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Most lenders were beginning to realize thatthe regions could not possibly service such a fast-growing domestic debt, andthis made the panic even worse. The secondary trade turnover began to go down:it was more and more difficult to find buyers for bonds which were rapidlylosing their value. Unwilling to record considerable losses, some investorscontinued to count on the redemption of the bonds on hand before the expectedcrash of the debt pyramid (Table 1.27).

Between April and June, the trade turnoverin subfederal bonds decreased by 33 per cent to 50 per cent. In the first halfof August, interest rates were already much higher than 100 per cent p.a., theinvestors switched over to the exchange market, and most of the subfederalissuers halted their bond auctions.

Table 1.27

Secondary market trade in subfederalsecurities
for the first half of 1997 and 1998 (inmillions of Rbs)

Issuer	1997	1998
Q1-2	Jan	Feb	Mar	Apr	May	June
St. Petersburg	12а810	3а708,3	578,7	898,5	706,5	765,2	421,1	338,3
Orenburg Oblast	1а716	1а449,1	191,4	323,6	275,3	331,0	167,8	170,0
Moscow	1а017	572,5	46,5	60,0	224,5	159,8	80,7	99,1
Omsk Oblast1	- - -	- - -	239,0	7,8	80,0	73,3	28,6	49,3

1а Trading startedin February 1998.

Source: Prime-TASS data.

The declaration of default on GKOs obligedTatarstan (as from August 19) and the Novosibirsk Oblast (as from August 25) topass a decision on mandatory restructuring of their bonds held by legalentities. Then, during September and October, default was announced on thebonds issued by the Republic of Sakha (Yakutia), the Sverdlovsk, Orenburg,Lipetsk, Irkutsk, Novgorod and Omsk oblasts and the bonds of the City ofChelyabinsk, the only municipal entity that had built a relatively liquidexchange for its own securities.

In mid-October, having failed to redeem itsown bonds on time, the Leningrad Oblast bought them off their holders withintwo subsequent weeks at a large discount on a voluntary basis.

In November, Moscow managed to get itsbonds redeemed, but with the investors' voluntary consent up to 40 per cent ofthe next issue was redeemed in noncash form, exchanged for tax benefits,housing certificates and newly issued municipal bonds.

The immediate cause of the defaults wasthat the issuers had exhausted their capacity for refinancing their liabilitiesby new borrowing due to the crisis on the financial market. As for the in-depthcause, it was the reduction of the overall volume of budget revenues: the lowertax collection level and delays in the receipt of federal transfers made itimpossible to redeem the bonds using own means. In a number of cases, asignificant share of the means obtained by floating regional bonds was used bythe authorized investment companies to deal in transactions involving GKOs,which after the federal default could not but undermine the stability of theloan bonds' financial schemes.

By early February 1999, out of the 11issuers who had established large and relatively liquid markets of their bondsonly Moscow, St. Petersburg and the Chelyabinsk Oblast managed to avoiddefaulting. The Irkutsk Oblast also managed to combat the difficulties andredeem the investors. The other major subfederal borrowers are having a hardtime implementing debt restructuring programs.

Off-board bonds.Even now, Russia does not have a developed infrastructure for over-the-countertrade in bonds, which covers bonds not figuring on the RTS lists.

The main reasons why an issuer ofsubfederal or municipal (local) securities does not have them listed on anexchange are usually as follows:

1. a relatively low volume of issue,which makes the formation of a market of this type of securitiespointless;
2. targeted issue of bonds thatprovides for their noncash redemption (housing loans) or bonds intended mainlyfor households (savings loans);
3. protectionist character of loansdesigned to maintain a high yield for a relatively narrow circle of privilegedinvestors;
4. absence of exchanges in the givenregion.

Legislative regulation of the debtmarket

The Law "On the Issue and Circulation ofGovernment and Municipal Securities" signed by the RF President on 27 July 1998gave the constituent members of the Federation a right to issue governmentsecurities leading to the formation of an external debt, providedthat:

• information about the revenues,expenditures, size of the fiscal deficit and the sources of its financing overthe last three years before the issue is provided during the governmentregistration of an issue prospectus for government securities;
• their budgets are executed in conformitywith the fiscal and tax law of the Russian Federation;
• permission for foreign exchangetransactions involving the movement of capital has been obtained;
• a credit rating has been given inaccordance with the international credit rating standard by at least twoleading international rating agencies;
• the standards set to the amount ofborrowing and the volume of expenditure on the redemption and servicing of alldebt liabilities are observed/met.

Under the law, "the RF constituent membersshall issue loan bonds with account of the priority of the state foreignborrowing of the Russian Federation".

On 31 July 1998, the President approved theBudget Code of the Russian Federation, under which the maximum amount of thegovernment debt of the RF constituent members and the debt of a municipalentity may not exceed the revenues of the relevant budget without account ofthe financial support from higher-ranking budgets. It also sets the ceiling onthe maximum time of the borrowing, 30 years for the RF constituent members and10 years for the municipal entities.

If a constituent member of the Federationfails to ensure the servicing and repayment of its debt liabilities and theservicing of the debt exceed 15 per cent of its budget revenues, or the maximumamount of the borrowing set by the law, "the authorized federal authority body"may initiate a revision of this member's budget and place the execution of thisbudget under the control of the RF Finance Ministry.

Similar steps are envisaged for themunicipal entities, the only difference being that control is to be executed atthe level of the RF constituent member.

The Budget Code envisages the establishmentof a Government Debt Book, which would contain information about the amount ofdebt liabilities of the Russian Federation, constituent members of theFederation, and municipal entities on the securities issued, the date of thesesecurities' issue, the use of these liabilities in full or in part, and otherinformation deemed necessary by the person in charge of keeping the GovernmentDebt Book of the Russian Federation.

Development prospects for the subfederal
and municipal debt market

After a sharp drop of the credit rating ofall domestic subfederal and municipal issuers, we should expect the transitionfrom the so-called general bonds typical of Russia to bonds secured not only bybudget guarantees but also the revenues from the funded project in question,that is, to "double-backed" securities.

It appears the most promising line to useborrowed money to finance the reconstruction of infrastructure facilities inhousing and utilities: the demand for their services shows low elasticity dueto the local monopoly status. Apart from sufficiently high rate of returns, theimplementation of such projects would make it possible to reduce the budgetload imposed by the need to subsidize housing and utilities: in 1998, 3.44 percent of GDP or 23.7 per cent of the local budget revenues was spent for thispurpose. The funding of infrastructure projects is usually a priority asregards the international financial organizations, which under certain termsgrant long-term loans even in the presence of high risks.

Cases of mass-scale default on municipaland regional debt markets have revealed the principal problems that need to besolved before these markets can make some headway. Apart from the political andcountry risks, the main obstacle to the attraction of financial resources isthe absence of institutional mechanisms protecting therights of the lenders who finance the RF constituentmembers and local government bodies.2

299 Securitization mechanisms formunicipal borrowing are also nonexistent.

First, should a region refuse to repay aloan, it proves impossible to execute court decisions passed in favor of thelender. Judicial practice connected with agrobonds shows that the availablelegal framework is unable to ensure the observance of investor rights in caseswhere the authorities of RF constituent members fail to honor theirobligations. The seizure, on judicial decisions, of individual bank accountsheld by administrations is ineffective, while the seizure of all the budgetaryaccounts of a region is impossible. Under default, a procedure for the exerciseof lenders' rights is absent.

To deal with the issue of protectinglenders' right would take more advanced legislation in the sphere of debtrestructuring procedure by the RF constituent members and the municipalities.In view of the experience of other countries, it may be sensible to pass aspecial law on the bankruptcy of municipal entities.

Second, there are no mechanisms forprotecting lenders' rights as regards control over the appropriate use ofborrowed money and management of the means of the loans' reserve funds, whichcauses their inefficient and/or illegitimate use. Neither is there a developedsystem of monitoring the implementation of investment projects and evaluatingthe credit risks they involve (trustee banks, rating agencies).

The system of control over the appropriateuse of borrowed money by municipalities and regions and the need to representthe interests of many small bondholders who would find it difficult to protecttheir rights individually makes it necessary to introduce the institution oftrustee banks, whose functions could, in principle, be assumed by specializeddepositories (in accordance with current RF legislation).3

300

The main functions of trustee banks are toensure the transparency of the issues, control over the latter's conduct, andprotection of end investors if the issuer fails to honor its obligations.Trustee banks control (monitor) the issuer's current financial status and themanagement of its reserve funds and collateral fir the loan. If the issuerfails to meet its obligations on the bonds, the relevant trustee bank presentsclaims to the issuer on using the reserve funds to repay the investors andrepresents the interests of bondholders as a collective lender in court after abankruptcy suit has been brought in.

Third, there are no mechanisms forsecuritizing loans, that is, uniting small-scale loans into a pool that couldprovide security for an issue of potentially liquid bonds into which non-bankinvestors could invest. As a result, it is practically impossible to set up asecondary market for municipal debt.

The formation of a system for municipaldebt securitization requires a debt market backed by either a pool of bankloans or a pool of small bond issues, that is, a market for asset-backedsecurities (ABSs). This raises the question of the need to guarantee or insurethe issues of such bonds and maintain their liquidity on the secondary market.While in late 1997, these functions could still be claimed by the largestRussian banks, at present potential candidates from among private financialinstitutions include only nonresidents.3

311

An alternative way to secure municipalborrowing could be developed using a model for the organization of a secondarymarket for mortgage loans that envisages setting up a specialized federalagency for lending to municipalities (along the lines of the Russian FederalAgency for Mortgage Lending and the US-based Fanny Mae, Ginnie Mae and FreddieMac).3

322

Such an agency could independentlyundertake large issues of potentially liquid bonds (maybe guaranteed by a thirdparty) backed by a pool of municipal debt on infrastructure projects boughtback on the secondary market.

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