RUSSIAN FINANCIAL CRISIS

Russian Financial Crisis 1998 | Kamran Shabbir

INTRODUCTION
The Russian financial crisis also called "Ruble crisis" or the "Russian Flu" hit
Russia in the year 1998. The Russian financial crisis took the world by
surprise and Russia was successful in fighting its inflation and was slowly
progressing as the GDP had turned into positive values and the prospects
very promising for the next year.
The meltdown of the Russian crisis of 1998 can be found in the Russia's
economic structure, internal environment and its political processes. Whilst
the crisis must be seen in the context of policy failures and abortive reform
efforts during the 1990s, its unfolding reflected mismanagement of the
opening of the country's financial markets to foreign lenders and investors
which left the country vulnerable to the risk that domestic financial
difficulties (such as those of the management of the market for government
debt instruments) could be transformed into a full-blown currency crisis.

Historical Background
The Russian Crisis of 1998 was triggered by overhauled peg of Russian
ruble, the external economic shocks of due to the Asian financial crisis of
1997/98 and the unsustainable accumulation of government debt. Though
these were the immediate causes for the Russian Crisis there were also
other factors that contributed to the crisis. Systemic weaknesses in the
Russian political economy were major causal factors that directly led to the
eventual crisis. The underlying weaknesses in the Russian banking system,
the power of the Financial Industrial Groups and the systems of tax
evasion, non-payments and arrears which all stemmed from the faculty and
the corrupt reform movement that characterized the break-up of the Soviet
Union and the collapse of the command economy lie at the heart of the
financial crisis and the endemic weaknesses in the Russian economy.
The process of economic transformation in Russia has been marked by a
prolonged transitional depression and macroeconomic instability: seven
years of continuing decline resulted in a cumulative drop of GDP by more
than 40% between 1989 and 1996; in that period there were also several
Russian Financial Crisis 1998 | Kamran Shabbir

outbursts of near- hyperinflation. The first radical effort to tackle inflation

was the IMF-supported stabilization programmed of 1995. It focused on tight
monetary control and nominal exchange rate targets; subsequently, direct
central bank financing of the budget was discontinued and the exchange rate
was placed under control. In the years that followed, Russia made marked
progress towards price and exchange rate stability and this prompted
positive expectations in the West and a widespread - but in the event
deceptive - perception that the country was pursuing the right course of
reforms.
There were numerous factors attributing to the decline in the GDP between
the 3rd quarter in 1997 and the 4th quarter of 1998:
The high government debt that Russia had to deal with following the collapse
of the Soviet Union, and the doubt that investors had to the ability of the
Russian government to be able to pay back their debt and not default
The decreasing oil prices also contributed to the deficiencies in GDP growth
as it lowered output this is due to the fact that Russia had to cut back on
its production of natural resources in order to maintain a level of profit in the
production of coal, oil, and natural gas
Furthermore, the Asian crisis caused speculation that like the Thai Baht, the
Ruble was also severely overvalued. The Central Bank of Russia tried to
defend the Ruble in the late fall, and on November 11, 1997, the CBR loses
$6 billion
Finally, the impending short-term debt that Russia owed to other foreign
countries in 1998 caused the sharp decrease in GDP in 1998.

Russian Financial Crisis 1998 | Kamran Shabbir

The fall of the Berlin Wall and the collapse of the Soviet empire were not
merely political events that marked the end of the nuclear standoff and the
arrival of democracy to the people of Eastern Europe.
The revolution in Russia was a peculiar phenomenon as the dissolution of
communism was an elite led project which involved the repudiation of an old
order without the turnover of power to a new elite backed by a fresh
ideological commitment. In Eastern Europe, the expulsion of Soviet troops
provided a rallying point for the people and a new ideological consensus
emerged which involved a removal of the old regime and the empowerment
of a new class of citizens backed by the masses. The physical change of
power and the rhetoric of liberation provided the political capital to the new
elites to embark on wholesale reform measures which transformed the
economic foundations of the state and engineered the creation of a new
political economic order based on Western principles of governance.
However, in Russia, these sweeping changes did not occur as quickly or as
thoroughly in the immediate years following the end of Soviet rule. There
was no public or elite consensus on the evils of the past as those in the elite
Soviet classes were the same elites still in power and the rhetoric of
liberation was ill suited to a Russian population who were the main
Russian Financial Crisis 1998 | Kamran Shabbir

perpetrators of the original conquests.

Economic Indicators
Since May 1998 Russia has experienced declining gross domestic product
(GDP), increasing inflation, increasing unemployment, and staggering
interest rates. These trends connote a halt to, and possibly a reversal of, the
progress, albeit limited, that Russia was finally making in establishing
sustainable economic growth and macroeconomic stability.

Falling GDP
Official Russian statistics estimate that the Russian real (adjusted for
inflation) GDP contracted 4.6% in 1998. This contraction occurred after the
Russian economy finally realized economic growth, although modest, of0.8%
in 1997, after having declined close to 40% since 1991. Russian GDP is
projected to drop even further in 1999.2 A contracting economy, especially
over a long period, leads to a deterioration in living standards.

Russian Financial Crisis 1998 | Kamran Shabbir

High Inflation
The Russian inflation rate in 1998, using the consumer price index, hit
84.4%. This figure appeared to be a significant setback for the Russian
economy which had realized a manageable inflation rate of 11% in 1997.3
High inflation rates (as high as 2,500% in 1992) had been a major challenge
to Russian economic policymakers ever since Russia embarked on economic
reform in late 1991, but they seemed to have gotten it under control until
recently. High inflation robs holders of rubles of potential purchasing power,
contributing to a decline in the living standard. Inflation is especially
debilitating financially to pensioners and others on fixed incomes.

The graph shows that inflation had fallen from 131% in 1995 to 22% in
1996 to 11% in 1997 and looked very promising for the next year.

Russian Financial Crisis 1998 | Kamran Shabbir

Rising Unemployment
Economic contraction has led to growing unemployment in Russia. By the
end of 1998, the Russian unemployment rate had reached close to 12%
having increased from 7.0% in 1994.5.
While the current crisis cannot be blamed entirely for the unemployment
problem, the decline in economic growth has set back attempts to reduce it.

High Interest Rates

For a critical period in 1998, Russian interest rates increased sharply as a
sign of loss of investor confidence. In May 1998, interest rates on GKOs, that
is Russian treasury bills used to finance government budget deficits, roughly
doubled from 27.8% the month before, to 54.8%. They continued to climb
and peaked at 135.3% in August 1998. Other critical interest rates also
climbed to very high levels. The Russian Central Bankss refinancing rate
spiked at 150% during the week of May 27 to June 4, 1998. While rates
have decreased they nevertheless remain high. High interest rates cripple
Russias ability to finance its government budget deficits and have stifled
investment in the non-government sector as well.

External Economic Indicators

In addition to (and related to) the deterioration in Russias domestic
economic conditions has been a worsening in a number of Russias external
economic indicators: exchange rates; foreign reserves; and trade. These
trends help to define the crisis.
7

Russian Financial Crisis 1998 | Kamran Shabbir

Fall in Value of the Ruble and Decline in

Foreign Reserves
The value of the ruble on foreign exchange markets plummeted. At the end
of July 1998, the exchange rate was $1=R6.235. By the end of August 1998
it had declined to $1=R7.905, a 21% depreciation. But by the end of
September the ruble had declined to $1= R16.064, a 61% depreciation in a
two month period. By early February 1999, the ruble stood at around
$1=23R. Commensurate with the sharp depreciation of the ruble has been
the decline in Russian government holdings of foreign reserves, including
foreign currencies. Until August 1998, the Russian government tried to
maintain a stable exchange rate for the ruble. But to do so required the
Russian Central Bank to sell foreign exchange for rubles when the ruble was
facing downward pressure. At the end of May 1998, the level of foreign
reserves stood at around $11 billion.7 The foreign reserves were augmented
in July by a $4.8 billion loan from the International Monetary Fund (IMF) but
have dropped since then. On August 26, the RCB announced that it
expended $8.8 billion over the last two months, $1.9 billion alone from
August 7 to August 14, in foreign reserves to defend the ruble. By the end of
November 1998, Russian foreign reserves were at $8.2 billion. Fall in Oil
Prices and Burgeoning Pressures on the Current Account. World prices for oil
and other raw materials have been declining, largely because of the Asian
crisis. Russia is heavily dependent on exports of these products for its
foreign reserves. In 1998, fuel, that is, crude oil and petroleum products
plus natural gas, accounted for 43% of Russian exports.10 On January 22,
1999, the price of Russian crude oil (Urals grade-32) was $11.20/barrel,
down from $15.79/barrel on January 1, 1998, and down from $22.85/barrel
on January 1, 1997.11
Due to the inefficiency in Russian energy production and transmission, the
current oil prices may be less than the average production costs for Russian
oil which underscore Russias need for foreign technology and investment to
boost productivity in the energy sector. The fall in oil prices has decreased
Russian export revenues causing the Russian current account to go from a
$3.9 billion surplus in 1997 to an estimated $4.5 billion deficit in 1998.

Russian Financial Crisis 1998 | Kamran Shabbir

Investor fears and worries severely weakened the Russian money markets
(stock, currency, and bond) this forced Russia to devalue the ruble, and
default on some risk, lowering prices and GDP further in 1998 and 1999.

Conclusion
The Russian Crisis of 1998 was mainly triggered due to Russias economic
structure, internal environment and its political processes. Russias 1998
failure was another instance of how financial globalization is related to the
crisis in an emerging market instead of better resource allocation and faster
growth. The crisis must be seen in the context of policy failures and abortive
reform efforts during the 1990s, its unfolding reflected mismanagement of
the opening of the country's financial markets to foreign lenders and
investors which left the country vulnerable to the risk that domestic financial
difficulties (such as those of the management of the market for government
debt instruments) could be transformed into a full-blown currency crisis.
Therefore, now the task of policy makers is to restore the financial stability
of Russia and reform its policies which will basically focus on building the
institutional framework for market based activity. Lessons from the Russian
crisis should not be restricted only to government's mismanagement of the
opening of its financial markets to foreign investors and lenders or the
vulnerabilities associated with reliance on capital inflows for financing fiscal
deficits but also irrational exuberance and herd behaviour of international
lenders and investors in entering as well as exiting emerging markets.
Russian crisis has once again emphasized the inadequacy of current
arrangements for dealing with global financial instability.
Russian Financial Crisis 1998 | Kamran Shabbir