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. Last Updated: 07/27/2016

Kremlin Credit Crunch

Something has occurred in the government domestic debt market. After a prolonged period of price rises for government securities and the corresponding fall in their yields, the market has radically changed. The price of all kinds of government securities has been falling for the past month -- at first the decline was even, but recently it has become almost precipitous.


Many interesting conclusions can be drawn from analyzing the reasons for this situation.


?First of all, President Boris Yeltsin has truly started his pre-election campaign. In his meetings with ordinary voters, he has made no excessive promises. Pensions, money transfers, subsidies to miners have all been allotted in the federal budget. Therefore, at first sight, the Treasury has a simple task: to finance all budget expenditures as planned. The Treasury, however, has not received the income it counted on.


The collection of revenues has not increased as much as budget planners wanted. During budget discussions in parliament, it was easy to change the tax compliance rate, which despite skepticism on the part of experts, government representatives often agreed to do. But what might have been politically expedient government policies in parliament at the time are now playing cruel tricks on the Russian people. In real terms, the federal budget's tax revenues have practically stayed at their 1995 levels.


Another unrealistic plan was to raise revenues from profit taxes in place of the excess-wage tax. The most stable source of replenishing federal budget expenditures, the excess-wage tax, was abolished. And the tax on profits, which was supposed to replace it, did not increase as planned. Moreover, the tax on profits is a highly unstable source of revenue since it tends to fluctuate significantly.


In sum, expenditures are going according to plan, and revenues are left far behind. But the race for the presidency has begun, and back wages to doctors and teachers must be paid on time. Therefore, the unplanned deficit must be financed at any price. For the government, any price means a low price for securities and enormous expenditures. The number of government securities has reached surplus levels and their price has fallen accordingly.


?The second interesting phenomenon in the government debt market is the fall in the demand for securities. A fall in demand linked with the increased risk of investing in government securities on the eve of the presidential elections is to have been expected. But something else occurred.


First, large commercial banks, which is to say the basic players on the market for government debt, can no longer hold on to the money that is transferred through them. Before, banks could, almost without any controls and all but free of charge, hold on to this money. Now, however, strict presidential control -- and often a threat is enough to exercise this control -- forces money to move more quickly. At first glance, the delays in bank payments seemed small, but when the constant flow of money that goes through the banks was taken into account, then its monetary impact (and corresponding demand for high-yield government securities) were rather significant.


Second, the Central Bank tried to lower inflation by squeezing the money supply. It was able to achieve a negative money growth in the first month of this year. The lack of money being circulated through banks and reduction of the money supply leads to the growth of the value of money, i.e., interest rates. Such an effect was accomplished last year, when strict monetary policy led to a temporary rise in real interest rates, which reached levels unprecedented in world economic history.


?The third significant development in the market for government promissory notes is that it supplanted private investment. Large government borrowing on the domestic market led to a crowding-out effect. The first harbinger of this was the attempt on the part of several large banks to use government securities as a deposit for the loans-for-shares auctions last year. The insufficient liquidity and high yield of alternative investment opportunities -- above all government debt -- was a reason for the relatively low equity investment and comparatively low price of the shares. A boom in private investment in 1995, on which the government counted so much, notwithstanding expert advice, never took place. This occurred partly because of the fantastic profitability of government securities and the high price of credit. Thus, private domestic investment this year, which was very low in comparison with the amount invested in foreign currency and sovereign debt, has become illusory.


In sum, the large deficit, which is financed by domestic borrowing, leads to a geometric increase of risk associated with investment in government debt, excessive supply of government bonds, the sharp fall in their price and consequent growth in the yields on government debt. Strict monetary policies create a shortage of money , which leads the price of money to increase. Moreover, high interest rates have never been a companion to an economic boom. Additional government expenditures, without sufficient international capital mobility, are almost entirely financed at the expense of private investment in the real economy.


The only possible solution to these problems is a sharp increase in the mobility of international capital. This means, above all, removing all technical restrictions on profit repatriations. Only in these conditions can the additional demand for government securities lead to an increase in their price and decline in their profitability. Only in these conditions will a part of the budget deficit be financed by fresh foreign capital and will national financial resources for private investment projects be freed up. Only in these conditions can real interest rates be lowered and economic activity be revived.





Pavel Teplukhin, former director of the London School of Economics, Moscow, is the newly appointed chief economist for the investment company Troika Dialog. He contributed this comment to The Moscow Times.