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. Last Updated: 07/27/2016

The Debt Swap Fiasco




The Russian government's handling of its debt crisis in recent days has been an unqualified disaster. Investors, stunned by the Aug. 17 "Default Manifesto," nervously awaited the government's restructuring terms for domestic ruble debt, known as GKOs and OFZs. The swap terms eventually unveiled Aug. 25 turned shock into anger. They amounted to state-perpetrated piracy, effectively confiscating the bulk of the capital lent by investors to the Russian government. The implied loss of capital is between 70 percent and 90 percent, depending on the valuation assumptions, leaving baffled investors to figure out just how raw a deal they've been offered.


In addition to offering obviously unreasonable financial terms, the Russian side has thought to perpetrate a deception. Prior to the announcement, foreign investors made it clear to the government and Central Bank representatives that discriminatory restructuring terms favoring Russian investors would be unacceptable. Regardless of this, the Central Bank then engaged in massive Lombard lending of rubles to Russian banks, accepting their "frozen" GKOs and OFZs as collateral. The banks then used the rubles to buy U.S. dollars from the Central Bank. Between Aug. 17 and Aug. 21, the Central Bank thus sold $1.7 billion, reducing its international reserves by 11 percent to $13.4 billion. In effect, the Central Bank has thus swapped favored Russian banks out of defaulted treasury debt and into dollars, leaving foreign investors and small Russian institutions holding the bag.


The market's response to restructuring terms was a unanimous thumbs down. Russian foreign currency debt and equities plummeted to new lows, as did the ruble, prompting the Central Bank to abandon intervention and indefinitely suspend ruble-dollar fixings on the Moscow Interbank Currency Exchange.


Burnt investors got busy considering their options for a counter move. The idea of forming a negotiating consortium and putting up a united front has quickly gained momentum amongst leading international financial institutions. That is the only practical option remaining. Chernomyrdin and his team will undoubtedly appreciate the fact that in addition to adverse market consequences, failure to reach an equitable solution will lead to political repercussions. Western financial institutions will appeal to their governments for intervention. Politicians in the Group of Seven leading industrial nations tend to listen to their constituents in such matters, lest they fall into disfavor come election time. It may well happen that these nations' taxpayers will induce their governments to reconsider the appropriateness of the International Monetary Fund's aid package for Russia. With the next disbursement of the IMF loan approaching, Chernomyrdin's team can ill afford to ignore investors' concerns.


In the "Default Manifesto," Kiriyenko and Dubinin had argued that Russia's inability to service its debt was caused by external economic factors. If that were true, "relief" would be warranted only so long as these factors persist. But Russia's slide into default was driven by not two, but three dominant factors. True, the Asian contagion led to a global revaluation of emerging markets risk, triggering an outflow of capital and raising the risk premium creditors demanded for financing Russia. True, the decline in world oil prices on the back of an economic contraction in Asia severely damaged Russia's balance of payments and dried up its export-dependent liquidity. But it is also the case that the crisis of confidence was a purely Russian factor. During the past five years Russia's leadership failed to restructure the real sector and make domestic products more competitive, while diversifying away from dependency on commodity exports. Over the past 10 months, the government showed little prowess in implementing desperately needed fiscal measures, first and foremost on the tax collection front. Over the same period, the Central Bank pursued an erratic and unsound monetary policy, which ultimately only compounded Russia's problems leading to the collapse of the currency and of the banking system. The straw that broke Russia's back was the crisis of confidence in it's own leadership. Asia and oil had nothing to do with that.


Russia's domestic policy shortcomings hardly justify picking the pocket of foreign and domestic investors. The real audacity of the government's swap terms is that its authors are purporting to strip capital from investors, whose taxes were paying their salaries while they were failing at their jobs. Investors would therefore rightfully demand that the Russian government take responsibility for the consequences of its actions and inaction, and that they participate in the eventual recovery of oil prices and global emerging markets.


Investors, who have for years funded Russia's reforms, will demand an equitable, nondiscriminatory market-based restructuring. Chernomyrdin's team would be well advised to rescind the "penny-wise-dollar-foolish" approach to policy that has prevailed of late, and negotiate in good faith.


An alternative to the government's restructuring plan would be to offer investors a portion of their holdings in cash, while restructuring the remaining debt into two types of bonds, one representing the principle originally put down on the bonds, repayable over 12 to 24 months, and the other, interest owed on bonds -- representing investors' profits -- payable over three to five years.


The restructuring package must adhere to the fundamental principles of repaying the capital invested in the shortest time possible and providing fair and equitable compensation for the opportunity cost of capital and risk borne by the investors.


It is imperative that Russia constructively resolves these issues as swiftly as possible. Until a restructuring is completed, Russia has little chance of regaining investor confidence, something it desperately needs to stabilize its economy and currency.


Robert Devane is a Moscow-based financial economist and investment adviser. He contributed this comment to The Moscow Times.