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08/06/1998 23:30:59 FEATURE - Russia's high-stakes game with bond buyers

By Catherine Evans

LONDON, Aug 7 (Reuters) - Russia's so-called debt crisis is not so much

about money, it's about confidence.

The sums involved are huge -- $20 billion worth of domestic debt falls due

before the end of the year -- but the question for the markets is not the extent

of Russia's indebtedness. It is how convincing a confidence game Russia can

play.

The country has just four months to persuade foreign investors -- many of

whom have already lost money backing Russia this year -- to lend it enough cash

to pay off the debt.

The stakes are high. If it fails, Russia will be in default, and the

financial community is unlikely to prove forgiving. If it succeeds, the problem

will be solved -- Russia will have years rather than months to pay back its

lenders.

"Unlike in many Asian countries, this is a flow-induced problem," said

Jerome Booth, an analyst at ANZ Bank in London.

"Flows do affect fundamentals, but if (outflows) are reversed, the

fundamentals problem disappears. Russia has the potential to rebound pretty

quickly."

Russian debt prices have plummeted in the last few months as general worries

about Asia-related volatility have combined with specific concerns about

political instability, inadequate tax receipts and a falling oil price to

undermine confidence in the country.

Domestic yields in particular have risen to punitive levels, forcing Russia

to look abroad for money with which to refinance maturing rouble debt.

Russia's plan is to clear its balance sheet of GKOs, the short-dated rouble

Treasury bills which since 1993 have been the government's principal source of

funding. It wants to replace them with lower-yielding, long-dated,

dollar-denominated bonds sold on the international market.

GKO yields are currently around 70 percent.

NO NEED TO INCREASE OVERALL DEBT BURDEN

Russia does not need to increase its overall debt burden, which at less than

50 percent of gross domestic product is relatively low by international

standards. For example, the Maastricht criteria calls for EMU members to have a

60 percent ratio.

Russia used proceeds from two Eurobonds sold in June to pay off maturing

GKOs, and last month completed a unique debt swap which saw $4.4 billion of GKOs

exchanged for two more Eurobonds.

But the massive volume of dollar paper Russia has issued in the past two

months has created problems.

Taken together, the four new Eurobonds total more than $10 billion. That

represents a 40 percent rise in the total stock of Russia's dollar debt, which

includes $29.4 billion face value of rescheduled Soviet-era commercial loans and

$8.7 billion face value of dollar-denominated fixed-rate bonds known as MinFins.

Since the first of these new Eurobonds was launched on June 3, Russia's

dollar debt has fallen to historic lows, and bankers say unsold paper continues

to wash around the market.

On Wednesday, Russia's benchmark 2018 Eurobond was trading at a premium of

1,177 basis points over U.S. Treasury notes, out from 940 basis points when the

debt exchange was completed on July 20.

In November 1996, when Russia returned to the international bond market for

the first time since the 1917 revolution, it paid a premium of 345 basis points

over Treasuries.

FOREIGN INVESTORS RELUCTANT

Back then, enthusiasm for Russia was high.

Nowadays, foreign investors are showing a marked reluctance to help bail

Russia out -- unless, they say, they see clear evidence the country has started

to tackle its fiscal deficit.

"They need to hold the rouble where it is, and they need to collect taxes.

If they can do that, then Russia would be a very good investment," said Thomas

Bell, investment manager at Templeton Investment Management in Edinburgh.

Brett Diment, a fund manager at Morgan Grenfell Asset Management in London,

said he was positive on Russia's economic fundamentals, but believed the backlog

of dollar paper would not be cleared until positive news on taxes persuaded

foreign investors to reverse sell-orders.

"We've had $10.15 billion of new paper in the last few weeks, while more and

more people have withdrawn from the market. It will take a while for the

technical factors to come clear, but then more people will come in," Diment

said.

Fear of further supply from Russia is also helping depress dollar debt

prices.

Russia has said it will sell no more than $2.0 billion more of Eurobonds

before year-end, with a return to the market expected in late October.

But with $12 billion of GKOs to refinance before November, when tax receipts

are forecast to pick up, many expect Russia to undertake another

rouble-for-dollar debt exchange.

"If domestic interest rates stay at current levels, there is a clear

incentive for Russia to do another exchange. That will have an impact on

supply," said ANZ's Booth.

He was sceptical about Deputy Finance Minister Mikhail Kasyanov's assurance

that the exchange was a one-off.

Booth said he believed Russia would seek to exchange another $4.0 billion of

GKOs for dollar bonds, taking the total swapped to more than $8.0 billion --

roughly one-quarter of the outstanding GKO stock, and close to half the amount

maturing before year-end.

MGAM's Diment said he thought an exchange would prove difficult with dollar

paper at current levels, but acknowledged that it made sense for Russia from a

debt management perspective.

But some believe a second exchange is unfeasible.

Because GKOs and dollar Eurobonds are such different debt instruments, they

tend to be purchased by different kinds of investors, who do not regard the two

as surrogates.

"We didn't take part in (July's) GKO exchange because we are a

short-duration fund and do not want seven and 20-year paper," said Nick

Davidson, deputy chief executive at WMB Asset Management.

The size of July's debt swap suggested that virtually all those eligible

exchanged their GKOs, leaving the remainder with rouble investors -- mainly

Russian banks.

Meanwhile, increased confidence in the rouble following last month's $22.5

billion International Monetary Fund-led financial aid package for Russia has

made swapping roubles for dollars less attractive.

Another disincentive for GKO holders is the simple supply/demand equation

-- as the stock of domestic debt falls, prices should benefit.

Last month's debt swap cut GKO yields dramatically, from a pre-exchange

peak of more than 100 percent to an average of just under 58 percent at the end

of July. Cancellation of new GKO auctions since the exchange was completed has

also buoyed the market.

But international investors remain wary, saying they want to see that

Russian yields are heading lower before they will buy Russian debt securities

again.

"We buy GKOs but they've been up and down like a yo-yo in the last few

months. We have also held Russia's dollar debt, but don't at the moment," said

Templeton's Bell.

"I would consider reinvesting if GKO yields came back to the 20 to 30

percent level."

Increased tax revenues aside, investor confidence is likely to hinge on a

more stable global environment and an increase in the price of oil, Russia's

major export.

A rising oil price should help Russia's fiscal balance, as increased profits

will allow hydrocarbon companies to pay off some of the billions they owe in

back taxes.

"People want to see Japan work through its problems a bit more, which will

take a couple of months. By then, we expect the oil price to be higher, which

will help Russia quite substantially," said ANZ's Booth.

"If that's true, big institutional investors will start buying, because

there is fundamental value there."

((Catherine Evans, London Newsroom, +44-171 542 8863, fax +44-171 542 8688,

uk.eurobonds.news@reuters.com))

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