Russian Currency Crisis Essay, Research Paper
Not so long ago, business was bullish on Russia. Moscow was experiencing a construction boom driven by multinationals and local entrepreneurs demanding office space. In 1996, the benchmark stock index, the Russian Trading System (RTS) was up about 120% and continued to climb in the first quarter of 1997. Long-held hopes about Russia nourished this dynamic, notwithstanding considerable evidence that the country had yet to establish the rule of law, a critical prerequisite for any state to become a true market economy. By mid-1997, however, Russia was already showing signs of political gridlock and economic stagnation. Unfortunately, these signs materialized into the Russian financial crisis in August, 1998. From a chronological perspective, the crash of the Russian equity and debt crash markets began in Asia during October 1997. Prior to the Asian financial disaster, at the zenith of the Russian markets in late 1996 and 1997 floods of foreign investment poured into Russia. The inflows of capital into the debt markets drove up prices and brought yields to as low as 20%. The debt load grew to as much as $70 billion as the Russian government took advantage of low yields to finance its deficit spending. When Asia collapsed in October 1997, emerging market interest rates increased and Russia began to have problems servicing its debt.In July 1998 the Russian markets became increasingly uneasy when the U. N.’s Economic and Social Council concluded that short-term growth prospects in Russia had deteriorated considerably and unless reforms and stability are introduced GDP growth could fall below its target. At this point Russia’s public debt was four to five times larger than annual budget revenues.As of mid July 1998 the benchmark stock index, the Russian Trading System (RTS), had lost nearly 75% of its value since October 1997. In early August, interbanks were paralyzed by liquidity shortages and a lack of investor confidence. This depressed stock prices to their lowest level in two years.The events of August 17, 1998 demonstrated to the West that virtually every national economic crisis results from a collapse of the currency. On that day, the Russian government devalued the ruble, defaulted on $40 billion of its debt, and ordered a 90-day moratorium on payments of some foreign debt by Russian banks. Simultaneously, Russian abandoned its defense of the ruble and devalued it.Further, the value of Russian state bonds (GKOs), which represented a major portion of bank portfolios, was wiped out overnight. Compounding the problem were forward contracts into which Russian banks had entered with their Western counterparts. Because GKOs are denominated in rubles, foreign banks sought to hedge themselves against the risk of a currency devaluation by using forward contracts. Unfortunately, the ruble fell so far that Russian banks were unable to pay off the forward contracts. By year-end the ruble had slipped from 6 to 23 rubles on the dollar.The Institute for Economic Analysis in Washington estimates at $70 billion the overall losses on GKOs held by foreign and Russian investors. The European Bank for Reconstruction and Development in London projects at $169.50 million its own losses in Russia for the first nine months of 1998. Estimates of American pre-tax commercial and investment banking losses arising from activities in Russia exceed $1 billion. Direct foreign investment also took a hit. In a September 1998 survey of its members by the American Chamber of Commerce in Russia, 72% of the respondents stated that their funds had become inaccessible as a result of bank restructuring and other actions by the Russian government in connection with August 17. In addition, 58% reported non-payment of receivables, combined with a decline in demand for their products or services; 28% reported the full or partial collapse of their distribution network; and 36% were forced by the crisis to delay payments to their own creditors. In a follow-up survey the 50 businesses responding estimated their losses, in the aggregate, at $500 million. Currently, Russia owes the London Club of Creditors $20 billion and the Paris Club of Creditors $40 billion. Russia offered to pay foreign bondholders 10% in cash, 20% in non-coupon securities tradable for tax debts or shares in Russian banks, and 70% in ruble denominated interest-bearing securities with maturities of as long as five years. The majority of foreign investors have balked at the idea saying that the restructuring is worth 5 cents on the dollar in relation to their original investment. Many creditors have considered using foreign courts to seize Russian property such as energy companies like Gazprom. Lehman Brothers Inc. recently won court orders freezing $128 million in the British units of three Russian banks that failed to honor foreign exchange contracts. Basically, Russia is in a financial hurricane. Central Bank Chairman Viktor Geraschenko has been printing money to cover the carrying costs of its debt. The government has acknowledged that printing money may push inflation up to nearly 45% by the end of 1999. On January 15, 1999 Russia reopened its debt market. On opening day the market mainly consisted of long-term bonds, known as OFZs, not covered by the default and of new securities issued to compensate holders of the defaulted debt. Worries over Russia’s solvency are likely to keep the domestic market in the doldrums. Foreign investors, unhappy with the government’s restructuring plans for the defaulted debt and unable to get their money out of the country, have little to gain by trading. The most likely sellers are troubled Russian banks trying to get their hands on Rubles.Another factor that caused the crash of the Russian markets and has contributed to the collapse of their economy is the depressed value of oil. The few oil companies that are publicly owned must pay taxes to as many or more than 30 different tax officials, ranging from local municipal authorities to national authorities. So the Russian government was dealt a lethal blow in July 1998, when British Petroleum and Russia’s Uneximbank announced that they would not bid in the July tender to privatize state producer, Rosneft. Moscow’s cash strapped budget urgently needed the $1.6 billion asking price to replenish dwindling foreign currency reserves. Shrinking reserves signaled a ruble devaluation and this contributed to investor skepticism about investing in Russia. According to Royal Dutch Shell group, who also pulled out of its joint bid with Gazprom and Lukoil Holdings, depressed oil prices had made the asking price for Rosneft too high. Gary Kinsey, a trader at Brunswick Warburg brokerage, summed up investor sentiment when he said, ” that it is risky for any fund manager to put money into Russia as long as there is still a threat of devaluation . Traders will be wary until an IMF loan package is announced, but even then there will be concern about a devaluation”. In May the Central bank tripled interest rates to 150% to keep investors from dumping rubles for other currencies. One month later, in June, the Central bank cut interest rates to 60% in hopes of fostering economic growth. Well, once the problems with Rosneft surfaced and materialized investors fled the bond markets driving yields back up to as high as 120%.
Bad policies translate into disastrous economic results. The extent of the economic contraction is still being felt around the world in depressed oil prices and availability of capital. The stock market is in free fall, having lost 80 percent of its value in a year. A fund manager from Texas named Dana McGinnis invested $200 million after a whirlwind, Morgan Stanley-sponsored visit to Moscow in late 1994. To the detriment of his investors, more than 100 of whom had invested a minimum of $1 million each in his hedge fund, he apparently failed to keep himself apprised of economic and financial developments in Russia and has since filed for Chapter 11 bankruptcy protection. A week later, III Offshore Advisers decided to liquidate a $450 million fund, largely due to losses suffered in Russia. But the more common story was George Soros, whose Quantum Fund lost close to $2 billion dollars betting on GKOs. Evidence suggests that only the most savvy and, perhaps, the best politically connected, escaped unscathed. Goldman Sachs, which played a prominent role in helping Russia to develop its bond market and to borrow billions from foreign investors, successfully protected itself by closing out its positions, worth hundreds of millions, just prior to the collapse of the ruble on August 17. Yet as late as July 1998, Goldman Sachs arranged a $6.4 billion bond swap, a transaction the firm touted to clients by buying ruble-denominated securities, and reportedly collected a $56 million fee. In July 1998 the International Monetary Fund had tried to help Russia by organizing a large-scale bailout package. The $22.6 billion loan was supposed to stabilize the government’s finances, safeguard the ruble and kick-start the economy. However, shortly after the release of the first $4.3 billion tranche, the ruble collapsed. In lieu of this the IMF froze the $4.3 billion tranche as well as the $2.1 billion tranche that was due in November. Russia has billions of dollars in debts to investors, state workers, pensioners, and is searching for sources of funding to close the gap. International lenders are basically Russia’s last hope. But the IMF has put off further disbursements until Russia meets an economic target. In this particular scenario the Russian budget is that economic target. So far the budgets that Russia’s lower house of parliament, known as the Duma, have proposed has left the IMF unimpressed. The IMF sees the proposed budgets as unrealistic in its assumptions on inflation, the ruble exchange rate and revenue. In Russia, however, the budgets are the toughest that has passed the Duma. The most anti-social and tightest budget in modern Russian history, the budget is built on several disputable assumptions. For instance, that inflation will remain at 30% and the ruble will remain steady at 21.5 rubles to the dollar – already higher than this week’s average of about 23 rubles to the dollar. If Russia begins to print money to service its debt then the chances are very slim that they will keep inflation at or below 30%. Also, that Russian tax collectors and other revenue raisers will meet a $20.5 billion target, despite government plans to cut the value-added tax. The United States is the last obstacle between the IMF and Russia’s $22.6 billion bailout package. If Russia rewrites its budget in the fashion that satisfies the IMF chances are that it would get funding but “No one believes they have the political will to collect taxes”. On the other hand the West’s reluctance to alienate Russia could play a part in an eventual IMF agreement with Russia. From a broad strategic viewpoint it may be counterproductive to push Russia out of the picture and deny funds. Seeing as though Russia has about 10,000 nuclear bombs at $200 million each. They could solve their current economic problem by selling a fraction of their nukes to countries willing to buy them. These are not things that the IMF is supposed to take into account, but sometimes these things do matter.President Boris N. Yeltsin issued a decree permitting the cash-strapped Russian government to auction off up to 5% of one of its most valuable assets — the natural gas monopoly Gazprom. The decree was a rare sign of Yeltsin’s involvement in tackling Russia’s worst economic troubles since the 1991 Soviet collapse. The government repeatedly has postponed the sale of Gazprom shares because of hopes of getting a better price. Russia’s financial troubles have scared away foreign investors and driven down share prices. But with the International Monetary Fund reluctant to give Russia more loans, the government has little choice but to sell more shares to pay off its huge debt. The government currently holds 40% of Gazprom shares, and said it may gradually reduce its holdings to 25%. If Russia cannot raise enough cash through taxes, loans or privatization sales, it may have to print more money to pay off overdue wages and pensions, which could lead to high inflation. Russia has been forced to weather what is at times a violent storm in its historic and dramatic change from government-controlled commerce to a free market economy. Thus far Russia has abused the foreign credit markets. Due to the fact that we live in such a global economy Russia will ultimately pay a severe price, above and beyond its monetary obligations, for once again messing with the big boys from the West.