Default in Russia in 1998
After six years of economic reform in Russia, privatization and
macroeconomic stabilization had experienced some limited success. Yet in
August 1998, after recording its first year of positive economic growth
since the fall of the Soviet Union, Russia was forced to default on its
sovereign debt, devalue the ruble, and declare a suspension of payments
by commercial banks to foreign creditors. What caused the Russian
economy to face a financial crisis after so much had been accomplished?
1996 and 1997. Optimism and Reform. In April 1996, Russian officials
began negotiations to reschedule the payment of foreign debt inherited
from the former Soviet Union. The negotiations to repay its sovereign
debt were a major step toward restoring investor confidence. On the
surface, 1997 seemed poised to be a turning point toward economic
stability.
• The trade surplus was moving toward a balance between exports and
imports.
• Relations with the West were promising: the World Bank was prepared to
provide expanded assistance of $2 to $3 billion per year and the
International Monetary Fund (IMF) continued to meet with Russian
officials and provide aid.
• Inflation had fallen from 131 percent in 1995 to 22 percent in 1996
and 11 percent in 1997
• Output was recovering slightly. A narrow exchange rate band was in
place keeping the exchange rate between 5 and 6 rubles to the dollar.
• And oil, one of Russia’s largest exports, was selling at $23 per
barrel—a high price by recent standards. (Fuels made up more than 45
percent of Russia’s main export commodities in 1997.)
In September 1997, Russia was allowed to join the Paris Club of creditor
nations after rescheduling the payment of over $60 billion in old Soviet
debt to other governments. Another agreement for a 23-year debt
repayment of $33 billion was signed a month later with the London Club.
Analysts predicted that Russia’s credit ratings would improve, allowing
the country to borrow less expensively. Limitations on the purchase of
government securities by nonresident investors were removed, promoting
foreign investment in Russia. By late 1997, roughly 30 percent of the
GKO (a short-term government bill) market was accounted for by
nonresidents. The economic outlook appeared optimistic as Russia ended
1997 with reported economic growth of 0. 8 percent. Revenue, Investment,
and Debt. Despite the prospects for optimism, problems remained. On
average, real wages were less than half of what they were in 1991, and
only about 40 percent of the work force was being paid in full and on
time. Per capita direct foreign investment was low, and regu regulation
of the natural monopolies was still difficult due to unrest in the Duma,
Russia’s lower house of Parliament. 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. This, Shleifer and Treisman suggest, may explain why federal
revenues dropped more rapidly than regional revenues. Also, the Paris
Club’s recognition of Russia as a creditor nation was based upon
questionable qualifications. One-fourth of the assets considered to
belong to Russia were in the form of debt owed to the former Soviet
Union by countries such as Cuba, Mongolia, and Vietnam. Recognition by
the Paris Club was also based on the old, completely arbitrary official
Soviet exchange rate of approximately 0. 6 rubles to the dollar (the
market exchange rate at the time was between 5 and 6 rubles to the
dollar).
The improved credit ratings Russia received from its Paris Club
recognition were not based on an improved balance sheet. Despite this,
restrictions were eased and lifted and Russian banks began borrowing
more from foreign markets, increasing their foreign liabilities from 7
percent of their assets in 1994 to 17 percent in 1997. Meanwhile, Russia
anticipated growing debt payments in the coming years when early credits
from the IMF would come due. Policymakers faced decisions to decrease
domestic borrowing and increase tax collection because interest payments
were such a large percentage of the federal budget.
In October 1997, the Russian government was counting on 2 percent
economic growth in 1998 to compensate for the debt growth.
Unfortunately, events began to unfold that would further strain Russia’s
economy; instead of growth in 1998, real GDP declined 4. 9 percent. The
Asian Crisis. A few months earlier, in the summer of 1997, countries in
the Pacific Rim experienced currency crises similar to the one that
eventually affected Russia. In November 1997, after the onset of this
East Asian crisis, the ruble came under speculative attack. The Central
Bank of Russia (CBR) defended the currency, losing nearly $6 billion (U.
S. dollars) in foreign-exchange reserves. At the same time, non-resident
holders of short-term government bills (GKOs) signed forward contracts
with the CBR to exchange rubles for foreign currency, which enabled them
to hedge exchange rate risk in the interim period. 7 According to Desai
(2000), they did this in anticipation of the ruble losing value, as
Asian currencies had. Also, a substantial amount of the liabilities of
large Russian commercial banks were off-balance-sheet, consisting mostly
of forward contracts signed with foreign investors. Net obligations of
Russian banks for such contracts were estimated to be at least $6
billion by the first half of 1998.
Then another blow was dealt to the Russian economy: in December 1997,
the prices of oil and nonferrous metal, up to two-thirds of Russia’s
hard-currency earnings, began to drop. 1998 Government, Risk, and
Expectations. With so many uncertainties in the Russian economy,
investors turned their attention toward Russian default risk. To promote
a stable investment environment, in February 1998, the Russian
government submitted a new tax code to the Duma, with fewer and more
efficient taxes. The new tax code was approved in 1998, yet some crucial
parts that were intended to increase federal revenue were ignored.
Russian officials sought IMF funds but agreements could not be reached.
By late March the political and economic situation had become more dire,
and, on March 23, President Yeltsin abruptly fired his entire
government, including Prime Minister Viktor Chernomyrdin. In a move that
would challenge investor confidence even further, Yeltsin appointed
35-year-old Sergei Kiriyenko, a former banking and oil company executive
who had been in government less than a year, to take his place. While
fears of higher interest rates in the United States and Germany made
many investors cautious, tensions rose in the Russian government. The
executive branch, the Duma, and the CBR were in conflict. Prompted by
threats from Yeltsin to dissolve Parliament, the Duma confirmed
Kiriyenko’s appointment on April 24 after a month of stalling. In early
May, during a routine update, CBR chair Sergei Dubinin warned government
ministers of a debt crisis within the next three years. Unfortunately,
reporters were in the audience.
Since the Asian crisis had heightened investors’ sensitivity to currency
stability, Dubinin’s restatement of bank policy was misinterpreted to
mean that the Bank was considering a devaluation of the ruble. In
another public relations misunderstanding, Kiriyenko stated in an
interview that tax revenue was 26 percent below target and claimed that
the government was “quite poor now. ” In actuality, the government was
planning to cut government spending and accelerate revenue, but these
plans were never communicated clearly to the public. Instead, people
began to expect a devaluation of the ruble. Investors’ perceptions of
Russia’s economic stability continued to decline when Lawrence Summers,
one of America’s top international-finance officials, was denied a
meeting with Kiriyenko while in Russia. An inexperienced aide determined
that Summers’s title, Deputy Secretary of the Treasury, was unworthy of
Kiriyenko’s audience and the two never met. At the same time, the IMF
left Russia, unable to reach an agreement with policymakers on a 1998
austerity plan. Word spread of these incidents, and big investors began
to sell their government bond portfolios and Russian securities,
concerned that relations between the United States and Russia were
strained. Liquidity, Monetary Policy, and Fiscal Policy. By May 18,
government bond yields had swelled to 47 percent.
With inflation at about 10 percent, Russian banks would normally have
taken the government paper at such high rates. Lack of confidence in the
government’s 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 government’s initiative to collect
more taxes in cash lowered banks’ and firms’ liquidity. 8 Also, in 1997,
Russia had created a U. S. -style treasury system with branches, which
saved money and decreased corruption, yet also decreased the amount of
cash that moved through banks. The banks had previously used these funds
to buy bonds. Also, household ruble deposits increased by only 1. 3
billion in 1998, compared with an increase of 29. 8 billion in 1997. The
CBR responded by increasing the lending rate to banks from 30 to 50
percent, and in two days used $1 billion of Russia’s low reserves to
defend the ruble.
However, by May 27, demand for bonds had plummeted so much that yields
were more than 50 percent and the government failed to sell enough bonds
at its weekly auction to refinance the debt coming due. Meanwhile, oil
prices had dropped to $11 per barrel, less than half their level a year
earlier. Oil and gas oligarchs were advocating a devaluation of the
ruble, which would increase the ruble value of their exports. In light
of this, the CBR increased the lending rate again, this time to 150
percent. CBR chairman Sergei Dubinin responded by stating “When you hear
talk of devaluation, spit in the eye of whoever is talking about it”.
The government formed and advertised an anticrisis 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 nation’s financial elite to a meeting at the
Kremlin where he urged them to invest in Russia. In June the CBR
defended the ruble, losing $5 billion in reserves. Despite all of the
government efforts being made, there was widespread knowledge of $2. 5
to $3 billion in loans from foreign investors to Russian corporations
and banks that were to come due by the end of September. In addition,
billions of dollars in ruble futures were to mature in the fall. In July
the IMF approved additional assistance of $11. 2 billion, of which $4. 8
billion was to be disbursed immediately. Yet between May and August,
approximately $4 billion had left Russia in capital flight, and in 1998
Russia lost around $4 billion in revenue due to sagging oil prices.
After losing so much liquidity, the IMF assistance did not provide much
relief.
The Duma, in an effort to protect natural monopolies from stricter
regulations, eliminated crucial parts of the IMF-endorsed anti-crisis
program before adjourning for vacation. The government had hoped that
the anti-crisis plan would bring in an additional 71 billion rubles in
revenue. The parts that the Duma actually passed would have increased it
by only 3 billion rubles. In vain, lawmakers requested that the Duma
reconvene, lowering investors’ confidence even further. Default and
Devaluation. On August 13, 1998, the Russian stock, bond, and currency
markets collapsed as a result of investor fears that the government
would devalue the ruble, default on domestic debt, or both. Annual
yields on rubledenominated bonds were more than 200 percent. The stock
market had to be closed for 35 minutes as prices plummeted. When the
market closed, it was down 65 percent with a small number of shares
actually traded. From January to August the stock market had lost more
than 75 percent of its value, 39 percent in the month of May alone.
Russian officials were left with little choice. On August 17 the
government floated the exchange rate, devalued the ruble, defaulted on
its domestic debt, halted payment on ruble-denominated debt (primarily
GKOs), and declared a 90-day moratorium on payment by commercial banks
to foreign creditors. The Aftermath Russia ended 1998 with a decrease in
real output of 4. 9 percent for the year instead of the small growth
that was expected. The collapse of the ruble created an increase in
Russia’s exports while imports remained low.
Since then, direct investments into Russia have been inconsistent at
best. Summarized best by Shleifer and Treisman (2000), “the crisis of
August 1998 did not only undermine Russia’s currency and force the last
reformers from office…it also seemed to erase any remaining Western hope
that Russia could successfully reform its economy. ” Some optimism,
however, still persists. Imports trended up in the first half of 2001,
helping to create a trade balance. At the same time, consumer prices
grew 20. 9 percent and 21. 6 percent in 2000 and 2001, respectively,
compared with a 92. 6 percent increase in 1999. Most of the recovery so
far can be attributed to the import substitution effect after the
devaluation; the increase in world prices for Russia’s oil, gas, and
commodity exports; monetary policies; and fiscal policies that have led
to the first federal budget surplus (in 2000) since the formation of the
Russian Federation.
As discussed earlier, four major factors influence the onset and success
of a speculative attack. These key ingredients are (i) an exchange rate
peg and a central bank willing or obligated to defend it with a reserve
of foreign currency, (ii) rising fiscal deficits that the government
cannot control and therefore is likely to monetize (print money to cover
the deficit), (iii) central bank control of the interest rate in a
fragile credit market, and (iv) expectations of devaluation and/or
rising inflation. In this section we discuss these aspects in the
context of the Russian devaluation. We argue that an understanding of
all three generations of models is necessary to evaluate the Russian
devaluation. Krugman’s (1979) firstgeneration model explains the factors
that made Russia susceptible to a crisis. The second-generation models
show how contagion and other factors can change expectations to trigger
the crisis. The thirdgeneration models show how the central bank can act
to prevent or mitigate the crisis.
The Exchange Rate and the Peg When the ruble came under attack in
November 1997 and June 1998, policymakers defended the ruble instead of
letting it float. The real exchange rate did not vary much during 1997.
Clearly a primary component of a currency crisis in the models described
here is the central bank’s willingness to defend an exchange rate peg.
Prior to August 1998, the Russian ruble was subject to two speculative
attacks. The CBR made efforts both times to defend the ruble. The
defense was successful in November 1997 but fell short in the summer of
1998. Defending the ruble depleted Russia’s foreign reserves. Once
depleted, the Russian government had no choice but to devalue on August
17, 1998.
Revenue, Deficits, and Fiscal Policy Russia’s high government debt and
falling revenue contributed significantly to its susceptibility to a
speculative attack. Russia’s federal tax revenues were low because of
both low output and the opportunistic practice of local governments
helping firms conceal profits. The decrease in the price of oil also
lowered output, further reducing Russia’s ability to generate tax
revenue. Consequently, Russia’s revenue was lower than expected, making
the ruble ripe for a speculative attack. In addition, a large amount of
short-term foreign debt was coming due in 1998, making Russia’s deficit
problem even more serious. Krugman’s first-generation model suggests
that a government finances its deficit by printing money (seigniorage)
or depleting its reserves of foreign currency. Under the exchange rate
peg, however, Russia was unable to finance through seigniorage. Russia’s
deficit, low revenue, and mounting interest payments put pressure on the
exchange rate. Printing rubles would only have increased this pressure
because the private sector would still have been able to trade rubles
for foreign currency at the fixed rate. Thus, whether directly through
intervention in the foreign currency market or indirectly by printing
rubles, Russia’s only alternative under the fixed exchange rate regime
was to deplete its stock of foreign reserves. Monetary Policy, Financial
Markets, and Interest Rates During the summer of 1998, the Russian
economy was primed for the onset of a currency crisis. In an attempt to
avert the crisis, the CBR intervened by decreasing the growth of the
money supply and twice increasing the lending rate to banks, raising it
from 30 to 150 percent. Both rate hikes occurred in May 1998, the same
month in which the Russian stock market lost 39 percent of its value.
The rise in interest rates had two effects. First, it exacerbated
Russia’s revenue problems. Its debt grew rapidly as interest payments
mounted. This put pressure on the exchange rate because investors feared
that Russia would devalue to finance its non-denominated debt. Second,
high government debt prevented firms from obtaining loans for new
capital and increasing the interest rate did not increase the supply of
lending capital available to firms. At the same time, for eign reserves
held by the CBR were so low that the government could no longer defend
the currency by buying rubles.
Three components fueled the expectations of Russia’s impending
devaluation and default. First, the Asian crisis made investors more
conscious of the possibility of a Russian default. Second, public
relations errors, such as the publicized statement to government
ministers by the CBR and Kiriyenko’s refusal to grant Lawrence Summers
an audience, perpetuated agents’ perceptions of a political crisis
within the Russian government. Third, the revenue shortfall signaled the
possible reduction of the public debt burden via an increase in the
money supply. This monetization of the debt can be associated with a
depreciation either indirectly through an increase in expected inflation
or directly in order to reduce the burden of ruble-denominated debt.
Each of these three components acted to push the Russian economy from a
stable equilibrium to one vulnerable to speculative attack.
In this paper we investigate the events that lead up to a currency
crisis and debt default and the policies intended to avert it. Three
types of models exist to explain currency crises. Each model explains
some factor that has been hypothesized to cause a crisis. After
reviewing the three generations of currency crisis models, we conclude
that four key ingredients can trigger a crisis: a fixed exchange rate,
fiscal deficits and debt, the conduct of monetary policy, and
expectations of impending default. Using the example of the Russian
default of 1998, we show that the prescription of contractionary
monetary policy in the face of a currency crisis can, under certain
conditions, accelerate devaluation. While we believe that deficits and
the Asian financial crisis contributed to Russia’s default, the
first-generation model proposed by Krugman (1979) and Flood and Garber
(1984) and the second-generation models proposed by Obstfeld (1984) and
Eichengreen, Rose, and Wyplosz (1997) do not capture every aspect of the
crisis. Specifically, these models do not address the conduct of
monetary policy. It is therefore necessary to incorporate both the
first-generation model’s phenomenon of increasing fiscal deficits and
the third-generation model’s financial sector fragility. We conclude
that the modern currency crisis is a symptom of an ailing domestic
economy. In that light, it is inappropriate to attribute a single
prescription as the prophylactic or cure for a currency crisis.
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