The Oligarchs (72 page)

One of the most acid critics of the tycoons in this period was Andrei Piontkovski, a one-time mathematician and nuclear weapons strategist who wrote an entertaining newspaper commentary about the influence of the oligarchy. He told me that the maneuverings of Berezovsky in the spring had been extraordinarily costly and senseless. The oligarchs “have been destroying themselves before our eyes,” he said. “I think there are no victors, only losers.”
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Piontkovsky was more correct than he realized.

 

The ruble was funny money. Russians did not trust their own currency, or the banks or government. They kept their money under a mattress—usually in dollars. Russia had an estimated $30 billion to $40 billion in American banknotes in circulation, the largest sum in any country outside the United States itself. Russians clung to their dollars because, both before and after the breakup of the Soviet Union, attempts to fiddle with the ruble had always led to chaos, and Gaidar's hyperinflation eroded any remaining public trust.
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So it was with some trepidation that the Russian government and Central Bank decided to make another ruble fix. On January 1, 1998, the Russian ruble was redenominated, which meant cutting three zeros off the end of the currency. What was six thousand rubles to the dollar became six, a strictly cosmetic change that was designed to wipe away the memory of hyperinflation and symbolize normalcy. Billions of new banknotes were printed months in advance. Fearing another panic, the government and Central Bank spent months preparing the population with advertising and soothing reassurances. “New zeros will never again appear on our banknotes,” Yeltsin promised.

Nothing happened. The redenomination passed quietly, without panic. Another threshold was crossed on the road to normalcy, or so it seemed. The ghosts of past inflation had receded. Chubais proudly declared that Russia had tamed the ruble. “We have a stable currency which, incidentally, has the same exchange rate as the French franc,” he boasted.
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Chubais told Yeltsin in February that he wanted to leave the government; he had been desperate to leave for a long time.
Yeltsin asked Chubais, “What's with the economy?” Chubais recalled telling Yeltsin that he felt comfortable leaving the government because nothing bad would happen to the economy in the year ahead.

“The economy should grow this year. Nothing of any scale, positive or negative, will happen,” Chubais said.

He was profoundly mistaken. It was the first of many errors in a troubled year for Chubais, who failed to see that Russia would suffer greatly from the changing winds of the global economy. He was in the raft with the tycoons as they blithely floated down the river. Russia was soon caught in the grip of two mighty dragons—writhing serpents of modern economics that tore the country apart. The first dragon was an explosion of debt. The second was a failure to recognize that the time had come for devaluation of the ruble. The dragons were creeping up together on Russia in the early spring. Many people saw the threat, but very few were certain that they would strike or when. Russia was in “crisis” so often that its leaders were paralyzed by crisis fatigue, numb to more alarmist warnings, and in this case the government contributed to the problem by reassuring everyone for too long that there would be no catastrophe. When it finally did hit—when the dragons attacked—it was too late to escape.

If you could have flown over Russia in early 1998 and viewed the economy in terms of topography, starkly different worlds would have appeared below. Spanning a landmass as large as the United States and Canada together, Russia had an economy that comprised several different realms. The timeless rural landscape remained rudimentary, isolated, and agrarian. Provincial urban Russia was a tableau of chaos and uncertainty. Industry functioned inefficiently; gargantuan factories churned out steel and automobiles but were forever plagued by losses. Workers, factories, and the government were all caught in a complex web of barter. Cash had almost disappeared from the economy. Large enterprises did 73 percent of their business in barter and paid only 8 percent of their taxes in cash. The swaps and trade-offs were a horribly distorting factor in everyday life, prompting two American scholars to conclude that Russia was becoming a “virtual economy” in which every important facet, such as prices, wages, and profits, were deceptive.
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Finally, if you flew over Moscow, you would have seen a world apart. Moscow was a throbbing boomtown before August 1998. The Moscow financial scene was cluttered with banks and exchanges,
tycoons and stockbrokers, and trappings of wealth and power. Moscow was its own sort of virtual economy, awash in easy money. It was ruled by the oligarchs and their political patrons. Their battles and whims echoed loudly in the Moscow media, which they largely owned. It was here, in this Moscow boomtown, that the crisis of 1998 unfolded.

The trouble began with the chronically undisciplined Russian government. The country's public finances were a black hole. Simply put, Russia spent more money than it had, every day. Special-interest lobbies such as agriculture, the military-industrial complex, the banks, and the huge Soviet-era factories hauled away truckloads of subsidies, with hearty encouragement from the Communist-dominated parliament. At the same time, tax collection was abysmal.
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When the government ran out of money, it simply stopped paying people. Russia was living beyond its means.

In the inflationary years of 1993 and 1994, one way to cover the deficit was to print more money, but that fueled hyperinflation. Chubais stopped that in 1995. Another way to cover the deficit was to obtain loans from the International Monetary Fund, which pledged a three-year, $10 billion loan starting in 1996 before Yeltsin's reelection.
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Beginning in 1993, Russia found still another inflation-free way to finance the deficits—it borrowed the money on capital markets. At home, the borrowing was through the high-flying, short-term bonds known as GKOs. The acronym stood for the Russian words
gosudarstvenniye kratkosrochniye obligatzii,
or short-term government obligations. The GKO came to symbolize all that was crazy about the stock and bond market boom. The bonds were denominated in rubles and usually had a three- or six-month term. When they were first floated in May 1993, the market was small. At the end of 1994, only $3 billion in GKOs were outstanding. But at the end of the election year of 1996 the total zoomed to $42.7 billion. In 1997, the year of the “young reformers,” the outstanding GKO debt went to $64.7 billion, and in mid-1998 it reached $70 billion. When risks seemed to be on the rise in Russia, especially before the 1996 election, the yields on GKOs soared, which meant the government had to pay even more to borrow even more. But the high yields also had a silver lining—the bonds were a wonderful source of easy money for Russian banks and anyone else who could get their hands on them. The GKOs sucked up capital that should have gone to productive investments. Victor
Huaco, the financier at Orion Capital Advisors Ltd. in Moscow, told me that a Russian company with $200 million would obviously rather put it in GKOs than invest in new equipment. “I can invest in new equipment and over a ten-year period get a return per year of 20 percent,” he said. “Or, I can invest in GKOs, and in six months get 100 percent.” The choice was easy money, once again.

Originally designed as a way for the government to raise money, the GKOs wound up costing money. The bonds took on a life of their own—they became an unsustainable pyramid scheme in which new investors were desperately needed to pay off the old ones, not unlike the MMM scam. In 1994, three-fourths of the proceeds from GKOs went to the Finance Ministry to help cover the deficit, but by 1997, a full 91 percent of the proceeds were being used
just to pay back earlier GKOs
, with only 9 percent going to the budget.
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After Yeltsin's 1996 reelection, global capital markets opened to Russia. Just as Khodorkovsky became hooked on Western finance, so too did the Russian federal government. Cities and regions also found borrowing irresistible.
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With a green light from the financial ratings agencies like Standard & Poors, Fitch IBCA, and Moody's Investors Service, Russian government officials were soon jetting around the world on so-called road shows touting Eurobonds, which are bonds sold to foreigners denominated in hard currency, such as dollars or German marks or Italian lira. The proceeds from Eurobonds pumped cash into the Russian budget and masked the festering deficit mess at home. Russia floated a total of $14.9 billion in Eurobonds in 1997 and 1998.
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The nagging, deepening budget deficit, and the borrowing to cover it, both at home and abroad, spawned the first dangerous dragon of 1998: debt. Russia was falling deeper and deeper into the maw.

The dangers took time to become apparent. In the feverish enthusiasm of the 1997 stock market boom, GKOs were seen as a hot investment. They were a government-backed Treasury bill, a sign of normalcy, a noninflationary way to pay for government spending. But as Russia soon discovered, an emerging market remained “hot” only as long as the suitors were ardent. Foreign investors could leave almost as soon as they came, for reasons entirely unrelated to Russia, and they did. Yeltsin courted prosperous South Korea in the 1990s at the expense of the decrepit North, and his diplomacy paid off as South Koreans helped fuel the portfolio investment boom. But when the financial storm hit East Asia in 1997, South Korean investors were the
first to abandon Russia. They quickly evacuated the GKO market and took their money out of the country. Brazilian investors fled too. The Russian Central Bank tried in vain to compensate by buying GKOs on the open market. The Central Bank burned up an astounding amount of money in November 1997—its reserves plummeting from $22.9 billion to $16.8 billion in that month alone—trying to stabilize the GKO market. In one week, it lost $2 billion, a frightening drain.
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It was a costly mistake, and the Central Bank decided it would no longer buck up the GKO market but use its precious reserves to support the ruble only. The Central Bank did not have enough reserves to do both jobs. Yeltsin approved the decision, and it went into effect December 1. Sergei Aleksashenko, then deputy head of the Central Bank, recalled watching nervously to see how investors would react. He was relieved when some investors returned to the GKO market and bought another $400 million of the bonds the next week. Aleksashenko recalled considering it “a serious sign that the hardest times were behind us.”
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He was wrong.

In order to keep luring investors and thus keep the budget deficit covered, on January 1, 1998, the Russian government liberalized the GKO market, making it much easier for foreign investors to buy GKOs and allowing them to get profits out. The casino doors were now fully open: new foreign investors took the place of the South Koreans and Brazilians. The GKO pyramid grew still larger. By the spring of 1998, foreigners held 28 percent of the GKOs.

Each Wednesday, the Finance Ministry paid off the GKOs that were coming due, but it was tricky to keep the pyramid from falling. The weekly game went like this: the government had to raise an average of 8 billion rubles to roll over existing debt as it matured. Each week it had to maintain the confidence of investors—about one-third of them foreigners—to reinvest enough money to pay off the bills coming due. With the oligarchs at war with each other, the budget hemorrhaging, and the Asian crisis bearing down on Moscow, investors had plenty to fear. As investors lost confidence and did not put their money back into GKOs, the government fell further behind, which caused investors to lose even more confidence, which caused the government to fall even further behind. A debt bomb was building up.

The crisis was aggravated by the decline in global oil prices. Oil was Russia's top export commodity; oil prices fell about 25 percent from 1997 to 1998, and tax revenues fell too. The government had to furiously
borrow still more to cover the shortfalls. A turning point came on April 1, 1998, when the Finance Ministry held its regular weekly auction of new GKOs but suddenly found itself short: for the first time, money collected from the new issue was less than the government needed to pay off the maturing GKOs. The government had to cough up another $164 million just to pay off the earlier investors. The GKO market, which was supposed to be financing the federal budget, now had to be financed
by
the budget. The shortfall between what was raised at the weekly auctions and what was needed to redeem the maturing GKOs was 3.7 billion rubles in May, 12.8 billion in June, and 10 billion in the first two weeks of July.
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The dragon roared.

Foreign investors liked the high-flying GKO market but demanded an insurance policy. The GKOs were denominated in rubles, so if the currency lost value during the three-month or six-month term of the bond, the investment would be a loss. The investors wanted protection against this risk, and Russia obliged because it needed them. The Central Bank approved a financial instrument known as a dollar-forward contract, in which the Russian commercial banks, for a fee, would cover any potential decline in the ruble—they would provide insurance against devaluation. These dollar-forwards were very lucrative as long as the ruble remained stable. The banks became a circus barker for the Russian state. “Come on in!” they shouted. “Big returns! Take it out safely in dollars when you leave!” The dollar-forwards business was snapped up by some of the tycoons, although it was risky. Later a Moscow court was considering a dispute between two banks over the dollar-forwards and ruled that they were not really financial contracts at all—but rather an unenforceable bet, a gamble, on the ruble rate. Vladimir Vinogradov's Inkombank was the biggest gambler, holding $1.8 billion worth of dollar-forwards, or about a third of the total, by July 1998. Potanin's Uneximbank had $1.4 billion, and Khodorkovsky's Menatep had $91 million. The Troika Dialog brokerage house estimated the total at $6.5 billion, based on bank reports, but the sum may have been higher. Brunswick Warburg, another brokerage, said the total was $9 billion.
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The big gamble was that the ruble would remain stable in the next six months, and in fact the Central Bank had promised it would.