The Russian financial crisis of 1998

In 1997, Russia’s economic growth was positive for the first time since the formation of the Russian Federation in 1991. Nevertheless, the country’s fixed exchange rate regime together with its fragile fiscal position appeared to be unsustainable when the international markets got affected by spillover effects of financial distress elsewhere in the world. In the course of 1998, the outbreak of a severe banking, currency and sovereign debt crisis could not be prevented.

Author:  Iris van de Wiel

August 13th, 1998
The Russian stock, bond and currency markets collapse as a result of fears for a ruble devaluation and a default on domestic debt. These fears had arisen during the previous months due to ongoing interest rate rises, capital outflows and the corresponding erosion of investor confidence in emerging markets. Annual yields on ruble-denominated bonds rise to more than 200%. Furthermore, the stock market is closed down for 35 minutes when stock prices fall sharply. Stocks have lost more than 75% of their value since the beginning of the year

August 17th, 1998
The government announces a set of emergency measures in order to prevent a further escalation of the crisis: •          A significant devaluation of the ruble; the bounds of the corridor in which the ruble is allowed to fluctuate are widened from 5.27-7.13 to 6.00-9.50 ruble to the US Dollar; •          A default on short-term Treasury Bills known as GKOs, as well as longer-dated ruble denominated bonds named OFZs; •          A 90-day moratorium on payments by commercial banks to foreign creditors.

September 2nd, 1998
The Russian Central Bank’s decides to remove the currency corridor and makes the ruble a freely floating currency. The ruble soon starts to depreciate sharply; in 3 weeks the currency loses two thirds of its value. The strong depreciation results in sharp price increases. Inflation rises to 27.6% in 1998 and 85.7% in 1999. As a result of food price increases, social unrest grows and citizens start to demonstrate in various cities.

Figure 1:  Reserves and the exchange rate

Source: World Bank

November 20th, 1998
The Russian Deputy Minister of Finance Mikhail Kasyanov declares the country would be able to repay less than USD 10bn of its USD 17bn foreign debt. In the following weeks, Russian bank deposits decrease by 15% compared to August 1998.

Aftermath
The Russian economy contracts by 5.3% in 1998. GDP per capita even reaches its lowest level since the formation of the Russian Federation in 1991 (see Figure 2). Sovereign debt restructurings take place in 1999 and 2000. An IMF agreement of USD 4.5bn, concluded in July 1999, is meant to help Russia to regain access to the international financial markets access. However, allegations of irregularities in the banking sector again have a negative impact on the country’s financial market access and government bond yields remain high during the course of 1999. Nevertheless, thanks to both the sharp depreciation of the ruble, which continues in 1999, and an increase of international oil prices, the Russian economy recovers rather quickly and grows by 6.4% in 1999, 10% in 2000 and 5.3% in 2001. Meanwhile, inflation falls from 85.7% in 1999 to 20.8% in 2001 and 21.5% in 2001. The unemployment rate, which was 13% in 1998 and 1999, decreases to 9% in 2001.

Figure 2:  GDP Growth

Source: World Bank

Although Russia accounts for only 4.2% of world GDP in 1997, the outbreak of the Russian crisis and the following sovereign default shock global financial markets for two main reasons. First, among the emerging markets, Russia is a major borrower of short-term capital. Second, the outbreak of the Russian crisis emphasizes the economic and financial fragility of emerging markets. At the time Russia’s sovereign default is the largest in history. As a result of the Russian crisis, spreads on sovereign bonds in other emerging markets and on long-term corporate bonds in industrial countries rise substantially. The financial havoc has a large impact on the global financial markets and contributes to the collapse of hedge fund LTCM, which requires a USD 3.6 bailout.

Economic History
The Russian crisis took place in the first decade of Russia’s transition from communism to a free market economy. The Soviet Union, of which Russia was the most important member, had a centrally planned economy, with a corresponding fixed-price system, full employment and small income differences. In the first five decades of its existence the Soviet Union experienced rapid industrialization and high economic growth, at least according to official statistics. However, in the 1970s, a long period of stagnation began, as the Soviet economy proved to be unable to innovate and the high expenditures on defense placed a heavy burden on the government budget. Mikhail Gorbachev’s reform policies,  glasnost, perestroika, uskoreniye  and  demokratizatsiya,  could not break this trend. Instead, these policies even contributed to the end of communism. The dissolution of the Soviet Union followed in 1991. This preluded a complete overhaul of the economic system. The economic team of new President Boris Yeltsin, thoroughly reformed the economy. Large parts of the economy that were previously in government hands were privatized. However, due to the lack of strong institutions the rule of law was weak and large parts of the economy came under the control of oligarchs. Russia’s transition to a market economy was a very painful one; in the years after the implementation of President Yeltsin’s reforms, investment collapsed, GDP started to decline sharply, income inequality increased rapidly, and poverty became widespread. Meanwhile, hyperinflation, resulting from the Russian Central Bank’s (CBR) loose monetary policy, increased to 874% in 1993.

Reform and rising optimism
In 1994, Russia adopted a stabilization program to lower the inflation towards single digits again. The main element of this stabilization program was a currency peg. The ruble was from then on allowed to fluctuate within a narrow band around 5 ruble per one US Dollar. Furthermore, the program aimed at reducing Russia’s fiscal deficit to less than 3% of GDP by 1998. As a result of the stabilization plan, inflation fell from 197% in 1995 to 47.7% in 1996 and 14% in 1997. Russia’s fiscal deficit also fell significantly, from 11% of GDP in 1994 to less than 5% of GDP in 1995. Meanwhile, the contraction of the economy slowly came to an end; GDP growth, which had been negative since 1991, rose from -12.6% in 1994, to -4.1% in 1995 and to -3.6% in 1996. It even became positive in 1997, as the economy grew by 1.4% that year.

Next to the stabilization program, several other factors contributed to the rising optimism as well: As a result of the positive economic developments, market sentiment turned positive. This coincided with a relaxation in restrictions on foreign portfolio investment. In the beginning of 1997, foreigners got access to the GKO market. Foreign investors reacted enthusiastically and foreign portfolio inflows rose sharply in the first quarter of 1997. Furthermore, Russia’s credit rating improved, which allowed the country to borrow less expensively. Meanwhile, the gross reserves rose from USD15.3bn in 1996 to USD24.5bn in mid-1997.
 * In 1993, a market for ruble-denominated government bonds, called the GKO, was installed. This provided the government with an extra, non-inflationary means to finance its budget deficit.
 * Both the World Bank and the International Monetary Fund (IMF) supported the Russian economy by giving financial aid, which demonstrated the improving relations with the West. Furthermore, the willingness of the government to enter negotiations about a payment rescheduling of the former Soviet Union debt in April 1996 had a positive impact on investor confidence;
 * The international price of oil, Russia’s main export product, started to recover.

Asian Crisis
However, in the fourth quarter of 1997, market sentiment deteriorated drastically as a result of the Asian crisis that had started with the collapse of the Thai baht in July 1997 and soon spread to several Asian countries. In November 1997, soon after the outbreak of the Asian crisis, the Russian ruble came under speculative attack. The Central Bank of Russia defended the value of the currency and lost nearly USD 6bn in foreign exchange reserves, which dropped from USD 23.1bn in the third quarter of 1997 to USD 17.8bn in the fourth quarter of that same year. World commodity prices started to drop as a result of the turmoil. Together with a decrease in the demand for nonferrous metals, an oil price drop severely affected Russia’s budget deficit and also its current account balance, which ran into deficit in the second quarter of 1997.

Domestic weaknesses
As market sentiment worsened, investors began to realize that Russia’s fundamentals were weak. First, tax collection in Russia was low and total government revenue was only 15% of GDP in 1997. The government was thus not able to provide the necessary economic infrastructure, including transportation, energy and public utilities. Furthermore, disagreement on the distribution of taxes arose between the various regions, as the share of regional tax revenues had grown at the cost of the federal revenues. Recurrent attempts to improve Russia’s overall tax collection only resulted in more tax evasion, capital flight, informal sector growth and corruption. Furthermore, only 40% of the workforce was paid in full and on time. This proved the institutional weakness of the Russian economic system, which directly resulted from the state’s weakness, in which public goods as law, order and public health were hardly supplied. As a result, barter became an important part of the Russian economy; estimates vary, though some argue that as much as 50 to 75% of exchange in industry took the form of barter in 1997. Moreover, the first war in Chechnya, which cost approximately USD 5.5bn placed a heavy burden on the government budget.

Meltdown
By mid-1998, international liquidity was low and Russia’s current account balance further decreased to-3.4% as international oil prices continued to fall. In an attempt to support the ruble and reduce capital flight, interest rates were hiked to 150% by the central bank. In July 1998, monthly interest payments on Russia’s debt rose to an amount 40% higher than the country’s monthly tax collection. Debt could therefore only be financed by the issuance of more debt. The subsequent parliamentary disapproval of an anti-crisis plan completely eroded investor confidence, which created strong downward pressure on the currency. Between October 1997 and August 1998, the government is said to have spent USD 7bn of its USD reserves in order to maintain the exchange rate regime. This could however not prevent the outbreak of the crisis in August 1998.

Effects on the banking sector
In December 1997, already several months before the actual collapse, the Russian banking sector got confronted with fund withdrawals by depositors. Problems accelerated in the summer of 1998; even the state-owned Sberbank, which held 85% of total household deposits, was among the many banks that were affected. The emergency measures announced on 17 August 1998 were put into place in order to halt the withdrawals. However, the following sovereign debt default inflicted losses on Russia’s already weak banking sector. Furthermore, it required Sberbank to take over the deposits held by six large Moscow banks, which accounted for 13% of total deposits. Sberbank and just a few other financial institutions received financial support from the CBR. In the months following the crisis, a bank restructuring strategy was implemented, which resulted in the closure of a large number of banks. Large numbers of deposit holders thereby lost their savings. Furthermore, a new, core group of viable institutions had to be established. The impact of the collapse of the banking sector on Russia’s corporate sector was rather limited, as the banking sector was not a major source of finance for most companies. Furthermore, only a limited amount of firms had access to international financing.

Concluding remarks
When investor confidence in emerging markets plummeted due to the Asian crisis, Russia’s weak domestic fundamentals became more and more clear. Eventually, the currency overvaluation, low tax collection, weak institutions, increasing reliance on short term foreign capital and the expensive first war in Chechnya caused the outbreak of a severe currency, banking and sovereign debt crisis. The crisis resulted in a renewed strong contraction of the economy and also affected investor confidence in emerging markets worldwide. Thanks to both the depreciation of the ruble and the increase in international oil prices, the Russian economy was able to recover rather quickly.