The Russian government failed to pay the third tranche of its OFZ domestic hard currency loan bonds, due on May 14. Six years ago, frozen deposits in Vnesheconombank were converted into third-, fourth- and fifth- tranche OFZ bonds. These bonds represent part of the former Soviet Union's debt and will probably be restructured.

Negotiations with creditors aimed at warding off a potential cross-default are still in progress, with investors demanding the early call-in of all tranches, totaling $11 billion, should any of the installments not be paid on time. The talks are also directed at reaching an acceptable agreement on OFZs.

The government says that payments on Russian debt-the OFZ sixth and seventh tranches, which together total $3.5 billion-will be paid on time and in full.

The decision to restructure the Soviet debt was made last fall following payment delays on debts to the Paris and London Clubs, which now exceed $3 billion. With the steady decline in both Russia's foreign currency and gold reserves-in the first quarter, the Central Bank spent $ 2.1 billion repaying foreign debt-investors were already bracing themselves for the worst.

Market players exposed in Russia had already written the possibility of a restructure into the price of OFZs. By mid-March, yields on third tranche OFZs exceeded 1,500 percent annual interest. In comparison, prior to the August 17 crisis, GKO yields jumped to only 200 percent annual interest.

There is a positive aspect to the decision to default on OFZ bonds, however. Russia sent a strong signal to foreign investors on the critical state of its federal finances. It also saved money with its decision not to service Soviet-era debt, increasing the likelihood that the country will meet its Eurobond and IMF repayments-default on which would halt any future loans accorded to Russia.

In fact, many observers say Russia's refusal to pay the OFZ bonds actually meets the demands of the Paris Club: that all of Moscow's Soviet-debt creditors, including individual investors and independent states, have equal rights. In early May, the Paris Club announced it would accept a delay in servicing the state debt of $8 billion (a fraction of the overall $42 billion), payment of which has either not taken place or is slated for 2000.

The risk of court proceedings against Russia following the OFZ default is minimal; none of the creditors own large parcels of the bonds and would not suffer big losses should restructuring take place. Dealing with a multitude of small investors is a lot easier than facing up to a few large creditors.

News of the government's intention not to pay the third tranche of OFZs in May had a positive psychological effect on the currency market, and led to a strengthening of the ruble. On May 17, Standard & Poor's ratings agency downgraded the third OFZ tranche from "CC" to "D" (default).

The rating for Russian Eurobonds also dropped from "CCC minus" to "CC," but for a different reason-the likely delay of IMF credits to Moscow after the government's dismissal on May 12.

But speaking at a briefing on that same day, acting First Deputy Finance Minister Mikhail Kasyanov, Russia's chief negotiator with foreign creditors, remained confident IMF credits would be available to Russia in the third quarter of this year.

Kasyanov said the Finance Ministry has no plans to use Central Bank hard-currency and gold reserves to service foreign debt in the third quarter.

The Central Bank spent $4 billion servicing foreign debt between September 1998 and May 1999. A further $2 billion is expected to be drawn from reserves by the end of June.

On May 17, the Duma's budget committee recommended deputies adopt on first reading amendments allowing the Russian government to use $4.5 billion from Central Bank reserves in the first half of 1999 for the 1999 budget. The Central Bank will make funds available to the government only in the form of a loan that will have to be repaid. In the first quarter of this year the government borrowed $2.1 billion from the Central Bank to service foreign debt.

The Finance Ministry says that as soon as external or domestic funding sources become available, it will stop drawing on Central Bank reserves.

That would be a welcome development for Russia, as drawing on currency and gold reserves to service foreign debt is an extraordinary measure, dictated only by the country's currently troubled financial situation.