of expenditures, from 22 to 15 per cent of GDP9 (Oding and Vasiliev 2003). The deficit was financed through borrowings on the domestic papers market and external credits. Despite all these drastic measures annual inflation remained high in 1995, 131.3 per cent, because of the inertia of inflation expectations and a lack of credibility regarding the shift towards an anti-inflationary monetary policy. After the failures of previous attempts to curb inflation, some time was required for the Central Bank to gain the reputation of being a prudential policy maker. In addition, the money supply grew rapidly because of the accumulation of foreign official reserves. By the end of 1995 the level of gross reserves stood at $17 billion, while net reserves were $6 billion (29 per cent of the monetary base). Monthly inflation was 4.2 per cent in December 1995, and the target level of 1 per cent was reached within a year. In 1995 a new Central Bank law was adopted which confirmed the institutional basis of the monetary authority’s new status as an inflation-fighter. This declared the formal independence of the monetary authority from the government and prohibited the direct crediting of the government. 2.2.2 Currency corridor To eliminate the persistency of inflation expectations, the nominal anchor was introduced on 5 July 1995 as an exchange rate corridor set


in the range 4,300–4,900 rubles/$. This was quite a flexible nominal anchor regime set initially for one quarter and then extended to the end of the year. On 1 January 1996 the currency band shifted upward to 4,550–5,150 rubles/$ where it remained for around half a year, as is plotted in Figure 2.4. The introduction of the currency corridor had a strong stabilizing effect on the foreign exchange. In fact, it stopped the speculative purchases of rubles and prevented the ruble from further nominal revaluation. The reason was that the gradual ruble devaluation during the first quarter of 1995 was combined with the tightening of monetary policy as a result of the sales of official reserves and a dramatic reduction in the level of the emission of inflationary money. As a result, the demand for the ruble assets increased quite strongly causing a reversal of the ruble exchange rate movement in the second quarter of 1995 (Figure 2.4). The stabilizing ‘honeymoon’ effect of the corridor on foreign currency speculation was clearly evident. The lower and upper bounds of the exchange rate eliminated incentives to speculate both against the dollar and the ruble, and the Central Bank significantly reduced foreign currency interventions. At first glance, this was a remarkable result, providing a lift for monetary policy making, but the Central Bank now faced a new problem. A considerable interest rate disparity 20 18 16 14 12 10 8 6 4 2 0 ⫺2

7000 6500 6000 5500 5000 4500 4000 3500

Ju l-9 O 5 ct -9 5 Ja n96 Ap r-9 6 Ju l-9 6 O ct -9 6 Ja n97 Ap r-9 7 Ju l-9 O 7 ct -9 7 Ja n98

-9

5

Ap r

Ja n

-9 5

3000

Exchange rate, roubles to dollar Corridor – upper bound

Corridor – lower bound Inflation rate, % per month

Figure 2.4 Foreign currency exchange regimes and inflation, 1995–97 Sources: CBR, Goskomstat.

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between the ruble and the dollar financial instruments (estimated as 80–100 per cent per annum in the middle of 1995) persisted as a result of the exchange rate regime and expectations of high inflation. Such a disparity caused dramatic financial portfolio restructurings that meant, in the case of Russia, intensive dedollarization and an inflow of speculative money into the expanding government paper market. The interest disparity was not eliminated for two reasons. First, the GKO supply grew faster than GKO demand which also increased as a result of the quasi-fixed exchange rate regime eliminating currency risk for investors. Second, the CBR had to sterilize official currency purchases to prevent excess growth of the money supply, implying the need for a further tightening of monetary policy. The fruits of macroeconomic stabilization were reaped in 1996 when the inflation rate fell to 21.8 per cent per annum. This was quite a good result by international standards, albeit reached at the cost of a real ruble appreciation of 79 per cent in 1995 (Table 2.1). Suppressing inflationary expectations and overcoming inflation inertia in the Russian economy were not straightforward tasks. Monthly inflation rates remained high until the beginning of 1996, and it took nearly a year for adjustment of the price behaviour of producers. The monetary authority had little room for manoeuvre, because of its credibility problem and the lack of available monetary instruments to control money supply. For these reasons, and due to the dedollarization of the economy, a significant real appreciation of the domestic currency was inevitable. The key problem was the irreversibility of the ruble appreciation caused by the hysteresis effect: having once been made expensive, the ruble had to remain so for several years. The main task for the Central Bank at that time was to build a reputation for prudential monetary policy making, and the costs of reversal would be too high. The ruble could not be devalued again without returning to the inflationary regime that would mean the failure of the crucial stabilization attempt of 1995 and entailing high political and economic costs. Moreover, as we will see below, the nominal anchor – even in the flexible form of a currency corridor – was not consistent with the loose fiscal policy. As a compromise solution, the monetary authority introduced a sliding corridor on 1 July 1996. The basic idea was to stabilize the real exchange rate and eliminate the excess external risks for home producers. The sliding corridor as depicted in Figure 2.4 ensured the rate of ruble devaluation 12.4 per cent rate over a period of 18 months, between 1 July 1996 and 1 January 1998 (averaged out from 17.7 per cent per annum in the second half of 1996, and 7.3 per cent per annum


during 1997). The annualized CPI inflation rate during this period was 11 per cent, implying the real ruble devaluation by 0.8 per cent in annual terms. Thus, the goal of the real exchange rate stabilization was reached. This was regarded by many as the regime switch from the nominal anchor of 1995–96 to inflation targeting based on standard monetary tools. Significantly, as Figure 2.4 demonstrates, the nominal exchange rate under the sliding corridor was closer to the lower bound, indicating upward pressure on the ruble. Actually, the post-stabilization currency exchange rate policy of the Central Bank was supporting the dollar rather than the ruble (we will return to this issue in Chapter 5). 2.2.3 Domestic debt expansion The policy tightening of 1995 entailed an intensive issuing of domestic public debt. In a sense, the monetary expansion of the inflationary period 1992–94 was now replaced by debt expansion. The effect of monetary tightening on the real ruble appreciation was aggravated by government debt expansion. For the same reasons the real GKO-OFZ yields and debt service expenditures increased substantially after 1995 (Table 2.3). In fact, the domestic debt expansion was not as substantial in 1995. As follows from Table 2.2, the volume of GKO-OFZ increased by 3 per cent of GDP in 1995. The federal budget deficit financing was 4.7 per cent of GDP in 1995, consisting of 3.2 per cent financed by domestic debt issues and 1.5 per cent financed by external sources, principally the IMF loans (Mau et al. 1998, p. 266). The excessive increase in public debt in 1995 can be estimated as around 1–1.3 per cent of GDP, not sufficient to threaten macroeconomic stability.

Table 2.3 Characteristics of domestic public debt in securities in 1994–98 Years

1994

1995

1996

1997

1998*

Average yield, %** Average real yield, %*** Average duration, days, by the end of period Debt service expenditures, % of GDP

295 25 50

168 13 90

80 48 150

25 13 235

38 28 292

2.6

2.3

4.7

3.6

4.0#

Sources: Russian Ministry of Finance, CBR, Batkibekov et al. (2003, p. 40, 83); * first half of the year, ** primary GKO-OFZ market annual rate, *** the same rate deflated with the CPI inflation rate for corresponding period, # for the whole year.

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Such a scale of public debt expansion cannot be called abnormal given that the stabilization attempt of 1995 was quite successful. But the emphasis should be made on debt structure management based on the market instruments. Table 2.3 demonstrates that the average duration increased several times after 1994, but that it still remained too short by the end of the 1990s. The lengthening of the duration required significant increases of yields to maturity, because of inflation and risk premium. An alternative solution would have been to increase the average duration of public debt to between five and seven years through the issuing of more Eurobonds. This would mean the partial replacement of GKO-OFZ by higher-quality, longer-term, and less costly instruments. As we have mentioned, Russia made substantial progress in external debt negotiations that could have permitted a solution of the government’s debt management problem, both external and domestic. Unfortunately, after the success of 1995 the widespread attitude of many politicians to domestic debt was as if it was a new inexhaustible source of budget deficit financing. Note that after the default of the GKO in 1998, the public mood became diametrically opposite, and the state’s debt policy became the subject of unjustified criticism. The government was often blamed for crowding out real investment and pyramiding domestic debt in the period since 1995. But at that time debt expansion was the only possible alternative to monetization and high inflation caused by the budget deficits. As was shown by the three years preceding macroeconomic stabilization, high inflation gave no hope for investment growth in the real sector of the economy. The role of ‘money vacuum cleaner’ attributed to GKO in 1995–96 had been played earlier by the foreign currency market. In effect, the public blamed the instrument instead of the policy. In addition, as will be shown in Chapter 4, the domestic debt dynamic was actually far from what is usually regarded as the financial pyramid. Admittedly, the expansion of public debt was a necessary precondition and a consequence of macroeconomic stabilization. The radical changes in the money supply regime were made over the course of several months, in spite of the fiscal imbalances and the increased costs of debt servicing. The government had to continue fiscal policy tightening in order to balance the budget, but further expenditure cuts would hardly be possible. On the contrary, the federal budget expenditures and deficit increased in 1996 for political reasons (presidential election and post-election political indeterminacy), prompting the domestic debt expansion at a higher pace. As Table 2.4 demonstrates, both expenditure and deficit grew by 3.7 percentage points of GDP, from 18.4 to 22.1 per cent of GDP, and


Table 2.4 Federal budget of Russia in 1995–98 (percentage of GDP) Year

1995

1996

1997

1998

Revenue Expenditure Deficit Primary deficit Inflation

12.8 18.4 4.6 2.6 131.4

13.8 22.1 8.3 2.5 21.8

12.5 19.5 7.0 2.2 11.0

10.8 15.7 4.9 1.0 84.4

Sources: Russian Ministry of Finance.

from 4.6 to 8.3 per cent of GDP, respectively. The outstanding domestic debt rose by 6.1 percentage points of GDP, from 8.4 to 14.5 per cent of GDP, while debt service expenditure doubled, from 2.3 to 4.7 per cent of GDP, as seen from Tables 2.2 and 2.3. As witnessed by these figures, fiscal expansion in 1996 was driven mainly by the upsurge in the costs of debt servicing. This should not come as any surprise, given that the real yield on domestic debt papers increased nearly four times, from 13 to 48 per cent per annum, as shown in Table 2.3. Thus, a policy of fighting inflation with tight monetary policy was followed by a policy of fiscal expansion, raising the issue of ‘unpleasant monetarist arithmetic’ suggested by Thomas Sargent and Neil Wallace (1981). This arithmetic is convincing: sustained fiscal expansion overwhelms an anti-inflationary monetary policy. Then the initial money base contraction leads inevitably to the money base expansion in the future. A simple monetarist model grounded on the quantity theory of money predicts that under such a policy mixture inflation can only be delayed.10 The ‘monetarist arithmetic’ argument is surely applicable to the case of Russia during the second half of the 1990s. As Table 2.4 shows, a powerful inflationary splash occurred in 1998 (because of the financial crisis dealt with in what follows). Fiscal policy tightening required radical fiscal reform. But the Russian government had no opportunities to increase the levels of tax collection or to reduce state expenditures within one or two years. Increasing nominal tax rates would not help either since it would induce the majority of enterprises to apply a variety of tax evasion schemes or shift activities into the ‘grey’ sector. Instead, radical and comprehensive tax and budget reforms were required for the systemic solution of the fiscal problems. The government did not have time for the preparation and implementation of such reforms because 1995–96 were the years of parliamentary and presidential elections.11 Social tensions were strengthening in the pre-election periods, constraining the government’s attempts to

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rationalize the system of budget expenditures. The most dangerous outcome could be the communist revenge that could cause political and economic chaos.12 In this situation domestic debt issues could compensate for the costs of disinflation and allow the postponement of the fiscal reform. The strategy of the government was to leave the status quo in the fiscal sphere until the presidential election and then, in the case of Boris Yeltsin’s success, to try to cope with the fiscal crisis. From the ex ante view, this was a rational political choice, provided that external conditions remained stable for several years.

2.3 The fragile banking system The banking system played a central role in the genesis of Russian finance and financial meltdowns of the 1990s. In the Russian market economy commercial banks were the first institutions to emerge, appearing alongside the cooperatives and small private business, as a result of the introduction of Gorbachev’s timid reforms that began in 1988. From the beginning of the radical market reforms in 1992, the banking system demonstrated impressive growth, but largely fueled by inflation and state budget incomes. Initially, this system was supposed to fulfill three functions: to be a network for a reliable payments system, to be a financial intermediary in the allocation of financial resources at home and in relations with foreign economies, and to provide finances for long-term investment projects in the domestic real sector. In the latter respect banks were supposed to replace the system of centralized planning. Theoretically, banks had to replace the administrative system in organizing effective monitoring and control over managers of enterprises in the interests of creditors. By providing an efficient allocation of resources banks could, in principle, become locomotives in the processes of modernizing the Russian economy. In reality none of the mentioned functions was fulfilled satisfactorily by the banking system. Its evolution under market transition of the Russian economy could hardly be predicted by any theory of banking. 2.3.1 Inflationary growth of banks The weakness of the Russian banking sector was (and remains) one of the main factors in the country’s financial fragility, although the rapid development of this sector in the 1990s veiled its inherent defects. The ‘hothouse’ conditions were created for the major domestic banks by the lack of competition with foreign banks, low entry costs, and easy inflationary incomes generated by the lax monetary policy.


On the one hand, the specificity of Russian banking in the 1990s was that banks typically were not financial intermediaries in any true sense and could more accurately be labelled semi-banks. Small and medium-sized banks were established to attract funds for their owners that invested it, first of all, in their own businesses. Semi-banks or ‘pocket banks’ were also established by large industrial enterprises as local financial mediators fulfilling specific financial services. These provided financial consolidation among associated members and access to short-term bank credits on preferential terms. Ownership and control over pocket banks could also accelerate payments in the interests of bank founders, as many enterprise directors explained in interviews (Ickes and Ryterman 1992, p. 340). Of course, these kinds of financial service, being useful for some individuals and enterprises, could not compensate for the absence of true banking activity of which the entire economy was in dire need. Because of the lack of norms of regulation and prudential behaviour, bank owners and shareholders typically had privileges in the allocation of credits implying inefficiencies of financial investment and risk mismanagement. Having been established solely to raise funds and close thereafter, many pyramid-like banks left the outside creditors and depositors cheated. Excessive risk taking and fraudulence were widespread during the early 1990s because entry into the banking system was very easy and the formal capital requirements were very low. Prudential barriers to entry in banking would have improved positive selection and eliminated such risks by individual investors. On the other hand, the state monopoly – Sberbank – dominated in the retail deposit market and accumulated up to 75–80 per cent of total household savings held in banks. The main reason was that Sberbank inherited from Soviet Gosbank a pervasive network of retail savings banks covering every region of the country. Another reason was the existence of implicit state guarantees to this bank as a state monopoly in retail banking that many people (especially old-aged) trusted in spite of the sad experience of the past and low value of these guarantees.13 Sberbank was not the only successor of the socialist financial system. At this time around 30 per cent of the Russian banks in the list of the top 100 had been established as aresult of the spinning off of specialized departments from the Soviet-era Gosbank (for example, Agroprombank, Promstroibank, Vneschtorgbank). The management of these banks typically lacked competence for financial decision making, but this deficiency was compensated to some extent by the lack of competition in domestic banking. The former state banks had an advantage over other

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commercial banks because they inherited a banking infrastructure. Banks that had emerged since the end of 1980s did not bear a large burden of unworkable or poorly collateralized loans to the real sector. Since the federal government and Vnescheconombank, as its debt agency, had taken on the external debt obligations of the Soviet Union, the new banking system did not need to write off many bad debts that had originated before the beginning of the reforms. Paradoxically, the Russian banking system appeared to be flourishing in the first half of the 1990s despite the demonetization of the economy. As we saw in Table 2.1, the real stock of money fell by two-thirds in 1992–93, implying that the money created by banks was also squeezed. Table 2.5 illustrates the development of Russian banking in the same period according to bank balances data. Although total bank assets were shrinking in real terms because of the impact of inflation, banking was still a very profitable business during this period. High inflation granted banks a free lunch from their control over money flows. Another reason was that banks hid their active participation in the foreign currency cash turnover required for the needs of tax evasion, capital flight, the shadow economy activity, money-washing and other semi-legal or illegal spheres of business. In addition, the banks’ top managers placed a particular emphasis on the outward attributes of success by spending a lot of money on luxury office buildings, exclusive cars, bodyguards, overheads and other items of wasteful expenditure. An impression of the successful development of banking was strengthened by its stark contrast with the deeply depressed sectors of the economy. Under high inflation the banking sector was in a privileged position that allowed it to obtain high profits from several sources: (i) The interest Table 2.5 Russian banking system under market transformations Year

1992

Number of banks 1,713 Real refinance rate ⫺12.2 (% per annum) Central Bank credits to 15 banks (% of GDP) Total assets of the banking 88 system (% of GDP) Total bank credits to the 33.6 non-financial sector (% of GDP)

1993

1994

1995

1996

2019 ⫺6.9

2517 4.4

2295 7.6

2030 6.5

5.1

2.4

1.1

0.6

54

56

36

36

20.4

19.6

12

10.4

Sources: OECD Economic Survey: Russian Federation (1997, p. 104); Yasin (2002, p. 374).


rate gap (the difference between lending and deposit rate) persisted irrespective of the sign of the real interest rate (the refinancing rate of the CBR was negative in 1992–93, as seen from Table 2.5 and Figure 2.2).14 Banks provided short-term loans to highly profitable spheres of business with rapid turnover like foreign trade. (ii) Authorized banks received centralized credits from the government and the Central Bank which was to be channelled to enterprises. They also serviced budget payments and, being at the origination of money flows, artificially delayed the terms of these payments using money free for short-term credit or speculation. (iii) Foreign currency speculation was a source of guaranteed profits for all banks until 1995, when the currency corridor was introduced. In some periods they could earn up to 70–80 per cent of total profits through foreign currency speculation (Doronin and Zakharov 1998, p. 526). In fact it was the preferential access of banks to money flows that endowed them with opportunities to speculate against the ruble. In our view, these sources of bank profits were indeed very significant under periods of high inflation, but this could not be reflected in bank balances due to bookkeeping tricks commonly used to minimize the taxation of profits. In the period of monetary tightening and the introduction of the currency regime the Central Bank’s inflationary credits were reduced and the discount window was suddenly closed for banks. The interbank credit market developed very rapidly and replaced the CBR credits as a source of short-term refinancing and redistribution of liquidity among banks. At the same time the GKO market replaced the foreign currency exchange as the main source of banks’ profits. Henceforth, the largest banks began also to attract international credits that were relatively cheap under the stable exchange rate regime. In general, the Russian banking system relied on various external financial sources of easy money that were abundant in the 1990s. Bank managers did not develop adequate expertise in risk assessment or the monitoring of borrowers. The returns on short-term credits and financial speculation covered major risks. Being vulnerable to these risks, the banking system, as a rule, did not provide long-term investments to the real sector. In 1997 the fraction of bank loans to non-financial enterprises was 31 per cent of bank assets in Russia.15 But the overwhelming part of these loans, 96 per cent of nominal value, was short-term with a maturity of less than one year. The largest banks played an active part in the privatization and redistribution of large parts of the former state property. But in this activity banks acted as short-term speculators rather than long-term investors

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or creditors. The lack of long-term credit supply by banks was complemented by the lack of long-term credit demand by production firms. The long-term investment projects in the real sectors were typically not initiated in the 1990s due to high inflation and unprotected property rights. It is notable that the absence of long-term contractual relationships between banks and firms had a positive consequence. It mitigated the negative effects of the 1998 financial crisis on the production sector of the economy. The crash of the largest private banks was not as catastrophic for this sector as would have been the case if the bankrupted financial intermediaries had been more heavily engaged in production activity. 2.3.2 The first banking crisis of 1995 Macroeconomic stabilization caused the first crisis of the Russian banking system in Summer 1995. Some banks did not believe in the success of the new stabilization attempt and held portfolios of assets and liabilities that were inappropriate for the new situation. They did not reduce their long positions in dollars and continued to supply ruble deposits at high interest rates. When the dollar exchange rate began to fall in Spring 1995 and the currency corridor was introduced, their losses became too high. Monetary tightening led to liquidity deficits and forced many banks to borrow in the interbank credit market. The credit risks became very high since these very same banks reduced their holdings of non-interest-bearing reserves at the Central Bank to compensate for the loss of profit opportunities. This kind of reckless behaviour was soon punished by the interbank market. Some banks suspended payments, immediately provoking the spread of non-payments chains across the whole banking system. The credibility problem in the bank community arose immediately, causing a severe liquidity crisis.16 The interbank lending rates increased several times (from 70–80 to 300–350 per cent per annum), while the daily turnover was reduced ten times. The interbank market divided into small segments with tiny trading operations. Finally it collapsed on 23 August when an accidental technical fault caused the complete suspension of operations. The banking system suffered a substantial shortage of liquidity, and the Central Bank operated very effectively to make necessary liquidity injections to troubled banks. It purchased the GKO from some banks and sold to others. Nevertheless, several big banks were bankrupted by this crisis and the total number of banks reduced by 10 per cent in 1996, as seen from Table 2.5, although the banking system as a whole was restored quite quickly after the crisis.


This was the first turmoil of the Russian financial system and it should have been instructive for the monetary authorities. First, it revealed that the banking system was inherently fragile, although it did not appear to be so in an environment of high inflation and wide-ranging profit opportunities. Second, it showed that liquidity crises required immediate intervention, and the Central Bank did indeed demonstrate competence and acquire considerable experience of the workings of the system. Third, the banking crisis of 1995 revealed serious problems in the areas of bank regulation and supervision. The Central Bank tried to introduce a new system of prudential regulation in 1996, but this did not achieve great success. New departments were created (for instance, OPERU-2) to improve control over the licensing and practices of banks. A thorough analysis of bank balances revealed that there were a considerable number of insolvent banks. Their proportion of the total assets of the banking system increased from 3 per cent in 1996 to 24 per cent in 1997, indicating serious problems in banking and providing a guide for the monetary authority to deal with these problems. This valuable information was not used effectively to improve the regulation of banks until the second bank crisis in 1998 led to large-scale exits and selection in banking. The new norms of capital adequacy and reserve requirements were intended to reduce credit and systemic risks. A long list of instructions for prudential regulation was written, but the best practices were hard to implement in the case of Russian banking. Bank owners and managers usually did not have a complete understanding of the nature and the threats of systemic risks – they refused to adopt prudential regulation in any form. Even if they did understand, they did not find the adoption of prudential risk management to be in their self-interest. As a result, attempts to improve the quality of banking did not have considerable influence on its susceptibility to risks. Another reason for this failure was that the expansion of domestic debt substituted inflation as a source of high profits that again concealed the need for risk management. During this period bank regulation appeared neither urgent nor even relevant. 2.3.3 Public debt and banks Both the banking system and the state’s financial system had emerged under the regime of inflation generated by high budget deficits and they acted as complementary to one another. In many aspects of its operation the state’s financial system had to rely on the banking system. The flows of tax payments, subsidies and centralized credits were intermediated

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by banks. The largest and most advanced banks were authorized to service budget payments until the State Treasury was established in 1998. Expansion of domestic debt after macroeconomic stabilization of 1995 occurred with dominating participation of banks that were the main suppliers of liquidity to the government. As a result, banks became the dominant holders of government papers. For example, by the end of 1996 the share of government papers in assets reached 56 per cent for Sberbank, the largest saving bank, and 40 per cent for SBS-Agro, the second saving bank at that time (Doronin and Zakharov 1998, p. 521). It can be said without exaggeration that at this time the banking system formed an important functional block in the government finance. Banks, in turn, benefited enormously from their close collaboration with the government. They obtained huge profits from credits provided by the CBR during the period of high inflation, and a large portion of inflation tax was received by banks (this is estimated, for example, at around 10 per cent of GDP in the period of high inflation, according to Astapovich 2003). The banking system gained as a result of the absence of competition with foreign banks that were subject to strong restrictions in respect of opening branches in Russia. Comfortable conditions were also guaranteed by the excessively high cost of the servicing of domestic debt. Government papers were the main liquid ruble asset for banks bearing high returns and, simultaneously, serving collateral for getting credits at home and abroad. Under such conditions the managers of banks typically had low incentives to care about risks. The top Russian banks authorized for servicing the budget payments had privileges to issue their own short-term bills guaranteed by the government. The latter also provided selectively guarantees to the so-called ‘system shaping’ banks for loans to production enterprises and budget recipients, thus subsidizing implicitly both creditors and borrowers. The first banking crisis of 1995 made urgent the issue of introduction of a deposit insurance system. It had to embrace a large fraction of ‘true’ (non-pocket) banks able to meet the standard requirements of prudential regulation. This system could, on the one hand, reduce systemic risks of bank runs and, on the other hand, provide incentives for management to improve the quality of banking. Unfortunately, the legislative initiative on deposit insurance faced very strong lobbying from vested interests that led to a delay of several years. Clearly if this system was introduced the state monopoly Sberbank would lose its monopoly position in the retail deposits market. In the absence of negative external shocks, both the state’s financial system and the banking system benefited from the symbiosis.


The problem lay in the fragility of this system. It worked pretty well when the economy was closed from capital inflows, and the ruble interest rates were sufficiently high. As it transpired, the tandem of banks and state finance was viable only under favourable external conditions, but proved to be highly vulnerable to shocks caused by the excessive mobility of short-term foreign capital. Both government finance and banks were subject to systemic risks magnified by their symbiosis. On the one hand, a fall in the prices of government securities would have a negative effect on bank liquidity, depreciate collateral and cause a bank panic. The interbank market as a source of liquidity for banks was based on government papers serving as collateral and was, for this reason, very much susceptible to credit risks. On the other hand, the insufficient liquidity held by banks sharply narrowed the opportunities for the government to refinance debt obligations, since banks were the principal suppliers of money for the federal budget. Such a vicious circle of risks magnified the crisis outcome of 1998. As a result, the financial system created in Russia was highly vulnerable to all kinds of risks. Its weak diversification, in terms of institutions, participants and instruments, increased the vulnerability of the economy to systemic risks both in general for financial markets and specifically for banks (as in the domino effects). As an institution of financial intermediation, the banking system was overexposed to such risks. The probability of such shocks in Russia was relatively high due to the insufficient confidence of the population in the banking system and the lack of deposit insurance. The financial markets were thin and highly volatile and could not provide an efficient allocation of property rights. As I have discussed in this chapter, for a number of reasons (high inflation in 1992–95, underdeveloped financial markets, insecure property rights), banks occupied a dominant position in the Russian financial system.17 The absence of full-fledged financial intermediary was the main problem underlying its inefficiency and fragility. In spite of its dominating role, the banking system in the 1990s was unable to provide large-scale transformations of savings into investment. Neither was it prepared for survival in the global financial system or even to compete with foreign banks at home, if the latter received free access to Russian markets. The motivation of bank managers did not differ essentially from the motivation of managers of privatized production enterprises. As in the real sector, political economy was in work: the ‘system-shaping’ banks received large portions of state financial resources, along with industrial dinosaurs. The owners and managers of

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these banks had substantial political ambitions but lacked a sufficient level of expertise in banking. They became especially influential following the second presidential election of 1996 and actively engaged in lobbying activities to secure access to cheap money resources and other privileges. Even after the 1995 bank crisis, which was the first alarm signal, the gauging of credit, currency, liquidity and other risks remained of secondary importance for the majority of commercial banks. Not surprisingly, the Russian banking system proved unable to sustain the shocks of the world financial crisis of 1997 and threatened to spread these shocks to the other sectors of the economy.

3 Virtual Economy and Fiscal Crisis

Introduction High inflation was suppressed, but Russia still faced persistently high fiscal deficits that led to an increasing debt burden. The financial policy of the government remained unsustainable, while the fiscal problems turned out to be much more complex than monetary tightening. The next step after macroeconomic stabilization was the implementation of a package of structural reforms in the fiscal sphere, financial and banking systems, natural monopolies, property rights institutions and so on. All of these reforms were very difficult to implement, time-consuming, and required strong political will and enormous efforts on the part of the authorities. The IMF approved the Extended Fund Facilities program of structural reforms to be implemented in the three-year period 1996–98. But from the very beginning it was on the brink of failure, first of all, because of the presidential election campaign in Russia that began at the end of 1995. The policy cycle was unfavourable to fiscal reform, which was most urgent, and led to a dramatic reduction in the level of tax revenues that made it impossible to undertake fiscal tightening. Taking into account the overwhelming need to support Boris Yeltsin, the IMF relaxed its position and permitted fiscal deficits above the targeted levels. This concession was politically motivated but it directly contradicted the logic of macroeconomic stabilization. But as one could expect, the standard logic of market transformations sometimes did not work in the case of Russia. The underlying problems aly not only in politics, but were essentially microeconomic in nature and were rooted deeply in the command economy distortions that had prevailed for many decades. The inability and unwillingness of the Russian 87

88


authorities to solve their fiscal problems can be explained by the extent of the structural problems inherited by the Russian economy. We base the analysis in this chapter on the concept of virtual economy introduced in the earlier work of Clifford Gaddy and Barry Ickes (1998, 2002). We agree with their key inference that during this period the essential parts of the Russian economy were not making progress towards market reforms, but were in reality actively moving away from the market. Directors of the former Soviet enterprises secured full control over production assets as a result of the large-scale privatization conducted in 1992–94. They discovered an easy way to survive under market pressure by using non-payments that spread initially because of the high inflation. The problem of non-payments might seem, at first glance, very specific but it turned out to be central to the Russian economy in the second half of the 1990s. The repeated attempts of the government to combat arrears were ineffective because it pursued an inconsistent policy towards the virtual economy. The state preferred to protect rather than to stimulate the restructuring of industries and allowed the non-market segments of the economy to survive and expand. As a result, through its own actions the government produced a severe problem of budget arrears that were underlying the fiscal crisis. This problem could not be remedied until the financial collapse of 1998. In our opinion, this line of reasoning captures the essential features of the Russian economy’s transition to a market system and sheds light on the nature of its fiscal troubles.

3.1 Virtual economy The chronic non-payment crisis began with the launch of reforms and persisted throughout the entire period of the transition to a market economy. As was demonstrated the Russian experience of market reforms, a major part of the economy could operate virtually without using money as a means of transactions. Firms purchased inputs, employed workers, and produced and delivered goods to other firms and to the government without paying or receiving any money. The government, in turn, managed to perform similar functions in their relations with taxpayers, providers of goods and services, and budget recipients. At first glance, these situations were absurd, but this was one of the realities of the Russian economy in the eight years from 1992 to 1999. Moreover, the case of overall non-payments had not been predicted by advocates and designers of market reforms. It became a surprise for many of them and a very serious challenge for Russian policy makers.

Virtual Economy and Fiscal Crisis 89

The key questions for scholars of the economy in transition related to the meaning of the emerging market economy without money, and the possible ways in which this economy could evolve. Although insightful theoretical ideas had been suggested (some are referred to below), this problem remained unsolved practically until the financial crisis of 1998 occurred and provided a kind of ultimate solution to this and other problems of the Russian economy. 3.1.1 The non-payment problem The first splash of arrears occurred in 1992 and then, after the temporary effect of inter-enterprise arrears netting, continued to grow dramatically, reaching 38 per cent of GDP by the middle of 1998. Arrears were widespread in the markets for production inputs, labour, short-term bank credits and in relations of enterprises with the state budget. At the beginning of reforms the inter-enterprise arrears were dominating, but in the second half of the decade the budget arrears and non-money payments played the key role. Figure 3.1 demonstrates the dynamic of various kinds of arrears, and Table 3.1 presents their size and structure by the first quarter of 1998. Inter-enterprise arrears were pervasive and nearly all sectors of the economy were enmeshed in this web of mutual indebtedness. The consumer market was an exception and remained an ‘arrears-free zone’ 40 35 30 25 20 15 10 5

Fe

bJu 92 l-9 D 2 ec -9 M 2 ay -9 3 O ct -9 M 3 ar Au 94 g94 Ja n95 Ju n N -95 ov -9 Ap 5 r-9 6 Se p9 Fe 6 bJu 97 lD 97 ec -9 7 M ay -9 8

0

Inter-enterprise arrears Total arrears

Tax arrears Wage arrears

Figure 3.1 Dynamics of arrears in 1992–98 (per cent of GDP) Sources: Goskomstat, Russian Ministry of Finance, Federal Tax Service.

90


Table 3.1 Size and structure of arrears in the first quarter of 1998 Type of arrears

Interenterprise arrears

Size, % of GDP* Share of total, %

15.9 43.7

Tax arrears Wage arrears Arrears to banks

15.4 42.2

2.9 8.0

2.2 6.1

Sources: Goskomstat; Alexeev (1998). *GDP in 1997.

because consumer goods and services could be purchased only for cash. Foreign trade was another such zone because export and import deals required payments in hard currency. The rest of the economy, including the public sector, adapted to making transactions without money. The arrears crisis emerged spontaneously as a sequence of several waves of non-payments among industrial enterprises. The first one was triggered by the price liberalization shock in 1992. High inflation rates caused the contraction of the real money supply and entailed liquidity shortages (which replaced persistent shortages of goods under the command economy). The working capital of firms shrank in real terms and could not be restored quickly because of the short-term credit rationing. Banks reduced the credit supply to the real sector because of the increased uncertainty of inflation and credit risks. Instead, firms that could not borrow from banks used their suppliers of intermediate inputs as implicit creditors. Production firms were thus forced to absorb a significant fraction of the credit risks within the economy. Because of the lack of liquidity, firms downstream delayed payments to firms upstream which then had to do the same, thereby causing a vicious cycle of arrears. Delays in receiving payments during high inflation further eroded the working capital of firms. The banking system contributed to the spreading waves of non-payments since, as was mentioned previously, it benefited from artificial delays of payments. In a way, the credit crunch was a natural response of the infant financial system to the outburst of inflation. For this reason at the beginning of the transition few observers saw any substantial problem with regard to inter-enterprise arrears in the Russian economy.1 The East European countries faced the same problem during their period of market transition, but overcame it in two–three years as inflation was suppressed. On the contrary, the crisis of non-payments in Russia turned out to be more persistent and aggravated just as inflation was being subjected to suppression.2 The Russian authorities were faced with a range of economic, social and political problems related to the arrears crisis. However, the focus


of mass media and political debates was given merely to wage arrears which indicated tough relations in the emerging labour market. Managers of enterprises faced semi-hard budget shortages with respect to wage payment in cash. But they often delayed it on grounds of cash shortages thus leaving workers without salaries for many months.3 Not surprisingly, the problem of wage arrears became one of the most sensitive political issues and was used by various political groups and opposition parties for political manipulations and blackmailing the government. However, wage arrears did not cascade (in contrast to inter-enterprise arrears), and their scale was not as great. As can be seen from Figure 3.1, accumulated wage arrears remained in the range 0.3–1.0 per cent of GDP in 1993–95 and 1.0–2.2 per cent of GDP in 1996–97. 3.1.2 Failure to fight arrears As has been mentioned above, the non-payment crisis was triggered initially by money overhang and inflation that destroyed the system of inter-enterprise settlements. Firms faced not only the substantial drop of demand caused by the economy opening and tight competition with imports, but also the sharp lack of finance for purchasing traditional inputs. They did not stop production and continued instead to deliver goods to habitual users disregarding their insolvency. As a result, in the first half of 1992 industries accumulated non-payments worth 3.2 trillion rubles (or 17.7 per cent of annual GDP). Under high inflation this debt burden would be diminished automatically. But arrears continued to build up as the result of liquidity constraints and because of the limited access to bank credits. As a response to this tendency, the Central Bank tried to solve the problem of non-payments through the adoption of a dual strategy described in detail by Barry Ickes and Randi Ryterman (1993). The first measure was a comprehensive mutual clearing of inter-enterprise arrears through the netting of all debts accumulated prior to 1 July 1992. The clearing procedure was aimed at eliminating gross debts, while the residual net debts and new flows of arrears were subject to easy credits aimed at bailing out indebted firms. As a result of this measure, the amount of arrears fell to around one-seventh of its earlier amount – from 3.2 to 0.4 trillion rubles (2.2 per cent of GDP). But this success was temporary since the substantial reduction of financial assets made enterprises even more liquidity-constrained. Liquidation of net debts required significant credit emission in the second half of 1992 that was the main source of increasing inflation.

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The second CBR initiative was to introduce strict financial discipline by imposing pre-payment requirements. This requirement could only work if enterprises possessed sufficient working capital. But at this time such conditions were not fulfilled, and the regulation had serious negative consequences. Being too stringent, this regulation had negative effects on enterprises that lacked working capital and could not secure short-term bank credits to pay in advance. Production, especially of highly processed goods, often required a large variety of intermediate inputs and a long time period, and was hardly possible without external financing. One way out of this situation was the adherence of enterprise directors to traditional relationships and links that allowed parties to obviate the pre-payment requirement. The Russian tradition of mutual responsibility4 made possible inter-firm coordination on the non-money exchange that protected both sides from ceasing operations. Such a strategic response on the tightening of financial constraints had very important consequences for the whole economy. The two radical measures adopted by the monetary authority would have been more effective in a situation in which financial markets and institutions were relatively developed in order to provide liquidity to firms and to prevent the onset of a credit crunch. The Russian authorities had not yet acquired an anti-inflationary reputation and had to demonstrate its firm adherence to the announced goals of macroeconomic stabilization. Otherwise the introduction of tough disciplinary measures for non-payers, like the 0.5 per cent per-day penalty attached to incur new arrears, would not be credible.5 Moreover, the tough measures had negative consequences because required additional centralized credits to cover new huge losses of financially distressed firms. The authorities could not make macroeconomic policy commitments in accordance with the attempts to tighten regulation on the micro level. As it turned out, in Summer 1992 Gaidar’s government had very serious disagreements with the new leadership of the Central Bank about the strategy with regard to reforms. In this situation any macroeconomic policy aimed at stabilizing the price level in the economy would be simply inconsistent. Admittedly, both authorities faced strong political constraints, and policy tightening would cause a catastrophic increase of unemployment that would be too dangerous, given the extremely unstable political situation in 1992–93. But the CBR revealed a strong preference towards the protection of domestic producers – even at the expense of making inflation close to hyperinflation. As we have shown in the previous chapter, the inflationary policy shift in the


second half of 1992 undermined the stabilization programme and unfolded the inflation spiral. The failure to impose payment discipline and hard budget constraints eroded the incentives of firms’ managers. The failure to stabilize the economy implied a loss of credibility that, in our view, was not restored even after the successful macroeconomic stabilization of 1995–96. More importantly, the state lost strategic leadership in making reforms: it became a follower in the game with big enterprises since it was forced to adopt the rules of a non-payment game established initially by firms. The attempts of the Central Bank to cope with arrears demonstrated the helplessness of monetary policy in this respect. On the one hand, attempts to prevent a new build-up of non-payments through centralized credits caused excessive money supply and contributed to inflation acceleration that had the same contractionary effects on the credit supply as the initial inflationary shock of price liberalization.6 On the other hand, the tightening of monetary policy in 1995–96 also caused a reduction of liquidity supply and contributed to a aggravation of the arrears crisis. Because of its microeconomic nature, the latter could be only partially attributed to the impact of a constrained supply of liquidity. 3.1.3 Emergence of the virtual economy Arrears were a symptom of the inherent deficiencies of the post-Soviet economic system rather than just a financial disease triggered by inflationary shock and aggravated by inconsistent macro policies. The basic problem for Russia’s transition was the inherited irrational and deeply distorted economic structure. It had been formed during 60 years of centralized planning by arbitrary administrative decisions and prices that were inconsistent with market valuation of goods and resources. Richard Ericson offered a very clear formulation of the essence of structural disproportions inherited by Russia: A structure of production – location, capital, employment, materials and energy use, etc. – had been created, without any regard for economic opportunity costs, in an environment free of economic valuation and only subject to consistency in arbitrary measured economic units … The basic factors were seriously undervalued (land was free and capital-in-place virtually so), raw materials and natural resources were undervalued, highly processed goods – in particular investment products and services – were seriously overvalued … Non-market prices hided inefficiencies, tremendous waste, exaggerating both net outputs and net income produced. (Ericson 1999, pp. 2, 6)

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The Russian economic structure at the beginning of the transition period was predetermined by incorrect relative prices, the systemic misallocation of resources and non-market links between enterprises. It had been insulated from the world economy and had essential disadvantages in the production of non-basic goods. It was overloaded by the militaryindustrial complex, and suffered from a geographical misallocation of production and many other structural defects. There were many obstacles to the economic structural adjustments in the 1990s. The markets for factors did not exist; labour was generally geographically immobile; much production capital was tied up in obsolete equipment, and new investment could not begin because of the high level of uncertainty.7 The main form of economic restructuring was through the reorganization of horizontal links between firms, entry and exit, and restructuring within firms. As the transition to the market began, the deep structural distortions were manifested at the firm level. A firm that had produced goods perceived as high value under the regime of permanent shortage could end up as loss-making or even value-destroying in the period of market transition. The case of negative value-added was possible if the market price of traditional output fell too low to cover the cost of intermediate inputs, once the economy was liberalized.8 Clifford Gaddy and Barry Ickes (2002) suggested a general measure of firm inefficiency called distance to the market and denoted d. A high d corresponds to a value-destroying firm and a low d to a viable firm. The distribution of a population of firms over d for a deeply distorted economy in transition is characterized by a much larger mean and skewness as compared to the well-functioning economies, as shown in Figure 3.2. A common

0

⫺ d

Figure 3.2 One-dimensional model of transition

d


story of transition was about the movement of the economy to market through the entry of new firms closer to market, the exit of old firms far from market and the reduction of the distance for firms surviving through restructuring. The corresponding shift of the distance distribution would bring about reduction of mean and skewness, as plotted in the figure. The threshold point d¯ denotes a critical distance such that firms in the tail d > d¯ are unable to survive. The common view on transition turned out to be in sharp conflict with the reality of the Russian economy in the 1990s. The assumption that firm viability could be ensured only through investment in reduction of d ignored the peculiar phenomena of widespread arrears and the survival of inefficient producers. The Gaddy–Ickes theory relied on an alternative ‘two-dimensional’ model of transition based on relational capital as a substitute to firm’s closeness to market. The relational capital denoted r is a non-tangible asset that the firms’ managers in the command economy had built up for various informal transactions like bargaining games for plan orders and resources and development of personal links with counterparties and authorities. The relational capital passed through Gorbachev’s semi-market reforms and even increased in value when the administrative system collapsed, because of the lack of both centralized planning and market discipline. Informal relations were essential for maintaining horizontal links and exchange in the destroyed economy. Precisely because this was, to a large extent, person-specific, the relational capital was easily privatized by firm directors that sought to earn all rents on assets under control, provided that the enterprises survived in the emerging market environment. The issue of survival under transition became crucial for directors. Returns on investment in restructuring were very risky and constrained by managerial competence insufficient for operating in the market environment and tied to firm-specific and obsolete technologies. The investment of resources and spending of efforts in relational capital was an alternative to restructuring. In many cases it was preferable because of the increasing returns to scale (the establishment of new relations required fixed costs). Figure 3.3 depicts two-dimensional transition with the population of firms marked by dots in the plane with coordinate axes corresponding to distance to market and relational capital. Arrows show the investment choice by firms between the two strategies of survival: through the reduction of distance to market or the build-up of relational capital. The viability constraint is line VC, above which in order to survive firms are either close to market or rich in relational capital. On the one hand, the reduction of distance to market is not

96

The Russian Public Debt and Financial Meltdowns r

0

VC

d

Figure 3.3 Two-dimensional model of transition

necessary for a firm to adapt to the liberalization of the economy if they have enough relational capital. On the other hand, the relational capital, as an alternative to market closeness, would be useless for firms’ viability if the virtual economy did not emerge, and the onedimensional model portrayed in Figure 3.3 would be valid. The privatization of relational capital was reinforced by the abovementioned non-money (voucher) privatization conducted in 1992–93. Its main goals were to reduce the burden of the state obligations to former state-owned firms and to provide strong incentives to firm restructuring. The state relinquished control over two-thirds of national production assets of which 60–70 per cent fell under the direct or indirect control of enterprise directors (see Box 2.2). Indirect control was ensured through the voting shares of employees who were typically loyal to directors and of affiliated outside companies that received shares at voucher auctions. The effect on incentives turned out to be negligible because firm directors had already obtained widespread opportunities for control and informal ownership rights. This was the case of privatization by and for insiders. It contributed to the virtual economy by legitimizing informal relationships and through the conservation of the status quo in the ownership structure that had existed since the beginning of reforms. Instead of the creation of strong incentives to restructuring, privatization by insiders created additional obstacles to movement to market. The absence of an effective bankruptcy mechanism and the widespread presence of soft budget constraints allowed a large number of non-profitable firms to survive.


The fraction of loss-making producers increased noticeably during the 1990s, for instance, from 23 in 1994 to 47 per cent in 1997 for manufacturing industries, construction and transport. To some extent, this tendency can be attributed to the tax-avoidance motive but, evidently, a large mass of inefficient producers was given an opportunity to survive without restructuring. 3.1.4 Survival in the quasi-market enclave The shocks caused by the liberalization of the economy and its opening up to foreign trade revealed deep structural distortions and caused radical changes in relative prices.9 Structural transformations and a reallocation of resources were necessary, but these processes were mitigated by the policies and the state that sought to bail out domestic producers. They suffered increased pressure of competition with imports and growth of domestic prices for the basic goods. The latter were regulated, and the government tried to keep control over convergence of the basic prices to the world level. Nevertheless, the initial energy price jump was very high: for instance, the gas price grew 4–5 times in dollar terms in 1993.10 The new energy prices turned out very high as compared to the level that pre-existed in the planned system (but were still very low when compared to the world levels: roughly eight times lower for gas, four times lower for oil, and six times for electric energy). The abrupt relative price shock was immense for an economy that lacked mobility of factors of production. Domestic producers had been insulated from global price shocks for many decades and had never before suffered such drastic resource price changes at home (not to mention that they had never had to respond to prices in the command economy). Adjustment to the basic price shocks at the firm level occurred in terms of the managerial efforts choice outlined above. The strategic choices faced by directors were to invest either in relational capital or restructuring. There were three main modes of strategic behaviour, according to the two-dimensional model of transition. Some firms tried not to accept arrears and required pre-payment, thereby selecting the strategy of moving to market. Others, with smaller relational capital and larger distance to the market, almost halted production activity and turned out to be non-viable. The third group of enterprises formed the core of the virtual economy and continued to produce by making losses hidden by widespread non-payments. The latter case allowed adjustment without restructuring and the survival of firms based on the maintenance of the soft budget constraints grounded on non-payments. The mechanism was the following. First,

98


the effective price of the basic resources and intermediate inputs in the virtual economy was much lower than in the market economy. This was because of the rapid inflationary depreciation of debts receivable built up on mutual arrears and of probable defaults on these debts (the effective price of inputs was near zero in the cases of bad debts). Second, non-payments made the financial position of firms in the virtual economy non-transparent. Unprofitable firms protected themselves from going bankrupt by making obscure valuation of assets and liabilities. As Ickes and Ryterman remark (2003, p. 233), ‘When enterprises provide credit to trading partners of unknown viability, they discover that they can obscure their own viability.’ The non-transparency of financial flows also widened opportunities for tax avoidance and shadow-economy activity. Third, parties that invested in relational capital instead of restructuring received mutual benefits from their partnership. Upstream suppliers accept non-payments as a means of preserving the market niche, while downstream purchasers received a reliable source of easy financing. The former incurred losses from high inflation in the bilateral relationship, but in the virtual economy as a whole inflationary losses and the gains of parties were, to a large extent, netted. As there was a reduction of inflation in Russia, the total volume of implicit borrowing through non-payments increased, providing clear evidence of the non-monetary nature of this phenomenon. By building up relational capital and accepting/issuing arrears firms could become members of the network of non-market survivors. Due to the wide spread of arrears, a quasi-market enclave emerged, large enough to shape the essential features of the economy as a whole. It provided an opportunity to mitigate the pressures of growing energy prices and competing imports on firm-members that could continue production in ways that were wasteful of resources. Gaddy and Ickes (1998) labelled this collective activity ‘mutual survival behaviors’. The large-scale privatization simplified the self-organization of a critical mass of enterprises endowed with sufficiently large volumes of relational capital into this enclave. It became the core of the virtual economy designed for the mutual survival of firms-participants with inferior technology without restructuring.11 The essential feature of the virtual economy is a network or informational externality implying that the return on relational capital is increasing in line with the total number of firms in this economy. The network of arrears was created through coordination among firms that involved mutual arrears and the quasi-market exchange of goods under low effective prices of the basic resources. The virtual economy operated


through the misuse of these resources and implicit subsidizing by the state and the state-owned natural monopolies through control over the domestic prices of oil, gas and energy (the explicit subsidies were formally abolished because of the pressure from the IMF). The network externality of the virtual economy was grounded in the mechanism of strategic complementarity between owners of relational capital. This implied the possibility of an inefficiency trap, a stable Pareto-inferior equilibrium with a large proportion of non-payments in firms’ revenues (which was exactly the case for the Russian economy). Allocative inefficiencies were caused by tremendously distorted effective prices of resources and intermediate inputs. The virtual economy was based on the non-market valuation of output through ‘personalized’ effective prices formed by non-payments. These prices did not convey relevant information on demand and supply and, as a result, the economy did not utilize alternative opportunities that would be useful under restructuring. Information asymmetries concerning the true value of assets and liabilities of firms were aggravated by non-payments that impeded investment in production capital. It is notable that the existence of a large exporting energy-resource sector in the Russian economy was the necessary precondition for emergence of the virtual economy. On the one hand, this sector produced valuable tradables that were exchanged for consumption imports. The latter were purchased by households as a reward for labour inputs in the virtual economy, among other inputs. On the other hand, the energy sector ultimately covered the losses of domestic intermediate and final goods providers. Although domestic oil and gas prices increased several times after price liberalization, the effective prices paid by manufacturers remained low due to non-payments. The low effective prices of basic resources and intermediate inputs allowed domestic manufactures to survive in the consumer goods market with transactions in cash and for world prices. Otherwise competition with imports would be unbearable because of the abrupt increase of the energy prices that coincided with the dramatic real ruble appreciation in 1993 and afterwards. Similar to the voucher privatization for insiders that maintained informal ownership rights, the virtual economy tended to maintain the traditional structure of effective relative prices and thereby ensured the artificial viability of inefficient domestic producers. Non-payments were not the only mechanism for their self-organization on the quasi-market base. Another important form was barter exchange and the circulation of surrogate papers veksels of a promissory notes type, both widespread in the second half of the 1990s.12

100


The share of barter in the inter-enterprise operations in manufacturing increased from 26 per cent in 1995 to 40 per cent in the middle of 1997. Barter operations as well as the issuance of veksels usually did not pass through firms’ bank accounts. They could be hidden from the fiscal authorities, although since 1994 the latter repeatedly and with little success tried to tax these operations. Although the basic reason for the origin of the barter system was tax evasion, it also became the essential part of the virtual economy. As Ickes and Ryterman (1992, p. 357) recognized, ‘it is difficult to disentangle the tax-avoidance motive for using barter from the payments-problems motive’. Barter operations relied primarily on the circulation of standard goods, including some tradable commodities which were the most convenient means of nonmoney exchange. Usually, these goods had distinct market valuation, were storable and highly liquid – they included, for instance, construction materials, fuel, alcohol, and foodstuffs. Self-organization of large domestic producers on the quasi-market basis also took place through the establishment of financial-industrial groups and holdings. In a manner similar to non-payment nets, vertical and horizontal integration was aimed at creating market niches, the easing of access to financial funds, and quasi-market pricing that ultimately distorted the rewards to factors and the allocation of resources. The arrears crisis revealed a set of fundamental problems relating to the economy in transition: structural rigidities inherited from the planned economy, improper managerial incentives under imperfect property rights, underdeveloped financial markets and the credit market failure, incredible policy commitments and the impact of political uncertainty on the transition to the market. The inconsistent policy of the state, relying on various forms of explicit and implicit subsidizing, eroded incentives for moving to market even for potentially viable firms.

3.2 Fiscal crisis The virtual economy theory of transition is helpful for understanding Russia’s fiscal problems among which the key one was the reduction of tax revenue in cash which was replaced with non-money tax payments by means of so-called money surrogates. This theory clarifies the nature of the Russian fiscal crisis manifested from the very beginning of market reforms and aggravated after macroeconomic stabilization. In our view, the government was to a large extent involved in the non-market mechanisms of the virtual economy. To a large extent the fiscal crisis was a fundamental consequence of the problems that the economy,


with its deeply distorted structure and wrong managerial incentives, could not obviate. 3.2.1 The nature of tax problems A new tax system was created at the very beginning of market reforms. The value-added tax (VAT), the payroll (pension and social) taxes, import duties and excises were imposed already in the first quarter of 1992. The new tax system was a basis for government finance in the modern market economy. The ability of the government to organize collection of taxes under total disorganization and chaos in 1992–93 was, without doubt, one of the most successful results of Gaidar’s cabinet. The new Russian tax system was based on the two pillars, the profit tax with a nominal rate of 32 per cent and the value-added taxes with a nominal rate of 28 per cent. The main burden of taxation was carried by the production sector of the economy because of the relatively low costs of tax collection. The income tax regime for households that ensured only around 10 per cent of consolidated budget revenue came from the very low incomes of population.13 As a result, the tax burden on producers was extremely high in nominal terms. The marginal rate of enterprise taxes (VAT, profit, payroll-social and turnover) exceeded 90 per cent. Only for the two main taxes, profit and VAT, was the marginal rate 60 per cent, given that the firm was not making a loss. But the enterprise taxes base was in many cases fictional because prices were distorted by the state policy to protect the virtual economy. The tax obligations of enterprises that were de facto loss-making or value-destroying were fictional as well.14 Not surprisingly, the effective tax burden was well below the nominal one and was very unevenly distributed across taxpayers. The actual tax burden was at its highest at the beginning of the reforms, despite the chaotic situation and political messes. The consolidated budget revenue was 28.8 per cent of GDP in 1992 and was notably decreasing subsequently, as seen from Table 3.2 below. The high nominal burden compensated for the imperfections of tax collection and narrow tax incidence which was the key problem. To a large extent, the state budget revenues on all levels were relying on the taxation of large former stateowned companies. They had long ‘financial histories’, were relatively transparent for fiscal monitoring and control, and could be taxed at lower costs. In addition, the Soviet-style directors of these firms were typically compliant – through inertia – to the long-standing tradition of obeying financial discipline (in the command economy deviations from the centralized financial plan were severely punishable). For a period

102


they continued to adhere to formal fiscal rules, and the fiscal authorities benefited from such restrained tax-avoidance behaviour. New businesses that flourished after the economic liberalization could find easier ways to avoid taxes. New practices were developed as a reaction to the excessive tax burden, and new enterprises gained experience in applying a spectrum of instruments for the so-called ‘tax optimization’ (by using transfer prices, fictive transactions and by establishing daughter enterprises and short-lived or fictional firms to minimize the VAT and profit taxes, by applying fictive life-insurance schemes to reduce the payroll taxes, and so on). Illegal collusion between taxpayers and the tax authorities was also widespread. Of course, tax administration was unsatisfactory in terms of the excessive costs of fiscal monitoring, verification and control for taxpayers. The tax authorities imposed long delays in VAT offsets on intermediate inputs. Under a regime of high inflation this was de facto additional taxation that transformed VAT into a kind of turnover tax, adding to the highly distorting effect of the regular turnover taxes. With time, a wide range of tax privileges and exemptions appeared because of lobbying activity and because of the influence of vested interests who had connections in the power ministries and the State Duma. All of these adverse ‘innovations’ resulted from the political compromises between the government and the opposition and aggravated the uneven tax burden on producers. Leaving aside these deficiencies, the tax system, nevertheless, was operational and ensured the enlarged government budget revenue at an average rate of 32–35 per cent of GDP which would be quite acceptable for many developed economies. Unfortunately, the trend of tax collection in the 1990s was negative. Table 3.2 presents the consolidated and enlarged government state budgets. Tax revenue for the latter diminished from 38.1 per cent of GDP in 1992 to 29.9 per cent of GDP in 1996. The key factor was the reduction of revenues on profit tax, VAT and foreign trade duties, as seen from Table 3.2 (foreign trade duties fell because of the abolition of export tariffs in 1995 mentioned above and import tariff privileges that made widespread tax avoidance possible). Although budget revenues increased for excises, property and some other taxes, the total tax revenue was falling substantially. The ineffectiveness of tax administration was usually blamed for this tendency. Firstly, privatized enterprises learned from new businesses to apply various legal, semi-legal and illegal schemes to reduce their tax burden. Secondly, in many cases tax avoidance became the guiding principle for firms-suppliers that accepted debts receivable and/or used

Virtual Economy and Fiscal Crisis 103 Table 3.2 Tax revenues of consolidated budget in 1992–98 (per cent of GDP) Taxes

1992

1993

1994

1995

1996

1997

1998

Income Profit Value-added Excises Foreign trade duties Others* Consolidated budget revenue Payroll Enlarged government budget revenue

2.3 8.3 10.5 1.1 3.7 2.2 28.8

2.6 9.8 6.6 1.0 4.0 2.0 25.9

2.9 8.0 6.1 1.2 3.1 3.7 25.0

2.3 7.4 6.0 1.5 1.5 3.9 22.8

2.6 4.4 6.5 2.4 1.0 4.8 21.5

2.9 4.0 6.6 2.4 1.1 5.5 23.8

2.6 3.6 5.8 2.4 1.4 4.2 21.7

9.3 38.1

10.0 35.9

9.8 34.7

8.5 32.4

8.4 29.9

9.0 32.8

9.4 31.1

Sources: Yasin (2002, p. 347); Institute for Economy in Transition. * property, rental, turnover and other taxes.

barter operations. They could resort to the virtual economy to disguise part of their activity from the fiscal authorities.15 As we see it, however, the crucial factor in the fall of tax revenues was the growth in the level of tax arrears. Federal tax arrears increased from 1.8 per cent of GDP in 1994 to 8.7 per cent of GDP in 1996, while federal tax collection in cash decreased from 7.8 per cent of GDP to 4.3 per cent of GDP. The system of tax administration was naturally designed for money-based transactions and could not be redesigned easily for taxation under the conditions of non-money exchange. Clearly, this system was not very successful but, taking into account the scale of the virtual economy, the formal routines and procedures of tax collection could not play the key role in the dramatic fall in tax revenue. Tax arrears resulted from the accumulation of unsettled taxpayers’ obligations to the fiscal authorities and firms’ decisions to postpone payments to the budget once the accounts were settled.16 The cash-based accounting used in Russia (inherited from the Soviet command system) created additional incentives to accumulate arrears,17 and diminished the pressure of tax discipline on enterprises. Taxable base as well as tax arrears would be much larger under the alternative accrual-based system, implying origination of tax obligations outstanding after delivery of goods and services. In this case tax obligations by an upstream firm would arise irregardless of whether or not cash revenue was received from a downstream firm. This would automatically cause accumulation of tax arrears by the former if the latter does not pay. Figure 3.4 demonstrates the dynamics of the accumulated tax arrears and the size of tax collection in cash for the federal budget. The presence

104

The Russian Public Debt and Financial Meltdowns 14 12 10 8 6 4 2

M

Ja n

-9

4 ay -9 Se 4 p9 Ja 4 n9 M 5 ay -9 Se 5 p9 Ja 5 n9 M 6 ay -9 Se 6 p9 Ja 6 n9 M 7 ay -9 Se 7 p9 Ja 7 n98

0

Federal tax collection in cash

Federal tax arrears

Figure 3.4 Federal tax arrears and tax revenue in cash (percentage of GDP) Sources: Goskomstat, Ministry of Finance, State Tax Service.

of annual cycles in the growth of tax arrears is evident: they fell at the end of each year as a result of the tax offsets applied by the fiscal authorities. These were tax credits issued as payment for goods and services delivered by firms that reduced their tax obligations. This way of netting debts did not solve the problem of arrears to the budget since the outstanding taxes of enterprises were not settled – they were reduced only temporarily – but the state obligations were increasing. As seen from Figure 3.4, the tendencies of rapid accumulation of arrears and decline of payments in cash were prevailing. The fiscal authorities fell into a vicious cycle. On the one hand, the multiplication of arrears caused contraction of tax base in cash. On the other hand, reduction of government incomes left budget recipients18 unable to pay to providers of goods and services prompting the proliferation of tax offsets, which then circulated as a kind of quasi-money. The fiscal crisis was thus unfolding through the networks of the virtual economy underlying non-payments. By this reason any improvements of tax administration would be, in our view, ineffective. In fighting the tax arrears the government applied many times the ‘carrot-and-stick’ policy measures. As an example of ‘carrot’ one can point out the reductions of the VAT rate in 1993 and the profit tax rate in 1994. The idea was to obtain the Laffer-curve effect of increased levels of tax collection, but this did not work out in practice. Firms in the virtual economy did


not get enough incentives for paying all taxes in cash (this would mean adoption of the alternative strategy of survival and would be an irreversible decision; moreover, disclosure of ‘true’ booking to the tax authorities was irreversible and risky as well: once detected as capable of paying taxes in cash firms would have been treated this way by tax authorities subsequently). Another ‘carrot’ was the Minfin decision in March 1994 on redemption of government and tax arrears through mutual offsets. Tax amnesties that freed non-payers from fees and penalties19 as well as the attempts to restructure the principal debts of enterprises did not help either. Enterprises continued making new tax arrears since they expected the state to forgive them again. As an example of a ‘stick’ one can point to the series of decisions taken in Spring 1994 to take control over the bank accounts of enterprises and block them or withdraw money in the case of overly large tax arrears.20 For persistent non-payers special accounts were introduced in 1995 under the control of tax authorities with discretion to withdraw all funds. These tough measures forced enterprises subject to this regulation to reduce legal turnover and increase non-payments and barter. Though high penalties and penalizing interest rates on tax arrears had been imposed, they only increased tax indebtedness but did not change the tax behaviour of firms. By the second quarter of 1998 the total volume of penalties and interest fees on non-payers was 261 billion denominated rubles (10.5 per cent of GDP in 1997) and was above the principal by 36 per cent. In fact, the rapid accumulation of penalties aggravated the problem of tax arrears by increasing the probability and the scale of new debt forgiveness by the state. In principle, persistent tax debtors could be bankrupted by the fiscal authorities, but the bankruptcy law did not give priority to the state as a creditor. In addition, the expected social costs that the state had to incur in each case of bankruptcy exceeded the volume of tax arrears by a significant amount, leaving aside the problem of social tensions that could be caused by large-scale bankruptcies. Thus, just like the vain attempts to use monetary policy against interenterprise arrears in 1992–93, neither carrot nor stick provided a solution to the problem of tax arrears. As we have seen above, both loosening and tightening the money supply to fight arrears had negative consequences. Both the fiscal and monetary policy tools were clearly inadequate because the government could not increase market pressure and impose effective regulation on the virtual economy. Radical tax reform was actively debated after the macroeconomic stabilization of 1995–96. But even if adopted, it would hardly be successful because of the

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presence of the large and rapidly expanding quasi-market segment of the economy. Another reason for delaying tax reform was political uncertainty in the period of the presidential election in the first half of 1996. Both the abrupt decline of tax revenues and the strong increase in the level of tax arrears occurred at the end of 1995 when communists and their allies won the State Duma election in December 1995, indicating the negative attitude of wide groups of citizens to market reforms. This was the worst political situation since the sharp civil conflict in October 1993. The probability of Boris Yeltsin being re-elected was extremely low. According to surveys of public opinion, only a small percentage of voters (between 6 and 8 per cent) would support Yeltsin if election took place at the end of 1995 or the beginning of 1996. It appeared to many that he had absolutely no chance to win his second presidential campaign. In this situation the decision not to pay taxes was the rational choice taken by many of the directors of former state-owned firms. Since the destiny of the market reforms (let alone the liberal-type government) was uncertain in the event of a communist victory, there was no need to obey the rules and fulfill the financial obligations. All of the debts of enterprises might be written off by the populists if they rose to power. Or these debts might be eroded by inflation because of the high probability of total nationalization and chaos in the economy. Some red directors who supported communists desired this outcome and therefore had a political motive for participating in this sort of tax sabotage. The aggravation of the fiscal crisis could benefit the opposition by undermining the main ‘administrative resource’ of Yeltsin’s team. Directors not engaged in the political struggle had to do the same in order to avoid the competitive disadvantage and thereby contributed to the spread of tax arrears (Sinelnikov and Trofimov 1997, pp. 141–2). 3.2.2 The state in the virtual economy As was shown in the previous chapter, the high levels of inflation were suppressed by the tightening of monetary policy in 1995. It was based on a nominal anchor and imposed the high costs of the real ruble appreciation and the real exchange rate increase. The commitment to tight monetary policy was not supported by fiscal policy measures, and the initial success of macroeconomic stabilization proved to be problematic. With regarding to fiscal policy, while non-interest budget expenditures were cut, there was no improvement in the level of tax collection. The tight monetary policy eliminated the resort to inflationary financing. Regular tax collection fell dramatically, and domestic debt


had already expanded too much while the debt service expenditures had grown, reaching 4.7 per cent of GDP in 1996 (compared with 2.5 per cent fixed in the annual budget). Fiscal deficits increased from 5.6 of GDP in 1995 to 7.7 per cent in 1996. The level of federal budget tax revenue (including tax offsets) stood at 11.2 per cent of GDP, which was 2.4 per cent of GDP below the level targeted in the budget law on 1996, while cash revenue (excluding tax offsets) was only 9.2 per cent of GDP. Table 3.3 demonstrates that the government systematically failed to fulfill annual budgets regarding tax collection and deficits. Obviously, such a dramatic worsening in the level of fiscal performance did not contribute to macroeconomic stabilization. As was mentioned above, the decisive factor in this worsening situation was political uncertainty. The continuation of market reforms relied entirely on Boris Yeltsin’s re-election as president. At first the IMF tried to pressure the government but relaxed its position because of the extraordinary political situation. The Extended Fund Facilities credit designed for support of the state budget reorganization and other structural reforms was neither abolished nor sustained despite the breach of the agreement with the IMF in terms of the key items of tax collection and budget deficit. As a compromise between forgiving as a result of political circumstances and maintaining the discipline, the IMF reduced this credit from the initially approved amount of $6 billion to $3.6 billion. The gap of $2.4 billion was made up by the new official non-tight credits granted by the French and German governments. This situation with financial support weakened the IMF reputation for toughness among Russian politicians who began to regard it as willing to compromise (and also as being politically constrained by the notion that ‘Russia is too nuclear to fail’). Unfortunately, the situation in the fiscal sphere did not improve after Yeltsin’s victory in June 1996. Yeltsin suffered from heart disease soon Table 3.3 Federal budget 1993–97 as approved and executed, three items: total spending, total income, budget deficit (IMF definition) all as a percentage of GDP 1993

Revenues Expenditures Deficit

1994

1995

1996

1997

Exec- Law uted

Exec- Law uted

Exec- Law uted

Exec- Sequ- Executed ester uted

14.9 20.6 –5.8

14.1 24.0 –5.6

12.0 17.6 –5.6

11.2 18.9 –7.7

20.4 31.8 –3.7

13.8 17.5 –3.7

14.6 18.9 –4.3

12.0 17.9 –6.0

Sources: Ministry of Finance; Charles Wyplosz and Nadezhda Ivanova (1998, p. 5).

11.0 17.8 –6.8

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after his re-election and this made him unable to fulfill presidential duties until the Spring of 1997. The newly appointed members of the government had insufficient political influence and competence to solve the mounting fiscal problems. In the event, in addition to all these troubles of the Russian policy cycle, the state budget was overloaded with spending obligations that had become unbearably large for a economy in transition (see Box 3.1). Under high rates of inflation the government had little concern about this issue. The expenditure items were fixed in the budget in nominal terms and were automatically reduced by intervening inflation. The Ministry of Finance usually underestimated inflation in its projections (only once, in the first half of 1994, when the abovementioned disinflation surprise took place, this proved troublesome for the government). When inflation was suppressed, the government could not resort to automatic reductions of the real budget expenses. Instead, it began to use politically and socially painful procedures of budget sequestering which, however, did not eliminate but rather postponed the state obligations to future periods.

BOX 3.1 Peculiarities of the Budget Process in Russia ‘Unrealistic’ annual budgets were adopted in the 1990s because of the informational and political constraints, and severe incentive problems. On the one hand, populists and lobbyists in the State Duma promoted the approval of excessive expenditure items without any guaranteed increases of budget revenues. The government had to give in, being aware of the probable lack of revenue and the difficulty of execution, in order to adopt the budget as it was and to have some rule of law in fiscal policy (in 1992–94 the budgets were adopted by the Duma too late, by the middle of each year). On the other hand, the Ministry of Finance lacked information about the true needs of the budget sectors and relied essentially on data relating to the actual spending of previous years. The elaboration of annual budget proposals was similar to games of bureaucratic bargaining for plans and resources under the command economy (in this respect the Ministry of Finance replaced the Central Planning Committee of the former USSR). The total volume of financial orders submitted by budget recipients essentially exceeded the expected budget revenue, and the Ministry of Finance applied a routine


procedure of rationing. Budget recipients anticipated cuts in orders and had strong incentives to increase their budget proposals above the real needs. The problem of the optimization of state budget expenses was put forward as a prior task of the government only a year after the presidential election, in 1997.

As a result, the disease of arrears that had spread initially among the industrial enterprises began to infect the fiscal authorities. Excess budget expenditures were either postponed or financed through issues of money offsets, a type of promissory note to be redeemed at some undefined future date. The so-called ‘Treasury Obligations’ (Kaznacheiskie Obligatsii, KO) were issued just after the disinflation surprise, on 9 August 1994 and were used for payments to enterprises. Because of the strong IMF pressure, the government abolished KO at the beginning of 1996, but expanded the issue of tax offsets that partially replaced tax revenues in cash.21 For example, in the critical pre-election situation of April 1996 around two-thirds of tax revenues were obtained in tax offsets (by July 1996 this fraction had been reduced to half, although this was still too high). The state was also issuing other money offsets to regulate the debts and credits of enterprises owed to and from the budget. As in the case of mutual inter-enterprise arrears discussed above, it was impossible to eliminate arrears between the budget and the economy sectors only by means of credit emission. Nevertheless, the surrogate instruments (money surrogates) became very attractive for the Russian financial authorities. Tax offsets allowed the Ministry of Finance to close numerous financial gaps that emerged under the tight money policy, tax arrears, and excessive budget expenditures. The fiscal authority found a convenient way to solve current problems especially acute in the election campaign, Firms providing goods and services to the state accepted surrogate payments because of overpriced contracts. The surrogate payments could be used for tax payments or transformed into liquidity in the secondary markets that emerged simultaneously with the expansion of the short-term ruble debt GKO-OFZ. The issuing of surrogate instruments aggravated disorder and was detrimental to the state’s finances. Normally, a government debt issue leads to an increase of the tax burden or to refinancing through the issuing of new debt in the future. In the case of tax arrears and offsets the government could face a heavier increase in its future tax burden22 or, alternatively, a need for refinancing through new issues of tax

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offsets in return for the redemption of the old ones. The latter case would lead to a tax crisis and an inevitable default on surrogate-based debt. In addition, building debt policy on surrogates meant the emission of personalized debt obligations and the creation of firm-specific financial products. Being based on non-transparent transactions, such a policy was similar to the use of tax exemptions and implicit subsidies to the virtual economy. The issue of money surrogates forced the government to make inefficient decisions in terms of the procurement and selection of investment projects. In many cases companies preferred to have tax debts and accepting payments in the form of tax offsets irrespective of their productive efficiency. The emission of surrogate instruments also had inflationary consequences. At first glance, their volume was not large when compared to the money aggregates, only 12–15 per cent of the M2 volume. But, according to Gresham’s law, the money surrogates had a much higher velocity and tended to crowd out true money from transactions between enterprises and the state budget. The circulation of these instruments did not affect the CPI index directly, since consumer goods could be purchased only for cash. However, because of the multiplicative effects, the surrogates increased total financial disorder in the economy – thus making the outburst of inflation a likely future outcome. It is important to understand that the use of the money surrogates was mutually beneficial for the individual participants. The budget recipients gained from the state transfer in any form, although they had to sell tax or money offsets at a high discount. Financial intermediaries received a premium for liquidity provision to the budget recipients and claimed redemption of surrogate papers from the government. Such transactions generated an additional interest burden that had been unforeseen in the state budget and increased the total volume of shortterm debt obligations. The authorized banks also provided direct shortterm loans to the budget recipients under government guarantees. All of these activities were non-transparent and had much in common with the chaotic building-up of Soviet external debt obligations prior to the first debt crisis (discussed in the first chapter of this book). But the key problem was that the state was becoming increasingly involved in the virtual economy. Arrears and tax offsets generated by the government induced the multiplication of arrears and widened the vicious circle of non-payments. Attempts to combat arrears were too late and inconsistent: restrictive measures contradicted the issuing of new instruments. For instance, the government of ‘young reformers’ appointed by Boris Yeltsin after his re-election declared the strong


intention of struggling with surrogates, but instead continued emissions at even larger volumes of money offsets (Yasin 2002, p. 263).23 The situation did not improve after the re-election: the total federal tax revenue (cash and non-cash) was only 70–80 per cent of budgeted levels in 1996–97, making it inevitable that the state would accumulate new unfulfilled obligations and arrears. Moreover, the share of federal tax payments in cash was only 60–70 per cent of tax revenue, indicating the involvement of the government in unfolding the spiral of nonpayments. Playing games with the virtual economy caused a further widening of fiscal gaps and contributed to the fiscal crisis.24 The government would be unable to support the virtual economy during the whole decade without the so-called ‘three fat boys’: Gazprom, the Unified Electric Systems (UES), and the Railway Ministry. They had been transformed from the Soviet ministries; the latter two remained under governmental control, while the state’s stake in Gazprom was only 40 per cent. In effect, Gazprom was now under the control of its top managers – the government had to negotiate with them rather than giving them orders. This was unsurprising since the main architect in the creation of Gazprom was prime minister Victor Chernomyrdin who had been the minister of the gas industry during the Soviet period and who had transformed this ministry into Gazprom at the beginning of the market reforms. Unlike the other natural monopolies, Gazprom was (and nowadays still is) the biggest exporting company in Russia controlling the gas pipeline networks and providing the largest inflow of foreign currency revenues for the economy and the state budget. By these reasons Gazprom was in the previous decade a ‘state in the state’ and possessed great autonomy from the government. As pillars of the virtual economy, the natural monopolies fulfilled the role of ‘budget donors’ of last resort. They were explicitly subsidizing the quasi-market sector through a policy of low prices and non-payments. For instance, the fraction of non-cash revenues was especially high in the case of UES: sometimes it exceeded 95 per cent of the company’s total revenue. In the Soviet economy electric power was extremely cheap or free, and that is why the so-called ‘strategic consumers’, such as the Ministry of Defence, tried to maintain this tradition by disregarding the UES bills. All of the natural monopolies were net creditors of the budget, because their own tax arrears were several times below the arrears of the state. Support for the state budget meant an implicit subsidy of the virtual economy which the state sought to support. The natural monopolies, nevertheless, benefited from these provisions. They gained from the monopoly pricing and the effective price

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discrimination among consumers using non-payments under their control. Although energy, gas and rail transport prices were formally regulated by the state, the annual price increases were initialized and given formal justification by the natural monopolies themselves. The government had to be a follower in the strategic price-setting game with these companies. It tried in vain and on many occasions to curb the growth of the prices charged by the natural monopolies. For instance, the ‘young reformers’ repeatedly used the mass media to criticize their management for charging ‘artificially high prices’. Several presidential and government decrees were issued to limit the growth of energy prices or, at least, to tie them to current CPI inflation rates. Since the levels of non-payments by energy consumers were also increasing, the direct impact of effective energy prices on inflation was not so large. But the growth in energy prices also had an indirect effect on growth, through signalling to downstream producers an expected economy-wide price increase. This mechanism of inflationary expectations coordination drove the so-called ‘cost inflation’ that was often claimed to be the main source of price growth after the macroeconomic stabilization.25 The government was strongly dependent on the natural monopolies as the budget donors and for this reason it was not inclined to implement anti-monopoly measures. The restructuring of Gazprom and UES only remained a popular theme of political and public debates (the suggested programmes for their reforming were unworkable and very far from being adopted or implemented). The state, however, was not completely powerless to affect the behaviour of natural monopolies. It possessed the potentially effective tools of control such as the licensing of exports (by Gazprom) and the neglecting of non-transparent dubious schemes adopted in the financial management of these companies. However, because of the political weaknesses of Yeltsin’s regime, the state could not use every available opportunity to impose binding incentive constraints on the natural monopolies. From the theoretical point of view, situations of this kind can be described in terms of incentive games between the state and the natural monopolies (see Box 3.2). In a Pareto-inferior equilibrium with arrears or barter the energy-exporting monopoly and the state are implicitly subsidizing the quasi-market sector of inefficient producers. The monopoly chooses the effective/barter energy price at home in accordance with the willingness of the state to protect the virtual economy from restructuring. The robustness of arrears/barter equilibrium allows the virtual economy to sustain monetary tightening, the formal elimination of state subsidies to enterprises, the world growth in energy


BOX 3.2 Incentive Games in the Virtual Economy The Ericson–Ickes (2001) model of the Virtual Economy captures the most essential features of the Russian economy of the 1990s outlined in this subsection. There are two production sectors in the model: the first is the gas-producing natural monopoly (Gazprom) generating export revenue and supplying gas at home, and the second is the manufacturing sector subject to restructuring or implicit protection by the state. Manufacturing firms are heterogeneous, having different energy-input coefficients, and Gazprom can discriminate between efficient and inefficient enterprises by engaging selectively in barter operations. The government chooses incentive parameters affecting the choice of the monopoly, the survival rate of manufacturing enterprises and the revenues at the disposal of the state. The barter equilibrium is shown to be robust in the sense that firms gaining from barter would refuse to restructure even if the barter ‘price’ of energy is sufficiently high. Without the option of virtual economy barter, all manufacturing firms would choose socially efficient restructuring. The model demonstrates that only substantial changes in the government policy trade-off (support of inefficient producers versus costly restructuring) can draw the firms out of the barter equilibrium.

prices, and various shifts of policy-related parameters (reflecting, for example, the attempts of the government to implement or imitate the structural reforms). To the extent that the fiscal crisis in Russia was a consequence of a robust non-money equilibrium with arrears or barter, the government had few opportunities to fight this crisis using the standard methods of macroeconomic governance. However, the IMF relied on conventional wisdom and suggested using these methods for Russia simply because they had been tested in some other emerging markets. 3.2.3 Making the oligarchs: the loans-for-shares deal The Russian government had to invent permanently non-standard ways to solve its recurrent problems. At the end of 1995 the key policy was to raise additional money to support Yeltsin’s forthcoming presidential campaign. He could offer voters very little evidence of progress during his first period in office. The market economy was not yet up and

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running and the overwhelming majority of ordinary people still suffered from the high costs of transition. The main contribution to households’ welfare was the reduction of inflation and the stabilization of the ruble’s exchange rate. The ruble appreciation made middle-class people wealthier and prompted a notable increase of consumption and imports. Those who could make savings gained from investment in ruble-denominated assets such as deposits in commercial banks and government savings bonds, which yielded astronomical real returns. But the majority of population had no savings at all. The suppression of inflation was not sufficient to compensate for the extremely low level of real wages and hidden unemployment, tremendous income inequality, and numerous social problems. The urgent task of the federal budget was to further the positive results and shift the attitude of potential voters in favour of the ruling political regime. As we have shown above, the government was hard-pressed in the fiscal sphere and relied on injections of additional revenue which could be viewed as political contributions. A ‘breakthrough’ idea was suggested by Vladimir Potanin and supported by Anatoly Chubais in the Spring of 1995. Potanin was the head of Oneximbank which had very rapidly (one can say miraculously) become one Russia’s top five banks. It was one of the creditors of Norilsk Nickel, ‘the pearl of the North’, a world-class non-ferrous and precious metal company with annual sales exceeding $2.5 billion. Potanin proposed taking management of this company in exchange for a loan supplied to the government to finance a budget gap in part. He organized a consortium of bankers to lobby the government officials. As collateral, the syndicate required controlling shares of the leading Russian export companies that had been excluded from the earlier voucher privatization. Formally, this loan was supposed to be redeemed after the presidential election, but in the event the government was unable to repay the debt the lenders seized the copllateral. In effect, it was a scheme of money privatization and it became known as the notorious ‘loans-for-shares’ deal. In addition to Potanin, the initial consortium of bankers included Mikhail Khodorkovsky, Alexander Smolensky, and some other rich people who became oligarchs after Yeltsin’s re-election. It was the first time that some of Russia’s largest financial players agreed about coordinated strategic actions and committed themselves to the division of national property. The initial offer to the government was a loan totalling $1.8 billion in exchange for the trust management of Norilsk Nickel and several leading oil-producing companies such as Yukos, Sidanko, Lukoil, and also the natural monopolies UES and Svyazinvest (however, these


last two were later excluded from the deal). Though the total amount of the loan was hundreds of times below the fair value of the collateral, the scheme was approved by the Russian government on 31 August 1995. The crucial role in the government’s adoption of this deal was the political support by Anatoly Chubais, at that time the first deputy premier. His approval was viewed as a guarantee of the scheme’s fairness and openness and helped to alleviate the doubts about this deal that had arisen in the international financial community. These doubts turned out to be reasonable, since the lenders were permitted to organize the auctions of collateral themselves and, hence, received carte blanche to completely exclude any competition. These auctions were conducted in November–December 1995 and, in contrast to the voucher privatization auctions, occurred without alternative bidders. I myself was aware of proposals from some foreign companies that exceeded the starting prices by ten times but were rejected by the organizers of auctions for technical reasons. Most of the potential competitors understood that they had no chance of winning and did not even try to participate in the auctions. The gap between the initial and final price typically did not exceed a few percentage points, indicating the identity of the seller and the buyer in each case. The results of the loans-for-shares auctions are presented in Table 3.4.26 In order to demonstrate its transparency, competitiveness, and fairness the government made a public announcement of the deal. Instead, the

Table 3.4 Results of the ‘loans-for-shares’ deal Company

Date of The stake Starting Final price Actual winner auction purchased price ($ million) (%) ($ million)

Norilsk Nickel Yukos Sidanko Sibneft

17 Nov. 8 Dec. 7 Dec. 28 Dec.

51 45 51 51

170 150 125 100

170.1 159 130 100.3

Lukoil Surgutneftegaz

7 Nov. 3 Nov.

5 40

140 66.7

141 88.9

Novolipetzky 7 Dec. Metal Company Others* —

15

30

31

Oneximbank Menatep Oneximbank Oil Finance Company Lukoil Surgutneftegaz, Oneximbank Oneximbank

—

—

66

—

Source: Author’s data. * Oil-producing company Nafta-Moskva, metallurgical company Mechel and three shipping lines.

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world could watch the outrageous examples of how property was typically reallocated, showing Russian crony capitalism in action. The total amount of the loan obtained by the government through the auctions was only half of the initial consortium’s offer. As can be seen from Table 3.4, the total state revenue was only $0.9 billion or 1.9 per cent of the federal budget revenue (0.2 per cent of GDP) in 1996. These funds could hardly ensure Yeltsin’s victory, but were eventually rewarded with the most attractive piece of national property. It became clear for everyone not involved in the ‘loans-for-shares’ deal that it was absolutely unfair and unreasonable from a national welfare point of view. At first glance ‘privatization for and by oligarchs’ was even more irrational in terms of economic policy objectives and benefits of the state than the ‘privatization for and by corporate insiders’ completed two and half years earlier. But despite the obvious absurdity of the proposal, this scandalous deal was driven by strong politically motivations. The first question arising in connection with this deal is why did Anatoly Chubais, at that time the leading economic reformer in the government, decide to support the loans-for-shares offer? It was clearly in conflict with the principles of openness, competitiveness, and fairness declared by the government and to which he personally, as a liberal economist, was an adherent. The budget crisis and the IMF pressure on the government to reduce the budget deficit were strong enough, but could hardly be a decisive argument, since the addition of one or two billion dollars of revenue could have little impact on the whole situation. In fact, Chubais tried to think and act in a strategic manner, and the most important issue for him was the creation of a class of big owners who would be able to affect strategic policy making in Russia. The oligarchic regime of power created as a result of the loans-for-shares deal in 1996 was supposed to become a framework for a future political system. The ‘loan programme’ was a convenient label that disguised what was essentially a privatization for oligarchs of the Russian ‘crown jewels’ at symbolic prices. In addition, the loans-for-shares deal could be used as a sort of poison pill in the event of Yeltsin’s defeat because it would have deprived any new government of a large chunk of state property. Finally, the loan-for-shares deal was thought to impair the position of ‘red directors’ and eventually to undermine their political influence. The second question is: why did Boris Yeltsin and his circle agree so quickly to the oligarchs’ offer? They did not think strategically like Chubais and were not responsible for raising the state’s budget revenue. In my view, the main motive for their adoption of the offer was a sort


of panic about the possibilities of a communist victory. The ruling elite needed political support at any price regardless of the long-term political consequences. But the true role of oligarchs in giving financial support to Yeltsin’s presidential campaign was very much exaggerated after the election by mass media under their control. They claimed that risk-taking justified the extremely low valuations given to state property prior to the re-election of Yeltsin. In fact, the loans the oligarchs supplied to the government were not exposed to a great risk of default in the case of Yeltsin’s defeat. A leftist government that would take power could abolish the loans-for-shares deal and leave the oligarchs without tremendous gains. But, acting pragmatically, this government would not necessary try to default selectively on public debt for purely ideological or political motives. The loans-for-shares credit to the state made only a small financial contribution to the election campaign. This was equal to roughly only one-tenth of funds raised by Yeltsin’s team for the same purposes through alternative sources. No collateral was required for other credits to the government, and the abovementioned budget transfers to regions ensured for Yeltsin the vital support of the regional authorities. The most important potential political support for Yeltsin would leave primarily for the regional authorities that had a lot of autonomy from the federal powers under his rule. The outcome of the election depended largely on the political preferences of these regional governors. The main problem was that at the very beginning of the presidential campaign the vast majority of the governors supported communists and their allies, and the most pressing task was somehow to reverse their leftist preferences. Yeltsin mobilized all of the reserves of the federal budget and beyond to secure the regional authorities’ loyalty. I am sure that the federal social transfers rather than the mythical support of ‘big bankers’ made essential changes in the course of election. The financial contribution by oligarchs to Yeltsin’s success was part of the mythology they built for themselves after the election. Of course, the aggressive support of Yeltsin’s campaign by the mass media and, especially, by the national TV channels played a significant role in the dramatic change of political preferences among the Russian population during the first half of 1996. But there was no need whatsoever to organize the loans-for-shares deal to ensure this support. For example, the ORT channel, the most popular station in Russia, was controlled by Boris Berezovsky who was in alliance with the Yeltsin family and became a member of the Potanin–Khodorkovsky coalition at the very end of the giveaway process. Russia’s two main media magnates

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of the 1990s, Boris Berezovsky and Vladimir Gusinsky, could have been rewarded for their loyalty to Yeltsin at a much lower cost. The third question relating to the loans-for-shares deal is: why did the Russian government not redeem the debt to oligarchs following the election of Yeltsin? As stated above, the fraction – 1.9 per cent of the federal budget revenue – was not so great as to warrant giving oligarchs state property worth many hundreds of billions of dollars. If the government had possessed the political will, it would have faced no obstacles to the repayment of the loans and keeping the collateralized shares even after the termination of the contract on 31 August 1996. The initial terms of the contract could be renegotiated, and this date could be postponed without giving rise to any serious criticism among the world’s financial community, because the unfairness and the cronyist nature of the deal were evident to everyone. As mentioned in Chapter 1, Russia entered the world financial markets in the Autumn of 1996 and could easily borrow abroad $0.9 billion plus interest. My answer is that by the end of Yeltsin’s re-election campaign the political system of Russia had been already captured by oligarchs.27 The virtual economy was thus supplemented with the virtual political system. The Russian term for this was semibankirshina, which means, literally, the power of seven bankers.28 In my opinion, the oligarchic rule in 1997 was extremely inefficient in all respects. The main negative factors were the illness of Yeltsin after the election, the total political mess, and the failure of the ‘young reformers’ to modernize the virtual economy and to ensure macroeconomic stability. Almost a year and a half after the election saw very little progress in terms of reforms in public finance and other spheres. All of these failures contributed to the Russian financial collapse in 1998. This policy capture implied the creation of a new political system. Together with the most valuable chunks of national property the oligarchs also secured political power. They began to consider the federal state as a privatized corporation in which they had invested money ($0.9 billion) and from which they naturally expected to get returns. After this time top state officials were viewed as managers of this ‘corporation’ and were supposed to serve their new owners and to forget about national welfare goals that they had originally appointed to fulfill. For me it was astonishing how the entire political system had been transformed in just a few months from the time of the re-election. As the first deputy minister of finance, I tried repeatedly to defend the federal budget from the burdensome pressure exerted by the ‘system-shaping’ oligarchic banks. For this reason I criticized the ‘loans-for-shares’ scheme from


its very beginning for obvious reasons of outrageous financial inefficiency. Nevertheless, after Yeltsin’s re-election I received a personal offer from Boris Berezovsky, at that time the grey cardinal near the king’s family, to become a member of his team as a condition of my staying in office. I could not accept this offer which meant fulfilling the work for the new oligarchic regime of power. I strongly believed – and still believe – that a top state official has to serve the goals of national welfare rather than the interest groups that sometimes capture politics. Because of my tough position I became the subject of a hysterical and dirty campaign in the mass media that was controlled by the oligarchs. Duels in modern times are not permitted, and there is no place for heroism in the spirit of Alexander Hamilton (see Box 1.2). The only possible response to the insinuations in the mass media was my decision to resign at the beginning of 1997. But even being aware of the cronyist nature of the ‘loans-for shares’ deal, I could not envisage all of its politico-economic implications for Russia. The very essence of the state changed dramatically, and the subsequent evolution of the Russian policy system had little influence on its essentials. Although bureaucrats forced the oligarchs from power after Yeltsin’s resignation at the end of 1999, they became in turn the true masters of the ‘corporation’ and operated primarily in their own interests. This attitude to power became a social norm. In a way all of the radical policy shifts that occurred in Russia after Yeltsin’s rule can be viewed as being consequences of the unsuccessful attempt to create a class of oligarchs in Russia. Unfortunately, most of the Russian liberal reformers offered an a posteriori justification of the loans-for-shares deal as a ‘necessary pact’ to ensure that the communists did not take control of the Kremlin in 1996. The reformers have not recognized that it was their great mistake, and this is very sad. If even liberal economists in Russia supported and tried to justify the model of crony capitalism, then bureaucrats could feel absolutely free in the radical revision of their functions. The very spirit and the essentials of the market reforms proved to be lost simply because of the $0.9 billion of additional revenue the federal budget received in 1996. In my view, this mistake was made unintentionally since the reformers could not foresee the negative long-term consequences of this pact for the economy and the political system of Russia. I concur with Crystia Freeland’s (2000, p. 170) observations of the deal: That ‘necessary pact’ turned out to be a Faustian bargain. The young reformers defeated the Communists, but they lost their souls in the

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process. They had come to power as democrats; to stay there, they created a shadowy, unelected cabal. They had come to power to create a fair, equitable, law-abiding market economy; to keep it, they sponsored one of the world’s sleaziest insider deals. Ultimately, loansfor-shares destroyed the young reformers: it cost them their ideals, their reputations, and eventually their jobs. Worse yet, ultimately, it scotched any short-term hopes there still were for the emergence of healthy, prosperous Russian capitalism. Instead, Russia’s market economy is now corrupt, distorted, and inefficient, and loans-forshares is both the cause and symbol of its malaise. The rule of oligarchs in 1996–97 led to an exacerbation of the internal struggle for political power and new pieces of the yet undivided state property pie. The most striking example was the privatization of Svyazinvest, a telecommunication holding, in 1997. This was the first occasion on which the government had made an attempt to design a privatization auction in the standard way to maximize the budget revenue. It obtained $1.7 billion for 25 per cent of shares, which was an extremely large volume in comparison with ‘money auctions’ (being, for example, ten times higher than the Norilsk Nickel auction revenue). This and some other attempts of the ‘young reformers’ to distance themselves from the oligarchic control provoked the informational war against the government. The key TV channels and other mass media under their control became a very effective weapon in the ‘cold civil war’ the oligarchs tried to unleash. In what follows we will return to this issue in our discussion of the mechanisms underlying the Russian financial crisis.

4 The Risks of Domestic Debt Expansion

Introduction As we have seen, the anti-inflationary monetary policy pursued in 1995–96 succeeded in reducing the level of inflation. A stabilization of inflationary expectations occurred in the second half of 1995 thanks to monetary policy tightening and the nominal anchor regime. But this stabilizing effect was not enough to reduce the real interest rates that soared due to constrained liquidity supply, the expansion in government debt, and the banking crisis of Summer 1995. From early 1996, the factor of political uncertainty sharply raised the risk premium in yields of domestic financial instruments. In this respect macroeconomic stabilization was not completely successful. The tightening of monetary policy was not supported by a reduction of the budget deficit – in fact, the deficit increased in 1996. For a number of reasons, including the 1996 presidential elections, political instability, and the struggle between oligarchic groups in 1997, the tax and budget reforms did not take place under Yeltsin’s second period of rule. The chronic budget crisis entered a phase of tension which, to some extent, was a consequence of macroeconomic stabilization. Additional budget funds had to be obtained because of the urgent need to finance social expenditures (mostly pensions and wages in the budget sectors). The government was engaged in creation of money surrogates escalating thereby the problem of non-payments that had become the main trouble for the whole Russian economy. The dramatic increase in the cost of debt servicing in 1996 was accompanied by new fiscal problems. The election race, together with a considerable decline in tax discipline, led to a rapid growth in the level of the domestic debt. The tax behaviour of enterprises worsened 121

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substantially, not only because of the political uncertainty, but also as a result of the evident tendency of the money surrogates to become the prevalent means of payments. The inability of the government to boost taxes in cash and to find an effective systemic solution to the fiscal crisis resulted in domestic debt expansion. Debt replaced inflation but, in turn, was posing a threat to macroeconomic stability. As we shall see in this chapter, the main problem was not the rate of debt accumulation per se. In fact, in real terms the volume of debt was tending to stabilize. The main problem lay in the composition of public debt which was overwhelmingly short-term and therefore strongly exposed to the risks of refinancing. Additional risks were created after the opening of the financial market because of the unsuccessful exchange rate risks management scheme applied by the monetary authorities. The short-term gains from this scheme for the domestic financial system were doubtful, but it made a substantial contribution to its vulnerability to external risks.

4.1 Dynamics of public debt in 1995–98 Thanks to debt financing, the authorities delayed inflation for several years, but could not eliminate the basic inflationary background. Debt expansion replaced the monetization of budget deficits, and the ultimate success of macroeconomic stabilization was conditioned on the conduct of radical and systemic fiscal reforms. But these reforms were delayed, creating the threat of sliding into a regime characterized by a higher inflation regime. The primary budget deficits in 1995–97 under conditions of monetary tightening, fiscal crisis, and political uncertainty led to a dramatic increase of debt service costs. The position of state finance was becoming increasingly fraught, with danger of a debt crisis and default. The government was forced to play a risky fiscal policy game using financial markets and the banking system. 4.1.1 A paradox of debt stabilization Surprisingly, despite the fiscal woes of Russia that led to the increasing of debt in the absence of economic growth, the total public debt remained stable in real terms. As seen from Table 4.1, government debt stood at around 50 per cent of GDP during the three-year period 1995–97. The paradox is that while the primary deficit was permanently high (around 2.5 per cent of GDP on average), economic growth was negative on average, and debt service costs were large (around 4.5 per cent of GDP on average), the level of total debt did not grow in real terms.

The Risks of Domestic Debt Expansion 123 Table 4.1 Russian public debt in the 1990s Year

1995 1996 1997 1998

Primary Interest payments Government debt Real GDP deficit growth % of GDP % of $ billions % of GDP (% of GDP) (%) revenues 2.2 2.5 2.4 1.3

3.6 5.9 4.6 4.6

28 47 38 43

170 201 218 242

50 48 50 77

– 4.0 –3.4 0.9 – 4.9

Source: Kharas et al. (2001, p. 14).

It was near 50 per cent of GDP in the period 1995–97 – a level considered acceptable by international standards for the emerging market economies. The explanation suggested, for instance, by Kharas et al. (2001) and Ickes (2007) is that the artificial real ruble appreciation entailed by the nominal anchor (by 85 per cent during the three years 1995–97) masked the true burden of external debt accumulation. The drastic increase of total state debt to 77 per cent of GDP in 1998, as seen from in Table 4.1, was caused by the debt crisis and the real ruble depreciation (which are the matter of our discussion in the following chapters). The real exchange rate appreciation in the period 1995–97 was not the result of fundamental changes, but rather a response to previous overshooting. This real ruble appreciation was therefore susceptible to external shocks, and created a problem of hidden external debt burden. Meanwhile, the former Soviet debt had been rescheduled by the end of 1997, reducing the threat to financial stability, at least until the end of the decade. As we have shown in Chapter 1, successful debt restructuring allowed the Russian government to remove the main burden of external debt servicing for a period of six or seven years into the future and, thus, to postpone the essential increase of the debt payments until 1999. The new sovereign debt of the Russian Federation did indeed grow rapidly in the middle of the 1990s – from $11.3 billion at the end of 1994 to $35.6 billion at the end of 1997 (Table 4.2). The main contribution in this new build-up of external debt was the result of the IMF–WB’s financial support of macroeconomic policy which cost $13.7 billion. The Russian Eurobond issues amounted only to $5.5 billion before the financial crisis of 1998. Even though the new external debt of the Russian Federation was growing in the 1990s, it was not so large as to play a decisive role in the deterioration of the state finances. The roots of the Russian debt crisis of

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Table 4.2 Russian external debt in the middle of 1990s ($ billion)

Total external debt Soviet debt New Russian debt Multilateral creditors* Eurobonds Other

1994

1995

1996

1997

1998

127.5 116.2 11.3 5.4 0.0 5.9

128.0 110.6 17.4 11.4 0.0 6.0

136.1 108.4 27.7 15.3 1.0 11.4

158.1 99.0 35.6 18.7 4.5 12.4

155.0 102.7 55.4 26.0 16.0 13.2

Sources: Russian Ministry of Finance; Vnesheconombank; Citibank. * Includes IMF disbursements to the CBR.

500 450

GKO

OFZ

400 350 300 250 200 150 100 50 0 1994

1995

1996

1997

Figure 4.1 Domestic debt in 1994–97 in GKO-OFZ (trillion rubles) Source: Russian Ministry of Finance.

1998 are usually seen in the tendency of domestic debt accumulation to accelerate in the period 1995–97 (see Figure 4.1). A popular accusation against the government was that it relied on excessive debt financing to combat inflation. Many people even accused the government of running a Ponzi scheme à la MMM and other pyramids against which the government had been struggling in earlier periods. The problem was that these people suffered a sort of money illusion. Domestic debt did indeed initially grow fast in real terms because of the small base effect, but it had begun to stabilize by the beginning of the financial crisis of 1998. This was also the case for total public debt, as can be seen in Table 4.1. It is also clear from Table 4.3 that the growth of domestic debt

The Risks of Domestic Debt Expansion 125 Table 4.3 Domestic debt of the federal government (end of period, percentage of GDP)

Total debt GKO OFZ Debt to the CBR Securitized credits Other

1994

1995

1996

1997

1998

18.9 1.7 0.0 9.60 3.1 0.0

12.73 4.27 0.70 3.96 1.95 1.85

18.07 9.49 1.56 2.78 1.37 2.87

21.8 11.0 6.59 0.0 1.17 3.05

21.79 0.62 11.32 0.0 1.05 2.13

Source: Ministry of Finance, Citibank.

140 GKO-OFZ

GKO-OFZ-Eurobonds

120 100 80 60 40 20

94 r-9 4 Ju l-9 O 4 ct -9 4 Ja n95 Ap r-9 Ju 5 l-9 O 5 ct -9 5 Ja n9 Ap 6 r-9 Ju 6 l-9 6 O ct -9 6 Ja n9 Ap 7 r-9 Ju 7 l-9 O 7 ct -9 Ja 7 n98 Ap r-9 8 Ap

n-

ec D

Ja

-9

4

0

Figure 4.2 Dynamic of real debt in market instruments (trillion rubles, base December 1993) Sources: Russian Ministry of Finance, Goskomstat.

in short-term market instruments, such as GKO, as a share of GDP was 151 in 1995, 122 in 1996, and 16 per cent in 1997. Figure 4.2 depicts the dynamics of the real debt volume in GKOOFZ deflated to the March 1993 CPI level. The upper part of the graph records the total debt outstanding in market instruments, including new Eurobonds issues that originated at the end of 1996. The strong tendency of real debt stabilization is evident. The jump in the volume of debt occurred on 15 March 1997 and relates to the securitization of CBR credits to Ministry of Finance into long-term fixed-rate bonds OFZFR with maturities of between four and 16 years.1 The Eurobond issues,

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obviously, did not change the entire picture. The reduction in the absolute volume of debt in the last few months before the August 1998 default is explained by the extraordinary anti-crisis measures undertaken by the government and described in further detail in Chapter 6. The evidence presented in Table 4.3 and Figure 4.2 suggests that the domestic debt stabilization occurred regardless of the real ruble appreciation. Two questions arise in connection with this evidence. First, why did domestic debt begin to stabilize? Secondly, if this debt was beginning to stabilize by the beginning of 1998, why did the debt crisis occur in that year? 4.1.2 Did the government play pyramid with debt? As was mentioned, the data in Figure 4.2 contrast with the popular view of Russian domestic debt as a financial pyramid. This was a key argument made against the attempt to bring about macroeconomic stabilization based on replacing inflation through the expansion of debt. Critics made repeated comparisons of the Russian government’s debt policy with financial bubbles that emerged in the period of wild financial markets in 1993–94 (and described above in Chapter 2). In addition to money illusion, this view was based on the observation that the government had to refinance its short-term debt by making new issues rather than by making repayments from the federal budget surpluses (that did not exist). But the fact that the government rolls over its debt does not necessarily imply a pyramid. In Appendix A4.1 I suggest a parsimonious test of whether outstanding debt dynamic is better described by a logistic or exponential curve. The latter case is strongly rejected for the domestic debt expansion period 1993–98 consistently with the evidence on real debt stabilization. The key reason for the tendency of debt stabilization was the drastic reduction in real interest rates after the resolution of political uncertainty in Summer 1996, and the opening of domestic financial markets discussed in what follows. The real interest rate dramatically declined because of Yeltsin’s victory in June 1996, even though the debt volume was already fairly large. This is made clear in Figure 4.3, which shows that the dramatic fall in the real GKO-OFZ yield occurred after the dramatic jump of a similar size in the second quarter of that year when the political uncertainty had been at its peak. As a result of the decline in government paper yields, the cost of debt servicing ceased its dramatic growth and there was a degree of stabilization of the volume of debt. This, however, did not eliminate the

The Risks of Domestic Debt Expansion 127 180 160 140 120 100 80 60 40 20

n98

-9 7

Ja

7 l-9

O ct

r-9 7

Ju

Ap

n97

-9 6

Ja

6 l-9

O ct

r-9 6

Ju

n96

Ap

Ja

5

-9 5

l-9

O ct

Ju

r-9 5 Ap

Ja

n95

0

Figure 4.3 Real annual GKO-OFZ yields (per cent) Sources: Russian Ministry of Finance, Goskomstat, author’s calculation.

3 2.5 2 1.5 1 0.5

Ja 3 n9 Ja 4 n9 Ja 4 n9 Ja 4 n9 Ja 5 n9 Ja 5 n9 Ja 5 n9 Ja 6 n9 Ja 6 n9 Ja 6 n9 Ja 7 n9 Ja 7 n9 Ja 7 n98 Ju l-9 8

-9

-9 Ju l

Ju l

3

0

Figure 4.4 The ratio of gross debt expenditure to budget revenue Source: Russian Ministry of Finance, author’s calculation.

vulnerability of public debt, as indicated by the relation of gross domestic debt service expenses2 to the federal budget revenue. This ratio, shown in Figure 4.4 for March 1993–August 1998, reflects the burden of debt refinancing for the federal budget. As shown in Figure 4.4, the debt service expenses were consistently below the federal budget revenue until February 1996, when the ratio

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jumped to 1.21. This sudden jump was a result of the abrupt increase in the debt burden caused by the 1995 stabilization attempt and the election period. The real interest rate peaked simultaneously with the increases in state budget expenditures. The next occasion on which gross debt expenditure exceeded budget revenue was in April 1996, and the ratio was 1.76. Beginning in July 1996, that is, after the presidential election and until the debt default in August 1998, this ratio was persistently above unity (with the exceptions of December 1996 and 1997 when the budget revenue splashed because of the large receipts of money surrogates). The average ratio of gross debt expenses to revenue was 1.52 in this period, indicating the rollover risk that emerged in 1996 and was not eliminated later on. These diagrams provide a solution to the paradox of Russian domestic debt dynamics. The debt was not increasing excessively as would be the case if there was a pyramid, and it was even stabilizing by the beginning of the Asian financial crisis of 1997–98. The problem, however, was the difficulty of rolling over debt due to short maturity. This was the source of debt vulnerability.

4.2 Domination of short-term debt As we have seen, the debt problem was due primarily to the unfavourable composition of public debt, its overwhelming concentration in short-term ruble papers. A considerable part of government debt services consisted of the costs of short-term securities redemption. As our estimates show, one of the most important factors that determined the size of debt service was the average maturity of government obligations (see Appendix A4.2). It was therefore desirable to reduce the burden posed by debt redemption, by lengthening the maturity of new issues. 4.2.1 Constraints on the lengthening of the debt duration The primary difficulty encountered in attempts to lengthen maturity were the high yields on longer-term paper. This was already becoming particularly apparent in the second half of 1995. This strategy of lengthening maturity was in conflict with the task of cutting current debt servicing, because even a minor lengthening would lead to significantly higher real yields. The growth in the supply of longer-term securities, which began in the second half of 1996, was limited by an insufficient demand on the part of the public. For this reason, all attempts to lengthen the duration of domestic debt duration ended in failure.

The Risks of Domestic Debt Expansion 129

If the public had developed some confidence in the benevolence of the government, it would have been obviously much easier to lengthen the maturity of domestic debt. Unfortunately, the widespread attitude to government obligations was opposite. Beliefs in pyramid-building by the fiscal authorities persisted because they were grounded in the negative experiences of previous years. The failures of the emerging financial markets in Russia seriously aggravated the credibility problem for the government in addition to the difficult task of building an antiinflationary reputation. The lack of good credit history of the government was the main obstacle to the sale of long-term ruble papers. If it could convince the public that GKO was not a pyramid, it would be much easier to increase maturity and reduce both the cost of debt service and the rollover risk.3 In this respect Russia was no exception. Short-term public debt was a dominant factor in the economies of most emerging markets because of the considerable risks of default and inflation losses. Governments, as a rule, needed short-term debt to implement radical tax and budget reforms or to switch from an inflationary to a stable-price regime of monetary policy. But the problem was that short obligations were excessive and this had been a critical factor in the financial crises that had occurred in a number of Asian and Latin American countries. The financial boom of the 1990s around emerging markets resulted in an increase of global short-term foreign debt from $1 trillion in 1995 to $2 trillion in 1998 (Rodrik and Velasco 1999). The search by hot money flows for lucrative and risky investment opportunities was a natural outcome of financial globalization. It was more surprising that the borrowers, both official and corporate, fell systematically into the trap of short-term obligations. Short money is easy to come by, but poses severe systemic risks. It is interesting to learn why borrowers so often fail to appraise these new risks and vulnerabilities. One possible explanation of this phenomenon is that financial management is often myopic, as well as financial policy making. It is, generally, difficult for policy makers to take a long-term view. As a consequence of the lack of a properly planned strategy of government debt management, the underestimation of risks clearly manifested in the debt policy pursued by Russian fiscal authorities in 1995–97. Although the Russian Ministry of Finance was worried by the high share of shortterm debt long before the debt crisis of 1998, it failed to act to solve the problem. Another explanation is that short-term debt, as a rule, crowds out longer-term obligations at the same level of quality. One might expect

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that this would simply cause a flattening of the yield curve. But the issuing of short-term obligations on a sufficient scale creates a new risk that the government’s financial position will worsen as a result of the possible need for rescheduling. This could shift the whole yield curve upwards at all maturities. Such a situation arises if liquid government assets are insufficient to cover all short-term domestic obligations (including bank deposits in the case of bank runs). This risk is systemic in nature and similar to the risk of bank runs. The risk of attack by government debt-holders makes government finance vulnerable to external shocks and, besides that, negatively affects government solvency in longer term.4 For this reason, the yields on long-term securities are affected by a wide variety of risks, whether or not the government is indeed in a position to service the long-term debt. If the government were to issue inappropriately expensive long-term securities, this would harm the government’s solvency and, as a result, would lead to a deterioration in the level of financial stability, even in the short term. But in issuing short-term debt, the government faces a rollover problem. This trap was typical for emerging market economies in the 1990s and led to the domination of short-term obligations in the areas of state and corporate debt. To some extent this trap explains the failure of the Russian Ministry of Finance to lengthen the average duration of domestic debt. In addition, the fiscal authorities’ decisions on the debt–asset structure often ignore the impact of this policy on public expectations. The shortterm debt is normally selected by weighing the debt service costs for alternative instruments, while the effects of excessive short-term debt build-up on investors’ anticipation of state solvency are disregarded. In many cases these effects were manifested in negative shifts of attitude to government finance that per se worsened its vulnerability.5 4.2.2 Short-term debt and financial crises Economists that have studied financial crises have developed a range of opinions about the role played by short-term debt. As Rodrik and Velasco (1999) argue, the accumulation of short-term debt by a number of countries served as the main catalyst for the 1997–98 financial crises. They make reference to the examples of Korea, Indonesia and Thailand, where the increase in short-term obligations was at its most rapid in the financial sector. Russia, Brazil and Mexico (the latter in 1994–95) are also examples of excessive accumulation of short government debt obligations. Another view presented by Diamond and Rajan (2000) interprets excess issue of short-term debt primarily as a consequence of


the key problem of illiquid assets of private borrowers. In some cases it may be necessary to resort to borrowing short-term in order to delay financial collapse.6 But it may be impossible to delay the crisis, if the burden of short-term debt is so great that the threat of creditors’ runs cannot be eliminated. As we see it, governments that are forced to borrow short-term do face the similar problem. The low liquidity of stateowned assets is indicated by low currency reserves and the inability of the government to raise budget revenues within existing fiscal institutions. In such cases the domination of short-term debt can be viewed as a side effect rather than a primary cause of financial crises. To a certain extent, Russia’s example confirms this idea. The ratio of Russian ruble-denominated short-term government debt outstanding (excluding the Central Bank and Sberbank holdings of GKO-OFZ) to the official currency reserves was 0.82 at the end of 1995 (under the official exchange rate). It jumped to 2.38 by the end of 1996 because of the political uncertainty described in the previous chapter. One can suggest that the short-term debt expansion provided a solution for the problem of the insufficient liquidity of state assets. By the middle of 1997 the ratio of the short-term debt outstanding to the official reserves had decreased to 1.86, but the state financial system became more vulnerable to external risks. This ratio increased again to 2.56 by the end of 1997 as a result of the Asian crisis. For various reasons discussed in what follows at this time the Russian government had fewer opportunities to rely on short-term borrowing than had existed 18 months before. As an effective solution to the problem of the low liquidity of state assets one can suggest the issue of long-term papers of essentially higher quality. The quality of a financial instrument is defined by the cost for the government of defaulting: a loss of a reliable borrower status by the government, a fall in the sovereign ratings, restrictions on access to the world’s capital markets, and so on.7 The status of high-quality bonds protects them from the risks that are specific for lower-quality debt instruments like GKO-OFZ. It would be much easier to increase the duration of high-quality debt, since the yields did not include excess risk premium. The Russian Federation achieved access to the international market of high-quality papers by making three pilot issues of Eurobonds at the end of 1996 and the beginning of 1997, after the completion of the negotiations on the rescheduling of external debt. A timely transformation of the structure of public debt would allow the government to reduce the vulnerability of the entire domestic financial system. Russia had quite a long window of opportunity that closed only in the

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first quarter of 1998, when the government resigned and the financial collapse became inevitable (as we shall see in Chapters 5 and 6). If the Russian fiscal authorities would take full advantage of the favourable one-and-a-half-year period and considerably lengthened the duration of their market obligations, they would have been able to reduce the debt burden. Unfortunately, the Russian authorities failed to implement the strategy of radical debt quality improvement. Of course, this would lead to an increase of debt service cost in the case of the devaluation of the ruble, but such a risk should not be exaggerated. For example, the government made an attempt to achieve a GKO–Eurobond swap just before the August 1998 default.8 As it turned out, the additional cost of debt service was not so high, as our calculation in Chapter 6 demonstrates. Importantly, the scale of ruble devaluation would have been considerably smaller if this strategy had been implemented and the threat of debt crisis was reduced considerably as a result of the low-quality debt replacement. A lower risk of the ruble devaluation would, in turn, diminish the burden of increased cost of external debt service.

4.3 Opening the domestic debt market As we have seen above, interest expenditures on servicing domestic government debt more than doubled in 1996 – from 2.3 per cent of GDP in 1995 to 4.7 per cent of GDP – while the total amount of securitized domestic debt increased by 73 per cent in real terms – from 8.4 to 14.5 per cent of GDP (as follows from Tables 2.2 and 2.3). Accumulated during the period of high interest rates, the short-term debt issues required large volumes of refinancing, while there was no fall in the primary budget deficit. In addition, the external debt payments were also expected to increase since the short- and medium-term IMF credits would begin to fall due. The threat of a new debt crisis became a reality, and the Ministry of Finance had to account very seriously for the rollover risks. To avoid these risks the government had to cut non-interest expenditures, restrict new borrowing at home and increase the levels of tax collection. This first-best strategy was hardly feasible because of the permanent fiscal crisis and the political constraints. The public debt crisis was postponed because of the breakthrough in the external debt negotiations in 1996 considered in Chapter 1. Recall that the government signed the comprehensive agreement on Soviet debt rescheduling and, as a result, Russia obtained the status of a creditor nation and near ‘investment grade’ sovereign ratings (BB by Fitch


IBCA, Ba2 by Moody’s and BB by Standard & Poor’s). These results opened a range of new methods to solve the Russia debt problem, but the authorities chose the easiest way. They continued the expansion of domestic debt and allowed access of non-residents to provide liquidity inflows that reduced the cost of new borrowings. 4.3.1 Liberalization of investment inflows The opening of the domestic debt market for foreign investment occurred in three stages. First, in February 1996 non-residents were officially allowed to enter the domestic debt market. They could participate at primary GKO auctions through resident banks-dealers and repatriate foreign currency profit under the control of the CBR. Non-residents were given only a restricted time during which they could invest and were guaranteed to earn an annual return of 19 per cent in dollar terms. The second round of domestic financial market liberalization occurred in August 1996, when the secondary GKO-OFZ market was opened with the repatriation of foreign currency profits through special Central Bank accounts labelled ‘C’. Non-residents were guaranteed a ruble return covering the Russian Eurobond yield, which was around 9 per cent, plus the expected rate of nominal ruble devaluation 6–7 per cent per annum (for 1997). The complete opening of the domestic debt market occurred on 1 January 1998. The guaranteed return on foreign investment was abolished, as well as restrictions on the time period of investment. But the CBR involved top Russian banks insuring non-residents against currency risks. Banks were delegated the right to sell forward contracts to foreign investors so that they could repatriate revenue at a fixed exchange rate. The mechanism of guaranteed/insured returns was introduced by the Central Bank to stimulate inflows of liquidity and turned out very attractive for non-residents. By the beginning of 1997, roughly one-third of the GKO outstanding was held by foreign investors. Their entry reduced the cost of public debt servicing and brought a temporary halt to its growth. As we have seen from Table 2.3, domestic debt service expenditures were reduced from 4.7 per cent of GDP in 1996 to 3.6 per cent of GDP in 1997, while the volume of securitized debt increased from 14.5 per cent to 16.8 per cent of GDP. But, as was shown above, the fiscal policy stance did not change and the budget deficits were not reduced. Furthermore, the liberalization of the domestic debt market created an illusion among Russian politicians that the fiscal problems were not severe enough as to require immediate and radical reforms. As we have seen, the same effects on

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political sentiments manifested when the GKO expansion replaced the monetization of deficits in 1995 and the money surrogate instruments were used as a tool to cope with the total arrears problem in 1996–97. What this sequence suggests is that many good developments were squandered as policy makers failed to take any advantage of the temporary relaxation of financial constraints. The decision to open domestic financial markets to non-residents was put forward by the IMF. It was severely criticized following the Russian financial crisis of 1998. Some critics, such as Padma Desai, considered this measure to be the key prerequisite of financial collapse (Desai 2000, p. 49). In my view, the idea to open the access to the debt market was not bad as a general principle. The key problem, in my opinion, was that the government used the short-term relief provided by foreign capital inflow as an excuse for delaying reforms. The admission of non-residents during this period was an easy decision but it may have weakened the level of budget discipline and lessened the incentives to begin reforms at that point. Another problem was that the opening of domestic debt market reduced the cost of debt servicing and thus provided an excuse for the lack of effective debt management. The authorities proved unprepared for the massive inflow of foreign capital because they lacked a clear understanding of how public debt policy was related to financial risk management. 4.3.2 Risk mismanagement Russian domestic debt was attractive for foreign investors because they initially disregarded the risk of GKO default. The Central Bank had an option to inflate or devaluate the ruble, thus making a domestic debt default unnecessary. Traditionally, the risk of default was viewed as being more relevant for foreign currency debt instruments like Eurobonds. This assessment of risks was based on the experience of sovereign debt defaults that had occurred in Latin America and other parts of the world over the course of the previous two decades. But since the currency risk of the ruble instruments was absorbed by the Central Bank, they were considered as low-risk and high-yield papers, especially after the Russian political risks were eliminated in Summer 1996. Investment in domestic debt seemed appealing both for risk-loving and conservative foreign investors. By guaranteeing the returns on GKO-OFZ in dollar terms the Central Bank absorbed currency risks but sharply increased the vulnerability of the domestic financial system. In effect, the scheme of foreign investors’ risk absorption transformed the short-term ruble-denominated


obligations into short-term dollar-denominated ones. Foreign investors earned relatively high dollar yields – as if they had purchased dollar papers. Two factors were important in this respect: the currency corridor regime, and an implicit obligation of the CBR, as a lender of last resort, to support the largest domestic banks as contracting parties9 in the case of currency crisis. As we see it, the issue of short-term obligations with dollar-pegged returns was an extremely unsuccessful and risky strategy of public debt management. The authorities did not contribute to a lengthening of the duration of the debt, but imposed additional currency risks on the domestic financial system. The emission of long-term debt in rubles was unavailable because of severe credibility problems and financial instability (the OFZ issues that circulated in the market typically had a longer maturity than GKO issues but still were short- or mediumterm papers). But the government could try to issue indexed long-term ruble-denominated obligations with maturities of at least five years that would reduce the refinancing and devaluation risks for both investors and the government. The author’s calculations show that the optimal government debt structure under uncertainty and the lack of credibility to monetary policy should include the long-term indexed instruments (Vavilov 2003, p. 278). But making this innovation in the public debt management would have required making some changes in the legal base and also creating new facilities for domestic debt service that the government even did not try to prepare in time. On the contrary, the issue of short-term hard-currency obligations was readily available in indirect form, through the de facto elimination of currency risks for investors. But this strategy was suboptimal because of the additional currency risks imposed on the domestic financial system and the additional rollover risks for the state budget. Unfortunately, the government and the CBR selected this strategy as the basic one in seeking to make domestic debt more attractive for non-residents regardless of the underlying risks. The problem of debt structure mismanagement was aggravated by moral hazard, which to a large extent provoked the boom in speculative inflows. Hard-currency earnings guaranteed returns to non-resident investors that were considerably in excess of LIBOR rates. The policy of encouraging their entry by hedging currency risks began in 1996, a critical year for government bonds, when it was necessary to lower their yields. But afterwards the authorities committed to provide free insurance for short-term investments in GKO-OVZ. This was the main reason why these investments continued even in the first half of 1998,

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despite the beginning of the financial crisis and a considerable increase in all kinds of risks. The share of GKO-OFZ purchased already in 1998 in their total volume outstanding was around 75 per cent by August 1998. Non-residents turned out to be the main purchasers while the Russian banks reduced the share of government securities in their assets by 30 per cent between January and July 1998 (we will discuss the role of the banking system in crisis outcome in Chapter 6). As we see it, a better choice would be to remove entry–exit barriers for non-residents but to leave the hedging of currency risks to their discretion. With the first manifestations of the financial crisis at the end of 1997, the strategy of risk sharing at the government’s expense really turned the authorities’ debt policy into a pyramid game with rising rates and degrees of risk.10 The scheme of risk allocation between resident banks and nonresident investors established by the CBR in 1997 was based on the forward currency contracts. They were concluded by Russian banks that purchased currency from non-residents entering the domestic debt market.11 The exchange rate risks were thus eliminated for the latter and taken by the former. Currency risk of the Russian banking system became systemic due to the fixed ruble exchange rate, which reduced incentives of banks to hedge and diversify their risks.12 The hedging of non-residents was thus not secured by the appropriate reinsurance of forward contracts on the world markets. A systemic risk generated by this contracting was inevitable because of the lack of financial markets at home, restrictions on ruble convertibility, and limited access to overseas reinsurance markets for Russian banks. Instead, they reinsured each other using similar over-the-counter forward contracts. As a result, highly correlated risks were accumulated within the Russian banking system and did not spread to other financial institutions. When the monetary authority organized this scheme of risk management it ignored the legal aspects, implying that the creditor of last resort had to take full responsibility in the case of defaults on forward contracts. It was also ignored that the basic systemic risks had been produced in the first place by the Russian fiscal and monetary authorities who had been responsible for the unsustainable debt dynamic and the mismanagement of risk. The authorities placed too much reliance on nonresident investors and foreign banks that provided liquidity but were prepared to move out of ruble assets at a moment’s notice or to halt the refinancing of Russian banks. The basic risks were propagated through domestic banks that were intermediaries, risk bearers, and beneficiaries


of this system. External funds were transmitted by banks to the state budget through the GKO market. The Central Bank held the reins of power over the banking system, the currency exchange, and the GKO market. It was supposed to manage the reallocation of risks between the sides to minimize any negative systemic effects. But as we now know, it designed instead a notorious mechanism of risk mismanagement that aggravated overall financial vulnerability. There was an additional source of system risks induced by financial liberalization. The largest Russian banks gained access to short-term credits in hard currency that were supplied by foreign banks. This occurred simultaneously with the opening of the domestic debt market and aggravated the total risk exposure of the domestic financial system. The improvement in sovereign credit ratings allowed some banks to secure cheap foreign loans. But the new credit ratings of these banks were not based on improved balance sheets and adequate bank supervision. As is shown in Table 4.4, the share of foreign currency loans began to grow immediately after the presidential election, indicating a higher degree of foreign currency risk exposure. Since the easing of the restrictions on foreign borrowing, Russian banks increased foreign liabilities as a proportion of assets to 17 per cent in 1997, compared with just 7 per cent in 1995 (Desai 2000, p. 49). In 1997 the six largest private banks obtained syndicated credits of $1.4 billion,13 while the total volume of foreign currency liabilities of the Russian banking system increased by $6 billion.14 Short-term foreign loans granted by foreign banks were collateralized with GKO and Russian Eurobonds. Domestic banks thus bore both price-related and default risks because of the margin calls on loans that were a source of liquidity risk. The rollover risk was present implicitly, since Russian banks did not have a strong enough reputation among the international financial community and could experience rejection in refinancing at any negative signal concerning insolvency. The systemic risk was also predetermined by the cross-default requirement that conceded pre-term redemption claims by creditors in the case Table 4.4 Share of foreign currency bank credits (per cent, beginning of period) Year

Total credits

Interbank credits

1996 1997

43.0 51.4

70.4 80.3

Source: Doronin and Zaharov (1998, p. 534).

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of default by any Russian bank. Such a combination of external risks sharply increased the probability of a new banking system crisis in the event of the Russian government facing any problems with public debt refinancing. Under healthier government finances the domestic banking system’s access to cheap foreign financial funds would have played a positive role. In principle, the opportunity to obtain cheaper and longer credits in foreign currency could improve banks’ balance sheets and, in particular, could lower the duration mismatch of bank liabilities and assets. However, 80 per cent of foreign loans were still short-term, with maturities of less than one year. Not surprisingly, the funds obtained abroad were channelled to speculative operations rather than to the financing of real investment projects that, typically, could not earn more than GKO. The speculative financial assets were usually ruble-denominated, resulting in a significant currency mismatch of total banks’ assets and liabilities. By the end of 1997 this had increased to nearly 40 per cent of their foreign currency liabilities (Astapovich 2003). Because of the forward currency contracts and margin call provisions, there was no diminution in the total currency and rollover risks of the banking system, even though GKO holdings of Russian banks were reduced in 1998. Banks are, by their very nature, a relatively fragile segment in any financial system. As deposit institutions, they are vulnerable to the specific risks caused by the term structure mismatch of assets and liabilities, or the threat of bank runs. In the case of Russia they also proved to be especially weak due to the lack of competition that had dominated in previous years and the strong interrelationship of the major banks with the state’s financial system. The bankruptcy risks were present for the leading domestic banks because of their overdependence on government securities. These banks proved to be susceptible to the risk of government paper default, in addition to being unprotected against the system currency risk. It is important to note that a set of new system risks, outlined in this section, was created artificially in connection with poorly designed financial liberalization and improper risk management on the macro level. 4.3.3 The issue of capital controls In theory, the regulation of capital flows can be aimed at achieving multiple goals. Among them are: (i) maintaining the balance of payments and the exchange rate regime; (ii) the support of macroeconomic stabilization; (iii) the support of domestic fiscal policy; (iv) ensuring monetary policy independence; and (v) the protection of the national


banking system. The introduction of capital controls requires a comparison of the losses and benefits related to these objectives. In the case of Russia there was a reduction in the costs of debt servicing, and the weak fiscal policy was supported by the opening of the GKO market in 1996. But two years later it was the outflow of foreign money, among other factors, that had a very negative effect on government debt refinancing and macroeconomic stability. The outflow of this hot money provoked the collapse of the exchange rate regime, the failure of macroeconomic stabilization and the crisis in banking. The systemic risks of domestic market opening were not assessed adequately. Actually, in the case of Russia political rather than economical costs and benefits were the driving force behind the liberalization of financial markets. On the one hand, the IMF brought strong pressure on the government to completely open up the GKO-OFZ market to nonresidents. The formal reason for such a requirement was that in July 1996 Russia had signed item VIII of the IMF charter providing convertibility of the ruble for current account operations such as the repatriation of capital incomes. In fact, in the adoption of the monetary programme for 1997 the IMF was seeking to secure at least some concessions from the Russian authorities who had firmly rejected any measures in relation to fiscal tightening and the regulation of natural monopolies. The opening up of domestic financial markets was easy to implement and seemed harmless in view of the favourable attitude of global investors. On the other hand, the Russian authorities readily conceded this requirement, although, according to the IMF’s rules, they could use some restrictions to protect domestic financial markets. The main argument behind the Central Bank’s support of the GKO market liberalization was that the capital controls in operation in Russia were actually very ineffective. Non-residents were present in this market on a semilegal basis, and the monetary authorities were reluctant to impose legal restrictions because of the difficulties and costs involved in legislative procedures (Alexashenko 1999, pp. 99–100). A considerable part of foreign hot money inflow was investment by residents from the offshore zones (e.g. Cyprus) that returned capital to Russia after several years of flight. In this situation the Central Bank preferred to abolish any restrictions rather than to put in order the process of capital flows. This strategy was less costly for the monetary and fiscal authorities that intended to benefit from financial liberalization disregarding the underlying risks of short-term capital inflows. In general, the issue of the effectiveness of restrictions on capital inflows is controversial. As with the international trade barriers, there

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are two types of such restrictions: in quantities and prices. The former concern permissible quotas of fund flows, the terms and rules for the repatriation of revenues, and the latter relate to the taxation of investment or reserve requirements. The need to use both types is particularly acute in periods of global financial booms that threaten the macroeconomic stability in countries that were recipients of capital inflows. After the Asian and Russian financial crises of 1997–98 it was widely believed that the control on inflow introduced ex ante is more credible and effective than the control on outflow introduced ex post in crisis situations to prevent capital flight. But even the effectiveness of controls on inflows is very unclear, as has been demonstrated by Budenich and Lefort (1997), Cardenas and Barreras (1997), Valdes-Prieto and Soto (1996) and Magud et al. (2005). The often-mentioned Chilean system of inflow regulation was introduced in 1992.15 This case demonstrates that the state control over capital inflows can be quite strict, even though the economic policy is generally liberal. The results of the Chilean system of control are ambiguous, but demonstrate a strong positive effect on the maturity of capital flows (Magud et al. 2006, p. 21). Of course, the case of the Chilean economy is a particular one since it was secured against the financial crises of the 1990s by firm state control of public finances and a healthy banking system, as well as the imposed strict controls on capital inflows. The paradox is that protection against booming capital inflows may not really be necessary under a system of reliable and transparent financial institutions and credible government policy. But otherwise, this regulation is relevant, especially if government finance and the domestic banking system are extremely weak, as they were in Russia in the middle of the 1990s. The Russian authorities should have paid more attention to the Chilean experience of investment maturity control and should have at least attempted to alter the term composition of capital inflows. The fraction of short-term speculative money inflow would be probably less significant and the risks of abrupt outflows and domestic debt refinancing would be lower.

Appendix A4.116 To check whether or not the Russian domestic debt was indeed explosive, one can consider two alternative hypotheses about domestic debt dynamics: exponential (or explosive) versus logistic growth. To test


between these hypotheses one can consider a simple equation for real debt dynamics: bt rt bt dt ,

(A4.1)

where bt is the real debt deflated with the consumer price index, bt is the real debt increase in period t, rt is the real interest rate, dt is the primary deficit. A necessary condition for a debt pyramid is the existence of a persistent positive feedback between the debt volume and the interest rate. The debt dynamics can be defined as a pyramid if a debt increase causes the marginal cost of debt servicing to increase or, at least, not to decrease. To apply this definition in a parsimonious way, let us assume a simple functional link between debt and real interest rate: rt a1 a2 bt ,

(A4.2)

where a1, a2 are parameters implying the debt growth as bt a1bt a2 bt2 dt .

(A4.3)

Equation (A4.3) is a logistic difference equation for real debt that can be estimated empirically. Any trajectory satisfying this equation is of logistic type for negative and exponential or explosive for non-negative a2 (under permanent primary deficit and constant real interest rate the type of debt growth is exponential). The hypothesis of exponential or explosive debt growth is rejected in favour of logistic growth if a1 0, a2 0. If, on the contrary, a1 0, a2 0, then the hypothesis of logistic growth is rejected, and debt growth is exponential (for a2 0) or explosive (for a2 0). The latter two cases correspond to debt pyramid or Ponzi game by the government. Equation for debt dynamic (A4.3) can be represented as a linear regression bt a0 a1bt a2 bt2 ad dt ut .

(A4.4)

where a0 is intercept, dt is dummy related to March 1997, the date of Central Bank credits securitization (dt is 1 for that date and 0 otherwise), ad is a coefficient of the dummy, ut is a stochastic term given as moving average of i.i.d. variables ut = ␧t l␧t 1. The primary deficit, according

142 Table

The Russian Public Debt and Financial Meltdowns A4.1

Coefficient 1) GKO-OFZ t-statistics 2) GKO-OFZEurobonds t-statistics

â0

â1

â2

â␦

ˆ␭

15.29 0.57 17.46

0.10 6.35 0.10

–8.74*10 –6 –5.83 –7.65*10 –6

2072.03 31.50 2188.20

0.55 4.88 0.58

0.58

5.70

–5.07

30.32

5.19

N = 61, GKO-OFZ: R2 = 0.94, DW = 1.88; GKO-OFZ-Eurobonds: R2 = 0.93, DW = 1.95.

to (A4.4), is assumed to be a serially correlated stochastic variable equal to the sum of the intercept and the moving average term, dt a0 ut. Parameters of (A4.4) have been estimated numerically for monthly time series of Russian debt and CPI for the period March 1993–May 1998 and for each of two curves depicted in Figure 4.2 (the volume of GKO-OFZ and GKO-OFZ-Eurobonds). The estimate results are collected in Table A4.1. For both regressions the coefficient at squared debt â2 is significantly negative, and the hypothesis of exponential or explosive growth of debt is rejected in favour of the hypothesis of logistic-type growth. The value of the coefficient with dummy variable âD 2072.03 is very closely related to the volume of debt securitized in March 1997, 80 trillion rubles. Multiplying this by the rate of inflation in period March 1993–March 1997, 3,927 per cent, we obtain 81.4 trillion rubles. Thus, the hypothesis of the exponential or explosive growth of real debt is strongly rejected for the debt expansion period 1993–98. In fact, the real debt dynamic was close to a stable logistic curve meaning the tendency of stabilization, as depicted in Figure 4.2.

Appendix A4.2 We estimated the following regression for gross debt service expenses for GKO-OFZ building on monthly data for the period September 1993–July 1998: yt c0 c1xt 4 c2 zt 4 cd dt′ ut

(A4.5)

where yt is real gross debt expenditure on GKO-OFZ servicing and redemption in period t, xt Rt bt indicates the real interest payments,


Rt is average primary auction rate in period t (per cent per month), bt is real debt volume; zt bt / Dt indicates the effect of average duration of debt on current debt burden, Dt is average duration for GKO-OFZ in months; dt′ is dummy variable related to March 1997, the date of Central Bank credits securitization ( dt′ is 0 for all dates prior to March 1997 and 1 subsequently), cd is the coefficient of the dummy d, and ut is a stochastic term. All quantitative variables are deflated to May 1993. The estimated coefficients of (A4.5) are presented in the following table: Coefficient Value t-statistics

cˆ0

cˆ1

cˆ2

cˆ␦

49.96 0.99

0.44 2.05

0.48 6.04

371.89 6.17

All factors are statistically significant. The effect of average duration on gross debt service expenditures accounts for the four-month lag. It is strongly negative, while the effect of one-time duration lengthening due to debt securitization is strongly positive.

5 The Causes of the Russian Financial Crisis of 1998

Introduction The crisis experience of 1998 should be a very serious lesson for the Russian authorities. It occurred at the turning point of economic development, when the market reforms and the macroeconomic stabilization had begun to bear fruit and the Russian economy had begun to recover after six years of dramatic decline. The situation in the pre-crisis year 1997 did not demonstrate apparent threats of financial chaos and currency regime collapse. Economic decline stopped: 1997 was the firstyear since the end of the 1980s when GDP growth had been positive with an annual rate of 0.8 per cent (the authorities planned 2 per cent for the following year 1998). The rate of inflation was lowered to 11 per cent, a rate that was unbelievably low when compared with the three-digit rates that were prevalent in the first half of the 1990s. The real interest rate diminished to notably lower levels, and banks began to expand credits to the real sector. Foreign investors were quite optimistic in spite of the macroeconomic and structural problems that faced the government and the CBR. The sovereign ratings of Russia were satisfactory and it was anticipated that they could be improved still further. By the beginning of the Asian financial crisis there had been a stabilization of domestic debt. Russia successfully restructured its external debt and entered the Eurobond market. Nevertheless, in August 1998 the domestic financial system collapsed, the ruble crashed, the state defaulted on its internal debt, and the antiinflationary monetary policy was abandoned. As we have seen in the previous chapter, although there was a stabilization of the volume of government debt in real terms, rollover risks had been increasing by the 144

The Causes of the Russian Financial Crisis of 1998 145

beginning of the Asian crisis of 1997. The Russian financial meltdown was caused by a number of fundamental factors (the chronic fiscal crisis, the costs of macroeconomic stabilization, mistakes in monetary policy, political factors, etc.), but the lack of debt management by the state made the domestic financial system especially vulnerable to external shocks. We devote three chapters of the book to the Russian financial crisis of 1998. This one provides a timeline of the main events, beginning with the external shocks of Summer 1997. It focuses on the fundamental factors of the crisis and discusses the role played by monetary policy. The next two chapters deal with the debt crisis and default and also provide analysis of the recovery after the crisis. Why do we pay so much attention to the Russian financial crisis? First, it was, in a sense, an experiment that highlighted some of the specific features and fragile aspects of the Russian financial system. Second, the crisis had a crucial impact on the course of economic and political development of Russia over the past decade or so. Third, it provided an important valuable experience of policy making in emergency situations. Fourth, more than a decade later the Russian financial system is still weak and vulnerable to external risks. The scenarios presented by the new crises may be very different from that of 1998, but the mistakes of the monetary and fiscal authorities could still be very similar to those made in 1997–98. For these reasons the analysis of the crisis is still of relevance for the adoption of preventive measures and the optimal choice of anti-crisis policies in future.

5.1 A brief history of the Russian crisis This section presents the course of crisis events embracing the time period between the Summer of 1997 and Autumn 1998. Figure 5.1 shows a diagram of the key events, beginning with the Russian stock market crash in October 1997 and followed hereafter by a more detailed historical review. July–October 1997. The first signs of the Asian crisis appeared as speculative attacks against the currency of Thailand. Stabilization prorammes and defensive measures such as currency controls were adopted in this country. The crisis intensified as it spread first to other Asian countries – resulting in a series of stock market crashes – and then came to Russia. On 28 October the Russian stock market dropped by 20 per cent. Foreign investors became anxious and began to dispose of ruble assets. The Central Bank purchased large volumes of GKO (1.2 trillion rubles – the

146


1997 October

The stock market fell by 20%; Capital outflow began.

1998 March–April

Chernomyrdin government resignation; Appointment of Kiriyenko

November

The first attack against the ruble; The refinance rate increased from 21% to 29%; CBR purchased GKO and lost $ 6 billion of reserves.

December

Oil price dropped from $19 to $13 per bar; Negotiations with IMF failed.

May

June–July

The third attack against the ruble; The refinance rate increased to150%.

The Ministry of Finance abolished GKO auction; Monetization of budget deficit; The IMF aid; The GKOEurobonds swap.

1998 January–February

The second attack against the ruble; Stock market fell by 30%; The ruble denomination and the wide band

August–September

Announcement of GKO default and 90-day moratorium on foreign payments by banks; Resignation of Kiriyenko cabinet; Failure of Chernomyrdin to reelect; Ruble devaluation by 225%

Figure 5.1 The timeline of main crisis events

equivalent of $2 billion) to support the domestic debt market. Nevertheless, the monetary authorities were not ready to make a radical policy shift in order to adopt the standard anti-crisis measures. Instead, the CBR tried to compromise between defending the exchange rate regime and preventing hikes in interest rates. The opportunities of early defensive measures were lost, merely, for political reasons and because of the fear that clear-cut actions could amplify panic moods among foreign investors. The Central Bank tried to keep seriousness of the problem secret for as long as possible (Yasin 2002, p. 394).


November 1997. The massive speculative attack against the ruble on 11 November triggered by the Asian crisis forced the Central Bank to increase the refinancing rate from 21 to 28 per cent. The serious threat to financial stability was thereby made public. To defend the ruble, the CBR sold $6 billion – 33 per cent of its official foreign currency reserves. In November the purchases of GKO by the CBR nearly doubled, amounting to 31 trillion rubles (Alexashenko 1999, p. 126), the equivalent of $5 billion. These operations were aimed to meet the demand of investors that preferred to hold foreign currency. A decision to make the defence of the exchange rate regime a higher priority was confirmed ultimately by the Central Bank (under strong pressure from the IMF). In spite of this policy announcement, official GKO purchases continued, albeit at a lower level. The reshuffling of the cabinet that occurred in November (Batkibekov et al. 2003, p. 59) clearly signalled the unwillingness of the authorities to cope with structural reforms under the threat of financial meltdown. December 1997. World oil, gas and metal prices dropped dramatically (the oil price fell to US$13 per barrel, as compared to US$19 per barrel at the beginning of 1997). Foreign investors began to reappraise the situation, and there was an intensification of the flight to quality. The average GKO yield increased from 18 per cent in October to 38 per cent, in spite of the massive purchases of the GKO by the CBR. The IMF approved about the granting of $57 billion of financial aid to South Korea. Negotiations between the Russian government and the IMF about additional loans to support financial stability failed because the Russian government rejected the recommended package of drastic fiscal measures. January–February 1998. Financial crises occurred in Hong Kong, Indonesia, and Malaysia, and this induced a second speculative attack against the ruble. These events coincided with the dramatic shift of financial investors’ attitude to Russia and resulted in a sharp fall on the Russian stock market, which fell by 30 per cent. At the same time, the Central Bank of Russia removed three zeroes from the currency. This policy action was designed to demonstrate the triumph of the monetary stabilization of 1995–96 and the sustainability of the Central Bank’s currency policy (the decision to re-denominate the ruble was adopted in July 1997, at the very beginning of the Asian crisis).1 At the same time, the currency band was widened significantly and set at 6.1 rubles/ $±15 per cent to permit sufficient flexibility in the management of exchange rates. The new regime signalled the potential readiness of the CBR to allow for a greater flexibility of the exchange rate. Domestic financial markets were completely liberalized, thereby opening the economy to

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portfolio investment and speculative hot money. Negotiations with the IMF recommenced in February and at this time emerging funds were officially requested by the Russian authorities. As a positive step of the government, a new tax code was prepared and submitted to the Parliament. March–April 1998. Viktor Chernomyrdin’s cabinet resigned unexpectedly, and the new prime minister was the relatively unknown Sergei Kiriyenko, appointed on 23 March. The resulting political uncertainty had a very negative impact on subsequent events. One immediate consequence was that there was an intensification of attacks against the ruble, and the Central Bank continued to defend the currency. The Parliament confirmed Kiriyenko’s appointment on 24 April, after much confrontation and political bargaining. The new cabinet began to formulate its own policies and became familiarize with the macroeconomic situation. That required another couple of months. Surprisingly, the Russian financial markets settled down. In the first four months of 1998 the GKO annual rate stabilized below 30 per cent. This appeared relatively attractive for profit-seeking nonresident investors. The share of non-resident holdings in domestic debt outstanding grew again – to 28 per cent – by the end of April. The stimulus for this inflow from non-residents was created by the actions of the Russian authorities. These included the weakening of capital controls, the firm adherence of the Central Bank to support the exchange rate, the high rate of return on GKO, and new hopes around negotiations with the IMF. May 1998. By the beginning of May information about the balance of payments of Russia in the first quarter of 1998 had become publicly available. The results turned out to be very disappointing and revealed fundamental flaws in the macroeconomic situation. A third large speculative attack on the ruble occurred on 14 May and this had a very strong destabilizing effect. On 15 May the Russian stock and debt markets fell dramatically, and the GKO yield began to rise, from 25–30 per cent at the end of April to 45 per cent. To protect the exchange rate regime, the CBR increased the refinancing rate from 30 to 50 per cent on 19 May on this single day it spent more than $1 billion of official reserves. These currency interventions turned out to be ineffective, and the refinancing rate was raised to the prohibitive level of 150 per cent on 27 May. This was the final attempt of the Central Bank to prevent the crisis through standard monetary instruments. The speculative attack was again beaten back for a while, but at the cost of a dramatic increase in interest rates.


June 1998. The Ministry of Finance failed to refinance its short-term debt because of the extremely high interest rate bids, which exceeded 50 per cent per annum. This implied an unsustainably large cost of debt servicing in subsequent months. Under such circumstances the Ministry of Finance rejected conducting the primary GKO auctions on 17 June. Instead, with no additional regular sources of budget incomes for the redemption of short-term debt, the Ministry of Finance began to borrow money from the Central Bank account. The CBR was the agent of the Ministry at the GKO auctions. The Ministry withdrew funds from the GKO account while the Central Bank had to replenish since no auction had taken place (Alexashenko 1999, p. 170). This ‘innovation’ meant a return to the direct crediting of the government by the Central Bank expressly forbidden by the law adopted in 1995. Excess ruble liquidity was immediately used by GKO investors for currency purchases that drained the official foreign reserves. The Central Bank tried to resist the actions of Minfin, but could not provide an effective solution to the problem of debt rollover. The CBR thus had no choice but to return to the monetization of the budget deficit, thus implying the failure of macroeconomic stabilization of the previous three years. July 1998. The public mood concerning the macroeconomic situation improved temporarily as a result of the success of negotiations with the IMF on financial aid to Russia.2 On 13 July an assistance package totalling some $22.6 billion was announced by the IMF, the Bank of Japan and the World Bank. The announcement of this credit line gave rise to overoptimistic expectations that the Russian government could prevent the default on its debt and resulted in a temporary reduction of GKO yields. But the stabilizing effect on expectations was very soon eliminated by new information on fiscal policy failures. Preliminary data on the macroeconomic performance in the first half of 1998 showed a reduction of budget revenue of roughly 0.5 per cent of GDP. A further piece of bad news was that the financial package was granted to Russia in tranches that were conditional on the budget performance rather than the full amount that would have given the Russian authorities a good chance to defeat speculative attacks. The IMF adopted a compromise solution which sharply worsened the mood of the markets. Prime minister Kiriyenko focused on the preparation of a comprehensive stabilization programme and its presentation to the State Duma, as required by the IMF conditionality. Financial markets meanwhile recognized that the true state of affairs had worsened substantially, and non-residents renewed the flight from the government papers. The first tranche of the assistance credit, some $4.8 billion, was used to defend

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the currency regime and disappeared in two weeks. The Ministry of Finance cancelled again the primary GKO auctions on 22 July because the interest rate bids were too high, and the government clearly could not service the new issues. The rejection by the government to sell GKO was anticipated as the beginning of systematic money emission for debt refinancing. Negotiations with the IMF about radical fiscal reform were close to deadlock. August 1998. Major Russian banks began to face severe problems with refinancing foreign loans collateralized with government debt. The banks also had to fulfill repurchase agreements with foreign banks, and this prompted them to sell large volumes of GKO-OFZ. This, in turn, caused a downward spiral on the government debt markets, both domestic and external. As a result, the currency crisis turned into the final and most dangerous stage, when domestic depositors began to panic and convert ruble assets into the foreign currency cash. President Boris Yeltsin publicly promised on 12 August that the ruble devaluation would not occur, but this did not help.3 The crisis outcome was triggered by a provocative article written by the international investor George Soros published in the Financial Times on 13 August.4 The new attack on the ruble left the Russian monetary authorities no time for thorough thinking about emergency measures. The stock market crashed, the currency market collapsed and the annual GKO yields exceeded 200 per cent. On Sunday 15 August, the top officials from the Central Bank and the Ministry of Finance (Sergey Dubinin, Sergey Alexashenko, Alexander Potemkin, Mikhail Zadornov, and Oleg Vyugin) held urgent meetings with the leading economic reformers Yegor Gaidar and Anatoly Chubais at Sergey Kiriyenko’s dacha. As a result, they adopted an unexpectedly radical measure: simultaneous GKO default, the devaluation of the ruble and a 90-day moratorium on bank payments to foreign creditors. This decision was announced on 17 August, the day that went down in history as the date of the Russian financial crisis. The motivation for such drastic actions was the government’s inability to redeem its shortterm debt and refusals by major Russian banks to fulfill their payments to foreign creditors. The Kiriyenko cabinet resigned on 23 August, and the GKO restructuring scheme was adopted by the new cabinet. September–October 1998. By the beginning of September the dollar exchange rate had exceeded the upper boundary of the initially announced band of 6–9.5 rubles/$. Foreign currency market failures and shortages manifested in liquidity constraints, long lines at retail currency exchanges, and even shadow currency trade. The foreign currency regime collapsed and the ruble was allowed to float on 2 September. In


one week the ruble exchange rate fell from 10 rubles/$ to 21 rubles/$. The two largest private banks – SBS Agro and Inkombank – were placed by the CBR under temporary administration, indicating a severe banking crisis. Inflation began to spiral out of control: in September the CPI increased by 36 per cent. An abrupt reduction in the level of imports created shortages of goods in the shops. The economic situation was close to the disorganization and chaos that had characterized the beginning of the 1990s. Inflation induced by the ruble devaluation was intensified by the banking crisis which entailed a massive extension of liquidity to offset the liquidation of bank assets and the squeezing of real money. There was also a worsening of the political situation: Yeltsin nominated Chernomyrdin as the prime minister, but his candidate was not appointed by the State Duma. A liberal anti-crisis programme that included the introduction of a currency board and drastic fiscal measures failed to gain political support. The new pro-communist government, headed by Yevgeniy Primakov, did not have any distinct plans to cope with the crisis. Fortunately, this cabinet was careful enough to reject adopting the populist anti-market measures that relied on command controls.

5.2 The fundamental factors of the crisis Although the Russian crisis occurred in the wake of the Asian crisis, it was ultimately triggered by a number of domestic factors. Traditionally, the macroeconomic policy mistakes made during the three years preceding the crisis (1995–97) have been cast as the scapegoat. The fundamental causes of the crisis can be to some extent attributed to the policy that turned out to be unsustainable under external shocks: ‘For all the talk of commodity prices and Asian contagion, the ruble crisis was the most part made in Russia’ (Ickes 2007, p. 1). Nevertheless, in 1997 the macroeconomic situation was quite uncertain and the crisis was not predetermined. Leaving aside the policy mistakes, the crisis resulted from a coincidence of various economic and political factors discussed in the previous chapters and summarized in this section. 5.2.1 The macroeconomic stabilization As has been shown in Chapter 2, the main aim of macroeconomic stabilization was to bring about a drastic reduction of inflation from the three-digit annual levels that had persisted in the period 1992–95. The anti-inflationary policy was the inevitable medicine for the monetary

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expansion of the first years of market reforms and, in any case, had to involve considerable macroeconomic and social costs. Inflationary expectations began to stabilize by the end of 1995 as the result of a tightening of monetary policy, the end of budget deficit monetization, and the currency corridor. The real interest rate increased sharply as a result of monetary policy tightening, while the stabilizing effect was accommodated by the government securities yields with some time lag. Figure 5.2 demonstrates dynamics of the real GKO rate in 1995–98. High peaks in 1995 relate to the period of macroeconomic stabilization that caused expansion of the domestic debt, the restriction of liquidity supply and unfolding of the first banking crisis in the Summer of 1995. Another adverse result of the tightening of monetary policy was the 79 per cent increase in the real ruble-to-dollar exchange rate in 1995. This is depicted in Figure 5.2 which shows the dynamic of the real effective exchange rate of the ruble in 1995–98. The ruble was overvalued by the beginning of crisis relative to the earlier trend. This was an inevitable cost of suppressing high inflation through the use of the standard tools of orthodox stabilization. The real exchange rate appreciation was irreversible, since the monetary authorities could not devalue the ruble without restoring inflationary processes. Admittedly, the Russian crisis of 1998 was, to a certain extent, a consequence of a macroeconomic stabilization that suppressed inflation,

Ju 5 l-9 5 O ct -9 Ja 5 n9 Ap 6 r-9 6 Ju l-9 O 6 ct -9 6 Ja n9 Ap 7 r-9 Ju 7 l-9 O 7 ct -9 Ja 7 n98 Ap r-9 8 Ju l-9 8 O ct -9 8

r-9 Ap

Ja n

-9

5

180 160 140 120 100 80 60 40 20 0

Real interest rate, annual percent Real ruble exchange rate, index 1995 = 100 Figure 5.2 Real GKO yields and real ruble effective exchange rate in 1995–98 Sources: IMF, the Ministry of Finance, Goskomstat.


but boosted the real ruble interest and exchange rates prompting excessive imports and inflows of short-term capital. 5.2.2 The fiscal crisis Many liberal economists abroad and in Russia, for example, Stanley Fischer (2000), Lawrence Summers (2000), Sergei Alexashenko (1999) and Evgeniy Yasin (2002), share the opinion that the Russian crisis occurred as a result of the disparity between the tough exchange rate and monetary policy and the weak fiscal policy. The monetary policy was not backed by fundamental fiscal reforms and yielded a short-term stabilizing effect, but its longer-term effectiveness was seriously in doubt. Stringent monetary policy did not correspond to the real state of the federal budget and, in particular, to the effective level of tax collection. Ideally, the implementation of tough anti-inflationary measures should have started simultaneously with radical tax reforms. The latter required, first of all, the elimination of tax arrears and the improvement of tax administration. Without these systemic measures requiring firm rejection of state support to the virtual economy, the public deficit remained permanently high. For several reasons, principally political constraints, tax reform had been postponed. The State Duma was opposed to the reform government and did not support radical fiscal laws. Of course, there was a certain risk that the attempts to overcome the chronic fiscal crisis would fail and cause a degree of destabilization. Moreover, the fiscal crisis strengthened as a result of the monetary tightening of 1995, since the government voluntarily relinquished the inflation tax revenue. 5.2.3 Policy cycle The issue of government debt allowed the financing of additional social expenditures and helped Boris Yeltsin to win the presidential election in 1996. In hindsight, the expansion of debt can be judged differently, but it provided an opportunity to fulfill some of the state’s social obligations and prevented the communists’ victory. From early 1996, as we have seen in Chapter 4, the real GKO yields were soaring as the result of political uncertainty and a very high risk premium (see Figure 5.2). This uncertainty lasted for around a year and a half because of the election and Yeltsin’s subsequent serious illness. The government made some attempts to reorganize the country’s public finances. But the political resistance to reforms was too strong, because of the weakness of Boris Yeltsin and the triumph of oligarchic groups. As it turned out,

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the government had very little time. When the first blows of the crisis began in Autumn 1997, strategic tasks became of minor importance because of financial pressures and the political confusion. 5.2.4 Public debt accumulation A gap emerged between the anti-inflationary monetary policy, on the one hand, and weak fiscal policy and ineffective public debt management, on the other hand. This gap was closed by the issuing domestic debt, implying that the pressure of delayed inflation was increasing due to the snowballing of debt service expenditures. The authorities sought avoiding inflationary risks, but came under the threat of debt crisis and restoration of the inflationary regime. As a result, monetary expansion was replaced by the short-term expansion of domestic debt. It was a risky game but still preferable to the inflationary policy which left no hope for investment growth in the real sector of the economy. The development of the public debt market in Russia was thus both a precondition and a consequence of macroeconomic stabilization. The role of ‘money vacuum cleaner’ attributed to GKO had been played in an earlier period by the foreign currency market. Although the domestic debt dynamic had been stabilizing before the crisis, the government could not eliminate the severe refinancing risks caused by short maturity of debt. On the one hand, the real ruble appreciation masked the expected burden of rescheduled external debt payments (which had to increase significantly after 1998) and thus weakened the incentives of fiscal authorities to pursue debt management. On the other hand, the high yields of ruble instruments under the fixed exchange rate stimulated foreign capital inflow into the GKO market. The opening of the domestic debt market in 1996 meant that public finance was exposed to the additional external risks. 5.2.5 Financial fragility A banking system relying on public debt and vice versa was one of the main factors behind Russia’s financial fragility at this time. During the first years of market reforms inflation, foreign currency speculation and the servicing of budget payments were the main guaranteed sources of incomes for banks. After the macroeconomic stabilization of 1995 banking profits were earned principally through the trading and holding of government debt. The oligarchic banks also gained a lot from the loans-for-shares privatization (discussed in Chapter 3). By the beginning


of the crisis the banking system was still in a privileged position and ignored many risks typical for proper banking. Following the first banking crisis in 1995 the Bank of Russia was trying to combine monetary control with the supervision and regulation of the banking system. The stability of the exchange rate was viewed as necessary to prevent a new banking crisis. An increase in the value of foreign currency liabilities under a quasi-fixed exchange rate regime made the balance sheets of many large banks vulnerable to even moderate ruble devaluation. Concern about the asset–liability mismatch prevented effective anti-crisis actions that the CBR could undertake, including a timely devaluation of the ruble. This conflict of objectives essentially constrained the policy options for the monetary authorities. This problem was aggravated because of the variety of exposures to new risks in connection with financial liberalization and induced shortterm capital inflows. After the Russian government received sovereign ratings at the end of 1996, the major Russian banks secured access to the international credit markets. The possibility of acquiring cheap money from abroad was secured through the adoption of the tight conditions of international banking and finance that differed radically from the hothouse financial environment at home. 5.2.6 The external shocks One external factor that contributed to the financial meltdown in Russia was the Asian crisis that began in Summer 1997. This also affected the emerging markets of Latin America and Eastern Europe and contributed to the fall in commodity prices in the second half of 1997. As a result, there was a deterioration in the Russian balance of payments: the trade balance fell from 5.2 per cent of GDP in 1996 to 3.5 per cent of GDP in 1997, and the current account reduced from 2.6 per cent of GDP to roughly 0 per cent. This had negative effects on the volume of official reserves and monetary stability, and, most importantly, on budget revenue which relied to a very large extent on revenues of commodity-exporting sectors. These shocks hit the economy strongly in Spring 1998, when disappointing data on the balance of payments in second half of 1997 also became available to the wider public. Dynamics of the oil price and the Russian stock market index RTS (Russian Trading System) indicating the exogenous adverse effects are depicted in Figure 5.2. Another way in which the Asian crisis affected Russia was the dramatic change in the attitude of portfolio investors to Russian financial

156

The Russian Public Debt and Financial Meltdowns 600

25

500

20

400 15 300 10 200 5

100

Oil price, $/barrel

Jul-98

Aug-98

Jun-98

Apr-98

May-98

Mar-98

Jan-98

Feb-98

Nov-97

Dec-97

Oct-97

Sep-97

Jul-97

Aug-97

Jun-97

Apr-97

May-97

Feb-97

Mar-97

0 Jan-97

0

RTS index

Figure 5.3 Oil price and RTS index Source: Energy Information Administration, USA; RTS.

markets. Conservative investors quit Russia at the very height of the Asian crisis in October–November 1997. They presumably understood a general reassessment of emerging markets and preferred to follow a more risk-averse approach to global portfolio management. Many of the problems of the Russian economy should have been evident when the domestic markets were opened in 1996. But the ruble exchange rate regime eliminated devaluation risks for non-residents and, as mentioned above, masked the true extent of the economy’s debt burden. At the beginning of 1998 speculators (some with higher risk appetites) returned to Russia led by expectations of very high short-term profits, but many of them panicked again in May of that year. The swings of investor moods with respect to Russian markets were, to a certain degree, psychological in nature. As Barry Ickes (2007, p. 1) pointed out, ‘The panic was arguably as irrational as the euphoria of the previous year: investor sentiment lurched from one extreme to the other, with little regard to the underlying fundamentals.’ The behaviour of foreign investors sometimes becomes very unstable, causing substantial difficulties for the domestic finance. Figure 5.4 offers a schematical representation of the causal links of the fundamental factors of the crisis. The endogenous factors related to macroeconomic policy are drawn with rectangles, while those of microeconomic and structural nature are drawn with ovals. The exogenous factors of domestic policy cycle and external shocks are drawn with circles.


The election campaigns 1995–96

Asian crisis and oil price drop 1997

Foreign currency regime 1995–96

Macroeconomic stabilization 1995

Russian crisis 1998 Domestic debt expansion 1996–97

Chronic fiscal and non-payment crises

Financial fragility

Figure 5.4 Fundamental causes of the Russian crisis

5.3 The Central Bank policy The role played by monetary policy in Russia’s crisis was particularly important but is also hard to pin down. The Central Bank could have prevented the crisis, and tried to tighten the policy to defend the ruble from speculative attacks, but ultimately it contributed to an aggravation of the crisis. The monetary authorities faced uneasy choices at the beginning of events that triggered the crisis, and, in fact, had little room to make good decisions when the situation became irreversible in Spring 1998. We have explained how the fundamental factors contributed to the Russian financial system’s vulnerability to external shocks. In the rest of this chapter we consider the impact of monetary policy, which, in our view, played the central rule in shaping the crisis scenario. My argument is that crucial mistakes in monetary policy had been made before the beginning of the crisis, and thus the Central Bank lost opportunities to diminish the vulnerability of the financial system to external shocks. It became exposed to various risks because of the insufficient accumulation of external reserves after the opening of domestic financial markets, and also by absorbing too many of the risks of the

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foreign currency regime. The tough anti-crisis policy adopted by the CBR affected both domestic banks and government finance. However, the adopted strategy of defending the ruble at any cost failed: devaluation was postponed as long as possible, but finally occurred with dramatic consequences for the financial system. 5.3.1 The trap of debt-based reserves The roots of the financial system’s weakness lay in its overexposure to the external risks of portfolio reversals. The inflow of short-term portfolio capital was the main source for official reserves accumulation in the period 1995–97. Building up debt-based reserves in emerging market economies is per se a source of liquidity. But it also creates rollover risks associated with foreign capital reversals. In the case of Russia these risks were aggravated because the external reserves were in fact underaccumulated relative to the volume of capital inflows. The amount of official reserves proved to be insufficient to protect the domestic financial system against abrupt capital reversals. This is a crucial point, so it is worth further explanation. The estimated amount of the portfolio inflow in 1996–98 was roughly $30 billion (see, for example, Yasin 2002, p. 405). According to the balance of payment data, the portfolio inflow after the presidential election was $1.7 billion in the second half of 1996, $18.4 billion in 1997, and $8.6 billion in the first half of 1998. The total volume of portfolio capital inflow in the period 1 July 1996 to 1 July 1998 was $28.7 billion. The Bank of Russia did not use these capital inflows to make adequate increases to the volume of official foreign currency reserves. Their total increase during the period under consideration was $2.3 billion (Table 5.1), demonstrating the dynamics of monetary policy indicators between the second presidential election in July 1996 and until the onset of the crisis in July–August 1998. By October 1997 the official reserves had grown by only $9.2 billion (from $13.9 billion in July 1996 to $23.1 billion in October 1997). The remainder of the portfolio’s capital inflow, roughly $9 billion, was channelled to finance the increase in the holding of government securities by the CBR. As can be seen from Table 5.1, the volume of claims to the Ministry of Finance held by the CBR increased in this period by 62.8 billion rubles, from 163.9 to 226.7 billion rubles or by $11 billion at the prevailing ruble-to-dollar exchange rates. As a result, the external reserves were insufficient, even though it was possible for the CBR to increase reserves to $32 billion by October 1997. Why was this opportunity to make the ruble less susceptible to capital reversals not utilized? It was principally because the priorities

The Causes of the Russian Financial Crisis of 1998 159 Table 5.1 Indicators of monetary policy in 1996–1998 (end of period) Date Official foreign reserves (billion dollars) Official foreign reserves (billion rubles*) Claims to the Ministry of Finance (billion rubles) Monetary base (billion rubles) Foreign reserves adequacy (%**)

June 1996 Dec. 1996 Sept. 1997 June 1998 13.9

15.3

23.1

16.2

70.9

85.1

135.4

100.4

163.9

187.4

201.2

226.7

146.3 48.4

152.2 55.9

196.1 69.0

190.1 52.8

Source: Central Bank of Russia and the author’s calculations. * evaluated with current exchange rate; ** The ratio of official currency reserves in rubles to monetary base.

of monetary policy changed following the presidential election of 1996. Inflation had been stabilized, and the Central Bank began to pay increased attention to the reduction of real interest rates in order to stimulate production, investment, and economic growth. The authorities were convinced that some weakening of monetary policy regime under the nominal anchor and increased inflow of foreign investment would not pose a significant threat to macroeconomic stability. In practice, such a shift of policy stance was too risky. The accumulation of sufficient foreign reserves could have completely backed the monetary base, as compared to only 69 per cent backing at the beginning of 1998 (Table 5.1). The increase in the second half of 1997 of GKO-OFZ holdings by the Bank of Russia’s assets meant that the government’s obligations were partially protected by the CBR holdings.5 At the same time the official reserves were largely debt-based and insufficient to prevent speculative attacks on the ruble. Another option for the CBR was to allow the exchange rate to float as early as the end of 1996 and to accumulate more reserves through a gradual devaluation of the ruble. A more flexible currency regime would make the domestic financial market less attractive for portfolio inflows. Moreover, a gradual devaluation of the ruble could stimulate domestic production and compensate for higher interest rates conditioned by a tighter money policy. Neither of these opportunities to reduce macroeconomic risks was utilized by the Central Bank. As a result, the volume of its external reserves was too small by the beginning of the crisis, as compared to the total volume of foreign capital inflows into Russia. The domestic financial system turned out to be weakly defended by reserves and vulnerable

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to external shocks. A year and a half before the crisis the monetary authorities adopted too risky a strategy of financial liberalization and bear responsibility for its failure. 5.3.2

A policy choice

As has been mentioned earlier, the Central Bank faced a conflict of objectives in respect of the maintenance of the exchange value of the ruble, the support of government finance, and the bailing out of the domestic banking system in the case of crisis. These tasks were obviously interlinked because a severe financial and currency crisis would have triggered inflation and destroyed both government finance and the banking system. These last two were both exposed, albeit to different extents, to the risks of abrupt changes in the ruble exchange rate and interest rates. The state budget would suffer more from the interest rate hikes jeopardizing domestic debt servicing. It could sustain a moderate devaluation of the ruble since the external debt burden had been postponed to the second half of 1999. But the banking system was strongly susceptible to both types of risks. Whether the currency or the GKO market was selected as a prior objective of support by the CBR, tangible losses would be incurred by the fragile banking sector. From the beginning of the crisis the Central Bank tried to achieve both goals, but it lost $6 billion of foreign reserves because of the GKO purchases. In November 1997, after some debates, the policy of defending the exchange rate was chosen. The CBR increased the refinancing interest rate from 21 to 28 per cent and temporarily ended the largescale support of the GKO market.6 The IMF approved the tightening of monetary policy, as the standard way to refute speculative attacks. This strategy was effective at the very beginning of the Russian crisis when the true state of fundamentals was unknown, but ultimately it failed. Figures 5.5 and 5.6 illustrate the pattern of monetary policy making during the crisis period. Figure 5.5 demonstrates policy swings, as indicated by changes to the refinancing rate. The waves of speculative attacks caused spikes in GKO yields in November 1997 and January 1998, leading the Central Bank to increase the refinancing rate to 42 per cent at the beginning of February. The situation stabilized for a while, and the refinancing rate was reduced to 30 per cent by the middle of March 1998. However, in May speculators resumed their attacks fuelled by panic moods, and on this occasion the refinancing rate was raised to 150 per cent. Such a tough measure was supposed to reveal the firm intention of the CBR to ‘fight for the ruble’ at any cost. The final rounds of this struggle took place in July, when the GKO yields soared to more

The Causes of the Russian Financial Crisis of 1998 161 160 GKO-OFZ yields

140

Refinancing rate

120 100 80 60 40 20

8 r-9 8 M ay -9 8 M ay -9 8 Ju n98 Ju l-9 8 Ju l-9 8 Ap

-9 M

ar

-9

8

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ar M

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-9

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ov -

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7

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Figure 5.5 The refinancing rate and the average GKO-OFZ yield in 1997–98 (per cent per year) Sources: The Central Bank of Russia, the Russian Ministry of Finance.

than 100 per cent and when the crisis outcome made it pointless to engage in any further manipulations of the refinancing rate.7 In addition to raising the ruble interest rates under direct and indirect control, the monetary authority substantially strengthened the mandatory reserve requirements. In the case of hard-currency deposits it rose from 6 per cent to 9 per cent in November 1997 and to 11 per cent in February 1998. These measures were aimed at increasing the demand for rubles but had a very painful impact on the whole banking system and, alongside other factors, contributed to severe liquidity problems in the interbank market in August 1998. The hard-nosed defence of the ruble led to significant shifts in the structure of CBR assets. Figure 5.6 demonstrates the dynamics of international reserves (including gold) and net domestic assets in dollar value. Net domestic assets increased in November 1997, as the CBR made efforts to support the domestic debt market. These assets then remained more or less stable, demonstrating the CBR’s adherence to the policy of protecting the ruble. However, shortly before the outcome of the crisis in August 1998, direct crediting of the government became regular, because of the failures of primary GKO auctions. As a result, the external reserves were partially substituted for the Ministry of Finance obligations, as seen in Figure 5.6. For the banking system the consequences of the ruble exchange rate defence were ambiguous. The devaluation of the ruble would have further increased the ruble value of currency liabilities of banks and

162


widened the mismatch between assets and liabilities, while the rise in interest rates would have devalued their ruble assets and brought about the systemic risks related to the value of collateral. By the beginning of the Russian financial crisis banks had considerable fractions of both foreign currency liabilities in total liabilities (near 20 per cent) and Russian government securities in total assets (23 per cent). By 1 January 1998, the gap between banks’ foreign liabilities and assets was $7.2 billion, and by 1 July 1998 this figure had reached $8.1 billion, nearly one-third of the sector’s total capital of $25.3 billion (Tompson 1999, p. 6). The ultimate choice of strategy to protect the banking sector depended on the personal incentives of the CBR heads. As it turned out, they were reluctant to allow even moderate ruble devaluation even when the balance of payments deterioration became evident. The stability of the exchange rate was a prior political task, and the ruble devaluation could probably lead to the removal of the Central Bank heads. Exchange rate control was traditionally the main target of the Russian monetary policy makers. On top of that, the Central Bank heads, Sergey Dubinin first of all, remembered quite well about the personal responsibility for the ruble devaluation after the ‘Black Tuesday’ of 11 October 1994 and tried to avoid the similar outcome as long as possible.8 The incentive constraints of devaluation became especially binding after the practically useless decision to remove three zeroes adopted in Summer 1997 and implemented at the beginning of 1998. As was mentioned, it was intended to demonstrate the success of macroeconomic 40 Net domestic assets

Foreign reserves

35 30 25 20 15 10 5

Ja nFe 97 bM 97 ar Ap 97 r-9 M 7 ay Ju 97 nJu 97 lAu 97 gSe 97 pO 97 ct N 97 ov D 97 ec Ja 97 nFe 98 bM 98 ar Ap 98 r-9 M 8 ay Ju 98 nJu 98 lAu 98 g98

0

Figure 5.6 Official foreign currency reserves and net domestic assets ($ billion) Source: Central Bank of Russia.


stabilization and the credibility of the exchange rate regime. After a pompous mass media campaign conducted in support of the new ruble during the second half of 1997, the Central Bank heads would look a little bit stupid if they recognized publicly the need of the new ruble devaluation. Leaving aside the incentive considerations, the best choice for the CBR was to devalue at the end of 1997, in advance of new waves of speculative attacks. By rejecting such an option, the Bank of Russia lost an opportunity to switch to a more flexible exchange rate regime in a timely fashion, without experiencing devastating effects on the domestic financial system. And even after the adoption of a formally more flexible regime in the first half of 1998 this policy was still not implemented. Devaluation costs were high during this period, but time was working against the ruble and these costs increased dramatically in Spring–Summer 1998. As William Tompson (1999, pp. 11–12) remarks, In hindsight, one of the major ironies of the situation is that the CBR’s success in defending the ruble for more than half a year prior to devaluation arguably made the crisis even costlier than it might have been. … If devaluation could not be avoided, it would have been better devalue sooner rather than later. A lengthy, expensive but ultimately unsuccessful defense of the currency represented the worst possible option. Ultimately, the CBR was forced to devalue the ruble when the situation became absolutely desperate and the devaluation costs were extremely high.

6 The Debt Crisis and Default

Introduction A temporary decline in political risks after the presidential election, the liberalization of the domestic financial market in 1996–97, and the stabilization of debt dynamics did not change the tendency for the budget’s debt expenditures to increase. Fiscal measures that may have averted the debt default were not implemented. The main reason was the weakness of executive power and the populism that dominated the State Duma. In addition to the permanent political struggle between oligarchic groups, political parties, vested interests and regional lobbies contributed to these difficulties. The government was weak, in particular, because it was strongly attached to domestic debt financing which was to a large extent managed by the oligarchic banks. It was also hardly possible to implement radical expenditure cuts while the government was already indebted to budget organizations that in turn generated wage arrears. The fundamental problem was that tightening fiscal policy during a chronic tax crisis would have a negative impact both on taxpayers and the least socially protected recipients of budget funds.

6.1 Failure to normalize the state budget To improve tax collection the government tried to focus on extraordinary and penalizing fiscal measures. Administrative methods were imposed to collect and reschedule tax arrears from the largest enterprises like the natural monopolies and the biggest oil companies. The latter were threatened with a loss of access to oil export pipelines controlled by the state. Tax offsets to the federal budget were abolished, but the new issues of money offsets occurred despite the special presidential 164

The Debt Crisis and Default 165

decree adopted in November 1997. Another special presidential decree was signed in December 1997 and aimed to reduce wage arrears in the budget sectors. The reduction by 47 per cent was achieved immediately by pulling financial resources from other budget items. Nevertheless, the total volume of budget arrears did not decrease and continued to grow in the first half of 1998 despite all of these anti-crisis measures.1 The government also tried to improve the institutional base of tax administration, as the crisis was ongoing. The fiscal authorities began to introduce accrual accounting for excise taxes, to transfer the treasury accounts from commercial banks to the Central Bank, and to improve the transparency of large taxpayers according to international accounting standards. These measures were fundamental and correct, but their implementation was sporadic. A comprehensive tax reform would require a new tax code aimed to simplify taxation, improve its transparency, fairness and stability, and to eliminate excessive tax exemptions. Unfortunately, the State Duma did not support the government in its fiscal initiatives. The first draft of the tax code was rejected in November 1997. The exacerbation of the financial crisis in May 1998 was, among other things, caused by the absence of significant improvements in fiscal policy. Table 6.1 provides a comparison of the federal budget performance for the first half of the year in 1997 and 1998. At first glance, the situation did not worsen much during the crisis: the deficit of the federal budget in both periods was on average 3.5 per cent of the GDP. The negative trends manifested, however, in the second quarter of 1998. The federal budget revenue in fact fell in the second quarter of 1998 by 0.5 per cent of GDP. Increased political uncertainty had a negative effect on the tax discipline of enterprises. Export and tax revenues from Table 6.1 Federal budget performance in the first half year in 1997 and 1998 (percentage of GDP) Month

January February March April May June Annual

Revenue

Expenditure

Debt service

Deficit

1997

1998

1997

1998

1997

1998

1997

1998

8.5 9.7 10.3 11.1 11.6 10.9 12.5

10.2 10.3 10.7 10.8 10.9 10.8 10.8

10.5 12.2 14.6 15.2 15.4 15.3 15.8

14.9 12.1 14.3 14.4 14.5 14.7 15.7

1.4 2.1 2.2 2.0 2.1 1.8 1.6

2.7 3.3 5.0 4.9 5.3 5.2 4.0

2.0 2.5 4.3 4.1 3.8 4.4 3.3

4.7 1.8 3.5 3.6 3.6 3.9 4.9

Source: Batkibekov et al. (2002, p. 67).

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the raw material sectors fell as a result of the drop in prices at the end of 1997. Finally, the government privatization programme failed: the total income from the sale of public property became negligible – being only 1.2 billion rubles ($0.2 billion) in the first half year of 1998. As a result of fiscal failures, the debt burden became unsustainable. Table 6.1 demonstrates that the cost of public debt service rose dramatically, beginning in March 1998. In the second quarter of 1998 the fraction of debt payments in federal budget expenditures was 33 per cent, while in the same period in 1997 it was 17.5 per cent. In the second half of 1998, the expected value of GKO redemption would have increased dramatically, because the GKO yields had jumped in previous months. The redemption of GKO would reach 202.6 billion rubles or 7.5 per cent of GDP. The share of federal budget expenditures was nearly 15 per cent of GDP, implying that the fraction of debt servicing in the second half of 1998 would reach 50 per cent of the federal budget expenditures. Such proportion indeed indicate unsustainable debt-pyramiding budget scheme. The government tried to offset the increase of debt servicing costs by a reduction of non-interest expenditures in the first half of 1998. These were initially planned at a nominal level of 375 billion rubles in cash for the whole year 1998 (14 per cent of GDP). In fact, only 110 billion (4.1 per cent of GDP) were spent in the first half of the year.2 Although this tightening of fiscal policy provided a partial solution to the budgetary problem, it caused social tensions. Because of the significant cuts to nearly all non-debt budget expenditure items (including defence), the federal budget expenditures in cash fell by 3.3 per cent of GDP in 1998 compared to the previous year. Wage arrears increased by 36 per cent during the first half year of 1998 compared to the same period in 1997. This strategy was politically and socially unsustainable, especially in the situation of a political crisis that followed the resignation of Viktor Chernomyrdin’s government in March 1998. The Stabilization Programme proposed by the Kiriyenko government in July 1998 was aimed at solving the acute issues of fiscal policy and the beginning of structural reforms. It proposed, for example, the rationalization of federal taxes and interbudget relations, improvements in tax discipline and administration, the elimination of non-payments and tax offsets, and reforms of the natural monopolies (Gazprom, Unified Electric Systems, the Ministry of Railways). The ultimate goal of the Stabilization Programme was to ensure a target level of primary surplus of 3 per cent of GDP. All these measures were very sound and confirmed the adherence of the anti-crisis government to the course of market reforms, but they were suggested too late, already at the height


point of the crisis. Besides that, the fiscal package did not receive political and legislative support of the State Duma. The programme required several years for implementation and signalled serious reform intentions of the government but, unfortunately, could not be an effective tool of emergency policy. If implemented in full, the measures proposed by the Kiriyenko cabinet could have increased budget revenue at the first stage by 3.7 per cent of GDP, providing, at least, a balanced federal budget in 1999. But in the situation of a worsening financial crisis, this programme of fiscal measures per se could hardly help solve the debt servicing problem of the second half of 1998. In any event, the stabilization laws were blocked by the State Duma in July 1998. Thus the only effective anti-crisis tool the government could try to use was active debt management.

6.2 Belated debt management In my view, one of the government’s main mistakes was that up to the last moment it ignored the possibility of a debt crisis. The increase in government obligations was not accompanied by effective measures to manage their dynamics and structure. In fact, debt management was not among the government’s priorities until the exacerbation of the crisis in May 1998. As was emphasized in Chapter 4, certain definite steps in this direction could have been taken by the fiscal authorities beforehand. They did not take advantage of the favourable period in 1996–97 to reduce the risk of default by converting short-term ruble obligations into long-term Eurobonds. Such an opportunity existed at the time thanks to the favourable balance of payments and the generally optimistic attitude of global investors towards the Russian economy. Active debt management was still a possibility in 1997, because of the more or less favourable world market situation. The strategy of pre-emptive debt restructuring would have allowed a reduction in debt servicing and, more importantly, the minimization of the rollover risks to which the short ruble papers were exposed. These risks were manifested strongly in Summer 1998, which saw the failure of primary GKO auctions. The key problem recognized by the fiscal authorities at the height of the crisis was the refinancing of domestic short-term debt in 1998–99. The list of GKO issues maturing in the last seven months of 1998 of the total face value of $32.7 billion is given in Table 6.2. In June 1998 the government began to take active measures to deal with the debt crisis. As seen from Table 1.6, the two Eurobond issues, worth a combined amount of $3.75 billion, were made in June. By that

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Table 6.2 Value of maturing GKO and OFZs, June–December 1998 Month June July August September October November December Total

Billions rubles

Billions dollars*

31.9 37.8 28.5 36.6 28.9 25.4 13.4 202.6

5.1 6.1 4.6 5.9 4.7 4.1 2.2 32.7

% of annual GDP** 1.2 1.4 1.1 1.4 1.1 0.9 0.5 7.5

Source: Kharas et al. (2001, p. 24). * Converted at 6.2 rubles to the dollar, the exchange rate to the end of June; ** The nominal GDP of Russian Federation in 1998 was 2,696 billion rubles.

time only a total of $5.25 billion Russian Eurobonds were outstanding since the opening of the market in November 1996. In the crisis period of Summer 1998 the total volume of new Eurobonds was $10.2 billion. The fiscal authorities aimed to achieve a radical change of the denomination and term structure of a state debt and a reduction of the level of outstanding short-term domestic debt. The main task of this strategy was to eliminate or reduce the risks of debt rollover in the second half of 1998. The anti-crisis debt management must have opened a new window of opportunities, both for the government and for the part of foreign investors seeking to avoid the threat of debt default. The key measure was a GKO–Eurobonds swap carried out in July 1998. This provided investors with an opportunity to convert GKO issues maturing in the 12-month period between July 1998 and June 1999 into seven- and twenty-year dollar Eurobonds. This policy was adopted on 13 July 1998. This attempt began simultaneously with the adoption of an international rescue package worth $22.6 billion that had been negotiated with the IMF and aimed to support the ruble and restore the confidence in ruble assets.3 The GKO–Eurobond swap was engineered by the investment company Goldman Sachs. It is an important example of market-based anticrisis debt management that is worth examining in some detail. In what follows we use the description given by Kharas et al. (2001, pp. 35–7). All GKO series maturing before 1 July 1999 were eligible for exchange. The total volume of this debt was $39.3 billion at face value and $32.3 billion at market value under the prevailing ruble exchange rate. The Ministry of Finance suggested very beneficial conditions of


exchange: it offered to buy at par the series maturing over the seven weeks to September 1998. The buyback dollar prices were based on the current exchange rates (thereby eliminating the devaluation risk completely). The minimal and maximal spreads over the benchmark US Treasury bonds were announced by the Ministry of Finance, and GKO holders were asked to bid. The swap took place on 24 June 1998. The results of the swap were as follows: $5.9 billion were exchanged at face value and $4.4 billion at market value (with a discount corresponding to the price 73.8–73.9 per cent indicated in last two rows of Table 1.2 above). The swap provided ruble revenue for the redemption of currently maturing GKO series in exchange for long-term foreign currency obligations. The yield to maturity for Eurobonds was 14.9 per cent for the seven-year papers, and 15.2 per cent for the twenty-year papers. The maximal spread relative to the benchmark US Treasury papers of a corresponding duration was set at 940 basic points. The Eurobond issues data in the last two rows of Table 1.2 correspond to the swap deal.4 At first glance, the results of the swap did not appear to be particularly successful. Only 15 per cent of the short-term ruble debt outstanding maturing before 1 July 1999 ($39.3 billion at face value) was converted into long-term dollar debt. But according to generally recognized estimates, at least 60 per cent of the total volume of GKO was held at that time by the Central Bank and the state-owned monopoly saving bank Sberbank. The former had already begun crediting de facto the government, while the latter would be rescued by the state in any event. These financial institutions were excluded from the swap since they did not create rollover risk for the government. The core short-term debt outstanding after the swap was thus only 0.4 $39.3 $5.9 $9.8 billion at face value. In fact, this core debt was not so large and could have been restructured. Under the extreme pre-crisis macroeconomic situation there was still a good chance to restructure the whole core shortterm debt outstanding and to eliminate the rollover risk completely. No doubt, the terms of the swap offered by the Ministry of Finance were attractive for GKO holders. Nevertheless, the majority of investors rejected the deal. It is important to understand why. Kharas et al. (2001, p. 37) suggest that the reason for this was the overly high appetite for risk on the part of investors. They anticipated that the West would always bail out Russia, so they preferred not to swap their GKO. Perhaps more important was the belief that Russia was ‘too nuclear’ and geopolitically important to fail. Moreover, the past experience of investment in emerging markets suggested that the sovereign rather than domestic

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debt default would be the main threat and assumed that the Russian government would act similarly to governments in emerging markets. Investors (and domestic banks) decided to continue gambling with GKO basing on available information that forward contracts of Russian banks with non-residents matured at certain dates. They reasonably believed that the Central Bank would protect the terms of contracting to help the major domestic banks and postpone the ruble devaluation. The final expiration date for forward contracts with non-residents was 15 November 1998. Hence, they assumed that no devaluation would take place before then. This fact and the adopted emergency package with a promised credit line of $22.6 billion inspired optimism about the sustainability of the currency regime – at least in the short run. Under conditions of a fixed exchange rate the short-term GKO with a handsome return of 50 per cent looked much more attractive than the long-term Eurobonds which yielded an annual dollar return of ‘only’ 15 per cent.5 Given the higher probability of external debt default, holding long-term Russian Eurobonds seemed an unattractive proposition, when compared to holding GKO which had only three–four months until their redemption dates. Unfortunately, this window of opportunity closed very quickly. Sovereign spreads on Russian debt began to increase rapidly, and the government could not repeat a new series of GKO–Eurobond swaps. Russian Eurobond prices dropped, with the trigger being the liquidation of positions by the major banks that tried to meet margin calls on foreign loans. They also perceived severe rollover risks and used the GKO–Eurobond swap to exchange as soon as possible the portfolios of Eurobonds for dollar cash (large volumes of syndicated loans fell due in August). One of the banks that sold heavily Russian Eurobonds after the swap was identified later as SBS-Agro, at that time the secondlargest retail bank in Russia (Kharas et al. 2001, p. 40). Thus, the systemic risks of the banking system stipulated the failure of the anti-crisis debt management attempt. The main objection against the GKO–Eurobond swap was that it would make the cost of debt servicing unsustainable after the crisis (Eurobonds are obligations of ultimate priority and do not presume any rescheduling and default). But as we have seen, the main problem for anti-crisis debt management lay not in too high spreads of newly issued Eurobonds. The total volume outstanding was still quite small, only around $10 billion, by the beginning of July 1998. A complete conversion of the core GKO debt outstanding after the swap, the equivalent of $9.8 billion, would have increased the total volume of Eurobonds to $19.8 billion, not


an extremely large obligation for Russia (only 4.6 per cent of pre-crisis GDP). Yield to maturity for the Eurobond issues of 15 per cent with a spread of 940 basis points seemed for many observers too high a burden for the budget. But a simple calculation reveals that this perception was wrong. Even at 15 per cent the annual interest burden would be less than 0.3 per cent of pre-crisis GDP denominated at the official exchange rate (or 0.7 per cent of post-crisis GDP). This would not be so high a price to pay for avoiding the domestic debt default. To some extent, the task of GKO restructuring was not solved because it was market-based and depended on the voluntary choices of investors. The majority preferred staying in GKO because of a misperception of devaluation and default risks. Ironically, this belief was supported by the efforts of the IMF and the World Bank to rescue Russia. But it is important to understand that the window for this snapped shut because of the increased vulnerability of the largest Russian banks to systemic risks. Their sales of new Eurobonds provoked a downward spiral in the government debt markets. This would have occurred in any case, because of the large volume of foreign loans terminating in August 1998, and the GKO–Eurobond swap only hastened the market crash. The swap deal, had it been completed, could have prevented the GKO default in August 1998 and might have had exerted some discipline in relation to fiscal policy. The subsequent domestic debt restructuring, had it been based on the swap, could have been implemented in an orderly manner with a lower level of financial losses for investors and reputation losses for the Russian government. It is worth noting that the London Club debt restructuring into Eurobonds two years after the crisis increased the total volume in circulation by nearly $21 billion – or 2.3 times. The heads of the Russian Ministry of Finance were very proud of that result and made the optimistic claim that they were now the leaders in the sovereign debt market (among emerging market economies), having overtaken Brazil. Nobody referred to a tightening of the debt burden for the Russian economy (Vavilov 2003).

6.3 17 August – the debt default The Russian authorities announced three draconian measures on 17 August 1998: (a) the abolition of the existing exchange rate regime and the announcement of a new ruble fluctuation band of 6–9.5 rubles/$ for the remainder of 1998 (de facto, the ruble devaluation); (b) a default on the domestic debt in GKO-OFZ, which was to be restructured at a later date; and (c) a 90-day moratorium on the repayments of private

172


loans in foreign currency (first of all, by the banking system). In my view, this package was one of the worst possible solutions, even given the extremely difficult situation at this time. The way the authorities preferred to cope with the crisis was unbelievable and absolutely unexpected by the public at large. The latter was prepared for tough measures, but not in such an extreme manner, and it received a strong dose of shock therapy. Why was the resolution of the crisis so severe? Only three weeks passed between the end of successful negotiations with the IMF and the adoption of the $22.6 billion credit line. Of course, the volume of financial aid to Russia was much smaller than was typical of other countries: Korea, Brazil and Mexico received significantly larger amounts in roughly similar situations.6 Nevertheless, the package would be sufficient to continue the struggle against the crisis. The attempt to implement the GKO–Eurobond swap demonstrated that domestic debt rescheduling was quite possible. The Russian government prepared an anti-crisis programme and, in principle, could have begun to implement it without the immediate support of legislative power. The market’s mood in the month before the crisis was still optimistic. The situation changed abruptly for the worse, however, because of the opportunistic behaviour of Russian banks which provoked a panic among investors in securities. The government was clearly unprepared for a dramatic worsening of the situation on the financial markets and acted very unconvincingly at the crucial moment. I can suggest a very simple commonsense explanation that emphasizes the role of the ‘human element’ in these events. Traditionally, August is a period of vacation in Russia (and other European countries). There have been previous examples in recent Russian history of political and financial messes that occurred in August simply because the top officials were absent.7 The timing of the financial crisis was therefore predictable in advance, and at the very beginning of 1998 I made a conjecture that August was the most probable date for a future crisis (in interviews with mass media and private conversations; see Box 6.1). As was predicted, the key people responsible for economic and financial policy making were indeed absent in August, and the severe worsening of the macroeconomic and financial situation occurred at this precise time. They cut short their vacations and returned to Moscow to make hastily one of the most important strategic decisions in modern Russian history. Their actions were quite astonishing: why did all these persons in charge of macroeconomic stability take their August vacations, in spite of the threat of severe crisis that became obvious at the end of July?


BOX 6.1 A Calendar Effect of Vacations as a Predictor of Crises in Russia Let me quote Nikolay Gonchar (Russian Profile magazine, No. 31, 1 September 2008, p. 44), at that time and still today a deputy in the State Duma: ‘At the end of 1997 I read an article by Andrei Vavilov, published in the ‘Money’ magazine with the sensational title ‘I know the crisis will come’. The article analyzed the next year’s balance of payments and made an inference about the inevitable devaluation of the ruble. It suggested to abolish the exchange rate regime and to permit a modest devaluation within 30 per cent to prevent a devastating financial crisis. However, the Central Bank of Russia heads rejected this opportunity. In December of 1997 the negotiations with the IMF failed because of the Russian government’s reluctance to implement tough fiscal measures. In February of 1998 the negotiations resumed and only then the issue of granting Russia an emergency assistance was formally introduced. It was an impression of inconsistency in the actions of the authorities who lacked a clear anti-crisis strategy. The Russian financial markets behaved very nervously from the beginning of 1998, confirming the doubts about the ability of the government to cope with the crisis. The officials tried to demonstrate that everything was normal and the threats were not serious. But at some point it became apparent that this was not just a demonstration of tranquility for public. The authorities really believed that Russia was not vulnerable to the crisis. Andrei Vavilov’s views expressed in the abovementioned article contrasted sharply with this attitude. In February 1998 I phoned him directly and asked when and how could there be a financial crisis in Russia. He replied that ‘certainly it will happen in the Summer, most likely in August, when everybody will be on vacation. The situation in the financial markets may dramatically worsen when nobody will be in office. They will return and in haste make the most foolish decision possible…’ Unfortunately, it turned out that Andrei Vavilov was right!’

To some extent, the decision to default on GKO was justified by the failure of emergency debt management in July 1998. There was a strengthening of the short-term budget restrictions: as much as 94 billion rubles (the equivalent of $15.1 billion at the pre-crisis exchange

174


rate of 6.2 rubles to dollar) were required for the redemption of maturing GKO-OFZ issues during just the three months of August–October 1998 (see Table 6.2). The peak load of 36.6 billion rubles ($5.9 billion) a month fell due in September, when a new government came to power. This burden exceeded the critical level and could not be served without a rescheduling of debt or a return to inflationary financing. The former was hardly possible given the panic among investors, while the latter had already begun de facto, following the cancellation of the primary GKO auctions by the Ministry of Finance. In addition, the situation with respect to external debt servicing was expected to deteriorate sharply as a result of the nearly twofold increase in annual payments in 1999. As I have discussed already, the fiscal package received no support from the legislative authorities. But even if the State Duma had approved the package, the stabilization programme would have brought no immediate results. The fiscal and structural reforms would require time to be effective, and thus could not provide an urgent improvement of the state budget and debt refinancing. Most likely, the authorities decided to default on the debt under the pressure of all these circumstances. But they were unprepared for the implementation of the default that required thorough strategic choice, qualified juridical support and a deliberate sequence of tactical actions. The decision to default was adopted spontaneously and gave an impression of a reckless step undertaken in despair by some major policy makers. The actions of the international financial organizations also contributed to the outcome of the crisis. The attitude of the IMF to the issue of rescuing the Russian financial system changed rapidly at the height of the crisis. The volume of the first credit tranche from the July emergency package was reduced from the initially announced $12.5 billion to just $4.8 billion. The optimism of investors about the effectiveness of financial aid was quickly dispelled. This was, in particular, because of the incomplete fulfillment of the initial agreement. The main goal of the financial emergency package was to restore confidence in the policy of the Russian authorities, but it was unsuccessful. Later on, when the issue of default was raised in the middle of August, the IMF initially agreed,8 albeit reluctantly, with the plans of the Russian authorities. But a couple of days after the official announcement was made on 17 August the IMF refused to support the default. Sergey Alexashenko, at that time a deputy chief of the Russian Central Bank, mentions in his memoirs (Alexashenko 1999, p. 226) that there may have been pressure on the IMF from some US banks or top government officials. From the outside, this appears to be a reasonable explanation of why the heads


of this organization made such radical changes to their position with respect to the Russian crisis. The scheme of domestic debt restructuring was not announced immediately. The plan, as actually implemented, was formulated three months later. There were discussions among policy makers and economists about the exact parameters and mechanisms of debt restructuring, and how the burden of losses should be distributed between different groups of investors. The ultimate losses from default for non-residents that did not leave the Russian financial markets promptly were tremendous: 95 per cent on average in dollar terms, of which 70 per cent of losses were due to the devaluation of the ruble. The ultimate GKO restructuring was literally grabbing, but the majority of foreign investors did not try to apply to the international courts. One of the main reasons for their acquiescence was that they accepted the default and devaluation risks voluntary, when rejected the initial GKO restructuring scheme offered by the Russian government in July 1998. Another reason was that Russia defaulted only on domestic debt, but behaved much more carefully with respect to its sovereign debt. It continued to service Eurobonds and IMF–WB debts and started negotiations on restructuring and securitization of its obligations to the Paris and London Clubs (see Chapter 7). It is noteworthy that the Argentine debt crisis of 2001 incurred higher total losses for investors than occurred in the Russian case. The Argentine government tried to pre-empt a catastrophic resolution of the debt crisis but also failed. It halted payments on its debt of $132 billion in December 2001 and announced the largest sovereign default in global economic history. The Russian swap offered prior to the crisis was more generous than the Argentine swap offered to debtholders in a similar situation (see Box 6.2), but the Russian post-default restructuring of debt was more punitive.

BOX 6.2 The Argentine Debt Default and Swaps Argentina proved to be in a severe financial crisis in 1999–2002. It occurred after eight years of successful liberal reforms that became a benchmark for other emerging markets. The cornerstone of the macroeconomic stabilization was a currency board providing peso convertibility under the one-to-one dollar peg. As a result, hyperinflation was suppressed to one-digit annual inflation rates; the

176


intensive inflow of foreign investment fuelled economic growth of above 5 per cent per annum on average. The radical macroeconomic stabilization was not, however, supported by adequate structural and fiscal reforms thus leaving unsolved the serious problems of fiscal federalism and corruption. The domestic financial system was exposed to the risks neglected under the currency peg. For example, 80 per cent of commercial banks’ liabilities were denominated in hard currency by 2001. The problems in the Argentine economy manifested by the end of the 1990s. Because of the dollar appreciation in the second half of the 1990s, Argentina lost its competitive advantages in foreign trade. This effect was especially pronounced after the Brazilian currency depreciation by 30 per cent during 2001. Contagion effects caused by the Turkish lira devaluation in February 2001 worsened the attitude of foreign investors towards the efforts by the Argentine authorities to make the reforms more profound. Finally, the world recession in 2001 knocked the Argentine economy down, while the beginning of the war with terrorism made the issue of its rescue less important for the global policy agenda. The reduction of export revenues led to the fiscal gap widening to 2.5 per cent of GDP in 2001. By the fall of that year the sovereign debt amounted to $132 billion or 45 per cent of GDP and continued to grow very rapidly. The government failed to improve the state budget despite the $40 billion emergency package promised by the international financial organizations. Meanwhile, the yields on government securities soared to punishing levels above 30 per cent (Syrmolotov 2003, p. 29). In this situation the Argentine government faced a dilemma between an external debt haircut admissible for foreign investors and the currency peg abolishment devastating for the domestic financial system (Blustein 2005, pp. 82–6). The authorities preferred to defend the peso and tried to restructure the public debt in advance to evade a catastrophic debt default of the Russian style. The near-term goal of the anti-crisis debt management was to reduce the debt burden. The first debt swap of government bonds worth $30 billion for securities of longer maturities was conducted in June 2001. The second debt swap was announced in November 2001 and was supposed to embrace state liabilities worth $55 billion. But the terms of this swap were not acceptable for investors because securities carrying yields near 30 per cent were offered in exchange


for new ones with longer maturity and rates as low as 7 per cent. This offer indicated the hopelessness of the whole situation, and the world rating agencies reduced the sovereign ratings of Argentine to near-default rates. The attempts of the government to toughen fiscal policy and impose financial controls caused dangerous social tensions and political crisis. The government had no other choice as to default on the sovereign debt in December 2001 and then to abolish the currency regime. Unlike the Russian GKO default which left foreign investors with 5 per cent of money invested, Argentina conducted its debt restructuring more patiently and completed it in 2005, three and a half years after its default announcement. This was a result of thorough multi-stage negotiations with foreign investors and the IMF on the terms of debt restructuring. The government of Argentina was initially seeking to repay only 25 per cent of the original debt in terms of the expected net present value of future payments. Ultimately, it agreed with the average 30 per cent rate of compensation on extended maturities.

In our view, one of the key factors behind the failure of anti-crisis policy in Russia was the weakness of the domestic banking system and its disproportionate ability to influence policy decisions in the 1990s. The Central Bank cared too much about the protection of the major banks and gave a lower priority to other aspects of the anti-crisis policy. For instance, the leading bankers were informed by the CBR in advance about the coming default and could sell their portfolios of GKO-OFZ beforehand. Many used this informational advantage, thus bringing about the final crash of domestic markets, but still remained exposed to currency and refinancing risks with respect to foreign counterparties. Kharas et al. (2001, p. 34) discuss the distribution of losses as estimated from the results of an ex-post audit of Russian banks: ‘34 per cent came from loan losses, 28 per cent from losses on currency forward contracts, and 13 per cent from losses on GKO’ (2001, p. 34). Domestic banks, in contrast to non-resident investors, did not suffer much from the default itself and used confidential information to attack the ruble. The same authors give important evidence: ‘Vladimir Potanin, a former deputy prime minister and head of Uneximbank, told reporters in early November 1998 that the bankers knew by 14 August 1998, that the ruble was going to be devalued on August 17.’ The lobbying activities

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of the leading Russian bankers were the key reason for the adoption of the moratorium on foreign payments related to principal debt, currency forward contracts and GKO repurchase agreements. Thus, the leading private banks received a carte blanche from the Central Bank to get rid of GKO and attack the ruble, while they were given solid protection from claims of foreign creditors by the moratorium on debt payments.9 Apart from the issues of the Central Bank’s incentives, the decision to default on debt, devalue the ruble, and freeze foreign payments was scarcely justified by any economic or political gains. The reputation of being a reliable borrower should have been more valuable for a nation that had only just entered the world’s financial markets. From the economic viewpoint, the short-term gain from default should have been compared to the economy’s long-term losses caused by the fall in international credit ratings and the lost access to global capital markets.10 Russia lost its reputation of reliable sovereign borrower, which existed in the late Soviet period and began to restore after five years of thorough work with debt management. This reputation was earned by the federal government at a sufficiently high price, largely due to the priority of debt servicing in previous years. From the viewpoint of a political game, the liberal government committed a strategic blunder by defaulting on the debt. It handed over to the subsequent left-centre cabinet an economy with a considerably lower debt burden. This made it easier to conduct future economic policy. Such a choice differed from the result in political economy where a government builds up its debt in order to limit the actions of a future government from the other party. This paradoxical outcome is explained to some extent by the fact that the liberal government of Sergei Kiriyenko only made the initial decision by default, while the details and the degree of harshness were determined by the subsequent devaluation of the ruble and the GKO rescheduling schemes worked out under the left-centre government of Yevgeniy Primakov.

6.4 A post-crisis inflation trade-off But before the appointment of a ‘heavyweight’ politician Primakov as prime minister on 11 September 1998 Russia plunged into a political vacuum. A week after the default was announced, Kiriyenko’s cabinet was dismissed. Boris Yeltsin twice nominated Viktor Chernomyrdin, and twice he was rejected by the State Duma. The political uncertainty aggravated the financial turmoil: the stupor of the payment system, bank runs, the sharp ruble devaluation far beyond the initially


announced band. This led to a worsening of the crisis and led Yeltsin to nominate Yevgeniy Primakov, a relic from the Soviet era. Primakov required three weeks to form a new government and one month to present a new anti-crisis plan. Given the paralysis of the government, the Central Bank actions, under its new heads,11 proved to be particular important in that period.12 The nominal ruble devaluation was nearly threefold and created a threat of spiralling inflation: in the half-year after August 1998, the nominal dollar-to-ruble exchange rate increased by 270 per cent, and the consumer price level rose by 98 per cent. The real ruble depreciated by 46.5 per cent during the last five months of 1998. The same outcome in real terms could have been achieved with less dramatic changes in the nominal variables. The latter were predetermined by the inflationary actions of the CBR before and after GKO default aimed at, initially, bailing out the banking system. Devaluations of different degrees have occurred in many countries, but they have not always entailed a switch to an inflationary regime. Figures 6.1 and 6.2 depict dynamics of the nominal exchange rate and rates of inflation and ruble devaluation for the two-year period 1998–99. Table 6.3 provides a record of monetary policy in the post-crisis period 1998–2000. Credits to the government increased by 104.3 per cent in the last four months of 1998 but stabilized thereafter. The increase of the monetary base was 40.2 per cent at the end of 1998, and then it

30 Dollar to ruble exchange rate 25 20 15 10 5

Source: CBR.

9 ov

-9

99

9

Figure 6.1 The nominal ruble exchange rate in 1998–99 (rubles/$)

N

Se p-

9 -9

l-9 Ju

9 ay M

ar

-9

9 M

n9 Ja

Ju l-9 8 Se p98 N ov -9 8

-9 8

-9

M ay

ar M

Ja

n9

8

8

0

180


115 95 75 55 35 15

9 -9

99

N ov

pSe

l-9

9

9 Ju

-9 ay M

ar

-9

9

99 nJa

CPI growth rate

M

8 -9

98

N ov

pSe

l-9

8

8 Ju

-9

8 -9

ay M

ar M

Ja

n-

98

5

rate of nominal ruble devaluation

Figure 6.2 Monthly inflation and the ruble devaluation in 1998–99 Source: CBR, Goskomstat.

Table 6.3 Growth rates of monetary policy indicators after August 1998 (per cent) Period Claims to the government Claims to banks Monetary base Inflation rate

September– December 1998

1999

2000

104.3

8.9

11.8

245.7 40.2 84.4

165.6 65.1 36.5

1.8 69.5 20.2

Source: CBR.

continued to expand at an even higher rate. The growth of credits to the banking sector was dramatic at the end of 1998 and 1999, as seen from Table 6.3. In absolute terms, the volume of credits to banks was 189 billion rubles – or 78 per cent of the absolute increase of monetary base during this period. The need to provide stabilization credits to banks was related to the payment crisis caused by the default and devaluation. Government securities made up most of the liquid assets of banks, while a considerable fraction of their liabilities were in foreign currency. Liquidity provision to banks was based on the reduction of mandatory reserve


requirements for ruble and dollar deposits from 11 to 7 per cent on 24 August and to 5 per cent on 1 December 1998. Banks also obtained stabilization credits and could swap the defaulted government securities for new instruments, short-term zero-coupon bonds (KBO) issued by the CBR. The special rules gave priority to some banks in the GKO-OFZ restructuring (Tompson 1999, p. 26). The refinancing of banks took place on a case-by-case basis, and was based on non-transparent procedures. In many cases large banks on the edge of bankruptcy had an opportunity to hide assets into the so-called bridge-banks established to escape financial responsibility to deposit-holders.13 Although some large banks were bankrupt or were transformed into newly established banks, the mechanism of selection worked poorly. During the crisis the Central Bank withdrew only 77 bank licences, and did it with the same average frequency as before August 1998 (13 per month on average). The Central Bank tried to conduct a gradual devaluation of the ruble after the forward contracts and most of the foreign payments by banks were completed by November 1998. The change in the ruble exchange rate dynamic is seen clearly in Figure 6.1. The policy of managed ruble devaluation presented guaranteed profit opportunities for banks that could obtain rubles cheaply from the Central Bank and sell them for dollars. Despite their intense engagement in this activity its profitability did not cease. In effect, the monetary authority was essentially subsidizing the banks through the provision of ruble liquidity.14 Liquidity injections to the banking system were designed to eliminate suspensions and the interruptions to interbank payments that persisted until the middle of 1999 when a centralized system was created for dealing with non-payments in banking.15 But during the period from Autumn 1998 to Winter 1998 the increase in the money supply to banks contributed to inflation because it enabled them to speculate against the ruble in the foreign currency market.16 This situation was aggravated by the uncertainty of the monetary authorities’ policy preferences. Surprisingly, the new heads of the Central Bank did turn out to be sufficiently conservative. After several months of liquidity injections into the banking sector the Central Bank stopped this policy because of the threat of inflation spiralling out of control.17 In Appendix A6.1 we suggest a simple theoretical model that demonstrates how a monetary policy trade-off between supporting banks and stabilizing the nominal exchange rate may produce an indeterminate outcome. In this model banks can speculate against the ruble in the foreign currency exchange using a preferential ruble refinancing by

182


the Central Bank. There may be two equilibria in the model: (i) with stable exchange rate; and (ii) with devaluation. If restrictions are imposed on the ruble convertibility to prevent capital flight, the equilibrium devaluation rate is getting higher. This model is relevant to the situation in the Russian banking system in 1998–99. It was highly vulnerable to liquidity restrictions, but incautious liquidity injections by the CBR could generate a high-inflation regime of refinancing. In this situation, different regimes of the banking system refinancing could be realized implying the indeterminacy of inflation expectations. Even without the monetization of the budget deficit, the monetary authorities were not very far from sliding into an inflationary spiral, partially, due to destabilizing speculation in the foreign currency market that absorbed a large part of the ruble liquidity supply to banks. Fortunately, this spiral was avoided principally because banks became politically weak and could not exert much pressure for a radical policy switch to the high-inflation regime. It is important to note that the anti-inflationary measures also included administrative controls over foreign currency operations such as the compulsory sales of export revenues introduced in Autumn 1998. The new system of morning and daily trade was established on the Moscow currency exchange (MICEX) at the beginning of 1998 to split foreign currency markets into two separate segments: one for foreign trade needs and one for currency speculation. Banks were required to deposit foreign currency purchased for imports at morning sessions. In addition, in April 1999 the CBR adopted restrictions on the current account ruble convertibility. These restrictions were imposed because, despite the CBR’s intention of conducting a policy of managed devaluation, the foreign currency market was on the brink of failure. For a while, until the strengthening of controls over the supply of foreign currency,18 the foreign currency market failed to clear with the Central Bank selling dollars. At the same time, the introduction of tough administrative measures could have led to a complete loss of control over the foreign currency turnover in the country and provokes a panic outflow of capital. This problem became particularly urgent at the end of 1998, when the dollar once again, after the highinflation period 1992–94, became the prevailing speculative asset.

Appendix A6.1: A model of banks supporting devaluation19 Consider a simple two-period model of liquidity provision to the domestic banking system in distress by the monetary authority. Refinancing


is used as a way of indirectly subsidizing banks that are in a privileged position to receive benefits from foreign currency transactions. In the first period the Central Bank supplies ruble loans to banks which purchase hard currency (dollars) in the currency exchange. As financial intermediaries, banks credit households with dollar cash to be used for transactions. In the second period banks exchange dollars repaid by households for rubles to redeem their debts to the Central Bank. Centralized ruble credits are supplied to banks at lending rates that are essentially below the market level. Domestic banks are thus enabled to earn profits not arbitraged away by competition with foreign banks having no access to cheap ruble credits. The Central Bank possesses control over the ruble exchange rate and pursues a deliberate policy of funding the banking system by maintaining exclusive arbitrage opportunities in foreign exchange operations. It takes the loser side in transactions with banks but shifts the burden of subsidizing the banking system to households paying inflation tax.20 Let us suppose that the monetary authority tries to compromise between the support of banks through refinancing their foreign exchange operations and the exchange rate stability. The policy problem is to select the ruble devaluation rate providing maximum to the objective function U p (e) a(e 1)2 /2,

(A6.1)

where p (e) is the banks’ total profit as a function of the second-period nominal ruble exchange rate e measured as rubles to dollar. The initial exchange rate is normalized to 1. The second term in (A6.1) is the squared devaluation rate.21 Parameter a is the weight the monetary authority attaches to devaluation losses incurred by households. The number of banks is unity. For the sake of simplicity we ignore uncertainty in the exchange rate dynamic. Both ruble and dollar interest rates are assumed to be equal to zero (the former are granted by the Central Bank very cheap while the latter are negligible as compared to the ruble devaluation rate). Banks earn profits: p (e) (e 1)z

(A6.2)

where z is the amount of dollars purchased by banks in the first period to meet the household transaction demand for dollars. This demand is motivated by the desire to replace partially the rubles as a means of

184


transactions. We do not model explicitly the household-maximizing behaviour and assume that the demand for dollars is an increasing function of the expected devaluation rate e e: z ql(e e ),

(A6.3)

and q is a parameter indicating the intensity of dollar demand. The function l(e e ) may be concave or convex. Intuitively, the latter case corresponds to the situation of the dollarization of the economy, when transaction demand for dollars is growing faster in percentage terms than the ruble devalues (as a result of the rapid replacement of transactions in rubles with those in dollars). We impose the following condition on the dollar demand function: l(1) 0,

(A6.4)

which means that households do not make dollar purchases if they do not expect there to be any change in the exchange rate.22 The monetary authority chooses devaluation rate e simultaneously with decisions by households to buy dollars basing on rational expectations: e e e.

(A6.5)

From (A6.1), (A6.2), the optimal devaluation rate selected by the monetary authority is e 1 z /a,

(A6.6)

Inserting (A6.3) into (A6.6) and using (A6.5) yields an equilibrium equation on the second-period exchange rate: e 1 ql(e )/a.

(A6.7)

Due to (A6.4), e 1 is the solution of (A6.7), implying the existence of a no-devaluation equilibrium with stable exchange rate. If the dollar demand function l(e) is concave, this equilibrium is unique, as seen from Figure A6.1 where the curve depicts the right-hand side of (A6.7). Under the stable exchange rate banks are not subsidized through foreign exchange transactions and the policy objective function (A6.1) is zero, U s 0.


45°

e 1 Figure A6.1 Zero-devaluation equilibrium

45°

1

e*

~ e*

e

Figure A6.2 Two equilibria under dollarization

Consider the case of convex dollar demand function l (e). There are two equilibrium points: 1 and e * >1 depicted in Figure A6.2 and corresponding to zero and a positive devaluation rate, respectively.23 In the devaluation equilibrium the Central Bank supports banks enabling them to earn arbitrage profits through dollar transactions. The policy objective function for the no-devaluation equilibrium is zero, while for the devaluation equilibrium it is Ud a (e * 1)2/2 > 0 U s.24 The monetary authority thus prefers devaluation to the exchange rate stability. Consider a simple comparative static exercise regarding parameter q for the case of dollarization. A decrease of this parameter may be related to administrative measures undertaken by the authorities to reduce foreign currency demand, for instance by imposing currency controls or other restrictions on the convertibility of the ruble. The dotted curve in Figure A6.2 depicts the shifted right-hand side of equation (A6.7) for

186


reduced q. The no-devaluation equilibrium does not change with the reduction of q, but the equilibrium rate of devaluation shifts upwards since ∂ e*/ ∂ q < 0. As a result, the devaluation equilibrium induces a higher demand for dollars under stronger restrictions on ruble convertibility. A larger volume of dollars has to be purchased by banks in the first period and a larger volume of rubles has to be repurchased in the second period to compensate for imposed currency controls. This causes an increase of ruble liquidity supplied by the monetary authority to support banks that, in turn, results in an increase of the equilibrium devaluation rate. As was mentioned above, the monetary authority in the model prefers devaluation to exchange rate stability. A possible intuition for this inference is that many Central Banks in reality are responsible for monetary stability, as well as for the stability of the banking system. The policy objective function given as (A6.1) corresponds to a post-crisis financial distress situation when rescuing the banking system becomes a superior goal for the monetary authority. One can suggest that under normal circumstances the policy preference should change, and the bank profits term π(e) should not enter the objective function of this authority. The devaluation equilibrium in the model may be the case only in the situation of dollarization when the dollar demand function is convex. Otherwise the monetary authority has to choose the exchange rate stability as the unique outcome of the game. The devaluation equilibrium in the case of dollarization is expectation-driven in the sense that the Central Bank devalues to subsidize banks if households expect devaluation and vice versa. This inference corresponds to the situation of the indeterminacy of gradual ruble devaluation and inflation that took place after the Russian crisis. One can suggest that the Central Bank of Russia behaved initially according to the devaluation equilibrium of the model and generated self-fulfilling expectations of further falls in the ruble and spiralling inflation. But subsequently, as it became clear that the banking system had escaped collapse, the preferences of the Central Bank changed dramatically. The need to subsidize banks ceased to have social significance, and the monetary authority switched from the devaluation–inflation spiral to the regime of low inflation (and no devaluation). The hypothesis of such a policy regime switch may to some extent explain why the macroeconomic situation in Russia stabilized very rapidly after the crisis (see discussion in Chapter 7).

7 Recovery After the Crisis

Introduction The crisis of 1998 affected the entire economic system in Russia. The future seemed very uncertain. International financial institutions (IMF 1998) gave a disappointing forecast for the Russian economy (most analysts predicted 1999 consumer price inflation would be in the range 80–200 per cent and that there would be a real GDP decrease of 4–10 per cent1). This pessimistic view was based not only on the aftermath of the crisis. The coming to power of the left-leaning government inspired the worst fears of the populist measures and hyperinflation. Meanwhile, the crisis itself, and also the decisions taken by the government and the Bank of Russia in August 1998, had a complex impact on the development of the Russian economy. It is clear today that the crisis has largely proved useful for Russia. However, the positive effect was not automatic. The government’s action played a huge role in addition to several external factors. And although the overall reconstruction programme for the Russian economy after 1998 was never comprehensive, many of the measures had a decisive influence on further developments. As a result, after years of recession, the Russian economy showed record levels of growth.

7.1 The results of the ruble devaluation 7.1.1 The growth in industrial production Economic theory suggests that currency depreciation leads to an improvement in a country’s levels of competitiveness2 (Marshall 1923; Lerner 1944). This leads to an influx of revenue and budgetary surplus. The excess supply of foreign currency requires intervention by the Central 187

188


Bank if the currency is not to appreciate. This intervention results in an increase in the supply of domestic currency. As a result, the economy is moving into a new equilibrium, which is characterized by a greater output and inflation ( Johnson 1958). Thus the short-term devaluation significantly increases economic activity. At the same time a gradual weakening of the currency has a less tangible effect on the growth of production. The distinguishing feature of the Russian economy in the first year after the crisis was the unexpectedly rapid growth in production. The key factors behind the economic recovery were the steep devaluation of the ruble and the beginning of the rise in oil prices. The first factor contributed significantly to the competitiveness of domestic industries, particularly in relation to imports. The second factor improved the budget. However, this explanation may not be exhaustive. The phenomenon of the rapid restoration of positive economic growth was the result of the interplay of a number of factors. 7.1.2 The increase in export revenues and reduced costs Along with the adverse effects of the fall of the ruble (inflation, the devaluation of the public’s ruble-denominated savings) devaluation had a positive impact on the economy. In particular, the weakening of the currency increased the volume of sales by the export-oriented companies, increasing the levels of cash and reducing the enterprises’ debt burden. Because their costs were primarily denominated in rubles,3 Russian companies found that their competiveness increased relative to imported goods. At the same time, the low value of the ruble compared to its purchasing power parity led to increased competitiveness for exports (see Figure 7.1). In addition, the fall in the ruble reduced the cost of production (measured in dollars) by two–three times compared with the period before the crisis of 1998. An important role in the recovery was also played by the higher prices for commodities and energy in world markets (see Figure 7.2), leading to an increase in the incomes of companies supplying these goods to the international market. The most important positive sign of recovery in the period 1999–2001 was the growth in the level of investment. Economic theory suggests that the foundation of long-term economic growth comes not from consumer demand but from investment. And since the crisis there have been clear positive developments in this respect in the Russian economy. The improving financial state of businesses led to an increased demand

Recovery After the Crisis 189 30 Export

Import

27 24 21 18 15 12

M

ar M 99 ay -9 Ju 9 l-9 Se 9 pN 99 ov -9 Ja 9 n0 M 0 ar -0 M 0 ay -0 Ju 0 lSe 00 pN 00 ov -0 Ja 0 n0 M 1 ar -0 M 1 ay -0 Ju 1 lSe 01 pN 01 ov -0 1

9

Figure 7.1 The dynamics of exports and imports of Russian goods ($ billion) Source: CBR.

35 Brent 30 25 20 15

ov -9 Fe 8 b9 M 9 ay -9 Au 9 g9 N 9 ov -9 Fe 9 b0 M 0 ay -0 Au 0 g0 N 0 ov -0 Fe 0 b0 M 1 ay -0 Au 1 g0 N 1 ov -0 1

8

98

N

g-

-9

Au

M ay

Fe

b-

98

10

Figure 7.2 The price of oil ($/barrel) Source: International Energy Agency.

for capital goods and hence a resurgence of investment in fixed capital.4 This was the result of the fall of the ruble and the favourable economic performance of the Russian economy after the crisis. The economic recovery led to increased demand for investment and that the improvements in the financial sector made this demand translate into more supply.

190


As the initial boost in competitiveness from the fall of the ruble began to evaporate, the boom in investment started to decrease. The absence of an effective mechanism to stimulate the flow of capital between different economic sectors also contributed to a decline in investment activity, even though earnings from commodity exports were growing. The increase in domestic demand became central to economic development. By the fourth quarter of 2000 the accelerated increase in the prices of energy, the rise in the exchange rate of the ruble, and the extensive growth of wages led to a decrease in profits and investments. 7.1.3 Domestic import substitutes At the same time as opposed to theory empirical studies show a mixed relationship between movements in the exchange rate and productivity. If the share of the domestic producers’ costs denominated in foreign currencies is significant, then the weakening of the domestic currency would cause a sharp increase in production costs, which could cause a decline in profitability. In this case, the devaluation will have negative consequences for the economy, causing both inflation and a fall in production (Gylfason et al. 1983). But this is unlikely in a large economy such as Russia. Staples dominated imports to Russia prior to the crisis of 1998. In addition machinery and equipment in imports was rather quickly replaced by locally produced products. Russia’s economy has proven to be sufficiently nimble in responding to the changing external conditions. Devaluation does not always leads to import substitution. Some studies (for example, Baldwin 1988) suggest that the stronger the shock in the currency market, the more likely will be the effect of the shock on import substitution. This is because during a gradual devaluation foreign producers may be able to adjust. But in the case of a rapid collapse of a currency, foreign manufacturers are not able to react quickly and they may lose market share to domestic producers. The devaluation in Russia along with the drop in real incomes increased the relative price of imported goods, resulting in a significant reduction of imports (nearly twice) in 1998 in compared with 1997. The standard of living decreased parallel to the smaller share of imports in total consumption. The ability of domestic producers to compete with imports depends on various factors. Most important are, preferences towards import price sensitivity, and the ability of producers to quickly adjust to shifts in demand (i.e., excess capacity). In addition, government policy

Recovery After the Crisis 191

may have an impact, for example, through trade policy – as in the case of restrictions on the supply of pipes from Ukraine. The government also increased the demand for domestic production through the increase in defence orders.5 Beginning in the first half of 1999 the ruble began to strengthen as a result of the growth in net exports and this began to gradually weaken the advantage of domestic producers. This situation caused a slowdown in manufacturing and a growing dependence on investments and innovative development strategies. As a result, by the end of 2001, the proportion of domestic production and imports in the Russian economy returned to the pre-crisis levels. Some research has shown (for example, Kadochnikov and Chetverikov 2003) that in conditions of low price elasticity for exports and higher elasticity for imports (which is typical of the Russian economy) a sustained long-term growth of the national economy may be maintained by periodic currency devaluation or through economic diversification. Until 2008 the government has been trying to act in both directions. However, without a rigid definition of the objectives and programmes of action, a single policy (often contradicting each other) leads to negative results. As a result, the authorities were unable to stem consumer price inflation and hold the ruble stable. 7.1.4 The other factors Following the crisis there was an increase in the disparity of energy prices between Russia and the world market. This was of great assistance to the industrial recovery in Russia.6 However, this situation was the result of the influence of domestic price controls and could not be maintained indefinitely. An important role was played by institutions. Thanks to the privatization in the early 1990s a functioning market economy was beginning to take shape in Russia. The emergence of independent producers who were willing to take advantage of the favourable economic conditions led to an expansion of production. In 1992–93 despite a low real rate of the ruble, all attempts to tighten fiscal and monetary policies have led to increased recession and mounting non-payments, but in 1999–2000 the situation changed dramatically. The devaluation, accompanied by macroeconomic stabilization, provided a strong impetus to producers (see Table 7.1). Despite the crisis, in 1999 the annual growth in industrial production reached 8.1 per cent, 2.5 per cent higher than in the pre-crisis level in 1997 (see Figure 7.3). But the real figures show a decrease in the

192 Table 7.1 The rate of growth of industrial production (per cent)*

Industry – in all fuel-energy complex power industry oil-producing industry oil-refining industry gas industry coal industry ferrous metallurgy non-ferrous metallurgy Manufacturing chemical and petrochemical industries timber, woodworking, pulp and paper industries industry of constructional materials food industry light industry

1997 January– 2000 January

1998 August– 2000 August

16.6 2.56 3.98 2.41 ⫺0.61 ⫺0.94 5.49 19.46 18.12 21.22 28.61

23.57 4.68 5.08 2.53 5.19 ⫺2.68 14.22 36.42 12.2 46.79 37.74

50.44

36.95

7.58

11.24

22.05 26.14

23.48 83.74

* The figure represents a change in the average index of production for each month of the reporting period relative to January 1990. Source: Center for the Economic Conditions of the Government of the Russian Federation (seasonally adjusted data).

2500 Industry production

GDP

2000

1500

1000

M

ar M 99 ay -9 Ju 9 lSe 99 pN 99 ov -9 Ja 9 n0 M 0 ar -0 M 0 ay -0 Ju 0 l-0 Se 0 pN 00 ov -0 Ja 0 n0 M 1 ar -0 M 1 ay -0 Ju 1 lSe 01 p0 N 1 ov -0 1

500

Figure 7.3 Trends in GDP and industrial production (billion rubles) Source: Goskomstat.


levels of output (real GDP in 1999 was only 98.1 per cent of the 1997 level). Obviously, the recovery of production in 1999–2000 went a long way to compensating for the drop that had occurred as a result of the crisis. Thus, the improvements in the economy during the ‘first phase’ boom from 1999 to 2000 were the result of several factors that had a positive impact on economic performance: • devaluation of the ruble, falling cost of production and an improvement in the terms of trade and thus the profitability of exports; • resurgence of investment demand based on the increased profits due to the devaluation; • growth in real wages since mid-1999 encouraged consumer demand (the growth in real wages did not lead to increased costs for the enterprises. The reasons is a compensation rise which resulted in improving productivity (see Figure 7.4) and a noticeable lag between consumer prices producer costs); • external factors (rising world prices for commodities). In summary, my assessment of the impact of devaluation on the economy of Russia is that this decline in the real exchange rate was inevitable in the wake of a financial crisis. Although it had positive short-term effects, it did not have a lasting, long-term impact on the economy.

100

102 Compensation

Productivity

96

60

94 0 -0 ar M

D

ec

99 p-

9 Se

-9 Ju n

ar -9 M

D

ec

98 pSe

Ju n

-9 ar M

-9 9

70

9

98

-9 8

80

-9 8

100

8

90

Figure 7.4 The dynamics of compensation and productivity, 1997 = 100 Source: RECEP (2000).

194


7.2 Fiscal discipline, consolidation and the end of financial chaos 7.2.1

The disappearance of cash surrogates

Various studies (including some empirical surveys) about the outbreak and the widespread use of the surrogate exchanges in Russia showed that the main causes of this phenomenon included the institutional legacy of the Soviet Union (Gaddy, Ickes 1998), a strict monetary policy, and the conflict of interest between creditors and owners (Morley 1992). It has been estimated that countertrade between Russian companies accounted for 50 per cent of all payment transactions in 1997, and 40 per cent of all federal taxes were offset. With the largest companies, things were even worse: 73 per cent of their payments were made using cash equivalents (see Table 7.2). In 1997, these companies paid just 8 per cent of taxes in cash. Remarkably, cash equivalent payments between the energy industry enterprises posed the most serious problem (see Figure 7.5). From the point of view of proceeds gained from sold commodities, energy industries differed considerably from other industries of the Russian economy. Non-cash payment transactions accounted for 20–50 per cent of all payments within the industry. In the energy industry, transactions using cash equivalents as payments for domestically sold goods averaged more than 70 per cent. At the onset of the 1998 crisis, the Russian economy saw positive changes. Ruble devaluation in August 1998 had a positive impact on the income structure of Russian companies.

Table 7.2 Cash and non-cash payment transactions between large companies

GAZPROM The share of payments made in the total amount of bills to pay Cash payments against all bills for domestically sold goods RAO UES OF RUSSIA The share of payments made in the total amount of bills to pay Cash payments against all bills drawn up to domestic consumers Source: Goskomstat.

1996

1997

1998

1999

70

63

67

65

8

6

10

13

77

80

88

87

12

25

20

21

Recovery After the Crisis 195 100 90 80 70 60 50 40 30 20 10

Offsets

Barter

9

9

ov -9 N

ct -9 O

99 pSe

Au

g-

99

9

9

Ju l-9

-9

9 ay -9

Bills

Ju n

9

Cash

M

r-9 Ap

-9 ar M

Fe

b-

99

9

0

Others

Figure 7.5 UES OF RUSSIA income structure (per cent) Source: Goskomstat.

There is admittedly one respect in which devaluation causes behavioural changes that contribute to a decline in barter. The extent to which the enterprises use money or barter is an economic decision. Because barter is costly, enterprises used cash transactions even when the use of barter was at its peak. When cash is more plentiful, there is a shift in the margin between using barter and using money. Real depreciation thus shifts behaviour towards an increased use of money. Thus devaluation and the access to export and consumer markets gave some impetus to the re-monetization of the economy. In addition, the disappearance of the short-term government bond market and interest rate decline encouraged an inflow of money into the real sector (see Table 7.3). Simultaneously, the monetization of the economy began. In the first half of 2000, more than 50 billion rubles were injected into the economy. This pushed up cash payments in the economy by between 35 and 40 per cent. Industrial companies’ payment delinquencies fell from 64 per cent of the output in August 1998 to less than 30 per cent in Autumn 2000, the share of barter dropped from 48 to 19 per cent, and the money supply/ GDP ratio grew from 15 per cent to 20 per cent. As a result of devaluation and the consequent increase in liquidity, the level of monetization grew substantially in the first two post-crisis years. Through the use of international experience the problem of payment delinquencies was effectively solved at both the company and government levels.

196


Table 7.3 The share of payment offsetting (per cent) Industry Ferrous metals industry Non-ferrous metals industry Chemical and petrochemical industries Machine-building Timber, woodworking and pulp and paper industries Construction Light industry Food industry

1996

1997

1998

1999

2000

63 42 58 46 45

64 38 60 60 51

59 13 55 55 42

23 5 27 22 29

17 31 18 15 21

45 51 30

54 58 21

72 44 28

29 26 18

22 14 14

Source: Institute for Economy in Transition.

As the large energy companies were one of the major links in the chain of netting, a key factor that had an influence on electricity payments were the policies led by regional energy commissions that prevented the hiking of electricity tariffs. As a result of the 1998–99 inflation, electricity prices doubled, however, the tariffs remained practically unchanged. As the result of a relative decline of the tariffs, payments for electric energy doubled. Also, in the second half of 1999, RAO UES OF RUSSIA began to adopt an aggressive financial policy. Companies who used countertrade were also required to make settlements in cash. In 1998, cash payments totalled just 10–20 per cent of all payment transactions, halfway through 2000, they exceeded 50 per cent. As cash payments grew, the economic benefits of netting began to fall sharply and after it reached the 40 per cent mark, amounts of netting and cash equivalents began to fall. One of the key measures undertaken by the RAO UES OF RUSSIA halfway through 2000 was the decision to fight cashless payments such as barter, promissory notes and netting. According to a special document, 100 per cent of electricity bills were to be paid in cash only. All forms of netting against current payments and debts were prohibited. Only housing and utility organizations and organizations funded from local budgets were granted some relief. Consumers from this category were required to make at least 70 per cent of their payments in cash. The documents stipulated a very efficient measure – electricity cutoff – to apply to all consumers who could not repay their electricity debts on time. As a result, barter, netting and cash equivalents began to disappear as types of payments (barter deals and cash equivalents declined almost two times, falling to 23.1 per cent in 2001 compared to the pre-crisis level).


7.2.2

Fiscal policy

Decisions taken by the government in August 1998 were focused on the alleviation of the escalating budgetary crisis. The devaluation of the ruble and the default on the domestic debt had a positive impact on public finances. First, the domestic debt payments were stopped. Second, budgetary obligations continued at their nominal levels, which were significantly depreciated in real terms. It was very important that during this difficult period for the economy of Russia, namely from September 1998 to May 1999, the government was able to maintain a tight fiscal policy that permitted the implementation of a number of non-populist measures. Along with the increase in production it enabled the growth of the actual tax revenues (see Table 7.4). As shown in Table 7.4 there was an increase in the tax revenues from industry, with the exception of the food industry. The decline occurred in services (transport, communications, finance and credit) which affected tax revenues. Certain tax segments did not follow their forecast for 1999: income tax, which is evident by virtue of reducing the welfare of the population; excise; tax on foreign trade.7 An important event for the budget was the adoption of the Tax Code, which prohibits the practice of basic tax deductions, as well as export duties on raw materials. In addition, the growth of prices for traditional Russian commodities exports – oil, gas, nonferrous metals and timber – helped to increase budgetary revenue. It is not just the relative values that increased, but the absolute amounts of tax collection were the Table 7.4 The dynamics of tax revenues in the consolidated budget (per cent) Total Industry including: power industry fuel industry ferrous and non-ferrous metallurgy light industry food industry agriculture transport communication building finance and credit Source: IET.

01.99 100 33.0 1.9 6.5 2.7

03.99 100 39.0 4.0 9.7 3.3

06.99 100 42.4 3.5 11.0 4.6

09.99 100 43.9 3.3 12.2 5.0

12.99 100 45.2 3.4 14.4 5.2

0.5 9.0 1.0 21.3 3.6 5.5 4.8

0.6 8.7 1.1 18.5 3.0 5.7 4.4

0.6 8.7 1.1 17.0 3.0 5.8 4.2

0.6 8.6 1.1 16.0 3.0 5.8 3.8

0.6 8.0 1.2 15.2 2.7 5.8 3.6

198


Table 7.5 Sources of financing of the budget deficit % of GDP, at the beginning of year

1994 1995 1996 1997 1998 1999 2000

State internal debt, including: securities credit of Central Bank service

21.7 0.2 18 0.6

14.5 3.1 9.6 2.6

11.5 5.2 3.7 2.3

16.2 11 2.6 4.7

18.7 16.8 0 3.6

28 17.9 0 4

13 11.8 0 1.2

Source: IET.

result of the developments of enterprises and declining share of self accounted barter in transactions between businesses. The expenditure increased as well.8 At the same time the cost of servicing the public debt has been reduced in comparison with the plan by 2.5 per cent. In addition the government has waived the extensive indexing expenditure items of the federal budget which coupled with other measures led to a decline in spending in 1998 to 14.5 per cent of GDP compared with 18.4 per cent in 1997. There were changes in the financing of the budget deficit (see Table 7.5). August crisis sharply reduced the federal budget revenues, but they were largely offset by operations targeted funding. However, the reduction of liquidity in the economy has limited the choice of sources to cover the deficit, which has led to shifts in the choice of financing. If the first deficit was financed through internal and then external borrowing, after the crisis these funding sources were closed and had to switch to issue financing.9 The result of the policy and the influence of the external factors brought about the elimination of budget deficit just a year after the crisis. For the first time since 1989 there was a budget surplus. 7.2.3

Tax reform

Tax reform was absolutely essential for the Russian economy after the crisis: the access to the overseas capital market was bound and the domestic channels of investment were broken. The main items of tax reform during the two-year period 1999–2001 were as follows: • the reduction of VAT rate from 20 to 14 per cent in 1999 and to 10 per cent in 2000 (this was not realized in full); • the reduction of the tax rate on profits from 35 to 30 per cent, the tax exemption of funds for investment and production;


• • • • •

the imposition of a sales tax at the rate of 5 per cent; the increase of the excise tax (with the exception of oil and gas); the imposition of a flat rate (13 per cent) for income tax; and increase of a property tax; a decrease of the assessments to social funds.

In total the tax reforms consisted of 21 separate bills. The idea of reform to the tax system appeared quite attractive: a reduction of some taxes would lead to an increase in production and would also reduce the levels of tax evasion. However, at first the tax reform had many opponents (including the Ministry of Finance representatives) who predicted substantial drops in budget revenues after the reductions in tax.10 G. Boos, the head of the Tax Ministry in 1998–99, considered the proposed government measures to be ineffective: ‘The program of tax reform isn’t complete. The separate measures as a rule don’t have an effect but lead to sizeable losses for budget.’ At the same time one of the designers of the tax reform and the Deputy Minister of the Finance Ministry in 1995–98, S. Shatalov, believed that ‘the realization of measures altogether would result in decrease of tax burden at 2 per cent GDP yet in the first year’. In economic theory the trade-off between tax rates and tax revenues is described by the Laffer Curve (Wanniski 1978). The Laffer Curve itself does not say whether a tax cut will raise or lower revenues. Revenue responses to a tax rate change will depend upon the level of the tax rate. If the existing tax rate is too high then a cut in tax rates would result in increased tax revenues. The economic effect of the tax cut would be positive. The proponents of tax cut used as its basis the Laffer Curve and defended their righteousness through citing successful examples of decreases in tax.11 In the event these bleak prospects were not realized. In practice, the tax reform resulted in positive changes in the economy: the percentage of tax in GDP increased from 4.5 per cent in October 1998 to 7.1 per cent in January 1999 and to 8.3 per cent in April 1999. So good results were achieved as a result of the following factors: • essential decrease in non-cash payments; • the growth of demand for domestic goods as a result of import substitution; • increase of demand for labour; • the restoration of the banking system and the stock market.

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7.2.4


Restoration of the banking system

The 1998 Russian crisis caused more damage to the banks than to any other sector. After customers withdrew their money from banks in the second half of 1998, personal deposits fell 15.6 per cent in nominal value and 52.4 per cent in real terms. The Central Bank cancelled 77 banking licences, that step affected some banks that in early August 1998 had been in the top 100 Russian credit institutions by capital (including Incombank, Russia’s largest private bank at the time). The financial crisis had a strong impact upon the banking system and urged the government to undertake radical measures. Many proposals to restore the stability of the economy were of a populist nature. Nevertheless, the government appeared strong-willed enough to avoid making hasty decisions. From August to December 1998, the Bank of Russia undertook a set of measures to support the banking sector.12 In 1999, a state corporation, the Agency for Restructuring of Credit Organizations (ARCO), was set up. In 2000, 21 credit institutions including SbS-AGRO (that in 1998 occupied the second position by the number of depositors, following the Savings Bank) were put under the ARCO control. Further, measures to restructure the banking sector were combined with the monetary policy. In particular, in the second half of 1999, the liquidity deficit was eliminated, and to neutralize excessive liquidity that threatened the currency market stability, the government used

BOX 7.1 Measures to Tackle the Crisis Measures to tackle the crisis proposed by G. Seleznev, Chairman of the State Duma, after E. Primakov took office as the Prime Minister: ‘Temporarily restrict monetary exchange activities; the Central Bank should pass a document to set a fixed ruble/dollar exchange rate – 7 rubles to the dollar... Negotiate temporary suspension of FOREX credit card operations with western financial organizations to stop the currency outflow... Introduce a temporary ban on foreign currency sales by currency exchange offices. Currency exchange offices should buy dollars, not sell... Commercial banks’ currency should be used exclusively for purchasing foodstuffs, essential goods and medicines’ (Kommersant September 1998).


such instruments as raising reserve requirements and placing credit institutions’ funds with the Bank of Russia (see Figure 7.6). Without a clear support mechanism, the state bailed out selected banks rather than introducing a coherent plan for the restructuring of the financial sector. The Central Bank’s lending activities and purchase of other banks’ debts supported the payment system and defended private deposits. However, the Central Bank made few steps to freeze the assets and gain control over operation of non-viable banks. In early 1999, the Bank of Russia submitted a banking revival plan to the government. According to the IFS estimates, the expenses needed to support insolvent banks would exceed $1 billion, and the total amount of funds required for the re-capitalization of the banking system was $5.7 billion. Around $2 billion would be spent on support of the current liquidity of those banks faced by financial difficulties. In any case, that strategy would not have been accomplished. Later, the Bank of Russia passed many such documents, but none of them yielded any tangible results. In the post-crisis period, there was an improvement in banking performance, in large part owing to the growth of the Russian economy’s macroeconomic indicators. This enabled credit institutions to increase their liabilities, assets and equities (see Figure 7.7).

620

18

570

16 14

520

12

470

10

420

8 6

370

4

Money supply, billion rubles Max-requirement, %

9 r-9 Ap

D

ec -

98

8 -9 Au g

r-9 Ap

D

ec -

7 -9 Au g

D

8

0

97

270

Ap r-9 7

2

ec -9 6

320

Min-requirement, %

Figure 7.6 Money supply and reserve requirement movements Source: CBR.

202


42

6 Assets

Equity

6

40

5 38

5

36

4 4

34

3 32

3

30

2 1999

2000

2001

2002

2003

Figure 7.7 Banking assets and equity movements (percentage of GDP) Source: CBR.

45 40

Corporate loans

Government bonds

35 30 25 20 15 10 5 0 1998

2001

2004

Figure 7.8 Corporate loans and government bonds (percentage of assets) Source: Ministry of Finance.

Russian banks focused on business and consumer lending. The net weight of loans and other funds given to non-financial organizations against total banking assets grew from 28 per cent in 1998 to more than 42 per cent by the end of 2003 (see Figure 7.8). In a context of growing personal incomes, there was a gradual revival in customers’ trust in financial organizations. In 2003, the level of personal deposits doubled, with long term deposits (those invested for more than a year) growing by almost 100 per cent. The Federal Law on the Insurance of Personal Deposits at the Russian Banks that provided


the government guarantees to commercial banks’ customers was an important step to boost customers’ trust in banks. As a result, deposits spread more evenly among credit institutions and the Savings Bank’s status as a monopolist in banking services weakened. However, the core reason for the banking system’s revival was the overall growth of the Russian economy. In the wake of economic growth, banking problems such as capital deficiency, the weak funding of the real sector, poor management, underdeveloped regional banks, old banking technologies and a lack of proper monitoring had not produced enough reforms of the Russian banking system and indeed the entire Russian economy. These problems caused the 2004 financial crisis and also undermined the stability of the Russian economy in 2008.

7.3 The debt burden easing after the default 7.3.1

The internal debt

The events of August 1998 actually removed the problem of domestic ruble debt from the federal government agenda. Approximately 70 per cent of commitments with maturities in 1998–99 were declared in default and the remaining tenders have been frozen until January 1999. In a context of 85 per cent inflation, the financing of these tenders was no longer a problem. Eugeney Kovalishin and I estimated (Vavilov 1999) that the amount of losses by the investors from the exchange of Short Term Federal Loan Bonds reached 95 per cent of the original investment.13 In fact, domestic debt has ceased to have any significant impact on the government’s finances. In January 1999, only five months after the announcement of the default, auctions of regular ruble government bonds resumed in the secondary market. However, liquidity was a serious problem in the Short Term Federal Loan Bonds market due to the narrow range of tradable securities and the reluctance of large investors to return to the Russian market. In addition, the profitability of the Short Term Federal Loan Bonds market was confined to a range by the monetary authorities (investors had no opportunity to bid higher than the maximum yield to maturity or lower than the minimum level of income). Gradually, against a backdrop of positive dynamics in the Russian economy, the rate of return of government securities declined and by the early 2000 it had dropped by 20–55 per cent per annum (see Figure 7.9).14

204


250 200 150 100 50

Ja nM 95 ay Se 95 pJa 95 nM 96 ay Se 96 pJa 96 nM 97 ay Se 97 pJa 97 nM 98 ay Se 98 pJa 98 nM 99 ay Se 99 pJa 99 nM 00 ay Se 00 p00

0

Figure 7.9 The dynamics of returns of government bonds in 1996–2001 (per cent per annum) Source: CBR.

Table 7.6 The debt burden on the Russian economy before and after the crisis (per cent)

Foreign debt/GDP Internal debt/GDP Foreign debt/export Foreign debt/federal budget revenues Internal debt/federal budget revenues Internal debt service/ federal budget revenues

1997

1998

1999

2000

2001

31 22 131 251

58 22 181 543

83 14 188 658

57 9 128 367

42 7 128 238

174

202

108

56

42

30

22

12

5

4

Sources: Ministry of Finance, Ministry of Economic Development, estimations by IFS (Vavilov 2003)

The default on government obligations and negotiations led to a substantial reduction in the burden on the budget for domestic obligations (see Table 7.6). The rehabilitation of the market has been hampered by the difficult situation of major banks – the very banks that before the crisis had held the bulk of the states’ domestic debt. Moreover, the failure of the Ministry of Finance in organizing the new issues of securities was owing to the large gaps between the different estimates of inflation made by


the government and the investors. At the beginning of 1999 the government insisted on keeping inflation below 12 per cent per annum, while the market estimated inflation would be around 20 per cent. As a result, the Ministry of Finance, as the result of institutional constraints, could not sell debts with a high nominal yield, but investors were unwilling to buy the paper under virtually negative real interest rates. Subsequently, the authorities were repeatedly forced to revise upwards their forecasts of inflation, but the official forecast still lagged significantly behind the estimates of the investors. The capacity of the rubledenominated debt market grew hardly at all. 7.3.2 The negotiations Let us consider the policy of public debt management as actually implemented by the government in 1998–2001. Immediately following the announcement of default, the Russian government began negotiations on the restructuring of the sovereign debt with its creditors and by the end of 2000 three key agreements had been concluded within the framework of restructuring the former Soviet debt. The first agreement on the restructuring of the Soviet debt was reached in August 1999 with creditor-members of the Paris Club.15 The Russian authorities intended to conclude an agreement on the universal restructuring of debt obligations by 2001 when the question on debt servicing faced the Paris Club again. In January 2001 the government even unilaterally refused to resume payments to the Paris Club, demanding that creditors restructure the Soviet debt. However, the strong position of Russia’s balance of payments made it impossible to achieve an understanding on the part of the creditors and soon the government was forced to resume payments in full. A key criterion determining the need to restructure foreign debt is the ability to pay. In negotiations with the Paris Club the key indicator was the balance of payments. As a rule, creditors consider the reserves of the Central Bank to be the key source to cover debt payments. In late 2000, an absolute majority of forecasts of the balance of payments for Russia, including the forecast of the IMF, were so optimistic that creditors saw no problems in Russia servicing and redeeming its debts. These forecasts proved accurate as the volume of gold and currency reserves approached $40 billion in the fall of 2001. In contrast to the Paris Club, a universal agreement was reached with another large group of foreign creditors, the London Club (we discuss the effectiveness of this restructuring in an appendix to this chapter).16 The restructuring scheme provided for write-offs, according to some

206


estimates up to 40–50 per cent of the debt. Debt reduction was achieved both by direct write-offs of $10.5 billion of the nominal value and by the gain received as a result of the interest rates on the new securities being set below market levels. The Russian government obtained an additional gain by extending the time periods for the redemption of debt obligations. The new Eurobonds term became a 30-year period with seven years’ grace instead of 15–20 years left before the redemption on the old debt obligations. In addition, the internal currency bonds17 of the third tranche (with a nominal value of $1,300 million) were exchanged for a parcel of new securities within the framework of the default resolution of November 1999. Investors had a choice between a parcel of an eight-year currency obligation similar to the internal currency bonds and of four-year ruble papers with a coupon rate of 15 per cent in the first year and 10 per cent annually in subsequent periods. Creditors’ losses as a result of the proposed restructuring scheme turned out to be relatively small (when compared to the restructuring of treasury bills and federal savings bonds). This was the reason the Finance Ministry completed the exchange on 30 November 2000, when it had originally been announced as undated. 7.3.3 The external debt In contrast to the domestic debt, the rapid accumulation of external debt (denominated in foreign currencies) immediately before the crisis, coupled with the devaluation of the ruble, created a significant problem. The devaluation increased the burden of this debt. It created a serious challenge for the government, that of servicing this external debt post-crisis.18 The default on the majority of the external debt19 did not solve the problem of debt burden – it merely transferred the burden from one phase to another. At the forefront of the challenge came the restructuring of the defaulted obligations. Many Russian economists and politicians suggested solutions for addressing the debt problem. There had been quite a wide range of expressed positions: some spoke of the urgent need to obtain a full debt cancellation from the creditors, while others proposed making payments in full even ahead of the original schedule. The Russian government was supportive of the negotiations about the debt load. But there were some factors which prejudiced the chances of achieving progress in negotiations about the restructuring of the Russian debt, including the necessity to negotiate with all of the


creditors, the different terms of the loans, the length of the process and so on. In addition, the improving macroeconomic indicators made any agreement to write off part of the commitments increasingly difficult. However, by 2000 the debt burden had declined significantly as a result of the combined effect of several factors: the de facto abandoning of government to issue new securities, the restructuring of the existing debt, the strengthening of the ruble and the resumption of economic growth.

7.4 Conclusion After examining the influence of various factors (including the government measures) on the Russian economy in the post-crisis years we can identify several important aspects of future development: • Devaluation of the ruble changed the very economic system and the conditions of its functioning. Typically, the fall of a currency provides only short-term improvements in trading positions, allowing the growth of production but not sustained economic growth. Global experience shows that a country could not achieve significant progress in economic development solely through a weakening of its currency (Morley 1992). Rather the beginning of growth is usually the result of the increase in domestic consumer demand and the inflow of foreign investments in production. The Russian experience justified this theory. • The economic growth in Russia in 1999–2001 can be described as a recovery (Bazarov 1925; Groman 1925). The principal feature of this growth was not related to the investment activity of business entities but was based largely on using the existing production capacity that remained idle because of the lack of demand or the general political or economic instability. More detailed analysis of given processes was presented by Russian economist Yegor Gaidar (Gaidar 2003). The recovery is characterized by rapid growth, but as the spare industrial capacity is exhausted, there is a slowing of the rate of the growth. Usually after three–five years, without any new impetus for development, such as a strong flow of foreign investments or structural reforms, the growth rates fade and attempts to support them could lead to macroeconomic imbalances. So far only a few countries (this applies especially to the Baltic countries, as well as Azerbaijan, Armenia and Albania) have managed to avoid a more serious crisis while maintaining recovery growth (IMF 2003).

208


• The economic policy of the Russian authorities was not the catalyst for the growth; it just stood to one side, transferring the problem of restructuring for sustainable and durable economic growth into the future. The economic actions were individual reactive solutions, specific objectives of the macroeconomic and structural policies. Nevertheless the authorities tried to adhere to a certain set of principles and these principles played a significant role in the further development of Russia, namely: ○ A responsible fiscal policy has become the most important contribution of the authorities to the maintenance of sustained growth in the period since 1998, starting with the 2000 federal budget which aimed to achieve a balance or a surplus regardless of fluctuations in oil prices. ○ Macroeconomic stabilization and the consolidation of state power in 1999 markedly reduced the economic uncertainty20 and contributed to lower inflation, and the restoration of investments in 2000 and especially 2001, particularly in the oil sector. ○ The tight fiscal policy also contributed to the sterilization of the inflow of foreign currency as the result of a significant surplus on the trade balance. Otherwise it would have led to a significant increase in the ruble rate or to a rapid growth in the money supply. ○ An important role in the rebuilding of the economy was played by the tax reform. The simplification of taxation has contributed to its effectiveness, reducing the distortion of economic activity. Many tax rates were significantly reduced and the tax base was expanded. The result was a weakening of the incentives for tax evasion. ○ The open discussion about possible consequences of the (proposed) measures helped expectations about the sustainability of the credit institutions amongst the citizens and led to a cooling of the rising inflation. This largely prevented the spread of panic in society and protected the financial system of the country from a widespread bankruptcy. ○ In addition, the balance of power at the time, engaged in efforts to further develop the economy, led to balanced decisions with regard to both short- and medium-term economic goals. In conclusion, it can be seen that the key factors that held the Russian economy from collapse have been the significant devaluation of the ruble, the debt reduction in August 1998, as well as the Central Bank and the government of the Russian Federation’s pursuit of a restrictive


monetary and fiscal policy. As a result, as early as 1999 – just one year after the crisis – instead of a fall in GDP there was a 3 per cent GDP growth rate.

Appendix A7.1: Restructuring of Obligations to the London Club In this section we offer a short analysis of the restructuring of the obligations to the London Club, which was approved by creditors in the first half of February 2000, primarily to provide an idea of possible ways to estimate the effectiveness of different restructuring mechanisms. Let us recall that the sides agreed to write off 37.5 per cent of the principal debt (PRIN) to the London Club, estimated at $22,200 million, within the framework of restructuring debt obligations to the club. The accumulated debt in interest payments executed as IAN ($6,800 million) was written off to the tune of 33 per cent. Instead of Vneshekonombank bonds, investors received 30-year Eurobonds with 2.25 per cent coupons in the first half-year, 2.5 per cent in the subsequent six months, 5 per cent in the next six years and 7.5 per cent annually beginning with the eighth year. The grace period (when Russia will pay only interest) was seven years, at the end of which the principal debt will also be depreciated. The schedule of nominal debt redemption at first provides for a growth of payments in 2007–08 from 1 per cent to 8 per cent in 2019 and the 2020s with a subsequent decline to 1 per cent in 2025–30. The debt on overdue interest payments, which on 31 March 2000 stood at $2,800 million, was restructured into 10-year Eurobonds with a six-year grace period and 8.25 per cent coupon annual income. A 9.5 per cent payment was made on the latter bonds at the time of their issuance. According to the Finance Ministry’s estimates, the overall reduction of Russia’s debt burden, with due account for falling interest payments and the difference between market discounts and coupon rates, was about 50 per cent. The IMF’s estimates in this field were rather more conservative; according to the fund’s experts, the actual debt relief was about 40 per cent. On 11 February 2000 (the last trading day before the agreement was concluded) average bond prices were as seen in Table A7.1. In the course of talks, Russia agreed to terms that were increasingly profitable for creditors and the quotations of its debts to the London Club rose. Moreover, market restructuring (offering of new Eurobonds to existing creditors of the London Club in exchange for bonds of the

210


Table A7.1 Initial data (per cent)

Eurobonds (USD2028) PRIN IAN

Price

Yield before redemption

78,8150 19,3125 22,0625

16,22

Source: Interfax.

Vneshekonombank in goodwill) would have saved a lot of time and money spent on the negotiations as a result of which Russia agreed at best to market terms. Of course, the market restructuring also involves a number of problems, the most important of which is that in placing a large volume of new Eurobonds the yield might turn out to be higher than observed currently for similar papers; in their turn, the prices of traded PRIN and IAN could begin to grow immediately after the announcement of their restructuring terms. But several comments should be made in this connection. First, Russian Eurobonds at the time when the agreement was concluded were obviously undervalued – the effects of the default on Soviet debt in August 1998 were still felt. The fact that the influence of this factor has been continuously declining is reflected in the steady growth of prices for existing Eurobonds of the Russian Federation. A year after the conclusion of the agreement on the restructuring of debts to the London Club, the yields of Eurobonds to be redeemed in 2028 fell to 15.3 per cent, and the yields of bonds issued in the course of restructuring (redemption in 2030) to an annual 15 per cent and the yields of both instruments fell below 15 per cent per annum. As to the debtor’s solvency, the ability of the Government of Russia to service the new Eurobonds, even with coordinated (i.e. maximally possible) write-off volumes, did not provoke any doubts among creditors – otherwise the latest talks with the London Club would have been continued. Second, the yields of obligations to the London Club existing at the time of the negotiations reflected the creditors’ real misgivings regarding the proper servicing of this debt. Offering a certain prize to investors during the exchange (as a result of the talks the prize actually provided to investors was already about 25 per cent) and, at the same time, adhering to an uncertain position regarding the servicing of the original debt to the London Club, it would be possible to prompt at least some of the investors to restructure less reliable papers (in this case Vneshekonombank bonds) into more reliable bonds (Eurobonds of the Russian Federation).


Investors subsequently had every chance of growing, and a considerable proportion of the PRIN and IAN holders aiming to obtain profit from rather risky investments in debt obligations of developing countries would obviously prefer to keep the obtained Eurobonds. Meanwhile, those who refused voluntary restructuring would take upon themselves extremely high risks: the government could decline to pay for the de facto subordinated obligations of the Vneshekonombank, and the split among the investors, introduced by voluntary restructuring, would considerably weaken the club’s possibilities of applying political pressure against Russia. In addition, the Russian authorities would demonstrate real work with the public debt, which would have a positive effect on future borrowings and would accelerate Russia’s entrance into world capital markets. Incidentally, the exchange of internal currency bonds 3 carried out in 1999–2000 occurred virtually on market terms and proved to be relatively successful. Rough estimates showed that before the declaring of default internal currency bonds 3 were traded at a price equal approximately to 35 per cent of par value, while in February 2000 investors received new bonds of the same kind to be redeemed in 2007 at a price of approximately 45 per cent. When this sum is discounted back to August 1998, according to the relevant yields of Russian series of internal currency bonds observed at the time (as a result of the decline in the risk of default these obligations’ yields did not differ very much from Eurobond yields with the same redemption periods), both sums turned out to be about the same. In other words, it was roughly the same for the investor to invest in high-risk internal currency bonds 3 before the crisis at an annual yield of more than 260 per cent (and an unknown situation with the redemption of these papers) or to obtain more reliable instruments in the course of restructuring, but with a yield of about 20 per cent. The Finance Ministry preferred a different way of solving the problem of obligations to the London Club – long-term talks. But essentially the coordinated option, if it did not infringe on Russia’s interests, certainly was not exclusively positive: the investors imposed terms that were sufficiently advantageous for them. If the position of investors turned out to be unexpectedly tough for the Finance Ministry, the question arises if it was expedient to step up the negotiation process. Incidentally, right after the restructuring terms were announced PRIN and IAN quotations rose by nearly 25 per cent; such was the prize, as estimated by the market, which the Russian government bestowed on creditors (at the new price level calculations according to the scheme described

212


above provide for optimal write-off at precisely the level proposed by the Finance Ministry). Exclusively from the economic viewpoint, Russia at best achieved market restructuring terms, although it is known that a creditor who has already invested in defaulted papers, as a rule, is prepared to agree to considerably less advantageous terms in order to return at least some of the money (above we have already analyzed this fact using the simplest theoretical models). It is obvious that political considerations had a considerable influence on negotiations with the London Club: the forthcoming presidential elections – the need to reduce international pressure on Russia and so on. But it should not be forgotten that debts are paid by future generations, and the choice that is made must take into account their interests as well. Russia already had the unfortunate experience of the ‘one-time’ restructuring of Soviet debts, and it is necessary to take this into account. Regular restructuring carried out once every five–seven years is bad form to say the least.

8 Yet Another Crisis, 2008–2009

Introduction We are writing this book in the midst of a severe crisis which began in Russia in 2008 and was probably still in place at the end of 2009. As always, the future is uncertain. The shape of the recovery is not yet known. While some cautiously forecast 1–2 per cent GDP growth in 2010, many analysts are already predicting growth of as much as 5 per cent. In this chapter we will try to find some parallels with the 1998 crisis and outline the main features of the current crisis. The 1998 crisis is already history, and most of its causes and consequences are clear enough to us now. Some lessons were learned, some were forgotten. The current crisis has caused a severe recession. We cannot be sure of the ultimate consequences of this crisis at this point as it is still unfolding. We can, however, attempt to answer two important questions. What are the primary causes of this current crisis? And what should be done to prevent such events in the future? The crisis was haphazardly tamed, but all the main imbalances are in place, and the same crisis could occur at any time. Our key assumption is that the 2008–09 bust was caused principally by a dual (or even triple) external shock. It is also apparent, however, that some features of the pre-crisis development period helped to determine the sharp slide and the weak recovery of the economy. Without understanding these particulars it is difficult to understand and to predict the future course of Russian development, as all the main features of the system persist. Despite the widespread belief that the government provided ample security support and conducted prudent management of the resource boom (see EBRD 2009) we believe there was much to be done to prepare for the crisis and we could expect better anti-crisis measures. 213

214


8.1 Two crises: how much in common? For many transition countries, particularly in CEE and CIS including Russia, the current crisis had much in common with the Asian Crisis of 1997. Again the key problems were a reversal of capital flows, and a bust in the asset markets, but public sector fundamentals had little relation to the onset of the crisis. The Russian crisis of 1998 was a rather different story (the crisis was mostly home-grown). We are quite certain that this crisis was driven mainly by external factors. Yet it should be noted that some of the internal problems persisted through years and predetermined the steepness of the decline. The effect of the crisis in 2008–09 was not equally devastating: for example, the public sector was clearly less adversely affected. There were sharp drops in both production (⫺15 per cent yoy at the end of 2008, ⫺13.4 at the end of 2009) and consumer demand, and GDP fell by 7.5–8.7 per cent in 2009 (IMF and WB estimates),1 but there was room for contraction as Russia grew rapidly before the crisis and economic agents (households, firms, authorities) managed to acquire reserves. It marked the collapse of an overheated economy, the end of an unsustainable growth path based on an energy price bubble, groundless investments and overborrowing. To summarize, the main similarity between the two crises was the oil price slide effect, whereas the main difference was the source and the magnitude of the sudden stop in capital flows. 8.1.1 The debt problem is still important In 1998, the crisis was associated with the previous accumulation and mismanagement of public debt and was triggered by the negative shock to the terms of trade and the sudden reversal of capital inflows. In 2008–09 it was mainly about private debt, as the level of public debt was substantially lower. On the brink of the acute phase of the crisis, in October 2008 the total (public and private combined) debt equalled US$548 billion, or 39 per cent of GDP. Nearly 90 per cent of this was private debt. But the structure of the debt was somewhat unconventional due to the large role that the state played in the economy. By our assessment, US$190 billion could be described as quasi-government and public debt combined.2 During the crisis the total amount of debt fell to 33 per cent of GDP. The shares of private and public debt remained almost the same. The government says there was no problem in relation to public debt. We do not accept this. The problem of public debt (which was central to

Yet Another Crisis, 2008–2009 215

the previous crisis) was transformed substantially, and Russia faced even greater amounts of short-term quasi-sovereign debt in 2008. We term quasi-sovereign those debts that could be attributed to firms with large public stakes with explicit or implicit bailout guarantees. Being the key final beneficiary, the government could be forced to provide a bailout to such firms in order to prevent the loss of the stake – or even bankruptcy. However, the policy of providing implicit bailout guarantees is tricky. It was shown in the literature that such guarantees encourage overinvestment, booms in asset prices and discourage firms and households from hedging their foreign currency exposure. The concept of quasi-sovereign debts is rather vague, as officials may ex ante always claim that the government will take no responsibility for the particular firm’s debt but break the promise ex post. In the Russian case the use of this concept was rather fruitful, as ex post it was revealed that government was quite ready to act as a lender of last resort (LOLR) for these companies.3 Unlike in other countries, banks by themselves were not initially at the core of the problem as the level of total adjusted book liabilities to GDP was quite low: 17.6 per cent in Russia against 90.4 per cent in the US or 393.5 per cent in the UK. So the main risk factor was quite different both from the previous crisis and from the current crises in other non-oil-exporting countries. Before the crisis the government was reluctant to pay enough attention to the growing amount of quasigovernment debt. Instead it was adjusting the balance of payments (BoP) in other ways. Pushed by the sometimes irrational political and prestige considerations of the Kremlin and at the same time lacking influence over major Russian corporations, the Ministry of Finance advanced with the repayment of the public debt in pre-crisis years of budget plenty. Top officials boasted internationally that the country had solved its inherited debt problem. Of course, this policy failed to solve the core problem of dependence on external financing, although it made easier to adjust to the crisis to several sectors, most notably to the banking system. The corporate sector was equally carefree, intending to continue to borrow, but failing to work out the perspective for global and local credit tightening. When the global credit crunch occurred, firms found no possibilities to restructure or to refinance debt. Instead, they faced margin calls as a result of the diminishing value of collateral. Capital markets froze and external bonds markets were closed, even for first-class Russian debtors for almost nine months. When they opened again in April, Gazprom sold US$2.25 billion of bonds. The oil giant Lukoil became the first

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private firm to borrow on the market in October 2009, after a drought that had lasted 15 months. 8.1.2 The external sources of the crisis and alleged immunity to the global bust The external shock of 1998 (when the price of oil fell by almost half ) was destructive as it hit the Russian economy at the end of a period of chronic shortage of exports revenues (a long period of low energy prices) and was accompanied by the sudden halting of capital inflows as a result of the aftermath of the Asian crisis and the stockpiling of short-term debt. The authorities had limited possibilities to deal with the shock as they had few reserves and the economy was weak for years after the transformation. On the contrary, in 2008 (and in fact for the ten past years) the preexisting condition was stable, with enormous windfalls partially accumulated as official fiscal and currency reserves, and partially dispersed through the economy as rents. Then the triple shock (cheap oil,4 negligible capital inflows, collapse of the world trade) came. There was a widespread belief that this time everything was different for Russia. The government and independent analysts stubbornly maintained their positive outlook: 2009 GDP growth was 6.7 per cent and 4.9 per cent respectively in October 2008 when the crisis gathered pace.5 Many observers, both inside Russia and elsewhere, believed in decoupling; that the rest of the world was less tied to the US economy. Russia seemed to many a country that could meet a crisis fully armed: accumulated reserves, twin surplus, low public debt, a relatively small financial sector, not loaded with derivatives. The common approach could be illustrated by the following quotation: ‘The limited effects suffered so far by Russia from the wave of financial instability that began in August 2007 – a far cry from the 1998 crisis (while recognizing the remaining structural fragilities of the Russian banking system) – also demonstrate how much the country has changed’’ (De Souza, 2008).6 The common belief, at that time, shared by many academicians and practitioners, was that Russia was likely to be immune to the global crisis as its roots lie in the real estate bubble,7 but of course the impact of flight to quality and the liquidity crunch was not anticipated, as few predicted even these events by itself. The magnitude of the shock was also underestimated: the most pessimistic forecast still had the underlying price of oil at a higher level than the actual spot price at the end of 2008. In 2008, Russian authorities were busy with anything but the proper preparation for the coming crisis. Russia and other oil-exporting


countries kept complaining about US economic policies, blaming them for the upcoming financial crisis, yet at the same time desperately wanted to continue to sell oil to the West at the highest possible price. One could label this an economic cognitive dissonance. Prior to the crisis, the government was puffed up and in earnest argued the necessity to adopt a detailed development strategy until 2020. So they were not concerned. Households and firms also demonstrated high levels of optimism. Economic theory states that if a country experiences a consumption boom (that is, the savings rate is comparatively low), its financial and banking sectors are weak and unable to cope with inflows of money and also a real exchange rate that is appreciating, then the country will be vulnerable to sudden stops and reversals of the current account (Roubini and Wachtel, 1998). In hindsight it is clear that all these factors were present in the Russian case, but few paid due attention to them. A constantly appreciating ruble under the managed float regime led to growing levels of imports, and large loans taken by banks and corporations in the (right, but not everlasting) premise of the ongoing revaluation of the national currency caused large interest payments. Higher volatility could frighten off some carry-traders. These two factors are crucial to an understanding of the tendency to cut back the current account. So even on the brink of the crisis Russia’s financial stance seemed to be impenetrable, not invulnerable. The sustainability of the current account was undermined and the out-of-bounds triple external shock was simply too heavy for the economy to cope with. We want to stress that external factors were key to the onset of this crisis – the Russian bust has not come out of nowhere, but was caused by the extraordinary global slump. At the first stage of the crisis even Russian authorities refused to admit the obvious. They denied the possibility that Russia would be affected. Even the C-word itself was banned, and officials used a wide range of euphemisms (difficult circumstances, temporary decline, and so on) to colour the truth. Finally, one of the deputy Ministers of Economic Development (Andrey Klepach) finally admitted that, probably, Russia was in recession. 8.1.3 Internal fragility In 1998, the crisis was mainly about Russia’s significant dependence on oil revenues and public debt and budget mismanagement. The crisis of 1998 hit a weak and unstable economy, that was still suffering from the transformation shift from planned to market conditions.

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In 2008 the risks associated with debt were transformed, and, generally speaking, Russia displayed characteristics that were seen on many occasions in middle-income ‘emerging markets’. Budget mismanagement was still the case in the form of pro-cyclical spending, and significant credit risks, such as, for example, large ‘hidden’ collaterals of the owners of the firms. Self-assured owners of domestic firms provided foreign banks with such large collaterals that when collateral values began to fall and banks demanded to adjust it, this triggered the collapse. Few expected that the ‘oligarchs’ could fail to meet margin calls. It became apparent that the economy was even more encumbered with debts than had been realized before. However, the richest people were not the only ones to blame. As in 1998, Russian monetary policy had a fallacious focus on exchange rate stability (although not in the form of a nominal anchor) and thus eliminated the fluctuations of the ruble exchange rate. Of course this time the conditions were reversed as the current account was large and positive and the Bank of Russia fought against the appreciation of the ruble, not devaluation. The Central Bank was under constant pressure from the president, the government and also various industrial lobbyists to prevent a revaluation of the ruble’s real exchange rate, but it was moving in a vicious circle. The CBR bought dollars to protect industrial competitiveness, and growth of the monetary base increased inflation, which caused further real exchange rate appreciation. Taking this into account, ex post the policy of ruble guided floating was not adequate as it encouraged substantial foreign-currency borrowing by banks and corporations. In hindsight it is quite clear that before 2008 two main signs of a classic case of an upcoming twin crisis were in place: ruble real exchange rate appreciation and a credit boom (for years the real average rate for loans was negative). At the same time, the other fundamentals were sound: strong BoP and budget surpluses were backed by the boom in commodity prices, so few paid attention to the growing risk. The boom took the form of a liquidity-driven bubble in commodity markets, fuelled by low interest rates in the US. This became the source of high prices for Russian tradables (principally raw materials and ferrous metallurgy production). On the one hand, the external conditions were rather different: up to this moment, there were no international crises in recent history that came as a result of the lender’s inability to finance. On the other hand, there was nothing new about falling prices for oil on the brink of a global recession. The problem was that the possibility of such a recession was being substantially underestimated.


It appeared that export-led, investment-driven Russian growth was unsustainable. When the prices for energy resources were high, the economy thrived. When oil prices fell, private expenditures and investments had to be cut back. The collapse of oil prices and gas consumption made it evident how dependent Russian economy was on oil and gas. Of course, this result was mostly predetermined by the inherited Soviet industrial structure and ‘rent addiction’, but that is only a part of the story: weak institutional reforms, a bad investment climate and the poor preservation of property rights should also be blamed. Another example of fragility is that less global, yet still important, Russian firms accumulated unusually large proportion of inventories during the period of boom (one-third of GDP).8 Many domestic managers were over-optimistic and overestimated future final consumer demand. To some extent the building up of massive inventories allowed the boom period to persist: factories still filled storehouses when it was time to stop. The build-up gave way to temporary inventory adjustment, but the difference between gross and fixed investment implied that the inventory contribution to the contraction of real GDP was around 10 per cent. The vulnerability of the economy became evident immediately after the initial slump caused by the credit crunch and export contraction. Then Russia experienced stagnation characterized by depressed consumer spending and low investments. It turned out that without external backing the economy’s engine is not working. 8.1.4 Perpetual weakness of the financial system The main Achilles’ heel of Russian development between the crises was an inadequate financial policy which contributed to the preservation of the under-developed financial system. It is quite large in comparison with Russia’s neighbours: by EBRD’s estimates9 its size is nearly 160 per cent of the GDP, whereas the financial system of Poland is 97 per cent of GDP and that of Kazakhstan is just 74 per cent. At the same time, its size is relatively small when compared with other developing countries: for instance, Thailand (190 per cent) or South Korea (300 per cent). Over the same period the Russian banking sector was growing rapidly, with its balance sheet expanding from 40 per cent of GDP in 2004 to 65 per cent in the end of 2008. The backbone of the banking sector remains Sberbank and VTB,10 ill-managed sluggish public institutions, largely driven by a political agenda, rather than by considerations of effectiveness. Numerous private banks have less effect and despite the fact that some of them are owned by foreign banks,11 their importance is small when compared

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with the state-run banks. Current capital adequacy (the capital to private debt ratio) is around 10 per cent, but in many cases capital is blown up. The Russian government is reluctant either to allow foreign banking capital to determine the shape of the Russian banking sector or to privatize dominant state-run banks. Without reforms or even regulatory pressure, the domestic banking sector had no chance to become the main mechanism of sorting viable investment projects from bad loans, and the self-fulfilling mechanism of the credit boom contributed to higher inflation, resulting in negative deposit rates, a lower capital base and an even greater dependence on wholesale financing from abroad. The programme of improving the capital base and the consolidation of the financial system (planned 2010–12) was late. International experience (Turkey provides a good example) shows that the banking sector could be strengthened quite quickly. The future choice for the authorities should be quite clear: provide a strong banking system or forget any hopes for the diversification of the economy. Other components of the Russian financial sector were no better. Thin and underdeveloped markets for corporate bonds and domestic public debt are clearly unable to cushion external shocks. The thin stock market (see Box 8.1) is also a problem. At the same time, weak and unsophisticated banks were loosely related to external derivative markets and so Russia had one fewer source of contagion: contrast to the situation in developed countries, balances were not overloaded with MBS, ABS, etc. Instead, Russian non-performing loans (NPLs) were mostly represented by overdue corporate debts, which grew rapidly during the deterioration phase. As Russian accounting rules allow for excessively flexible treatment of bad loans and the courts are clearly unfriendly to creditors, we can mostly observe loans restructuring and prolongation instead of credit resumption. Overdue corporate loans were quite stable at 4.5 per cent12 of the loan book of the largest banks. There are no credible estimations of the NPL to GDP ratio, but the second wave of crisis is often linked to a rise in this measure. It’s still unclear how it will play out, but the danger of Japanese-style lock-up (characterized by sluggish economic growth and prolonged tight credit conditions) could be a long-term danger. Inflation will diminish the acuteness of the problem, however. Sometimes the rescheduling process was rather strange: some firms received lines of credit from a state-run bank immediately after defaulting on another credit from a different state-run bank. Prudential regulations are satisfied, but the real picture is a bleak one. Inadequate practices of concealing bad debts did not encourage overseas bankers and the volume of syndicated credits inflow fell 10 times.


BOX 8.1 Spurious Russian Market: All Shades of Grey Upbeat markets always lure investors, and usually (as in case of Russia) there are significant premiums for different country-linked risks. Figure 8.1 shows that if one could invest in Russia at an early stage, this would benefit significantly in comparison with the general world stock market. The Russian market was one of the favourites for investors until mid-2008, when stocks began to collapse. This meltdown resulted in an 80 per cent fall in the value of the economy, represented by shares. The World Bank admitted: ‘Russia’s stock market in that period performed worse than most other countries, and its sovereign spreads were unusually high – despite strong pre-crisis macro fundamentals.’13 After a while, following a recovery on the commodity markets capitalization began to rise and on September 2009, Russian stocks were again among the best emerging market performers. Gains in the Russian equity market were particularly strong in March and April, outperforming other emerging markets. For example, the exchange rose 27 per cent over the month of March 2009. The Russian stock market was one of the fastest-growing sectors of the world economy over recent years, increasing 18 times since 2000, and a great amount of speculative ‘hot’ money flooded

3.60 MSCI World

RTS

3.40 3.20 3.00 2.80 2.60 2.40 2.20

9 -0 Ja n

-0 8 Ja n

-0 7 Ja n

-0 6 Ja n

5 -0 Ja n

-0 4 Ja n

-0 3 Ja n

-0 2 Ja n

-0 1 Ja n

Ja n

-0 0

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Figure 8.1 Russian Stock Market vs. MSCI World, 2000–2009 (in logs) Sources: RTS; Bloomberg; author’s calculations.

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onto the market. This process seemed more or less rational against the background of improving ratings, a positive current account and the stable overall macroeconomic situation.14 However, despite higher yields and sound fundamentals, another important case for the flourishing state of the market was the enormous inflow of ‘grey’ money from the informal sector of the economy. We would like to warn against the Russian stock market by paying attention to its disadvantages, which tend to be overlooked by those who neglect important institutional features of the particular economy in their search for easy money. Until recently, many observers cherished hopes that the Russian stock market was absolutely different from the situation in the 1990s. According to this widespread belief, Russia has gone from being a speculative bubble to become a real investment case. They have seen that the Russian banking system since the 1998 crisis was somehow performing the role of a normal banking system (transforming savings and wholesale financing into loans), not just playing stock markets and investing in government securities, so some thought that the stock market had become ‘civilized’ and ‘normal’. After the liberalization of Gazprom shares many western funds decided to invest in Russia, and the stock market continued its strong performance. Morgan Stanley used RTS as one of the components of its widely recognized developing market indices. Normally stock market liberalization and development decrease the costs of capital, which leads to greater investment and increased productivity, at least in the immediate aftermath of the liberalization. Some experts supposed that the Russian economy will continue to strengthen and categorize Russia alongside Brazil, India, and China (the other so-called BRIC economies) as among the world’s fastest-growing economies. But the situation is quite misleading: it can be seen that Russia’s export structure closely mirrors its stock market, with only small-cap companies existing outside the oil and gas and the metals industries. Despite some institutional developments, the Russian market is non-transparent, speculative and fed either by speculative money from major international funds of by grey domestic money. The initial phase of growth occurred in the early 2000s. It came after the rhetoric of Russian authorities led to the widespread impression that property rights had become increasingly secure, and contributed to a stock-market boom which saw the major stock index (RTS) increasing by around 50 per cent per year during 2001–03.


The spread of Russian sovereign debt over US Treasuries declined by significantly more than the average spread for emerging markets in recent years. This also reflected fiscal consolidation and monetary stabilization as well as the global search for yield. Counter-intuitively (if we abstract from rising oil prices) the market continued to grow quickly after 2003–04, when the state exerted dominance over a handful of large businesses. However, consider the intrinsic scheme of this ‘equivocal miracle’: officials extract rents from the budget, accumulate considerable assets and find ways to invest them on the Russian stock and real estate markets. As they do not have a legitimate secure channel for investing abroad, they have a very strong home bias.15 Domestic firms also used external channels to invest in Russia through the backdoor. Sometimes money was first transferred abroad and then returned in the form of foreign investments.16 Another source of money coming to the stock market was the inflow of credits from the Central Bank to state-run and commercial banks: it is clear, therefore, that the recent rally was clearly fuelled by liquidity provided by the monetary authorities. These public-linked rents were either siphoned off the budget or extracted from the corporate sector in exchange for informal protection. Alas, this is the reality of Russian economy, not an exaggeration. The size of the informal sector is extremely hard to measure, but it is undoubtedly relatively large comparing Russia with its peers.17 And as the market was extremely thin and narrow and had very little connection with the domestic economy,18 it was easily inclined to manipulation. Do not forget the absence of the insider trading prohibition legislation,19 take note of the total share of public, state-owned and quasi-public enterprises with large incentives to invest money accumulated through the avoidance of taxes, consider public funds coming to the market through semi-official channels, and then be ready to see moves that are unlikely to be seen on any other market, including many exotic countries. Generally speaking, Russian officials exploited public funds for their own use. Needless to say such an episode would induce an immense scandal in any developed country, but in Russia it is usually misapprehended or neglected. With improvements in budgetary discipline, the possibilities for such illicit profits would vanish – that is why the level of discipline is quite low and why there are no significant signs of progress. The state’s influence on the equity market is not always disguised: sometimes the officials come out into the open. Even during the

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outbreak of the crisis, the government rushed to provide support to the stock market, and this measure was an evident outlier to the usual set of state-run policies. At the end of 2008 the government decided to invest substantial resources from the National Welfare Fund (approximately 8–10 per cent of its volume) in Russian stocks, giving the mandate to buy stocks to Vneshekonombank (VEB) (once planned to be a prospective Development Bank, then acting like an investment agent on the stock market and finally resembling nothing so much as a government purse). In any case, it does not seem normal for a government’s investment arm to act like a hedge fund, daring to gamble with the money of future generations money without any clear reporting in the government’s accounts. Russian officials publicly overstated the probability of increasing the Fund’s portfolio, but in fact it was an unconventional measure aimed to ease the meltdown on the market and to save some ‘oligarchs’ from other upcoming margin calls and help some officials to quit the market on higher levels. A similar story emerged from the Moscow real estate market, when city officials orchestrated an auction to buy up a stock of unsold apartments in order to help developers. The auction appeared to have some apparent signs of collusion. To give you an illustration, just imagine the Federal Reserve Bank of New York directly buying stocks on NYSE or the New York City’s Mayor ordering the redemption of Manhattan penthouses with public funds, not for the benefit of creditors, but to assist the real estate proprietors. Pretty much the same episodes occurred in Russia and unfortunately did not raise any public concerns. Ultimately the Russian market appeared to be a speculative bubble, as in fact many had predicted. For example, the investor ‘guru’ Jim Rogers20 stated: ‘Russian equity markets were overvalued and could burst sooner rather than later, revealing the skeletons in the cupboard of its outlaw capitalism. I wouldn’t put a nickel of my own money in Russia, and I wouldn’t put a nickel of your money there either. When that happens, people will look around and say, how did that happen? That’s when we’ll find out about all the skeletons in the cupboard.’ So why should we pay much further attention when Russian stocks take off or tumble if we are not professional high-risk speculators? There is little evidence that it has any influence or any real links with the Russian economy (although banks’ balance sheets can be


one such channel). Stocks play only a minor role in capital financing in Russia, free float is extremely small. Not only are Russian stock indices bad predictors of Russia’s development; they basically do not reflect anything but the moods of very specific investors (insiders, officials and speculators). Foreign investors should ask themselves, why are Russian stocks doing so well when the economy is so weak? Despite the dreams of reformers in the early 1990s, domestic equity markets are by no means mechanisms for the effective reallocation of capital. In summary, you can see these markets going up and down, but don’t be disappointed when you see that the fundamentals of the economy are reluctant to change: the Russian stock market is about gaming and laundering, not about transformation and modernization.

8.1.5 Inevitable crisis? In both crises we can distinguish three main features that made the crisis inevitable: The first one is the vulnerable structure of the economy (energy export, and labour-intensive industries such as machinery construction). The second one is the low level of expertise among the ruling elite. The absence of decisions or oversimplified rules of thumb are used quite commonly instead of deep analysis and circumspect actions following a clear road map. The third one is the population’s state of actual preparedness to accommodate economic shocks. One important aspect of this is the low level of trust in the Russian economy. From our point of view, the crisis which occurred in Russia was nothing but the most natural thing, a logical consequence of the fundamental flaws in the Russian economy and society. Some call this crisis a disaster, an absolutely unpredictable event that occurred by a pure coincidence of rare exogenous factors. We would like to disagree with this – for three principal reasons. First of all, as we have seen, the collapse occurred as a result of the dependence of the country’s economic growth on oil and gas revenues and wholesale financing through the capital account of the BoP. The entire structure of the economy represented a colossus with feet of clay, and thus the external shock led to a collapse. Second, the crisis occurred due to poor goal-setting and policy making. Year on year we have seen the same pattern: policy makers did not prepare detailed accounts, but rather stuck to the previously chosen policy, neglecting any alternatives. They tried to create the appearance

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of rationality in their decisions through an attempt to be consistent with the earlier choices. In behavioural economics this phenomenon is known as ‘self-herding’ – we would label it economic stubbornness. Such decisions on the part of the Russian authorities made a great contribution to the severity of the crisis. Third, an important factor is the persistent general feeling among Russians that each crisis is a catastrophe, rather than an opportunity. Unfortunately, Russian society seems to have no ‘built-in’ crisis adaptation mechanisms. One of the main reasons for this is the government’s paternalism, which has blocked public initiative for years. We do not say that nothing can help with that: financial proliferation, an improvement of spatial, social and professional mobility possibilities and simply the accumulation of more experience would eventually help. The phenomenon of social-economic dependence from the state goes beyond the bounds of economic theory, being a popular topic in sociology. Sociological research shows that this dependence not only survived the collapse of the Soviet Union, but even strengthened in the 1990s because of the misery of large groups of people and the behaviour of political actors, supporting this sentiment to retain political control. At the end of 2008, half of the Russian population had a ‘pessimistic’ view of the prospects for the Russian economy, anticipating that the crisis situation would persist for years. The mood of the Russian public was agitated by different rumours about the upcoming crisis.

8.2 Anti-crisis policy In response to the shock the government and the Central Bank quickly proposed an enormous programme of budget and monetary stimuli. In this section we consider the actions undertaken by Russian authorities to ameliorate the crisis and to stimulate the economy. We illustrate several notions of financial fragility, overview fiscal and monetary policy but start with ruble exchange rate mitigated depreciation. 8.2.1 A story of two devaluations Devaluation in 1998 was a result of classic sudden stop of hot money inflow, the failure of the dollar corridor, reserve depletion and was protracted and at the same time large and effective. The decision to make the devaluation not as sharp as it could be was made under pressure from the banking system. The pre-crisis infamous Boris Yeltsin’s ‘There will be no devaluation’ expression was well-known. In Autumn


2008 the President’s counselor Arkadiy Dvorkovich had to give the same promise. In 2008–09 ruble depreciation (this began in mid-November of 2008 but the culmination was in January 2009) was caused by a free-fall in the price of oil, the subsequent deterioration of the current account and the sudden end of capital inflows. It is likely that devaluations in neighbouring countries also had some effect. As in 1998, the political decision to devalue the ruble was preceded by a period of the artificially unreasonable stabilization of the domestic currency. This period was of most benefit to the banking system. At the end of the capital inflow stage, the ruble came under pressure from banks which wanted to secure external debt repayments for themselves and their clients. To protect the ruble and smoothen the transition period (and to secure social stability), monetary authorities first allowed the use of reserves, which resulted in a significant loss of them. Between July 2008 and March 2009 Russia lost around 37 per cent of its initial stock of reserves, or 28.5 per cent from the maximum to the end of the year. The reserves ceased to grow in August 2008 when they reached US$598.1 billion. As in 1998, the Central Bank showed its virtually invariable high degree of dependence from the executive branch of power. The gradual decline in the value of the ruble was principally a politically motivated measure. In fact, the government had to draw down reserves to cover private losses and help the banking sector. But the rhetoric used was rather different: first, it was declared that the gradual approach and the loss of reserves was the price of accommodation of the population and the corporate sector to the new state of affairs. Second, the monetary authorities were afraid that such an aggressive move would cause a panic and a serious macroeconomic destabilization. Even if that was to be the case, the price was probably too high and the same results could be achieved with a combination of one-off devaluation and a resolute defence of the new equilibrium in the face of the currency speculators. Most likely in that case Russia would achieve a substantially higher level of reserves and the economy would not suffer from the effect of exchange rate overshooting. During the gradual depreciation the ruble lost 25 per cent against the euro–dollar basket. It was well below the 1998 level devaluation as well as of those in South Korea, Thailand in 1997 and many CIS and CEE countries in 2008. On the contrary, the politically motivated Central Bank of Russia provided large banks with access to ruble resources (see Section 8.2.3) and at the same time allowed them to ravage the currency market. If it had gained any credibility in recent years, this would eventually be

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lost unless there was an improvement in Russia’s external balance. CBR was a central bank that supported currency attack against its domestic currency through ruble financing and gradual devaluation. Quite an unusual experience, isn’t it? President Dmitry Medvedev, Prime Minister Vladimir Putin and the governors of the Central Bank fiercely defend this ‘gradual’ decision, and we still believe it was a mistake. Russian authorities unreasonably set their hopes on official reserves and predictably allowed the overuse of this resource. According to Aizenman and Sun (2009), only half of the emerging economies drew down their reserves as part of the adjustment mechanism during the current crisis. A lack of prudent economic assessment should also be blamed. The authorities did not take into account the possibility of a massive outflow of capital (more than US$130 billion) and subsequent currency crisis. This possibility was not presented in any known survey or scenario. The use of independent expertise could eventually cost less than multi-billion losses resulting from a feeble attempt to save a handful of inefficient banks. 8.2.2 On Russian fiscal stimulus In 1998, the initial impulse of devaluation was so large that all subsequent measures were secondary. Evgeniy Primakov’s government abstained from any policies and thus stabilized the economy better than was expected. On the contrary in 2008, entering the crisis with pockets full of laid-up reserves, the Russian Federation entered the international fiscal 10 8 6 4 2 0 ⫺2

2006

2007

2008

2009

⫺4 ⫺6 ⫺8 Figure 8.2 Budget surplus/deficit in Russia, 2005–2009 (per cent of GDP) Sources: Ministry of Finance; IMF.


stimulus21 challenge. Russian fiscal policy made a sharp turn: the difference between the surplus in the last pre-crisis year (2007) and the deficit of 2009 was dramatic: the gap was 13.1 per cent of GDP (against the G20 average of 5.9 per cent). Of this amount, 4.1 per cent was related to discretionary measures (twice the average), and 9.3 per cent for other factors, mainly declining tax revenues as a result of the shrinking of tax bases and weakening compliance. Along with actions aimed at preventing the collapse of the financial sector, the government developed a large set of measures, including previously adopted tax breaks, increases in social payment (mainly through pensions), an increase in public demand for goods and services (particularly in the defence sector, agriculture and the car industry). Low budget incomes and large spending naturally resulted in a large projected budget deficit in 2009 (projected as –6.6 per cent by the IMF). Regional budget gaps were financed from federal transfers. However, the stimulus package, unlike in some other countries, was large, inefficient and late. Being by some estimates the third-largest expansionary programme in the world,22 the Russian stimulus was supposed to compensate for the decline in private spending, but, in fact, because of the inefficiency and rigidity of budgetary procedures, it was concentrated in Q4 2009 and failed to become an effective measure. According to the official estimates half of the pledged annual stimulus had been implemented through mid-year, including one-third for expenditures aimed to help ‘systemic’ entities, but these figures reflect funds made authorized but not expended, which is associated with a substantial lag in Russia. It is worth noting that Russia (along with two of its three BRIC counterparts, Brazil and India) abstained from including any investment expenditures into the package. It was a sharp contrast with many other G20 countries which had capital spending as the second-important item of disbursements. Economic theory provides inconclusive answer upon the effectiveness of multipliers but government investment other things equal seems to the one of the efficient measures (see van Brusselen 2009). Even the simplest subsidy programmes were poorly constructed. The Russian car sales subsidies programme was less effective than it could be, being too restrictive in comparison even with highly criticized ‘cash-for-clunkers’ programmes in the West. In both the financial and corporate sectors the government announced the temporary shift to ‘manual governance’ (case-by-case decision making), in some cases building specific production chains. The case of the Pikalevo small industrial complex, where Prime Minister Putin

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personally had to push owners of three private firms to sign an agreement to resume production, was given widespread media coverage. To stabilize the labour market, it was announced that a number of sanctions could be imposed by the government against any firm unwilling to secure working hours for its employees. The government committed to help both large conglomerates and small and medium-sized enterprises, but really only ‘systemic’ firms received any tangible support (even the special list of 295 firms was created, documenting the preferences of the government). The list contained all of the familiar names: Gazprom, Rosneft, Norilsk Nikel, Rusal, Evraz, NLMK, Metalloinvest and many other large firms. We do not believe the Russian stimulus package had much effect on the stability of the economy. It was not in effect when the economy was struggling, and its execution coincided with improving external conditions. The negligible investments share also highlights the inability of using the shock for development. A return to a normal fiscal policy is crucial in future. The government should remember the experience of the crisis and limit the appetites for more budget noninterest disbursements. Otherwise it will continue to feed inflation. The key actions the government should take are related to the return to sound and sustainable budget policy. Budget expenditures should be contained, debt policy should become a rightful part of the fiscal policy agenda, not only in terms of proper public debt management but also in monitoring the external debts of the largest corporations (at least in those where the government has representatives on the boards). 8.2.3 Monetary policy response On the brink of the crisis in Autumn 2008, the Central Bank and the government managed to save the Russian financial system from collapse, despite the fact that the CBR was already in difficulties. During the first stage of the international financial crisis the bank was still behind the curve, trying to curb inflation: it raised the reserves ratio at the beginning of September to 5 per cent only to cut it to 1.5 per cent just 18 days later. At the same time, monetary authorities resumed tightening as the base rate was raised from 10.75 per cent to 13 per cent before the end of the year. Other moves were more appropriate for the credit crunch emergency case. The list of actions included: available federal budget funds auctioning among commercial banks; an easing of discount window credit conditions easing (less strict collateral requirements); a rapid increase in the capital of state-run banks; some interbank lending guarantees (the Central Bank provided interbank


lending insurance for 18 banks); and the establishment of a higher deposit-insurance limit. Probably the key short-run measure during the first stage was the provision of 220 billion rubles rolled over via daily repos. The total monetary easing in Russia was enormous:23 CBR provided 2.3 trillion rubles (USD 89.2 billion) during just three months (August– October 2008) and added 1.7 trillion (US$60.9 billion) in November. Liquidity provision and other support by Central Bank is estimated by the IMF24 at 11.6 per cent of GDP. This was more than in the US (8.2 per cent) or India (8.3), and slightly more than in Brazil (10.8), but substantially less than in large energy-producing countries such as Norway (21.0) or Saudi Arabia (30.6). The state also quickly orchestrated a series of bailouts of commercial banks (KIT-finance,25 Svyaz bank, Globex and others),26 using VEB and Deposit Insurance Agency. This reduced the possibility of a classic run on banks,27 but the enhanced liquidity enabled capital outflows. It was a sharp contrast with the previous crisis, when cash-constrained Russian authorities tried to bail out SBS-Agro bank for US$330 million, but the attempt failed. The bank had strong political ties before the wreckage, which helped it, among others, to build a so-called bridge-bank and to escape some claims. During the recent crisis the state had the option of stepping in because of the previous accumulation of reserves, an option that was largely unavailable in the 1990s. The cumulative cost of just two bank bailouts (Sviaz-bank and Globex) was around US$4.5 billion, a far greater amount than in 1998.28 In 1998 massive public and private defaults of banks on external and internal obligations occurred, causing substantial financial havoc. Thus the problem of the failure of trust on the interbank market was surmounted by decisive central bank action to provide liquidity, but that was only beginning. Even the ample short-term support for the banking system was not sufficient to solve the problem of the structural weakness of Russia’s financial system and to enable the supply of credit. The challenge was quite clear: up to the year-end the scheduled external debt repayment of all the agents in the economy was around US$43 billion. Either the banking sector could extend credit domestically, or the economy could find itself in even deeper trouble. There was only one way to make debt repayment less of an ordeal, and the government confirmed it would step in, preparing for the biggest bailout in recent history. The Central Bank of Russia not only quickly established its role as a lender of last resort but temporarily made the refinancing facility the

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primary source of monetary injections into the economy. It allowed banks to secure uncollateralized loans (first for six and then for 12 months), an unconventional move according to standard international practice.29 Almost 220 banks participated in this programme. The CBR had to use uncollateralized loans as banks clearly did not have enough liquid securitized assets that could be used as collateral. Another unconventional move was to transfer national welfare funds through VEB to commercial banks (in the form of capital loans) and even to support the stock market (see Box 8.1). Consequently, the support of staterun banks was crucial as they became the main vehicle to save troubled corporations. In 2008–09 the government provided a capital injection of 425 billion rubles to VTB, Rosselhozbank, Rosagroleasing and VEB from 2008–09 supplementary budgets. The direct combined injection of capital to the banking system can be estimated as one per cent of GDP, roughly the same as in France. Soon after the initial external shock struck the Russian economy, a severe credit crunch occurred. It only strengthened as a result of the banks’ need for dollar liquidity and mounting overdue loans which undermined the banks’ balance sheets. In this highly uncertain environment, it resulted in a domestic credit crunch and the monetary authorities put a lot of effort into persuading bankers to enable the credit channel of financing. On the one hand, banks needed to build up reserves to protect themselves from bad loans (mostly corporate credits in the Russian case), on the other hand they were urged to provide loans to the households and firms. The Central Bank tried to implement credit easing, but with little success. It was relatively difficult because of the high uncertainty, the low priority given to the Bank’s interest rate policy in the past (the key rate has principally and indicative meaning). Few firms were ready to borrow when the real average rate became positive and large: it averaged 30 per cent according to the WB estimates.30 Concerning the interest rate path, the tightening episode was an ambiguous move. Russia continued the policy of rising rates that began in February 2007 to fight inflation in an environment in which most of the world’s central banks rushed to relax monetary policy in order to ease the credit crunch. Leading central banks had cut interest rates to very low levels, and Russia was moving in the opposite direction. Probably the hike in key policy rate (CBR refinancing rate) undertaken in Autumn 2008 was not in retrospect a wise decision. By increasing the key rate two percentage points – from 11 per cent to 13 per cent – the CBR tried to discourage Russian banks who have found it profitable to


borrow money from the CBR’s emergency facility and to dump domestic currency. According to the IMF, ‘monetary policy has been directed toward safeguarding stability through higher interest rates’.31 But the problem of ruble stability could have been solved in a different manner: through a rapid devaluation and a credible commitment to defend the currency at the new level. The episode came to a conclusion at the end of April 2009 when it became apparent that the pace of inflation was slowing. With all that, when asked for an interim judgement, the IMF called the initial policy response in late 2008 ‘swift and substantial’. This is true if we take into account short-term considerations: the concerns about a systemic crisis were eased. Again, however, we believe that the monetary authorities were careless before the crisis and overprotective during the course of it. Their diverse and sometimes unconventional set of measures had some effect only because the government had stockpiled reserves before because of their large windfalls. The use of reserves allowed the government to mask first the financial and then the industrial slump, but only an improvement of the terms of trade in 2009 saved the situation and restored popular support. The authorities did not dare to allow the system to be purified by the crisis. Instead of the harrowing experience of the crisis, the banks were bolstered by the state. Public policy may have encouraged future moral hazard behaviour of the banks and have thus perpetuated the core problem by preserving the weak banking sector.

8.3 Impact of the crisis 8.3.1 Fewer jobs, less income In 1998 Russia faced high unemployment and falling incomes, but there were better prospects for the future as the result of the improving external demand and import substitution. Dual external shock and domestic demand collapse as a result of the credit crunch had a dramatic impact on the Russian industrial sector32 (on average, it fell 19.4 per cent during Q2 and Q3 of 2009). Struggling enterprises rushed to release labour and lower labour costs, first through reduced working hours and lower wages, then through layoffs and forced retirement in the face of public pressure to keep hoarding labour. Unemployment peaked in February 2009 (9.5 per cent against 7.1 per cent in February 2008 and 14.6 per cent in February 1999). Some local problems were eased through public works and,33 seasonal job and weak recovery in the second half of 2009. The falling income

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of households (5.1 per cent fall (yoy) in real disposable income in Q3 2009) caused a further depression of the socio-economic positions of the vulnerable part of the population, and, according to WB estimates, 6–9 per cent more will fall into poverty. The propensity to save has risen dramatically, and the savings to income ratio was approximately 15 per cent in October 2009 (compared with 6 per cent in 2008), which seems to signal an end of the current phase of the consumer boom. Consumer demand remained weak, and the sales of durable goods suffered because of the pessimism. Construction and retail sales were the worst-performing sectors in the nontradables sector. In sharp contrast to 1998, on this occasion there were no signs of import substitution, because of weak depreciation in real terms, the lack of spare capacity and tight credit conditions. Russian producers already had a substantial share of those sectors where import substitution is possible (for example, food processing), and a future increase in the domestic share is difficult without loose credits. Even substantial protectionist measures were not sufficient to change the trend: imports fell mostly as a result of the slump in investments and again tight credits. With a recovery in domestic demand we will witness a gradual return to high levels of imports. Weak economic activity and restrictive monetary policy caused consumer inflation to subside temporarily (it is estimated at 8.1 per cent in 2009), following the slow growth in producer’s prices. It is crucial that monetary authorities use this groundwork to reach stable single-digit inflation. In summary, it will take three or four years to recover from this crisis, even if there is a resumption of moderate growth within the Russian economy. Eventually if in the presence of favourable external conditions the oil and gas rents will be dispensed in the economy in direct form, or as a result of credit or budget policy the population will begin to consume more, and the industry will start to grow again, but it will be the same unchanged model of growth. 8.3.2 Shattered economy, preserved status quo? In 1998, at least some ‘oligarchs’ went bankrupt, while others were bailed out by the government. Another key feature of support for many noted businessmen was allowing debtors to neglect creditors’ interests. Loose legal constraints allowed powerful interest groups to elude bankruptcy claims from lenders. Weak enforcement may cause long-term problems for the economy by encouraging moral hazard behaviour.


Alas, despite many changes in legislation and the business environment, the problem of the low respect for contracts persists.34 In 2008, the government solved most of the debt problems of the owners of the largest production conglomerates and their owners, providing the emergency aid from reserves through VEB.35 It allowed them to repay margin calls to global banks. The rapid response to and discharge of private losses by the government could be a result of fears that foreign banks (after acquiring collaterals) would sell the stakes in Russian companies dirt cheap to other actors which could attempt to restructure inefficient companies through a massive release of labour. These concerns were largely unfounded. Foreign companies were certainly not so eager to acquire a minor share in a Russian conglomerate, following their best knowledge of the Russian institutional environment and business climate. That was true especially when most financial institutions sought ways of improving their balance sheets after the flight to quality episode occurred. Sometimes it was not just about political influence as many industrial groups have leverage over the government through unemployment and the threat of worker unrest. A notorious example of such behaviour is AvtoVAZ (now a part of the Rostechnology conglomerate). As recently as November 2009 the government committed to provide a recurrent support tranche of US$1.9 billion to this abundantly labour-intensive firm,36 just an episode in the continuing flow of contracts, tax breaks, and subsidies for many such firms. Soft budget constraints are still a problem for the Russian economy and ex-post crooked debt insurance demoralizes the managers and owners of Russian firms. Of course, to some extent the backing of the Russian government was costly for the positions of some oligarchs, but only a few of them really suffered. The valuations of many of the largest publicly traded companies rebounded, meaning that estimations of personal losses were now outdated. Some large developers had to lose out but they were not the ‘first-class oligarchs’. The status quo seems to be unshaken.

8.4 What is next? As we stated earlier, it is not clear how the crisis will end for Russia. But even if we do not know the particular timing and exit strategy of the authorities, it is rather clear what needs to be done in future. It is virtually impossible to envisage a bright future for Russia without a reorganization of the state. The long-term performance of Russia will be determined by whether or not the society and the authorities

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will be able to bring in more political and economic freedom to the system. This was said on many occasions by various people in different circumstances. Numerous calls for political, institutional, structural reforms were heard, but mostly in vain. In addition, as may be clear from the analysis offered throughout this book, another key is the reform of the financial sector. High rates of growth may exist temporarily in economies which have relatively weak financial systems, and there is no clear evidence that a stronger financial system could protect the economy from external shocks. Nevertheless, the banking sector should be seriously restructured as it drags the economy backwards, and creates endogenous fragility. International best practices in banking reform are well-known and should be used extensively in Russia. The authorities should not allow a crisis to go to waste, to quote Rahm Emmanuel. We call for policies to strengthen the financial sector and we believe this book is a good starting point for public policy debates in Russia. A crisis may induce policy change,37 but only if the ruling elite perceives that the previous policy is not working. The common belief is that Russia did not experience a serious deterioration of the status quo and so there is no need for significant reforms in Russia in the near term. Powerful groups of vested interests which have not been reshuffled by the crisis will act as a further block on the intentions to reform. Presumably, a hypothetically responsible ruling group with a longterm planning horizon could challenge this view. Recently we have heard a plea for modernization from the President.38 Suppose this intention is credible, our book provides ample proof that the financial sector should be transformed in order to secure more sustainable development. But the political subject should be able and willing to listen, argue and act accordingly. This is possible only if we see a political competition that creates the demand for professional economic expertise. A self-assured obscurant autocratic regime will take no advice, until it is hit by the next crisis.

Notes Introduction 1. One main reason was that too many observers failed to recognize the importance of oil to the Russian economy, and thus the extremely low oil price, combined with the temporary collapse of production, led to a decline in economic performance that was all too easily attributed to the effects of the reforms. 2. It is interesting to note how hard the US struggles today to keep General Motors alive even though this is only one company, and the US has many other successful auto producers (although they are not all US-owned). Imagine if there was a GM in every state of the US. Would it be imaginable to shut them all down at once? 3. The authorities demonstrated carelessness in their perception of the threat of the crisis and acted too late to prevent it. As an example, an attempt to prevent the debt default by a voluntary swap of the short-term rubledenominated securities into long-term Eurobonds was realized in July 1998, only a month before the default occurred. This belated measure could change nothing and, paradoxically, only accelerated the outcome of the crisis. This episode was of secondary importance in the sequence of wrong policy decisions, but it is curious per se and described in detail in this book as an example of the unrealized potential of effective debt management. 4. The volume of official reserves held by Russia in October 2008, at the beginning of capital flight caused by the global economic crisis, was $557 billion. The volume of these reserves was 24 times less, only $23 billion, at the similar point when the Asian financial crisis began to affect Russia the same way in October 1997.

1 The External Debt Crisis of the 1990s 1. The date of the first debt default in Russian history is 21 January 1918 when ‘the government of the new Soviet Republic issued a one-page decree dismissing all external debt obligations of tsarist Russia’ (Sinyagina-Woodruff 2003, p. 532). It was a great shock to world finance, since by the end of the First World War Russia had the largest external debt in the world (and also the second largest government debt after France), which increased during the war 2.5 times, reaching 80 per cent of Russia’s national income in 1918. 2. ‘This position of financial isolation was a conscious policy of the Soviet government, not a result of creditors’ punishment of the 1918 repudiation. During the whole post-war period of Stalin’s governance the USSR accepted only two foreign loans. One was received from the USA in October 1945 as a targeted 30-year loan which was supposed to help the USSR pay for part of the goods supplied through lend-lease during the Second World War. 237

238

3.

4.

5.

6.

7.

8.

Notes In January 1947 the USSR stopped servicing this loan, as bilateral relations grew sour. Another 5-year 3 per cent credit was extended by Sweden in October 1947 to pay for some imports of Swedish industrial equipment’ (Sinyagina-Woodruff 2003, p. 534). The USSR also declined the Marshall Plan grants that could have helped to restore the economy after the Second World War. Anders Åslund (1995, p. 42) vividly describes complete disorder in the Soviet price system aggravated due to the attempts of partial semi-market reforms: ‘Certain prices floated freely and rose enormously because of the huge monetary overhang, while most prices remained regulated. For instance, in early 1990, the Soviet wholesale price of one ton of crude oil was 30 rubles, which also happened to be the free retail market price of one package of Marlboro cigarettes. Moreover, enterprises paid one another in noncash or account rubles, which were legally separated from the cash rubles used on the consumer market. At that time, the black market rate of one cash ruble was three noncash rubles. Hence, with the right connections, it would be possible to buy three tons of crude oil for one package of Marlboros, or less than $1, when the world market price of one ton of crude oil exceeded $100. Similarly, the regulated price of a flight from Moscow to Vladivostok was $7, whereas the market price of a cab ride between the airport in Moscow and a downtown hotel was $10. Prices that were less than 1 per cent of the world market price were a commonplace.’ The wholesale prices became de facto more flexible than the official retail prices because of the developing horizontal links between enterprises. Gaps between retail and wholesale prices were increasing rapidly and subsidized by the state which was trying to retain control over retail prices and to avoid radical price reform for as long as possible. This policy contributed to a growth of budget deficits, inflation acceleration, and a building up of state debt. In 1987 there were only six state-owned banks in the USSR that differed in their service functions: Gosbank (general and commercial), Sberbank (savings), Vneshekonombank (foreign), Promstroybank (construction), Agroprombank (agriculture), and Zhilsotsbank (social and small business). Reforms in 1988–89 led to the emergence of new banks formed as joint-stock companies. By the end of 1991 there were over 2,000 commercial banks in the former Soviet Union – 1,500 of them in Russia and 500 just in Moscow (Ickes and Ryterman 1992, p. 340). The Council for Mutual Economic Assistance, an economic union of the USSR and the Eastern European countries that attempted to facilitate artificially economic exchange and integration in the communist block. There was no foreign currency exchange in the Soviet economy, and trading firms borrowed transferable rubles at artificially low exchange rate set by the state to purchase imports. Normally, these operations yielded arbitrage returns at rates of several hundred per cents per annum. The state thus subsidized de facto this sort of foreign trade at the expense of external debt growth to importing countries. Therefore the emission of transferable rubles implied uncontrolled expansion of external debt. Formally, these debts resulted from imbalances in the foreign trade settlements in favour of the creditor country by the time of disintegration of the Soviet Union.

Notes 239 9. Unfortunately, the monetary authorities of the new Russia did not learn much from the mistakes of their Soviet predecessors, as will become clear from our discussion of Russian financial crisis of 1998 in what follows. 10. For example, the famous chicken parts called in Russia ‘Bush legs’ after President George Bush senior. The Bush legs were imported to Russia for many years subsequently and from time to time were the subject of trade conflicts between Russia and the United States. 11. It was adopted in 1934 and prohibited private US banks and corporations from extending credits to external borrowers that did not honour loans from the US government. 12. Another 40 per cent of the Paris Club debt was issued by five countries: Italy, the USA, Japan, France and Austria (Kheifetz 2002, p. 104). 13. In my view, the main lesson from the Noga case for Russian authorities was that they should have established relations with international businesses very selectively and carefully. They should not have tried to compromise with people that sought to make extra benefits from financial disorder that was inevitable under dramatic political and economic transformations at the beginning of 1990s. The reputation of business-friendly government should be built by loyalty to the international norms and adherence to the rule of law rather than by doubtful generosity at the expense of the state budget. 14. For instance, nearly 70 per cent of Soviet machinery production was linked to the industrial-military complex. The Eastern European countries did not face the structural problems of such a scale as the CIS countries did. The attitude of creditors to the former was more favourable because of the perspective of economic and political integration with Western Europe. The market reforms in Eastern Europe began at right time and were conducted in a more deliberate and orderly fashion than the similar reforms in the CIS countries. 15. Not long before its collapse the Soviet Union resumed negotiations with Britain and France whose citizens and institutions were the main holders of Russian pre-revolutionary bonds. As a result, Russia swapped the gold stock of 5.5 tons deposited at Barings Brothers bank for the British government’s obligation to settle all of the claims of private British holders of the Russian Empire bonds. The value of this gold stock was about 10 per cent of the total claims presented. According to a similar agreement with France Russia paid $400 million as compensation to debt-holders, covering only 1–2 per cent of total par value (Sinyagina-Woodruff 2003, p. 535; Kheifetz 2001). In fact, both of these agreements meant the forgiveness of Russia’s debt repudiation of 1918 and permission to enter the world’s capital markets. It would, therefore, be politically incorrect to require a new forgiveness of debts as soon. 16. The volume of this fund was $1 billion; the Russian reformers planned to accumulate a similar fund worth $6 billion after price liberalization and then to fix the ruble. 17. Of course, the reformers of the first wave and I myself were aware of the complexities of stabilization attempts and the failures to combat inflation in some Latin American and other countries in previous decades. Nevertheless, optimistic moods were dominating. As was believed, a radical attack on the

240

18.

19. 20.

21.

Notes macroeconomic imbalances could outstrip consolidation of anti-reforming and lobbying groups against reforms and create a policy framework sustainable to populism. Of course, any measure of the Soviet economy output was based on nonmarket evaluation of goods and services and was substantially upward biased. In my view, the official Soviet statistics tended to overestimate the economy’s final output and, hence, the Russian GDP fell in the 1990s less than twice. For instance, the dollar-denominated federal budget revenue was $43 billion in 1995. To me this decision resembled the previously mentioned Gorbachev’s antialcohol campaign launched in 1986. The state again threw away voluntary a big lump of budget revenue by prohibiting the only way of effective oil tax collection that was available in the 1990s. As, for instance, suggested by Robert Barro (1974) for a representative agent model economy with certainty and non-distorting taxes and extended in the subsequent literature, for instance, Barro (1997). These extensions demonstrated deviations from the basic principle of Ricardian equivalence and relevance of debt management to dynamic policy-making.

2 The Domestic Financial System and Inflation 1. The reserve requirements essentially did not affect money supply: being set at a 10 per cent level for time deposits shorter than one year (5 per cent for longer ones) in February 1992, and increased to 20 per cent (15 per cent) in April 1992, these requirements remained fixed until 1995. 2. The implicit Russian trade subsidy to other CIS countries (e.g. through the exports of cheap energy resources) was no less than 13.2 per cent of its GDP, meaning that in 1992 Russia gave away 22.5 per cent of its GDP to other CIS countries (Åslund 1995, p.126). 3. The similar effect occurred through the subsidy of foreign equipment purchases that was helpful for importers but troublesome for producers of analogous equipment at home. 4. The state budget deficit in 1992 amounted to 29.4 per cent of GDP and was financed at 18.6 per cent of GDP through inflationary money issues and 11 per cent of GDP through external borrowing by the government (Sinelnikov and Trofimov 1998b, p. 198). 5. Viktor Chernomyrdin is known for many witty comments that became sayings, for instance: ‘We hoped for the best, but it turned out as usual’ which indicated an absence of pomposity that was unusual among Russian top officials. 6. The government usually gained from undervaluing inflation in the annual budget proposals, implying an automatic reduction of the real budget expenditures. In the first half of 1994 it lost in terms of these expenses from the disinflation surprise during that period. 7. The abrupt fall of the ruble resulted from a series of speculative attacks that the Central Bank had been trying to resist for several weeks. The nominal ruble exchange rate dropped by 20 per cent in September 1994 as compared

Notes 241

8.

9.

10.

11.

12.

13.

14.

to 6.6 per cent in August because of the excess money supply in the Summer. The official reserves fell dramatically from $6.5 billion at the end of June to $3.8 billion on 10 October. Trying to avoid the depletion of the reserves, the CBR stopped intervening in the currency exchange on 11 October and the ruble fell. These were Sergei Dubinin and Viktor Gerashchenko, respectively. Later on both worked successively as chiefs of the Central Bank. The former became its chairman within a year, whereas the latter replaced the former in four years, after the financial collapse of 1998. The style of Sergei Dubinin’s governance can be characterized as extremely risk-averse because of the criminal investigation of the causes of ‘Black Tuesday’ that concerned him personally and continued for a number of years. For example, the federal budget expenses on defence, education and the subsidizing of enterprises were reduced in 1995 by 44, 47, and 50 per cent, respectively. Inflationary expectations do not play any role in this inference. For the case of money demand depending on the expected rate of inflation Thomas Sargent and Neil Wallace obtained a paradoxical result that ‘tighter money today leads to higher inflation not only eventually but starting today; tighter money today lacks even a temporary ability to fight inflation’ (1981, p. 2). The simplistic monetarist prediction that monetary policy ensures control over inflation is easily disproved within the context of the simple monetarist framework that includes the government budget constraint. Both elections took place the second time in the newest Russian history: the former – after the new constitution adoption and establishment of State Duma in 1993, and the latter – after the first Boris Yeltsin victory in 1991. By 1996 the socialist parties had taken power in several Eastern European countries by exploiting the difficulties relating to market reforms. The Russian communists were quite different from the European-style socialists ‘with human faces’, and their possible victory in the presidential election in 1996 would, without doubt, cause difficulties for the economy and the society. Sberbank originated from the network, including many thousands of savings banks that were spread throughout the country. People had a strong habit and used to trust this bank, although it cheated many millions of households in 1991 when Sberbank suddenly froze deposits. This happened just before the price liberalization and subsequent jump in inflation. Obviously, Sberbank gained at the expense of deposit-holders. The restructuring and indexation of Sberbank deposits began several years later. It was quite formal since deposits were devalued many hundreds of times by inflation, and indexation did not cover any essential part of the losses. A similar situation in respect of retail deposits devaluation was repeated after the financial crisis of 1998 discussed in Chapter 6. The abovementioned (in subsection 2.1.3) increase of ruble deposits supply in 1993 under high interest rates could provide positive real yields for depositors and partially replace savings in dollars. But at that time it was not the main activity of banks except for Sberbank. Some banks were far-seeing and tried to develop retail business to create infrastructure and take the market niches in advance.

242

Notes

15. For comparison, in the USA during the same time period the fraction was 55–60 per cent. 16. The development of the global financial crisis in 2007–08 demonstrated once again that there is a fundamental defect in any interbank market. It is very convenient as a source of funds during boom times, but proves to be very damaging in slumps when the information asymmetry problems are revealed most severely. 17. Generally speaking, the question concerning the role of commercial banks as the main institutions of financial intermediation is quite a controversial one. The main argument in favour of their dominant role is that banks have more incentives and opportunities to monitor enterprises as compared to other participants and institutions of the financial market (for example, Mishkin and Savastano 2002). Theoretically, the corporate bond market cannot provide full disclosure of information about enterprises through prices because of the free rider problem: there is no sense to invest money to obtain information if prices convey it (Grossman, Stiglitz 1980). It is possible, however, to object that the informational efficiency of financial markets would increase if enterprise activities become transparent and they make use of modern accounting standards.

3 Virtual Economy and Fiscal Crisis 1. In two pioneering articles on the arrears problem in the Russian economy Barry Ickes and Randi Ryterman (1992, 1993) suggested a detailed analysis of the new phenomenon, based on interviews with a large number of Russian officials and firm managers. Both papers provided insightful explanations of incentives and policy mistakes underlying the origins of the non-payment crisis. These articles also contained early warnings of its further aggravation a posteriori fulfilled. 2. The inter-enterprise arrears resembled, at first glance, trade credits that are high enough in some developed economies. For instance, in 1995 the total volume of trade credits was 20 per cent of GDP in the UK and 35 per cent of GDP in France. This analogy is somewhat misleading. First, inter-enterprise mutual debts in the Russian economy were based on informal bilateral agreements rather than formal contracts and were very often not redeemed despite the inflationary depreciation of firms’ balances. Second, although the magnitudes of inter-enterprise arrears were not high according to the world standards (for instance, 15 per cent of GDP in the first quarter of 1998), the level of monetization in the Russian economy was low (for comparison, the volume of M2 was nearly the same). Third, the fraction of non-money instruments in settlements between firms was very high and increased over time. As a result, the fraction of cash reduced from 67 per cent in 1992 to 38 per cent in 1997. 3. Real wages were typically very small, and additional inflationary losses were very painful for employees. Workers were often compensated with goods produced by firms and had to sell these themselves, spending many hours on the street. These facts, showing the flagrant disregard for the law, were indicative not only of the labour market slackness but also of generally unprotected workers’ rights. For a number of reasons the labour force was

Notes 243

4.

5. 6.

7.

8.

9.

10.

11.

12.

generally immobile, and there were no institutions for the protection of workers’ rights. The hidden unemployment was very high, probably considerably exceeding the official unemployment rate of 12–15 per cent calculated according to the standard methodologies. Wage arrears were partially entailed by the situation in the labour market which was unfavourable to employees and caused considerable social tensions. The principle of strong mutual responsibility is specific to the Russian mentality and social relations and known as krugovaya poruka. It originated from the patriarchal way of life involving the dominant state hierarchy and had a very long historical tradition, for instance, in serfdom institutions. The first version of the bankruptcy law was adopted in November 1992 and redrafted in October 1994, but it was still unworkable for several years. At that time the CBR heads were evidently ignoring the link between money supply and price growth. They announced that the economy could not manage with the real money supply because prices were rising, and that the Central Bank should resolve the money shortage by issuing more money (Åslund 1995, p. 75). In 1980 the average age of plant and equipment was 9.5 years, in 1995 it was 14.1; the volume of capital investment in 1997 was less than 24 per cent of its 1990 level (Erickson and Ickes 1999, footnote 7, p. 3). The case of value-destroying production under market prices was demonstrated by Richard Ericson (1999) in the abovementioned article basing on the input–output matrices for the Russian economy. The basic relative price shift was a dramatic drop in industrial good prices relative to raw materials. The economy-wide relative price shifts after the price liberalization in 1992 were also caused by the abolishment of a turnover tax. It was a cornerstone of the centrally planned price system and defined a gap between retail and wholesale prices exceeding 90 per cent of turnover for some goods. As a result of the abolition of the turnover tax, some firms that supplied technology-specific intermediate inputs and maintained monopoly positions could capture a significant share of the turnover tax as temporary monopoly rents. On 1 February 1993 the government raised regulated gas prices for industrial consumers from $1.8–2.7 to $6 per thousand cubic metres and for households – from $0.4 to 1. On 20 July 1993 gas prices were raised to $9 per thousand cubic metres for the former and to $2 for the latter. Thus, over the course of only six months the growth of dollar gas price was fourand fivefold for industrial consumers and households, respectively. The virtual economy theory relies on the story of self-organization of inefficient producers which is relevant to the Russian economy during the 1990s. An alternative theory focuses on the economic disorganization caused by the breaking of the old production links and the search for new ones (as suggested, for instance, by Blanchard and Kremer 1997). The latter explains the dramatic fall of production but ignores the wide spread of arrears, the most essential and peculiar feature of the Russian transition to market. Barter emerged in the Soviet economy as a way of evading sharp shortages through the development of horizontal links between enterprises thus being a ‘weapon’ against the absurdities of the administrative system. It spread as a means of transactions among enterprises (a ‘brick money’ phenomenon)

244

13.

14.

15.

16.

17.

18.

19. 20.

21.

22. 23.

Notes under the planned economy collapse and because of high inflation at the beginning of the market reforms. Later, in 1995–96, barter was widely used by the virtual economy to cope with the consequences of disinflation. As a rule, households did not posses enough factors of production to be rewarded at the high level. At the beginning of market reforms they practically did not own production assets and did not receive dividend incomes; real wage was also low on average. The enterprise taxes were introduced to substitute for the abovementioned turnover tax which had been a pillar of the Soviet tax system and made no sense in a market economy. However, the new tax system was misaligned with the structure of the economy. Low domestic energy prices implied low oil rents and oil taxes, while tax obligations of industrial enterprises were in many cases virtual. At different periods of time these authorities consisted of the Ministry of Finance, the Ministry of Tax Collection, and also the Tax Police, the Federal Customer Service and the Federal Treasury that were responsible for formation of different items of the state budget revenue. Tax arrears could originate from the barter exchange if it was booked. The latter could be necessary for the enterprise management in order to withdraw cash from the bank account for making wage payments to employees. Under the cash-based accounting applied in Russia a firm-recipient gained from delaying payment because inflation reduced the real value of VAT or profit tax. A firm-supplier received side payment in cash compensating depreciation of the nominal amount finally settled. Details of this mechanism are described by Ickes and Ryterman (1992, pp. 356–9). By ‘budget recipients’ I mean government agencies that receive money from the Ministry of Finance for the purchase of goods and services. These agencies range from a school or a hospital in a provincial town to the Ministry of Defence. The most radical case of tax arrears forgiveness was the writing off of all debts of the agricultural sector to the state budget in April 1996. The payment system inherited from the Soviet Union left enterprises with one bank account to be used for legal cash withdrawals that the authorities could easily control and block. The Ministry of Finance formally fulfilled the IMF requirement but in fact the issue of money surrogates was expanded under a different name, Kaznacheiskie Nalogovye Osvobojdeniya (Treasury tax offsets). Because tax offsets were company-specific and inelastic to supply as compared to standard debt instruments. Admittedly, the team assigned by Boris Yeltsin at the beginning of 1997 was relatively ineffective and provided results that were well below their initial ambitions and public expectations. It failed because of the unsuccessful attempts to begin structural reforms and financial mismanagement prior to the crisis of 1998. It is hard to argue against the sharp characteristic of ‘young reformers’ given by Clifford Gaddy and Barry Ickes (1998, p. 8): ‘The new government team in Moscow are thoroughly conversant with the Virtual Economy, much more than they are with the ‘market’. The heralded group of ‘young reformers’ in Moscow are in fact almost to a man sons of the Russian ‘Rust Belt’, the large industrial cities of the Urals and Volga Valley that are the home of the Virtual Economy. The local governments, even the

Notes 245

24.

25.

26.

27.

28.

banks and oil companies, in which they served before coming to Moscow, were all active and willing participants in their regional Virtual Economies.’ The negative side of money surrogates was the loss of financial control and the erosion of fiscal discipline. Nevertheless, there was a positive side in the diversification of domestic financial markets, instruments, and participants. Many new actors, in addition to commercial banks, were involved in the exchange of monetary and tax offsets. The secondary market for surrogates could, in principle, become a basis for the civilized money market with standard instruments such as bills, notes, and derivative contracts. This market has not emerged in Russia until now, partly because the financial authorities cared little about building a modern institutional framework that could replace the ‘financial jungles’ with obscure and unfair rules. A different sort of causality worked the other way round: higher prices set by the natural monopolies implied an increase of tax collection in cash and thus preconditioned a further decline of inflation. Vladimir Potanin won the golden (or platinum) prize – control over Norilsk Nickel. He also acquired the oil company Sidanko (transformed later into TNK-BP). Among other winners that received the oil-industry prizes were Khodorkovsky (Yukos), Alikperov (Lukoil), Bogdanov (Surgutneftegaz), Abramovich and Berezovsky (Sibneft). After the election Vladimir Potanin became a deputy prime minister, and Boris Berezovsky was assigned the post of deputy-secretary of the Security Council. Neither of these appointments added much to the real status and political influence of these persons. This is an allusion to semiboyarshina, literally the power of seven boyars: a short period of very chaotic oligarchic rule in Russia at the beginning of the seventeenth century.

4 The Risks of Domestic Debt Expansion 1. To securitize debt to the Central Bank, the Ministry of Finance issued 13 tranches of OFZ-FR totaling 80 trillion rubles or 3.2 per cent of GDP; the corresponding excess OFZ increase in 1997 is presented in Table 4.3. 2. Including debt redemption financed merely through new debt issues. 3. The temporary stabilization of domestic debt dynamics in 1996–97 enabled the authorities to lengthen the maturity of government securities through the formal restructuring of non-market government obligations. At the end of September 1997, the average maturity of government papers was 320 days, whereas in early 1997 it had been 105 days. To a large degree this was reached artificially, through the securitization of the Central Bank credits mentioned above. New obligations remained in the CBR portfolio and were not supplied to the market. As we saw in Figure 4.2, the sharp increase in the volume of government bonds occurred in March 1997, but it did not reflect any significant shift in the composition of the outstanding market debt. 4. The classical Diamond–Dybvig (1973) model of bank runs interprets this situation as a ‘bad’ equilibrium in the game between patient and impatient investors and the bank. Regarding the debt crisis as an attack by short-term

246

5.

6.

7.

8.

9.

Notes securities holders, it is also possible to refer to multiple equilibria and selffulfilling expectations. This analogy was first used by Calvo (1988). In his model the debt holder lacks confidence in the solvency of the government because others may have similar beliefs. This could lead to a situation in which the government becomes insolvent in a ‘bad’ equilibrium, which emerges depending upon the subjective assessment of default risks by participants. A formal model of creditors’ run on government obligations was also suggested by Alesina, Prati and Tabellini (1989). The Rodrik–Velasco (1999) model of debt crisis shows that the borrower weighing yields on short- and long-term debt chooses the former as a source of financing. This is a consequence of the yield term structure incorporating the risks of creditors’ attacks on the debt, implying losses by long-term bond holders. But if the borrower accounts for the effect of short-term debt issue on the probability of attacks and assesses the losses incurred by liquidation of its assets, he chooses the long-term debt. This eliminates the risk of attack on the debt and yields a Pareto-efficient allocation of finance. Diamond and Rajan (2000) compare the crisis situations in Korea in 1979–80 and 1997–98. In both instances Korea confronted a credit boom at first and then a sharp increase in the current account deficit to 6.4 per cent in 1979 and 4.7 per cent in 1996. But these crises had different influences on the country’s solvency. In the first case the short-term debt was 8.4 per cent of GDP (while total debt was 31.3 per cent of GDP) and 97 per cent of official currency reserves. It was still possible to increase the share of the short debt to 15 per cent in 1980, thus ensuring the inflow of liquidity into the economy. In the second case the short-term debt constituted 15 per cent of GDP (total debt was 34.6 per cent of GDP) and 300 per cent of official reserves. Possibilities of new borrowings were completely exhausted and a $57 billion IMF credit tranche was required to prevent the collapse of the Korean financial system. The accumulation of short maturity obligations in the 1990s corresponded to a sharp increase in investments into small and medium-sized businesses that were much less liquid than those of large corporations who have better access to external financing. The crucial issue is how to get these costs imposed on a sovereign borrower. Eurobonds allow effective punishment for default, firstly, through restricted access to international financial markets. For example, in August 1998 Russia defaulted on domestic low-quality debt rather than Eurobonds, because of the substantially lower costs of defaulting. We will discuss this issue in detail in Chapter 6 devoted to the financial crisis. As we will see, this attempt at anti-crisis debt management failed because of the banking crisis, but it did demonstrate the relevance of such a strategy. Obvious and concealed guarantees on the part of the government to the banking system explains the fact that in a number of countries in Southeast Asia, such as Korea, Malaysia, the Philippines and Thailand, the financial crisis did not involve considerable budget and current account deficits during the previous period. The currency crisis in these countries was, to a certain extent, due to the expectations of inflationary actions on the part of the governments. That would be inevitable in the case of a bank crisis. Support of

Notes 247

10.

11.

12.

13.

14.

15.

16.

the financial system in such a crisis would most probably result in inflation incomes, since the crisis of the banking system leads to a disruption of the account system and a slump in output. Under these circumstances debt issue and an increase in tax revenues is hardly likely (see: Burnside et al. 1998). The issue of short-term treasury bills with guaranteed currency yields reproduced the Mexican situation of 1994. The Tesobonds, short-term dollar papers, issued in Mexico were intended to attract and retain hot money, and also to improve the state of bank balances. Such a policy turned out to be unsound and had a negative effect on the confidence in the government, peso stability and led to the financial crisis of 1994–95. With a dollar yield several hundred basis points higher than the LIBOR rate, these instruments really proved to be attractive for speculation using derivatives and contracts (swap agreements and repo deals). They made it possible to attract credit resources from the US monetary market under collateral of Mexican papers. Such deals increased the fall in government paper quotations in a currency crisis situation resulting in the inability of the Mexican government to refinance the domestic debt. According to the over-the-counter currency forward contracts Russian banks took on the obligation to sell dollars to non-residents at fixed rates and dates (bunching around the 15th day of each month). The similar mechanism guaranteed GKO yields through repo operations collateralized with the Ministry of Finance. The Russian banking system thus insured non-residents by assuming the main bad risks. Moreover, margin calls underlying such insurance were a source of additional liquidity risks for domestic banks. In principle, had the CBR signalled a desire for a flexible exchange rate, Russian banks would not build up portfolios with currency mismatch. But this begs the question of how the CBR could credibly make such a signal. For further details on the relationship between hedging incentives and the fixed currency exchange rate, see Burnside et al. (1999) and Eichengreen and Hausmann (1999). Among those were Inkombank, Rossiyskiy Credit, SBS-Agro, ONEXIM-bank, MENATEP, MFK. They were very powerful and policy-engaged in the 1990s, and all of them collapsed after the financial crisis of 1998. Systemic currency risks and mismatches result from negative externalities neglected by private borrowers, in addition to wrong incentives induced by the exchange rate regimes. This was a common phenomenon in many emerging market economies in the 1990s. To prevent the accumulation of short-term risky debt, the restrictions in Chile prohibited borrowings for domestic companies and banks with credit ratings lower than BBB or BBB+ and limited the absolute size of loans (Edwards 1998). The reserve requirement was 30 per cent on less-than-year foreign investments including commercial credits. However, even in Chile speculators managed to bypass the restrictions by means of export contract prepayment or the illegal conversion of funds. Broad opportunities were provided by offshore swaps between short- and long-term foreign currency debt obligations of Chilean banks. The Chilean authorities abolished the reserve requirements in September 1998, because of the current account deficit. The appendix is coauthored with Georgy Trofimov.

248

Notes

5 The Causes of the Russian Financial Crisis of 1998 1. For the first time since 1925 Russia made currency reform that was not confiscatory. 2. On behalf of the Russian side the negotiations were led by the chief economic reformer Anatoly Chubais. 3. It is almost a universal rule that if authorities promise not to make devaluation, it occurs. In normal times nobody talks about devaluation and there is no need for such announcements. The promise to defend the ruble firmly given by the Russian President to public signalled that devaluation would occur very shortly thereafter. 4. George Soros actively invested in Russian assets before the crisis. He participated in the privatization auction of the telecommunications holding Svyazinvest that is mentioned in Chapter 3 and won the blocking stake in coalition with Vladimir Potanin. A few days before the publication of the Financial Times article Soros declined to offer a loan to the Russian government, even though this had been personally requested by Anatoly Chubais. 5. By the middle of 1998 the CBR’s portfolio of these assets, together with the state-owned monopoly Sberbank’s holdings, totalled at least 60 per cent of outstanding domestic government debt. 6. This rate served merely as a monetary policy indicator, rather than a working tool for liquidity provision to banks. In some periods it deviated substantially from the market interest rate, but indirectly influenced these rates through signalling about the short-term CBR intentions. 7. As I have mentioned above, monetary policy alone is insufficient to defend the ruble if other aspects of macroeconomic policy are incompatible with the stability of the ruble. 8. Although no fault could be placed on either Sergei Dubinin or Viktor Gerashchenko for the events of ‘Black Tuesday’, the prosecutor still launched a case against them (opened in 1994 and still under investigation in 1998). It was the sward of Damocles for the former as the acting CBR chief. No doubt, a removal from this position would have been a minor consequence compared to a new case and a possible arrest.

6 The Debt Crisis and Default 1. It is important to note that all previous attempts to introduce extraordinary efforts to increase tax collection in cash also failed. For example, an Emergency Tax Commission with special powers in selective control over enterprises was established in October 1996 and headed by the prime minister Viktor Chernomyrdin. However, in practice it proved ineffective. Ironically, the authorities had counted on the very name of this commission to have a substantial impact. The previous ‘Emergency Commission’ was established by Vladimir Lenin after the Bolshevik coup in 1917 and was headed by Felix Dzerzhinsky. Its abbreviation (‘CHEKA’ in Russian) became a symbol for mass terror against citizens. 2. Some revisions of the draft 1998 budget were adopted as early as December 1997, after the first GKO yield jump (Tompson 1999, p. 14): the planned debt

Notes 249

3.

4.

5.

6.

7. 8. 9.

10.

11.

service expenditures were increased first by 10 billion rubles ($1.7 billion or 0.4 per cent of GDP) and then by 25 billion rubles ($4.3 billion or 0.9 per cent of GDP). It was announced on 13 July 1998 and included $15.1 billion from the IMF, $6 billion from the World Bank and $1.5 billion from the Government of Japan. The swap issue of 24 July 1998 included about $ 3 billion of a sevenyear maturity 8 per cent coupon bond issue, and a twenty-year maturity 11 per cent coupon bond of the same amount, plus $0.5 billion of new twenty-year bond issue. All foreign investors, obviously, planned to get rid of GKOs completely in November 1998. William Tompson (1999, p. 19) mentions that the top officials urged leading Russian bankers not to convert GKO in order to facilitate the exit of foreign money from the market. Some of these bankers did not follow the advice because of prudence and, in all likelihood, certain informational advantages. ‘Russia was offered a much smaller financing package ($22.6 billion, or 5.8 per cent of its GDP) than Indonesia ($40 billion, or 18.1 per cent of GDP), Mexico ($47 billion, or 13.5 per cent of GDP), or Korea ($57 billion, or 11.7 per cent of GDP)’ (Kharas et al. 2001, p. 42). For example, the unsuccessful attempt at a military coup on 21 August 1991 entailed Michael Gorbachev’s failure and the disintegration of the USSR. According to Alexashenko’s memoirs (1999, p. 224). The actions of the monetary authority to rescue the top banks proved to be futile. Sergei Alexashenko (1999, p. 203) recognized that one of the leading Russian banks ‘Imperial’ announced its insolvency on foreign liabilities on Friday 14 August. The threat of cross-default claims would imply a widescale banking crisis, and the authorities decided to announce the extraordinary package at just this time. These costs may have appeared to be much higher ex ante than they turned out to be ex post, especially as oil prices rose to very high levels after the crisis and improved Russia’s credit rating. Foreign investors returned to the Russian financial markets very quickly, as if they had all forgotten about the losses they had incurred in 1998. But in the long term the ex post losses for Russia from the GKO default are still high. For example, the ambitious idea that became recently popular among the Russian top officials to make the ruble a world reserve currency are hardly likely to be implemented because of the damage to its reputation that Russia caused in 1998. The CBR’s new chairman, Viktor Gerashchenko, assumed his position for a second occasion. He was previously known as a highly inflation-tolerant central banker, who was partially responsible for uncontrolled price growth in 1992–94. The Economist magazine labelled him ‘the worst central banker in the world’ after the ‘Black Tuesday’ of 20 October 1994. His second term in office and, in particular, the anti-crisis measures undertaken under his governance suggested that those remarks were premature and unfair. After 1998 Viktor Gerashchenko acquired the reputation of being an efficient crisis-fighter. The label of ‘the worst central bankers in the world’ should be pinned to those who are responsible for crisis-making in Russia and other countries.

250

Notes

12. William Tompson (1999, pp. 22–3) vividly describes that situation by quoting headlines in the Russian mass media: ‘While the politicians dithered, the Central Bank, for better or for worse, acted. In an oblique commentary on this state of affairs, the weekly ‘Kommersant-Vlast’ carried a photograph of newly appointed CBR Chairman Viktor Gerashchenko on the cover of its 22 September 1998 issue with the caption ‘Master of the Country’ (‘Khozyain strany’). Not for nothing did Finansovaya Rossiya ask in one headline, ‘Are there limits to the powers of the Bank of Russia?’ (24 September 1998).’ 13. Because of the crisis, the total volume of deposits shrank by 15.6 per cent or 52.4 per cent in real terms. To compensate partially the losses of households the Central Bank bailed out household deposits in some of the major private banks that were under distress (SBS-Agro, Menatep, Mosbiznesbank, MOSTbank, Promstroibank, Inkombank and others). Deposit-holders were offered an option to open equivalent ruble deposits in the state monopoly Sberbank (with no compensation for inflation losses), as an alternative to laying down claims to bankrupted banks in court. Around 350,000 depositors used this option. 14. This is not too dissimilar from what occurred in the early 1990s and also in 2009. 15. A creator of this mechanism was Andrei Kozlov, a young economist, who took the position of the CBR’s deputy chief after devaluation. Earlier, he played an important role in the emergence of the GKO market in 1993. He contributed a great deal to the stabilization of the banking system after the crisis of 1998 and was assassinated in 2007 because of his all-out struggle against money-laundering banks. Diligence and adherence to rules by government officials engaged in financial management and banking regulation may still be a very risky job. 16. In addition to the need to refinance the deeply distressed banking sector, the CBR began to inflate because of the budget deficit monetization. In particular, sovereign debt payments in 1998–99 were ensured partially through foreign currency purchases in the domestic currency exchange. 17. The macroeconomic performance of Russia during the period of crisis was poor: in 1998 GDP fell by 5.3 per cent, unemployment increased to 13.2 per cent, and the real disposable incomes of population fell by 16 per cent. To prevent further worsening, the Central Bank could try to weaken the regime of domestic crediting even more. 18. For example, the requirement for exporting industries to sell foreign currency to the Central Bank, and also limitations on the participation in the sessions for trading currencies. 19. This model is coauthored with Georgy Trofimov. We are thankful to Edward Green, Barry Ickes, and Alexey Pomansky for their suggestions and helpful comments. 20. Banks’ liabilities in foreign currency are ignored in this model. The subsidization of the Russian banking system in 1998–99 by means of the gradual ruble devaluation took place after some banks had defaulted on foreign loans, while others had fulfilled their foreign payments. Devaluation, hence, allowed banks to benefit from speculation against the ruble. The current crisis demonstrates the similar situation. In 2008–09 the CBR granted very cheap ruble loans to the banking system, totalling nearly $60 billion under the substantial gradual ruble devaluation (by 53 per cent

Notes 251

21.

22.

23. 24.

in nominal terms for the time period between the end of June 2008 and the end of February 2009). As ten years earlier, the key idea of the authorities nowadays is to support domestic banks with guaranteed profits yielded from foreign exchange operations. Under the PPP condition the nominal exchange rate would coincide with the nominal price level, and the second term in the objective function (A6.1) would be equivalent to the squared inflation. The goal of exchange rate stability as reflected by the second term of (A6.1) can be viewed as an intermediate goal for maintaining the price level stability Banks in the model earn profits in rubles. The model can be easily transformed to consider profits in dollars: p *((e –1)e ) = (1 – (e –1)e )Z, where Z is the household demand for rubles as an increasing function of the expected ruble revaluation rate, similar to (A6.3). Using (A6.5), the authority’s objective function (A6.1) would be written as p * (e –1) – a (1 – e –1) 2/2. For the case of convex (e) one can impose condition l () > 1 that guarantees existence of the second equilibrium. Taking into account (A6.2)–(A6.3) and (A6.7), we have: U d = (e * – 1) q l (e *) – a (e * – 1)2/2 = a (e * – 1)2 – a (e * – 1)2/2 = a (e * – 1)2/2.

7 Recovery After the Crisis 1. World Economic Outlook, 1998. 2. As a devaluation of the exchange rate means a reduction of the price of exports, quantity demanded will increase. At the same time, the price of imports will rise and the quantity demanded will diminish. The net effect on the trade balance will depend upon price elasticities. If goods exported are elastic to price, the quantity demanded will increase proportionately more than the decrease in price, and total export revenue will increase. Similarly, if goods imported are elastic, total import expenditure will decrease. Both will improve the trade balance. 3. As a result, during the nine months of 1999 costs of production of industrial goods declined compared with the same period in 1998 by 13.7 per cent, while profitability increased by 17.4 per cent. 4. In 1999, for the first time in eight years, investments in fixed assets rose for the whole economy by 1 per cent and manufacturing by 8.8 per cent. International investment activity resumed rapidly in 1999 and the volume of foreign direct investments (FDI) exceeded pre-crisis levels by 26.7 per cent. 5. As a consequence, the share of domestic goods in the retail market rose from 52 per cent in the first half of 1998 to 71 per cent during the fourth quarter of 1998 and by the third quarter of 1999 it reached 73 per cent. 6. The increase in prices in the electricity sector in 1999 was only 14.4 per cent, gas industry –22.1 per cent, coal –32.2 per cent, with an average growth of prices for an industry at 67.3 per cent. 7. The increase in revenues helped reduce the budget deficit in 1999 to 1.2 per cent of GDP, compared to 6 per cent in 1997. 8. As compared to the budgeted figure the actual federal expenses were exceeded by 17.8 per cent in 1999. 9. This could cause hyperinflation but the government has used a number of restrictions on money circulations in the country.

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Notes

10. The Ministry of Finance estimated the budget deficit in 1999 at 70 billion rubles as a result of the tax reform (Ivanter 1998). 11. The 1964 tax cut proposed by Kennedy reduced the top marginal personal income tax rate from 91 per cent to 70 per cent by 1965. In the four years following the tax cut, federal government income tax revenue increased by 8.6 per cent annually and total government income tax revenue increased by 9.0 per cent annually. 11. One of the measures to tackle the crisis was personal deposit transfer from the six largest retail banks to the Savings Bank. That decision anticipated the system of guaranteed deposits as the Central Bank made it possible for people to place their savings with a state-owned bank whose reliability was guaranteed by the state. As a result, in early 1999, according to the Federal State Statistics Service, 350,000 depositors transferred their funds to the Savings Bank whose liabilities then totalled 4.42 billion rubles. Savings Bank’s personal deposits grew from 76.7 per cent to 83.5 per cent. In addition, to normalize payment operations, the Bank of Russia several times (18 and 25 September and 2 October 1998) performed the clearance of arrears between credit institutions, those measures resulted in payments worth 30 billion rubles (75 per cent of all delayed transactions). Finance was taken from the Special Reserve Fund that was supposed to receive commercial banks’ incomes from government bond repayments. 12. As a result, the share of non-residents in the Russian market in 1999 was minimal. In general in 1999–2000 the servicing of domestic debt amounted to no more than 60–70 billion rubles, or less than 10 per cent of the federal budget revenue. 13. For comparison the return of Russian Eurobonds in 1999 was at 20–35 per cent per annum. 14. According to the agreement payments due in 1999–2000, totalling $8,300 million, were restructured as obligations to be redeemed in 16–20 years with a grace of 1–1.5 years and increasing payments. 15. In February 2000, following protracted negotiations, an agreement was concluded with the London Club. According to the agreement $31,800 million debt was restructured into Eurobonds of the Government of Russia (earlier obligations to the London Club had a formal status of Vneshekonombank liabilities worth $21,200 million). 16. Internal currency bonds (OVVZ) were the internal liabilities of government but were nominated in dollars. 17. With an average exchange rate of 24.8 rubles/US$ the ratio of external debt to GDP increased to 83 per cent in 1999, compared to 31 per cent in 1997. 18. In 1998 Russia announced a technical default on its debts to Germany which were covered by the restructuring agreement with the Paris Club. From September 1998 to June 1999 Russia did not make its debt payments to the Paris Club. The total value of missed payments was equal $1.8 billion. In addition, in December 1998 the Russian government breached the terms of the agreement with the London Club and did not fulfill the payments under PRIN (principal of loans). In May 1999 the participants of the London Club decided to adjourn the discussion about Russia bankruptcy until they received Russia’s official request to restructure the debt. On 31 May the total value of postponed payments was equal to $26.4 billion. According to our estima-

Notes 253 tions, the restructuring decreased Russia’s external loans by 40–50 per cent of the discounted value of debt (see Appendix A7.1). 19. Such decreased risk reveals, for example, the lowering of the risk premium paid for Russian sovereign debt and corporate debt denominated in foreign currencies. The spread of Russian sovereign obligations, compared with US treasury bonds (EMBI + Russia) fell over 1999–2000, much more than the average spread on emerging markets (EMBI +). That figure also reflects the fiscal consolidation.

8 Yet Another Crisis, 2008–2009 1. Recent data shows a 9.8 per cent slide. 2. Russia has the lowest public debt to GDP ratio level among the G20 countries. 3. It is worth noting that quasi-sovereign debt is not the same as the debt of any firm that was bailed out with the use of public funds. One should pay attention to the expectations of the lenders. It matters whether they consider the government to be able to step in and help troubled firms. Unfortunately, lenders’ beliefs are mostly unobservable. So it is an open question whether or not we may draw analogies between US and Russian experience in LOLR efforts. 4. If we take only the Urals price into account, it fell by two-thirds. Ore and metals prices decline (also with magnitude of 2.5–3 times) provided future deterioration of terms of trade. 5. October 2008 consensus forecast (Vedomosti newspaper). 6. De Souza (2008). 7. In a recent paper A. Rose and M. Spiegel (2009) have shown that in fact, there was little evidence that countries with deeper exposure to the US suffered more during the crisis. This empirical study revealed that the way that economists, newspapers, and officials understood the crisis was to some extent flawed. 8. Development Center’s estimates. 9. These estimates (actual 2008) define the financial system assets as the sum of banking sector assets, stock market and bond market capitalization. It should be noted that in the case of Russia the bank sector share is only around 34 per cent, substantially lower than in Poland (75 per cent), Kazakhstan (82 per cent), Thailand (74 per cent) or Korea (70 per cent). 10. The top five banks account for nearly half of the sector’s assets. According to official statements, Russian authorities are concerned with the ‘too big to fail’ problem, but in fact nothing has been done to improve the situation over the years. It seems that the shortsighted government enjoys the possibility of gathering profits in the banking sector, and building national financial champions. The improving of efficiency and prudent systemic risk assessment are yet to come to the foreground. 11. The share of foreign banks in the Russian financial system is around 23 per cent. 12. CBR data, September 2009. Moody’s estimates 20 per cent NPL level with a recovery rate of 30 per cent, and S&P produce an astonishing ratio of nearly 40 per cent (with a higher recovery rate)

254

Notes

13. The World Bank in Russia, Russian Economic Report No. 19. 14. Goriaev and Zabotkin (2006) provide an example of the common sentiment: ‘Ultimately, the key determinants of the Russian stock market’s long-run trends are economic growth and further re-rating of country risk and firmspecific risks by the investment community. However, short-run movements in Russian stocks are to a considerable extent induced by fluctuations in other financial markets, both domestic and international. Those which are widely considered as being of primary importance include global equity markets (especially, emerging markets), commodity markets (in particular, crude oil), FX and interest rate trends, and the domestic money market.’ 15. This bias is also strengthened by the unwillingness of many international institutions to deal even with clean and just capitals which come from Russia. 16. That is the way Cyprus has become a leading investor to Russia. 17. Satarov (2007) estimated the volume of ‘business-related’ corruption as 54 per cent of GDP. The methodology of estimates is ambiguous, however. 18. This feature is shown by some empirical studies: see Anatolyev (2005) and Lucey and Voronkova (2005). 19. At the time of writing, there is only administrative responsibility, and the law establishing criminal liability for insider trading conspiracy is still in the process of adoption by the parliament. Law enforcement records simply do not exist at present. 20. Reuters (2007). 21. We base our account on official statements actual November 2009. All figures mentioned should be considered to be estimates, and used with respect to possible future revisions. 22. The widely-used 2.5 trillion rubles (US$81 billion) estimate is misleading as it mixes together fiscal expenditures, central bank lending and tax breaks. The total amount will only be known in the future. 23. Despite this, nominal M2 aggregate fell by 6.1 per cent. In real terms M2 contracted by 10.3 per cent in 2008 and 31.8 per cent real growth in 2007. 24. IMF (2009a). 25. Through Alrosa and RZD (public corporations in diamonds mining and railways, respectively). 26. Weak prudential supervision problem: the former Central Bank deputy governor Dmitry Tulin disclosed that the CBR knew enough of the problems of many banks, but not only allowed them to enter the deposits insurance system, but also opened its eyes to the misallocation of assets and the artificial inflation of capital. 27. In October 2008 small and medium-sized banks experienced deposit outflows of around 10–12 per cent, partly as a result of just deposit conversion. This was not a traditional run on the banks. 28. The Russian banking sector lost fewer than 50 banks between September 2008 and September 2009, but most of them were rather small. 29. The head of the CBR, Sergey Ignatiev, argued that the Bank had no other choice but to provide such loans even taking large credit risks. 30. 6.8 per cent in 2008, PPI-adjusted figures. Russian Economic Report No. 20 (November 2009). 31. IMF (2009) World Economic Outlook (October 2009): Sustaining the Recovery.

Notes 255 32. Manufacturing was the worst-performing sector. 33. The total effect of public works and hidden unemployment could be estimated as three million workers, more than half of the number of unemployed (5.8 million, ILO methodology), see Zubarevich (2009). 34. Ironically, Roland Nash of Renaissance Capital finds that weak enforcement may lead to short-run benefits as banks roll-over loans instead of claiming collateral, thus preventing domino effect. This ‘spare-thy-neighbour’ policy is certainly bad for long-run productivity. (Hat tip for Barry W. Ickes for pointing out to this issue). 35. For instance, RUSAL obtained a US$4.5 billion emergency credit from VEB at least until 2010. ‘Over-leveraged tycoon’ Oleg Deripaska pledged 25 per cent stake in Norilsk Nickel as a collateral. Certainly he was bailed out! 36. In 2008, AvtoVAZ produced six cars per worker employed, whereas Mazda Motors managed to reach 34. 37. ‘That economic crises seem either to facilitate or outright cause economic reforms is part of the new conventional wisdom of reforms’ (Tommasi and Velasco (1996)). 38. ‘Forward, Russia!’, the President’s manifesto published in gazeta.ru. Accessed at http://eng.kremlin.ru/speeches/2009/09/10/1534_type104017_221527. shtml.

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Index Agency for Restructuring of Credit Organizations 200 Agroprombank 79 Albanian financial pyramid 63 Alexashenko, Sergey 150, 153, 174, 249 anti-crisis policy 226–33 Argentina, debt default/swaps 175–7 arrears 89–91 failure to fight 91–3 inter-enterprise 89, 242 size and structure 90 tax 89, 103, 104 Asian crisis 49, 129, 144, 147, 214 commencement of 145 Åslund, Anders 16, 238 asset–liability mismatch assets 155 banks 202 illiquid 131 net domestic 162 AvtoVAZ 235

number of 18 vulnerability of 138 Barro, Robert 240 barter exchange 99–100, 113 decline in 195, 196 Berezovsky, Boris 117, 118, 119, 245 beznalichnyye 17 Black Tuesday 70, 71, 163, 241, 250 Bolshevik Revolution 65 BRIC countries 222, 229 bridge-banks 181 budget deficit 5, 17, 228, 240 finance sources 198 and inflation 43 monetization of 7 budget donors 111 budget process 108–9 budget recipients 244 budget revenue, and debt servicing costs 127 budget surplus 228 ‘Bush legs’ 239

bailouts 231 balance of payments 148, 155–6, 215, 218 Bank of Russia 201 banking system first crisis 82–3 fragility of 78–86, 154–5 growth of 51 inflationary growth 78–82 market transformations 80 and public debt 83–6 restoration of 200–3 restructuring 236 weakness of 8, 51, 177 banks 238 assets 202 liquid 180 bridge-banks 181 equity movements 202 foreign liabilities 137–8

Camdessus, Michel 12 capital adequacy 83, 220 capital controls 138–40 effectiveness of 139–40 prices 140 quantities 140 capital inflow regulation of 140 use of 158–9 value of 158 capitalism 5 capitalist revolution 8–9 cash equivalents 196 cash payments 17, 194 cash settlement centres 54 cash shortages 55 cash-based accounting 103 Central Bank 8, 42, 52 asset shifts 161–2 C accounts 133 262

Index 263 monetary policy 157–63 prudential regulation 83 Central Economic-Mathematical Institute of the Russian Academy of Sciences 42 Central Planning Committee (Gosplan) 13 centralized planned economy 20 Chernobyl 15 Chernomyrdin, Viktor 39, 58, 70, 111, 148, 178, 240, 248 ‘Chernomyrdin’s epoch’ 58 Chilean system of inflow regulation 140 China 19 Chubais, Anatoly 63, 114, 115, 116, 150, 248 CIS (Commonwealth of Independent States) countries 26 classical socialism 12 Comecon countries 19 commercial loans, short-term 35 commodity export taxation 47 compensation 193 consumer price index 52 corporate loans 202 cost inflation 112 Council for Mutual Economic Assistance 238 credit crunch 215–16, 233 credit expansion 54 social consequences 55 creditor nation status 132 creditors of last resort 20 crony capitalism 116 Cuba, sovereign debt 38 currency corridor 72–5 currency unification 46 Czech Republic 5 debt 12–20 constraints of duration 128–30 default 171–8 dynamic and structure 37 external see foreign debt foreign 13–14 forgiveness 27–31 government see public debt internal see domestic debt

public see public debt quasi-sovereign 215 real 125–6, 141 debt accumulation 15 debt addiction 15–20 debt burden easing of 203–7 foreign debt 206–7 internal debt 203–5 negotiations 205–6 post-crisis 204 pre-crisis 204 debt contagion 151, 176, 220 debt crisis management of 25–40 onset of 20–5 debt forgiveness 105 debt management belated 167–71 institutions 40 market-based 47–9 debt rescheduling 130 debt restructuring 3, 27, 41 London Club 41, 171, 209–12 Paris Club 36, 41, 205 debt rollover 149 debt servicing 12 and budget revenue 127 costs 121–2, 132, 142–3, 165, 166 debt stabilization 122–6 debt structure mismanagement 134–6 debt-based reserves 158–60 decoupling 216 demonetization 55 Deposit Insurance Agency 231 Desai, Padma 134 Deutsche Bank 32 devaluation 70, 74–5, 123, 163, 179, 207, 226–8 banks supporting 182–6 consequences of 187–93 domestic import substitutes 190–1 export revenue growth 188–90 growth in industrial production 187–8 and inflation 180 managed 181

264

Index

devaluation equilibrium 185, 186 Diamond–Dybvig bank run model 246 distance to market 94, 95–6 dollar-pegged short-term yields 134–5 dollar–ruble exchange rate 59, 70, 150–1 dollarization 185–6 domestic debt 7, 8, 124 easing of 203–5 expansion 75–8, 121–43, 154 exponential 140–2 logistic 140–2 federal government 125 government pyramids 126–8 as percentage of GDP 77 real 125–6 restructuring 175 securities 68, 75 see also GKO domestic debt market, opening of 132–40 liberalization of investment inflows 133–4 non-resident investors 133–4 risk mismanagement 134–8 domestic financial system 50–86 Dubinin, Sergey 150, 241, 248 Dvorkovitch, Arkadiy 42, 227 Dzerzhinsky, Felix 249

Eastern Europe 5, 34 Economic Expert Group 42 economic reform 5 economic restructuring 94–5 economic structure, distortion of 93–4 economic transition see transition economy acceleration 15 emerging markets 218 Emmanuel, Rahm 236 energy prices 97, 99 post-crisis increase 191 Ericson, Richard 93, 243 Eurobonds 6, 8, 32, 76 first issue 47–8 GKO–Eurobond swap 168–72

Russian issues 39, 48, 123, 125–6, 131–2, 167–8 European Bank for Reconstruction and Development 37 Evraz 230 exchange rate 52, 179, 218 abolition of 171 consequences of ruble defence 162 effects of monetary tightening 152 floating 151, 159 ruble–dollar 59, 70, 150–1 excise duties 101, 103 accrual accounting 165 increase in 199 export revenue growth 188–90 Extended Fund Facilities 45, 87, 107 external debt see foreign debt external finance channels 37–8 external shocks 155–6, 213, 216 federal budget 77, 107 failure to normalize 164–7 performance of 165 federal debt obligations 68 Federal Property Management Committee 63 financial crises 100–20 Asian 49, 129, 144, 145, 147, 214 Latin-American 129 Russian see Russian financial crisis and short-term debt 130–2 financial liberalization 1, 6, 8 risks of 137 financial markets, origins of 51–69 financial policy weakness 219–25 financial pyramids see pyramidbuilding firms inefficiency of 94–5 quasi-market enclave 98 fiscal crisis 153 fiscal deficit 107 fiscal policy 197–8 fiscal stimulus 228–30 Fischer, stanley 12, 45, 153 food supply problems 21–2 foreign currency control 18 exchange inflation 73

Index 265 reserves 162 speculation 60, 81 see also exchange rate foreign debt 13–14, 25, 38, 124 default 21 as disciplinary device 40–7 extent of 36 and macroeconomic policy 40 rescheduling 36–7, 205–7 servicing 42–3 foreign debt crisis 6–7, 9, 10, 11–49 foreign loans 137–8 collateralization of 137 refinancing problems 150 foreign trade 13 duties on 103 liberalization 19, 59 forgiveness of debt 27–31 fragility banking system 78–86, 154–5 internal 217–19 Freeland, Crystia 119 G7 group 12, 31 Gaddy, Clifford 88, 94, 245 Gaidar, Yegor 2, 51, 58, 150, 207 Gaon, Nessim 23 Gazprom 58, 111, 113, 166, 215, 230 cash/non-cash payment transactions 194 GDP 41, 54 domestic debt as percentage of 77 fiscal deficit as percentage of 107 government debt as percentage of 122–3 and industrial production 192 and inflation 56 Gerashchenko, Viktor 53, 71, 241, 248, 249 Germany 35 GKO annual rate 148 maturity values 168 as ‘money vacuum cleaner’ 76, 154 trade 66–9, 74 cancellation of 149–50 yields 152, 160–1, 166

GKO–Eurobond swap 168–72 objections to 170–1 rejection of 169–70 GKO-OFZ holdings 159 trade 150 yields 127, 131, 134–5, 150 dollar-pegged 134–5 global creditor nations 39 Globex 231 Goldman Sachs 168 Gonchar, Nikolay 173 Gorbachev, Mikhail 1, 3, 12, 15, 20, 249 Gosbank 17, 20, 42, 53 Gosudarstvennye Kaznacheiskie Obligatzii see GKO government bonds 202 bank holdings 84 declining yields 126–7 returns 204 government debt see public debt Green, Edward 250 Gresham’s law 110 ‘grey’ money 55, 221–5 gross domestic product see GDP Gusinsky, Vladimir 118 Hamilton, Alexander 28–30, 119 Hungary 5, 35 hyperinflation 92 hysteresis effect 74 IANs 37 Ickes, Barry 88, 91, 94, 156, 242, 245, 250 illiquid assets 131 import duties 101 import substitution 190–1 imports 189 income tax 101, 103 flat rate 199 independent producers 191 India, sovereign debt 38 industrial production fall in 21 and GDP 192 post-recovery growth 187–8, 191–2

266

Index

inflation 6, 43, 50–86 failure to combat 56–60 falling 74 foreign currency exchange 73 and GDP 56 high 90 and refinance rate 57 and ruble devaluation 180 and ruble–dollar exchange rate 59 trade-off 178–82 inflation spiral 52–6 inflow see capital inflow Inkombank 151, 247 insider privatization 96 inter-enterprise arrears 89, 242 interest rates falling 126 increasing 152 peak 128 internal debt see domestic debt International Monetary Fund 7, 12, 32, 37, 41–2, 44, 139 assistance package 149 influence on domestic policy 45–6 investment growth 188–90 investment inflows, liberalization of 133–4 Kaznacheiskie Nalogovye Osvobojdeniya 244 Kaznacheiskie Obligatsii 109 Kheifetz, Boris 14 Khodorkovsky, Mikhail 114 Kiriyenko, Sergei 148, 149, 166, 178 Kit-finance 231 Klepach, Andrey 217 Kovalishin, Eugeney 203 Kozlov, Andrei 250 krugovaya poruka 243 Laffer curve 104, 199 Latin-American crisis 129 lender of last resort 215 liquidity crisis 82 liquidity injection 181 loans commercial short-term 35 corporate 202 foreign 137–8, 150

non-commercial 22 non-performing 220 loans-for-shares deal 113–20 results of 115 London Club 12, 26, 31 debt restructuring 41, 171, 209–12 negotiations 32, 205–6 long-term securities, yields on 130 Lukoil 114, 115, 215–16 macroeconomic indicators 53 macroeconomic policy, and foreign debt 40 macroeconomic stabilization 7, 69–78 and banking crisis 82 failure of 121 and financial crisis 151–3 Madoff, Bernie 63 manual governance 229 market economy 5, 191 market reform 2, 88 market-based debt management 47–9 mature socialism 13, 16 Mavrodi, Sergey 61–2 MMM pyramid 61–2 Stock Generation pyramid 62 Medvedev, Dmitriy 42, 228 MENATEP 247 Metalloinvest 230 MICEX 53, 67, 182 Minfin 105, 149, 169 MMM pyramid 61–2, 124 monetarist arithmetic 77 monetary expansion 56 monetary policy 157–63 choice of 160–3 debt-based reserves 158–60 indicators of 159 growth rates 180 response to crisis 230–3 monetary tightening 70–2, 82 effects on exchange rate 152 failure of 121 money auctions 120 money supply 201 money surrogates 100, 109–10, 121

Index 267 money surrogates – continued cash payments 17, 194 disappearance of 194–6 non-cash payments 17, 194 Mongolia, sovereign debt 38 monopolies 111–12, 166 Moscow Interbank Market for Currency Exchange see MICEX mutual debts evaluation 34–5 mutual survivor behaviours 98 nalichnyye 17 Nash, Roland 255 National Welfare Fund 224 necessary pact 119–20 negotiations 31–5 net domestic assets 162 netting 196 New Economic School 42 new payments system 54 no-devaluation equilibrium 184–5 Noga 23–4 non-cash payments 17, 194 non-commercial loans 22 non-payment problem 89–91 non-performing loans 220 non-pocket banks 84 non-resident investors 133–4 forward contracts 170 hedging of 136 non-transparency 98 Norilsk Nickel 114, 115, 120, 230 Novolipetzky Metal Company 115, 230 Obligatsii Federalnogo Sberegatelnogo Zaima (OGSZ) 68 Obligatsii Federalnogo Zaima see OFZ OFZ 68 maturity value 168 oil exports 15–16 oil prices 3–4, 9, 14 and economic recovery 189 and Russian Trading System 155–6 oil production 16 oligarchs bankruptcies among 234–5 financial contribution of 113–20 ONEXIM-bank 114, 247

OPERU-2 83 optimal dynamic taxation 49 Paramonova, Tatyana 71 Pareto-inferior equilibrium 99, 112 Paris Club 12, 22, 26, 31, 33 debt restructuring 36, 41, 205 negotiations 32, 46, 205 Russian membership 38–9 payment ofsetting 196 payroll taxes 101 Perestroika 15 wage growth and budget deficit 17 petrodollars 13–14 Pikalevo complex 229–30 pocket banks 79 Poland 5, 35 financial reform 40 Poletayev, Yuri 33 policy cycle 153–4 Pomansky, Alexey 250 Ponzi games 61 Potanin, Vladimir 114, 177, 245 Potemkin, Alexander 150 pre-payment requirement 92 price control 140 price liberalization 51, 54, 56, 90, 93 price shocks 97 Primakov, Yevgeniy 151, 178, 179, 228 PRINs 37 privatization by/for insiders 96 relational capital 96 voucher 63–5, 99 productivity 193 profit tax 101, 103 profiteering 22 promissory notes 99–100 decline in 196 Promstroibank 79 public debt 69–78, 123, 214–15 accumulation of 154 and banking system 83–6 dynamics of 122–8 short-term 122, 128–32 public debt–currency reserve ratio 131 Putin, Vladimir 228, 229–30

268

Index

pyramid-building 60, 61–2, 124 Albanian 63 government 126–8, 129 MMM 61–2 Stock Generation 62 quasi-market enclave 97–100, 112 quasi-sovereign debt 215 Railway Ministry 111, 166 re-monetization 195 real debt 125–6, 141 recession 213 recovery 187–212 debt burden easing 203–7 fiscal discipline 194–203 restoration of banking system 200–3 red directors 45, 65, 106, 116 refinancing failure of 149 increase in 147 and inflation 57 rate 161 relational capital 95 privatization of 96 rent-seeking behaviour 57 rescue of enterprises 54 reserve requirements 161, 201 Rhyzhkov, Nikolai 15 risk mismanagement 134–8 Rodrik–Velasco model 246 Rogers, Jim 224 Rosagroleasing 232 Rosneft 230 Rosselhozbank 232 Rossiyskiy Credit 247 Rubin, Robert 12 ruble devaluation see devaluation floating of 151 fluctuation band 171 overvaluation of 152 re-denomination 147 speculation 147 see also exchange rate ruble zone 46–7, 55 ruble–dollar exchange rate 70, 150–1 and inflation 59

Rusal 230 Russia forgiveness of debt 27–31 takeover of Soviet debt 26–7 Russian Central Bank see Central Bank Russian financial crisis ‘calendar effect’ 172–4 causes of 144–63 Central Bank policy 157–63 debt and default 164–86 factors contributing to 151–7 external shocks 155–7 financial fragility 154–5 fiscal crisis 153 macroeconomic stabilization 151–3 policy cycle 153–4 public debt accumulation 154 history of 145–51 impact of 233–5 inevitability of 225–6 inflation trade-off 178–82 present situation 213–36 recovery 187–212 Russian stock market 221–5 Russian Trading System, and oil prices 155–6 Ryterman, Randi 91, 242 sales tax 199 Sargent, Thomas 77, 241 Sberbank 66, 79, 131, 169, 219, 241 SBS-Agro 151, 170, 247 self-herding 226 semibankirshina 118 semiboyarshina 245 shadow economy 98 shock therapy 50, 51 failure of 58–9 short-term debt 128–32 constraints on debt duration 128–30 and financial crises 130–2 short-term federal loan bonds 203 Sibneft 115 Sidanko 114, 115 Smolensky, Alexander 114 Sobolev, Boris 27 Soros, George 248

Index 269 sovereign borrower status 31, 178, 246 sovereign credit 11 sovereign credit rating 39, 144 sovereign debt 32, 38, 239 Stabilization Programme 166–7 Stock Generation pyramid 62 stock market crash 145, 148 Stolypin, Peter 2 strategic choices 26–31 strategic consumers 111 structural distortion 93–4 structural reforms 87 Summers, Lawrence 12, 153 Surgutneftegaz 115 surrogate instruments see money surrogates Svyaz bank 231 Svyazinvest 114, 120 Syria, sovereign debt 38 system shaping banks 84, 85, 118 system transformation 44 tax arrears 89, 103, 104 tax avoidance 98 tax burden 101 Tax Code 197 tax credits 104 tax offsets 104 tax optimization 102 tax reform 105–6, 165, 198–9, 208 tax revenues 103 post-crisis 197 tax system 101–6 Tesobonds 247 three fat boys 111 Tompson, William 163, 249, 250 transferable rubles 19 transition 94–5 one-dimensional model 94 two-dimensional model 96 treasury obligations 109 Trichet, Jean-Claude 46 triple shock 216 Trofimov, Georgy 250 Tulin, Dmitry 254 unemployment 233–4 Unified Electric Systems 111, 114, 166, 196

cash/non-cash payment transactions 194 income structure 195 USA Jones’s Act 22, 33 post-Revolution debt restructuring 28–30 ‘vacation effect’ 172–4 value-added tax 101, 102, 103 reduction in 198 Vavilov, Andrei 173 veksels 99–100 viability constraint 95 Vietnam, sovereign debt 38 virtual economy 88–100, 103, 243–4 emergence of 93–7 failure to fight arrears 91–3 incentive games 113 network externality 99 non-payment problem 89–91 quasi-market enclave 97–100 role of state in 106–13 virtual political system 118 Vneshekonombank 20, 23, 25, 33, 35, 79, 224, 231, 232 Vneshtorgbank 33, 79, 219, 232 voucher privatization 63–5, 99 Vyugin, Oleg 150 wages 243 arrears 89, 166 cash 17 growth in 17, 193 Wallace, Neil 77, 241 World Bank 37 Yasin, Evgeniy 153 Yeltsin, Boris 2, 39, 45, 58, 71, 87, 106, 107, 110, 116, 153, 178, 226, 241 young reformers 45, 110, 112, 118, 245 Yugoslavia 19 Yukos 114, 115 Zadornov, Mikhail 150 zero-coupon bonds 181 Zhirinovsky, Vladimir 69

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