Vavilov the russian public debt and financial meltdown (2010)

1.2 The Russian debt: beginning of management 251.3 External debt and macroeconomic policy 40 2 The Domestic Financial System and Inflation 50 2.1 The origination of financial markets 51

The Russian Public Debt and Financial Meltdowns

Andrey Vavilov

The Russian Public Debt

and Financial Meltdowns

Andrey Vavilov

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1.2 The Russian debt: beginning of management 25

1.3 External debt and macroeconomic policy 40

2 The Domestic Financial System and Inflation 50

2.1 The origination of financial markets 51

2.2 Macroeconomic stabilization and public debt 69

3 Virtual Economy and Fiscal Crisis 87

4.1 Dynamics of public debt in 1995–98 122

5.1 A brief history of the Russian crisis 145

5.2 The fundamental factors of the crisis 151

6.1 Failure to normalize the state budget 164

6.4 A post-crisis inflation trade-off 178

Appendix A6.1: A model of banks supporting devaluation 182

7.1 The results of the ruble devaluation 187

7.2 Fiscal discipline, consolidation and the end of

7.3 The debt burden easing after the default 203

Appendix A7.1: Restructuring of obligations

List of Figures, Tables and Boxes

Figures

I.1 The real oil price, 1979–2008 ($/barrel) 4

1.1 The Soviet external debt and the oil price, 1970–93 14

1.2 Russia’s external debt payments and debt increase in the

2.1 The CPI inflation and the nominal exchange rate in 1992 52

2.2 Refinance rate and inflation in 1992–94 (per cent per

month) 57

2.3 Inflation and the ruble-to-dollar exchange rate in 1993–95 59

2.4 Foreign currency exchange regimes and inflation, 1995–97 73

3.1 Dynamics of arrears in 1992–98 (per cent of GDP) 89

3.4 Federal tax arrears and tax revenue in cash

4.1 Domestic debt in 1994–97 in GKO-OFZ (trillion rubles) 124

4.2 Dynamic of real debt in market instruments

(trillion rubles, base December 1993) 125

4.3 Real annual GKO-OFZ yields (per cent) 127

4.4 The ratio of gross debt expenditure to budget revenue 127

5.2 Real GKO yields and real ruble effective exchange rate

5.4 Fundamental causes of the Russian crisis 157

5.5 The refinancing rate and the average GKO-OFZ yield in

5.6 Official foreign currency reserves and net domestic assets

6.1 The nominal ruble exchange rate in 1998–99 (rubles/$) 179

6.2 Monthly inflation and the ruble devaluation in 1998–99 180

7.1 The dynamics of exports and imports of Russian goods

7.3 Trends in GDP and industrial production (billion rubles) 192

7.4 The dynamics of compensation and productivity,

7.5 UES OF RUSSIA income structure (per cent) 195

7.6 Money supply and reserve requirement movements 201

7.7 Banking assets and equity movements (percentage of GDP) 202

7.8 Corporate loans and government bonds

7.9 The dynamics of returns of government bonds in

8.1 Russian Stock Market vs MCSI World, 2000–2009 (in logs) 221

8.2 Budget surplus/deficit in Russia, 2005–2009

Tables

1.1 Oil production by the USSR in 1988–91 (million tonnes) 16

1.2 Nominal wage growth and consolidated state budget deficit

in the USSR in the period of Perestroika, 1985–91 17

1.3 The number of banks in the USSR in 1988–90

1.4 Russian external debt ($ billion, end of period) 36

1.5 Dynamic and structure of new Russian debt in the 1990s

1.6 Sovereign debts owed to the Russian Federation by the

1.7 Russian Eurobond issues in the 1990s 48

2.1 Annual growth rates of nominal and real macroeconomic

2.2 Russian domestic debt in securities in 1993–96

2.3 Characteristics of domestic public debt in securities in

1994–98 75

2.4 Federal budget of Russia in 1995–98 (percentage of GDP) 77

2.5 Russian banking system under market transformations 80

3.1 Size and structure of arrears in the first quarter of 1998 90

3.2 Tax revenues of consolidated budget in 1992–98

3.3 Federal budget 1993–97 as approved and executed,

three items: total spending, total income, budget deficit

(IMF definition) all as a percentage of GDP 107

3.4 Results of the ‘loans-for-shares’ deal 115

4.2 Russian external debt in the middle of 1990s ($ billion) 124

4.3 Domestic debt of the federal government (end of period,

4.4 Share of foreign currency bank credits (per cent, beginning

5.1 Indicators of monetary policy in 1996–1998 (end of period) 159

6.1 Federal budget performance in the first half year in 1997

6.2 Value of maturing GKO and OFZs, June–December 1998 168

6.3 Growth rates of monetary policy indicators after August

7.1 The rate of growth of industrial production (per cent) 192

7.2 Cash and non-cash payment transactions between large

companies 194

7.3 The share of payment offsetting (per cent) 196

7.4 The dynamics of tax revenues in the consolidated budget

7.5 Sources of financing of the budget deficit 198

7.6 The debt burden on the Russian economy before and after

Boxes

1.3 The Problem of Mutual Debts Evaluation 34

3.1 Peculiarities of the Budget Process in Russia 108

3.2 Incentive Games in the Virtual Economy 113

6.1 A Calendar Effect of Vacations as a Predictor of Crises in

Russia 173

6.2 The Argentine Debt Default and Swaps 175

8.1 Spurious Russian Market: All Shades of Grey 221

Acknowledgements

Many colleagues have provided comments and suggestions for

improv-ing this book A special thanks goes to Georgiy Trofimov, who provided

invaluable assistance in improving the book’s content Also I would like

to thank Alexey Pomanskiy, Galina Kovalishina and Vladimir Kreyndel

of the Institute for Financial Studies and Dr Barry W Ickes of the Penn

State University for their participation in the discussions and extremely

helpful comments

Andrey Vavilov

Introduction

Great social revolutions are inspired by big ideas, implemented by

enthusiasts of these ideas, fostered by big finance, and may be

sponta-neously affected by unforeseen eventualities To some extent this is true

with regard to the Russian capitalist revolution that began in 1991 and

continued throughout the final decade of the twentieth century It was

a materialization of the basic idea to transform radically the decaying

communist system into a modern market economy that would be able

to survive and develop in the post-industrial world The idea was not

new at that time because the unprecedented economic transformations

had already been occurring in Eastern European and some developing

countries and had proved to be pretty successful in many cases

The processes of economic liberalization began around the world

in the 1980s and led to tectonic changes that would have certainly

affected the former Soviet Union Fortunately, the last Soviet leaders,

headed by Mikhail Gorbachev, were prudent enough to reject any new

radical communist experiments and even tried to modernize, albeit

unsuccessfully, the communist system The author of this book is part

of a generation of young economists brought up under the intellectual

influence of the liberal ideas of that epoch Twenty years ago all of us

were very enthusiastic about the beginning of radical market reforms in

Russia Some got a lucky and rare chance to implement these big ideas

in practice when the new post-communist Russia was born as a

sover-eign state in 1991

This book presents a participant’s observations and thoughts in

hind-sight about the revolutionary events that occurred during the last decade

of the past century The book presents a history of Russian finances that

played a very important role in the Russia’s transition from communism

to capitalism Usually financial issues remain in the shadow of historical

events or personalities They are typically neglected by historians who are reluctant to pay much attention to the dull matters of debts and credits But in the case of Russia these issues were paramount because the attempts at economic transformation were very closely interrelated with the resolution of a cornerstone problem of public debt.

This problem arose in the late 1980s and mirrored the serious

eco-nomic troubles of the Soviet Union that were hidden for many years

by official statistics The excess and rapid build up of external debt obligations by the USSR alongside ineffective attempts to introduce semi-market reforms eventually caused the Soviet debt crisis and led to the insolvency of the state There is no coincidence in the fact that the bankruptcy of the Soviet Union in December of 1991 occurred simul-

taneously with its disintegration The history of the Soviet debt crisis and default is a story of the agony and death of the Soviet Empire The subsequent history of new Russian debt origination, accumulation, and

a new crisis, which is the principal subject of this book, is essentially

a more intriguing story of the successes and failures behind Russia’s transition to markets

Market reforms started in Russia in the aftermath of the Soviet

bank-ruptcy and in a political situation of considerable complexity The new Russian government headed by Yegor Gaidar was formed by the first Russian president, Boris Yeltsin, at the peak of his charisma, as a team

to conduct some radical economic reforms Being widely perceived as

a team of ‘whipping boys’, it had to fulfill three concrete tasks First, the government of reformers had to undertake urgent measures to pull the country out of a deep economic crisis and to prevent a widespread social catastrophe Second, it had to launch the great capitalist revolu-

tion in Russia, something that the previous liberal reformers in tsarist Russia (the predecessor of the USSR), such as Peter Stolypin, had failed

to accomplish eighty years earlier Third, the government of post-Soviet young reformers had to solve the Soviet debt problem in a civilized manner

These three tasks were mutually interrelated The economic crisis could

be resolved only on the basis of a market that was yet to be created In introducing its reforms the Russian government needed political support from the governments of developed countries that were official creditors

of the Soviet Union At the same time the success of reforms was the only way for the Russian government to become eventually solvent so that it could pay back Soviet debts The solution of the debt problem was,

thus, a necessary condition for overcoming the economic crisis under which the Russian Federation was born as a new political entity

Negotiations around the Soviet debt restructuring, hence, became

the key strategic issue for the Russian authorities The recognition and

restructuring of this debt made possible a civilized solution of the

sover-eign debt problem, for the first time since the Bolshevik revolution and

Russia’s sovereign debt default in 1917 Russia assumed responsibility

for the Soviet Union’ foreign debt in full, although this implied a very

high additional financial burden for the newly created state But, on

the other hand, the debt assumption opened new options for Russia

to enter the global capital markets several years later Another strategic

reason for the Soviet debt assumption was maintaining the status of a

nuclear superpower (infirm but still alive) that Russia inherited from the

USSR as its legal successor Of course, leaving these strategic

considera-tions aside, a more rational choice might have been instead to issue new

debt at the beginning of the transition to facilitate this process and to

smooth out household consumption Successful reforms would, after

all, lead to higher future incomes, so it would be sensible to finance

some of the painful reforms from richer future generations But as the

successor to the bankrupted Soviet Union, the Russian Federation could

not borrow any more before the resolution of the Soviet debt problem

This vicious circle made the whole situation relating to the external

financing of Russian reforms very difficult

Another problem was that the Russian economy proved to be heavily

exposed to fluctuations in the price of oil ‘Her majesty, the oil price’

dictated the course of the most important events in Russia’s history of

the last four decades, since the large Siberian stocks of oil were opened

for exploitation Figure I.1 depicts the dynamic of the real oil price for

the thirty-year period 1979–2008 The price jump at the beginning

of the 1980s ensured large export revenues but weakened the Soviet

rulers’ incentives to make reforms The first attempts to modernize the

socialist system were initiated by Mikhail Gorbachev after the dramatic

drop in the oil price in 1986 which turned out to be strong enough to

cause the Soviet economy to fall first into crisis and then to collapse

The attempt to introduce semi-market reforms was in fact a ‘false start’,

but the Soviet Union received huge volumes of foreign credits, as a

seemingly upward price reversal manifested in 1989–90 (as seen in

Figure I.1) But when the true market reforms started in 1992, the oil

price began to fall again A period of radical market transformations in

the period 1992–99 thus coincided with a period of very low oil prices

Its drop fostered the initiation of radical reforms in Russia but at the

same time made it very difficult to implement these reforms As seen

from Figure I.1, the minimal level of the oil price was reached in 1998,

a year of the Russian financial collapse that had a shocking effect on the global financial system.

Although the Russian government agreed to assume the debt

obliga-tions of the Soviet Union in 1992, it was able to reduce the debt burden temporarily as a result of its negotiations with the clubs of foreign creditors and G7 governments Russia received a seven-year breathing space to bring about its capitalist revolution This book contains a par-

ticipant’s personal view, with hindsight, of the political and economic processes in Russia that, being coupled with very unfavourable oil price movements during that period, led this revolution to the financial crisis and a new debt default in 1998

This book focuses on the problems and obstacles to the reform of the Russian economy with a special emphasis on state debt policy This was the field of my personal activity as a member of the first and second cabinets that implemented radical reforms When the state debt policy was designed initially, my colleagues and I shared the optimism that the debt burden would be eroded by economic growth that would be generated sooner or later by the market economy We overemphasized the word ‘sooner’ and underestimated the difficulties that Russia would have faced in the transition to the market economy One could not foresee the size of the forthcoming economic decline in the 1990s that was devastating for the Russian economy.1

Figure I.1 The real oil price, 1979–2008 ($/barrel)

Source: The Federal Reserve System, the International Energy Agency.

It was completely disorganized at the very beginning of market

reforms, and, as I have mentioned, the main task of the reforming team

was to prevent a catastrophe, rather than to transform deliberately the

economy into a well-designed model Of course, a programme of reforms

had been prepared according to the standard logic of economic

liber-alizations and approved by international experts But the programme

could not envisage all the scenarios of transition and, in particular,

it ignored a number of important features that were specific to the

Russian economy There was no theory of the transition to the market

applicable to any country (since there was no reason to elaborate such

a theory earlier) The experience of East European countries, on which

the Russian reformers placed too much initial reliance, turned out to be

not particularly useful For reasons that I will discuss in this book, the

economic transformation in Russia differed drastically from any earlier

experience of other countries

It had often happened in Russian history that policy measures

designed initially as benevolent, turned out to have unforeseen

con-sequences The post-communist reforms were a good illustration of

this regularity, and reformers in Russia faced an immense gap between

desires and possibilities They could not prevent, for example, huge

budget deficits and persistent three-digit annual inflation, the

wide-spread non-payment crisis, the chronic fiscal crisis, a huge polarization

of incomes and horrifying poverty, and the rise of extremely sharp

social problems The market economy institutions developed slowly,

while important structural reforms were incomplete and inconsistent

or delayed indefinitely The economy suffered from a lack of

transpar-ency in nearly every sphere, and this made it difficult to attract foreign

investment in the production sector The rule of law, respect for

owner-ship rights, the creation of a good investment climate, and the building

of a trustworthy reputation by the state, remained empty slogans that

were used for political demagogy and manipulations

One crucial difference is that Russia had experienced the planned

economy for a much longer time and in greater depth than the East

European post-communist countries Three generations of Russians

did not know about the market economy, while people familiar with

capitalism were still alive in Poland, Hungary, the Czech Republic and

other countries, where old traditions of individual activity and

respon-sibility had not been forgotten completely Even though the Russians

were unaware of capitalism, many of them were enthusiastic about new

opportunities for self-actualization and enrichment that appeared as

the reforms began Unfortunately, very soon these hopes turned out

to be vain for the majority of people that could not find their place

in the new environment and reach success But their failure to adapt

to emerging markets was not their fault because this environment was very chaotic

In my opinion, the unintentional results of Russia’s market transition were caused not by people’s mentality, but rather by the burdensome legacy from the Soviet era The Russian economy inherited a huge monetary overhang, implying that the economic liberalization had to begin from a tremendous inflation outburst This was a shock for both domestic producers and households The inherited economic structure was inefficient – due to arbitrary administrative decisions adopted previously in the command economy – and needed to be transformed dramatically But the costs to the Russian economy of such structural adjustments were extremely high On the one hand, the majority of domestic producers were used to the paternalism of the state and could not survive in the market – their cost structures were just not viable On the other hand, the state could not permit the majority of enterprises

be closed at one instant.2 It would be hardly possible to build a new economy on ruins of the old one in the absence of new investment and knowledge An acceptable strategy was therefore to search for compro-

mises that were, of course, in conflict with the radical approach that the reformers had initially tried to implement

Thus, the Russian government was trying to pursue conflicting goals and, at the same time, was faced by severe political constraints The most serious problem was that the state had to maintain its social expenditures and obligations which were too high for an economy in deep distress In relative terms these obligations were similar to those typical for the developed European economies The state also continued

to support inefficient production enterprises The burdensome Soviet legacy, the unfavourable terms of trade, and the excess state obliga-

tions made inevitable huge budget deficits and emission of money

or debt

As is made clear by from the title of this book, the public debt policy

of Russia in the 1990s is the main theme of our analysis I try to

under-stand the dualistic features of the debt in the Russian transition Even though the external Soviet debt was a burden for the economy, its assumption furthered the integration of Russia into the global financial system As a result of the resolution of the debt problem, Russia received

sovereign ratings in 1996 and entered the Eurobond market The

exter-nal debt that Russia committed to service and pay back was a discipline

device for economic policy making at home The Russian financial

system was dependent on external debt, but this circumstance deterred

pro-inflationary political forces and compensated for the lack of

politi-cal support to market reforms In particular, the International Monetary

Fund had some political influence on domestic financial policy and

thereby contributed to the macroeconomic stabilization of 1995–96

This stabilization was a hard-won victory because inflation was

reduced at the cost of creating a whole set of new macroeconomic and

financial risks The monetization of budget deficits that had been the

policy of ‘choice’ was replaced by domestic debt issues which were

ruble-denominated, short-term, and high-yield This kind of

stabiliza-tion was a compromise solustabiliza-tion justified by the absence of any other

scheme to combat inflation, by the lack of credibility of state policy, and

by the chronic fiscal crisis There was also some optimism that

some-how growth would accelerate enough so that the debt dynamics would

not worsen (a sufficiently optimistic scenario always exists to justify any

policy ex ante) The growth in domestic debt, however, created

addi-tional refinancing risks and increased the threat of a budget crisis in the

near term as a result of the high costs of debt service In contrast to the

external debt which was managed in cooperation with the international

financial organizations, the domestic debt was under the full discretion

of national authorities and was therefore a source of many risks

On the one hand, the opening up of the domestic debt market was

a breakthrough in the organization of securities exchange in Russia It

contributed to the emergence and development of domestic financial

markets on a modern basis The Russian Ministry of Finance that took

control of this process was the main generator of financial development

during that period On the other hand, an opportunity to cover budget

deficits by borrowing in rubles had perverse effects on the incentives

of policy makers Domestic debt was viewed as an unlimited and easy

source of funds for the state budget, and the problem of a sustained

budget deficit seemed to be solved easily This political myopia

mani-fested itself sharply during the second presidential election campaign

in 1996 when the domestic debt was used to finance additional

large-scale expenditures of the state budget

A comprehensive fiscal reform was delayed, although, in my view, it

could hardly have been implemented during the 1990s The obstacles

to such reform were fundamental, and this was a deep-rooted problem

which was also a consequence of the Soviet legacy The government

formally abolished subsidies to privatized production enterprises but

continued to support them implicitly As a result, the government

was heavily involved in the economy-wide non-payment crisis, and a significant part of the state’s financial flows relied increasingly on barter

schemes and monetary surrogates This was the most essential feature of

the Russian fiscal crisis that the authorities could not deal with

The risks of domestic debt proliferation were aggravated after the

open-ing of the domestic debt market for non-residents in 1996 This was a good idea in principle, but its realization essentially neglected the fragil-

ity of the domestic financial system Financial liberalization prompted hot money inflows that made it urgent to improve risk management

by the state On the contrary, the ruble exchange rate regime and the scheme of hedging of non-residents’ ruble holdings introduced by the Russian Central Bank led to outrageous currency risk mismanagement The extreme weakness of the Russian banking system was another fun-

damental factor of Russia’s financial fragility Domestic financial markets could not eliminate or diversify away the excess financial risks Though the Russian government entered the Eurobond market in 1996, it did not manage to rationalize its public debt structure The authorities misused the new opportunities opened by financial liberalization and only aggra-

vated all kinds of financial risks The financial crisis of 1998 with its sharp

ruble devaluation and the default on domestic debt was the culminating point of this reckless policy

A large part of this book is devoted to a description of the Russian financial crisis I consider this to be a cornerstone event in recent Russian history which resulted from many previous mistakes and omis-

sions and which has had a major impact on the subsequent economic and political development of the country The genesis of this crisis

is traced back to the previous Soviet debt default, and then through the period of market transformation in 1992–97 I pay special atten-

tion to the fundamental factors that the Russian authorities could have had very little impact on even if they had acted prudently in all circumstances I also emphasize the key policy mistakes, first of all, the lack of risk management and debt management, and the failures of monetary policy.3

The Russian capitalist revolution began with the radical economic

lib-eralization in January 1992 and was finished with the radical resolution

of the financial crisis in August 1998 Was this attempt to build Russian capitalism in several years a failure? I think not The Great French Revolution of 1789–94 was in my view not a failure, although it flooded France with blood and eventually brought Napoleon Bonaparte to power Even more so, the Russian capitalist revolution was not a failure Russia avoided a civil war and the blood that would be associated with

it, as a possible scenario in the early 1990s The government of reformers

prevented famine and social cataclysms that were very well familiar to

Russia in its previous history of the twentieth century

The economic transformations that were very hard to implement

in Russia and that were indeed several times on the brink of failure,

ultimately bore fruit It turned out that after the crisis of 1998 Russian

people were living in a country that was quite different to the one it

had been a decade earlier The market economy has been created, and

as a result of this Russia experienced spectacular economic growth in the

period 2000–08 Of course, it was driven by even more spectacular oil

price growth, but even this type of quasi-exogenous economic growth

would have been impossible in the command economy This was the

first occasion, after many decades of dominating economic absurdity,

that market forces had been in action and benefited the majority of

the popu lation Most important is that Russia today has a perspective

of further development which the communist system did not have in

principle

The civilized solution of the external debt problem in the 1990s

stim-ulated the economic integration of Russia with the developed world

Many new developments occurred, including the creation of a legal

basis for markets, the market economy infrastructure and institutions,

the modern systems of learning for professional market participants All

of these building blocks of the modern market economy demonstrated

the ability to work and develop after the crisis

It is worth noting that in the 1990s economic policy making was a

much harder task than it is today The problems that policy makers

faced in the 1990s were, in my view, much more difficult than those

to be encoun tered today, even despite the global crisis that is seriously

affecting the Russian economy If, for example, the oil price was $25 per

barrel in the first half of 1998 instead of $10 per barrel, Russia could,

most likely, have avoided default If, on the contrary, the oil price

had fallen in 2008 to $25 per barrel, it would be a catastrophe for the

Russian economy and financial system despite tremendous financial

reserves accumulated by the state in the current decade.4 Financial

man-agement in the low-oil-price regime required much greater effort,

profes-sionalism, smarts, and enthusiasm of policy makers than is required

when oil prices are very high The current generation of policy makers

has been spoiled by such prices and firmly shielded from the bad

sur-prises by the huge financial reserves of the state I am not sure that

under tougher circumstances this generation would be able to act as

selflessly as our generation did

The book attempts to make this experience comprehensible, being based on both a description of recent Russian history and some personal

reminiscences about the transition to the market Nevertheless, it is neither a historical book, nor a political memoir; rather, it is an attempt

to provide an assessment of economic policy in hindsight I have tried

to make such an assessment both from the view of an insider – a policy maker involved in making macroeconomic policy – and from the view

of an outside observer of the course of events During the historical period described in this book I occupied both roles I was an insider during the ‘breakthrough period’ of the capitalist revolution 1992–97 and became an outsider a year before the financial crisis of 1998

Needless to say, there is no shortage of studies of this crisis, so the

ques-tion may be asked: why is another one needed? Many of these studies were completed just after the 1998 default and thus lack some his torical perspective Moreover, many of these studies are most focused on cast-

ing blame This book, on the other hand, offers a more comprehensive picture with the advantage of perspective gained from the decade since the crisis And rather than search for who to blame, this book focuses

on the key aspect of debt management as the central theme to

under-standing the crisis The grim decennial anniversary of 2008 provided another reason to write this book, as the deterioration of understanding

of the real causes of Russian crisis demonstrated by both domestic and international public became apparent

The book is structured as follows Chapter 1 provides an account of external debt management in Russia in the 1990s which created a basis for integration into the world economy Chapter 2 examines the inter-

action of the newly established financial markets and banking system, and also the link to the inflation-taming policy Chapter 3 character-

izes the specific concept of the virtual economy in the application to the problem of budget arrears and, more broadly, to the problem of the chronic fiscal crisis Chapter 4 presents a road map to understand the development of public debt management in Russia Chapter 5 contains

a thorough account of the causes of the devastating Russian financial crisis of 1998 Next, Chapter 6 provides a description of how the crisis actually unfolded, and Chapter 7 explains how Russia recovered from the

consequences of the crisis Finally, Chapter 8 compares the situation and development in Russia during the current world crisis with the responses

to the previous crisis

Russian external debt has played a very important role in its recent

history At the beginning of the 1990s the Soviet Union found itself

in a severe debt crisis that caused the bankruptcy of the state and the

collapse of its planned economy To a large extent the external debt crisis

was caused by strategic mistakes made by the Soviet authorities over

the course of the previous two decades This crisis dictated the course of

economic development of Russia in the 1990s and the current decade

The debt burden was unbearable for the country in deep distress, and

a rescheduling of debt was inevitable as the only possible and civilized

way to solve the problem When the market reforms began in 1992, the

external debt became the subject of comprehensive negotiations with

western governments The process was aimed, above all, at achieving

support for market reforms in the new Russia

It was the first time in Russian history that top officials had negotiated

with foreign partners about the key issues concerning development of

the national economy Negotiations on debt restructuring continued for

several years and brought significant results in 1996 They allowed the

Russian Federation to define its status as a legal successor of the Soviet

Union Russia remained a superpower, in particular, because it

voluntar-ily assumed all of the obligations of the former USSR As a byproduct

of successful debt negotiations, Russia received sovereign credit ratings

that opened the doors to the world of global finances

This chapter concerns the issues of external debt management of the

1990s that, in my view, provided a foundation for Russia’s integration

with the world economy and for the creation of modern market

insti-tutions at home The theme is of particular interest to me because of

my personal involvement in resolving the debt problems During five years, in 1992–97, I participated in the negotiations with the Paris and London Clubs of creditors, the International Monetary Fund and the World Bank, regular G7 ministers’ meetings and so on I was lucky to get acquainted with famous economists like Stanley Fischer, Lawrence Summers, Michel Camdessus, Robert Rubin and many others that were involved in the process They sympathized with Russia and its reforms and put in a lot of effort to assist Russian authorities with building new market institutions My contacts with such persons were very useful and

provided a good opportunity of getting good advices and learning much

about the ways of economic and financial policy making

As a key Russian policy maker in the 1990s, I was seeking to

intro-duce a new style of work for the financial authorities based on the open economy ideology and giving a priority to market instruments Negotiations about external debt were the first steps in the organiza-

tion of public debt management and the creation of financial markets

at home Debt servicing was an effective discipline device for the fiscal and monetary authorities, for whom the IMF was an economic supervi-

sor for several years For various reasons discussed in subsequent

chap-ters of this book, the economic performance of the past decade was controversial But there is no doubt that the economic and financial system of modern Russia was created in those years on absolutely new principles

1.1 The Soviet debt

For many years the Soviet government had no foreign debt burden All obligations of the Russian Empire to foreign countries were repudiated immediately following the socialist revolution of 1917.1 Subsequently, under the regime of ‘classical socialism’, there was no need for external borrowing The Soviet economy was close to autarkic and, presumably, self-sufficient in terms of the development of its domestic resource base Foreign trade and currency flows were insignificant and subject to centralized government control The dominant feature of this economy was a permanent shortage with hidden inflation and budget deficits For several decades, the Soviet authorities could use various direct and indirect channels to extract incomes and property from citizens for the needs of the state and had no need to secure external funds The pred-

ecessors of Mikhail Gorbachev were not inclined to take international financial obligations that would imply any kind of dependence from foreign governments or international financial organizations.2

1.1.1 Petrodollars and the foreign debt

For this reason, the USSR had virtually no foreign debts until the second

half of the 1970s Foreign trade was balanced since the government

made import purchases in strict correspondence with concurrent export

revenues But the ‘mature socialism’ of the 1970s became a period of

rapid growth in consumption, both public and private, not least in

connection with the discovery of new colossal oil and gas fields in West

Siberia in the 1960s World oil prices were at high levels that allowed

the planning authorities to import large amounts of equipment and

consumer goods The arms race and the inherent inefficiency of the

planned economy placed obstacles in the way of the rapid increase in

living standards for the mass of the population But being obliged to

fulfill at least some of the populist promises and slogans concerning the

welfare of citizens (for example, an abstract ‘communism’ to be built by

1980 or a more concrete ‘separate apartment for every family’ after the

same year), the authorities began to borrow abroad They based on

opti-mistic expectation of further oil price increase in the long term after a

series of hikes in oil prices in the middle of the 1970s and the beginning

of the 1980s As a result, the external debt increased more than 15 times,

from $1.8 billion to $29 billion, in the 15 years from 1971 to 1985

At that time the Soviet Union was considered by foreign creditors

to be a first-class borrower (corresponding to AAA sovereign credit

ratings) This reputation was gained by the centralized control over

export revenues and currency flows and the tradition of stern financial

discipline maintained over many years But the expectations of

increas-ing oil prices proved wrong, as became obvious in the middle of the

1980s, after the dramatic fall in the world oil price, shown in Figure 1.1

The state revenue from raw materials exports also declined, but the

economy remained technologically dependent on imported goods

Production decisions in the planned economy were based on fixed

natural proportions that were typically irrelevant and non-responsive

to changes in relative prices

The living standards of Soviet citizens did indeed improve in the

1970s, and their new consumer habits made it almost impossible to

introduce drastic restrictions on consumption imports (the ‘mature

socialism’ leaders were reluctant to reduce consumption levels) In

addition, financial decisions under the planned economy were

pre-determined entirely by detailed natural plans adopted by the Central

Planning Committee (Gosplan) The latter followed a bureaucratic

rou-tine of one-year planning that had nothing to do with sophisticated

matters of intertemporal choice under uncertainty A new convenient

way of solving the problem of chronic shortages through external financial sources of imports was discovered, but the underlying risks were ignored completely Thus, as a result of the rigidities of the planned economy, the desire of the population for higher living standards, and the myopia of financial decision makers, the Soviet Union chose to embark on large-scale borrowings, and the external public debt had reached about $32 billion by the mid-1980s.

Western banks were eager to provide loans that were considered to

be riskless, especially against expected cash flows of oil and natural gas export revenues But the true external debt burden of the Soviet economy was unknown because of statistical data imperfections result-

ing from price distortions in the planned economy and the peculiarities

of national accounting in the USSR The indirect estimates of Soviet GDP were typically upward-biased, implying that the estimates of debt-

to-GDP ratio were downwards biased, as Boris Kheifetz (2002, p 113) pointed out, although, admittedly, any estimates of Soviet GDP and the economy potential on the PPP basis could hardly be correct In addition, both official and commercial lenders of the Soviet Union dis-

regarded the underlying systemic and political risks and neglected the possibility of sovereign debt default Actually, the centralized planned system could have collapsed as early as the end of the 1970s, if the new stocks of energy resources in West Siberia had not been discovered and utilized This ‘manna from heaven’ gifted 15 years of life to the socialist system, while the generous external debt financing of the 1980s helped

to continue its agony for several more years

0

1970 1972 1974 1976 1978 1980 1982 1984 1986 1988 1990 1992

20406080100

120

05101520253035

External debt, $ billion US crude oil price, $/barrel

Figure 1.1 The Soviet external debt and the oil price, 1970–93

Sources: Russian Ministry of Finance, Energy Information Administration USA.

1.1.2 The debt addiction

The tendency of debt accumulation changed as the domestic and

foreign policy of the Soviet Union was modified in the second half of

the 1980s At this time Mikhail Gorbachev was engaged in the policy of

Perestroika – an attempt to modernize socialism that ultimately failed

but led to a dramatic increase in budget expenses For instance, the

‘economy acceleration’ programme, proposed by the Nikolai Ryzhkov

government in 1986, was based on the idea of large-scale centralized

investment in the machinery industries Additional state funds were

required to deal with the extraordinary consequences of the Chernobyl

catastrophe in 1986 and the Spitak earthquake in 1987 The resolution

of numerous social and ethnic conflicts that emerged after 1987 also

required considerable government expenditure The anti-alcohol

cam-paign launched in the same year undermined an important source of

tax revenues since the official sales of alcohol were essentially reduced

(and, as a result, the illegal production of surrogate alcohol increased

sharply)

The Soviet leaders could easily increase overseas borrowing, thanks to

the sympathies of the western political leaders for Mikhail Gorbachev

and the democratic tendencies in the USSR under his governance But

as it turned out, the political sympathies to Perestroika resulted in the

doubling of the Soviet sovereign debt during in the five-year period

1986–90, from $31.4 to $62.5 billion (see Figure 1.1) These new

bor-rowings were financed both by the governments and the private banks

of developed countries In our view, two fundamental factors were

decisive in bringing about the expansion of the state’s uncontrolled

external debt

First, the world oil price nearly halved in 1986–87, from US$25 to

US$13 per barrel (Figure 1.1), and oil production in the USSR fell

dur-ing the subsequent four years by 17.4 per cent, as seen in Table 1.1 At

the same time the productivity of the existing oil fields was decreasing,

while the opening of new fields became more costly The fixed

invest-ment required for the creation of new oil capacities increased on

aver-age by 80 per cent over the period 1986–90, while total investment in

oil industry grew by only 28 per cent in the same period (Gaidar 2006,

p 287) This led to a dramatic reduction in the level of exports and state

budget revenues In 1988 the total volume of Soviet exports reduced by

46 per cent as compared to the plan target level (Gaidar, 2006, p 264)

The export of oil halved in 1990–91, from 124 to 61 million tonnes By

the beginning of the 1990s the state’s falling oil revenues were spent

primarily to service Russia’s external debt (Gaidar, 2006, p 264) Despite

the decline in the level of imports, the foreign trade deficit increased twice during the three years of Perestroika 1986–88, and tenfold dur-

ing the 12-year period 1976–88

Second, the reduction of exports coincided with the awkward attempts to transform the system of centralized planning undertaken since 1987 The communist authorities tried to return to the semi-

market reforms that were introduced in the 1960s but ended for ideological reasons in the 1970s During that period (the ‘golden era’ of mature socialism) the Soviet economy did not face a problem of short-

ages that was as severe as it became in the middle of the 1980s The time

for experiments in the style of Yugoslavia or Hungary had been missed because of the macroeconomic imbalances accumulated during the two decades An attempt to introduce some elements of the Chinese model into the Soviet economy was also unsuccessful: the majority of the population had been accustomed the paternalism of the state and did not have strong incentives to pursue individual activities

The key problem with making semi-market reforms was that the

par-tial weakening of administrative control was in conflict with the parpar-tial freedom given to state enterprises in 1987 The price structure was subjected to extreme distortions because of state controls, and prices typically did not convey true information about the level of market demand.3 Another serious problem was the wrong managerial incen-

tives of state enterprises They benefited from the removal of

admin-istrative pressure and the newly emerged opportunities for choice by increasing, initially, the nominal wages of employees at the expense of the state in a financial irresponsible manner As Anders Åslund (1995,

p 48) remarked, ‘The paramount problem was that wages rose more than twice as fast as they had previously As a consequence, enterprise taxes declined and the budget deficit expanded’ (see Table 1.2) The managers

of state-owned firms tried to ‘sit on two chairs’ by selling outputs and inventories at market prices while purchasing intermediates at fixed prices through channels of administrative supply.4 New cooperatives

Table 1.1 Oil production by the USSR in 1988–91

that appeared as a result of the law adopted in 1988 typically served as a

bridge between the planned system and the new market segments of the

economy State enterprises established affiliated cooperatives and could

effectively exploit the deficiencies of both systems This kind of

behav-iour was a typical product of Gorbachev’s partial reforms that gave rise

to rapid inflation under total shortage that were mutually reinforcing

The velocity of money was increasing with shortages, while

precaution-ary purchases of storable goods were spurred by accelerating inflation

Nominal wage increase was a consequence of the partial freedom

granted to enterprises and was eventually financed by the state It hence

generated budget deficits, as Table 1.2 demonstrates, that resulted in

the type of open and uncontrolled inflation which had previously been

hidden by shortages of goods In part, inflation was accelerated through

the mediation of commercial banks that began to emerge in 1988 from

branches of the state monopoly bank Gosbank or as new financial

institutions By the beginning of the 1990s the number of commercial

banks had grown rapidly, as seen in Table 1.3, but without adequate

professional learning to banking by bank managers and under very

weak regulation.5 The authorities, nevertheless, believed that the new

banking sector would become a locomotive of the market economy and

desired to give it the ‘green light’ But the true goals and services of early

commercial banks were very far from these optimistic hopes

Banks broke a distinction between cash and non-cash money that

had been a cornerstone of monetary control in the command economy

Wages to workers were paid in cash (nalichnyye), while payments between

enterprises were made in non-cash (beznalichnyye) This system allowed

the monetary authority to balance, in principle, aggregate wage

pay-ments with aggregate consumer demand and, thus, to maintain control

over consumer price inflation But commercial banks had the

opportu-nity to transform the non-cash accounts of enterprises into cash and,

in fact, were established in many cases simply for this purpose These

Table 1.2 Nominal wage growth and consolidated state budget deficit in the

USSR in the period of Perestroika, 1985–91

operations were widespread and masked under credit supply to the real sector As a result, the monetary authority began to lose control over cash

in circulation that it had been able, more or less effectively, to exercise previously Gosbank tried to avoid the monetary loosening generated

by the new banking sector and to constrain its overly rapid expansion using administrative measures But this contradicted the Soviet law on banking adopted in 1988 which was based on lax regulatory rules and,

in particular, weak capital requirements This law aimed to facilitate new entry in banking and, in my view, was too liberal for the economy that made only first steps in transition to the market

Under these circumstances the state could not prevent the partial loss of foreign currency control and allocation that occurred in the late 1980s Before Gorbachev’s attempts to introduce market reforms, the export revenues of all Soviet enterprises were transferred to the government It allocated foreign currency to industrial and trade min-

istries that purchased producer and consumer goods abroad When new cooperatives and private commercial banks appeared in 1988, the currency regulation weakened considerably But even this bounded financial independence of enterprises, commercial banks, and regional powers caused the destruction of centralized financial controls and

a dramatic reduction in the level of export revenues that had during earlier periods accumulated at the centre The loopholes in financial legislation provided banks with an opportunity to generate cash flows, resulting in the uncontrollable growth of fiat money in the economy In

this situation the permission of foreign currency circulation led to the emergency of the foreign currency ‘black holes’ As a result, by the end

of 1991 the newborn foreign currency market of Russia was engulfed in

a profound crisis

At the same time the geography of external borrowing by the state was widening noticeably beyond the traditional loans obtained from developed countries The new official creditors were now represented

by the oil-producing and new industrial economies such as Kuwait,

Table 1.3 The number of banks in the USSR in

Saudi Arabia, the UAE, and South Korea A large amount of the new

Soviet debt was also created through the help of the former socialist

countries, including Comecon countries,6 Yugoslavia, and China

The latter case deserves attention The original debts of the USSR to

the Comecon countries amounted to $24 billion, roughly one-third

of total Soviet foreign debt by the end of the 1980s The emergence of

these obligations provides a good illustration of the workings of some

loopholes in the poorly managed system of currency controls The

new rules allowed joint enterprises to convert the ruble revenues from

imports into the so-called ‘transferable rubles’ Initially, these rubles

were used as pure accounting units in trade between the USSR and the

Comecon countries and were not supposed to be a means of exchange

It is important to note that under the command economy these

coun-tries, typically, exchanged the lower-quality goods they produced for oil

and gas imported from the USSR (they exported higher-quality goods

to western countries in exchange for superior imports) Trade with

the socialist economies of East Europe was of no benefit to the Soviet

economy – it exchanged severely underpriced basic resources for

over-priced manufacturing of inferior quality This trade was, to a large extent,

constructed for artificial political reasons and shrank by around 80 per

cent after the introduction of foreign trade liberalization in 1991–92

But earlier, during Gorbachev’s reforms, imports from the Comecon

countries were increasing because of highly profitable re-export to the

USSR of trade items such as computers and office equipment.7 In

addi-tion, because of the weakened financial regulations, many trading firms

applied schemes based on false import contracts with no delivery of

goods used to withdraw cash from bank accounts

Under such circumstances the Soviet authorities made a mistake by

giving the transferable rubles an artificial status of hard currency with

a fixed one-to-one exchange rate with the dollar The Soviet financial

system thereby insured the currency and inflation risks of trading

operations with the lower-quality trade partners of the Soviet Union

Adverse managerial incentives could be one of the factors behind such

‘generosity’ on the part of the state, although a more likely reason lay

in the widespread incompetence of the financial decision makers in the

planned economy Obligations in transferable rubles were presented for

payment after the Comecon fell apart8 and thus increased the

sover-eign debt of Russia As a posterior expertise of the Comecon and other

Soviet debts by the Russian Ministry of Finance revealed in 1992, its

considerable part originated due to poorly designed experiments by the

Soviet government in making semi-market reforms.9

Generally, by the end of the 1980s, the planned system in the Soviet Union had been de facto destroyed It had moved from the inefficient but somewhat ordered and viable routines of short-term planning to the chaotic ‘spur of the moment’ style of decision making The main task of the authorities became the urgent closing of numerous financial gaps Commands were given to obtain any credits on any terms, and the

issues of alternative costs were not discussed

1.1.3 The first debt crisis onset

The first difficulties in debt servicing were manifested in 1989 when domestic borrowers began suspending payments for import contracts Although the government still continued to service external debt, trade credits were not repaid in time by Vneshekonombank that emerged from a department of Gosbank specialized in foreign payments opera-

tions related both to trade and the state debt management (this bank later received the status of a government agency for external debt management) The state was a recipient of all foreign credits, and the suspension of payments in trade was a negative signal, raising the issue

of state credibility The majority of foreign banks stopped providing loans to the Soviet government for both import purchases and foreign debt refinancing The banks required additional official guarantees and suggested that they should resort to the governments of developed countries to make new borrowing (Gaidar 2006, p 267) The latter conditioned the granting of new credits on domestic and foreign policy issues, including the need for radical market reforms in the USSR and concessions in disarmament and Soviet control over East Europe These strategic issues became a subject of debt negotiations with the foreign governments that took the role of ‘creditors of last resort’ for the bank-

rupting Soviet Empire

The Soviet authorities were neither prepared to begin the radical market reforms, nor had they any consistent strategy to solve the urgent problems of foreign payments They recognized the seriousness of the problem, but this circumstance aggravated the situation in relation to external debt In July 1990 Mikhail Gorbachev hinted publicly about the

need to restructure the state’s external debts, and this was perceived by creditors and financial markets as an additional negative signal (Gaidar

2006, p 268) Taking into account the long tradition of deep secrecy in Soviet policy making, an official recognition of severe problems with foreign debt was seen as clear evidence of very big troubles

The fundamental cause of the foreign debt crisis that began in 1990 was the chronic economic crisis of the centralized planned economy

Although it was hidden under official statistics, it clearly manifested

from the middle of the 1980s through strengthening shortages and

rising black market prices The bust occurred in 1990, when the Soviet

GDP declined by 4 per cent When the Soviet Union collapsed in the

last quarter of 1991, the chronic economic crisis was transformed into

a full-scale economic disaster The fall in industrial production in 1991

was catastrophic – 21 per cent, with GDP falling by 11 per cent The

ruble inflation was accelerating: nominal household incomes increased

in that year by 300 per cent, although the CPI growth rate was ‘only’

160 per cent since retail prices were still under state control The money

overhang ran alongside the debt overhang In two preceding years,

1990–91, the volume of external debt increased by 26 per cent – by

$8.6 billion in 1990 and $12.4 billion in 1991 To a large extent, the total

financial collapse was a byproduct of the total collapse of the state

In this situation the external debt default was inevitable, as a result

of the balance of payments crisis and the huge state budget deficit

A large fraction of budget incomes had to be spent on debt servicing

and high interest payments (under annual interest rates of 8 per cent

on average) The complete fulfillment of debt obligations would require

$15–17 billion per year or roughly 40–50 per cent of expected budget

incomes But the latter continued to be squeezed because of the

disor-ganization in finance, and the economy approached a situation of debt

overhang The main trouble for the monetary authorities was the loss

of control over export revenue flows and the absence of a legal foreign

currency market The Soviet government had no other choice but to

continue external borrowing at an increasing pace But now the main

task was not to solve numerous current problems in the governance of

the centralized economy, but rather to evade the total economic and

financial collapse

The situation became extremely dangerous because of the threat of

social unrest in many cities The market economy mechanisms were

only emerging (the ‘invisible hand’ was either absent or too weak as

yet to fulfill its work), while the administrative system of consumer

goods production and allocation had been destroyed completely The

delivery of food was a supreme policy issue: the threat of famine became

real during that period, especially in the larger cities Russian history

had provided an important lesson: the abovementioned revolution of

1917 was triggered initially by short interruptions of food delivery to

Petrograd, at that time the capital of Russia Similarly, at the beginning

of the 1990s the opportunity to borrow abroad became, essentially,

a matter of national survival With the free access to foreign markets

for goods that Russia was enjoying by that time, the crucial issue was fundraising to make the necessary purchases of foodstuffs.

Under many credit agreements signed in the crisis period of 1990–91, direct deliveries of goods were carried out, of which about 80 per cent was grain Naturally, creditors who did not receive current payments refused to carry out their obligations with regard to the supply of goods Since the problem of foodstuffs was perceived at that moment as being highly urgent, obligations to the USA, the main supplier of grain and cheap food,10 were met in full According to the USA’s Jones’s Act,11 the delivery of goods by credit line to another country had to be suspended

if interest payments were not made in a timely fashion Such a priority of payments that the Russian government adhered to left practically noth-

ing for its official creditors in Western Europe, principally Germany The latter held 45 per cent of Russian debt under the Paris Club agreement,12

but had strong political motivations – the unification of the state and the withdrawal of Soviet troops – for making generous concessions in nego-

tiations around Soviet debts to German government, firms and banks

Commercial credits to the Soviet government were linked to

con-tracted imports and financed by the first-class banks abroad due to the guarantees provided by the Soviet government For instance, in 1991

65 per cent of such loans provided by German banks and 80 per cent of those by English banks were guaranteed by the German and UK govern-

ments, respectively (Kheifetz 2002, p 139) The Soviet government also provided guarantees to foreign banks supplying non-commercial loans that supposedly had to cover the balance of payments deficits Unlike commercial loans, these were not monitored by the foreign banks and remained under the discretion of the Soviet authorities In fact, many of

these credits were misused and disappeared in the period of the Soviet Union disintegration, 1990–91

Note that commercial credits to the USSR allowed many western firms

to make some large-scale clearances of excessive inventories Quality controls on behalf of the Soviet customs service were practically absent Not surprisingly, a large fraction of imported goods were of low quality and overpriced Foreign producers used exclusive opportunities to make extra profits without essential risks Trading firms engaged in this kind

of business made widespread use of opportunities to make extremely profitable arbitrage on price gaps As was mentioned previously, the domestic prices of tradable goods in the Soviet economy were many times below the world level

In addition to all these opportunities for a ‘free lunch’ a large number

of fraudulent deals were contracted under provisions that gave the

right to counterparties of the Soviet Ministry of Finance to conduct

accounting The former abused their opportunities to artificially build

up financial claims that were presented later to the Russian government

One of the best-known examples of such dubious business is the

notorious ‘Noga case’ originated in 1990 and whose repercussions still

reverberate in Russia (Box 1.1) This case became a symbol of

disor-der in commercial and financial relations between the Soviet/Russian

authorities and international business at a period of dramatic political

and economic transformations.13

BOX 1.1 The ‘Noga Saga’

The Swiss firm Noga (Noga d’Importation et d’Exportation SA) headed by

Nessim Gaon was engaged in international trade and financial

opera-tions At the beginning of the market reforms in Russia Gaon tried

to establish a long-term partnership between the new Russian

gov-ernment that came to power in 1990 and the Swiss banks Gaon

organized a syndicated credit line worth $420 million to finance the

subsidizing of Russian agriculture programme Urojai-90 (Harvest-90)

and also imports of foods, electronics, construction materials,

chemi-cals, and so on, in exchange for oil products This deal was essentially

a non-transparent barter scheme relying on non-market relative

prices As was typical for such contracts, imported goods to Russia

were overpriced, while oil products exported by Russia were severely

underpriced The expected profit rates of trading firms for such deals

were normally hundreds of per cent per annum in dollar terms

Although Russia delivered its oil products in advance, imports by

Noga were in many cases delayed or not delivered at all For this

reason the Russian government decided to reject the continuation

of the deal This was in the Summer of 1992 when many similar

barter agreements inherited from the USSR were cancelled or

rene-gotiated on a market basis Importantly, from the middle of 1992

the Russian government began to apply the market exchange rate

of the ruble in all export and import operations implying the need

for the renegotiation of barter contracts However, the specific

prob-lem with Noga lay not only in the very vague contractual terms, but

also in the absence of any interbank agreement (Vneshekonombank

did not participate initially in this deal as a financial intermediary)

The Russian government thus assumed the full financial

responsibil-ity for the deal, implying a possible loss of sovereign immunresponsibil-ity

I had to cope with the Noga deal in my work in the Russian Ministry

of Finance Nessim Gaon claimed $800 million as compensation for the

lost opportunities Such a large amount of Russia’s engagement with one

small firm aroused my suspicion and I decided to check the Noga claims

carefully Since bank documentation was not available for us, an

interna-tional audit company was hired by the Ministry of Finance to check the

legal validity of these claims As independent auditing confirmed, Russia

did not have debts to Noga because it delivered oil products in advance of

contracted imports, and by the beginning of 1993 Noga was actually a net

debtor of the Russian government.

In 1994 Noga applied to the Stockholm arbitrage which recognized only

$23 million of its claims Meanwhile Russia revealed counter-claims to

Noga worth $30 million that were also verified by the international trial

As a result, by the beginning of 1997 Noga and the Russian Ministry

of Finance were close to settlement and mutual debts offset But just at

this moment I resigned the Ministry of Finance office Unfortunately, my

successors could not complete this deal at the very final stage because of

the lack of experience and incentives They were merely engaged in the

domestic policy issues such as the division of national property among the

oligarchs (to be discussed below in Chapter 3).

If the Russian authorities had completed the Noga deal in a timely

fashion, it would not have had serious consequences For three years

Gaon did not protest the arbitrage decisions because the Russian

counter-claims were well-founded But in 2000, as it became clear

that Russia had suspended its actions indefinitely, Gaon renewed

his legal proceedings This time Noga gained for the simple reason

that no Russian official found time to defend Russia’s interests in the

international trial To enforce the Russian government to pay,

over-seas Russian assets were seized on several occasions, as, for instance,

the sailing research ship Sedov in Brest, France in 2000, and the

for-eign bank accounts of 70 Russian organizations Similarly, in order to

evade the arrest, Russian military aircraft had to leave France 2001

A collection of 54 Russian paintings from the Pushkin Museum,

Moscow being exhibited in Switzerland in 2005 were also seized and

later returned to Russia after the great scandal Noga even threatened

to arrest the Russian president’s airplane In 2006 the debts of Noga

to the western banks were purchased by an intermediary, but in

2008 Noga began to make new financial claims against the Russian

government It appears likely that the Noga Saga will go on!

Meanwhile the official financial reserves were dwindling Foreign

currency reserves fell from $15.3 billion in 1988 to $7.6 billion at the

beginning of 1991 The state sold the official stock of gold: $2.7 billion

in 1990 and $3.8 billion in 1991 Ultimately, this stock dwindled away

to nearly nothing: in January 2002 only 200 tonnes remained

The date of the first debt default in the history of new Russia is 19

November 1991, when Vneshekonombank ceased its payments without

any official announcement The obligations of this bank were

trans-formed later into the sovereign debt of Russia which grew by $4 billion

(corresponding to unpaid trade contracts) and by nearly $8 billion

(cor-responding to blocked accounts) The status of Vneshekonombank as a

government agency (similar to the status of Fanny Mac and Freddie Mae

in the USA) guaranteed, formally, sovereign immunity Nevertheless, the

ending of payments to commercial creditors of the state was, de facto,

the state default To protect the Soviet foreign assets inherited by Russia

from the claims of foreign creditors, a state-owned Vneshtorgbank was

established as a bridge-bank with no debts In addition to recognition of

the Soviet debts, Vneshekonombank issued special instruments,

quasi-Eurobonds, in the period 1988–90 worth about $3 billion that were not

traded in the open market Foreign currency long-term bonds of a

nom-inal amount of about $13 billion were issued by Vneshekonombank in

1993 and 1996 to securitize its obligations These bonds (OVGVZ) fell

into the category of domestic debt papers since the major part of initial

creditors were domestic firms and organizations

1.2 The Russian debt: beginning of management

By the end of 1991 the USSR had thus become bankrupt and

disap-peared as a political entity The Russian Federation, its successor,

auto-matically found itself in a state of external debt default In a literal

sense the defaulted Soviet debt turned out to be an ‘original sin’ of the

newly born state The ‘expiation’ of this sin became an urgent problem

of the Russian Ministry of Finance after the beginning of radical market

reforms in January 1992

At this time the volume of Soviet foreign debt amounted to $85

billion Its rapid growth at the end of the 1980s and the beginning of

the 1990s resulted from the crisis of the planned economy and a series

of chaotic and wrong decisions adopted to postpone the economic

collapse and prevent the bankruptcy of the state These decisions were

essentially ineffective and served only to aggravate the problem of

excess debt burden in the economy The Soviet external debt inherited

by New Russia consisted, first, of $38.5 billion owed by the USSR to the Paris Club of official creditors, second, of $22.5 billion debt to foreign commercial banks – members of the London Club of private credi-

tors, and, third, of about $24 billion recognized as debts to the former Comecon and other socialist countries

Because of the chaotic borrowing decisions taken during the late Soviet period, the proportion of short-term debt with a maturity of two years or less in the overall volume of debt was quite high – nearly

20 per cent The fulfillment of the initial payment schedule had to be carried out in the first half of the 1990s, but this was above the coun-

try’s financial capabilities For instance, foreign debt service and interest

payments during the three-year period 1992–94 were $18 billion per annum on average, according to the initial schedule This was twice as high as the actual external debt service in the second half of the 1980s which had been $8.5 billion per annum on average

1.2.1 Strategic choices

Such an extra debt burden would be unbearable for any economy in deep economic and political distress During that period a fall in Russian export revenue continued, undermining the state budget It was clear that in the economic situation in which New Russia found itself the accumulated external debt obligations could not be repaid Strategic deci-

sions on this subject had to be adopted by the new Russian government, and the alternatives for making the strategic choice were fairly clear

(A) Russia takes full or partial responsibility The original accord between

the former Soviet republics – the CIS (Commonwealth of Independent States) countries – provided for joint responsibility for foreign debts and the proportionate distribution of foreign assets The shares of republics in debt-assets were supposed to be corresponding to their fractions in foreign trade, output and population size The share of the Russian Federation, calculated as 61.3 per cent, was fixed in the initial agreement on debt recognition and servicing, proposed by the finance ministers of G7 and signed on 4 December 1991 in Moscow But

this agreement turned out to be ineffective from the very beginning Despite joint responsibility for Soviet debts recognized formally by all participants, only the Russian Federation agreed to make payments The

reason was that the principle of joint responsibility meant that if one side rejected to pay, others took its obligation All the CIS countries but Russia preferred to be free-riders and the latter had to take the role of a sole legal successor of the USSR with respect to all debts and assets Of course, these countries did not decline to take responsibility for debt

service directly Instead, their representatives simply demonstrated their

unwillingness to take any debt obligations in the process of multilateral

negotiations on the Soviet debt with the Paris and London clubs

In fact, the former Soviet republics were reluctant to deal with these Clubs,

as soon as the issue of debt payments was touched on in negotiations For

example, I remember Boris Sobolev, then deputy finance minister of Ukraine,

who was very enthusiastic in expressing his opinion in general discussions of

sharing responsibility for the Soviet debt among all CIS countries Yet usually

he disappeared or at best pretended not to be concerned with the issue each

time it came to the necessity for Ukraine to repay its debts.

In addition, it would be hard to implement any joint responsibility

agreement It was absolutely unclear how to divide between the

repub-lics’ debts owed to different countries and of different terms, priorities

and other quality characteristics The question of the benefits and costs

of transferring the Soviet Union’s debts and assets to Russia virtually did

not arise at that time (although it was actively debated later in political

and economic circles) It is important to note that Russia accepted full

responsibility for debts on its own, with no hard pressure by creditors

and G7 governments As a result, it became the only counterparty of

the creditors: from April 1993 it established a bilateral framework for

negotiations with the Paris Club Obviously, the exclusion of other

former Soviet republics from negotiations greatly simplified the process

of searching for a mutually beneficial and comprehensive agreement

on Soviet debts

(B) Russia claims forgiveness of debt or takes tough commitments Another

dilemma was to restructure the whole debt or to try to agree with

credi-tors about partial forgiveness The Russian government chose the first

strategy, although the experience of forgiveness of Polish foreign debts

(touched on in what follows) could justify the second strategy However,

most of the Russian reformers were optimistic about the expected effects

of shock therapy in Russia They believed that comprehensive economic

liberalization and tight monetary policy would bear fruit within a year

or two The subsequent beginning of sustainable levels of growth would

provide an automatic reduction of the debt burden Unfortunately,

this scenario did not materialize, mostly because of the anti-reformist

political pressure in Russia and the specificity of the inherited economic

structure.14

The true burden of the external debt on the Russian economy was

undervalued by the reformers They did not anticipate that the

mar-ket transformations would be so painful and the contraction of the

economy would be so deep and long Nevertheless, if the strategy of