1998 Russian Financial Crisis - Background and Course of Events

Background and Course of Events

Declining productivity, an artificially high fixed exchange rate between the ruble and foreign currencies to avoid public turmoil, and a chronic fiscal deficit were the reasons that led to the crisis. The economic cost of the first war in Chechnya,estimated at $5.5 billion (not including the rebuilding of the ruined Chechen economy), also contributed to the crisis. In the first half of 1997, the Russian economy showed some signs of improvement. However, soon after this, the problems began to gradually intensify.

Two external shocks, the Asian financial crisis that had begun in 1997 and the following declines in demand for (and thus price of) crude oil and nonferrous metals, severely impacted Russian foreign exchange reserves. When the East Asian financial crisis broke out in 1997, prices for Russia's two most valuable sources of capital flows, energy and metals, plummeted. Given Russia’s fragile economy, the rapid decline in the value of those two capital sources resulted in an economic chaos in the country where GDP per capita fell, unemployment soared, and global investors liquidated their Russian assets.

A political crisis came to a head in March when Russian president Boris Yeltsin suddenly dismissed Prime Minister Viktor Chernomyrdin and his entire cabinet on 23 March 1998. Yeltsin named Energy Minister Sergei Kiriyenko, then 35 years old, as acting prime minister. On 29 May 1998, Yeltsin appointed Boris Fyodorov as Head of the State Tax Service. The growth of internal loans could only be provided at the expense of the inflow of foreign speculative capital, which was attracted by very high interest rates.

In an effort to prop up the currency and stem the flight of capital, in June 1998 Kiriyenko hiked GKO interest rates to 150%. The situation was worsened by irregular internal debt payments. Despite government efforts, the debts on wages continued to grow, especially in the remote regions. By the end of 1997, the situation with the tax receipts was very tense, and it had a negative effect on the financing of major budget items (pensions, communal utilities, transportation etc.).

A $22.6 billion International Monetary Fund and World Bank financial package was approved on 13 July 1998 to support reforms and stabilize the Russian market by swapping out an enormous volume of the quickly maturing GKO short-term bills into long-term Eurobonds. This had started to be implemented with some success by 24 July 1998, yet the Russian government decided to keep the exchange rate of the ruble within a narrow band. Although many economists, including Andrei Illarionov and George Soros, urged the government to abandon its support of the ruble.

On 12 May 1998, coal miners went on strike over unpaid wages, blocking the Trans-Siberian Railway. By 1 August 1998 there were approximately $12.5 billion in debt owed to Russian workers. On 14 August 1998 the exchange rate of the Russian ruble to the US dollar was still 6.29. Despite the bailout, July 1998 monthly interest payments on Russia’s debt rose to a figure 40 percent higher than its monthly tax collections.

Additionally, on 15 July 1998, the State Duma dominated by left-wing parties refused to adopt most of the government anti-crisis plan so that the government was forced to rely on presidential decrees. On 29 July Yeltsin interrupted his vacation in Valdai Hills region and flew to Moscow, prompting fears of a Cabinet reshuffle, but he only replaced Federal Security Service Chief Nikolay Kovalyov with Vladimir Putin.

At the time, Russia employed a "floating peg" policy toward the ruble, meaning that the Central Bank decided that at any given time the ruble-to-dollar (or RUR/USD) exchange rate would stay within a particular range. If the ruble threatened to devalue outside of that range (or "band"), the Central Bank would intervene by spending foreign reserves to buy rubles. For instance, during the year prior before the crisis, the Central Bank aimed to maintain a band of 5.3 to 7.1 RUR/USD, meaning that it would buy rubles if the market exchange rate threatened to exceed 7.1 rubles per dollar. Similarly, it would sell rubles if the market exchange rate threatened to drop below 5.3.

The inability of the Russian government to implement a coherent set of economic reforms led to a severe erosion in investor confidence and a chain reaction that can be likened to a run on the Central Bank. Investors fled the market by selling rubles and Russian assets (such as securities), which also put downward pressure on the ruble. This forced the Central Bank to spend its foreign reserves to defend Russia's currency, which in turn further eroded investor confidence and undermined the ruble. It is estimated that between 1 October 1997 and 17 August 1998, the Central Bank expended approximately $27 billion of its U.S. dollar reserves to maintain the floating peg.

It was later revealed that about $5 billion of the international loans provided by the World Bank and International Monetary Fund were stolen upon the funds' arrival in Russia on the eve of the meltdown.

On 13 August 1998, the Russian stock, bond, and currency markets collapsed as a result of fears from investors that the government would devalue the ruble, default on domestic debt, or both. Annual yields on the ruble denominated bonds were more than 200 percent. The stock market had to be closed for 35 minutes as prices plummeted. When this happened, it was down 65 percent with a small number of shares actually traded. From January to August 1998 the stock market had lost more than 75 percent of its value, 39 percent in the month of May alone.