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RUSSIAN FINANCIAL CRISIS
The Russian financial crisis, which began in 1998, was caused by both internal and external economic weaknesses. The crisis made underlying economic problems more evident. Pre-existing vulnerabilities included exposure to exchange rate volatility through issuance of United States (US) dollar-denominated bonds, and dependence on an export-oriented economy. During the crisis, halting of foreign demand for Russian metals and energy led to a severe downturn and a sudden liquidation of Russian assets. External shocks from the Asian financial crisis exacerbated the crisis and eventually necessitated an IMF bailout.
Causes of the Crisis
The Russian financial crisis was one in a series of crises after Asia, but was also rooted in fiscal shortcomings that began prior to 1998. The Soviet Union had disintegrated in large part due to bankruptcy of the Soviet state, and Russia continued to struggle with the debt crisis that this created (Vavilov 2010). Without fiscal reform, the government struggled to operate effectively. The cash tax collection of September 1996 was disastrous and hence government wages and social expenditures could not be paid, resulting in a vicious cycle of non-payments (Gilman 2010). Government expenditures meanwhile only increased through 1996. Tax arrears were essentially subsidies to the debtor institutions. Weak fiscal performance contributed to high interest rates and political uncertainty. The inability to collect sufficient taxes to fund government spending repressed further economic reform. Poorly designed tax rules and tax administration, and the pervasiveness of criminal gangs who both collected “taxes” and provided protection, led to severe fiscal shortfalls. Government budgetary expenditure was also undisclosed, preventing external advisors from helping matters. Tax revenues in 1997 were again disappointing, leaving the government in a quandary over its budgeted expenditures.
Financial liberalization did not help matters. Current account convertibility was introduced in 1996, while capital controls were easily averted. A large amount of foreign money flowed into the stock market in 1996 as investors expected high returns. The formal granting of permission to foreigners to purchase Russian government bonds prompted a surge in foreign investment in 1996 and 1997 (Buchs 1999). GKO1 government bonds were purchased in large amounts, at $1.6 billion in 1996, and more than $4 billion in both Q1 1997 and Q2 1997. Banks, weak institutions that lacked true independence, acted as a conduit for government debt investment (Pinto and Ulatov 2010). Banking liabilities accumulated (Perotti 2002).
What is more, through 1997, political instabilities mounted as President Boris Yeltsin’s health deteriorated and many government officials were sacked (Gilman 2010). President Yeltsin’s ratings were low to begin with, as Communists and Nationalists opposed Reformers. Most observers were aware that decisions were made (funds and projects appointed, state assets distributed) according to insider preference rather than economic or politi?cal efficiency. In addition, corporate governance was very poor due to the privatization process, and firms were still in a process of adjustment to the new economic circumstances. These destabilizing events occurred even though macroeconomic fundamentals improved: the trade surplus was moving toward balance, the IMF and World Bank continued to provide aid (after rigorous negotiations) to stabilize the economy and prevent ruble devaluation, inflation had fallen, and output was rising (Chiodo and Owyang 2002). As the Asian crisis had shown, macroeconomic fundamentals were no longer sufficient for economic growth or even stability. Hence the domestic conditions were ripe for crisis.
In addition, the Russian financial crisis of 1998 was triggered in part by contagion from Southeast Asia. Contagion from the Asian financial crisis threw the country into a downturn. In late September 1997, Korean and Brazilian investors, experiencing crisis at home, withdrew from Russian assets to cover their positions at home (Gilman 2010). By October 1997, investors nervous about contagion from the Asian crisis began to pull out of the stock and bond (GKO) markets. Foreign bondholders began to abandon GKOs. Most owners of the GKOs were foreign investors and the large Russian domestic banks (Sutela 1999). At the end of 1997, yields began to rise on Russian debt as the government significantly increased the amount auctioned.
Events of the Crisis
In November 1997, the Russian central bank had lost 25 percent of its foreign reserves. Investors started pulling their investments out of the Russian stock market, which depressed equity prices and put further downward pressure on the currency. Due to concerns about emerging markets caused by the Asian financial crisis, the ruble went under a speculative attack at the end of 1997 and the beginning of 1998, and a net outflow of funds from the government bond market occurred, causing rating agencies to downgrade Russia’s outlook.
In response, the Russian Central Bank (CBR) raised interest rates to boost investor confidence and help defend the ruble against external pressure, but bankers opposed this tightening of monetary policy. The stock of government securities became larger than the ruble money stock by 1998. Sberbank held up to 40 percent of the GKO stock and most household ruble savings, which were used to pay the public deficit. The outflow of funds from the bond market continued after President Yeltsin limited foreign ownership in the national electricity company in May 1998, and after the anti-crisis plan was opposed in the State Duma (Buchs 1999).
To make matters worse, falling oil prices reduced Russia’s oil revenue
(Chiodo and Owyang 2002). Through 1998, some large banks were undertaking extensive risks, borrowing large amounts in foreign exchange from abroad to make profits from high-yielding GKOs and purchase the foreign exchange on maturity to repay the loan (Gilman 2010). The current account balance fell and then turned negative in the first half of 1998 (Desai 2003).
The political situation within Russia continued to deteriorate, with the Duma rejecting policies that would conform to IMF loan covenants. Government churning brought in Sergey Kiriyenko as Prime Minister with an inexperienced new team. Fiscal imbalances continued, and the government attempted to collect more taxes in cash, reducing banks’ and firms’ liquidity. The central bank attempted to stave off a potential devaluation crisis by raising the lending rate to banks and decreasing the growth of the money supply, both of which had unintended adverse consequences on government revenues and liquidity.
Without a concrete solution to Russia’s financial troubles, investors started to grow impatient and withdraw their funds. This led yields on three-month GKOs to rise to 50 percent in 1998, and to 90 percent later that same month. New Russian debt was issued at successively higher interest rates, which further undermined investor confidence. Banks came under scrutiny after Tokobank found itself unable to meet margin calls against collateral held to secure foreign credits. Interbank loan defaults ensued as several large banks, including Tokobank and SBS-Agro, became insolvent (Perotti 2002).
The large-scale loss of confidence in Russia’s economy put the ruble under serious pressure. In response, the exchange rate had to be fiercely defended, and the Russian stock market fell 20 percent. Soon after, Russia and the IMF were able to reach an agreement to release $670 million to bolster the economy. In July 1998, facing a weighted average interest rate on GKOs of 126 percent, Kirienko canceled GKO auctions and offered to convert outstanding bonds into medium- and long-term notes denominated in dollars. The conversion had the following features: it was to be voluntary and market-based, allowing swaps only on GKOs maturing before July 1, 1999. Those wanting to convert their bonds could receive an equal amount in terms of market value of 7- and 20-year dollar eurobonds (Pinto and Ulatov 2010).
The conversion restored a degree of confidence in the economy and prompted the IMF, the World Bank, and the Japanese government to offer $22.6 billion in assistance. The weighted average yield of outstanding GKOs fell to 53 percent. The reforms agreed to as conditions for the IMF loan were again stalled by the Duma, leading the IMF to scale back assistance. The failure to push reforms through the Duma demonstrated Russia’s political weakness.
The Russian economy then had to deal with a liquidity crisis. Russian banks received loans from abroad, and in exchange posted GKOs as collateral. As Russian banks began to sell off the government debt to exchange for foreign currency to meet the margin calls, global markets became nervous. Sberbank itself redeemed all of its GKO holdings falling due in July for 12.4 billion rubles ($1.28 billion) (Gilman 2010). Foreign currency reserves continued falling, from $19.5 billion in July 1998 to $16.3 billion in August 1998. The ruble was still imperiled from loss of foreign investor confidence (Buchs 1999), and Russian-era external debt had increased by more than $16 billion between June 1 and July 24, 1998 (Pinto and Ulatov 2010).
On August 13, George Soros wrote in the Financial Times that Russia’s crisis was in the “terminal” stage and called for a devaluation of the currency and the creation of a currency board to keep the ruble pegged to the dollar or a European currency (Gilman 2010). This caused panic among global investors and Russia’s sovereign foreign debt was downgraded to junk bond status. Despite the fact that the central bank extended emergency credits to banks, the stock exchange and the ruble collapsed. The ruble, which had remained relatively stable for three years beforehand, lost most of its value. On August 23, the Russian cabinet resigned, effectively annulling any outstanding agreements with the IMF. This frightened markets, and the sell-off continued. On August 31, 1998, $1 could be exchanged for 7.905 rubles. On September 9, 1998, $1 could be exchanged for 20.825 rubles. In 1998, the Russian stock market lost 89 percent of its value. Figure 7.1 shows the sharp increase in the ruble-dollar exchange rate.
The sharp ruble devaluation exacerbated the banking crisis and household deposits were frozen to prevent further bank runs. The Central Bank shifted private deposits to Sberbank. The lack of bank transparency contributed to a liquidity crisis (Sutela 1999). To exacerbate matters, the collapse of the GKO assets wiped out bank assets, which caused a solvency crisis. Insolvent banks were not declared bankrupt, and bank owners engaged in asset-stripping (Perotti 2002). As costs rose, imports of consumer goods came to a halt. Consumers hoarded food as Russians panicked.
Outcomes of the Crisis
The crisis lowered living standards even further and added to the personal woes of the population. Although exporters gained from the currency devaluation, there was a further sharp decline in real wages. In real terms, household income fell by 20 percent due to the crisis, while the average
Figure 7.1 Ruble-dollar exchange rate
amount of government transfers fell by 18 percent, and help from relatives declined by 40 percent. The poverty rate increased from 22 percent to 33 percent. Using household survey data,2 Lokshin and Ravallion (2000) confirm that welfare declined as a result of the crisis. Problems with wage and other payments remained.
Russia quickly recovered from the crisis as world oil prices rose in 1999 and 2000. In addition, the new administration under Yevgeny Primakov used monetary financing and currency controls to restore basic financial services (Shppel 2003). The administration also engaged in aggressive fiscal tightening. Rapid import substitution occurred as domestic costs fell in comparison to those of international competitors. This shifted up the merchandise trade surplus. Output rebounded, inflation slowed, interbank payments were restored, and federal government revenue collection quickly rebounded.
As a result of the crisis, Russia’s privatization process was stalled and the need for tax reform was highlighted. Some viewed the economic liberalization process as a mistake, while most agreed that better reform practices were in order. Clearly, Russia’s difficult transition from a planned to a market economy was made even more difficult by weaknesses imposed due to financial globalization, in which the economy was exposed to external capital flows and global contagion (Pinto and Ulatov 2010). The Russian crisis also underscored the premise that sound macroeconomic fundamentals were insufficient for a positive investment climate; microeconomic and structural economic conditions also matter.
Political Economy of the Russian Crisis
The Russian crisis was seen as a turning point in Russia’s development after the break-up of the Union of Soviet Socialist Republics (USSR). Some believed, at the time, that Russia would enter a longer period of crisis due to severe economic fragilities, although this did not come about (Robinson 2007). The economy was moving away from outright dysfunction, with negative value-added production, to a market-based system. Economic churning occurred alongside political churning. The political elite was increasingly divided, especially between center and local leaders, as some reforms failed.
Indeed, the Russian crisis was exacerbated by the sharp turnover in the Russian government in 1998, when President Boris Yeltsin fired the entire government and appointed Sergey Kiriyenko Prime Minister. Kiriyenko was in office for only a short period, from March 1998 until August 1998, when he was fired. Prime Minister Kiriyenko was known as a reformer, and was necessarily at odds with the oligarchs in power. Yet it was the oligarchs who supported President Yeltsin, and their presence in the parliament halted legislation. President Yeltsin in return began to legislate by decree.
Within this period of conflict, the executive branch, the Duma, and the Central Bank of Russia were all at odds. The Duma was forced to confirm Kiriyenko as Prime Minister in April 1998, the Central Bank Chair Sergei Dubinin signaled a potential debt crisis which was read as impending devaluation, Kiriyenko claimed that the government was “quite poor now,” and Lawrence Summers, Deputy Treasury Secretary, was turned away from meeting with Kiriyenko by his aide in a political gaffe (Chiodo and Owyang 2002). By the time the IMF left Russia without reaching an agreement on an austerity plan in May 1998, investor sentiment had taken a sharp blow.
Prime Minister Viktor Chernomyrdin was reappointed by President Yeltsin after Kiriyenko was dismissed, but the parliament rejected him and nominated their own candidate, Yevgeny Primakov. This defeat for the President exacerbated the political crisis, especially because Primakov lacked experience in managing economic affairs. However, young reformers continued to comprise about half of the ministries, maintaining the path of reform. Political volatility continued even as the crisis subsided. We now turn to the Brazilian financial crisis, which was triggered by contagion from the Asian and Russian financial crises.