The program also contained a relatively novel element—a requirement that many of the reforms the Russians were promising must take the form of legislation approved by the State Duma, instead of presidential decrees. The issue was a major bone of contention between Russia and the Fund. For much of Russia’s half dozen years as an independent country, Yeltsin had frequently exercised the right to govern by decree, evoking mounting criticism that he was running roughshod over democratic principles and making no effort to forge a national consensus around a domestic program. The Russian reformers argued they had no choice but to rely on decrees, given the Communist domination of the Duma, and they warned that insisting on Duma approval of reforms would only increase the risk of an adverse market reaction to the IMF rescue. But after going along with ignoring the Duma for years, the Fund was demanding legislative support for reform, in part because Russian enterprises were citing lack of Duma approval as one reason they were ignoring tax laws.
The announcement of Russia’s deal with the IMF on July 13 evoked an initial roar of approval on financial markets. Russia’s main stock index, which had fallen by more than half since April, rocketed upward by 17 percent on July 14, a record in percentage terms. Yields on GKOs, after climbing to well over 100 percent the week before, receded to nearly half that level. The IMF scheduled an Executive Board meeting on Monday, July 20, to approve the program, and Yeltsin announced he was going on vacation.
The euphoria quickly subsided as new strains arose between the Fund and Russia in the days leading up to the board meeting. On July 17, the Duma balked at tax legislation submitted to fulfill conditions of the Fund program, and the Kremlin nullified a provision that Chubais had negotiated to trim government pension payments. To show that the IMF would refuse to overlook Moscow’s backsliding, Camdessus brokered a deal to cut the first disbursement under the program from $5.6 billion to $4.8 billion, with the other $800 million to be disbursed in September provided Moscow fulfilled its promises by then.
As skeptical board members listened over an informal lunch at the IMF on the day of the board meeting, Chubais, who had flown to Washington especially for the occasion, pleaded for their understanding. He explained peculiarities in the Russian economy that, in his view, helped account for why Russia was taking so much longer to put its house in order than had other former Communist countries such as Poland. One of the factors, he said, was the importance Soviet leaders had placed on building up the defense industry, which meant the economy was saddled with vast numbers of military-oriented factories that were hard to shut down. Another was the Soviet planners’ decisions to place large amounts of production in remote locations like the Arctic north, even though transportation costs were prohibitively high by conventional capitalist standards. Responding to questions about the prospects for Duma passage of the reforms pledged under the IMF program, Chubais said that the odds were favorable so long as Yeltsin made a personal effort to convince parliamentarians that the country faced a historic crisis.
In a meeting that lasted into the early evening, board members sharply questioned staffers in European II about the viability of the program, but, as one executive director put it, “Finally, we had to approve. Our political masters had already approved the deal.” The board members from G-7 countries, who caucused separately that day, agreed they were being forced to vote for something they didn’t think would work. “You had the strong feeling, would the Russians respect you in the morning after the vote?” said another director. “And the answer was no.”
But the vote, of course, was yes, prompting a relieved Chubais to tell his Russian colleagues, “Now we are safe.” It was a gamble—in many ways, an entirely Justifiable one—by the G-7. A financial collapse in Russia would risk not only contagion infecting other emerging markets but also political unrest in the world’s second-largest nuclear power. The rescue provided at least some hope that the Kiriyenko government would get a few months’ breathing room, which might be Just enough to push through some serious reform measures. Sure, the Duma would probably show contempt for the program—and in fact, the parliamentarians went on summer recess in late July after passing only the least controversial portions. But Kiriyenko and his ministers were champing at the bit—and they quickly obtained presidential decrees accomplishing much of what the Duma rejected, including quadrupling the land tax and raising individuals’ pension contributions (although the decrees soon came under constitutional challenge in the courts).
A crucial question remained: What about the foreigners who had recklessly poured money into the country—especially the GKO holders, who had been enjoying such obscenely high returns on their investments? Had their midnight phone calls to the hotel rooms of IMF officials paid off? Would the bolshoi paket go simply to ensure that they could cash in their GKOs for dollars a few weeks or months down the road? Or would they somehow be bailed in and induced to help the country survive financially, as South Korea’s creditors were? The answers would come in one of the most dispiriting episodes of the crisis.
Among the investment banks that thronged into Russia in the 1997-1998 period, one stood out for the splashiness of its presence: Goldman, Sachs & Co., Bob Rubin’s old firm, which celebrated the opening of its new Moscow offices on June 18, 1998, by hosting a gala event at the baroque House of Unions, once a private club for Russian nobles. Adding a geopolitical sheen to the gathering, Goldman flew in former U.S. President George Bush, who imparted some cheery words after meeting with Yeltsin. “Certainly Russia has big economic problems today,” Bush told the crowd of financiers, industrialists, and government officials. “But never underestimate the power of freedom and free markets. I am optimistic. I believe Russia is going to thrive.”
The opulence of Goldman’s party was matched by its aggressiveness in pursuing business with major Russian companies and government agencies that were seeking sources of foreign capital. Amid the hot market atmosphere following the 1996 reelection of Yeltsin, competition raged among Western investment banks for the fees they could earn by selling bonds issued by Russian borrowers to mutual funds, pension funds, and insurance company investors in the United States, Europe, and Asia. Goldman proved adept at winning lucrative business with clients such as oligarch Mikhail Khodorkovsky, whose Menatep group and Yukos oil affiliate borrowed hundreds of millions of dollars from foreign institutions in deals that Goldman arranged.
As the IMF rescue was moving toward finalization in early July 1998, four senior Goldman executives brainstorming at the firm’s New York headquarters came up with a proposition they thought would appeal to their most important Russian client of all—the government. That very evening, a Goldman representative who had been planning a trip to Moscow took off armed with an outline of the proposal to present to Russian officials. Some of the Russians, including Finance Minister Mikhail Zadornov, were leery, but others embraced it enthusiastically. To hear IMF and Russian officials tell it, the Fund kept a discreet distance from the Goldman scheme, providing its blessing while treating the details as matters the Russians and Goldman should negotiate between themselves. Only later, after Goldman’s plan went forward, would Fund officials recognize what a misfortune was brewing.
Goldman’s plan appeared rooted in sound financial reasoning. The firm was proposing that Russia could do essentially the same thing that Korea had done—that is, change its very short-term debt into longer-term debt, thereby dispelling the panic in the financial markets. Whereas in Korea’s case, the short-term debt consisted of loans from foreign banks, Russia’s short-term debt consisted of GKOs, whose owners were proving increasingly reluctant to buy new bills when the old ones matured, despite the opportunity to earn yields of 50-100 percent. Over the next few months, the Russian government would face such a burden paying interest on GKOs and redeeming maturing ones—the projected outlay in rubles was equivalent to about $32 billion in the second half of 1998—that its ability to obtain the money it needed to fulfill its obligations was open to serious doubt.
The obvious solution, as Goldman saw it, was for Russia to offer GKO holders a deal, in which they would give up their high-yielding GKOs and receive in return long-term bonds paying lower interest—the sweetener being that principal and interest would be payable in dollars rather than rubles. Goldman had already demonstrated its prowess at marketing these sorts of dollar-denominated bonds, called Eurobonds, to foreign investors; the firm managed a $1.25 billion sale of such bonds for the Russian government in June. So with the same adept salesmanship, Goldman could rid Moscow of its most dangerous, destabilizing financial problem—the near-term costs of paying off the GKOs. Russia would still have to pay stiff interest of about 15 percent per annum on the Eurobonds—and it would have to pay in dollars—but at least the terrifying specter of imminent catastrophe would recede.
But one key element present in the Korean case was missing. No official force or suasion was being mustered to prod Russia’s foreign creditors into participating in the debt exchange. The Western hedge funds, banks, and other investors who owned GKOs numbered in the thousands, and they could not be summoned for meetings at the Federal Reserve Bank of New York, or even called on the phone by government officials, to be persuaded that it was in their collective interest to surrender their short-term claims for long-term ones. Such an approach had worked in Korea because bank executives are susceptible to that kind of pressure. In Russia, the only alternative the High Command could see was for short-term creditors voluntarily to accept the GKO-for-Eurobonds exchange. (Technically, of course, Korea’s creditors acted “voluntarily,” but Russia’s would be subjected to no governmental pressure whatsoever.)
Over the July 18-19 weekend, Goldman executives at the firm’s London office watched documents pour out of fax machines as GKO holders sent in forms stating how much of their GKOs, if any, they were willing to exchange for Eurobonds. The results, announced on July 21, were disappointing: Investors holding only about $4.4 billion in GKOs, around one-third of the total held by foreigners, had agreed to the exchange conceived by Goldman, which offered them the choice of taking either a seven-year Eurobond yielding 14.88 percent, or a twenty-year Eurobond yielding 15.12 percent. In sum, Russia was still stuck with a huge short-term debt problem.
What went wrong? Why didn’t most foreign investors go for the deal? An important part of the answer is that foreign investors had undergone an attitudinal change, now that the IMF was coming through with the bolshoi paket. Since the Fund had shown once again that it would stand behind Russia, high-yielding GKOs seemed a lot less dicey, and many GKO holders decided they ought to hang onto them, at least for the few weeks or months until they matured. “I spoke to a ton of investors during this period,” said Al Breach, a Moscow-based economist who worked as an adviser to the Russian government at the time of the exchange, “and it was so clear. The market went from shit-scared to greedy. People were saying, ‘Why should I exchange [GKOs for Eurobonds]? The ruble will hold, so why should I give up these returns?’”
That, indeed, was a commonly expressed view among market participants at the time. Shortly after the announcements of the IMF rescue and the Goldman plan to make its exchange offer, The Wall Street Journal Europe reported: “With the threat of a ruble devaluation now waning, some debt analysts wondered what incentive investors had to exchange the high-yield ruble denominated GKOs for safe and stodgy Eurobonds. One trader said the swap could mean trading ‘a bronco for a mule.’”
Similar sentiments appeared in the “Emerging Markets Daily” published by Merrill Lynch on July 16. The report advised investors owning GKOs that they ought to consider trading in some of their holdings for Eurobonds. But it also contained the revealing comment that GKOs posed “little risk of devaluation with the new IMF loans.” Investors holding GKOs maturing in the next few weeks would be particularly foolish to participate in the exchange offer, according to the report, which added: “Remember also that the IMF loan virtually assures a stable exchange rate, at least through the summer.”
In other words, thanks to a bailout loan provided courtesy of the world’s taxpayers, a bunch of punters in the international money markets decided it was safe for them to continue collecting ruinously high interest payments from the Russian government for a few more weeks or months, instead of accepting a longer-term, lower-interest payback that offered the country at least a chance of getting its economic act together. Of course, it is unfair to blame these investors for acting in their own self-interest, but their shift from “shit-scared to greedy” following the unveiling of the IMF rescue suggests something is rotten in the state of the international financial system.
The events of August 17, 1998, were now approaching. Greed would soon revert to shit-scaredness. And by many accounts, the Goldman deal exacerbated Russia’s problems, because of a bizarre set of chain reactions that ensued.
Goldman evidently underestimated—and the IMF definitely failed to foresee—that issuing several billion dollars worth of new Russian Eurobonds would cause an imbalance in the market. Together with a couple of smaller deals and the Goldman GKO-for-Eurobond deal, the supply of Russian Eurobonds more than tripled, from $4.3 billion to nearly $14.5 billion, in about six weeks. Just like wheat, pork bellies, or any other product, bonds tend to fall sharply in price when their supply dramatically increases, and that is what happened to Russian Eurobonds, which went from trading at around 100 cents on the dollar in June to 80 cents at the time of the Goldman deal to about 50 cents in mid-August.
The price drop in the Eurobonds proved problematic because Russian banks had bought many such bonds with dollars borrowed from abroad. As the losses on their bonds mounted, the Russian banks got margin calls from their creditors—that is, demands to pay the loans back before the value of the collateral (the bonds) fell any further. The margin calls, in turn, triggered a mad scramble by Russian banks to pay their creditors off—which meant that a massive amount of capital was flowing out of the country, with rubles being exchanged for dollars in large quantities. “What we didn’t know was how the Russian banks had this significant exposure to Russian Eurobonds,” a senior IMF economist said. “When there were margin calls [on the banks], that precipitated a lot of outflows.”
Many of Goldman’s competitors remain bitter over what they contend was the firm’s reckless behavior in initiating the GKO-for-Eurobonds deal, which earned Goldman a reported $56 million in fees. The IMF, too, has come in for plenty of criticism for giving Goldman the green light. “Both the Russian Finance Ministry and the IMF seemed tone deaf to the realities of the market for Russian securities,” contended Charles Blitzer, the head of emerging-markets research at Donaldson, Lufkin, and Jenrette in London. “They Just wouldn’t take seriously warnings that the [Goldman] exchange could backfire. Why did the crisis happen in August? Why didn’t the Russians get three months of breathing room to do what they promised? I think the exchange was the key thing.”
For their part, Goldman officials maintain that the opposite is true, that the exchange might have saved Russia if many more investors had accepted it, since that would have reduced pressure on the Russian government to pay interest and principal on the GKOs still outstanding. The Russian government, they note, encountered grave difficulty servicing the GKOs in the first few days of August.
Maybe Goldman’s explanation is right, or maybe its detractors’ account is. Whichever version has more merit, the havoc that befell Russian markets so soon after the IMF rescue was another blot on the Fund’s record. By the week that David Lipton arrived in Moscow to deliver his warning, most of the $4.8 billion the Fund had disbursed to Russia was gone, handed over by the central bank to investors exiting the country’s market. The crowning blow came in a letter to the editor by George Soros, prominently published in the Financial Times on Thursday, August 13, after Russian stock prices had dropped by more than one-quarter in six trading days and yields on GKOs had soared to about 150 percent. Soros, who had been trying unsuccessfully behind the scenes to organize a
n emergency loan for Russia that would have combined private and Western government funds, proposed in the letter that Russia should devalue the ruble by 15 to 25 percent, and then impose a currency board. His letter began: “Sir: The meltdown in Russian financial markets has reached the terminal phase. ...”
Trying to grab a week’s vacation on the Greek island of Mykonos in mid-August 1998, Stan Fischer was having difficulty finding much time to relax. His only other holiday that summer, a week’s trip to Martha’s Vineyard with his family in early July, had been ruined by constant conference calls about the terms of the bolshoi paket, which forced him to spend hours atop a sand dune talking on a cellphone. (“Stan,” his wife teased him, “do you know how ridiculous you look?”) Now the IMF deputy managing director was anxiously keeping an eye on the deteriorating condition of Russia’s stock and bond markets. On the evening of Thursday, August 13, he bought the Financial Times and turned immediately to Soros’s letter. “That was it. I knew we were done for,” Fischer said.
Fischer called Camdessus, who was on vacation in France, and told his wife that they would have to return to Washington over the weekend, several days earlier than planned. The airplane on which they flew was equipped with phones, so Fischer was able to spend much of the flight making calls. To ensure that other passengers couldn’t overhear his conversations, Fischer had to sit under a blanket—an arrangement that, he conceded, “was not very dignified.” But then, the world financial system was on the eve of one of the most traumatic episodes in its history.
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