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. Last Updated: 07/27/2016

Debtor's Prison




Despite a recovering economy and enforced isolation from fresh foreign debt, Russia has done little to bring its debts down to manageable size.


Igor Semenenko reports.


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Back in 1981, with oil prices reaching $35 a barrel and a drilling frenzy spreading across the globe, numerous economic gurus were predicting that $100 per barrel was just around the corner.


Had those forecasts materialized, Nikita Khrushchev's 1950s prediction that the communist era would begin in 1980 would have been off by only a couple of years.


Instead, oil prices slumped lower and lower, first encouraging Mikhail Gorbachev to start his reforms of the Soviet economy, then undermining his efforts. In order to keep household consumption standards at the usual levels, the initiator of perestroika turned to the international markets with extraordinary appetite: In less than 10 years he more than doubled the Soviet Union's debt burden, taking on some $40 billion in new loans and raising the overall debt burden to $76 billion.


From then on, successive regimes in Moscow have piled up more and more debt because they found it impossible to cut spending or raise revenues.


When oil hit $10 a barrel in 1985, the Soviet government rushed to the international markets, borrowing money to finance current expenditures.


A Debtor Born


The Soviet Union actually began restructuring talks in 1991, just a few months before the communist regime collapsed. Thus, when President Boris Yeltsin took the helm, default was already staring the new administration in the face.


In 1992 the government began talks with the Paris Club of creditor nations and the London Club of private creditors over debts inherited from the Soviet Union. These had stood at about $80 billion when Russia took them on, but they were growing every year thanks to the unpaid interest on the loans and the interest on the unpaid interest - a snowballing process that looked set to crush Russia under its fiscal weight.


Russia was asking creditors for debt rollovers every 90 days for the six years it took to close deals with the two clubs. When that happened, in 1997, Soviet-era debts had grown to some $95 billion.


Meanwhile, a series of poor top-level decisions on debt taken in the late 1980s and early 1990s exacerbated the problem.


"It is not that decisions were made for the sake of private benefits, but that very often they were made without thorough consideration," says Yevgeny Kovalishin, a researcher with the Institute of Financial Research.


For example, Prime Minister Nikolai Ryzhkov in 1989-91 allowed former Soviet-bloc countries to convert rubles held on escrow accounts with the Soviet Union into hard currency claims at the official rates of exchange, which back then were far above the real market value of the currency.


As a result, the Soviet Union ended up with unnecessarily heavy debts to East Germany, Poland, Hungary and other Eastern European countries. Most of these escrow account debits had been built up when these countries began supplying modern equipment - mostly personal computers - to Moscow, selling them at huge markups in exchange for oil. The oil had been underpriced to subsidize the building of socialism in Soviet satellite states.


The $8 billion of debts to Germany were the easiest to handle, Kovalishin says. These were simply written off when Russia was withdrawing troops from East Germany in 1994 as payment for costs incurred by the army.


However, other debts were less readily disposed of. Those owed to Poland, also some $8 billion worth, have been disputed by the Russian side, which claims that Warsaw's debts to Russia were equal in size, and has insisted on a mutual write-off of the debts.


Even though discussions with former allies often trailed off into technical details, many Eastern European countries keep putting forward claims on Russia.


Russia recently offered to repay part of its debt to the Czech Republic with oil supplies.


Another series of unwise decisions centered on MinFins - bonds issued to rollover debts to corporations whose hard currency accounts were frozen in the Soviet Union's foreign trade banks, Vneshtorgbank and Vneshekonombank, when the country dissolved.


In all Russia issued some $11 billion worth of MinFin bonds in seven tranches. While most of these bonds were fairly straightforward, the sixth and seventh tranches puzzled many analysts. These last two tranches were issued in 1996 after heavy lobbying from a group of financial institutions that had supported Yeltsin in his campaign for reelection.


The total value of the sixth and seventh tranches, which resulted from conversion of escrow accounts in Vneshekonombank into dollar-denominated bonds, was $3.6 billion.


"The whole scheme called for a lot of questions," Kovalishin.


The banks in question had bought up a range of what might be called virtual currency accounts, ones that held money paid by Soviet allies to buy various goods from the Soviet Union - often weapons. The Soviet system of subsidizing such purchases usually meant that these purchases were backed by export proceeds. After the Soviet Union collapsed, there were numerous accounts holding "dollars" that had been used in settlements with Afghanistan or Cuba, or special "pounds" used for settlements with longtime Soviet ally Syria.


A group of Russian banks had bought up these accounts, usually paying 1 to 10 cents on the dollar. When they successfully lobbied the government into issuing MinFin bonds to cover these liabilities of Vneshekonombank, they were able to sell the MinFins on the secondary market, getting yields of 400 percent and more for what would otherwise have been worthless debts.


Extracurricular Activities


Meanwhile, Russia was piling up new, post-Soviet debts at an impressive rate - and it would have piled up more at an even faster rate had it not been for the reluctance of Western lenders to extend credits until Russia had an International Monetary Fund program in place. But once the IMF and Moscow had struck a deal, Russia started taking easy money from all and sundry, from the IMF, the World Bank, governments or private lenders. In less than six years, Russia borrowed almost $30 billion from the IMF and the World Bank, leaping from nowhere to become the Fund's biggest, and most embarrassing, borrower.


Only once did the State Duma balk at the government's attempts to borrow more money.


When Viktor Chernomyrdin was fired as prime minister in spring 1998 and the Kremlin nominated Sergei Kiriyenko as his successor, then-President Yeltsin told his aides to solve any problems the Duma members might have in order to smooth the way for his new favorite.


The Presidential Administration - the Kremlin's property management department that was run by Pavel Borodin - left no string unpulled, offering all manner of perks to the deputies.


It even went so far as to offer to build a new parliament building, at a cost of $2 billion, according to estimates made by Borodin.


"Borodin by that time had finished the reconstruction of the Kremlin with the help of Mabetex and was looking for some new occupation," former Yabloko Duma Deputy Viktor Gitin said late last year in an interview.


Borodin suggested that the Duma include the $2 billion price tag in Russia's external borrowings program for 1999, which is approved as part of the annual budget.


"We have preliminary agreement from a number of foreign companies and prime banks regarding the issuance of several tranches of bonds worth $2 billion with a maturity of five to 30 years," Borodin wrote in his letter to the Duma.


The Duma rebelled at Borodin's proposal and voted it down, although the government still went ahead with heavy borrowings the same year.


Once new Prime Minister Kiriyenko took the reins, he revealed just how parlous a state the country's finances were in. By then, thanks to IMF and World Bank credits, plus several Eurobond issues, Russia's foreign debts had bulged to $122 billion.


Unfortunately, thanks to Asian flu, the state debt pyramid known as GKOs and - what else - low oil prices, Kiriyenko's solution for the country's woes entailed yet more borrowing.


By the end of his regime, Moscow's external debts stood at $145 billion, the largest one-year increase in the history of modern Russia. Debts assumed after 1992 surged from $32.2 billion as of Jan. 1, 1998, to $52 billion by Dec. 31 the same year.


After it defaulted on GKOs, the government was only able to go on servicing Eurobonds and loans from the IMF and the World Bank. Soviet-era debts again slipped back into effective default.


Dear Prudence


Perhaps one of the most salutary effects that the 1998 crisis has had is that it effectively isolated Russia from global capital markets. Since Aug. 17, 1998, Russia has only borrowed some $1.64 billion from international lenders.


Part of this came as a $640 million IMF tranche released last summer - the first credit under an 18-month, $4.5 billion credit program that has since been suspended due to Russian noncompliance with some conditions and the chill cast on relations with the West by the Chechen war. That tranche was used to pay off existing IMF debts that came due, so it could hardly be characterized as fresh, additional borrowing. The rest of the money has come from the World Bank and Japan, released under previously agreed credit programs that had been suspended after the August 1998 crash and have now been suspended again along with the latest IMF program.


During that same period, Russia has paid off about $8.9 billion, with much of that going to the IMF and the World Bank. However, thanks to the suspension of payments on Soviet-era debts, by end of 1999 Russia had only reduced its external debts by $700 million according to official figures.


Meanwhile, the government piled up fresh domestic debts, borrowing 22 billion rubles last year from Vneshekonombank and Sberbank to fill gaps in the budget and another $4.5 billion from Vneshtorgbank, Vneshekonombank and the Central Bank to service foreign debts.


The government raised 99.4 billion rubles ($4.2 billion) in placements of various state paper, with two-thirds of the total amount bought by the Central Bank.


It also borrowed 15 billion rubles in nonmarket bonds placed among banks in private deals, of which it repaid all but 500 million rubles by year's end.


Much of the debts raised at home were repaid last year and were therefore not reflected in macroeconomic statistics reported at the end of 1999, a fact publicly admitted by the government.


"In order to fulfill monetary supply targets new funds within the fiscal year were drawn on a repo basis," reads a Finance Ministry report on the 1999 federal budget's execution, posted on the ministry's web site.


Thus, public debts continued to pile up due to the continuing service of debts assumed after 1992 and the capitalization of interest on debts inherited by the Soviet Union.


Official public debt therefore amounted to 108.73 percent of gross domestic product by the end of last year.


Of these foreign debts amounted to $158.8 billion and domestic debts made up for $21.6 billion.


The figure of $158.8 billion includes $45 billion borrowed after 1992, $102 billion of Soviet-era debts and $11.1 billion of MinFin bonds at face value.


Debts at the end of 2000 could again edge down, perhaps hitting as low as $146 billion, primarily due to the recent write-off of $10.6 billion of debts to the London Club.


Carry That Weight


But while Russia's debts are impressively large, the big question is whether or not it can service them. Japan is the world's biggest debtor in absolute terms, with 645 trillion yen ($6.3 trillion), or 130 percent of GDP, owed by central and local government. It has been amassing ever larger public debts over the past two years as it desperately tries to claw its way out of recession. But despite Japan's large and still mostly efficient economy, coupled with domestic borrowing costs that are so low as to be almost negligible, Tokyo has no problems servicing its growing debt.


Russia is very different from Japan, however. Despite being one of the five most indebted emerging market countries in the world in absolute terms, Russia ranked only 11th in terms of the total amount paid out for foreign debt servicing in the middle of the 1990s. It was not even included in the list of the 40 countries with the highest debt to GDP ratio or debt service to exports ratio - the two most common yardsticks for judging a country's capacity to service foreign debts.


Last year Russia paid out $5.2 billion in principal payments and $3.7 billion in interest payments, for a total of $8.9 billion, according to preliminary estimates made by independent analysts.


That would give a debt-servicing-to-GDP ratio of 3.6 percent for 1999, down from 5.5 percent in 1998 but triple the level in pre-crisis 1997, when debt servicing was a tiny 1.2 percent of GDP.


Meanwhile, the debt-servicing-to-exports ratio is 11.9 percent. Both figures were at generally acceptable levels.


Even if Russia were to increase its debt servicing to $12 billion a year - the maximum it can afford according to government officials - then the ratio of debt service to exports would be at most between 16 percent and 19 percent; the higher figure would occur in an environment characterized by low commodity prices on world markets.


Such a level of debt payments - or even slightly more - is well in line with Russia's capabilities, says Charles Blitzer, chief international economist with Donaldson, Lufkin and Jenrette.


"Russia does not have bad numbers," Blitzer says. "It's the first occasion I can recall where a country running massive current account surplus is unable to service its debts."


But when it comes to a choice between meeting its liabilities and crossing powerful local interest groups, Moscow has regularly preferred default.


Fiscal Failures


"The debt-to-exports ratios show whether or not the economy in general generates enough currency to make external payments," says Yevsey Gurovich, deputy head of the Economic Expert Group, a semi-independent think tank with links to the Finance Ministry.


As a net exporter of internationally competitive goods, the Russian economy generates enough cash to pay all its maturing debts.


However, these figures reflect only one aspect of the debt service problem, the second being related to the dire fiscal situation.


The federal government simply does not have sufficient tax revenues to buy all the hard-currency denominated export proceeds.


Maturing debts amount to about 20 percent of annual export proceeds, about half the level for Argentina and Brazil.


But Russia's overall debt burden is six times fiscal revenues, which is in turn triple the level for other emerging market economies.


"In Russia the problems of debt service lie on the fiscal side," Gurovich says.


"Not every country has a three-level fiscal system," he adds. "And this cannot change overnight."


The Finance Ministry faces the unfortunate situation where all the debt burden lies on its shoulders, while about half of total budget revenues are collected at the regional and municipal levels, Gurovich says.


This means that the federal government is simply unable to buy all the proceeds from exports, because its revenues are too low.


It could only do so if the total size of the budget or the primary surplus were higher. Until that happens, the only way that Russia can buy export dollars is by printing money, which runs the risk of boosting inflation. Indeed, when it started to run short of cash last year, the off-market bond schemes it used were effectively a means of printing extra rubles.


Resurrection Shuffle


With the London Club agreement in its pocket, a first tentative post-crash GKO issue under its belt and high hopes of reaching a deal with the Paris Club after the presidential elections, Moscow is even beginning to think that a return to international capital markets could be possible at some stage in 2001.


Hard as it may be to believe it after Russia stiffed foreign GKO investors left holding paper worth some $40 billion at the time of the 1998 default, the international community has a short memory when it comes to bad debtors.


Since 1975 there have been 12 defaults on sovereign debts denominated in local currencies, including Argentina, Brazil and Venezuela as well as Russia.


Brazil defaulted on debts worth $62 billion in 1990. Furthermore, Brazil and Argentina were the only two countries over the past 25 years to twice fail to honor liabilities denominated in foreign currency.


Judging by Brazil's example, Russia's plan to stage a comeback to international markets next year seems realistic, assuming that agreements with the IMF and the Paris Club have been finalized before any international capital markets are contemplated.


Even after the 1990 default - and the drawn-out and bitter battles over restructuring those debts - Brazil continued to borrow billions every year throughout the 1990s.


Price to Pay


Nevertheless, Russia will pay a hefty price for its previous misdemeanors, analysts say.


With debt issues, there are three factors usually considered in the following order of succession: global trends, current and future situation and the borrowers' history, says Peter Boone, head of research with Brunswick Warburg in Moscow.


"The fact that [Russia] defaulted twice [in 1991 and 1998] would not be all that important compared to the country's current and future situation. In theory, Russia could end up in the same bracket as Brazil."


In a best-case scenario Russia could tap capital markets as early as the fourth quarter of this year or early next year. Being optimistic, one could assume Russia would have to pay a 5.5 to 5.6 percentage point premium over U.S. interest rates, says Boone.


Helena Hessel of Standard & Poor's rating agency's London office gave a similar analysis of Russia's situation.


"If you're asking whether or not Russia will have to pay a premium on return to the capital markets, the answer is a big YES," she says.


Russia's issuer credit rating is still SD - selected default - the lowest among 83 sovereign debt ratings issued by S&P.


The SD rating can be changed only when the London Club agreement is ratified and MinFin series IV has been restructured, she adds.


Under S&P's methodology, nonpayment to Paris Club does not constitute a default.


Russian Eurobonds are currently rated CCC+, with a positive outlook, which is also one of the lowest ratings and means that the probability of default is very high. Indonesia is the other main country whose debt is rated CCC+.


Should Russia resolve all its outstanding debt problems, it is likely that the country's Eurobonds - and any new issues - would be rated somewhat higher, perhaps B-, which is why the outlook on the current CCC+ rating is positive, Hessel says.


The latest comparable case has been Pakistan though the country defaulted on its Eurobond. After successful rescheduling, the newly restructured debt was rated B-, a very low rating that incorporates both past reschedulings and also a high probability of future nonpayment.


S&P currently rates Bolivia, the Cook Islands, Pakistan, Romania and Surinam as B-.


Default Setting


Despite Russia's gradually improving economic situation, many still rate it as a good chance for another default in the next decade.


According to Moody's rating agency, there is a 12.2 percent probability that the government will default within 12 months. And the agency says that the probability of default over the next eight years stands at 48 percent. This means that - according to Moody's - buying bonds issued by, for example, Papua New Guinea, Nicaragua, Fiji, Iran or even neighboring Kazakhstan, is a better bet than buying Russian Eurobonds on the secondary markets, let alone any putative future issue. All the above countries' bonds are rated a notch or two higher than Russia's Eurobonds, which Moody's currently lists at B3.


This is the same rating Moody's gave to Canadian oil company Hurricane Hydrocarbons Ltd. - some 18 months before its default in May 1999 - and to Mexican construction company Bufete Industrial - rated B3 two and a half years before the company went bankrupt last July.


In fact, SBS-Agro was rated B1 back in 1998, higher than Moody's current rating for Russian Eurobonds.


Even though corporate ratings are different from sovereign ones, default rates among legal entities nevertheless provide a good measure of the risk associated with holding public debt.


"Bonds which are rated B generally lack the characteristics of desirable investment," Moody's writes in its rating definitions.


"Assurance of interest and principal payments or of maintenance of other terms of the contract over any long period of time may be small."


Russia's sovereign debt payments peak at $7 billion in 2003, by which time the odds will be three to one that the government will say there is no cash left in the vaults to meet these payments.


The market measures the risk accordingly, with Eurobonds yields now almost twice as high as in fall 1997, shortly before the Asian flu dampened debt markets for emerging economies.


Eurobonds were then traded at a premium, with the Russian issue maturing in 2007 priced at 102.68 - a 9.57 percent yield that was some 8 percentage points below the 16.37 percent yield investors could earn if they buy the paper now.


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1999 Federal Government Debt ($Bln)


New Borrowings Payments


International lenders 1.63 4.44


Russian sovereign debt 1.20 4.24


Vneshtorgbank and Vneshekonombank 2.00 -


Central Bank 2.50 -


Vneshekonombank and Sberbank 0.34* 0.34


Total 7.67 9.02


*already fully repaid Source: Finance Ministry


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Emerging market


countries with highest


debt burdens*


$ bln


Brazil 178


Mexico 157


Indonesia 129


China 128.8


Russia 124.78


*end of 1996 Source: Economist


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What price Eurobonds?


Issue Maturity Sept. '97 March '00


Price Yield Price Yield


11/27/01 102.07 8.65% 90.46 15.78%


05/25/04 103.68 8.23% 78.50 16.72%


06/26/07 102.68 9.57% 73.79 16.37%


Source: Reuters


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Debt Loadings


Total Debt/ Annual Debt Total Debt/


exports payments/ annual budget


exports revenues


Russia 185% 21% 617%


Brazil, Argentina 450% 40% n.a.


Average,


emerging markets 168% 27% 200%


Source: Economic Expert Group


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Russia's Dangerous Debts


Year Total debt payments Payments due Payments due Cumulative probability


due on sovereign debt to private creditors


of default


$Bln $Bln $Bln %


2000 9.23 7.56 1.67 12.23


2001 9.64 6.99 2.65 20.71


2002 7.36 5.81 1.55 27.27


2003 10.19 7.05 3.14 32.53


2004 7.86 5.39 2.47 37.54


2005 7.45 4.92 40.66


2006 3.02 0.94 43.95


2007 4.77 3.22 47.84


*average cumulative rates from 1 to 8 years for Moody's corporate borrowers in similar investment grade Source: State Duma, Moody's Investors Services