1998 Russian financial crisis

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The Russian financial crisis (also called "Ruble crisis" or the "Russian Flu")
hit Russia on 17 August 1998. It resulted in the Russian government and the Russian
Central Bankdevaluing the ruble and defaulting on its debt.

Contents

[hide]

1 Background and course of events

2 Crisis and effects

o 2.1 Inflation

o 2.2 Fiscal

o 2.3 Agriculture

o 2.4 Political fallout

3 Recovery

4 Effects on countries in the world

o 4.1 Baltic states

o 4.2 Belarus

o 4.3 Kazakhstan

o 4.4 Moldova

o 4.5 Ukraine

o 4.6 United States

o 4.7 Uzbekistan

5 See also

6 References

7 External links

Background and course of events[edit]

See also: Sergei Kiriyenko's Cabinet

Declining productivity, an artificially high fixed exchange rate between the ruble
and foreign currencies to avoid public turmoil, and a chronic fiscal deficit were the
reasons that led to the crisis. The economic cost of the first war in Chechnya,
estimated at $5.5 billion (not including the rebuilding of the ruined Chechen
economy), also contributed to the crisis. In the first half of 1997, the Russian
economy showed some signs of improvement. However, soon after this, the
problems began to gradually intensify.

ASIAN FINANCIAL CRISIS

Two external shocks, the Asian financial crisis that had begun in 1997 and the
following declines in demand for (and thus price of) crude oil and nonferrous metals,
severely impacted Russian foreign exchange reserves.[1] When the East Asian
financial crisis broke out in 1997, prices for Russia's two most valuable sources of
capital flows, energy and metals, plummeted. Given Russias fragile economy, the
rapid decline in the value of those two capital sources resulted in an economic
chaos in the country where GDP per capita fell, unemployment soared, and
global investors liquidated their Russian assets.[2]

POLITICAL CRISIS

A political crisis came to a head in March when Russian president Boris

Yeltsin suddenly dismissed Prime Minister Viktor Chernomyrdin and his
entire cabinet on 23 March 1998.[3]Yeltsin named Energy Minister Sergei
Kiriyenko, then 35 years old, as acting prime minister.

BOND MARKET

By May 18, government bond yields had swelled to 47%. With inflation at about 10
percent, Russian banks would normally have taken the government paper at such
high rates. Lack of confidence in the governments ability to repay the bonds and
restricted liquidity, however, did not permit this. As depositors and investors
became increasingly cautious of risk, these commercial banks and firms
had less cash to keep them afloat. The federal governments initiative to collect
more taxes in cash lowered banks and firms liquidity.

On 29 May 1998, Yeltsin appointed Boris Fyodorov as Head of the State Tax Service.
The growth of internal loans could only be provided at the expense of the inflow of
foreign speculative capital, which was attracted by very high interest rates.

ANTI- CRISIS PLAN

The government formed and advertised an anti-crisis plan, requested assistance

from the West, and began bankruptcy processes against three companies with large
debts from back taxes. Kiriyenko met with foreign investors to reassure them.
Yeltsin made nightly appearances on Russian television, calling the nations financial
elite to a meeting at the Kremlin where he urged them to invest in Russia. In June
the Russian Central Bank defended the ruble, losing $5 billion in reserves.

In an effort to prop up the currency and stem the flight of capital, in June 1998
Kiriyenko hiked GKO interest rates to 150%. The situation was worsened by irregular
internal debt payments. Despite government efforts, the debts on wages continued
to grow, especially in the remote regions. By the end of 1997, the situation with the
tax receipts was very tense, and it had a negative effect on the financing of
major budget items (pensions, communal utilities, transportation etc.).

A $22.6 billion International Monetary Fund and World Bank financial package was
approved on 13 July 1998 to support reforms and stabilize the Russian market by
swapping out an enormous volume of the quickly maturing GKO short-term bills into
long-term Eurobonds. This had started to be implemented with some success [citation
needed]
by 24 July 1998, yet the Russian government decided to keep the exchange
rate of the ruble within a narrow band. Although many economists, including Andrei
Illarionov and George Soros, urged the government to abandon its support of the
ruble.

On 12 May 1998, coal miners went on strike over unpaid wages, blocking the Trans-
Siberian Railway. By 1 August 1998 there were approximately $12.5 billion in debt
owed to Russian workers. On 14 August 1998 the exchange rate of the Russian ruble
to the US dollar was still 6.29. Despite the bailout, July 1998 monthly interest
payments on Russias debt rose to a figure 40 percent higher than its monthly tax
collections.

Additionally, on 15 July 1998, the State Duma dominated by left-wing parties

refused to adopt most of the government anti-crisis plan so that the government
was forced to rely onpresidential decrees. On 29 July Yeltsin interrupted his vacation
in Valdai Hills region and flew to Moscow, prompting fears of a Cabinet reshuffle, but
he only replaced Federal Security Service Chief Nikolay Kovalyov with Vladimir Putin.

At the time, Russia employed a "floating peg" policy toward the ruble, meaning that
the Central Bank decided that at any given time the ruble-to-dollar (or RUR/USD)
exchange rate would stay within a particular range. If the ruble threatened to
devalue outside of that range (or "band"), the Central Bank would intervene by
spending foreign reserves to buy rubles. For instance, during the year prior before
the crisis, the Central Bank aimed to maintain a band of 5.3 to 7.1 RUR/USD,
meaning that it would buy rubles if the market exchange rate threatened to exceed
7.1 rubles per dollar. Similarly, it would sell rubles if the market exchange rate
threatened to drop below 5.3.

The inability of the Russian government to implement a coherent set of

economic reforms led to a severe erosion in investor confidence and a chain
reaction that can be likened to a run on the Central Bank. Investors fled the
market by selling rubles and Russian assets (such as securities), which
also put downward pressure on the ruble. This forced the Central Bank to
spend its foreign reserves to defend Russia's currency, which in turn
further eroded investor confidence and undermined the ruble. It is
estimated that between 1 October 1997 and 17 August 1998, the Central Bank
expended approximately $27 billion of its U.S. dollar reserves to maintain the
floating peg.

It was later revealed that about $5 billion of the international loans provided by
the World Bank and International Monetary Fund were stolen upon the funds' arrival
in Russia on the eve of the meltdown.[4][5]

On 13 August 1998, the Russian stock, bond, and currency markets

collapsed as a result of fears from investors that the government would
devalue the ruble, default on domestic debt, or both. Annual yields on the
ruble denominated bonds were more than 200 percent. The stock market had to
be closed for 35 minutes as prices plummeted. When this happened, it was
down 65 percent with a small number of shares actually traded. From January to
August 1998 the stock market had lost more than 75 percent of its value,
39 percent in the month of May alone.[6]

Crisis and effects[edit]

On 17 August 1998, the Russian government devalued the ruble, defaulted on

domestic debt, and declared a moratorium on payment to foreign creditors. [7] On
that day the Russian government and the Central Bank of Russia issued a "Joint
Statement" announcing, in essence, that: [8]

1. the ruble/dollar trading band would expand from 5.37.1 RUR/USD to 6.09.5
RUR/USD;

2. Russia's ruble-denominated debt would be restructured in a manner to be

announced at a later date; and, to prevent mass Russian bank default,

3. a temporary 90-day moratorium would be imposed on the payment of some

bank obligations, including certain debts and forward currency contracts. [9]

On 17 August 1998 the government declared in the Joint Statement of the

Government of the Russian Federation and the Central Bank of the Russian
Federation that the state securities (GKOs and OFZs), with due dates through 31
December 1999, would be transformed into new securities. The terms of the
GKO/OFZ restructuring were also determined in the following acts:

Decree of the Government of the Russian Federation 1007 of 25 August

1998

Decree of the President of the Russian Federation 888 of 25 August 1998

 Decree 1787- of 12 December 1998 on novation of state securities

Federal Law on Top-Priority Measures in the Field of Budget and Tax Policy [10]

GKO bondholders made few attempts to pursue litigation in domestic courts. [11]

At the same time, in addition to widening the currency band, authorities also
announced that they intended to allow the RUR/USD rate to move more freely within
the wider band.

At the time, the Moscow Interbank Currency Exchange (or "MICEX") set a daily
"official" exchange rate through a series of interactive auctions based on written
bids submitted by buyers and sellers. When the buy and sell prices matched, this
"fixed" or "settled" the official MICEX exchange rate, which would then be published
by Reuters. The MICEX rate was (and is) commonly used by banks and currency
dealers worldwide as the reference exchange rate for transactions involving the
Russian ruble and foreign currencies.

From 17 to 25 August 1998, the ruble steadily depreciated on the MICEX, moving
from 6.43 to 7.86 RUR/USD. On 26 August 1998, the Central Bank terminated ruble-
dollar trading on the MICEX, and the MICEX did not fix a ruble-dollar rate that day.

On 2 September 1998 the Central Bank of the Russian Federation decided to

abandon the "floating peg" policy and float the ruble freely. By 21 September 1998
the exchange rate had reached 21 rubles for one US dollar, meaning it had lost two
thirds of its value of less than a month earlier.

On 28 September 1998 Boris Fyodorov was discharged from the position of the
Head of the State Tax Service.

The moratorium imposed by the Joint Statement expired on 15 November 1998, and
the Russian government and Central Bank did not renew it.

Inflation[edit]

Russian inflation in 1998 reached 84 percent and welfare costs grew considerably.
Many banks, including Inkombank, Oneximbank and Tokobank, were closed down as
a result of the crisis. The salaries of miners alone were to consume $919 million,
more than one percent of the federal budget. By August 1998, the government had
paid $4 billion to settle miners strikes. Prices for almost all Russian food items had
gone up by almost 100%, while imports had quadrupled in price.

Many citizens were stocking up for bad times and throughout the country shop
shelves were being emptied, leaving a shortage of even the most basic items, such
as vegetable oil, sugar, matches or washing powder. The crisis reduced demand for
food and lowered food consumption, because substantial depreciation of the ruble
significantly raised domestic prices for food products. The crisis also increased
social tension. The middle class that was already forming by that time had some
hope for stability.

The confidence of crisis prevention crumbled as millions of people lost their life
savings due to banks closing. On 7 October 1998, demonstrations were held in
many cities: around 100,000 took to the streets in Moscow, In Vladivostok 4,000,
in Krasnoyarsk 3,000 and in Yekaterinburg 6,000. Defence Minister Igor
Sergeyev cancelled his scheduled visit to Greece in the first week of October 1998,
in order to be at hand should matters get out of control. Select military units were
placed in a state of readiness. On 20 October 1998, President Boris Yeltsin also
signed a presidential decree banning "mass protests" in Moscow between the hours
of 10 pm and 7 a.m.and limiting them to a maximum of five days.

As the crisis deepened, regional governors had been introducing emergency

measures: In Krasnoyarsk Krai in Siberia, governor Aleksandr Lebed, had signed a
resolution to hold down prices "using administrative methods", a television report
said. The authorities in the far eastern city of Vladivostok had banned deliveries of
food to areas beyond the port city, and there had been talks of introducing rationing
there. In Russia's Kaliningrad enclave on the Baltic, the governor announced a
suspension of tax payments to the federal authorities.

Fiscal[edit]

Regional budgets also suffered from the 1998 crisis. Spending [specify] declined from
18.2% of the GDP in 1997 to 14.8% of the GDP. [citation needed] Spending on the economy
(by 1.5% of the GDP) and social expenditures (by 1.6% of the GDP) were reduced
especially heavily. The expenditures continued to decline in the following period.
They[specify] dropped another 1% of the GDP in 1999 to 13.8% of the GDP, and to
10.8% of the GDP in the first quarter of 2000. One of the main factors in the
reduction was the decline in subsidies for housing and municipal services, from
3.5% to 2.7% of the GDP.[citation needed]

Agriculture[edit]

See also: Agriculture in Russia

The main effect of the crisis on Russian agricultural policy has been a dramatic drop
in federal subsidies to the sector, about 80 percent in real terms compared with
1997, though subsidies from regional budgets fell less. [12]

Political fallout[edit]

See also: Yevgeny Primakov's Cabinet

The financial collapse resulted in a political crisis as Yeltsin, with his domestic
support evaporating, had to contend with an emboldened opposition in the
parliament. A week later, on 23 August 1998, Yeltsin fired Kiriyenko and declared his
intention of returning Chernomyrdin to office as the country slipped deeper into
economic turmoil.[13] Powerful business interests, fearing another round of reforms
that might cause leading enterprises to fail, welcomed Kiriyenko's fall, as did
the Communists.

Yeltsin, who began to lose his hold on power as his health deteriorated, wanted
Chernomyrdin back; in a televised address to the nation, Yeltsin said that
heavyweights such as Chernomyrdin, who was ousted as prime minister in March
1998 for failing to vigorously promote economic reforms, were needed to stem the
nation's financial collapse. Yeltsin also suggested that Chernomyrdin would be
named his successor as president when Yeltsin's term expired in 2000. But the
legislature refused to give its approval. After the Duma rejected Chernomyrdin's
candidacy twice, Yeltsin, his power clearly on the wane, backed down. Instead, he
nominated Foreign Minister Yevgeny Primakov, who on 11 September 1998 was
approved by the State Duma by an overwhelming majority.

Primakov's appointment restored political stability, because he was seen as a

compromise candidate able to heal the rifts between Russia's quarreling interest
groups. There was popular enthusiasm for Primakov as well. Primakov promised to
make the payment of wage and pension his governments first priority, and invited
members of the leading parliamentary factions into his Cabinet.

Communists and the Federation of Independent Trade Unions of Russia staged a

nationwide strike on 7 October 1998 and called on President Yeltsin to resign. On 9
October 1998, Russia, which was also suffering from a bad harvest, appealed for
international humanitarian aid, including food.

Recovery[edit]

Russia bounced back from the August 1998 financial crash with surprising speed.
Much of the reason for the recovery is that world oil prices rapidly rose during 1999
2000 (just as falling energy prices on the world market helped to deepen Russia's
financial troubles), so that Russia ran a large trade surplus in 1999 and 2000.
Another reason is that domestic industries, such as food processing, had benefited
from the devaluation, which caused a steep increase in the prices of imported
goods.

Also, since Russia's economy was operating to such a large extent on barter and
other non-monetary instruments of exchange, the financial collapse had far less of
an impact on many producers than it would had the economy been dependent on a
banking system. Finally, the economy had been helped by an infusion of cash. As
enterprises were able to pay off debts in back wages and taxes, in turn consumer
demand for goods and services produced by the Russian industry began to rise.

For the first time in many years, in 2000 unemployment fell as enterprises added
workers. Since the 1998 crisis, the Russian government has managed to keep social
and political pressures under control, and this has played a vital role in bringing
about the current recovery.[dubious discuss]

Effects on countries in the world[edit]

he financial crisis spread panic throughout the world financial system.

Baltic states[edit]

The Russian crisis affected Baltic countries more than expected. Estonia, Latvia
and Lithuania sank into recession. Figures for 1999 showed a heavy decline in
exports from these countries to Russia, in addition to a significant decline
in growth rates of these economies. Food and beverage as well as processing
industries as a whole suffered the most.

Belarus[edit]

Overall, economic activity slowed down substantially in the immediate aftermath of

the Russian crisis, with output growth falling from about 8.5 percent in 1998 to 3.4
percent in 1999. Both exports and imports contracted substantially, resulting in a
drop in the current account deficit from a 6.1 percent GDP in 1998 to 2.2 percent in
1999. Externally, exports to Russia, which accounted for more than 60 percent of
total exports, fell during the second half of 1998 by 10 percent.

Demand for Belarusian products was weak through 1999, showing signs of recovery
only during the final quarter, with the revival of economic activity in Russia. Also, in
the first quarter of 1999, compared to 1998, except for investments, all budget
expenditures were smaller. The biggest cuts were made in national security (a 1.9
GDP, compared to 2.5 percent in the first quarter of 1998) and social policy (1.5 and
2.4 percent of GDP, respectively) where expenditures were lowered almost by one
third.

Kazakhstan[edit]

The Russian crisis was a hard blow to the Kazakh economy. Kazakhstan lost its
pricing competitiveness and its exports were in shambles. On the other hand, cheap
Russian goods were flowing into the country, essentially killing domestic industries.
There was huge pressure on the tenge, the Kazakh currency, and Kazakhstan's
balance of payments worsened. However, the NBK continued to maintain the value
of the tenge. In fact, they had spent close to a billion dollars to maintain the level of
tenge. Their foreign exchange reserves halved.

Moldova[edit]

Moldova received an IMF special mission advising the government on how to cope
with the effects of the Russian crisis. At that time Russia bought 85% of Moldova's
wine and brandy, as well as most of its canned goods and tobacco. After the ruble
crashed, most Russian importers put deals with Moldova on hold. Moldovan
president Petru Lucinschi was quoted as saying that the Russian crisis had cost
Moldova as much as five per cent of its GDP. The country's parliament was
discussing a programme aimed at reducing imports and searching for new markets
outside Russia.

Ukraine[edit]

The crisis cost the Ukraine a lot as well: the Hryvnia devaluated by 60%, domestic
prices increased by 20%, and the National Bank of Ukraine lost 40% of its gross
reserves.

United States[edit]

The U.S. stock market, following a decade of rapid and accelerating increases,
began to slip in early August 1998, amid fears about Asia and Russia. The Dow
Jones Industrial Average fell 984 points, or 11.5%, in 3 days at the end of August, to
a level 19% below its July peak. This more than erased the year's market gains. The
U.S. stock market remained depressed until October, when a series of interest
rate reductions by the Federal Reserve propelled it back upward.[16]

Uzbekistan[edit]

In the central Asian state, the government banned free unlicensed sales of food,
most of which is imported from Russia, as a preventative measure against prices
rising and subsequent panic.

References[edit]

1. Jump up^ Russian Federation: International Reserves and Foreign

Currency Liquidity, IMF, 25 June 2012

2. Jump up^ Russian Financial Crisis of 1998: An Economic Investigation,

International Journal of Applied Econometrics and Quantitative Studies
Vol. 1-4 ,2004.

3. Jump up^ "Online NewsHour: Russia Shake Up- March 23, 1998".
Pbs.org. Archived from the original on 9 November 2010. Retrieved 3
November 2010.

4. Jump up^ "Radio Free Europe/ Radio Liberty". Rferl.org. 27 June

2002. Archived from the original on 26 May 2011. Retrieved 14 May
2011.

5. Jump up^ "Foreign Loans Diverted in Monster Money Laundering".

Worldbank.org. Archivedfrom the original on 7 November 2010.
Retrieved 3 November 2010.
 6. Jump up^ A Case Study of a Currency Crisis: The Russian Default of
1998

7. Jump
up^ http://research.stlouisfed.org/publications/review/02/11/ChiodoOw
yang.pdf

8. Jump up^ "Joint Statement by the Government of the Russian

Federation and the Central Bank of the Russian Federation On the
Exchange Rate Policy", August 17, 1998.

9. Jump up^ STATEMENT of the Government of the Russian Federation

and the Central Bank of the Russian Federation 17 August 1998

10.Jump up^ Federal Law No 192- of 12 December 1998 on Top-

Priority Measures in the Field of Budget and Tax Policy.

11.Jump up^ e.g. Federal Commercial (Arbitrazh) Court of Moscow

District [FASMO] No -40/172-00 of 1 February 2000.

12.Jump up^ Web Archives: View Archived Page. Ers.usda.gov. Retrieved

on 2013-10-23.

13.Jump up^ "Online NewsHour: Russia's Crisis September 17, 1998".

Pbs.org. Archived from the original on 8 November 2010. Retrieved 3
November 2010.

14.Jump up^ Stiglitz, Joseph (9 April 2003). "The ruin of Russia". The
Guardian (London). Retrieved 21 April 2010.

15.Jump up^ "CIA The World Factbook Russia". Cia.gov. Archived from
the original on 14 May 2011. Retrieved 14 May 2011.

16.Jump up^ David M. Kotz, "Russia's Financial Crisis: The Failure of

Neoliberalism?", University of Massachusetts, 1998

External links[edit]

The Crisis in Russia: Some Initial Observations by Brian Henry and James
Nixon, Economic Outlook, Vol. 23, No. 1, November 1998 (subscription
required).

An Analysis of Russia's 1998 Meltdown: Fundamentals and Market

Signals by Homi Kharas, Brian Pinto and Sergei Ulatov, Brookings Papers on
Economic Activity, #1, 2001 (subscription required).

Lessons from the Russian Crisis of 1998 and Recovery by Brian Pinto, Evsey
Gurvich, and Sergei Ulatov, The World Bank, February 2004.
 Why Did the Ruble Collapse in August 1998? by Padma Desai, The American
Economic Review Vol. 90, No. 2, 2000 (subscription required).

The Bank of Russia and the 1998 Rouble Crisis by William Tompson. In
Vladimir Tikhomirov (ed.), Anatomy of the 1998 Russian Crisis (Melbourne:
CERC, 1999).

A Case Study of a Currency Crisis: The Russian Default of 1998 by Abbigail J.

Chiodo and Michael T. Owyang.

Chronology of the Russian Financial Crisis 1998 by Clifford Chance.

Lessons of the Russian Crisis for Transition Economies by Yegor Gaidar,

Finance and Development, Vol. 36, No. 2 (June 1999).

Welfare Impacts of the 1998 Financial Crisis in Russia and the Response of the
Public Safety Net by Michael Lokshin and Martin Ravallion, The Economics of
Transition 8 (2), July 2000 (subscription required).

Overview of Structural Reforms in Russia after 1998 Financial Crisis by S.A.

Vasiliev, International Monetary Fund, 16 February 2000.

International investors, contagion and the Russian crisis by Alexei Medvedev,

BOFIT #6, 2001.

Financial crisis in the Russian Federation by Thierry D. Buchs, Economics of

Transition 7 (3), 1999 (subscription required).

The Russian Default by Saul Estrin, Business Strategy Review 9 (3),

September 1998 (subscription required).

Russia's Tax Crisis: Explaining Falling Revenues in a Transitional Economy by

Daniel Treisman, Economics & Politics 11 (2), July 1999 (subscription
required).

1999 IMF World Economic Outlook, Interim Assessment, Ch. II: The Crisis in
Emerging Markets, International Monetary Fund, December 1999.

Russia and the IMF by Nigel Gould-Davies and Ngaire Woods, International
Affairs 7 (1), January 1999 (subscription required).

Lessons from the Russian Meltdown: The Economics of Soft Legal

Constraints by Enrico Perotti, International Finance 5 (3), 2002 (subscription
required).

Russia's Silent Middle Class, by Carol Clark, CNN, September 1998

In the third of our five-part series, in which we look at five historical debt
defaults we look at the Russian crisis of 1998 and how it offers a lesson
to eurozone leaders on the importance of managing contagion.

What happened

In 1997, Russia was on the verge of gaining the confidence of international investors
after six years of post-Soviet reforms. Inflation seemed under control and the rouble
was pegged to the dollar.

But beneath the surface, all was not well. Real wages were less than half of their
1991 level - and the tax-gathering infrastructure was shambolic. Then the bursting
of asset bubbles in Thailand, South Korea and Indonesia triggered the Asian crisis,
which provoked a downward spiral in the commodity prices on which Russia relied.
The rouble then began to be targeted by investors.

In July 1998, a $22.6bn IMF package was approved to stabilise the country. The
centrepiece of the package was a swap of short-term government bills for longer-
term eurobonds. However, by August the rouble sell-off was again in full swing.

George Soros, among others, declared the only route out for Russia was devaluation
but the government continued to support the rouble, even as public sector wages
went unpaid.

What was done

On 17 August, the Russian government finally bowed to market pressure and

devalued. It also defaulted on all domestic debt and declared a moratorium on
foreign debt. Two weeks later, the rouble allowed it to float freely.

But, according to Nick Firoozye, head of European interest rates strategy at Nomura,
Russia did not default in a manner that was considered appropriate. He said: It
was selective about who it paid.

However, when the moratorium on foreign debt passed on November 15, the
Russian government did not renew it and recommenced paying holders of its
eurobonds.

Less than a year later, Russias economy had recovered to pre-crisis levels and it
has continued to grow rapidly since, riding the boom in commodities.

What was learnt?

Alexey Moiseev, head of macroeconomy analysis at VTB Capital, believes there is at

least one clear lesson from the Russian crisis for eurozone leaders, that managing
contagion must be the foremost priority.
The Russian crisis dangerously undermined several central Asian states, as well as
presenting problems in eastern Europe and the Baltics. These countries found that
their substantial exports to Russia were decimated by the collapsing rouble in
addition to the increasing pressure placed on their treasuries by increasing spreads
on emerging market bonds following the crisis.

The crisis also played a major role in the collapse of Long Term Capital Management,
which had put big bets on falling spreads following the Russian meltdown, the
hedge fund lost $550m on August 21 alone, according to a World Bank working
paper.

Russia itself, however, did recover remarkably quickly.

Michala Marcussen, head of global economics at Societe Generale, believes this

was, in part, because the policymakers got their head around the problem
relatively quickly.

However, there was also a good deal of luck though, she adds: Oil was critical to
the recovery. Not something Greece can hope for.

She adds that the Russian response did also pioneer one course of action that may
offer Greece a path out of the current morass. Russia saw the beginning of the
reprofiling idea imposing a moratorium on foreign creditors and averting a far
worse banking crisis was not a bad idea at all in the context.

THE RUSSIAN DEFAULT WHAT HAPPENED?

BY CULLEN ROCHE WEDNESDAY, NOVEMBER 16TH, 2011

The Russian financial crisis and eventual default is often cited as a counterargument
to one of the principle MR ideas that a sovereign currency issuer should not be able
to go bankrupt. Its a complex subject that is worth spending some time on.

Russia was a rather unique situation. Most people who study the Russian default are
fixated on the fact that Russia defaulted on their debt. They focus almost entirely on
the ultimate cause of death without actually studying what led to the default. This is
similar to studying a man who dies of a heart attack and concluding that his bad
heart was what was wrong with him. And while that might be true, a more thorough
examination is likely to show you that a series of things (diet, smoking, lack of
exercise, etc) actually led to broad problems that ultimately culminated in a heart
attack. This lack of analysis leads many observers to conclude that Russia had too
much debt, defaulted, end of story. This sort of simple analysis leads to simple
conclusions which leads to misconceptions. The truth, as is generally the case, is
more complex.
When one looks at the history of Russia you actually find many similarities with my
conclusions in Hyperinflation Its More Than Just a Monetary Phenomenon. In the
case of Russia, we actually have many of the same elements leading to
hyperinflation and then default. In this particular case, we have loss of a war,
regime change, collapse of the tax system, political corruption, foreign denominated
debts and collapse of productivity. In other words, from an MR perspective, this
country was ripe for self destruction as they met almost all of the criteria that
precede a hyperinflation and/or crisis resulting from ceding of monetary sovereignty.

I dont have nearly the time or the space to cover the sequence of events in its
entirety, but its important to understand that Russias eventual hyperinflation and
1998 default is actually rooted in the break-up of the USSR which occurred in 1991.
The dissolution of the USSR was the largest dissolution of any socialist state and
resulted in 15 sovereign states. Russia was the surviving state formerly known as
the USSR and the burden that accompanied this was extraordinary. As you can
imagine, the collapse of one of the worlds super powers was highly traumatic as the
government and its people attempted to transition. Here we have the first two
common elements in hyperinflations loss of a war & regime change. The third
crucial element was foreign denominated debts from their Soviet predecessors. How
problematic was this? Pravda explains how Russia only just managed to pay off this
heavy burden a few years ago:

The Soviet Union left a huge debt after its collapse. Russia became the only
country to inherit not only the foreign property of the former USSR, but all of its
foreign debts as well. It was extremely hard for Russia to serve the debt because
the economy was declining steadily in the beginning of the 1990s. The Soviet debt
had been restructured four times before the default of 1998. By 1999 Russia
managed to either write off or delay the payments to private creditors (the London
Club, for instance). However, such a compromise proved to be impossible with the
Paris Club of Creditors.

From an MR perspective, the story essentially concludes itself right there. This
country was never truly sovereign because it was essentially a currency user when
the new regime was established and Russia was saddled with the foreign
denominated debts of the old USSR. In other words, ceding your monetary
sovereignty proved disastrous as were now seeing in Europe. But theres actually
more to it than just that. Their errors multiplied as the years went on.

Many analysts and critics of the Russian default like to imply that Russia was simply
spending uncontrollably and that their default is an excess of spending and
government largess. But thats not exactly accurate. Turmoil in the regime change
and political disunity made tax collections increasingly difficult as the new regime
took control. The St Louis Fed citescorruption and the drop in tax collections as the
primary cause of the ballooning deficit:
Another weakness in the Russian economy was low tax collection, which caused
the public sector deficit to remain high. The majority of tax revenues came from
taxes that were shared between the regional and federal governments, which
fostered competition among the different levels of government over the
distribution. According to Shleifer and Treisman (2000), this kind of tax sharing can
result in conflicting incentives for regional governments and lead them to help firms
conceal part of their taxable profit from the federal government in order to reduce
the firms total tax payments. In return, the firm would then make transfers to the
accommodating regional government.

The country would eventually go to the IMF in 1996 seeking aid. This further
relinquished their sovereignty. All the while, inflation was ravaging the country
leading to unrest and increased economic turmoil. Their rolling hyperinflation
leftover from the trauma of the collapse of the USSR never really ended. Even into
the late 90s the country suffered from high double digit inflation:

The lack of economic diversity (their economy was highly dependent on oil exports)
and foreign denominated debts made it vital that they grow via their trade surplus.
In attempting to achieve this the country further ceded sovereignty by
implementing a peg to the US Dollar. Further, in 1998 the Russian government cited
the tax issue as a serious risk to the regime. They attempted a complete overhaul of
the tax system, but the damage had already been done. As the Asian Crisis erupted
in the late 90s the fragility of the Russian economy was exposed. The government
attempted to protect the Ruble during the crisis leading to massive hemorrhaging of
FX reserves. In a 1998 paper Warren Mosler explained the impact of this policy:

The marginal holder of ANY ruble bank deposit, at any Russian bank, had a choice
of three options before the close of business each day.

(I will assume all rubles are in the banking system. Actual cash is unnecessary for
the point I am making in this example.)

The three choices are:

Hold rubles in a clearing account at the Central Bank

Exchange ruble clearing balances for something else at the CB.

Buy a Russian GKO (tsy sec), which is an interest bearing account at the CB

b. Exchange rubles for $ at the official rate at the CB

For all practical purposes, 2a and 2b competed with each other. Russia had to offer
high enough rates on its GKOs to compete with option 2b. In that sense interest
rates were endogenous. Any attempt by the Russian Central Bank to lower rates,
such as open market operations, would result in an outflow of $US reserves. The
conditions for a stable ruble could not coexist. The net desire to save rubles was
probably negative, the failure to enforce tax liabilities resulted in deficit spending
even as the government tried to reduce spending, and the higher interest rate on
GKOs increased government spending even more.

At the time GKO rates were around 150% annually, and the interest payments
themselves constituted at least the entire ruble budget deficit. It seemed to me that
higher rates of interest were the driving factor behind the excess ruble spending
which led to the loss of $US reserves.

With the $ in high demand due to a variety of factors, such as domestic taxed
advantaged $US savings plans, insurance reserves, pension funds, and the like,
and, exacerbating the situation, what could be called overly tight US fiscal policy,
there was, for all practical purposes, no GKO interest rate that could stem the
outflow of $US reserves.

The main source of $ reserves was, of course, $ loans from both the international
private sector and international agencies such as the IMF. The ruble was overvalued
as evidenced by the fact that $ reserves went out nearly as fast as they became
available. The Russian Treasury responded by offering higher and higher rates on
its GKO securities to compete with option 2b, without success. This inability to
compete with option 2b is what finally leads to devaluation under a fixed exchange
rate regime.

But that wasnt all. The global economy began to decline sharply as the Asian
Financial Crisis unfolded in 1998. Russia was particularly hard hit as the oil and non-
ferrous metals markets collapsed. The shock was enough to drive investors to
believe that the Ruble would be massively devalued or debts would be defaulted on.
In other words, Russia was built on a poor foundation and then driven into the
ground as a series of events battered their economy and government.

In sum, you had a nearly perfect environment for a major economic calamity. And
like my study of past hyperinflations, we find that the Russian default was actually
much more than just a monetary phenomenon. In fact, it was rooted in much more
devastating and complex issues than merely running high sovereign debts. The
primary causes include regime change, loss of a war, foreign denominated debt and
loss of monetary sovereignty via a pegged currency.

N.B. - It should go without saying that this situation is not even remotely analogous
to the current situation in the USA.

Addendum A brief note on willingness to pay via Warren Mosler:

An extreme example is Russia in August 1998. The ruble was convertible into $US
at the Russian Central Bank at the rate of 6.45 rubles per $US. The Russian
government, desirous of maintaining this fixed exchange rate policy, was limited in
its WILLINGNESS to pay by its holdings of $US reserves, since even at very high
interest rates holders of rubles desired to exchange them for $US at the Russian
Central Bank. Facing declining $US reserves, and unable to obtain additional
reserves in international markets, convertibility was suspended around mid August,
and the Russian Central Bank has no choice but to allow the ruble to float.

All throughout this process, the Russian Government had the ABILITY to pay in
rubles. However, due to its choice of fixing the exchange rate at level above
market levels it was not, in mid August, WILLING to make payments in rubles. In
fact, even after floating the ruble, when payment could have been made without
losing reserves, the Russian Government, which included the Treasury and Central
Bank, continued to be UNWILLING to make payments in rubles when due, both
domestically and internationally. It defaulted on ruble payment BY CHOICE, as it
always possessed the ABILITY to pay simply by crediting the appropriate accounts
with rubles at the Central Bank.

Why Russia made this choice is the subject of much debate. However, there is no
debate over the fact that Russia had the ABILITY to meet its notional ruble
obligations but was UNWILLING to pay and instead CHOSE to default.

Transcript of Russian Financial Crisis 1998

The Russian Crisis '98 The First Chechen War ended -1996
Russia's finance minister, Mikhail Kasyanov
budgeted 3.5 billion rubles to pay for the military campaign
Instead, it spent 5 billion rubles (New York Times, Jan 25, 2000) The course of
events Improvements :
Inflation fell from over 200% in 1995 to 11% in 1997
Debt inherited after USSR breakup restructured 23 years, Paris/London club of
creditor nations
GKO sales succesful Initial Growth IBudget deficit : 7 -8 % of GDP
Revenues fell sharply : 12% from their peak in 1997
Debt piling up mainly inherited:
External : $120 bn Internal : $80 bn
GKO sales succesful Costs of growth Building pressure Real wages had fallen
Routine delays to payment workforce
Paris club judged Russian debt by faulty standards :
Pre USSR exchange rate
Assets in debt owed to USSR by other nations like cuba
Growth expected to offset debt growth East Asian Crisis - 1997 Russian growth in
past years due to exports

Mainly oil, gas and non ferrous metals

Demand for and hence prices of exports dropped

Drop in Current account significantly Chaos in Government Poor tax collection : new
tax code introduced

Effectively uselss : key components missing

Tensions Grew: President Yelstin dismissed entire government - March 1998

Kiriyenko - New prime minister The road to ruin Unsuccesful dealings with IMF : No
aide due to refusal of restriction
Fears of devaluation arise as debt surmount
New treasury system : Flow of funds restriction through banks
Bond return 48% over inflation 10%, yet still little demand Desperation policies
Short term interest rate increased from 30 % to 50 %
Air of uncertaininty still persisted, no change in deposits.
Oil price reached record low ($11/barrel)
Interest rate hiked yet again to 150% this time! Countermeasures Crisis plan
announced : (Govt spending cuts)
Misintepretation
Govt refused to float exchange rate
Wanted to keep investor confidence intact
Total spending of about $5 billion in Forex reserves
Maturity of loans and futures neared
IMF assistance - 11bn dollars (4bn immediate) The tide of uncertainty August 13th
stock , bond and currency markets collapsed
Jan Aug, the stock market fell about 75%
17th Aug floating exchange rate announced
Ruble devalued by 34% , ER : 9.5 Rub/$
90 Day moratorium announced to pay forieng creditors
August 18th exchange rate risen to 11 Rub/$ Hales Argument The Russian Crisis
Came about as a result of domestic factors and not external ones! External Factors
Trade Channel
Speculative Channel External FactorsWas Asia the culprit? External Factors defined
as : contagion spread from the South Asian Crisis
Contagion: Eichengreen, Rose and Wyplosz (1996) which means:... an increase in
the probability of a speculative attackon the domestic currency which stems not
from domestic fundamentals" such as money and output but from the Existence of a
(not necessarily successful) speculative attackvElsewhere in the world. Possible
External Factors: Trade Channel-I The trade channel refers to the possible increase
in exports from the Asian countries once their economies crashed
How Devaluation in Asian Economies would increase their exports- J Curve Effect
Equivalent to an increase in Russian imports from Asia
Russian current account balance worsens
Downward pressure on the Ruble NO! Trade from East Asian countries accounted for
only 3.28% of the total Russian trade volume!
Imports actually fell during the period Asias devaluation = Russias trade deficit?
Did Russian suffer from a Trade Deficit because of Asia? Possible External Factors:
Trade Channel-II The Competitive Mechanism Approach: Cheap Asian Exports might
cannibalize Russian Exports or a demand fall in Asia might decrease price of Russian
Exports
Russias Exports did decrease
30% of Russias exports were in the form of oil and natural gas and oil prices fell
27% from $23 to $17 per barrel between January and May 1997 Is Competition
Mechanism to blame? Did oil prices decrease due to the demand fall in Asia? NO!
Counter: The Oil prices did decrease, but because of the OPEC supplying more to
increase their market share
increase in supply of oil from OPEC countries by 2.25 million barrels per day
Whist demand in Asia remained stagnant due to the East Asian Crisis
Reliance on the world oil price costs Russia External Factors: Speculative Channel
Financial Crisis in Asia might lead to a Financial Crisis in Russia
How?
Hedge funds would want to liquidate most risky assets first; those of emerging
markets
As Russia was an emerging market, price of Russian Assets would decrease
Investors would expect devaluation
Investors would want to sell Ruble as soon as possible
Downward pressure on Ruble Did Bad News from Asia lead to the Financial Crisis?
Bad News : an event that decreases Russian Asset Prices
Good News: an event that increases Russian Asset Prices NO! Hales regression
model takes Russian Asset price as dependant variable and Bad News from Asia
(and other regions) as independent variables
Dummy variables used for Bad News
Similar approach followed for Good News
Result: None of the explanatory variable coefficients turned out to be significant
Internal Factors Deficit Accumulation and Ineffective debt management by the
Russian Government
Speculative attacks on Currency
High Interest Rate
Banking crisis Deficit Accumulation and Ineffective Debt Management Deficit
financing was done through short term commercial bonds
This meant that deficit was constantly rolled over
In August 1998, commercial banks stopped supporting the Governments debt
financing
This signalled default
According to Russian Center of Economic Reforms, in 1998, Russian government
had to spend $1.3bn weekly for debt service and repayment. Clearly this debt
burden was impossible for Russia to bear. Speculative Attack Most of the currency
reserves in Russia rested in the hands of the private sector
Most of the debts accumulated by the government
The debt burden rested 35% more on the government in comparison to the private
sector during 1995-98
Russian government was heavily dependent on the private sector for liquidity.
This essentially meant that the demand for currency should increase due to the
shortage that the government faced.
But this wont allow the Russian Currency to remain pegged
CBRs credibility came under doubt which led to a speculative attack, i.e.,
expectations of a devaluation Banking Crisis structure of Russian commercial banks
made them vulnerable to any currency shocks
By August 1998, foreign liabilities were 30% in excess of the foreign assets
the banks mostly held domestic assets
Currency devaluation speculations caused expectations of default from banks
Self fulfilling prophecy: expectations of default led to actual default!
Example: in May 1998 when Toko Bank (one of the largest banks at that time) was
declared bankrupt THE ROLE OF EXPECTAtE is the risk premium. THE ROLE OF
EXPECTATIONS IN EXPLAINING THE CRISIS High Interest Rate The Monetary policy of
keeping high interest rate by decreasing money supply was used to keep the value
of the Ruble intactTIONS IN EXPLAINING THE CRISIS (Basdevant Hall model) The
relation between the exchange rate and expected exchange rate is as follows:
Where Et is the nominal exchange rate, EEt is the expectation made at t for EEt+1,
DRt is the domestic interest rate, FRt is the foreign exchange rate and
However, the high interest rate slowed down the economy as it decreased
investment
Also, the purpose of high interest rates was not achieved due to expectations of
devaluation Kafeel Zaheer
Usama Qamar
Sharoon Ahmad