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”.
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