The Chastening

by Paul Blustein

  Sergei Dubinin, the bearded, heavyset chairman of Russia’s central bank, was also on vacation that week, in Italy, and he too made immediate plans to cut his holiday short when he saw Soros’s article. As he rode into Moscow from the airport on Friday, August 14, Dubinin observed Muscovites lined up by the scores at the city’s ubiquitous currency exchanges, clamoring for dollars. Up to that point, ordinary citizens had shown few signs that the crisis was affecting their behavior, but now the news media were reporting that two major banks, SBS-Agro and Inkombank, had defaulted on their obligations, and rumors of a collapse in the banking system were causing hordes of people to switch their savings into greenbacks. At some currency exchanges, rubles were trading at eight to the dollar, more than 20 percent below the government’s target rate. “We can play games against the market, against the banks even,” Dubinin said. “But we can’t do anything if the entire population wants to change rubles into dollars.”

  On Friday evening, Dubinin met with other top central bank officials, and the group unanimously concluded that trying to maintain the ruble’s value against the dollar had become fruitless. A meeting was arranged for about 9 P.M. to inform Kiriyenko of the decision, which was legally the central bank’s responsibility. For the thirty-five-year-old prime minister, the move would be hugely awkward politically, Dubinin and his aides knew, especially since Yeltsin had issued a ringing pledge that very day on national television that “there will be no devaluation of the ruble.” The central bank offered a small face-saving suggestion: Kiriyenko could decide exactly which day of the following week to announce the devaluation. After a short discussion, the prime minister adjourned the meeting until the following morning.

  On Saturday, about a dozen of Russia’s top policymakers met at the prime minister’s dacha to confront the fact that under the circumstances of runaway interest rates and an evaporation of market confidence, continuing to pay interest and principal on the GKOs was no longer sustainable. They considered two alternatives, each abhorrent in its own way. Under the first alternative, the central bank would simply create the rubles needed for debt service—which would technically meet the government’s legal obligations to its creditors, but at the cost of an explosion in the money supply that would likely rekindle hyperinflation. The group quickly rejected this option, said Sergei Alexashenko, the central bank’s deputy chairman, because “it would have meant the loss of all macroeconomic stability.”

  The second option was in effect a default on the GKOs, under which the government would renounce its obligation to make interest and principal payments on the short-term bills and instead give their owners longer-term bonds—in other words, force them to accept a deal similar to the Goldman exchange offer (though on worse terms). “It was a bad solution, but at least it meant we could keep the basics of macro stability,” Alexashenko explained. Devaluation of the ruble would have to accompany this move, the group agreed, because the announcement of the default would surely intensify the panicky rush to convert rubles into dollars—of which the central bank lacked a sufficient supply.

  Now the questions facing the Russians were difficult: How badly, and how permanently, would their country be punished by international investors for its violation of the market’s code that a debtor must never, ever renege on its obligations? And, as the only internationally recognized arbiter of countries’ financial conduct, could the IMF help mitigate the impact of the default by issuing sympathetic or even supportive rhetoric? Or would the Fund take a critical stance and worsen Russia’s plight?

  The first signals came when Odling-Smee flew into Moscow from Washington Saturday night. Immediately after dropping his bags at his hotel, he headed to the Liberal-Democratic Club downtown for a dinner meeting with Chubais; Gilman, the IMF’s Moscow representative; and former Deputy Prime Minister Gaidar, who was working as an adviser to the government. Chubais, who himself had Just rushed back from a holiday in Ireland, was understandably in a funk. When Odling-Smee suggested that the Russians concentrate on “damage control,” Chubais shot back: “It’s not damage control. It’s disaster control.” Gilman later had stark comments about the session: “Here we were dealing with a completely new situation. Never had a country defaulted on its own treasury obligations in this fashion. We were trying to figure out the implications. There was a lot of concern about runs on banks, runs on the currency, a breakdown of institutions, a scarcity of goods. No one knew what the social and political consequences would be. We all had the feeling we were standing on the edge of a cliff.”

  The Fund officials’ initial reactions to Russia’s plans for default and devaluation came as something of a relief to Chubais and Gaidar. Odling-Smee said such moves were probably “inevitable,” given the predicament Moscow was in. The main point of the dinner, though, was not to negotiate but to consider the possibility that some alternative might exist besides the default-devaluation route. Although the IMF was neither willing nor able to provide a lastditch emergency loan, Odling-Smee raised a tantalizing suggestion: Perhaps the G-7 would be willing to lend a few billion dollars more on a bilateral basis. Chubais questioned whether any real purpose would be served by making inquiries along those lines; on his last trip to Washington, he said, he had been told that G-7 largesse was strictly limited to what was contained in the July package. But Odling-Smee, though not in any position to promise G-7 bilateral funding, told the Russians that in his Judgment, the prospect of default put a whole new cast on the situation, and it was worth at least pressing to find out whether the G-7 would be worried enough about the consequences to come across with more money.

  This slender hope was dashed, however, in a G-7 deputies’ phone call that was Joined by Fischer, who was horror-struck at the economic and political devastation he thought likely to follow a Russian default—both in Russia and beyond. Fischer raised the idea of a $20 billion loan for Russia from the G-7, in effect proposing a Mexicostyle package, large enough to buy out all the foreign GKO holders Just as the Mexican rescue had been large enough to buy out all of the tesobonos. But the G-7’s willingness to lay any further wagers on Russia had run out. Hardly had Fischer begun to present the suggestion than Germany’s Jürgen Stark interrupted him. “Stan, stop here,” Stark said. “Who will pay for it? Germany will not pay for it. We are not in favor of any additional money, either bilateral or IMF.”

  With no chance of another rescue, the Russians were racing on Sunday, August 16, to refine the details of their default-devaluation plan. Rumors were beginning to sweep Moscow that drastic measures were afoot, and if the markets opened on Monday morning without a government announcement, pandemonium would surely erupt. The broad consensus among Finance Ministry and central bank officials was that the government should close the GKO market on Monday and Tuesday and announce the terms for an “involuntary” exchange in which foreign GKO holders would receive one type of bond and domestic holders a different one. The bond for foreigners would pay a low interest rate, perhaps 3 percent, but it would have a sweetener of being payable in dollars. The bond for residents of Russia would provide an initial cash payment, but it would be denominated in rubles. (Russia would not default on all its official debts; the government’s Eurobonds, for example, would continue to be serviced in full.)

  Late Sunday afternoon, Kiriyenko and Chubais flew by helicopter to Yeltsin’s dacha to obtain his formal blessing for the decisions taken at meetings of which the president had been blissfully ignorant. To preserve Yeltsin’s sense of presidential authority, Kiriyenko and Chubais offered him a choice about how the ruble should be devalued. The Russian currency could be allowed to float—that is, sink—against foreign currencies, without limit. Alternatively, it could be allowed to trade within a wider range than before, so that instead of staying in a band 15 percent above or below 6.2 rubles per dollar, it would move in a range of 6 rubles to 9.5 rubles per dollar. Yeltsin chose the latter alternative, which allowed him to claim, albeit with tortured logic, that he was sticking with the same curre
ncy system and abiding by his no-devaluation pledge.

  But on Sunday evening, as the Russians were putting what they thought were the final touches on their plan, it blew up. Around nine o’clock, Odling-Smee arrived at Kiriyenko’s office in the White House with bad news: The IMF had grave concerns and wanted Moscow to postpone its announcements to give time for cooperative consultations with the country’s creditors. The Russians were outraged. Their impression, based on their earlier conversations with Odling-Smee, was that although the Fund obviously wouldn’t welcome the default, it was prepared to accept the government’s broad plan and would issue a statement that would help limit the fallout. Indeed, in phone calls with IMF staffers early Sunday from Paris, where he was returning from vacation, Camdessus had struck a sympathetic note, acknowledging that Russia clearly lacked the resources to pay off the GKOs and that printing rubles would be a shortsighted way out of the mess. But now, at almost literally the eleventh hour, the Russians were faced with the prospect that the Fund would issue condemnatory rhetoric that would worsen the country’s image as a deadbeat and international pariah, making it all the more difficult for Moscow to obtain hard currency in the future. “It was a very unpleasant surprise for us,” Dubinin recalled.

  Based on his most recent conversation with Camdessus, Odling-Smee said the IMF’s view was that the unilateral nature of the default plan was unacceptable. Instead of simply dictating the terms to GKO holders, Russia ought to first try hammering out a mutually agreeable approach, the Fund insisted, and as a sign of its good faith, the government should convene an emergency session of the Duma to enact further reforms.

  Why was the IMF suddenly adopting a tougher stance so late in the weekend? Maybe Camdessus came under pressure himself from the U.S. Treasury; maybe some other factor was at work; maybe signals were mixed and wires crossed. In any event, the view that the Fund’s position had changed “is the way it appeared to the Russians,” Odling-Smee acknowledged. “I don’t think it was necessarily the managing director’s mind that was changing. It may be that I didn’t convey properly what he said, or the Russians misunderstood.”

  Kiriyenko told Odling-Smee that, having obtained the president’s approval for the planned actions, he could not change course now. And there was another problem: Too many people knew what the government was contemplating. The oligarchs had gotten wind of the discussions and had been briefed—an outrageous favor to special interests in one sense, but according to Russian officials, their main motivation was to ensure that the oligarchs would use the media outlets they owned to help prevent panic among the general population.

  Shortly after midnight, an emotional, exasperated Chubais went to Odling-Smee’s room at the Metropole Hotel, where he talked to Camdessus directly in Paris. He told the IMF chief that Russia needed a supportive statement from the Fund, lest the country become totally isolated and vulnerable to lawsuits by creditors. When Camdessus insisted that the government reconvene the Duma, Chubais retorted that it was impossible. After leaving the hotel, Chubais spent a wild night pleading Russia’s case with other Western officials, including Summers, Lipton, and others. At 5 A.M. Moscow time, he called Aleksei Mozhin, Russia’s IMF executive director in Washington, frantically trying to track down Fischer.

  Monday, August 17 dawned with both sides—the Russians and the IMF—unsure of what the other would do. At an early morning meeting in Kiriyenko’s office, Chubais reported to other top policymakers about the adamant position taken by Camdessus. A decision was made: Although the ruble devaluation would go ahead as planned, and Russia would announce its intention to restructure its GKO debt, the precise terms of the restructuring would be deferred. “These measures are tough ones, quite radical ones,” Kiriyenko told the media. “But they are inevitable ones.”

  To the Russians’ relief, Camdessus’s statement later that day contained no condemnatory language, and he even left open the possibility that the IMF would deliver the second tranche of its loan to Moscow in September:As a preliminary reaction, I am of the view that, in the new context created by these measures, it will be especially important for the Russian authorities to take all necessary steps to strengthen the fiscal position. The authorities should also spare no effort to find a cooperative solution to their debt problems, in a close dialogue with Russia’s creditors.

  More generally, it is important that the international community as a whole, both public and private sectors, show solidarity for Russia at this difficult time.

  Global financial markets initially shrugged off the Russian developments on August 17. Stocks and bonds in emerging markets fell, with a couple of countries’ stock markets hit hard—notably Turkey’s and Hungary’s, down 5.4 percent and 3.2 percent respectively. But European markets, following an early plunge, recovered on the strength of a rally on Wall Street that sent the Dow Jones industrial average up nearly 150 points. News reports in the following day’s papers explained the Dow’s move as a technical bounce following several weeks of declines.

  It was a delayed reaction.

  “Thank you for standing by,” an operator’s voice said, speaking to an audience of institutional investors and traders on Wednesday, August 26, 1998. “Welcome to the Deutsche Bank Russian debt restructuring and global implications conference call.”

  Nine days had passed since August 17, and global financial markets were starting to catch on to the implications of what had happened in Russia. Germany’s main stock index was down 7.2 percent. Stock indexes in emerging markets all over the world, particularly in Latin America, had suffered double-digit losses. The market for U.S. bonds such as convertibles and high-yield corporates was undergoing one of its most brutal downturns in memory, and bonds of emerging-market countries had fallen so far out of favor that, on average, purchasers of those bonds were demanding four full percentage points in additional yield than before August 17.

  Many market participants were upset that the IMF and the rest of the High Command had failed to prevent Russia from defaulting and devaluing the ruble. But few were so unhappy as the host of the Deutsche Bank conference call, David Folkerts-Landau, the bank’s global head of emerging-markets research. And now, Folkerts-Landau was going to strike back, by issuing a chilling prediction about the likely contagion effects of the Russian default. Other emerging markets, notably Brazil, were seriously imperiled, he warned, because “the rules of the game have changed substantially.... If you’re a rational investor and you saw what happened to domestic currency investors in Russia, you know now that could happen to you in Brazil.”

  When Folkerts-Landau talked, people in the world of emerging-markets investing listened. A dashing, bearded native of Germany who attended school in England as a teenager, the forty-nine-year-old Folkerts-Landau held a Ph.D. from Princeton and boasted a fifteen-year career at the IMF capped by the directorship of the Fund’s Capital Markets Group. At the Fund, Folkerts-Landau had impressed some of his colleagues, while irritating others, with his relentless drive and cocksureness. When he left the IMF in late 1997 to Join Deutsche, he lured about a half dozen IMF economists to work with him, and he quickly established himself as a leading authority in divining the likely actions of the Fund, the G-7, and emerging-market governments. But now, in the wake of August 17, he had egg on his face—and losses to account for.

  Deutsche Bank was one of the largest foreign holders of GKOs, with about $290 million of Russian treasury bills in its portfolio; indeed, on the very day of Folkerts-Landau’s conference call, the bank would lose its cherished triple-A credit rating from Standard & Poor’s, mainly because of its exposure to Russia. When the IMF was readying its bolshoi paket in July 1998, Folkerts-Landau had assessed the likelihood of a ruble devaluation at near-zero, and he continued to believe during the first half of August that Russia would be bailed out in the end because of its geostrategic importance. Many of his clients—the Soros and Tiger hedge funds among them—had invested in GKOs partly on the basis of his advice and were facing horrendous loss
es, Just as Deutsche was. But Folkerts-Landau was aggrieved about another matter as well.

  For five days—Wednesday, August 19, until Sunday, August 23—Folkerts-Landau had bargained with Russian officials in Moscow over the deal that GKO holders would receive. He had gone there at the invitation of the Russian government, which asked Deutsche Bank and J. P. Morgan & Co. to participate in the negotiations as part of an effort to consult cooperatively with creditors instead of unilaterally imposing the terms of how they would be repaid. But the talks had failed to produce an acceptable deal for GKO holders, in Folkerts-Landau’s opinion, and for this he blamed his former colleagues at the IMF.

  Folkerts-Landau had sought a plan that would have given each GKO holder securities yielding 40 to 50 percent. This was “a solution that we perceived as being fair to the Russians, fair to the foreign investors, and fair to the domestic holders of Russian securities as well,” he told the conference call. “It was our sense that by Saturday [August 22] there was an—I wouldn’t say an agreement—but there was an understanding that things were moving along on these lines. Then the Russians ran this plan on Saturday, late Saturday evening by the IMF. This is where the problems began.”

  IMF officials in Moscow, Folkerts-Landau complained, had scuttled the deal—using the Fund’s leverage as the only likely external lender to Russia in years to come—because they believed the government probably couldn’t afford to pay the 40-50 percent interest rates that the plan envisioned. Ridiculing their calculations as faulty, he said: “There are two ways to interpret this. One of them is to say there was a certain amount of maliciousness involved. But the most charitable way is that I have taken most of the financial expertise with me into London out of the Fund, these people that I have hired.”