When a Russian's word is his bond

Aides to Alexander Livshits, the Russian deputy prime minister, admitted they were nervous when they went into a meeting with bankers and institutional investors in the City on Friday.

When you are trying to raise $500m or more in Russia's first foreign bond issue since the Revolution of 1917, it does not help to have investors constantly reminded of defaults on Czarist bonds and - worse still - of a freeze as recently as this summer on interest payments on domestic bond issues.

Furthermore, the International Monetary Fund (IMF) has been threatening to delay the next stage of a $10bn loan to Russia.Mr Livshits' officials were expecting a difficult session.

The new foreign bond issue is far more important than its size suggests, because its reception in the markets will be the first clear indication of whether Russia's reformed economy is winning the confidence of inter- national financial markets.

Mr Livshits' objective is to persuade investors to accept a respectable single-figure interest rate and not demand a double-figure rate that would cast aspersions on Russia's standing.

He rejected reports that the interest rate would have to be 11 per cent, which might be seen as a vote of no confidence. Bankers came away from the meeting saying the issue could squeeze in at under 10 per cent.

Mr Livshits had come hotfoot from Frankfurt on a roadshow promoting Russia. Certainly, he had some good news on the economy to help his campaign.

Russia seems to have reached a turning point, with inflation reduced over the last year and the possibility of real economic growth resuming in 1997 after six years in which the contraction has totalled 35 per cent. GDP is officially still falling. But a report on Russia by IBCA, the London credit rating agency, says the statistics are misleading, not only because of the huge black economy but also because Russian managers understate their output to avoid tax.

Electricity production, a better measure of overall activity than GDP, has fallen by only half as much and it is this which provides the evidence that the economy has been growing again.

Official GDP was down 5 per cent in the 12 months to June but electricity output was up 2 per cent and real economic output may have risen rather more.

Another positive indicator is that debts to foreign governments and banks are reaching manageable proportions as a result of rescheduling, and the cost of servicing them will remain low well into the next decade.

Several credit rating agencies have assigned investment grade ratings to Russia, as a prelude to the Eurobond issue, ranking it around the level of Argentina and Mexico. The investment banks promoting the issue, JP Morgan and SBC Warburg, have put out favourable assessments of the economy.

But at each step of his roadshow, Mr Livshits has been assailed with questions about two defaults - one historical, dating back to Czarist days, and the other very recent, relating to events this summer.

Though not likely to stop the bond issue, which will probably be launched later this month, the defaults were an awkward reminder of how important politics are in assessing Russia's ability to pay.

An advertisement in the Financial Times on Friday warned investors that Russia had issued bonds between 1822 and 1914 which were still listed on the Paris bourse, but which had ceased to pay interest, "ruining hundreds of thousands of subscribers who had put their trust in Russia".

A minor diversion, you might think, because most holders of defaulted Russian bonds settled for a token payment from the Soviet Union a decade ago.

However, the French bondholders, who refused to settle, say that Russia promised, as part of a treaty with France only four years ago, to redeem the bonds, but has not done so.

This makes it a rather more serious question. The bondholders have complained to the credit rating agencies, Moody's, Standard & Poor's and IBCA.

An early settlement does not seem likely. Russia has its own outstanding claims against France that it believes offset the Czarist debts and which were rolled into the 1992 agreement.According to Alexander Smirnov, Russia's chief foreign debt negotiator, the bondholders should be claiming against their own government rather than Russia.

The other default was technical, but more serious because it was this year. To allay fears in Western markets, Mr Livshits' officials announced that the government would be prepared to pay up. This modern default is indicative of the administrative and legal chaos which is the downside of investing in Russia.

In June, interest payments were frozen on $24bn (pounds 14bn) of Russian Ministry of Finance bonds, issued to investors in 1993. Some unissued bonds had been stolen from bank vaults in Grozny, Chechnya. The government discovered to its horror that far more were in circulation than had been officially issued.

Differences between civil and criminal law have confused the rights and wrongs of the affair, but Mr Livshits' statement indicated that once these legal problems were sorted out the ministry would honour all the bonds.

It is no surprise to find that administrative problems inside Russia are also behind the IMF's unwillingness to release the latest monthly tranche of a $10bn three-year loan. The fund is concerned at the enormous scale of tax dodging by companies.

It is these issues of how the economy is managed, the amount of crime in the business community and the political rivalry over the succession to President Yeltsin that ought to be of most concern to investors.

Nevertheless, soundings suggest the bond issue will be a success. Investors are impressed by Russia's sheer determination to achieve respectability and by the likelihood that it is too important to the West to be allowed to fail. The bottom line is that Russia is likely to be bailed out, like Mexico, if it gets into trouble.