The Russian Financial Crisis of 1998

The Russian Financial Crisis of 1998

The 1990s in the history of our country has become the time of serious trials. No wonder they are still marked as “The Wild and Evil ’90s” and simultaneously known under other epithets in regard to that period. The logical conclusion of the epoch became the financial crisis in Russia in 1998, briefly called default.

The so-called technical (situational) default broke out on August 17, 1998. The people are still remembering how exactly 3 days before that event none other than the President of Russia Boris Yeltsin assured citizens that the situation was under control, and the devaluation of ruble was not even possible. What happened was another powerful blow to the image of the government and the President himself; ultimately, it significantly contributed to the change of the power.

Understanding the terminology.

The Russian Financial Crisis of 1998

What is crisis? The term derives from the Greek «turning point». This is kind of transitional state, a turning point when the usual methods of management don’t work. The economic and social processes in the society are most frequently exacerbated to the limit in crisis situations.

Default is a crisis that, first and foremost, is connected with insolvency and non-performing debt. It can be:

— corporate;
— banking;
— national (sovereign).

In the case of the Russian financial crisis of 1998, we are dealing with a sovereign default. Why is it also called technical? The reason is that, fortunately, it didn’t become comprehensive and fatal but temporary and quite local. It was explained by concrete reasons that were possible to cope with.

Announcing the technical default on August 17, the Central Bank and the Cabinet of Ministers explained what it meant. First of all, the government recognized its inability to pay the domestic debt, in other words, obligations related to payments on the debt securities. The government uses such securities as loan securities, bonds, Treasury bills in order to attract funds for the development of the economy and the fulfillment of social obligations. And at the same time it regularly repays its creditors. When the state cannot repay neither interests nor the main debt, this is a technical default in a classical form.

The peculiarity of the moment laid in the situation that developed for the first time in the modern history. Never before has any country refused, albeit temporarily, to service domestic debt in national currency.

Did the default creep up unnoticed? The background of the problem.

Crisis is a frequent phenomenon, from time to time the planet is shaken by local and global financial and economic crises. They don’t arise out of nowhere, the causes and prerequisites of cataclysms usually ripen for years and even decades.

During the entire period of the 1990s, the economy of the country was choking on the budget deficit. 5-8% of the country’s GDP was the usual size of the income and the expenditure imbalance. In order to patch that budged hole, there was created GKO – Gosudarstvennoye Kratkosrochnoye Obyazatyelstvo. The Ministry of Finance first released it in May 1993.

The Russian Financial Crisis of 1998

On the eve of the crisis, these securities had a good yield: about 140% per annum. The problem was that the profitability was achieved not by investing in the economy or output but by banal speculations. GKO turned into a kind of financial pyramid, which, without a solid economic foundation, was bound to collapse.

Domestic debt by the beginning of the Russian financial crisis of 1998 amounted to $200 billion. The government also borrowed money outside the country, hence there was a parallel growth of sovereign external debt. At that time, it reached a huge amount of $150 billion. Then, our current international reserves were estimated at $12,5 billion for comparison.

The root of the problem grew out of the sluggishness of the Soviet economy, but in the 90s the increase of crises phenomena became especially noticeable. The collapse of USSR had the most negative impact on the overall state of the economy. In the same 1991, there was held Pavlovskaya financial reform that severely hit the purses of ordinary Russian and almost deprived them of bank savings.

Then, there was 1994 with its “black Tuesday”. The government decided not to credit the budget deficit anymore. The attempt to reform the tax system failed: most of the country’s economy remained “in the shadows”.

The situation has worsened in 1995-96, when the tax collection was catastrophically low. In that years, the state had to increase the use of GKO, but the stagnation continued. In many factories, the salary wasn’t paid for several months, there were only rare advances like products or other goods. Barter began to replace cash settlements everywhere.

The risk factors that became the causes of the crisis.

Experts point out several objective and subjective reasons for the Russian financial crisis of 1998. External prerequisites were the situation with a significant drop in the cost of energy in the world markets (particularly in those years they remained the main item of our exports); in addition, there were exacerbated crises phenomena in the economy of Asian countries, and then around the world. One more reason for the default was the catastrophically increased sovereign debt.

The catalyst for the problem was the collapse of the USSR. As a result of this geopolitical catastrophe, the external debt of the government was hanged on Russia as the successor of the Union. The country didn’t have time to pay even interests on those obligations, the situation deteriorated with each passing day.

The main internal driving force of the crisis was the pyramid of GKO and failures in the economy as a whole. Those crises “bells” became apparent in the growth of non-payment from both the government, private companies and impoverished population.

The other side of the problem was the departure of many enterprises in the shadow business, using fraudulent schemes of activity, which significantly undermined the tax base of the budget. The government tried to get out of a tight spot by raising tax rates, but the collection of taxes only fell.

Speculators roamed the equity market and other sectors of activity. Plants, factories, small firms were being resold at ridiculous amounts, the level of production was constantly declining. The IMF and other international organizations, potential investors didn’t dare to invest money in a sinking country. Moreover, the world financial crisis had already spread around the planet.

The government made a fatal mistake, deciding that the country’s agriculture was too expensive. As a consequence, it was destroyed. About 60% percent of food in those years was imported from abroad, but it was a cheap production; therefore, the quality of it caused many complaints. Against the background of cheap import, domestic quality goods couldn’t stand the competition and went bankrupt. That concerned not only farmers but also industrial enterprises.

As a result, the country was overwhelmed by inflation, the government largely lost control of financial flows and the ruble exchange rate. Came to governance in mid-1998s, “reformers” such as Kiriyenko, Chubais, Nemtsov and their teams tried to settle distortions of cuts in the expenditure side of the budget. But it didn’t solve the problem but strengthened mistrust to the power. The country was living on the verge of food riots.

Chronology of events.

On August 5, 1998, the government, amid a shortage of domestic funds, went to an unprecedented increase in the limit of foreign borrowing. It was allowed to increase it from $6 billion to $14 billion. IBRD responded the next day. The bank allocated one and a half billion dollars for the systematic restructuring of industry and other sectors of the economy.

Russian securities, already weakly liquid, fell sharply in price on August 11. When on the exchanges, that fall of quotations reached the mark of 7.5% the trades were stopped. Banks began feverishly to buy up currency. By the evening of that day, some banking business sharks stopped operational activities. On August 12, the shortage of currency increased.

On August 13, 1998, there was a turning point in the history of the Russian financial crisis of 1998. The long-term credit rating of the Russian Federation was downgraded by several rating agencies, in other words, the international financial market reacted very negatively to the events in our country.

On August 14, the President Yeltsin made famous assurance regarding rumors about the upcoming devaluation of the ruble: “It will not be. No. Firmly and clearly”. At the time of this statement, the dollar was still uniquely low: 6 rubles 27 kopecks.

On August 17, Sergey Kiriyenko, the head of the Cabinet, said on behalf of the country’s leadership that payments of GKO, as well as their purchase and sale, are frozen (first for 3 months, and on August 19 that decision was extended indefinitely). That statement caused the collapse of the ruble: the dollar was worth 9,5 ruble, and on September 9 the price got closer to 21 rubles. It became impossible to receive bank deposits.

The Russian financial crisis of 1998, as usual, turned into a political one. On August 21, the State Duma demanded the resignation of the Cabinet. Yeltsin signed a decree on the 23rd. Viktor Chernomyrdin was appointed an acting head of government.

We must remember that those events were unfolding against the background of “act of denomination”, in other words, the exchange of money for banknotes of other nominal value. The denomination of banknotes, as well as the scale of prices, changed in the ratio of 1:1000. The corresponding decree was signed by the President since August 1997. The exchange of money directly and gradually went from the beginning of 1998. It was believed that the main exchange would take place during 1998, although officially it could be carried out until 2002.

What is the bottom line? Economic consequences of the crisis.

The devalued national currency gave a powerful impetus to the growth of inflation. The weak ruble also had other negative consequences: gross domestic product reduced by three times (down to $150 billion). For comparison, it is enough to say it was even slightly less than the GDP of Belgium. Production decreased even more, and there was a further decline in tax collection.

Summing up the main negative results of the Russian financial crisis of 1998, it is necessary to mention such figures: in 1998 alone, the Russian economy suffered losses of $96 billion. 19 billion of them were the losses of the country’s population, the rest is the losses of the budget, corporations and banks. A number of banks went bankrupt and were closed.

The country’s external debts rose to $220 billion, which is 5 times more than the annual income of Russia at that time (and almost half of GDP). If we add to this the domestic debt on government orders, wages and other expenses, we get the total debt of the government in the amount of double GDP. It is more than $300 billion in absolute figures. The export of capital abroad also increased. About 1,2 trillion dollars (8 GDP) went there.

Russian problems could not but affected the world processes. The global financial crisis became one of the phenomena interconnected with our default. Europe experienced a sharp increase in the cost of energy. Economic growth slowed even in the most prosperous countries in Europe and Asia.

Social upheavals.

The crisis and inflation led to the bankruptcy of a number of banks, and, as a result, many Russians simply left with nothing, losing their savings. Then the process was aggravated by the uncontrolled rise in prices. Only for 4 months of 1998 (August-December) the cost of food rose by 63%, other goods by 85%.

Delays in salaries, social benefits and pensions became commonplace, which led to a sudden drop in income and living conditions as a whole. The latter decreased about three times. Many lost jobs, unemployment became a national disaster: about 11,5% of the working-age population.

How the situation was remedied.

The default in Russia gave a fivefold devaluation of the ruble, which was stopped only in 2002. Since 2003, a slow strengthening of the ruble began. Partly, positive results were achieved due to changes in the external environment: oil prices began to grow again, the inflow of foreign capital into the country increased.

Within the country, reforms began with changes in the government. Sergei Stepashin was appointed the Minister of Interior Affairs, Igor Ivanov received the leadership of the Ministry of Foreign Affairs, Sergei Shoigu took the post of the Minister of Emergency Situations. Chernomyrdin worked at the head of the Cabinet for about a year, then, in August 1999 he was replaced by Vladimir Putin. And soon he replaced Yeltsin as the President.

Exchange rates somehow managed to stabilize by the end of September: a dollar was worth 15 rubles. The government introduced a floating rate, which was the only correct one in the market condition. Debts of GKO were restructured, which made it easier to pay off them in the future.

Another important measure of the new leadership was a moratorium on the payment of bank debts, it was 3 months. There was also a banking reform, a group of so-called system building (key) banks, to which the Central Bank issued stabilizing loans.

The bright side of the medal.

Philosophers insist that the crisis is not necessarily time of trials but also of new opportunities. The Russian financial crisis of 1998 is not an exception. Paradoxically, it gave a range of positive consequences.

The main one, according to analysts, was the reorientation of the country’s economy from the commodity market model to the diversified one. It was the start of diversification of the economy, a number of industries, such as chemical, forestry, building began to develop. There was even the revival of agriculture. With all these processes, the economy began to rise, which contributed to the solution of a number of social issues.

A range of export-oriented enterprises received a real short-term benefit from the default: the rapid rise of the dollar helped these plants to get out of debt for the purchase of raw materials, pay off employees on salary debts and even make a profit. These enterprises had an opportunity to be engaged in modernization of production and soon became flagships of our industry.

The Russians have become more balanced in building relationships with banks; and the banks, for its part, have built a system of deposit insurance (not without government intervention).

In the international arena, the government has managed to increase its credit rating and reduce the percentage of IMF loans. But the amounts of borrowed funds gradually began to curtail by seeking the reserves of growth within the country. The level of public debt has decreased to 13% of the country’s GDP. This is one of the best indicators in the world.