Originally Published in FINANCIAL TIMES

Wednesday, July 8, 1998


How to save the rouble

Personal View

Martin Feldstein

Russia should use the international bond markets, not the IMF or G7 to rebuild its foreign reserves and shore up its currency.

Russia desperately needs more foreign exchange reserves. Its reserves have fallen by about a third from more than $2Ob a year ago. The foreign-currency debt obligations coming due in the next 12 months are 50 per cent greater than available reserves, the kind of imbalance that triggered last year's run on the South Korean won. And the current account deficit is depleting reserves at the rate of $1b every two months.

Russia's reserves are not enough to reassure foreign creditors they will be paid if they choose not to roll over existing loans. To prevent a run on the rouble, the Russians were temporarily forced recently to raise the rouble interest rate to a staggering 150 per cent.

A collapse of the rouble would reverse the prodigious achievement of reducing annual inflation to just 7 per cent now from 130 per cent in 1995. A rise in inflation now would tell the Russian people that the government had failed at the most visible aspect of economic policy. A collapse of the rouble would also reinforce the Russians' fear that foreigners are dominating their economy, strengthening the nationalists who could replace Boris Yeltsin, the president, and his reform-minded government with an anti-western Russia-first regime.

So the Russians have a lot at stake in rebuilding reserves to a level that is strong enough to prevent a successful attack on the rouble. Mr Yeltsin and Anatoly Chubais, Russia's recently appointed chief negotiator with the International Monetary Fund, have said that they want to raise $10b to $15b. They want to borrow this from the group of seven large industrial nations or from the IMF on more favorable terms than the market would provide.

At the recent G7 meeting, these countries passed the responsibility on to the Fund. Although the IMF is currently talking with the Russians about new credit, it is very unlikely to lend the Russians anything like the amount they need. It has been difficult enough for the Russians to prize the latest $670m of previously agreed lending from the Fund because of Russian failure to achieve the economic reforms that the Fund wants. That failure has been made likely, if not inevitable, by the make-up of the Russian parliament, the Duma. This is dominated by opposition politicians who oppose the IMF policies in principle and who would gain from the economic chaos that would follow a rouble collapse. The IMF has said that any additional credit would take months of tough negotiations and Mr Chubais has said that Russia will not accept all and every IMF condition just to get cheaper financing.

So what about the alternative of raising money in the markets? The Russians recently raised $4hn in the eurobond market, pushing the interest rate on Russian 10-year dollar bonds from 12 per cent to 15 per cent. It would be good if Russia could raise an additional $15b of long-term funds in this way, even if the interest rate were pushed up towards 20 per cent. Although borrowing $15b at 20 per cent and investing it in US Treasury bills at 5 per cent would cost Russia $2.2b a year, that would still be a low-cost insurance against economic disaster: $2.2b would be less than 3 per cent of Russian exports and only 0.4 per cent of Russia's gloss domestic product. Even paying more than 20 per cent to borrow long-term dollars could be a good investment in Russia's future stability.

But amazingly, the IMF's chief representative in Russia has publicly advised the Russians against rebuilding their reserves by more long-term borrowing because of its high cost. The IMF is right to stress the desirability of cutting the current account deficit by correcting Russia's fiscal imbalance. But such cuts cannot work quickly enough to prevent the sort of potentially devastating consequences that currency collapses have visited upon those Asian countries that lack large reserves. Removing the risk of currency collapse would also permit lower interest rates on Russia's rouble debt, significantly shrinking the country's budget deficit.

It may be impossible for the Russians to borrow enough in the markets even if they are willing to pay more than the current rate on Russian dollar obligations. Foreign lenders are rightly nervous about the country's ability to repay such large liabilities. The Russians wisely sought to supplement their borrowing by offering to sell Rosneft, the largest Russian oil company, to foreign buyers at an attractive price. There is enormous value in Russian assets and enterprises that have yet to be privatized. Russia will attract additional dollars as foreign companies buy roubles to make new investments in Russia. But all that takes more time than Russia has if it wants to avoid a devastating currency run.

What then can be done? A new kind of Russian bond, which I will call a Privatization Bond, might allow the Russians to tap the international bond market for larger amounts and at lower cost than traditional privatization bonds. The new instrument would be denominated in dollars but, unlike other bonds, would not have a fixed maturity. The bonds would instead be acceptable by the Russian government as payment for privatized assets and could be used instead of dollars as a way of financing investments in joint ventures or other forms of direct investment.

Investors who buy Privatizations Bonds could use them for these purposes or could sell them to any prospective buyer of Russian assets. They would know that the Russians had a strong incentive to redeem the Privatizations Bonds quickly to raise new money by further Privatizations.

By issuing $l5b of Privatizations Bonds, the Russians would obtain $15b in foreign exchange reserves while having no new dollar obligations (other than the need to make dollar interest payments.) This would have doubled Russia's foreign exchange reserves while leaving its short-term foreign exchange obligations essentially unchanged.

By using the market to increase reserves instead of depending on deals with the IMF or the G7 countries, Russia would maintain control over its own economic policies and the government of Sergei Kiriyenko, the prime minister, would deal with opposition parties in the Duma from a position of strength.

With ample reserves, the Russians could use a small or gradual devaluation of the rouble to regain competitiveness and increase taxable profits something considered too risky to attempt in the current situation. Lastly, when the Russians achieve current account surpluses, they could retire some of these bonds through open market purchases rather than through asset swaps.

It is time for the Russians to stop seeking special deals from the IMF and the G7 countries and to use the market to save the rouble. Borrowing against the future proceeds of privatizations sales may hold the key to protecting the rouble today.

The author is professor of economics at Harvard University and president of the National Bureau of Economic Research