Default in Russia in 1998
After six years of economic reform in Russia, privatization and macroeconomic stabilization had experienced some limited success. Yet in August 1998, after recording its first year of positive economic growth since the fall of the Soviet Union, Russia was forced to default on its sovereign debt, devalue the ruble, and declare a suspension of payments by commercial banks to foreign creditors. What caused the Russian economy to face a financial crisis after so much had been accomplished?
1996 and 1997. Optimism and Reform. In April 1996, Russian officials began negotiations to reschedule the payment of foreign debt inherited from the former Soviet Union. The negotiations to repay its sovereign debt were a major step toward restoring investor confidence. On the surface, 1997 seemed poised to be a turning point toward economic stability.
• The trade surplus was moving toward a balance between exports and imports.
• Relations with the West were promising: the World Bank was prepared to provide expanded assistance of $2 to $3 billion per year and the International Monetary Fund (IMF) continued to meet with Russian officials and provide aid.
• Inflation had fallen from 131 percent in 1995 to 22 percent in 1996 and 11 percent in 1997
• Output was recovering slightly. A narrow exchange rate band was in place keeping the exchange rate between 5 and 6 rubles to the dollar.
• And oil, one of Russia’s largest exports, was selling at $23 per barrel—a high price by recent standards. (Fuels made up more than 45 percent of Russia’s main export commodities in 1997.)
In September 1997, Russia was allowed to join the Paris Club of creditor nations after rescheduling the payment of over $60 billion in old Soviet debt to other governments. Another agreement for a 23-year debt repayment of $33 billion was signed a month later with the London Club. Analysts predicted that Russia’s credit ratings would improve, allowing the country to borrow less expensively. Limitations on the purchase of government securities by nonresident investors were removed, promoting foreign investment in Russia. By late 1997, roughly 30 percent of the GKO (a short-term government bill) market was accounted for by nonresidents. The economic outlook appeared optimistic as Russia ended 1997 with reported economic growth of 0. 8 percent. Revenue, Investment, and Debt. Despite the prospects for optimism, problems remained. On average, real wages were less than half of what they were in 1991, and only about 40 percent of the work force was being paid in full and on time. Per capita direct foreign investment was low, and regu regulation of the natural monopolies was still difficult due to unrest in the Duma, Russia’s lower house of Parliament. Another weakness in the Russian economy was low tax collection, which caused the public sector deficit to remain high. The majority of tax revenues came from taxes that were shared between the regional and federal governments, which fostered competition among the different levels of government over the distribution.
According to Shleifer and Treisman (2000), this kind of tax sharing can result in conflicting incentives for regional governments and lead them to help firms conceal part of their taxable profit from the federal government in order to reduce the firms’ total tax payments. In return, the firm would then make transfers to the accommodating regional government. This, Shleifer and Treisman suggest, may explain why federal revenues dropped more rapidly than regional revenues. Also, the Paris Club’s recognition of Russia as a creditor nation was based upon questionable qualifications. One-fourth of the assets considered to belong to Russia were in the form of debt owed to the former Soviet Union by countries such as Cuba, Mongolia, and Vietnam. Recognition by the Paris Club was also based on the old, completely arbitrary official Soviet exchange rate of approximately 0. 6 rubles to the dollar (the market exchange rate at the time was between 5 and 6 rubles to the dollar).
The improved credit ratings Russia received from its Paris Club recognition were not based on an improved balance sheet. Despite this, restrictions were eased and lifted and Russian banks began borrowing more from foreign markets, increasing their foreign liabilities from 7 percent of their assets in 1994 to 17 percent in 1997. Meanwhile, Russia anticipated growing debt payments in the coming years when early credits from the IMF would come due. Policymakers faced decisions to decrease domestic borrowing and increase tax collection because interest payments were such a large percentage of the federal budget.
In October 1997, the Russian government was counting on 2 percent economic growth in 1998 to compensate for the debt growth. Unfortunately, events began to unfold that would further strain Russia’s economy; instead of growth in 1998, real GDP declined 4. 9 percent. The Asian Crisis. A few months earlier, in the summer of 1997, countries in the Pacific Rim experienced currency crises similar to the one that eventually affected Russia. In November 1997, after the onset of this East Asian crisis, the ruble came under speculative attack. The Central Bank of Russia (CBR) defended the currency, losing nearly $6 billion (U. S. dollars) in foreign-exchange reserves. At the same time, non-resident holders of short-term government bills (GKOs) signed forward contracts with the CBR to exchange rubles for foreign currency, which enabled them to hedge exchange rate risk in the interim period. 7 According to Desai (2000), they did this in anticipation of the ruble losing value, as Asian currencies had. Also, a substantial amount of the liabilities of large Russian commercial banks were off-balance-sheet, consisting mostly of forward contracts signed with foreign investors. ............
