A brief history of the Russian crisis

A brief history of the Russian crisis

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July–October 1997. The first signs of the Asian crisis appeared as speculative attacks against the currency of Thailand. Stabilization programs and defensive measures such as currency controls were adopted in this country. The crisis intensified as it spread first to other Asian countries – resulting in a series of stock market crashes – and then came to Russia. On 28 October the Russian stock market dropped by 20 per cent. Foreign investors became anxious and began to dispose of ruble assets. The Central Bank purchased large volumes of GKO (1.2 trillion rubles – the equivalent of $2 billion) to support the domestic debt market. Nevertheless, the monetary authorities were not ready to make a radical policy shift in order to adopt the standard anti-crisis measures. Instead, the CBR tried to compromise between defending the exchange rate regime and preventing hikes in interest rates. The opportunities of early defensive measures were lost, merely, for political reasons and because of the fear that clear-cut actions could amplify panic moods among foreign investors. The Central Bank tried to keep seriousness of the problem secret for as long as possible (Yasin 2002, p. 394).

November 1997. The massive speculative attack against the ruble on 11 November triggered by the Asian crisis forced the Central Bank to increase the refinancing rate from 21 to 28 per cent. The serious threat to financial stability was thereby made public. To defend the ruble, the CBR sold $6 billion – 33 per cent of its official foreign currency reserves. In November the purchases of GKO by the CBR nearly doubled, amounting to 31 trillion rubles (Alexashenko 1999, p. 126), the equivalent of $5 billion. These operations were aimed to meet the demand of investors that preferred to hold foreign currency. A decision to make the defence of the exchange rate regime a higher priority was confirmed ultimately by the Central Bank (under strong pressure from the IMF). In spite of this policy announcement, official GKO purchases continued, albeit at a lower level. The reshuffling of the cabinet that occurred in November (Batkibekov et al. 2003, p. 59) clearly signalled the unwillingness of the authorities to cope with structural reforms under the threat of financial meltdown.

December 1997. World oil, gas and metal prices dropped dramatically (the oil price fell to US$13 per barrel, as compared to US$19 per barrel at the beginning of 1997). Foreign investors began to reappraise the situation, and there was an intensification of the flight to quality. The average GKO yield increased from 18 per cent in October to 38 per cent, in spite of the massive purchases of the GKO by the CBR. The IMF approved about the granting of $57 billion of financial aid to South Korea. Negotiations between the Russian government and the IMF about additional loans to support financial stability failed because the Russian government rejected the recommended package of drastic fiscal measures.

January–February 1998. Financial crises occurred in Hong Kong, Indonesia, and Malaysia, and this induced a second speculative attack against the ruble. These events coincided with the dramatic shift of financial investors’ attitude to Russia and resulted in a sharp fall on the Russian stock market, which fell by 30 per cent. At the same time, the Central Bank of Russia removed three zeroes from the currency. This policy action was designed to demonstrate the triumph of the monetary stabilization of 1995–96 and the sustainability of the Central Bank’s currency policy (the decision to re-denominate the ruble was adopted in July 1997, at the very beginning of the Asian crisis).1 At the same time, the currency band was widened significantly and set at 6.1 rubles/ $±15 per cent to permit sufficient flexibility in the management of exchange rates. The new regime signaled the potential readiness of the CBR to allow for a greater flexibility of the exchange rate. Domestic financial markets were completely liberalized, thereby opening the economy to portfolio investment and speculative hot money. Negotiations with the IMF recommenced in February and at this time emerging funds were officially requested by the Russian authorities. As a positive step of the government, a new tax code was prepared and submitted to the Parliament.

March–April 1998. Viktor Chernomyrdin’s cabinet resigned unexpectedly, and the new prime minister was the relatively unknown Sergei Kiriyenko, appointed on 23 March. The resulting political uncer tainty had a very negative impact on subsequent events. One immediate consequence was that there was an intensification of attacks against the ruble, and the Central Bank continued to defend the currency. The Parliament confirmed Kiriyenko’s appointment on 24 April, after much confrontation and political bargaining. The new cabinet began to formulate its own policies and became familiarize with the macroeconomic situation. That required another couple of months. Surprisingly, the Russian financial markets settled down. In the first four months of 1998 the GKO annual rate stabilized below 30 per cent. This appeared relatively attractive for profit-seeking nonresident investors. The share of non-resident holdings in domestic debt outstanding grew again – to 28 per cent – by the end of April. The stimulus for this inflow from non-residents was created by the actions of the Russian authorities. These included the weakening of capital controls, the firm adherence of the Central Bank to support the exchange rate, the high rate of return on GKO, and new hopes around negotiations with the IMF.

May 1998. By the beginning of May information about the balance of payments of Russia in the first quarter of 1998 had become publicly available. The results turned out to be very disappointing and revealed fundamental flaws in the macroeconomic situation. A third large speculative attack on the ruble occurred on 14 May and this had a very strong destabilizing effect. On 15 May the Russian stock and debt markets fell dramatically, and the GKO yield began to rise, from 25–30 per cent at the end of April to 45 per cent. To protect the exchange rate regime, the CBR increased the refinancing rate from 30 to 50 per cent on 19 May on this single day it spent more than $1 billion of official reserves. These currency interventions turned out to be ineffective, and the refinancing rate was raised to the prohibitive level of 150 per cent on 27 May. This was the final attempt of the Central Bank to prevent the crisis through standard monetary instruments. The speculative attack was again beaten back for a while, but at the cost of a dramatic increase in interest rates.

June 1998. The Ministry of Finance failed to refinance its short-term debt because of the extremely high interest rate bids, which exceeded 50 per cent per annum. This implied an unsustainably large cost of debt servicing in subsequent months. Under such circumstances the Ministry of Finance rejected conducting the primary GKO auctions on 17 June. Instead, with no additional regular sources of budget incomes for the redemption of short-term debt, the Ministry of Finance began to borrow money from the Central Bank account. The CBR was the agent of the Ministry at the GKO auctions. The Ministry withdrew funds from the GKO account while the Central Bank had to replenish since no auction had taken place (Alexashenko 1999, p. 170). This ‘innovation’ meant a return to the direct crediting of the government by the Central Bank expressly forbidden by the law adopted in 1995. Excess ruble liquidity was immediately used by GKO investors for currency purchases that drained the official foreign reserves. The Central Bank tried to resist the actions of Minfin, but could not provide an effective solution to the problem of debt rollover. The CBR thus had no choice but to return to the monetization of the budget deficit, thus implying the failure of macroeconomic stabilization of the previous three years.

July 1998. The public mood concerning the macroeconomic situation improved temporarily as a result of the success of negotiations with the IMF on financial aid to Russia.2 On 13 July an assistance package totalling some $22.6 billion was announced by the IMF, the Bank of Japan and the World Bank. The announcement of this credit line gave rise to overoptimistic expectations that the Russian government could prevent the default on its debt and resulted in a temporary reduction of GKO yields. But the stabilizing effect on expectations was very soon eliminated by new information on fiscal policy failures. Preliminary data on the macroeconomic performance in the first half of 1998 showed a reduction of budget revenue of roughly 0.5 per cent of GDP. A further piece of bad news was that the financial package was granted to Russia in tranches that were conditional on the budget performance rather than the full amount that would have given the Russian authorities a good chance to defeat speculative attacks. The IMF adopted a compromise solution which sharply worsened the mood of the markets. Prime minister Kiriyenko focused on the preparation of a comprehensive stabilization program and its presentation to the State Duma, as required by the IMF conditionality. Financial markets meanwhile recognized that the true state of affairs had worsened substantially, and non-residents renewed the flight from the government papers. The first tranche of the assistance credit, some $4.8 billion, was used to defend the currency regime and disappeared in two weeks. The Ministry of Finance cancelled again the primary GKO auctions on 22 July because the interest rate bids were too high, and the government clearly could not service the new issues. The rejection by the government to sell GKO was anticipated as the beginning of systematic money emission for debt refinancing. Negotiations with the IMF about radical fiscal reform were close to deadlock.

August 1998. Major Russian banks began to face severe problems with refinancing foreign loans collateralized with government debt. The banks also had to fulfill repurchase agreements with foreign banks, and this prompted them to sell large volumes of GKO-OFZ. This, in turn, caused a downward spiral on the government debt markets, both domestic and external. As a result, the currency crisis turned into the final and most dangerous stage, when domestic depositors began to panic and convert ruble assets into the foreign currency cash. President Boris Yeltsin publicly promised on 12 August that the ruble devaluation would not occur, but this did not help.3 The crisis outcome was triggered by a provocative article written by the international investor George Soros published in the Financial Times on 13 August.4 The new attack on the ruble left the Russian monetary authorities no time for thorough thinking about emergency measures. The stock market crashed, the currency market collapsed and the annual GKO yields exceeded 200 per cent. On Sunday 15 August, the top officials from the Central Bank and the Ministry of Finance (Sergey Dubinin, Sergey Alexashenko, Alexander Potemkin, Mikhail Zadornov, and Oleg Vyugin) held urgent meetings with the leading economic reformers Yegor Gaidar and Anatoly Chubais at Sergey Kiriyenko’s dacha. As a result, they adopted an unexpectedly radical measure: simultaneous GKO default, the devaluation of the ruble and a 90-day moratorium on bank payments to foreign creditors. This decision was announced on 17 August, the day that went down in history as the date of the Russian financial crisis. The motivation for such drastic actions was the government’s inability to redeem its shortterm debt and refusals by major Russian banks to fulfill their payments to foreign creditors. The Kiriyenko cabinet resigned on 23 August, and the GKO restructuring scheme was adopted by the new cabinet.

September–October 1998. By the beginning of September the dollar exchange rate had exceeded the upper boundary of the initially announced band of 6–9.5 rubles/$. Foreign currency market failures and shortages manifested in liquidity constraints, long lines at retail currency exchanges, and even shadow currency trade. The foreign currency regime collapsed and the ruble was allowed to float on 2 September. In one week the ruble exchange rate fell from 10 rubles/$ to 21 rubles/$. The two largest private banks – SBS Agro and Inkombank – were placed by the CBR under temporary administration, indicating a severe banking crisis. Inflation began to spiral out of control: in September the CPI increased by 36 per cent. An abrupt reduction in the level of imports created shortages of goods in the shops. The economic situation was close to the disorganization and chaos that had characterized the beginning of the 1990s. Inflation induced by the ruble devaluation was intensified by the banking crisis which entailed a massive extension of liquidity to offset the liquidation of bank assets and the squeezing of real money. There was also a worsening of the political situation: Yeltsin nominated Chernomyrdin as the prime minister, but his candidate was not appointed by the State Duma. A liberal anti-crisis programme that included the introduction of a currency board and drastic fiscal measures failed to gain political support. The new pro-communist government, headed by Yevgeniy Primakov, did not have any distinct plans to cope with the crisis. Fortunately, this cabinet was careful enough to reject adopting the populist anti-market measures that relied on command controls.