Russian ‘Bondage’: Moscow’s Financial Breakout Gets Underway with Wildly Oversubscribed Eurobond Sale

(Washington, D.C.): Official
Washington may have not been paying close
attention but a momentous and
potentially ominous development took
place late last week — Russia’s
first international bond offering since
1917. This offering was eagerly
anticipated by “emerging
markets” and other fund-managers for
some time, as evidenced by the response:
Originally planned to raise $500 million,
the Kremlin’s debut issue was
over-subscribed by 100% (i.e., $1
billion) despite the extraordinarily low
interest rate offered (3.45 percent over
the five-year U.S. Treasury note rate)
and a relatively long-term maturity (five
years). ⁽¹⁾

What is Wrong With This
Picture?

Is Russia’s new access to the
international capital markets desirable?
The conventional wisdom holds that
Russia’s entry into the sophisticated
Western securities markets can only
accelerate Moscow’s integration into the
international financial and trading
systems. Some believe that it will also
serve to advance the decentralization of
economic decision-making and cause the
Russian leadership to be more responsive
to the markets.

Unfortunately — as is made clear in
the attached
CNBC interview with the William J.
Casey Institute’s Roger W. Robinson, Jr.
and column
which appeared in today’s Washington
Times by the Center for Security
Policy’s director, Frank J. Gaffney, Jr.
— these potentially positive
developments have a distinct downside: For
the first time since the Russian
Revolution, the Kremlin has the
opportunity to borrow massively from
sources other than Western governments,
commercial banks and multilateral
institutions. Now securities firms,
pension funds, insurance companies,
corporations and individual investors, to
name but a few, can and will be
tapped by Moscow.

Therein lies the rub. These sources
offer Russia an opportunity for
“financial breakout” — a goal
arguably even more coveted by the Russian
security services and foreign policy
apparatus than it is by the fledgling
Russian financial community.
Interestingly, in the final years of the
Soviet Union, Mikhail Gorbachev launched
a charm offensive aimed at Western
investors in the hope of keeping a
failing communist system on Western
life-support until the Kremlin could
construct a more viable economic system
(one such gambit was the oxymoronic
“command market” economy).

A key component of this
“Save-the-Union” plan was to
issue Soviet bonds in Western markets.
Such unconditional, general-purpose,
non-transparent, undisciplined sources of
cash, obtained at an inexpensive rate,
lent themselves nicely to underwriting a
range of foreign policy and security
priorities that might otherwise have been
unsupportable. Accordingly, the USSR
issued about seven or eight Eurobonds in
major currencies (yen, lire, francs,
Deutsche marks, etc.) that ultimately
yielded Moscow about $1.8 billion. The
crowning achievement of this
eleventh-hour “Perestroika
Bonds” salvage effort was to be a
direct run on the U.S. capital markets,
involving a dollar-denominated offering
out of New York. At the time, however,
certain legislative and political
impediments — now removed —
stood in the way.

Back in the USA

According to the London Financial
Times, some 44% of last
Thursday’s $1 billion bond issue was
bought up by US fund managers.
The remainder was placed with investors
in Asia (30%) and Europe (26%). As a
result, it is reasonable to
assume that certain American investors
will now end up — wittingly or
unwillingly — holding Russian bonds in
their mutual funds, pension funds and
insurance portfolios.

Moscow could, in short, be on its way
to recruiting over time formidable
new American and Western lobbies.
These lobbies could — as was recently
done in the case of Mexico’s tesobonos
— bring pressure to bear on the U.S.
government to make investors whole in the
event of a future Russian liquidity
crisis. The Kremlin is also
simultaneously creating powerful new
political constituencies which will
fiercely resist the imposition of US
economic, financial or other sanctions
against Moscow for serious misdeeds
around the world. After all, such actions
could seriously damage bond repayment
prospects.

Worse yet, these constituencies could
unknowingly be contributing to the
funding of activities inimical to U.S.
interests. Based on experience with the
Soviet system — which General Alexander
Lebed contends is still largely alive and
well — and contemporary evidence, it is at
least as likely that bond proceeds
will end up funding: the new Topol M
mobile ICBM and other strategic
modernization programs; the Kremlin’s
efforts to exercise control over secular
Muslim states in the oil-rich Caspian Sea
region; a robust international espionage
program (recently on display in
Washington); large-scale supplier credits
for the sale of two nuclear reactors and
arms to Iran; the completion of the two
irretrievably-flawed nuclear reactors
near Cienfuegos, Cuba; and other
operational aspects of what the Casey
Institute calls the “Primakov
Doctrine.”

Calling the 105th Congress

Do average Americans really have in
mind helping finance these activities
inimical to U.S. security interests? Is
the Congress going to abdicate its
responsibility to scrutinize the foreign
policy, national security and economic
implications of this Russian financial
breakout into the western securities
markets? If not, prompt hearings on the
subject must be convened in the 105th
Congress in the relevant House or Senate
forums, including foreign relations,
banking and finance, national security
and intelligence committees. The
following are among the questions
legislators should be examining:

• Where are the cash
  proceeds from this and other
  Russian bond issues going and how
  are they being used? The
  Western firms managing bond
  offerings would probably argue
  that the money is going to help
  reduce the country’s fiscal
  deficit — a deficit that would
  be considerably worse if wage
  arrearages were cleaned up. Is
  this true?
• Even from an economic and
  market perspective this Eurobond
  offering appears premature at
  best and reckless at worse.
  For example, at a time when the
  IMF has suspended disbursement on
  its Extended Fund Facility to
  Russia to protest anemic tax
  collection efforts, is it in
  Russia’s best interest to be able
  to attract totally unconditional
  and undisciplined cash from the
  securities markets? What does
  that do to the IMF’s efforts to
  hold Russian feet to the fire on
  even modest systemic reform?
• The European and American
  credit rating agencies appear to
  have judged that the thoroughly
  politicized IMF disbursements
  during the Yeltsin election
  campaign are a sure sign that
  Moscow would not be permitted by
  G-7 or other Western governments
  from falling below a certain taxpayer-underwritten
  floor. Are such
  judgments warranted? Will the
  Congress be prepared to bail out
  investors in the event of a
  Russian liquidity crisis?
• Is it not troubling that
  this bond offering debut comes in
  advance of a formal
  reconciliation and signing of a
  rescheduling agreement for some
  $100 billion in unpayable Soviet
  debt owed to Western governments
  and banks? From an
  investor’s point of view, is it
  not worrisome that the Russian
  Ministry of Finance was recently
  obligated temporarily to withhold
  payment on domestic
  dollar-denominated bonds
  (MinFins)?

The Bottom Line

In sum, the West has been down this
road before — with many of the same
players. The diversion of untold
billions of dollars of borrowed Western
funds by Moscow in the Soviet era to
finance activities inimical to Western
security interests is a fact. The past
default by the Kremlin on billions of
dollars of US taxpayers money is likewise
a fact.

Accordingly, the burden of proof
should be on the Securities and Exchange
Commission, the Treasury and State
Departments, the Federal Reserve and
ultimately the White House to explain to
the public: What is substantively
different this time?
What safeguards and prudent financial
disciplinary measures are in place now to
protect the financial and national
security equities of the United States?
American taxpayers and investors alike
have a “need-to-know.”

– 30 –

1. In part, this
response may be due to the elaborate road
show around the United States put on by
the co-lead managers of the first Russian
Eurobond offering — J.P. Morgan and SBC
Warburg, along with the Russian Ministry
of Finance. An even more important
consideration, however, is probably the
“gift” rating bestowed by the
European and American credit rating
agencies — far higher than is warranted.
For more on Russia’s inflated rating see
If you like the Rigging of the Lebed
Dismissal, You’ll Love the Rigging of the
Global Credit and Securities Markets
(No. 96-C 100,
17 October 1996).