The Russian Crisis 1998

Economic Report
Other authors

In 1997, Russia’s economic growth was positive for the first time since the formation of the Russian Federation
in 1991. Nevertheless, the country’s fixed exchange rate regime together with its fragile fiscal position
appeared to be unsustainable when the international markets got affected by spillover effects of financial
distress elsewhere in the world. In the course of 1998, the outbreak of a severe banking, currency and
sovereign debt crisis could not be prevented.

Author: Iris van de Wiel

Point of no return
August 13th, 1998
The Russian stock, bond and currency markets collapse as a result of fears for a ruble devaluation and a default
on domestic debt. These fears had arisen during the previous months due to ongoing interest rate rises, capital
outflows and the corresponding erosion of investor confidence in emerging markets. Annual yields on ruble‐
denominated bonds rise to more than 200%. Furthermore, the stock market is closed down for 35 minutes
when stock prices fall sharply. Stocks have lost more than 75% of their value since the beginning of the year

August 17th, 1998

The government announces a set of emergency measures in order to prevent a further escalation of the crisis:
• A significant devaluation of the ruble; the bounds of the corridor in which the ruble is allowed to
fluctuate are widened from 5.27‐7.13 to 6.00‐9.50 ruble to the US Dollar;
• A default on short‐term Treasury Bills known as GKOs, as well as longer‐dated ruble denominated
bonds named OFZs;
• A 90‐day moratorium on payments by commercial banks to foreign creditors.

September 2nd, 1998

The Russian Central Bank’s decides to remove the currency corridor and makes the ruble a freely floating
currency. The ruble soon starts to depreciate sharply; in 3 weeks the currency loses two thirds of its value. The
strong depreciation results in sharp price increases. Inflation rises to 27.6% in 1998 and 85.7% in 1999. As a
result of food price increases, social unrest grows and citizens start to demonstrate in various cities.

Figure 1: Reserves and the exchange rate

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Source: World Bank

November 20th, 1998

The Russian Deputy Minister of Finance Mikhail Kasyanov declares the country would be able to repay less
than USD 10bn of its USD 17bn foreign debt. In the following weeks, Russian bank deposits decrease by 15%
compared to August 1998.

Aftermath
The Russian economy contracts by 5.3% in 1998. GDP per capita even reaches its lowest level since the
formation of the Russian Federation in 1991 ﴾see Figure 2﴿. Sovereign debt restructurings take place in 1999
and 2000. An IMF agreement of USD 4.5bn, concluded in July 1999, is meant to help Russia to regain access to
the international financial markets access. However, allegations of irregularities in the banking sector again
have a negative impact on the country’s financial market access and government bond yields remain high
during the course of 1999. Nevertheless, thanks to both the sharp depreciation of the ruble, which continues in
1999, and an increase of international oil prices, the Russian economy recovers rather quickly and grows by
6.4% in 1999, 10% in 2000 and 5.3% in 2001. Meanwhile, inflation falls from 85.7% in 1999 to 20.8% in 2001
and 21.5% in 2001. The unemployment rate, which was 13% in 1998 and 1999, decreases to 9% in 2001.

Figure 2: GDP Growth

Source: World Bank

Although Russia accounts for only 4.2% of world GDP in 1997, the outbreak of the Russian crisis and the
following sovereign default shock global financial markets for two main reasons. First, among the emerging
markets, Russia is a major borrower of short‐term capital. Second, the outbreak of the Russian crisis

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emphasizes the economic and financial fragility of emerging markets. At the time Russia’s sovereign default is
the largest in history. As a result of the Russian crisis, spreads on sovereign bonds in other emerging markets
and on long‐term corporate bonds in industrial countries rise substantially. The financial havoc has a large
impact on the global financial markets and contributes to the collapse of hedge fund LTCM, which requires a
USD 3.6 bailout.

Economic History
The Russian crisis took place in the first decade of Russia’s transition from communism to a free market
economy. The Soviet Union, of which Russia was the most important member, had a centrally planned
economy, with a corresponding fixed‐price system, full employment and small income differences. In the first
five decades of its existence the Soviet Union experienced rapid industrialization and high economic growth,
at least according to official statistics. However, in the 1970s, a long period of stagnation began, as the Soviet
economy proved to be unable to innovate and the high expenditures on defense placed a heavy burden on
the government budget. Mikhail Gorbachev’s reform policies, glasnost, perestroika, uskoreniye and
demokratizatsiya, could not break this trend. Instead, these policies even contributed to the end of
communism. The dissolution of the Soviet Union followed in 1991. This preluded a complete overhaul of the
economic system. The economic team of new President Boris Yeltsin, thoroughly reformed the economy. Large
parts of the economy that were previously in government hands were privatized. However, due to the lack of
strong institutions the rule of law was weak and large parts of the economy came under the control of
oligarchs. Russia’s transition to a market economy was a very painful one; in the years after the
implementation of President Yeltsin’s reforms, investment collapsed, GDP started to decline sharply, income
inequality increased rapidly, and poverty became widespread. Meanwhile, hyperinflation, resulting from the
Russian Central Bank’s ﴾CBR﴿ loose monetary policy, increased to 874% in 1993.

1994 – 1996
Reform and rising optimism
In 1994, Russia adopted a stabilization program to lower the inflation towards single digits again. The main
element of this stabilization program was a currency peg. The ruble was from then on allowed to fluctuate
within a narrow band around 5 ruble per one US Dollar. Furthermore, the program aimed at reducing Russia’s
fiscal deficit to less than 3% of GDP by 1998. As a result of the stabilization plan, inflation fell from 197% in
1995 to 47.7% in 1996 and 14% in 1997. Russia’s fiscal deficit also fell significantly, from 11% of GDP in 1994
to less than 5% of GDP in 1995. Meanwhile, the contraction of the economy slowly came to an end; GDP
growth, which had been negative since 1991, rose from ‐12.6% in 1994, to ‐4.1% in 1995 and to ‐3.6% in 1996.
It even became positive in 1997, as the economy grew by 1.4% that year.

Next to the stabilization program, several other factors contributed to the rising optimism as well:

In 1993, a market for ruble‐denominated government bonds, called the GKO, was installed. This provided
the government with an extra, non‐inflationary means to finance its budget deficit.
Both the World Bank and the International Monetary Fund ﴾IMF﴿ supported the Russian economy by giving
financial aid, which demonstrated the improving relations with the West. Furthermore, the willingness of the
government to enter negotiations about a payment rescheduling of the former Soviet Union debt in April
1996 had a positive impact on investor confidence;
The international price of oil, Russia’s main export product, started to recover.

As a result of the positive economic developments, market sentiment turned positive. This coincided with a
relaxation in restrictions on foreign portfolio investment. In the beginning of 1997, foreigners got access to

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the GKO market. Foreign investors reacted enthusiastically and foreign portfolio inflows rose sharply in the
first quarter of 1997. Furthermore, Russia’s credit rating improved, which allowed the country to borrow less
expensively. Meanwhile, the gross reserves rose from USD15.3bn in 1996 to USD24.5bn in mid‐1997.

1997 – 1998
Asian Crisis
However, in the fourth quarter of 1997, market sentiment deteriorated drastically as a result of the Asian crisis
that had started with the collapse of the Thai baht in July 1997 and soon spread to several Asian countries. In
November 1997, soon after the outbreak of the Asian crisis, the Russian ruble came under speculative attack.
The Central Bank of Russia defended the value of the currency and lost nearly USD 6bn in foreign exchange
reserves, which dropped from USD 23.1bn in the third quarter of 1997 to USD 17.8bn in the fourth quarter of
that same year. World commodity prices started to drop as a result of the turmoil. Together with a decrease in
the demand for nonferrous metals, an oil price drop severely affected Russia’s budget deficit and also its
current account balance, which ran into deficit in the second quarter of 1997.

Domestic weaknesses
As market sentiment worsened, investors began to realize that Russia’s fundamentals were weak. First, tax
collection in Russia was low and total government revenue was only 15% of GDP in 1997. The government was
thus not able to provide the necessary economic infrastructure, including transportation, energy and public
utilities. Furthermore, disagreement on the distribution of taxes arose between the various regions, as the
share of regional tax revenues had grown at the cost of the federal revenues. Recurrent attempts to improve
Russia’s overall tax collection only resulted in more tax evasion, capital flight, informal sector growth and
corruption. Furthermore, only 40% of the workforce was paid in full and on time. This proved the institutional
weakness of the Russian economic system, which directly resulted from the state’s weakness, in which public
goods as law, order and public health were hardly supplied. As a result, barter became an important part of
the Russian economy; estimates vary, though some argue that as much as 50 to 75% of exchange in industry
took the form of barter in 1997. Moreover, the first war in Chechnya, which cost approximately USD 5.5bn
placed a heavy burden on the government budget.

Meltdown
By mid‐1998, international liquidity was low and Russia’s current account balance further decreased to‐3.4% as
international oil prices continued to fall. In an attempt to support the ruble and reduce capital flight, interest
rates were hiked to 150% by the central bank. In July 1998, monthly interest payments on Russia’s debt rose to
an amount 40% higher than the country’s monthly tax collection. Debt could therefore only be financed by the
issuance of more debt. The subsequent parliamentary disapproval of an anti‐crisis plan completely eroded
investor confidence, which created strong downward pressure on the currency. Between October 1997 and
August 1998, the government is said to have spent USD 7bn of its USD reserves in order to maintain the
exchange rate regime. This could however not prevent the outbreak of the crisis in August 1998.

Effects on the banking sector

In December 1997, already several months before the actual collapse, the Russian banking sector got
confronted with fund withdrawals by depositors. Problems accelerated in the summer of 1998; even the state‐
owned Sberbank, which held 85% of total household deposits, was among the many banks that were affected.
The emergency measures announced on 17 August 1998 were put into place in order to halt the withdrawals.
However, the following sovereign debt default inflicted losses on Russia’s already weak banking sector.

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Furthermore, it required Sberbank to take over the deposits held by six large Moscow banks, which accounted
for 13% of total deposits. Sberbank and just a few other financial institutions received financial support from
the CBR. In the months following the crisis, a bank restructuring strategy was implemented, which resulted in
the closure of a large number of banks. Large numbers of deposit holders thereby lost their savings.
Furthermore, a new, core group of viable institutions had to be established. The impact of the collapse of the
banking sector on Russia’s corporate sector was rather limited, as the banking sector was not a major source of
finance for most companies. Furthermore, only a limited amount of firms had access to international
financing.

Concluding remarks
When investor confidence in emerging markets plummeted due to the Asian crisis, Russia’s weak domestic
fundamentals became more and more clear. Eventually, the currency overvaluation, low tax collection, weak
institutions, increasing reliance on short term foreign capital and the expensive first war in Chechnya caused
the outbreak of a severe currency, banking and sovereign debt crisis. The crisis resulted in a renewed strong
contraction of the economy and also affected investor confidence in emerging markets worldwide. Thanks to
both the depreciation of the ruble and the increase in international oil prices, the Russian economy was able to
recover rather quickly.

References
Araki, N. ﴾2001﴿, ‘Exchange Rate Policy of Russia: Lessons to learn from Russian experiences’, Economic and
Social Research Institute

Baig, T. & Goldfain, I. ﴾2000﴿, ‘The Russian Default and the Contagion to Brazil’, Washington: IMF

Chiodo, A.J. & Owyang, M.T. ﴾2002﴿, ‘A Case Study of a Currency Crisis: The Russian Default of 1998’, The
Federal Reserve Bank of St. Louis

Moody’s, ﴾2009﴿, ‘Emerging Market Corporate and Sub‐Sovereign Defaults and Sovereign Crises: Perspectives
on Country Risk’

Pinto, B. & Ulatov, S. ﴾2010﴿, ‘Financial Globalization and the Russian Crisis of 1998’, Washington: The World
Bank

Sutela, P. ﴾1999﴿, ‘The Financial Crisis in Russia’, Helsinki: Bank of Finland, BOFIT

Author﴾s﴿
Other authors
+31 30 21 62666
economics@rn.rabobank.nl

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