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. Last Updated: 07/27/2016

Russia Stuck Between a Rock and a Hard Place

Angry foreigners demand better terms for their frozen debts, while Russian banks struggle to survive, but Russia has no money to suit both their needs.

Investors will remember Aug. 17, 1998 for a long time. Six weeks after the government froze 240 billion rubles ($40 billion at the time, $15 billion at Monday's official Central Bank rate) in treasury bills, or GKOs, the dust is yet to settle.

Infuriated foreign investors have descended on the Kremlin, demanding a better restructuring deal for the $15 billion they hold in short-term debt. The deal announced last month would give back only an estimated 4 percent of the dollar value.

To please the International Monetary Fund, foreigners have been promised the same treatment as local investors, but the Central Bank is under pressure to offer favorable treatment to Russia's banks. They all but collapsed after the crash of the GKO market, which accounted for over 20 percent of their assets and almost all their liquidity.

The Russian government and the Central Bank now appear to be stuck between a rock and a hard place.

"They are pulled between the need to rescue the Russian banks and the need to offer the foreigners a satisfactory restructuring deal f one they can afford from the budgetary point of view," said David Riley, Russia analyst with rating agency Fitch IBCA.

Russia surprised the markets Aug. 17 when it admitted defeat after a 10-month battle to avoid a devaluation that had cost the country billions of dollars.

The same day it decided to call a moratorium on commercial debt and to freeze the local debt market, which was restructured a week later. The three measures set a snowball in motion that is still gaining momentum.

Analysts said Russia's main short-term worry is to establish a working banking system, so that the paralyzed economy gets going again.

"When the government defaulted and devalued, it was like a double whammy for the banks," said Robert Devane, an independent investment adviser. "They were not only left holding worthless paper but their other ruble-based assets became worthless as well."

In an effort to help the banks, the Central Bank was quietly extending billions of rubles in Lombard loans to banks and accepting frozen GKOs as collateral f although the banks seemed to have their own survival plans.

In the four days from Aug. 17 to Aug. 21, the Central Bank admits it spent 56 billion rubles on Lombard and overnight lines. But instead of paying off their creditors, the banks promptly bought dollars with the money.

Ten days ago, the Central Bank allowed banks to dip into their mandatory reserves to pay off debts. The reserves are to be replenished with freshly printed rubles, for which the Central Bank would receive banks' frozen GKOs.

Banks lacking the GKOs to cover their debts were to be declared bankrupt. The swap results suggest that some banks did not fully reveal their debts, but the Central Bank has not named the offenders. Analysts attributed this decision to political considerations, as powerful banks such as Inkombank and Unexim have reportedly made the list.

Foreign investors also complain that the Central Bank has also allowed top Russian commercial banks to change their frozen GKOs for short-term Central Bank bonds, known as OBRs.

But Russian banks themselves have given the cold shoulder to the OBRs, dubbed bobry, or beavers, by the market. The bank managed to place between 100 million rubles and 200 million rubles of OBRs from the 9 billion rubles issued.

So were the Central Bank's actions skewed toward bailing out banks that had its ear? Some say the Central Bank's actions were keeping afloat banks that should be declared insolvent. Others said they were necessary as the banking system's failure was holding up payments at all levels.

No one can say how much it will cost to refinance a core of the banking sector, nor which banks will be chosen.

"The Central Bank did what it could under the circumstances, though its actions should have come much earlier," an analyst with the financial information agency Rating said.

"Instead of simply giving the banks credits, the Central Bank demanded the GKOs as collateral. ? It was a measure of the bank's standing."

Some analysts said the Central Bank's action was mistimed. "It was the worst mistake the Central Bank could have made," said Alexei Zabotkin, a fixed-income analyst with United Financial Group. "When the foreigners saw the terms being changed for Russians, they decided not to accept them under any circumstances."

Foreigners, however, felt that Russia started out on the wrong foot by thrusting the restructuring terms onto them, instead of consulting them first.

"[The restructuring deal] was unilateral and not market-friendly, which was probably the main reason why investors have negative sentiments toward Russia," Fitch IBCA's Riley said. "It was not just the money."

The Central Bank's subsequent actions added insult to injury, as they belied the government's original claim that all investors would be treated equally.

A group of 25 leading foreign banks wrote to the Russian government protesting against the unilateral restructuring plan and demanding equal terms for all investors.

Following the protests, government officials have offered several versions of what the swap deal should look like. Finance Minister Mikhail Zadornov last week proposed redeeming all T-bills maturing between Aug. 19 and Sept. 16 as opposed to swapping them for some cash and paper as stated in the original plan.

"We have worked out such a scheme and are sure that we will be able to get a compromise," Zadornov said. "The approach must be fair to allinvestors."

While redemption sounds generous, it would involve a big loss for investors who will be receiving rubles that have fallen in value by about 60 percent.

Negotiations between foreigners and the Russian government left the foreigners with empty hands last week, but with a warning from Central Bank chairman Viktor Gerashchenko that "greedy" and "stubborn" investors would get nothing.

Zadornov also suggested that long-term frozen GKOs should be used as a means of payment during privatization deals. This would have created a market for the securities. These measures will ease losses by investors and minimize the Russian budget's losses, he said.

But economists question where Russia will find the money to follow Zadornov's recommendations. Redeeming just securities that mature before Sept. 16 will require 10 billion to 12 billion rubles.

The plan to use the GKOs during privatization was also criticized because it will deprive the budget of much needed cash.

But analysts said foreigners will have to accept losses because Russia is too broke to offer better terms.

Foreign bankers demanded that a restructuring should involve no cash, but dollar-denominated paper with a maturity longer than what was originally offered.

But analysts pointed out hitches. "What exchange rate will you use while changing the ruble paper into dollar bonds?" Riley asked. "And people already holding Russian dollar-debt will not be happy to see more of it on the market."

There is also another point of view: that investors walked into the "mess" with their eyes open. Apart from state-owned Sberbank, few chose to exercise the safety conduit offered to them in July f to restructure their GKOs into lower yielding but safer dollar-denominated Eurobonds.

"It's hard to feel sorry for these people," said one analyst at a bank participating in the talks. "They knew all the time that 150 percent yields carry a default risk."

The consensus is that few Russian banks will survive the default's effects, while foreigners must retreat to lick their wounds.

And Russia may do well to forget about placing more debt f domestic or sovereign f for a long time, said a director of a leading Western fund. "The government won't get another penny from either Russians or foreigners."