SSRN-id1428996

8/8/2019 SSRN-id1428996

http://slidepdf.com/reader/full/ssrn-id1428996 1/14Electronic copy available at: http://ssrn.com/abstract=1428996

1

Magomet Yandiev

Associate Professor, PhD in Finance

Moscow State University (Lomonosov MGU)

HISTORY

OF SUB-FEDERAL AND MUNICIPAL BONDS MARKET IN RUSSIA

Abstract. In the clause the history of occurrence and development of the market of

sub-federal and municipal bonds in Russia is described. Interesting examples from

real practice are shown.

Keywords. Sub-federal and municipal bonds, bonds market, financial markets,

history, Russia.

1. Stages of the Market Growth and Development

By 2007, Russian sub-federal bonds market, i.e. the market trading in bonds

issued by the Subjects of the Russian Federation and municipal authorities, had

emerged, but its grouping has still a long way to go, and, upon the whole, most sub-federal bond issues are illiquid. They are practically not traded in the market, with the

exception of the bonds issued by such major issuers as Moscow or Saint-Petersburg.

The reason is that professional market participants prefer to buy sub-federal bonds

and hold them until their redemption.

It is assumed that Russian sub-federal bonds market dates back to 1992 when

the first five issuers registered their bond issue prospectus for an overall amount of

5.6 million redenominated roubles. In those times an average issue totalled 1 million

roubles ($2,400). 14 years later, by the beginning of 2007, an average issue has

reached the figure of 1 billion roubles ($ 37.8 million).

Russian sub-federal bonds market underwent three major stages. The first

stage, which was largely governed by a general crush on bond issuing, lasted till

1997. Back then, there were periods when up to 5-6 new bond issues were registered

8/8/2019 SSRN-id1428996


2

over a single month. Bonds were often issued for short-term loans and bond duration

was less than a year.

The peak growth of borrowing observed in 1997 was followed by a downturn.

This downturn is quite explainable even regardless of the ill-famed financial crunch

of 1998. The fact was that by 1997, Russian sub-federal bonds market, which formed

part of emerging and still small Russian financial markets, had been saturated with

regional and municipal securities. It was necessary to take some sort of break and

analyse the lessons learned. The situation was further complicated by the 1998

August Crunch. As a result, the debt refinancing potential of the regions was

minimized and professional market participants chose to wait for full redemption of

the issued bonds without showing any interest in prospective new issues.

The second stage of Russian sub-federal bonds market development went

under the slogan of earlier debts repayment. It lasted until around 2000 and was

characterized by the peak security redemption level. A number of other important

events that happened at the same time with the redemption contributed to the

dramatic improvement in sub-federal bonds issuers’ financial base. To be more

specific, the Russian Parliament passed two important documents: the Budget Code,

which brought under regulations a number of controversial issues related to public

sector debt, and a Federal Law on the state and municipal securities issue and

circulation procedure. Besides, the RF Ministry of Finance had carried out a huge

amount of work to promote harmonization of inter-budgetary relations. All the above,

as well as the unexpected swell in budget revenues at all levels (amidst rouble

devaluation and rocketing global prices of raw materials) restored the market

participants' confidence in the borrowing power of regional authorities.

In this connection it is worth mentioning that while in 2000-2001 some midsize

and major commercial banks and financial companies believed that lending funds to

public authorities was not just unprofitable or risky but nothing less than improper by

2004-2006, they had adopted a downright opposite attitude to this issue.

The third stage of Russian sub-federal bonds market development – a new

growth phase - started around 2001 and lasted until 2005. It was followed by a new

8/8/2019 SSRN-id1428996


3

reduction in the volume of the borrowed funds. However, this time the reduction was

far less drastic than during the second stage. Upon the whole, professional market

participants trusted the issuers, and a significant part of the debt was successfully

refinanced.

The diagram in Fig. 1 shows that the duration of each stage (the distance

between the borrowing and redemption peaks measured in years) generally co-insides

with the average duration of lending periods. Over the first stage, an average lending

period was equal to 1-2 years, and over the third stage it increased to 3-5 years.

Relying on this trend, we can reasonably suggest that the fourth stage, which is

starting now (2007) and which will be dedicated to repayment and refinancing of the

previously incurred debts, will last until 2009-2010 and will be duly followed by a

new long-term increase in the volume of funds attracted from the sub-federal bonds

market. During the fourth stage bonds are likely to be issued for the average period of

7-10 years.

Development of the market of sub-federal bonds in 1995-2006

Figure 1

0

10

20

30

40

50

60

70

80

1995 1996 1997 1998 1999 2000 2001 2002 2003 2004 2005 2006

м

л р д . р у б л е й

It is involved from issue of bonds Bond redemption

Source – Federal Treasury of Russia, and also materials of the interrogations lead by

the author in 2000-2006. Calculations are executed by the author.

8/8/2019 SSRN-id1428996

http://slidepdf.com/reader/full/ssrn-id1428996 4/14

4

At the same time, there can be little doubt that MICEX (Moscow Interbank

Currency Exchange) will remain the only exchange trading market place to float and

trade sub-federal bonds.

2. Types of issued securities

Currently, sub-federal securities are issued in the form of bonds, which are

regarded as a means of budget deficit monetization. But it has not always been the

case. The market still has vivid memories of the times when security issues were

characterized by the diversity of bond forms and raised fund applications.

In 1994-1997 a number of key Russian regions, obviously inspired by the

behaviour of the federal authorities, organized local auctions similar to short-term

government bond auctions held at the federal level. Local authorities, for instance in

Novosibirsk Region, called their securities short-term regional bonds.

Evidently, trying to oppose something to the wave of non-payments which

swept over Russia in the 1990-s, local public authorities issued all kinds of surrogate

securities under the guise of bonds. Among those surrogate securities were “Tax

Exemptions”, which were circulated in the cash form and allowed their holders to

settle outstanding tax debts, and “Treasury Bonds”, which were issued almost single-

piece to new investors. There were bonds, which provided for the issuer's right to

non-monetary redemption of their nominal value: for instance, issuers could repay

their debts with pipes or bricks. There were other bonds issued for “debottlenecking”

of non-payments, and sometimes they implied mandatory subscription to a loan for

local enterprises. Apart from that, there were bonds issued to finance budget-funding

entities.

One of the most famous loans was the so called “Gold Loan” issued to raise

funds for the implementation of a commercial gold mining project. There was a great

number of “telephone”, “housing”, and “road construction” loans. Some bonds were

issued with a noble purpose of “protecting personal savings against inflation”. The

purity of its intent was highly questioned in those times and remains highly

questionable today.

8/8/2019 SSRN-id1428996


5

For the most part, the above securities were issued in Russia and valued in the

national Russian currency. However, some bonds intended for foreign investors were

issued in western countries. Euro-loans are common practice for a normally

functioning economy. Unfortunately, the launch of a regional euro-bonds issue

process was ill-timed due to low budget revenues, unstable rouble and high political

risks. Regional euro-bonds had low value; they were traded at a huge discount and,

although it may sound high-flown, they actually discredited Russia’s national image.

As a result, the Russian Government made a critical decision to ban the issue of euro-

bonds at the regional and municipal levels. The only exception was made for the

bonds issued with the purpose of refinancing the issues already in circulation.

However, in spite of the existing ban, ineffectual regulation of the loan

management issues provided by the RF Budget Code (the existing restrictions on the

attraction of commercial credit facilities are inadequate) allows the issuers to get

round the provisions of this document. Let me give you an example of how a major

regional public authority managed to side-step the ban some years ago. Formally, the

public authority obtained a loan from a foreign bank consortium and the member-

banks, in their turn, issued bonds. The end investor bought the bonds issued by the

banks, and the banks issued a loan to the said public authority. On the surface

everything seemed to be within the limits of the law.

Campaign for the restructuring of regional commodity debts (mostly incurred

through purchasing petrol for state-run agricultural enterprises) has left an especially

lasting memory with the market participants. Officially, the campaign was initiated

by the Russian Ministry of Finance, but we have a good reason to believe that it was

a commercial project developed and implemented by one of the then major banks.

The bank had even planted an agent into the Ministry structure. The bank’s agent was

a Ministry official responsible for the above commodity debt restructuring. The idea

of the project was as follows. For a number of years, Russian regions had been

receiving commodity loans from the Ministry of Finance, which they practically

failed to repay, relying on the old soviet-era assumption that they would “receive

total absolution” and that all their debts would be written off. Still the transition from

8/8/2019 SSRN-id1428996


6

the soviet to the free-market management methods implied a switchover, though

gradual, to the “living within one’s means" principal. The regions were offered a

choice either to settle their debts immediately or give the problem a more civilized

form, i.e. to restructure their commodity debts into sub-federal bonds.

The number of indebted regions amounted almost to sixty. Some of them

repaid their debts to the Ministry of Finance without waiting for the further

development of the situation. However, the majority did not believe that they would

ever be made to pay their debts.

In 1995-1996, regional authorities issued bonds in the volume that

corresponded to their respective debts. The issued securities were handed over to the

Ministry of Finance for repayment of commodity debts. To turn the bonds into cash,

the Ministry of Finance launched a series of bond auctions. As a result of those

auctions, in the majority of cases, the ownership of the bonds with a questionable

prospect of redemption passed to foreign investors, who had fallen under the spell of

appropriate market behaviour demonstrated both by the Ministry of Finance and the

regional authorities through giving a civilized turn to the resolution of their disputes,

which was absolutely unusual for a post-communist country. However, the spell was

soon broken, as the regional authorities, who in the point of fact did not care about

the formal side of their debt, and who had been unwilling to repay their commodity

debt, equally failed to redeem the securities into which the commodity debt had been

restructured. For purely political reasons, the Russian Government and the Ministry

of Finance did not impose any sanctions against the indebted regions.

Due to the new issuers’ irresponsible behaviour, this type of securities,

officially known as agricultural bonds has acquired an informal name of “mucky

bonds”, which was offensive but fully justified. Even by the end of 2006, some

regions had outstanding agricultural bond debts.

3. Borrowed Funds Management

Sure enough, for the most part, the borrowed funds were used properly, i.e. for

the purposes of budget reinforcement. However, some borrowers appeared to be

8/8/2019 SSRN-id1428996


7

extremely inventive. Thus, the regional authorities of Novgorod Region decided to

invest all the borrowed funds received from the first issue of regional bonds into

short-term government bonds (known in Russia under the acronym of GKO), i.e. into

the securities issued by a superior federal authority, which provides transfers, and

grants loans and guarantees to regional authorities and, in the case of Novgorod

Region, helps to form a significant share of the regional budget revenues. But the

regional administration went even further and formed a guarantee fund equal to 100%

of the total issue amount. In other words, they borrowed one rouble to withdraw

another rouble from their budget. And all those ventures were undertaken with a

single purpose of creating a positive credit history.

Here is an example of another, less sophisticated, use of the borrowed funds.

Immediately after the issue of bonds, the funds received from the offering were “tied

up” on a deposit account. The borrower followed a seemingly wise logic, believing

that this measure helped to minimize the bond loan risks and improve its

attractiveness to investors through a bond offering.

Some issuers did not place much value on originality and followed well-

trodden paths. Many of them “guzzled away” the funds received from the issue in the

first few days. This attitude can be partly justified by the fact that in most cases they

were used to pay the outstanding salary amounts, which often had been accumulating

for months. Others tried to transfer the received cash assets to the non-budgetary fund

and spend them without control of people’s deputies and law enforcement authorities.

One of the most striking and memorable examples of using the borrowed funds

was demonstrated by Saint Petersburg. In the mid-1990s, its authorities carried out a

large-scale restructuring of the region’s state debt through the redemption of its huge

indebtedness under commercial credits and loans with the funds raised upon bonds.

This operation can be regarded as a classical example: it enabled the issuer to

considerably extend the loan period and reduce the loan-servicing expenses.

Another common way of using borrowed funds for issuing loans to local

businesses. Budgetary loans were granted not only to state unitary enterprises but also

to private businesses. Due to the protected character of all information related to the

8/8/2019 SSRN-id1428996


8

regional finance, the huge (sometimes twenty-fold) spread between the interest rates

at which the public authority borrowed funds from investors and issued loans to the

local enterprises and businesses did not arrest the public attention. The borrowers

demonstrated black ingratitude in response to such “kindness”. More often than not

they violated repayment schedules and hardly ever repaid the loans borrowed from

the public authority. If we lay aside emotion, it is obvious that this mechanism of

using borrowed funds is irrational.

However, sometimes investors remained true to their principles. Thus, in the

mid-1990s, Khabarovsk Territory and Taldomsky District (Moscow Region) public

authorities failed to place a single bond.

At other times, to get investors interested in the bonds, the issuer would resort

to all kinds of tricks. On one occasion, an agency bank controlled by the issuing

authority started to provide daily bilateral bond quotations, in the point of fact,

performing the functions of an off-exchange market maker. Needless to say, there

was a large price spread. But in the majority of cases, the players used the old tested

method of pegging the coupon rate to federal bond (e.g. GKO short-term government

bonds) parameters.

For federal authorities the sub-federal bonds market has never been a priority.

Currently, the state administration of this sector is carried out by the Russian

Federation Ministry of Finance. During the first and second stages of Russia's sub-

federal bonds market development, the Ministry registered bond issue prospectus,

and later it began to register general loan terms and coordinate the amount of funds

raised for the given year. Interestingly, in the mid-1990s, Russia's sub-federal bonds

market was controlled by the Securities and Stock Market State Commission (the

predecessor of today’s Federal Financial Markets Service), which, in its turn,

alongside with the Ministry of Internal Affairs, the Ministry of Defence and the

Federal Security Service was controlled directly by the President of Russia.

The RF Ministry of Finance has proved to be a fairly successful market

regulatory authority. Despite inefficiency of certain issuers, which failed to prepare

quality bond issues or took a decision to issue bonds in spite of being in a poor

8/8/2019 SSRN-id1428996


9

financial condition, the RF Ministry of Finance has quite successfully withstood

political pressure and upon the whole prevented registration of loans, which may

cause problems for the Russian sub-federal bonds market.

4. Problems of Market Development

The regional and municipal bonds market was created over a short historic

period and its initiators had no time for dwelling on the problems, which cropped up

in the course of its development. Market participants and the regulatory authority had

to solve them, as one might say, on the go.

One of the first dilemmas faced by regional and local authorities was a choice

between handing out salaries to state employees and paying off debts in the context

of acute revenue shortage. It was necessary to decide whether it was more important

to ease social tensions or keep a spotless credit history. In the years of the lowest

revenue income levels the bond issuing regional authorities demonstrated the art of

diplomacy: they publicly proclaimed the importance of debt settlement, while

targeting alleviation of social strain.

Another problem was connected with the lack of professionals. Even when

some local authorities managed to provide appropriate training for their specialists

and create a high functioning team, often learning by trial and error, they failed to

keep it – salaries in the public sector were low and the “freshly hatched”

professionals were soon bought over by the head-hunters from commercial entities.

Many problems occurred through the fault of professional market participants,

especially at the initial stage of the market development. Some of them simply forced

regional and municipal authorities to issue loan bonds and had no concern

whatsoever for the latter’s bond servicing and redemption potential. Once the bonds

were issued and commissions received they left the issuers to deal with the

consequences. What is more, quite often they were unscrupulous enough to offer

their services for negotiating fictitious bond transactions, which allegedly gave an

appearance of the bonds liquidity. Fortunately for the issuers, they learned their

lessons fast.

8/8/2019 SSRN-id1428996


10

Long after the emergence of the Russian sub-federal bonds market, the notion

of insolvency was practically inapplicable to public authorities. The prevailing

opinion was that a public authority could not fail to repay its debt, and that it was a

reliable borrower “by default”. When the market was confronted with a series of

credit defaults, it turned out that not only the professional market participants but also

the issuers were baffled by such turn of events. No one new what behaviour was best

in that situation. Besides, there was no business ethics to speak of. In some cases,

public authorities opened new accounts almost everyday and used them for budgetary

receipts in order to avoid the execution of enforcement orders for the recovery of

their bond arrears.

In this context, market participants were almost grateful to major global rating

agencies when the latter offered their rating services. To many market participants

this offer seemed to be the only way out of the existing deadlock as they thought that

rating companies, being totally independent from both conflict parties, would be able

to carry out professional evaluation of the risks. Rating agencies initiated numerous

conferences and publications in specialized business and financial press; they

frequently organized meetings with issuers and professional market participants. One

of the popular slogans in those times was: “A low rating is better than no rating.”

Finally, as it often was the case in the 1990s, getting a rating became really

fashionable. Today this fashion has died out and ratings present interest only to the

regions that intend to carry out long-term and large-scale borrowing policies.

A number of controversial issues still lead to a clash of opinions. One of such

issues is: “Should public authorities arrange for loans when they have deposited

funds?” In a simplified form, the discussion has taken the following turn.

Representatives of regional financial authorities insist that bonds should de issued

when the region can demonstrate deposited funds to prospective investors as a

guarantee of a successful loan. In their opinion availability of funds will reduce the

loan cost. On the other hand, representatives of regional financial regulatory and

audit authorities claim that borrowing is justified only when there is a shortage of

8/8/2019 SSRN-id1428996


11

funds and when all alternative budget replenishment resources have been exhausted.

In this case, borrowing should be carried out regardless of poor financial conditions.

Another controversial issue is related to the reverse repurchase procedure

carried out by the issuer. This procedure has not yet been brought under regulations,

and sometimes this fact makes professional market participants suspect the issuers of

incorrect behaviour. To be more specific, they suspect that some issuers may

repurchase their bonds through affiliated structures for further market distribution.

Such behaviour on the part of the issuer will inevitably undermine healthy market

competition and plays havoc with security market prices.

5. Market Openness and Transparency

Any market is based on trust, while trust is based on openness. However,

practice shows that this commonplace truth was not universally known, especially at

the initial stage of the Russian sub-federal bonds market development.

When in 1999, the author carried out his first survey “Borrowing Capacity of

RF Federal Subjects Public Authorities”, only 11 of the 87 regional authorities, risked

to provide information about the volume and the structure of their state debt. The rest

looked for and “successfully found” justification for their refusal to cooperate on this

issue. We will give you a few examples of this attitude.

Astrakhan Region – “Provision of the requested information contradicts the

terms of the loan contracts signed by the Regional Administration and may entail

penalty sanctions on the part of our counteragents.”

The Administration of Vologda Region demanded to explain the reason for

collecting this sort of information.

The Republic of Mari-El – “The requested information is confidential and shall

not be subject to circulation.”

Murmansk Region – “The Department of Finance does not think it fit to carry

out this request as the requested information are not included in the approved forms

of reporting on the implementation of the consolidated regional budget…”

8/8/2019 SSRN-id1428996


12

Rostov Region – “Provision of information requested by third party

organizations is outside the scope of the Regional Ministry of Finance employees’

responsibilities and shall be regarded as additional amount of work.”

Stavropol Territory – “Information about budgetary loans is confidential

information and its circulation is restricted to the Territorial Government and

Governor’s Administration on the need-to-know principle.”

I would like once again to point out that the described events took place in the

late 1990s. Today, we do not face such problems in the above regions.

In the course of the seventh survey of this kind carried out in 2006, 53 regional

and territorial administrations, practically as many as the year before, gave full and

accurate answers (the accuracy was checked against the information supplied by the

RF Ministry of Finance and other federal authorities). As we see it, the resource for

further growth of the number of full and accurate answers has been exhausted (it

should be remembered that in 1999 there were only 11 answers of this kind).

Evidently, deputy (parliamentary) enquiries, which have been used to request the

information over the recent period, now fail to impress the local officials and are

insufficient to achieve 100% participation of the regions in the survey. As a partial

consolation we can remind that even the Ministry of Finance sometimes fails to

receive 100% feedback from the regions.

Nevertheless, the number of regional and territorial authorities that persist in

keeping secret the information on the structure of the state debt is gradually reducing

and now (2007) there are only seven left. They include Oryol Region, Saratov

Region, Tyumen Region, Kabardino-Balkaria Autonomous Republic, North Ossetian

Autonomous Republic and Koryak Autonomous Area authorities who have so far

ignored all official requests for information.

Practice shows that for a long time lack of due procedure for keeping record of

debts was one of the main reasons for the concealment of this information. Let us

study some examples.

The Government of Saint Petersburg well known for its innovative budget and

financial reforms, used to keep records of municipal indebtedness without including

8/8/2019 SSRN-id1428996


13

collateral and guarantee amounts, while records of foreign currency debts were kept

on the basis of the exchange rate as of the date of the loan instead of the current

exchange rate. As a result, recalculation of the official municipal debt burden as of

1.01.2001, which was carried out following the introduction of the new Budget Code,

more than tripled the outstanding debt amount from 4.1 billion RUB to 14.8 billion

RUB.

Moscow Government, over a long period following the August Default of

1998, kept records of its foreign currency borrowings in accordance with the “pre-

crisis” exchange rate, although the current exchanged rate was 2-3 times higher. In

this way, Moscow Government formally complied with one of the Moscow Duma

requirements for the so-called “maximum volume of borrowings”, which was initially

established in roubles. At the same time it should be noted that Moscow was one of

the first federal subjects to initiate regulation of borrowings. Moscow Government

introduced the first Unified Register of Municipal Bond Obligations and, although,

the information was declared confidential, all interested parties could receive a

special extract from Register. Besides, Moscow was the first federal subject to start

making centralized decisions on the borrowings at the level of the City Government

and expressly declared its unconditional commitment to the fulfillment of its

liabilities.

In some territories, budget-funded entities were de-facto entitled to take

independent decisions on the attraction of borrowed funds on an equal basis with the

centralized public decision-making body. In other federal subjects, there was a certain

lack of coordination with regard to the attraction of borrowed funds at the level of top

public officials, when each of the regional deputy heads may carry out their own

borrowing policies, without submitting it for anybody’s approval.

Sometimes, the documents, which established the rights and obligations of the

parties, were lost. Thus, in 1998, Yaroslavl Region and the RF Foreign Trade Bank

(Vnesheconombank) were disputing the case in which the regional administration had

allegedly acted as a guarantor for a local varnish and paint factory. The regional

8/8/2019 SSRN-id1428996


14

administration claimed to have taken on such obligations and the bank insisted that it

had no documentary record of this fact.

Currently, regional debt management has been set in order.

6. Future of Sub-Federal Bonds Market

It goes without saying that over the period of the market existence issuers and

professional market participants have gained valuable experience and worked out

certain patterns of market behaviour. For instance, now one can hardly imagine that

the issuer should choose the issue manager skipping the tender process.

To conclude the overview of the Russian sub-federal bonds market

development, I would like to mention a benchmark event of a paramount importance.

This event is a new order adopted for the appointment of the heads of regional

administrations. Notwithstanding the fact that the new order does not affect financial

laws, it has significantly changed the attitude of professional market participants to

the risks connected with sub-federal bonds. To be more specific, the introduction of

the new order has brought down the risks. The general attitude was expressed by one

of the professional market participants, who said: “Whoever appoints the governor,

will be held responsible for his debts.” It means that if a region faces financial

problems, professional market participants will expect the federal government to

interfere.

Documents

SSRN-id1428996