Pulling Russia Back From The Brink

How Yeltsin and his economic team scrambled to save Russia from a financial meltdown

On Saturday night, Nov. 15, Russian First Deputy Prime Minister Anatoly B. Chubais ushered American investment banker Boris Jordan into the Russian White House. Caught up in an ethics scandal, Chubais was fighting for his political life, and by the end of the evening, President Boris N. Yeltsin would fire three of Chubais' key aides. But Russia's top economic policymaker worked through the Saturday Night Massacre. Foreign investors were pulling billions of dollars out of Russia's bond and equity markets, and Chubais was worried that the ruble and Russia's banking system could collapse.

Jordan was frank. Meeting with Chubais and his ally, First Deputy Prime Minister Boris Nemtsov, he said that Russia's Central Bank had to jack up interest rates sharply or spend billions to support the ruble. Says Jordan: "I told them this crisis was far more serious than previous ones because it did not arise from problems inside Russia." Chubais and his aides later met with representatives of the International Monetary Fund and World Bank. On Dec. 1, the Central Bank finally raised rates to 36% but only after spending $4.5 billion to defend the ruble.

OFF GUARD. For the first time, Russia's top economic officials are grappling with the harsh realities of global markets. Russia has had plenty of home-grown calamities in its fledgling capitalist history, but this fall, it was outsiders who were roiling things. In the aftermath of the Asian currency and stock market collapse, investors from Brazil and South Korea dumped $4 billion in high-interest Russian Treasury bills. Other foreign investors sold $1 billion more. Some Russian blue-chip equities fell 50% from their 1997 peaks. Caught off guard, Chubais, Nemtsov, Russian Central Bank Chairman Sergei K. Dubinin, and Yeltsin teamed up to prevent financial disaster.

So far, they seem to have calmed the markets. But if Russia is to stay off the speculators' hit list, its economic czars will have to take far more drastic action to solve chronic problems of poor tax collection and bloated state spending. Meanwhile, higher rates are likely to drag down Russia's economy just as it was beginning to pick up for the first time in six years. Now, instead of growing 3% to 5% in 1998, the economy probably won't start to take off until 1999.

To be sure, Chubais and Dubinin miscalculated when Asian markets began to tumble in September and October. Chubais was distracted by political battles. He and Dubinin didn't even seem worried on Oct. 28, when Hong Kong's market crash reverberated across the globe. Meeting with international investors in London, Chubais declared that Russia's stock market would continue to post strong gains. Stocks began falling the next day, while foreign investors also fled the T-bill market. The full force of the withdrawals didn't hit until late November because Russia requires a one-month wait before foreign investors can begin repatriating hard currency.

On Nov. 10, Dubinin announced that the Central Bank was raising interest rates from 21% to 28% and lifting reserve requirements for Russian banks. Investors were already worried about a ruble collapse. And Russians were growing jittery about a planned Jan. 1, 1998, currency reform that will knock three zeros off the ruble's face value. Any threat of devaluation would cause ordinary Russians, who lost their savings in previous currency reforms, to abruptly exchange their rubles for dollars. Says Robert Devane, head of fixed-income trading at Moscow-based Troika Dialog: "The Central Bank was facing a situation which could easily [have gone] from crisis to a complete meltdown."

Chubais and Dubinin wanted to avoid a ruble devaluation at almost any cost. Stabilizing the ruble was one of their proudest achievements. At the same time, Chubais didn't want to increase state borrowing costs by hiking rates too high. They had little choice. By late November, yields on T-bills rose as high as 50% while the stock market continued to plunge. The tumult in the markets savaged the balance sheets of Russian banks, sparking fears of massive bank failures. Banks were losing money on both stocks and bonds.

A currency crisis would have been fatal for banks with huge currency exposure. More than half of the $16 billion in foreign funds in the Treasury bill market were hedged by forward ruble contracts with Russian banks. If the value of the ruble fell dramatically, the banks would have had to cough up millions of dollars to fulfill these contracts. As the crisis peaked in the last week of November, the Central Bank spent $3.5 billion of reserves to keep the ruble stable. In a last-ditch bid for a cash infusion, Central Bank First Deputy Chairman Sergei Alexashenko and Presidential Adviser Sergei Vasilyev flew to Washington on Nov. 27 to seek emergency aid from the U.S. and ask the IMF to release a $700 million loan disbursement that had been delayed because of Russia's lousy tax collection record. They came back empty-handed.

A few days later, Yeltsin and his economic team at last mounted a broad offensive. On Monday, Dec. 1, the Central Bank announced its rate hike to 36% and pledged to keep backing the ruble. On Dec. 2, Chubais met with Western investment bankers to ask for a bridge loan of up to $2 billion. On the same day, Dubinin called Russia's six top bankers to his office and assured them that the Central Bank would do everything necessary to support the biggest banks. Later, Yeltsin made a surprise visit to the Duma to beg opposition lawmakers to approve the first draft of his tough 1998 budget. They did by a wide margin of 95 votes.

NAGGING PROBLEM. Convinced that the ruble was stable, investors started buying T-bills again. Equities also bounced back, with the local RTS index rising 19.9% to 387 by Dec. 9, before slipping to 369 on reports that Yeltsin was sick with a cold. The short-term financial crisis over, Chubais breathed a sigh of relief. "The rise in foreign debt securities is a sign of growing investor confidence," he says.

But Chubais, Dubinin, and team still face serious, long-term challenges. Before the rise in interest rates, Russian banks were just beginning to make loans to industry. Few companies will be willing to borrow at rates exceeding 40%. Now, Chubais says, it could take three to six months for Russian industry--and the economy as a whole--to get back on the road to recovery. Others say it will take longer.

Russia's government finances represent another nagging problem. Moscow is addicted to borrowing because it can't seem to collect taxes. Partisan politics is partly to blame. The Communist-dominated Duma has blocked crucial legislation to reform the taxation system. But the government has also handed out expensive tax exemptions and been reluctant to enforce the bankruptcy law against tax debtors. Facing higher borrowing costs, government officials are already admitting that Russia's state deficit may creep up in 1998 above the 4.7% of gross domestic product targeted in the budget.

Even so, international financial institutions seem ready to offer Russia a financial cushion before the start of the New Year. The World Bank is expected to approve $1.6 billion in new loans at a meeting in mid-December. The IMF is signaling that it will release the delayed $700 million loan payment, and could come through with additional emergency aid if Russia cleans up state finances. The last few weeks have proved that Russia's economic team can mobilize quickly when crisis strikes. But they also revealed how much Russia has been living on borrowed time.

Before it's here, it's on the Bloomberg Terminal.