The 1998 Russian Financial Crisis. Part 1: Course of Events

The Russian financial crisis (also called “Ruble crisis”) hit Russia on August 17, 1998. It was exacerbated by the global recession of 1998, which started with the Asian financial crisis in July 1997. Given the ensuing decline in world commodity prices, countries heavily dependent on the export of raw materials, such as oil, were among those most severely hit. (Petroleum, natural gas, metals, and timber accounted for more than 80% of Russian exports, leaving the country vulnerable to swings in world prices. Oil was also a major source of government tax revenue).

The sharp decline in the price of oil had severe consequences for Russia. However, the primary cause of the Russian Financial Crisis was not the fall of oil prices directly, but the result of non-payment of taxes by the energy and manufacturing industries.

Course of Events

Prior to the culmination of the economic crisis, the GKO bonds ( GKO = Gosudarstvennoe Kratkosrochnoe Obyazatelstvo which are Federal Loan Bonds ) issuance policy was described as similar to a pyramid scheme or Ponzi scheme (Hyman Minsky 1992), with the interest on matured obligations being paid off using the proceeds of newly issued obligations. Note however this scheme is used in the issuance of currency through a Central bank but is limited by *Fractional-reserve banking practices.

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 background to the meltdown. The economic cost of the first war in Chechnya that is estimated at $5.5 billion (not including the rebuilding of the ruined Chechen economy) was also a cause of the crisis. In the first half of 1997, 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, also impacted Russian foreign exchange reserves. 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 March 23. Yeltsin named Energy Minister Sergei Kiriyenko, aged 35, as acting prime minister.

On May 29, Yeltsin appointed Boris Fyodorov 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 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 December 1996, the total debts on wages reached more than 47.1 trillion Rubles. By the end of 1997, the situation with the tax receipts was very tense, and it had a negative effect on the financing of the major budget items (pensions, communal utilities, transportation etc).

A $22.6 billion International Monetary Fund and World Bank financial package was approved on July 13 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 July 24, 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 May 12, 1998 coal miners went on strike over unpaid wages, blocking the Trans-Siberian Railway. By August 1, 1998 there were approximately $12.5 billion in unpaid wages owed to Russian workers.

On August 14 the exchange rate of the Russian Ruble to the US dollar was still 6.29. Despite the bailout, July monthly interest payments on Russia’s debt rose to a figure 40 percent greater than its monthly tax collections. Additionally, on July 15 the *State Duma dominated by left-wing parties refused to adopt most of government anti-crisis plan so that the government was forced to rely on presidential decrees. On July 29 Yeltsin interrupted his vacation in Valdai Lake region and flew to Moscow, prompting fears of a Cabinet reshuffle, but he only replaced Federal Security Service Chief Nikolai Kovalyov with Vladimir Putin.

Realizing that this situation was unsustainable, investors continued to flee Russia despite the IMF bailout. Weeks later the financial crisis resumed as the real value of the Ruble resumed its decline. Russians sought frantically to buy Dollars, but these had become scarce. Foreign investment rushed out of the country, and the ensuing financial crisis triggered an unprecedented flight of capital from Russia.

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

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 Ruble denominated 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.

Click HERE for Part 2.

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* Fractional-Reserve Banking refers to a financial system in which some fraction of the deposits can be used to finance profitable but illiquid investments.

*A Eurobond is an international bond that is denominated in a currency not native to the country where it is issued. It can be categorised according to the currency in which it is issued. London is one of the centers of the Eurobond market, but Eurobonds may be traded throughout the world - for example in Singapore or Tokyo.

Eurobonds are named after the currency they are denominated in. For example, Euroyen and Eurodollar bonds are denominated in Japanese Yen and American Dollars respectively.

*The State Duma in the Russian Federation is the lower house of the Federal Assembly of Russia (legislature), the upper house being the Federation Council of Russia. The Duma is headquartered in downtown Moscow, a few steps from Manege Square. Its members are referred to as deputies. The State Duma replaced the Supreme Soviet as a result of the new constitution introduced by Boris Yeltsin in the aftermath of the Russian constitutional crisis of 1993, and approved by the Russian public in a referendum.

*The World Bank ( formally established on December 27, 1945 ) is an internationally supported bank that provides loans to developing countries for development programs with the stated goal of reducing poverty.

*The International Monetary Fund (IMF) is an international organization that oversees the global financial system by observing exchange rates and balance of payments, as well as offering financial and technical assistance. Its headquarters are located in Washington, D.C., USA.

The International Monetary Fund (IMF) was conceived in 1944, with a goal to stabilize exchange rates and supervise the reconstruction of the world’s international payment system. Countries contributed to a pool which could be borrowed from, on a temporary basis, by countries with payment imbalances.