the russian financial crisis- from crash to cash

Introduction

On the dawn of 17th August 1998, the Russian economy was at the brick of collapse. Soon after the east Asian crisis, the world saw another disastrous collapse of an entire economy. The perils of darkness for the Russian economy seemed darker because the severe impact of the East Asian crisis acted as a catalyst to the Russian financial crisis. Leading up to 1998, Russia had undergone various economic reforms, moreover, in 1997, Russia experienced growth for the first time since the dissolution of USSR. Following the East Asian Crisis, the Ruble was subject to a speculative attack and the Central Bank of Russia lost nearly $6 billion in foreign-exchange reserves in efforts to stabilise the Ruble. At the end of 1997, prices of non-ferrous metals and oil (to less than $11/barrel) began to drop. Investors’ confidence took a huge blow due to events like the appointment of Sergei Kiriyenko, expectations of devaluation of the Ruble and the failure of IMF to reach an agreement about austerity measures. The stock market collapsed on 13th August following a devaluation of the Ruble on 17th August.

Causes of the Crisis

In dissecting the current crisis and trying to explain the reasons it developed two sets of related causes. The most immediate and direct causes are the government’s financial imbalances and the Russian fiscal policies that have made Russia very vulnerable to the vagaries of the global financial markets.  From 1995 and until recently, the government had financed much of its budget deficit by borrowing in capital markets and issuing treasury bills, known by the Russian acronym GKOs, and bonds. On the upside, borrowing allowed the government to dramatically reduce inflation from a peak annual rate of 2,500% in 1992, to around 11% by the end of 1997. However, the low inflation rate was superficial given stating that the employees were not paid, and parts of the economy had increased bartering thereby relying on other nonmonetary means of payment such as interenterprise debt. On the downside, the Russian government had to offer high yields on its treasury bonds to attract necessary capital. As a result, the borrowing added a new and heavy debt service burden to the Russian budget. Debt service expenditures had accounted for more than 30% of total Russian expenditures.

The second and the more fundamental cause was based on the Tax regime and the Virtual Economy of Russia. The Russian tax regime as pointed out by many western creditors, was highly inefficient. It consisted of 200 different types of taxes at various levels of government making administration of the regime unduly burdensome. In addition to this the government granted tax exemption to favoured sectors and enterprises reducing their potential revenue. Other structural problems included the administrative relationship between the federal government in Moscow and the regional and local governments. 

Role of IMF

In the 1990s, Russia was one of the biggest borrowers from IMF, having borrowed approximately $20 billion to deal with the 1998 crisis. The IMF approved a loan of $11.2 billion to deal with the immediate effects of the crisis.  The conditions for Russia were framed so to promote a stable macroeconomic environment through low inflation and stable exchange rates of the Ruble, lowering of fiscal deficit, encouragement of savings and effective channelization of the same, regulation of the banking sector (specifically improving bankruptcy procedures, and liberalisation of the markets

Geopolitical Implications

The perception of many is that the IMF served as a linkage of the West to Russia. Since the US does hold a vast share of the votes in IMF and by far the greatest influence of all members, it is said the US attempted to further the cause of capitalism in Russia after the dissolution of the USSR. This was especially seen as a threat in a time after the Cold War. Rather than direct intervention by the United States, intervention through IMF would be less controversial. The Russian public would also not perceive IMF intervention as a threat to their sovereignty. Other countries feared than unstable domestic conditions would lead to political instability and Russia, being a nuclear superpower, that would have been dangerous. Therefore, they supported the transition to a market economy. The downfall of the Russian economy shows how deeply integrated the world economy had become. Falling oil prices (Russia’s largest export by value was oil) and the East Asian financial crisis served as triggers for the sharp depreciation of the Russian Ruble.

Recovery

The August 1998 devaluation represented a pure windfall for Russia’s raw materials exporters. The devaluation represented a massive, positive cash shock for these enterprises and for local economies based on them. As a result of the devaluation, tax revenue increased, and wage, pension, and tax arrears fell. The devaluation also had modest benefits for a small sector of the economy that gained a price advantage relative to imports. Another significant change that the Russian economy saw was a recovery in consumption and investment which was attributed to the growing positive sentiments of people. However, the question remains as to how long this positive trend can be sustained and how effective can it be in the long-term?

Conclusions

In conclusion, 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 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.

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