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. Last Updated: 07/27/2016

Russian Financial Markets Nosedive

Russia's financial markets showed dangerous signs of succumbing to a second bout of Asian flu Thursday as the stock market crashed for the third straight day.

The Moscow Times Index of 50 leading shares fell more than 5 percent Thursday, capping a three-day slump that has wiped 14 percent off its value. The index stood at 196.43, down from 227 Monday.

The week has destroyed the fragile recovery in the early months of this year, pushing the market lower than its nadir in January at the depths of the financial crisis in Asia. (See story, Page 5.)

Even more worrying for the new government of Prime Minister Sergei Kiriyenko, the market has punished the government by driving up interest rates on government debt to around 40 percent, up from 20 percent a few months ago.

After a brief recovery in the early months of this year, interest rates have returned to the dangerously high levels of the start of the year, dashing hopes that the government will see a fall in its borrowing costs this year.

Market analysts have voiced fears that Russia is more vulnerable to a fresh round of financial shocks than it was last October, when the Asian crisis first struck.

The current falls in Asian markets have been triggered by instability in Indonesia, but this time Russia itself has deeper problems. The Central Bank now faces depleted reserves after defending the currency during the first round of the Asian crisis from October to January.

Weak world oil prices have also hurt oil companies, which dominate the Russian stock market and in turn hit the federal budget, which depends on oil taxes for much of its revenue. And markets are concerned with the inexperience of the new government, which was appointed less than a month ago and contains few familiar faces.

"When the first wave hit the market, Russia had relatively strong reserves, a year and half of a running bull market behind it and a reasonably stable political situation," said Robert Devane, head of fixed income at brokerage Troika Dialog.

The shortfall in oil revenues and the increase in debt repayment expenses has forced the government to announce special measures.

President Boris Yeltsin signed a decree Thursday reiterating that the government would cut expenditures if funding ran short.

Kiriyenko warned last week that as much as a quarter of the spending promises that Russia's 500 billion ruble ($81 billion) budget might not be fulfilled.

One big problem for the government is that the Russian 1998 budget provided for debt servicing expenses of 152 billion rubles, already about 30 percent of total spending.

But that was based on average interest rates of 25 percent for the year. In the light of the recent jump in rates, the debt costs now look far too low. Interest expenditure is expected to be at least 30 billion rubles higher than originally projected.

Because of this squeeze, analysts are concerned that the government may not be able to meet about 250 billion rubles of short-term debt that will fall due over the next year.

"Right now Russia is experiencing a rapidly ballooning debt overhang," said Devane. "If there is a second wave of the Asian crisis today, it would be substantially more vulnerable than half a year ago."

Kiriyenko has reiterated that one of his priorities is to reduce Russia's debt burden. But this week scared the markets.

The Finance Ministry usually meets the cost of repaying maturing loans by borrowing more money. "It is like a vicious circle," said Alexei Trunyayev, a debt trader at Aton brokerage. "They have to keep placing more in order to redeem maturing debt."

But the market was so soft Wednesday that the government could not place new debt to repay its loans that fell due and was forced to scramble to find 1.5 billion rubles from its own reserves.

Devane said Wednesday's auction can be regarded as a "borderline disaster." Interest rates on government debt shot up in trading Thursday.

Alexander Morozov, an economist with the World Bank in Moscow, said that the market was waiting for the new government to prove it could take drastic measures, cutting expenditure to meet the crisis.

"The government has to first show a record of achievement, which will be treated positively by the market and only then will they get the confidence to return to the market and bring interest rates down to sustainable levels."

He said that if non-residents decided to pull out completely from Russia and start selling rubles, the Central Bank's reserves might be inadequate to save the situation. The Central Bank's hard currency reserves have fallen to $16 billion compared to $24 billion in October.

Finance Minister Mikhail Zadornov denied Russia was vulnerable to a second bout of Asian flu. "Today, the Russian financial system and its hard currency reserves is ready for any crisis on world financial markets", he said. "There will be no devaluation of the ruble, no financial crisis in Russia this year".

But U.S Deputy Treasury Secretary Lawrence Summers, who visited Moscow Thursday, said that Russia will need careful economic management to weather the coming months.

"It is an important moment of challenge, particularly in light of developments in emerging markets in general," Summers said.