Wednesday, August 3, 2016

"Bank of Russia: 25 years of Regulating Currency and Bank Crises"

From EconoMonitor:
This year Russia will celebrate the 25th anniversary of the Belavezha Accords signed by Boris Yeltsin at the end of 1991. At that time, he declared declared the dissolution of the Soviet Union, and launched a series of painful but necessary reforms that turned citizens’ lives upside down. These reforms not only involved the basic institutions of a market economy (market prices, private property, etc.), but also the creation of Russian regulatory bodies. In particular, the Central Bank was established as a result of the transformation of the Russian department of the State Bank of the USSR into the Russian Republican Bank. The next 25 years paved the way for the Central Bank to conduct an independent policy, the main obstacles of which were numerous crises of the Russian economy and banking sector.

Hyperinflation of 1992-1994
The first challenge that Russia faced at the beginning of the reforms was hyperinflation. The only way to overcome hyperinflation was to completely refuse to cover the fiscal deficit at the expense of centralized loans of the Bank of Russia. The first efforts to avoid using them were made around the time the market reforms were launched. From January through April 1992, the Bank of Russia did not lend the government a dime (data from the annual report of the Bank of Russia for 1992).

However, in August 1992, the substantial easing of monetary policy began after commercial banks became obliged to provide companies with funds for their operating activities and the cleaning up of their payable accounts; then, the Central Bank reimbursed all costs. These actions affected inflation dynamics: if from May through August, average monthly rates worked out at 12.6 %, then from September through December, they were already at 21.4%. At the beginning of July, the ruble exchange rate stood at 125.3 RUB/USD, but by the end of December, it had fallen to 414.5 RUB/USD. Subsequently, for the next two years, Russia was coping with triple-digit inflation that hit 840% (1993) and 214.8% (1994), respectively. The policy of financing the fiscal deficit at the expense of the Central Bank’s loans was to blame. Eventually, “Black Tuesday” led to the rejection of this policy; on October 11, 1994, the ruble exchange rate weakened by more than a quarter – from 2,833 to 3,926 RUB/USD. After that, the Board of Directors of the Central Bank, with Viktor Gerashchenko at the head, was dismissed.

The Banking Crisis of 1995
In 1995, the government stopped printing money to finance the fiscal deficit, and inflation dropped as a result: If in January their monthly rates were 17.8%, in July they fell to 5.4%. This led to a number of problems for a range of financial institutions, as their business models were based on the principle that the value of borrowed money diminished faster than the time of payment. Then, this money was used for FOREX and interbank operations. It was the interbank lending market collapse at the end of August that contributed to the crisis. A domino effect was triggered in the banking sector, and in the evening of August 25, 1995, more than 150 banks were unable to close their credit positions; consequently, the interbank lending market crashed. Thanks to the prompt intervention of the Central Bank, which lent 2 trillion rubles (not yet denominated) to the banks, the crisis did not affect the major players in the sector, and that was why so few people noticed it. At the same time, a range of banks were forced to stop functioning: if from 1993 to 1995 the number of commercial banks rose from 1,715 to 2,439, from 1996 to 1997 that figure skyrocketed to 2,029 (the Association of Russian Banks data).

The Default of 1998
From 1996 to 1997, banks’ investments in government bonds (called GKOs) were three times higher as usual (hereinafter “Centre of Development” Institute estimates), and they became the main source of financing the fiscal deficit. At the time of the Asian financial crisis in autumn 1997, which caused capital outflow from developing countries, GKO market rates began to rise dramatically: from September 1997 to May 1998, their fluctuation range was 30-40%; in June, rates rose to 60% and ultimately reached 120% in July. However, investors were not interested in debt securities issued by the Russian Government at such rates: During the auctions of July 23 and 30, and the auctions of August 5 and 12, the Ministry of Finance failed to raise a dime. In the second half of 1997, commercial banks reduced bond investments as a result of yield decline, and in 1998 they got rid of these bonds altogether because of the impending threat of the loss of liquidity. On the morning of August 17, the government refused to service and cover their debt liabilities.

The direct consequence of the default was the crash of the biggest banks of the time, namely “Menatep,” “SBS,” “Inkom,” “Onexim,” “Most,” and “Mosbusinessbank.” Andrey Kozlov, the first deputy chairman of the Central Bank, initiated the transfer of these institutions’ deposits to “Sberbank,” which stopped the outflow of capital. If in the third quarter these banks’ ruble deposits (Sberbank’s excluded) dropped by 46%, in the fourth quarter deposits went up by 13% compared to the first half of the year.

In addition to the government default and the bank run, the depreciation of the ruble caused serious damage to banks’ stability. From August to the end of December, the ruble weakened from 6 to 20.7 rubles per dollar. The devaluation hindered banks from repaying foreign-currency loans, and liabilities reached 8 billion dollars by August 1. Given the situation, they could only hope that their foreign creditors would agree to negotiate a debt restructuring. On August 17, the Central Bank declared a 90-day moratorium on foreign debt repayment aimed at facilitating the negotiations. The first group meeting between creditors and debtors was held in Moscow on September 2; however, it did not work out as planned, as the Board of Directors of the Central Bank went through substantial changes in the middle of September, and banks had to negotiate with their creditors one on one.
The crisis resulted in a sharp decline of bank capital: From August to September, the value of their assets decreased by more than 200% – specifically from 67 to 20 billion rubles. Overall, the default ended the period of extensive development of the Russian banking system based on either seizing a part of the state share premium (1992-1994) or generating income from investments in state debt securities (1995-1998)....