20th anniversary of Russia's 1998 default

Twenty years ago, on August 17, 1998, Russia announced a technical default on main types of sovereign debt securities to the amount about $72.7 million. 

The market reforms that were conducted after the break of the USSR led to hyperinflation and the economic collapse. In 1997, some exterior signs of stabilization emerged - inflation shrank to 10% (best indicator since 1991), the dollar rate stabilized in the range of 5,000-6,000 pre-redenominated rubles. In 1997, the national economy showed growth for the first time - by 1.4%. Despite these factors, the economy remained in a grave crisis, industries were not developing, the tax collection rate was low.

In an attempt to reduce inflation the Central Bank artificially maintained a higher ruble rate and abandoned the issue of money. This in particular led to irregularity of payments of pensions and salaries.

The government borrowed funds to finance the budget deficit. For this purpose the state used mainly federal loan bonds (OFZ) in particular state short term bonds (GKO). The state short term bonds were introduced in 1993 and in February 1996 the government allowed foreigners to buy them. These securities were a very risky financial instrument, the yield on them often exceeded 100% which made them attractive for investors. A buyer of GKO could fully pay off his investments in several months, provided that the situation on the market was good.

The volume of the government’s short-term liabilities grew from 76.6 trillion rubles in 1995 to 436 trillion rubles in 1997. At the same time, most of the funds raised from the sale of new bonds were used to pay off old ones. Prime Minister Yevgeny Primakov and head of the Central Bank Viktor Gerashchenko, who both took office in September 1998, admitted later that the GKO system actually functioned as a pyramid scheme. Investors who made money on GKOs transferred these funds abroad instead of financing the national economy.

By the early 1998, Russia's foreign debt had reached $182 bln (40% of GDP). Of this amount $167 bln fell to the share of the state. The government spent 30% of the federal budget to service the national debt, TASS recalls.

The crisis in the countries of South-Eastern Asia in mid-1997 fueled a sharp deterioration in the financial situation in Russia. It led to a decrease in foreign investment in the developing markets and a drop in demand for Russia’s short-term bonds. Besides that the early 1998 saw a collapse in energy prices: a barrel of Brent crude oil, that previously traded at $20, fell in price by a half. As a result the inflow of new investors in the Russian economy stopped and it became more difficult for the state to pay interest on the bonds that were issued earlier.

In this situation, some Russian and international economists began to talk about the inevitability of the devaluation of the ruble as one of the measures to combat the crisis. For example, the British financier George Soros proposed weakening the ruble by 15-20% and called on the IMF and the G7 to allocate $32 bln on assistance to Russia.

Sergey Kiriyenko who was appointed as Russia’s new Prime Minister on April 24, 1998, announced his intention to reduce state borrowings. At the same time, he vehemently rejected devaluation, because, according to him, the hard ruble was "the face of the country." Head of the Central Bank Sergei Dubinin upheld the same position.

In 1998, then Russia’s President Boris Yeltsin promised three times that there will be no devaluation: on May 28 at a meeting with the heads of television channels, on July 9 at a press conference in the Kremlin and August 14 talking to reporters at the airport of Veliky Novgorod.

By August 1998, the authorities had run out of resources to finance public debt and maintain the ruble. By that time the national debt totaled almost $200 billion (44% of GDP). Panic started to spread on the market, the yield on GKO bonds jumped to 140-190%. At that time, the dollar to ruble rate was 6.2 rubles.

The government and the Central Bank took extraordinary measures trying to stabilize the situation. On August 17, 1998, Kiriyenko announced the reforms to bring in order financial and budgetary policies. These measures actually meant a default on the main types of government debt and devaluation.

In particular, the Russian authorities suspended fulfillment of obligations to non-residents on loans, transactions in the futures market and on collateral transactions for 90 days. The government decided to revise the terms of servicing the debt on short-term bonds, which at the time was $72.7 bln. The purchase and sale of GKO bonds was halted.

At the same time, the government refused to maintain a stable ruble exchange rate against the dollar, which led to its devaluation. The Central Bank announced transition to a floating exchange rate of the national currency within the new "currency corridor." The borders of this corridor were sharply expanded (to 6 - 9.5 rubles per dollar).

On August 23, 1998, Yeltsin signed a decree dismissing Kiriyenko from the post of Prime Minister. He appointed former Prime Minister Viktor Chernomyrdin as an acting Prime Minister. But the State Duma, lower house of parliament, did not support the return of Chernomyrdin. On September 11, 1998, Yevgeny Primakov became the new head of the Russian government. On the same day head of the Central Bank Sergey Dubinin resigned and was replaced by Viktor Gerashchenko.

On August 17, right after the publication of the government's decree, exchange offices stopped selling currency. The ruble rate depreciated three times on the stock exchange. On September 8, the Bank of Russia lowered the rate to 20 rubles to the dollar. After that, the national currency strengthened to 8 rubles (on September 15, 1998), but then plummeted again to 20 rubles to the dollar in December 1998 and 25 rubles in April 1999.

The default led to the collapse of large banks that had invested in GKO bonds such as Inkombank, Mosbusinessbank, SBS-Agro, Most-Bank, etc. According to estimates of the Institute for the Economy in Transition, these banks held from 37% to 68% of all deposits of the county's population.

According to the calculations of the Moscow Banking Union, the losses the Russian economy suffered due to the crisis of August 1998 amounted to $96 bln. In particular, the corporate sector lost more than $30 bln, while the population lost $19 bln. Direct losses of commercial banks amounted to $45 bln. Russia’s GDP fell by a half from $404.9 bln in 1997 to $195.9 bln in 1999. By the end of 1998, inflation leapt from 11% to 84.5%. The crisis undermined the trust of Russian citizens and foreign investors in Russian banks and the national currency.

Despite the devastating consequences of the default, the devaluation of the ruble helped the Russian economy become more competitive. A sharp decline in imports pushed the development of domestic production expanding opportunities for exports. The government took measures to improve collection of taxes, in particular, in 2001 it set a flat schedule of personal income tax for individuals at 13%.

The collapse of the so-called "GKO pyramid" contributed to the improvement of the financial sector. In the 2000s, Russia significantly reduced its national debt (since 2007 it has not exceeded $70 bln or 5% of GDP). The government created a system of stabilization funds. In 2003, the Deposit Insurance Agency was established to preserve the deposits of individuals.

Ex-Chairman of the Bank of Russia Sergei Dubinin (from November 22, 1995 to September 11, 1998) said that default does not threaten Russia at present in any form and the Russian economy has absolutely nothing similar to developments occurred in 1990s.

"We have no significant sovereign debt, particularly the short-term, domestic one. Default does not pose a threat to us in any way. The Russian sovereign debt on the whole, including the international one, is less than 20% of GDP. It is balanced by currencies," TASS cited the ex-official as saying. "The floating exchange rate is a very good tool that does not give any promises to pay debts at a fixed rate. Nobody expects this. The banking system is relatively stable in this regard."

He noted that the global economy at present hardly faces a crisis of a scale occurred in 2008-2009.

"We are more likely to see higher frequency of financial crises without transition to a severe stagnation. Frankly speaking, I do not think that the crisis of the scale in 2008-2009 threatens the global system. It has adapted to challenges it faces," Dubinin added.

The professor at the department of the stock market and investments at the Higher School of Economics, Alexander Abramov, speaking with Vestnik Kavkaza, noted that avoidance of the 1998 default could have been possible only if the government and the Central Bank had pursued a more coherent economic policy, which was unlikely at that time.

According to him, important lessons were learned from those events. "The government began to pay more attention to the accumulation of foreign exchange reserves, decisions at the level of the government and the Central Bank became more coordinated and informed. I think that the government's actions are quite consistent even now, during the current complicated era of sanctions," the expert said.

"But in order to avoid such defaults, we need constant economic reforms, we need to change the structure of the economy, which, unfortunately, is currently being done to a lesser extent," the professor at the department of the stock market and investments at the Higher School of Economics complained.

Nevertheless, according to the expert, the repetition of the 1998 default will not happen in the country. "Then the country had less than $15 billion of foreign exchange reserves, now this amount is close to $0.5 trillion. I think that the most painful point in Russia is devaluation risks. Unfortunately, we have not eliminated the factors that caused it, we haven't  managed to diversify the economy. When inflow of currency to the country depends on  prices of external energy resources, then serious devaluation risks remain," Alexander Abramov concluded.

The advisor on macroeconomics to the CEO of the 'Opening-Broker' brokerage house, economist Sergey Hestanov, in turn, recalled that the government's mistakes, which led to the default, were made long before August 1998. "In fact, the default was caused by the combination of two factors - the artificially maintained ruble exchange rate and the budget deficit financed by borrowing. That is, specific persons or decisions were insignificant here, since the government's overall financial strategy was catastrophic," he pointed out.

At the same time, the default was not exceptionally negative for the Russian economy. "First, it clearly demonstrated the harmfulness of the fixed ruble rate, because if the ruble was not fixed, it would smoothly devalue and no default would happen. Second, it pushed the government to take a more responsible approach to the forming of the budget. There was a powerful import substitution in many sectors, the competitiveness of Russian exports increased sharply. After the weakening of the ruble, salaries of oilmen, gas workers, metallurgists, and petrochemists increased, which caused the economic growth, which have continued in the country until 2012 with a break in 2008-2009," the economist said.

"Today, such a 1998 default is highly unlikely. But it does not mean that default in the popular understanding is impossible, such as a severe economic recession and a decline in the standard of living . Now any external shock, including falling oil prices and strengthening of the sanctions pressure, can cause a noticeable decrease in people's incomes, although formally it will not be considered a default," Sergey Hestanov concluded.