he Russian Crisis 1998

Economic Report
September 16, 2013, by

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In 1997, Russias economic growth was positive for the first time since the formation of the Russian
Federation in 1991. Nevertheless, the countrys 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

Point of no return
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 Banks 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 countrys 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 Russias
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 Russias 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 Gorbachevs reform
policies, glasnost, perestroika, uskoreniyeand 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. Russias
transition to a market economy was a very painful one; in the years after the implementation of
President Yeltsins reforms, investment collapsed, GDP started to decline sharply, income inequality
increased rapidly, and poverty became widespread. Meanwhile, hyperinflation, resulting from the
Russian Central Banks (CBR) loose monetary policy, increased to 874% in 1993.

1994 1996
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 Russias 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. Russias 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:

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, Russias main export product, started to recover.
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, Russias 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.

1997 1998
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 Russias 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 Russias 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 Russias 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 states 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 Russias current account balance further decreased to3.4% 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 Russias debt rose to an amount 40% higher than the countrys 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 Russias 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 Russias
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, Russias 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.

References
Araki, N. (2001), Exchange Rate Policy of Russia: Lessons to learn from Russian experiences, Economic
and Social Research Institute
Baig, T. & Goldfain, I. (2000), The Russian Default and the Contagion to Brazil, Washington: IMF
Chiodo, A.J. & Owyang, M.T. (2002), A Case Study of a Currency Crisis: The Russian Default of 1998,
The Federal Reserve Bank of St. Louis
Moodys, (2009), Emerging Market Corporate and Sub-Sovereign Defaults and Sovereign Crises:
Perspectives on Country Risk
Pinto, B. & Ulatov, S. (2010), Financial Globalization and the Russian Crisis of 1998, Washington: The
World Bank
Sutela, P. (1999), The Financial Crisis in Russia, Helsinki: Bank of Finland, BOFIT

Tags: International, Central and Eastern Europe, Russia

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