Missteps by Moscow Spur Russian Turmoil

MOSCOW -- In the story of how Russia's markets collapsed in May, give at least a couple of paragraphs to a simple mistake by a provincial government aide.

It happened that Lawrence Summers, America's top international-finance official, was in Moscow in mid-May when worries growing out of renewed Asian troubles were rising, and Mr. Summers requested a meeting with Prime Minister Sergei Kiriyenko. But an aide to the youthful new prime minister, hailing from Mr. Kiriyenko's hometown 250 miles east of Moscow, knew only that this Mr. Summers was a deputy secretary of the treasury -- a title unworthy of an audience with a Russian prime minister.

Word leaked out that the two had failed to meet. Then, an International Monetary Fund team left town without agreeing with Russia on a 1998 austerity plan. Investors, already nervous that the country would be unable to pay its debts, feared a rift between Russia and its Western government financiers, despite public support by Mr. Summers for Russia's efforts. Over the next two weeks, a bad situation worsened, as ruble-holders rushed to convert to dollars, stock prices plunged, and a near-panic brought Russia to the brink.

A look at how the crisis unfolded shows how long-brewing financial troubles combined with misunderstandings, bungled policy initiatives and unfortunate coincidences to undermine the Russian economy.

The nation has pulled back from the precipice, in part by successfully selling $1.25 billion of new Eurobonds and bringing down interest rates somewhat. The Central Bank Thursday slashed its overnight lending rate for banks to 60% from the sky-high 150% set a week earlier, and yields on one-year government bonds fell 6 1/2 percentage points to 48%. While plenty of disarray remains, Russia has recently put on an unusual display of coordination between the government, the Central Bank and the Kremlin.

Still, investors say the country is likely to need a support package worth billions of dollars from the West to emerge from its current financial hole, and it has to convince the world it has learned some lessons. Russia will need to show that its new promises of reform, such as to pass and implement a new tax code, are real. For this latest Russian crisis, while punctuated by things as simple as the misunderstanding involving Mr. Summers, is rooted more deeply: in a changed global outlook toward emerging nations, and in Moscow's repeated failures to follow through on reform pledges.

When the emerging markets of the world were flush, Asian nations got by on their track record of growth and Russia got by on good intentions. That no longer cuts it with global investors. Since the Asian debacle, they are more demanding, says Dirk Damrau, head of research at the Moscow brokerage firm MFK Renaissance. "And Russia has been found lacking," he says.

That is clear from the way investors, domestic and international, have punished Russia this spring. Its stock market, which skyrocketed in 1996 and part of 1997, is down 48% so far this year. For the month of May, it fell 39%. That puts stocks just above where they were in a frightening period two years ago before President Boris Yeltsin defeated a Communist candidate and won re-election.

Amid the latest crisis, government-bond yields briefly soared above 70% annually. The still-lofty rates threaten that unless investors come back into the bond market and drive down yields, the finance ministry will bankrupt itself paying interest. Already, a third of government revenue goes to interest, and billions of dollars in obligations are due in the coming months.

Until the most recent troubles in Asia -- riots in Indonesia, more evidence of Japan's deep ennui, a nuclear race on the Indian subcontinent -- Russia appeared to have escaped the ravages of the Asian monetary maelstrom. Its notoriously poor tax collection was improving. Economic data showed growth for the first time in seven years. Credit Suisse First Boston declared the country a buy. Boris Jordan, an American who has become one of the biggest players in Russia's stock market, went on vacation to Disney World.

Then all hell broke loose. Here is how it happened.

The Background

Russia's May crisis is broadly rooted in global conditions, but it traces as well to some blunders here in Moscow.

As markets around the globe stumbled in October, the Russian Central Bank made what many consider a critical mistake: Instead of defending the currency, it used reserves to intervene in the bond market to hold down interest rates. The end result was to wipe out a significant part of the country's gold and cash reserves.

Still, Russia experienced only collateral damage in the fall and winter. The government, then headed by Prime Minister Viktor Chernomyrdin, issued a series of reform pledges. Investors gave Russia a second chance. The ruble held steady, and yields on one-year government bonds, after rising as high as 40%, settled back below 30% by year end. The Russian stock market's fourth-quarter drop, while a jolting 21%, was little more than a dip compared with the butchery in some emerging markets.

Investors were reassured by news that the Russian gross domestic product, on the wane for seven years, actually rose slightly in 1997. The Communist-dominated parliament, known as the Duma, passed a budget that many thought was the most realistic ever, calling for spending cuts and a smaller deficit.

Indeed, in the first quarter of 1998, the deficit held to its target of below 4.6% of GDP, far smaller than the 8.1% of GDP a year earlier. In May, MFK Renaissance said that "since the end of January, more progress has been made on improving Russia's fiscal prospect than in the whole of 1997." The firm planned a lavish investor conference at the end of May, with entertainment by traditional folk dancers and champion U.S. jet-skiers.

Sensing Russia had escaped the emerging-market uncertainties posed by Asia's troubles, Mr. Yeltsin fired his entire government, including Mr. Chernomyrdin, the 60-year-old prime minister who had waxed hot and cold on market reforms in his six-year tenure. Mr. Yeltsin brought in Mr. Kiriyenko, a young, untested former banker who had been in government less than a year. The move boded well for the future, assuming the 35-year-old had time to get up to speed.

He didn't.

Mr. Kiriyenko's approval in late April was the last good day the Russian stock market would see for a while.

Asia Again

Just as Mr. Kiriyenko was forming his government, the Asian crisis was heating up again. Financial markets grew concerned that the U.S. Federal Reserve would tighten interest rates in response to strong U.S. growth. "The interest-rate story changed the bias of the marketplace," says Phillip Hildebrand, global strategist for Moore Capital Management in New York. With higher rates from the Fed, emerging-market debt could go nowhere but down. He recommended that his investment firm sell, among other assets, some of its Russian debt.

Unsettling news piled up. Riots erupted in Indonesia, and then the Suharto government fell. Rumors circulated of a German interest-rate increase. Credit agencies downgraded Korean banks. India shocked the world by conducting nuclear tests.

"Russia got attacked when Asia came back," says Zoran Konstantinovic, vice president at ED&F Man Global Markets Inc. in New York. "People's appetite for risk was shrinking, and they looked around at countries most likely to be affected."

The response wasn't merciless. The Russian stocks began to fall, but bond investors actually gave Russia two weeks to calm them down.

The opportunity, investors say, was missed.

P.R. Stumbles

The first in a series of public-relations gaffes began in early May. Central Bank Chairman Sergei Dubinin warned government ministers of a debt crisis looming within three years, a responsible thing for a central banker to inform ministers about. But the Russian press was in attendance. "Of course, it was not said for public consumption," says Sergei Alexashenko, first deputy chairman of the Central Bank.

That same week, while the Russian stock market was tumbling, Mr. Yeltsin had to sign a law limiting foreign ownership of Unified Energy Systems, the national electric-power monopoly and one of the country's few blue-chip stocks. The Duma had overridden his veto. Stocks fell further.

More jitters ensued when statements by Mr. Dubinin, the Central Bank chairman, were misinterpreted to mean the bank was considering devaluing the ruble. He actually was just restating bank policy, but investors' focus shifted to the currency's stability.

The miscues continued. Prime Minister Kiriyenko, in one of his first interviews, disclosed that tax revenue was 26% below target. Saying so was part of a policy change, to be frank and open. "We must realize that we're not wealthy enough," he said. "Moreover, we must honestly say that we're quite poor now."

The two-week-old government was in fact making plans to slash spending and raise revenue, but that word was never communicated adequately. "They did all they could," says Evegeny Yuriev, president of Aton, a Russian brokerage firm. "The only thing they undervalued was the value of P.R."

By the end of the second week in May, word had leaked out that the IMF and Russia were at odds over how to cut spending. Some investors within Russia also had heard that Mr. Summers of the U.S. had come and gone without seeing the prime minister. A lot of people started putting two and two together. Right afterward, some big investors "started to sell their [government-bond] portfolios and all Russian securities," says the Central Bank's Mr. Alexashenko. The following Monday, May 18, yields on government bonds soared to 47% as some investors bailed out.

The reaction caused Mr. Jordan, head of MFK Renaissance, significant concern. Normally, with inflation running below 10%, at least some Russian banks would step in to take the government paper at such high rates. Their poor appetite for the bonds was an ominous sign of a local lack of confidence and a liquidity problem in the banking system.

The reason for the lack of liquidity is just one of the ironies of the Russian crisis. It was in part the result of much-needed reforms that, at another time, would have been lauded by investors. "The crisis hit us exactly ... when a number of good things have been happening," says Aleksei Mozhin, Russia's delegate to the IMF.

The government in 1998 had eliminated tax offsets -- paper issued by government agencies to pay for goods and services, which the recipients could use to reduce their tax bills. Without offsets, banks and other companies had to come up with more cash to pay taxes, and that reduced liquidity. "They were doing all the right things -- that's what makes this so irritating," says Jim Nail, senior analyst in London for Soros Global Research.

Another policy change also hurt. For years, the government had used commercial banks to pay its bills. Last year, it moved to a U.S.-style treasury system, with branches of its own. The change saved money, reduced corruption and made payments more timely. But an unforeseen result was a fall in the cash moving through banks that these banks once used to play the government bond market.

So when the crunch hit, the Russian banks couldn't help.

A Last Chance

It can never be known whether Russia could have halted the forces gathering against its markets, but it might have had one last chance in the third week of May. When markets began to drop on Monday, May 18, the Central Bank responded by jacking up its lending rate for banks to 50% from 30%. It used $1 billion of its scarce reserves within two days trying to defend the ruble. The moves, Mr. Alexashenko concedes, were "still not enough."

An IMF team had landed in Moscow that week to complete negotiations with the government on resuming the country's $9 billion loan program with the fund. A deal would have been the first real good news. But the two sides couldn't come to agreement, and the team left. "This was interpreted as a sign of significant disagreement with the fund," says Mr. Mozhin, Russia's delegate to the IMF. An IMF official says the fund had little choice; substantial differences remained, and the fund wasn't going to lie about it.

It was only by Monday the 25th that the Central Bank appeared to realize there was a major loss of investor confidence in Russia. By then, events had a momentum of their own. Demand for government bonds plunged; their yields leapt above 50%.

By Wednesday the 27th, the situation was out of control. The government failed to sell enough bonds at its weekly auction to refinance debt coming due. In the baroque palace in the center of Moscow that is the Central Bank's headquarters, an emergency meeting was convened.

A Breather

The directors gathered and, for what appeared to be the first time, made a decision that would put the them ahead of the crisis. At first there was debate, but then an obscure board member, the head of the bank's legal department, made a shocking proposal: Raise the Central Bank's lending rate to commercial banks by 100 percentage points, to 150%.

There was silence, Mr. Alexashenko recalls. Then opposition. Then realization that it was the only feasible course.

The Kiriyenko government also began to understand the need for concerted action. It formed and publicized an anticrisis plan and began rare bankruptcy procedures against three companies with significant debts for back taxes. It dispatched Anatoly Chubais, well known in the West as the man behind many of Russia's most significant economic reforms, to Washington to sound out the West about assistance. The prime minister began meeting with foreign investors to reassure them.

The Clinton administration lent a hand by pledging to support an international aid package for Russia, although not promising any U.S. funds.

At this past Wednesday's bond auction, the Russian Central Bank held a firm line on interest rates. And the finance ministry in late afternoon took a gamble and gave Goldman, Sachs & Co. the go-ahead to sell the $1.25 billion in bonds. They sold in 25 minutes.

President Yeltsin, who sometimes disappears in a crisis, also got in on the act. He appeared nightly on Russian television and summoned the nation's financial elite to a well-publicized Kremlin meeting, jawboning them to invest in Russia. He fired the head of the state tax service and brought in Boris Fyodorov, the outspoken former finance minister known as an economic reformer.

All of this, some Russia experts say, just gives Russia breathing room. Without significant progress quickly, panic could come again as quickly as the recent stability has set in.

By the end of this September alone, $2.5 billion to $3 billion in loans from foreign lenders to Russian corporations and banks come due. If those loans aren't renewed, there could be another run on the ruble. Billions of dollars in ruble futures, used to hedge investments in rubles, will also mature by the fall.

The plan at the moment is to raise about $10 billion, but the source is unclear. In the past few days, the Russian government has said it doesn't want additional assistance from the IMF and would prefer to go to the public markets for the money -- another attempt to show its confidence. The objective is to replace short-term Russian debt with long-term Eurobonds, which are denominated in dollars.

Still, Group of Seven finance officials are scheduled to meet in Paris next week to discuss Russian aid. They are likely to be asking the same question that is on the mind of investors: whether this time the Russian government means it when it talks about reform, or whether the recent pledges are one-time promises to muddle through the crisis.

"In the past, they would get themselves through the crisis and then relax," says Vladimir Potanin, one of the country's wealthiest businessmen. "This government will not have that opportunity."


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