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Foreign Debt

FOREIGN DEBT

The first stage in Russia's involvement with international capital markets was associated with the great drive for industrialization that marked the final decades of the nineteenth century. The backwardness of the country's largely rural economy implied substantial needs for imports, which in turn meant foreign borrowing. The epic railway construction projects in particular would not have been possible without such financing.

With growing volumes of Russian debt floating abroad, the country became increasingly vulnerable to speculative attacks, which could have proven highly damaging. The skillful policies of finance ministers Ivan Vyshnegradsky and Sergei Witte averted such dangers. By imposing harsh taxes on the rural economy, they also managed to promote exports from that sector, which made for a healthy trade surplus. As a result of the latter, by the end of the century the currency qualified for conversion to the gold standard.

Russia thus entered the twentieth century with a stable currency and in good standing on foreign capital markets. The Bolsheviks put an end to that. By deciding to default on all foreign debt of Imperial Russia, Vladimir Lenin effectively deprived the Soviet Union of all further access to foreign credit. Since the economy remained backward, all subsequent ambitions of achieving industrialization thus would have to be undertaken with domestic resources, or with the goodwill of foreign governments offering loan guarantees.

An early illustration of problems resulting from the latter scenario was provided during World War II, when the Soviet Union received substantial military assistance from its western allies, shipped via the famed Murmansk convoys. Known as "Lend-Lease," the program was not originally intended as a free gift, but during the subsequent Cold War the Soviet Union refused to make repayments. In 1972 the United States followed a previous British example in forgiving ninety percent of the debt. When Vladimir Putin became president in 2000, about $600 million of the remainder was still outstandingand more had been added.

Toward the end of the Soviet era, much-needed modernization of the economy produced growing demands for imports of foreign technology, which in turn required foreign credits. Eager to have good relations with Mikhail Gorbachev, many Western governments gladly offered guarantees for such loans. By the end of 1991, with the Soviet Union in full collapse, those loans went into effective default. The total of all outstanding Soviet foreign debt came to almost $100 billion.

The first decade of Russia's post-Soviet existence was heavily marked by problems surrounding the handling of that debt. While foreign creditor governments remained insistent that it be repaid, they were also willing to offer substantial new credits in support of Russia's economic transition. The Russian government responded by evolving a strategy for debt management that rested on aggressively threatening default on old debt in order to obtain forgiveness, rescheduling, and fresh credits.

Much of the subsequent political wrangling would revolve around Russia's increasingly controversial relations with the International Monetary Fund (IMF). An initial credit of $1 billion was granted in July 1992, when Russia became a member of the Fund. In 1993, a further $1.5 billion was paid out, under a special "Systemic Transformation Facility" (STF). As Moscow failed to live up even to the soft rules of the STF, the IMF withheld disbursement of an agreed second $1.5 billion tranche.

Following severe criticism for having failed to offer proper support, in April 1994 the Fund decided to release the second tranche of the STF. The essentially political nature of the relation was now becoming evident. Despite Russia's continued problems in honoring its commitments, in April 1995 the IMF granted Russia a $6.5 billion twelve-month credit, and in March 1996 it agreed to a three-year $10.1 billion "Extended Fund Facility."

The latter was the second-largest commitment ever made by the Fund, and there was little effort made to hide its essentially political purpose. The objective was to secure the reelection of Boris Yeltsin to a second term as president, and the IMF was not alone in offering support. On a parallel track, France and Germany offered bilateral credits of $2.4 billion, and the "Paris Club" of foreign creditor governments agreed to a rescheduling of $38 billion in Soviet-era debt.

The latter was of particular importance, in that it opened the doors for Russia to the market for Eurobonds. Receiving its first sovereign credit rating in October 1996, in November the Russian government placed a first issue of $1 billion, which was to be followed, in March and June of the following year, by two further issues of DM2 billion and $2 billion, respectively. Up until the crash in August 1998, Russia succeeded in issuing a total of $16 billion in Eurobonds.

As the Russian government was gaining credibility as a debtor in good standing, other Russian actors, ranging from city governments to private enterprises, also began to venture into the market. Russian commercial banks in particular began securing substantial loans from their partners in the West.

Compounding the exposure, the Russian government was simultaneously saturating the market with ruble-denominated government securities, known as GKO and OFZ. While these instruments technically represented domestic debt, they became highly popular among foreign investors and therefore essential to the issue of foreign debt.

The final stage of Russia's financial bubble was heralded with the onset of the financial crisis in Asia, during the summer of 1997. At first believed to be immune to contagion by this "Asian flu," in the spring of 1998 Russia was becoming seriouslyill. In May, the Moscow markets were in free fall, and by June the IMF was under substantial political pressure to take action. Some even warned of pending civil war in a country with nuclear capacities.

Following protracted negotiations, on July 13 the Fund announced a bailout package of $22.6 billion through December 1999, which was supported both by the World Bank and by Japan. A first disbursement of $4.8 billion was made on July 20, and the financial markets began to recover confidence. On August 17, however, the Russian government decided to devalue the ruble anyway and to declare a ninety-day moratorium on short-term debt service.

The potential losses were massive. The volume of GKO debt alone was worth about $40 billion. To this could be added $26 billion owed to multi-lateral creditors, and the $16 billion in Eurobonds. There also were additional billions in commercial bank credits, including about $6 billion in ruble futures contracts. And there still remained $95 billion in Soviet-era debt, some of which had been recently rescheduled.

In the spring of 1999, few believed that Russia would be able to stage a comeback within the fore-seeable future. One foreign banker even stated that he would rather eat nuclear waste than lend any more money to Russia. The situation was aggravated by suspicions that the Russian Central Bank was clandestinely bailing out well-connected domestic actors, at the expense of foreign investors. It was also hard for many to accept the Russian government's unilateral decision to ignore its Soviet-era debt and to honor only purely "Russian" debt.

A year later, fuelled by the ruble devaluation and by rapidly rising oil prices, the Russian economy was making a spectacular recovery. In 2000, the first year of the Putin presidency, GDP grew by nine percent. The federal budget was finally in the black, with a good margin, and foreign trade generated a massive surplus of $61 billion. Despite this drastic improvement in economic performance, the Russian government nevertheless appeared bent on continuing its policy of threatening default in order to secure further restructuring and forgiveness of its old debts.

For the German government in particular, this finally proved to be too much. When the Russian prime minister Mikhail Kasyanov hinted that Russia might not be able to meet its full obligations in 2001, Chancellor Gerhard Schroeder informed Moscow that in case of any further trouble with Russian debt service, he would personally do all he could to isolate Russia. The effect was immediate and positive. From 2001 onward Russia has been current on all sovereign foreign debt (excluding the defaulted GKOs).

In support of its decision to fully honor its credit obligations, the Russian government made prudent use of its budget surplus. By accelerating repayments of debt to the IMF, it drew down the principal, and by introducing a strategic budget reserve to act as a cushion against future debt problems, it strengthened its credibility. The reward has been a series of upgrades in Russia's sovereign credit rating, and a calming of previous fears about further rounds of default.

While this has been positive indeed for Russia's international standing, it has not come without a price. Every billion that is paid out in foreign debt service effectively means one billion less in desperately needed domestic investment. In that sense, it will be a long time indeed before the Russian economy has finally overcome the damage that was done by foreign debt mismanagement during the Yeltsin years.

See also: banking system, soviet; banking system, tsarist; economic growth, soviet; economy, current; industrialization; lend lease.

bibliography

Hedlund, Stefan. (1999). Russia's "Market" Economy: A Bad Case of Predatory Capitalism. London: UCL Press.

Mosse, W.E. (1992). Perestroika under the Tsars. London: I.B. Taurus.

Stone, Randall W. (2002). Lending Credibility: The International Monetary Fund and the Post-Communist Transition. Princeton, NJ: Princeton University Press.

Stefan Hedlund

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