Russia, 1998. What Went Wrong?

On the 13th of August, 1998, the stock, bond, and currency markets of a recently liberalised Russia collapsed. Confidence in the strength of the ruble and the Russian government plummeted. The stock market even closed for 35 minutes with stocks having lost 75% of their value since January of that year. 4 days later, Russia defaulted on their own state bonds and commercial banks declared a 90-day moratorium to foreign creditors. In this article, I will examine the events that led up to Russia’s currency and sovereign debt crisis, and how Russia was exceptionally susceptible to such a disaster.

Until the spill-over of the Asian crisis, market sentiment was positive. There was a growing enthusiasm about business opportunities in Russia. The country had grown accustomed to Boris Yeltsin’s shock therapy and neo-liberal reform. Inflation had fallen from 1995’s 131% to a more appealing 11% by 1997. The trade surplus was finally balancing out and the price of oil, which made up nearly half of Russia’s export revenue, had doubled in a year to $23 per barrel. The then deputy managing director of the IMF even claimed that Russia “has achieved macroeconomic stabilisation.” This prompted a further relaxation on foreign investment regulation, which would only aggravate the fallout that ensued. However, the collapse of the Thai baht in 1997 caused a worldwide flight from emerging markets as fearful investors sought to make up for losses in Asia with gains elsewhere. Events in the Pacific prompted a series of speculative attacks on the ruble (selling rubles, thereby depreciating the exchange rate), for fears of the Thai baht being only the first of many currencies to collapse. However, this attack was neutralised by the Central Bank of Russia (CBR). To maintain the currency peg that existed at the time, 5.27-7.13 rubles to the dollar, the CBR spent $6 billion in foreign-exchange reserves. Fatefully, this would prove a waste of much-needed reserves to prop up a currency destined for devaluation. To add fuel to the fire, capital inflows dropped by 280% going into Q4 of 1997 and oil prices fell dramatically, as a result of the global recession. This placed further pressure on the current account balance, as every dollar the oil prices fell, the Russian government lost roughly $1bn in revenue. These events were inevitable; the Asian crisis was merely the spark that lit the flame.

Russia’s predisposition to such a crisis was evident. Its own domestic fragility, once apparent to investors, would augment the negative sentiment caused by the Asian crisis. A fiscal imbalance and an inability to correct it meant the government was not able to counteract external shocks to its economy. The liberalisation and privatisation that had been deemed so successful had birthed several fatal flaws. Fundamental institutional reform of the tax system had been neglected by politicians. The government levied confiscatory marginal income tax rates which were changed erratically and enforced arbitrarily. This resulted in negligible tax revenue as very few people and businesses paid them. In most cases, the Russian economic system failed to even allow for the payment of taxes, as only 40% of the workforce was paid in full and on time. To further exacerbate the issue, the government had control over the oil and gas business (Gazprom), and therefore controlled its prices, inexorably reducing profits of such firms. However, due to the profitability of oil in Russia, these firms were among a select few who actually would have been able to pay taxes in full. In 1997 tax arrears reached 34% of tax collection, compared to 4-6% for Canada, USA and Australia. Such non-payments fed directly into the chronic tax deficiency, increasing the primary fiscal deficit and government borrowing. The extent to which this occurred is portrayed by (Pinto et al., 2010) who attribute 65% of new government borrowing from 1996-1997 to these tax arrears. To intensify the constraint on the budget deficit, Russia spent $5.5 billion on the first Chechen war, and a further $27 billion on maintaining its ‘floating peg policy’. This is the only solution to defending a currency under a fixed exchange rate regime, according to Krugman’s first-generation model (1979). To put the icing on a growing mountain of fiscal deficit and institutional failure, there is strong evidence to suggest that billions of dollars of IMF loans were either stolen or ‘lost’ by the Russian government during the years of the crisis.

The Russia case challenges economic orthodoxy with regard to globalisation. Financial globalisation was unequivocally a factor that enabled the unsustainable fundamentals which induce such a national crisis, instead of simply reducing costs as David Ricardo’s comparative advantage trade theory would lead us to believe. The financial liberalisation that followed the dissolution of the Soviet Union allowed for foreign involvement in the highly demanded GKO market, (short term government bonds). GKOs were initially offered in 1993 domestically, with inviting yields that would reach 260% in 1995. They were meant as a non-inflationary means of financing the government deficit, but would turn out to be a major source of the currency crisis that occurred. By 1997 a third of participation in the GKO market was foreign. This meant spill-overs from Asia in 1997, as investors exited the GKO market hurriedly, protracted the unsustainable fiscal position. Further, there was the paradoxical effect that financial speculation caused money from real sectors to be flooded into a market that was part of the government’s debt pyramid. A debt the government had little intention or ability to finance, given the moratorium and restructuring that followed soon after.

The crisis exposed the deep institutional flaws of a neo-liberal Russia, still dominated by the Nomenklatura. Also, it challenged the naïve assumptions of Russia’s transition and emphasised the economic fragility of emerging markets. The crisis demonstrated a clear miscalculation when opening Russia’s markets to foreign capital inflows, thus leaving the country vulnerable to the risk of domestic issues being exacerbated into a fully-fledged currency crisis. Moreover, this disaster highlights the irrational fervour and herd behaviour of foreign investors when entering and exiting emerging markets.

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