Russian Crisis of 1998 Year: Monetary and Financial Sector - Essay Example

RUSSIAN CRISIS OF 1998 YEAR: MONETARY/FINANCIAL SECTOR Introduction It is with no doubt that the Russian currency crisis of 1998 can be described as one of the worst crisis of all time. Chiodo and Owyang (2002) define currency crisis as a speculative attack on a country’s currency that can culminate in an involuntary devaluation and a likelihood of debt default. The currency crisis that occurred in Russia resulted to default on private and public debt as well as the devaluation of the ruble (Kharas et al., 2001). This situation synonymously referred to as ‘’the Russian meltdown,” “devaluation and default of August 1998,” and “Russia 1998.” Currency crises more often than not occur as a result of various economic conditions such as low foreign reserves or large deficits. This paper will mainly focus on monetary/financial sector during the Russian Crisis of 1998. There are three models that can lead to a speculative attack on the currency, which include the expectation of possible monetary and fiscal responses to awaiting crises. 2. Historical background Russia had just come from economic reform that had occurred for six years though this macroeconomic stabilization and privatization had experienced some inadequate accomplishment. August 1998 was the first time Russia was making its first positive economic development and growth from the time the Soviet Union fell. Hence, Russia declared a forced non-payment of its sovereign debt, devalue the rubble and force commercial banks to deter payments to foreign creditors. One of the puzzling questions is what then triggered the Russian economy to experience such tremendous financial crisis despite all the efforts put in place? Devaluation and default of August 1998 is a case of financial globalization that can be associated with a crisis in an emerging market instead of better allocation of resources and enhanced growth. The rubble was announced by the government on August 17, 1998, and embarked on restructuring of its rubble debt falling towards the end of 1999. The face value was estimated to be worth $45 billion before the crisis’ exchange rate. The government declared a 90-day moratorium in regards to the settlement of private external debt. This strategy didnt help since the biggest banks in Moscow collapsed, and this prompted an advisory to depositors to transfer their deposits to government owned saving banks such as Sberbank. The following table indicated in Appendix 1 shows situation as it was in Russia from 1996-1998, and what occurred after the crisis 3. The optimism of the Russian reforms This started at a time when the Russian authority were trying to recover the payment of a debt that was solely acquired from the previous Soviet Union. Towards the beginning of the year 1997, there was positivity in relation to the restoration of the economic stability. Surplus of trade seems to be moving towards a balance between import and exports as indicate in Figure 1 below; Figure 1 At this time, the Western had a good relation with Russia, and they thought they could bail them out. The World Bank willing to offer financial assistance to Russia of around $2 and $3 billion per annum. Inflation was an a decline trend, and it fallen 131% in 1995 to 11% (see Figure 2 Figure 2 Source IMF Russia was permitted to join the Paris Club of creditor nations after reorganizing the payment of $60 billion in the preceding Soviet Union in September 1997. Another agreement with the London Club after one month for $23 billion was signed, which analysts had predicted it would improve the country’s credit ratings. By late 1997, 30% of GKO was held by non-resident. That year the Russian economic had grown by 0.8%. 4. Revenue, Investment, and Debt Despite these efforts to revive the economy, the problem continued to persist, and something like real wage continued to less than half of with they were in full and on time. Direct foreign investment continued to be less, and it became difficult to regulate natural monopolies, which was as a result of Russia’s unrest of the lower house (Duma). Another challenge the government of Russia experienced is difficulty in collection of tax, which prompted the public deficit to remain high. The only primary source of tax shared was from regional and federal government. According to Shleifer and Treisman (2000) this form of tax sharing could result in a conflict of interest between the local and national government. A justification as to why the federal government was experiencing a decline in tax collection. The method in which Paris Club recognized Russia as creditor nation was questionable in terms of qualification. Some of the assets that were presumed to be held by Russia were jointly owned former Soviet Union and countries like Cuba and Monrovia. Russia continued to anticipate growth that made their debt grow. 5. Liquidity, Fiscal Policy and Monetary Policy Government bond yield began to swell on May 18 to about 47% while inflation stood at about 10%. A condition that could prompt the Russian banks to take this papers with the high interest but lacked confidence as they vied the federal government lacked the ability to repay the bonds with a restricted liquidity. Investors and depositors were very cautious about risk, and this made commercial banks have less cash to keep them afloat. Most of the firm’s liquidity was reduced due to the government’s efforts to increase collection of more cash (Malleret et al., 1999). The system that the federal government had adopted in 1997, which means saving more money but decreased circulation of money reduced liquidity. Liquidity in the country was also reduced by households who accounted for only 1.3 billion in 1998 as compared 29.8 in 1997. The CBR considered increasing the lending rate to banks from 30% to 50%, which prompted to spending of $ 1 billion of Russia’s reserve to defend the ruble (see figure 3). Figure 3 Source CBR Oil prices continued to decrease, and this time one barrel was costing $ 11 per barrel, which was 50% less what had been costing. Gas oligarchs and oil prices were pushing the devaluation of the ruble, which would consequently increase the ruble value of export. This scenario forced the CBR to push the lending rates once again to 150%. This crisis was too much, and the government opted for a bailout from the West, and also began bankruptcy process against three companies that had huge debts from tax trails (Popov, 2000). Political authorities and other financial experts met to formulate the way forward. The efforts by the government seemed effortless since there was about 2-3 billion that Foreign investors lent Russian corporations. Consequently, during September there appeared to be a maturity of futures. July IMF agreed to offer the country additional $ 11.2 billion, of which $4.8 was to be dispatched immediately (Chiodo and Owyang, 2002). The assistance from IMF could not rescue Russia since the country had lost so much in Liquidity in preceding months. 6. Default and devaluation On August 13, 1998 the Russian stock, currency market, and bond collapsed due to investors’ fear that the government would default on domestic debt, devalue the ruble or both. The Russian stock market was reported to have been closed for 35 years as prices fell. When the market closed, it was reported to be less 65%, and a tiny number of shares traded that particular day. The stock market had lost about 75% of its value from January to August and 39% in the month of May alone. The following figure (4) shows Russians stock market’s boom and smashed. Figure 4 SOURCE: http://red-stars.com/financial. The exchange rate was floated by the government on august 17, defaulted on its domestic debt, devalued the ruble, GKOs were dismissed, and then declared a 90-day moratorium on payment by commercial banks to foreign creditors. 7. Conclusion The exchange rate was floated by the government on August 17, defaulted on its domestic debt, devalued the ruble, and GKOs dismissed. Finally, a 90-day moratorium on payment by commercial banks to foreign creditors was declared. Russia ended the year with a decrease of 4.9% in real out, which was not expected. As indicated in Figure 1, there was a decrease in imports and increase exports that prompted the caused the ruble to collapse. These theories discussed above explains the Russian crisis in depth from the financial and monetary perspective. The four major factors that can explain the speculative attack according to Chiodo and Owyang (2002) include: 1. An exchange rate peg and a central bank responsible for defending it with a reserve of foreign currency. 2. An Increase in fiscal deficits was prompting the government to monetize money. 3. The control of interest rates by the central bank, where the credit market are delicate. 4. Future expectations of rise in inflation or devaluation References Chiodo, A., & Owyang, M. T. (2002). A case study of a currency crisis: The Russian default of 1998. Federal Reserve Bank of St. Louis Review, 84(November/December 2002). Kharas, Homi, Brian Pinto, and Sergei Ulatov. 2001. “An Analysis of Russia’s 1998 Meltdown.” Krugman, Paul. “A Model of Balance-of-Payment Crises.” Journal of Money, Credit, and Banking, August 1979, 11(3), pp. 311-25. Malleret, T., Orlova, N., & Romanov, V. (1999). What loaded and triggered the Russian crisis? Post-Soviet Affairs, 15(2), 107-129. Pinto, B., & Ulatov, S. (2010). Financial globalization and the Russian crisis of 1998. Popov, V. (2000). Lessons of the Currency Crisis in Russia and in other Countries. Problems of Economic Transition, 43(1), 45-73. Shleifer, Andre and Treisman, Daniel. Without A Map: Political Tactics and Economic Reform in Russia. Cambridge, MA: MIT Press, 2000. Appendix 1 adapted from Chiodo and Owyang (2002) A TIMELINE of RUSSIAN EVENTS April 1996 1997 Negotiations with the Paris and London Clubs for repayment of Soviet debt begin. Trade surplus moving toward balance. Inflation around 11 percent. Oil selling at $23/barrel. Analysts predict better credit ratings for Russia. Russian banks increase foreign liabilities. Real wages sagging. Only 40 percent of workforce being paid fully and on time. Public-sector deficit high. September/October 1997 Negotiations with Paris and London Clubs completed. November 11, 1997 Asian crisis causes a speculative attack on the ruble. CBR defends the ruble, losing $6 billion. December 1997 Year ends with 0.8 percent growth. Prices of oil and nonferrous metal begin to drop. February 1998 New tax code submitted to the Duma. IMF funds requested March 23, 1998 Yelstin fires entire government and appoints Kiriyenko. Continued requests for IMF funds. April 1998 Another speculative attack on the ruble. April 24, 1998 Duma finally confirms Kiriyenko’s appointment Early May 1998 Dubinin warns government ministers of impending debt crisis, with reporters in the audience. Kiriyenko calls the Russian government “quite poor.” May 19, 1998 CBR increases lending rate from 30 percent to 50 percent and defends the ruble with $1 billion Mid May 1998 Lawrence Summers not granted audience with Kiriyenko. Oil prices continue to decrease. Oil and gas oligarchs advocate devaluation of ruble to increase value of their exports. May 23, 1998 IMF leaves Russia without agreement on austerity plan. May 27, 1998 CBR increases the lending rate again to 150 percent. Summer 1998 Russian government formulates and advertises anti-crisis plan. July 20, 1998 IMF approves an emergency aid package (first disbursement to be $4.8 billion). August 13, 1998 Russian stock, bond, and currency markets weaken as a result of investor fears of devaluation; prices diminish. August 17, 1998 Russian government devalues the ruble, defaults on domestic debt, and declares a moratorium on payment to foreign creditors. August 23-24, 1998 Kiriyenko is fired. September 2, 1998 The ruble is floated. December 1998 Year ends with a decrease in real output of 4.9 percent. Note CBR, Central Bank of Russia Read More