ROUBLE CRISIS, AGAIN

In May, the rouble came under more pressure than at any time since Black Tuesday in October 1994.
Since the introduction of the currency corridor in 1995, the strong rouble has served as a nominal an-
chor for the economy, helping bring down inflationary expectations and giving foreign investors the
confidence to lend to the Russian government, banks, and companies. Commitment to the rouble cor-
ridor limited the Central Bank’s ability to print money, and forced the government to finance its defi-
cits in non-inflationary ways – by borrowing on the domestic and international bond markets. Infla-
tion has been brought down from 200 percent per year in early 1995 to 8 percent today. The anchor is
now at risk, threatening to undermine Russia’s hard-earned stability. This report analyses what has
brought Russia’s currency to the brink of devaluation.

Fiscal balances
With a low initial stock of domestic debt, the bond market did not at first impose severe constraints
on government finances. But high interest rates and profligate borrowing, especially during the 1996
election season, caused the stock of GKO's to rise from 3.5% at the end of 1995 to 13.5% of GDP
two years later. Most of this debt was short-term, with an average maturity of under a year. In the
spring of 1997, the government began a gradual deficit reduction, assisted by falling interest rates. In
the first four months of 1998, the government brought the deficit down to 4.4% of GDP by running a
primary surplus (the deficit minus interest payments) of 0.5% of GDP.

Budget deficit (%, GDP)

1

-1

-2

-3

-4

-5

-6

-7

-8

-9

-10
1996 Q 1 1996 Q 2 1996 Q 3 1996 Q 4 1997 Q 1 1997 Q 2 1997 Q 3 1997 Q 4 1997 Q 1

Prim ary deficit Interestpaym ents

Source: Ministry of Finance

RUSSIAN ECONOMIC TRENDS, June 1998 1

The fiscal tightening is an important achievement, and has reduced the government’s need for new
financing. But even though it is currently not borrowing to finance its current spending, the govern-
ment must still raise an average of 8 billion roubles each week to roll over the existing domestic debt
as it matures. Each week, as the debt comes due, investors decide anew whether to keep their capital
in rouble assets. The government must therefore constantly work to retain confidence both in its own
creditworthiness and in the rouble’s on-going stability. When investors grow less willing to hold rou-
bles, the government must offer higher interest rates. These higher interest rates increase the govern-
ment’s debt burden and feed investor concerns about whether the government will be able to pay
them back.

Existing GKO/OFZ debt coming due for repayment during 1998 (R bln)
12

10

0
05.08

09.09
03.06

24.06

26.08

02.09

30.09
23.09
08.07

29.07
22.07
10.06

19.08

16.09
12.08

28.10

09.12

23.12
17.06

01.07

15.07

07.10

14.10

04.11
21.10

25.11
18.11
11.11

Principal due Interest payments

Source: CBR

The concern is not that the government will actually default on its debt obligations. Rather, investors
fear that if interest rates rise to punitively high levels – both for the government and for companies in
the real economy – the Central Bank will be tempted to loosen monetary policy in an attempt to
lower interest rates. In the process, the real value of the debt would fall, but the rouble would be sac-
rificed. During the recent crisis, yields on rouble-denominated debt have soared, while dollar-
denominated debt yields have hardly moved, evidence that investors are concerned about the cur-
rency rather than the government’s likelihood of default.

RUSSIAN ECONOMIC TRENDS, June 1998 2

Interest rates on dollar and rouble debt
60

50

40

30

20

10

0
30.09 14.10 28.10 12.11 26.11 10.12 25.12 14.01 28.01 11.02 25.02 12.03 26.03 09.04 23.04 08.05 25.05

Interest rate on Russian dollar MinFin debt Inflation adjusted interest rate on Russian rouble debt

Source: Moscow Times, Troika Dialog

GKO's, Rouble deposits and M0 (R bln)

400

350

300

250

200

150

100

50

0
12.95 03.96 06.96 09.96 12.96 03.97 06.97 09.97 12.97 03.98

M0 R ouble deposits G KO & O FZ (m arketvalue)

Source: CBR

RUSSIAN ECONOMIC TRENDS, June 1998 3

 Demand for rouble assets
Russia’s domestic debt is not high by international standards. The trouble is that Russian households
and companies, for a variety of reasons, have been unwilling to keep their capital in roubles. The
stock of rouble-denominated government debt has grown larger than the total stock of rouble depos-
its in commercial banks.
With the slight economic recovery in 1997, the financial health of Russian companies improved, and
corporate rouble deposits grew. But households, who saw the real value of their deposits wiped out
during the 1992 inflation, remain unwilling to commit their savings to rouble assets. Russians are
also discouraged from holding roubles by inefficient banks offering low interest rates and few serv-
ices to depositors, and by ever-inquisitive tax inspectors. Instead, the preferred instrument both for
savings and for many transactions remains dollar cash. In the second half of 1997, household rouble
deposits increased by $1.2 bln, with time deposits actually falling by $0.9 bln, while Russians bought
a net $9.6 bln of foreign currency cash, perhaps driven by fears that the January 1 re-denomination
would be confiscatory. Household purchases of foreign cash in the last quarter of 1997 were $5.9 bln,
exactly matching the decline in Central Bank foreign exchange reserves over the same period.

Non-resident purchases of GKO's, resident purchases of foreign cash and changes in reserves,
1997 ($ bln)
10

-2

-4

-6
Q1 Q2 Q3 Q4

N et non-resident inflow s into G K O s N et purchases of foreign currency cash by residents Increase in foreign exchange reserves

Source: CBR

It is foreigners who have made up the difference. Their holdings of GKO's and OFZ's increased
sharply during the late 1996 and the first half of 1997, a period when emerging debt markets were
buoyant around the world. Foreigners’ share of the government rouble debt market increased to
roughly 30% in the summer of 1997. Then in July, Thailand devalued the Baht, setting off a chain of
events that was to lead to a sea change in market sentiment. Russia as a large emerging market bor-
rower was severely hit. Investors became much more cautious about taking on Russian risk, and de-
manded a higher interest rate to do so. Since the Russian debt markets are dependent on foreign par-
ticipation, the CBR had to let interest rates rise sufficiently to keep the foreign investors in the mar-
ket and thus to assure the stability of the rouble.

RUSSIAN ECONOMIC TRENDS, June 1998 4

Higher interest rates have turned out to be sufficient to stem the outflow of foreigners, who continue
to own almost a third of the market. Even in the last quarter of 1997, when the sell-off was particu-
larly severe, there was a net inflow of $0.2 bln into GKO's. Foreign investors have been price sensi-
tive, coming into and out of the market depending on the interest rate level and the perceived “fun-
damental” risk. The graph below shows that periods when the exchange rate was at the top of the
CBR’s daily intervention band (i.e. when the CBR was purchasing dollars and so replenishing re-
serves) coincided with periods of falling GKO interest rates, and vice-versa.

Interest rates and capital movements*

5 80

70

4
60

50
3

40

2
30

20
1

10

0 0
01.10 15.10 29.10 12.11 26.11 10.12 25.12 13.01 27.01 10.02 24.02 11.03 25.03 08.04 22.04 07.05 22.05

Daily exchange rate as a proportion of CBR 's daily intervention band (lhs) Six-month G KO interest rate (rhs)

* The lower line is the position of the MICEX daily rate inside the daily intervention band of the CBR. Peri-
ods when it is at the top of the band are those where the CBR is buying dollars and so building reserves. At
these times of capital inflows interest rates on GKO's are falling (the upper line). Periods when the exchange
rate is at the bottom of its daily band are those where the CBR is supporting the rouble by selling dollars for
roubles. At these time of capital outflows the interest rate on GKO's is increasing.
Source: CBR, Troika Dialog

In the euphoric investment climate of the first ten months of 1997, Russian banks took the opportu-
nity to borrow heavily in the syndicated loan and Eurobond markets. Foreign liabilities of the bank-
ing system increased from 11% of total liabilities at the beginning of 1997 to 17.5% at the end of the
year. The banks used these foreign funds to invest in Russian assets: treasury bills, regional and cor-
porate bonds, loans to the private sector, and equity. During the course of 1997, Russian banks saw
their foreign liabilities overtake their foreign assets. By the end of March 1998, foreign liabilities ex-
ceeded foreign assets by about $6.5 bln, not including off-balance sheet rouble forward exposure.

RUSSIAN ECONOMIC TRENDS, June 1998 5

Foreign assets and liabilities of commercial banks (R bln)
120

80

17.2%

40
11%

8.5%

0
01.96 03.96 05.96 07.96 09.96 11.96 01.97 03.97 05.97 07.97 09.97 11.97 01.98 03.98

Foreign liabilities Foreign assets

Note: percentages refer to the share of total bank liabilities. Liabilities do not include off-balance sheet items
such as rouble forwards.
Source: CBR

After the Asian crisis hit Russia in October 1997, the flow of foreign money came to a halt. None-
theless, Russian banks must continue to find foreign currency to service these loans, and may find
themselves needing to repay the principal as well if their creditors refuse to roll the loans over when
they come due. These rollovers have been thrown into doubt by the sharp decline in the value of
banks’ assets, which has made them much less attractive credit risks. Banks have been forced to sell
off assets at extremely low prices to meet their obligations. Fears about the solvency of Russian
banks have come to a head since the Central Bank placed Tokobank, one of the top twenty banks and
a heavy borrower from foreigners, into administration when it became clear that it would be unable
to make payments to its creditors.

The drop in Central Bank foreign exchange reserves – driven by the outflow of households and the
reduced inflow of foreign capital – led the monetary authorities to raise interest rates, causing an ac-
tual decline in base money. Without any new inflows of capital into the banking system, this has
made credit extremely tight and further driven down asset prices.

RUSSIAN ECONOMIC TRENDS, June 1998 6

Base money and Gross International Reserves of the CBR (R bln)
180

160

140

120

100

80

60

40

20

0
01.97 03.97 05.97 07.97 09.97 11.97 01.98 03.98

Base money G ross international reserves

Source: CBR

Outlook
Falling GKO yields late this week may mean that the worst of the current crisis has past. But points
of weakness remain. To avoid a renewed crisis, the government must take a number of steps. First,
the federal government must continue to cut its deficit, both by forging ahead with its plan to cut ex-
penditures and by drawing on other sources of revenue – most importantly, by recovering revenue
that has been lost to wasteful regional governments. Second, the government should consider con-
ducting a greater proportion of its borrowing in foreign currency at longer maturities. Third, Russians
must be convinced to hold more roubles. Currency stability is necessary but not sufficient. Russia
needs a more efficient, trustworthy banking system. International experience of banking reform show
that introducing foreign competition into the retail banking sector is the most direct way of improv-
ing bank efficiency and reducing dependence on volatile foreign capital flows.

In the short term, the need to maintain confidence in the rouble will impose a straightjacket on the
government’s behaviour. The need to roll over billions of roubles of GKO's each week puts eco-
nomic policy under constant scrutiny from foreign and domestic investors. Any sign of wavering
from the course of reform by the government would incur immediate punishment from the bond
market, and would put the rouble in jeopardy once again.

RUSSIAN ECONOMIC TRENDS, June 1998 7

 ECONOMIC UPDATE
Output GDP and investment (1995=100, SA)
105
There is now GDP data for the first four months
of 1998. However, that data is likely to be re- 100
Real GDP
vised which makes comparisons with 1997 dif- 95

ficult to interpret. Revisions to 1998 data are

90
likely to imply a flat economy more or less. A
definite verdict has to await further work by Go- 85

skomstat. More generally, growth is likely to 80

falter this year due to repeated periods with
turmoil on Russian markets. High interest rates 75
Fixed investment
and lack of funding will again delay the long- 70

awaited recovery of the economy. 01.96 04.96 07.96 10.96 01.97 04.97 07.97 10.97 01.98 04.98

Industrial production numbers show some

moderate growth. The January-April average Industry (1995=100, SA)
was about 0.8 % higher than the average for 105
Energy and fuels output
1997 as a whole. Agricultural production in- 100
creased by about the same amount. Indicators
of activity in the construction sectors were in- 95 Industrial production
conclusive. While, real construction works were 90
down by 0.8 % in January-April 1998 over the
85
full-year 1997 number, dwellings completed
were up by 2.7 %. Freigth transportation turn- 80
over went down by 1.4 %. 75

70
01.96 04.96 07.96 10.96 01.97 04.97 07.97 10.97 01.98 04.98

Aggregate demand
The demand indicators suggest less gloom. Consumer expenditures and retail sales
Real wholesale trade was 1.4 % higher in (1995=100)
January-April than in the same period in 1997. 120 Consumer expenditures
Meanwhile, real retail sales went up by 3.2 %. 115 Retail sales
By contrast, real paid services went down by 110
0.7 %. Thus, demand seems to be increasing 105
although real incomes have been falling. In the 100
95
first four months of this year, real disposable
90
household income was down by 7.4 % over the
85
same period in 1997.
80
01.96 04.96 07.96 10.96 01.97 04.97 07.97 10.97 01.98 04.98

RUSSIAN ECONOMIC TRENDS, June 1998 8

Wages
Real wages and wage arrears
The trend towards higher accrued wages has- 300 150
continued so far in 1998. In April, the average
monthly wage was 8.3 % higher than in April 260
Real wage arrears,
140
Dec-1995=100
last year. The increase between the first four (left scale)
months of 1997 to the first four months of 1998 220 130
Real monthly wage due,
was even higher at 9.5 %. However, this devel- 1995=100 (right scale)
opment has been matched by a further unwel- 180 120

come runup of wage arreas. Nominal wage ar-

rears amounted to R 50.1 bn at end-April com- 140 110

pared to R 39.7 bn at end-1997 and R 36.7 bn

at end-April 1997. 100 100
01.96 04.96 07.96 10.96 01.97 04.97 07.97 10.97 01.98 04.98

Arrears
Arrears and Bank Credits & Loans, % of
March figures for non-payments were again
GDP*
disappointing, with all types of arrears, includ-
ing government wage debt, rising by 4- 5.5% 45.0

compared to the previous month. In an attempt 40.0

to collect some of the nearly hopeless tax 35.0

debts, the government issued a new resolution 30.0

To employees
on May 22. It aims at centralising all of state 25.0
To budget &
claims to the companies at the Federal Bank- 20.0 extra-budgetary

ruptcy Service and introduces a ‘quick bank- 15.0

ruptcy’ procedure which attempts to raise 10.0

To suppliers
money for creditors through a sale of an enter- 5.0
Bank loans & credits
prise as a going concern. This option may 0.0
01.96 04.96 07.96 10.96 01.97 04.97 07.97 10.97 01.98
make bankruptcy more acceptable to local
*Data is for the four sectors of the economy (industry,
authorities, as it softens social implications of agriculture, transport & construction) prior to January
insolvency procedure. 1998 and for the whole of the economy from January
1998

Prices Inflation rates, % per year

Inflation has been declining steadily. The
twelve-month increase in the CPI amounted to 25

only 7.9 % in April, down from 15.3 % in April of

the year before. As before, service prices rose 20

particularly fast, increasing by 16.5 % as com-

pared to 6.5 % for food and beverages, and 15
Consumer
6.3 % for non-food goods. Producer price infla- price index
10
tion has decelerated even more rapidly and is
now running at only 3.9 %. This favorable trend
5
attests to the success of the authorities in tam- Producer price index
ing inflation. However, inflation is not likely to
0
fall much further, while it would rise again if the 01.97 03.97 05.97 07.97 09.97 11.97 01.98 03.98

rouble would weaken in a major way.

RUSSIAN ECONOMIC TRENDS, June 1998 9

Foreign Trade
The trade surplus showed the usual seasonal
improvement in March, reaching $ 2.3 bn in the Merchandise exports and imports ($ bn)
10
first quarter of 1998. Still, exports were 14% 9
lower than in March 1997. Price of Russian oil 8 Exports
continued to fall, with exporters trying to off-set 7
these effects by charging above-the-market 6
prices on exports to CIS countries, a reverse of 5
the situation that prevailed before 1998. Last 4

year’s balance of payments figures published 3

Imports
by the CBR showed 1997 current account sur- 2

plus shrinking to $3.3 bn, or 0.7% of GDP from 1

$12.1 bn in 1996 on the back of falling trade 0

01.96 04.96 07.96 10.96 01.97 04.97 07.97 10.97 01.98
surplus and widening deficit in interest and divi-
dends payments. Foreign direct investment Source: Goskomstat
increased 2.5 times last year reaching $6.2 bn.

The budget
In the first four months of 1998, the federal
budget ran an IMF-definition deficit of 4.4% of
Federal budget deficit, % GDP
GDP, down from 8.5% in the first four months
6
of 1997. The primary budget, not including debt
4
service expenditures of 4.9% of GDP, ran a
2
surplus of 0.5% of GDP in the same period. 0
The primary surplus in the month of April was -2 Debt service
0.8% of GDP, meaning that the federal gov- -4
ernment has run primary surpluses for an un- -6
precedented third consecutive month. -8
Primary balance
-10

The deficit reduction was achieved by reducing -12

federal spending to 15.3% of GDP in the first -1401.96 04.96 07.96 10.96 01.97 04.97 07.97 10.97 01.98 04.98
four months, down from 18.9% in the same pe-
riod of 1997. Major cuts have occurred in
spending on subsidies to industry and agricul-
ture and on aid to other CIS countries. Regional
governments have also begun to pay back the Federal revenues and expenditures, % GDP
loans they took from the federal government in 35
late 1997 to settle wage arrears to their em-
30 Federal expenditures
ployees.
25

Federal tax collection slipped in April to 9.2% of 20

GDP, down from 9.5% in March and 12% of 15
GDP in the same month of 1997. Revenue for
10
the first four months rose to 10.9% of GDP Federal revenues
between January and April, up from 10.4% in 5

the first four months of 1997, but remained be- 0

low the government’s budget target. Regional 01.96 04.96 07.96 10.96 01.97 04.97 07.97 10.97 01.98 04.98

and local revenues were a robust 11.8% of

GDP in the first quarter, slightly higher than the
same period of the previous year.

RUSSIAN ECONOMIC TRENDS, June 1998 10

Interest rates Interest rates and inflation, % per year
160
The CBR increased interest rates three times in
May. The final rise brought the Refinance rate 140
CBR
R efinance rate
and the Lombard rates to 150% on May 29. 120

This is the highest level since February 1996, a 100

time at which inflation in the preceeding 12 80

months had been 90%. In the year to April 60 6 month G KO

1998, the inflation rate was down to just about yield
40
8%. The level of the refinance rate reveals the
severity of the crisis that hit Russian markets in 20 CPI

May. 0
01.10.97 27.11.97 29.01.98 27.03.98 26.05.98

Source: Troika Dialog, CBR

Financial markets
Moscow Times $ Index 1997-1998
The Russian stock market suffered its worst 450
falls in May. It was down 40% in the month, hit- 400
ting lows at levels that occurred in between the
350
two rounds of the presidential elections in June
300
1996. Markets were very thin and sentiment
250
very bearish. One of the main futures exchange
200
collapsed. Rumours of bank and brokers losses
150
abounded. By the end of May, the Moscow
100
Times was 70% below its peak of the summer
of 1997. 50

0
12.96 03.97 05.97 07.97 09.97 10.97 12.97 03.98 05.98

Source: Moscow Times

The exchange rate

The rouble exchange rate and daily inter-
As discussed in the special section to this re-
vention band (R/$)*
port, at the center of the crisis was the stability 5.80
of the rouble. Though it fluctuated inside the
5.85
Central Bank’s daily intervention band over the
course of the month, the rate did not change 5.90
much more than normal. Indeed, in the month, 5.95
it fell by its usual average of 0.5% against the 6.00
dollar. However the pressure on it was severe, 6.05
with the CBR using about $1.5 bn of reserves
6.10
to defend its stability. This reduced reserves to
6.15
$14.6 bn at the beginning of June.
6.20
01.09 29.09 27.10 24.11 23.12 23.01 20.02 23.03 20.04 20.05

* MICEX exchange rate

Source: CBR

RUSSIAN ECONOMIC TRENDS, June 1998 11