Working paper No.77

An Analysis of the Currency and Financial Crisis in Russia

by

Bolkhovitina Elena

Ministry of Economy of the Russian Federation

March 2000

Department of Research Cooperation Economic Research Institute

Economic Planning Agency Tokyo, Japan

Any opinions expressed here are those of the author and not

those of the institution to which the author belongs.

Ministry of Economy the Russian Federation

AN ANALYSIS OF THE CURRENCY AND FINANCIAL CRISIS IN RUSSIA

Prepared by Bolkhovitina Elena

Moscow, 1999

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Bolkhovitina Elena

AN ANALYSIS OF THE CURRENCY AND FINANCIAL CRISIS IN RUSSIA

1. INTRODUCTION An extraordinary economic situation that prevailed in Russia in 1997－1998 led to a

widescale economic crisis. The crisis had a negative impact on all the spheres of the country's economy, especially on the financial system.

The financial crisis became apparent on August 17, 1998 when the Ruble was floated and the default on treasury bills (the so called GKOs) was announced. The crisis led to a lot of consequences in every sphere, such as:

－ Devaluation of the national currency (by around 250% by December 1998) and monthly inflation rate of about 45%;

－ Collapse of all financial markets - treasury bill market, exchange market and capital market;

－ A profound bank crisis which paralyzed the system of payments; － Growth of inter-enterprise arrears and tax arrears to the budget system; － Increase of dollarization of the national economy and flight of capital; － Deepening of the budget crisis - which was caused by reduction of the tax base and cutback

of imports, tax payment impediments in banks and impossibility of debt financing of the budget deficit;

－ Further aggravation of the debt crisis - which was caused by growth of external debt and debt service costs caused by the devaluation of the Ruble).

And, finally, the worst result of 1998 crisis was decrease of the real incomes and consumption standards of the population by about one quarter. The quantity of families living below the poverty line has dramatically increased.

The reasons behind the Russian crisis of 1998 are rather complex. The extraordinary economic situation that developed by 1998 was the result of the following reasons:

First, it is macroeconomic imbalances which appeared in the pre-transition period and further deepened during the transition period;

Second, absence of a balanced economic strategy and, as a result, incompleteness of institutional and structural reforms as well as incoherence of macroeconomic policy.

Third, it is the external shock - the world financial crisis, and significant decrease of world prices for raw materials.

2. MACROECONOMIC IMBALANCES

Basic drawbacks of the Russian economy rendered it inefficient and imbalanced, that is susceptible to crisis. Those drawbacks were macroeconomic imbalances which emerged in the pre-reform period and were further aggravated during the transition period and incompleteness of structural and economic reforms.

By the time the reforms were introduced, technological base of the Russian economy had a capital-intensive energy sector, a huge defense industry, a poorly developed consumer industry and an inefficient agriculture. Such production structure led to a situation when energy resources formed the basis of national exports.

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Production was monopolised to a very great extent, with competition practically non- existent, production capacities were largely depleted and investment were insufficient to ensure expanded reproduction.

In addition, at the end of 1980s stagnation was accompanied by rapid and uncontrolled growth of per capita incomes (13% annually). The imbalances that arose between supply and demand were covered by the foreign trade which led to a situation when external debt of the USSR tripled (from 29billion US$ in 1985 to 96.6 billion US$ in 1992).

Thus by the beginning of 1990s the Russian economy presented such a model of reproduction, which lacked efficiency and balance and, hence, stability.

After disintegration of the USSR the necessary transformations for transition to the market economy were made. However these transformations were too fast, without control over feedback, Besides they did not take into account the features of Russia or the initial economic conditions, its geographical position and extent and its social mentality. All those factors also made their contribution to the crisis.

Price liberalisation. The pace of price liberalisation was rapid, but the financial policy wasn't tight. This has led to large decline in production output and high inflation rate.

Privatisation of state enterprises also was carried out rapidly. It was made on voucher basis by distribution of property among the population. As a result, no additional financial resources were involved in the economy. Besides, subjected to privatization were the majority of efficiently working enterprises, especially those in exporting industries and natural monopolies. As a result, the government has lost a significant part of its tax base. The state enterprise sector has not been subject to financial discipline, and important legislation still remain to be introduced.

Creation of the banking system. Privatisation of banks was also rapidly implemented but the Central Bank became independent and started to conduct an independent policy only in 1995 (after adopting the Law on the CBR). The existing banking system is still inefficient, badly managed and controlled. It does not fulfil its function of servicing the real sector and promotes outflow of capital abroad.

The external sector. Since the beginning of reforms the state has introduced and is still maintaining full current and capital account convertibility. However the absence of effective measures of currency exchange regulation has resulted to massive capital outflow.

The reduction of the government co-ordination of economic activity. Having rejected direct regulation of economic activity, the government has not completed the creation of institutes and effective mechanisms of state regulation of economy.

Due to the above described disadvantages, system imbalances have become deeper. They partly determined the 1998 economic crisis. Among these imbalances are:

1.The imbalance between the rate of consumption and the rate of production. The production recession was deeper than the decrease in consumption during the transition period.

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Chart 1

Source: Goskomstat of Russia

2.The imbalance between production and employment. The reduction of employment was

essentially less in relation to production recession.

Chart 2

Source: Goskomstat of Russia

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The result of it is low productivity of labor force and, accordingly, low levels of real wages and social transfers.

3.Disproportions between existing capacities and low levels of their use. During a pronounced recession of production physical volume of accounted fixed assets was not reduced. It has significantly reduced return of fixed capital and its real cost.

4.Deformed balance of payments. Throughout the period of reforms disbalances of currency flows widened: large volumes of capital flight coexisted with expansion of external borrowing.

5.Deformed budget. Reduction of tax base could not entirely provide financing of state and social institutes and growing volumes of national debt service (see Table 1,2).

Those typical disproportions of planned economy were strengthened by the disproportions

which have appeared in the transition period. The government has not managed to create an effective mechanism of state regulation.

Thus the lack of structural reforms, rapid introduction of open economy, the inability

of the government to create efficient public institutions, a deformed system of economic motivation, barterization of economic interactions, orientation to export of raw materials, import pressure rendered the Russian economy inefficient for growth and inclined to crisis .

3. STATE FINANCES AND MONETARY POLICIES

The other domestic reasons behind Russian crisis of1998 were: － long-term budget deficit, which was mostly financed through short-term domestic debt; － the stock of debt was unsustainable for the government to service; － the short-term maturity of the debt; － contradiction between tough monetary policy and deficit budgetary policy; － underdevelopment of the banking sector and the lack of a legal framework, regulation

and supervision by the CBR. Throughout the period of reforms Russia was subjected to a constant and periodically

aggravating budgetary crisis. At a first glance the budget deficit values of 5 to 7 per cent do not seem catastrophic.

Chart 3

Source: Russian Ministry of Finance

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Needless to say, such a deficit is high, but it is especially high for a country that has gone through a seven-year crisis, a 40% drop of GDP, a non-recurrent economic growth and substantial public spending programs .

Starting from 1995 the Government embarked on the policy of macroeconomic stabilization. The macroeconomic stabilisation was built around a sharp tightening of monetary policy, some fiscal correction and a fixed exchange rate. As a result annualized inflation fell to below 5% in the first half of 1998, but sources of instability remained largely unaddressed. The money surrogates and widespread tax evasion should be seen as the reverse side of the announced stabilisation. Subsequently, in 1996 the budgetary crisis was again quite acute.

The macroeconomic dynamic, with out-of-control public finances and tightening monetary policy, led to rising interest rates and a squeeze of bank credit to enterprises. In this environment, enterprises reacted by reallocating credit and innovation in quasi-monetary instruments. As firms became increasingly illiquid, they accumulated arrears and began paying their tax authorities in kind rather than in cash.

Widespread tax evasion and use of mutual offsets for tax obligation shrank not only the aggregate level of revenues but also the monetary component.

Chart 4

Source: Russian Ministry of Finance

On the expenditure side, expenditure control was achieved primarily through sequestration that were in turn linked to large accumulations of government arrears. The government arrears, through multiplicative effect, involved the counrtry's economy as a whole.

Thus, the aim of balancing the national budget has never been achieved.

Recognizing that budget deficit was large for years, the ways of covering the budget deficit and the interaction of the fiscal and the monetary policy are very important. Before 1995 the budget deficit was largely financed with Central Bank credits. In 1993 the domestic treasury bill (government short-term loan bonds - the so called GKOs, and federal loan bonds - OFZs) market was created and the government was able to receive domestic loans.

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The next step was to make a wide use of treasury bills with hidden participation of foreign capital. Non-residents, attracted by high interest rates of government securities (during the election campaign of 1996 they reached 195 per cent). In 1997, non-residents were officially given access to the market and purchased up to 25－30% of GKOs.

A key factor in an attempt to deal with the problem of covering budget deficit is reduction of the real cost of credit.

The key factor in this situation is the behavior of interest rates. During 1997 the Government and monetary authorities managed to steadily reduce the

profitability of government securities, although the federal budget deficit remained large (see chart 5).

In this situation, the reduction of the yield on government securities was promoted by a large-scale inflow of foreign capital observed in the middle of the year: the changes in the Government undertaken in March 1997 favorably affected the moods of foreign investors.

Objectively, in 1996－1997 (up to the autumn) the external conditions for the receipt of loans were the best in a long time. In 1996, both the physical volume of the Russian export and the prices for many products, especially oil, rose. The world economic growth was high in the 1990s, and the environment for the inflow of foreign capital was the most favorable. Russia was able to borrow in the world market at quite moderate interest, knocking down the domestic rates of interest on the government's liabilities for debts.

As a result, the GKO yield decreased from 32.8% in January to 18－19% in July-August 1997. But this proved short-lived: in the spring of 1998, after the three waves of the financial crisis, interest on GKOs rose to reach 60－70%. (see chart 5 ).

As a result of the world financial crisis, which affected Russia in late 1997－early 1998 and destabilized the financial markets, a dramatic outflow of short-term, speculative foreign capital was observed. The cost of borrowed funds sharply increased, the rate of interest on GKOs rose significantly. A new round of financial cataclysms in May 1998 also forced the Central Bank to raise the rate of refunding from 30% to a shocking 150%. (see chart 5).

Such profitability of operations in the financial markets was by far higher than the possible profit rate in the real sector, even in the most efficient sectors. As a result, transfer of financial resources from the real sector to financial sector was sharply intensified, working capital shrank, arrears grew, the tax base and budget revenues decreased.

The high rate of interest on GKOs led to a quick rise of the share of domestic debt servicing in the country's budget in the next few years.

Debt started to fed itself, thereby increasing share of revenues from government securities was used to cover the preveous liabilities. The share of revenues used to finence budget deficit dramatically decreased. (see table 3)

Rapid growth of treasury bills and bonds market was associated with a dramatic increase in the domestic debt. Between 1995 and mid－1998 the stock of outstanding treasury bills soared from 4 to 17% of GDP. The external debt was around 125－135 billion US$. The common stock of federal debt became unsustainable (see table 2).

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GKO

Yie

ld a

nd D

iscou

nt R

ate

CBR

Ch

art 5

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Moreover, the domestic debt was largely short-term. Chart 6

Source: Helmenstein, C. and Krylova, E. (1998) The Russian GKO market: Anatomy of Crisis. East European

Chronicle No. 4/ August 1998. Erste Bank.

The short maturity of government debt was a technical reason for the Russian crisis.

Underdevelopment of the banking sector has been stressed as one more reason for the Russian crisis. The liberalization of financial markets was not accompanied by creation of appropriate legal base, Institutions of control and supervision to ensure liquidity.

The number of large and reliable banks in Russia is insignificant (ratio of bank assets to GDP in 1998 were less then 40%). Russian financial go-betweens have so far had a modest place in the movement of capital flows: they have no infrastructure for long-term savings, and they substantially increase the price of loans for the borrowers. They service mainly government borrowing instead of real sector.

Russian banks were not adequately prepared for the exchange risk. On the contrary, they underwrote forward contracts (estimates vary between $5b－$20b) with foreign investors.

These rendered the economy more vulnerable to crisis. Thus the fragility of the country's financial system and the high share of foreign speculative

capital invested into government securities made Russia dependent on the world system of risks.

For the estimation of exchange rate stability it is necessary to study the correlation of the Central Bank's currency reserves and base money.

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Chart 7

Source: CBR

While currency reserves did not increase from mid－1995 until mid－1998 (except for the year

1997 when they grew due to influx of short term foreign investments), the base money almost doubled.

Currency Reserves and Base Money

June 1995

June 1996

June 1997

June 1998

Currency reserves, bill. US$.

10.1

12.8

20.4

11.2

Base money, bill.rubl. 99.0 158.1 205.5 193.8 Source: Goskomstat of Russia, CBR

This constantly growing gap has made devaluation absolutely inevitable. Moreover, the closer to 100 per cent is the ratio between currency reserves and the base

money, the less is the probability of sharp destabilization of the exchange rate. Until the beginning of 1998 this ratio remained at the level of 60－80%, which allowed CBR to smoothly decrease the exchange rate. If level of this parameter is lower, and the Central Bank continues to maintain this situation for a long time, without changing the exchange rate, devaluation will inevitably follow and will be much more dramatic. The situation in Russia in 1997－1998 clearly demonstrated this phenomena.

In all the phases, the general policy of the Central Bank was designed to prevent the national currency exchange rate from crashing. The resources at the disposal of the Government and the Central Bank did not go far enough to support the three key markets: the stock market, the securities market, and the ruble market. By the end of May they managed to keep the ruble from crashing while a significant part of investors had left. The index of the stock of the Russian sellers of raw materials, in fact, blue chips, fell three time of the crisis; the GKO rate shifted from 19% to a

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peak of 46－70%. The Central Bank's rate of refunding flew up to 150% so that to make the anti- ruble operations more expensive for those banks and investors who borrowed rubles in the hope to play against the ruble by purchasing dollars (see chart 5).

Having protected the ruble, the RF Central Bank prevented a sharp increase of losses for the foreign holders of the state “ruble” debt. In addition, the CBR protected the banking system which would suffer heavy losses in case of devaluation.

4. IMPACT OF EXTERNAL FACTORS ON THE RUSSIAN CRISIS

The foreign influence on the Russian crisis may be viewed as a consequence of two factors:

First, those connected to changes in the forein trade conditions; Second, those connected to the influence of the contagion-effect.

With regard to the first, the Russian economy was heavily affected by a rapid fall in the

world prices of raw materials. Crude oil, oil products and metals accounted for 40% of the Russian exports in 1997.

Russia has had a healthy current account surplus. With huge trade surpluses (around USD 20b yearly) the current account has been nicely positive during 1994－1997 (the negative service balance in Russia diminished the current account surplus already in 1997)

Chart 8

Source: CBR

However, at the end of 1997 and more in the start of 1998 the lower raw material prices

turned the current account to small deficit. Moreover, the lower raw material prices decreased the ability of Russian enterprises to pay

taxes and further hampered the government finances. It had a very negative effect on the country's ability to service state debt and promoted the

advance of the crisis.

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With regard to the contagion-effect, the currency devaluations in Asia worked as a trigger in

the Russian case. Investors became more risk averse towards all emerging markets and started to look more carefully at the fundamentals in Russia. They decided that the stock of federal debt became unsustainable, and a currency crisis was imminent.

5. CONCLUSION One factor cushioned the impact of the financial crisis in 1997－1998 upon the Russian

economy: the relative isolation of the financial sector from the real one. In this case, the reference is made to the low level of the enterprises' debt liabilities towards

bank and other (even short-term) loans. Since most enterprises have no funded debts and significant bank lines on which they were dependent, the blow at the banking sector did not disrupt the operation of the real sector. The latter suffered mainly in the sense of reduced opportunities for attracting financial resources by issuing stocks and bonds due to the rise of interest rates. A backward financial sector hampers economic growth but precludes mass-scale sudden bankruptcies, as happened in Thailand, Malaysia and Indonesia.

The crisis of 1997－1998 effectively made us realize that we need to go over from pure macroeconomics to in-depth structural reforms. Reforms in the social sphere (especially the pension reform) and a reform and partial restructuring of the natural monopolies have their own merits and are important in their own right. They should be implemented in any case so as to raise economic efficiency, specifically, the efficiency of government regulation and public spending and reduce the scope of government financing. At the same time, it has to be recognized that budget problems have in fact forced the implementation of structural reforms.

Of tremendous importance are the interaction of the fiscal and the monetary policy and the ways of covering the budget deficit.

Introducing order in this sphere would require several years. The long-term repairs should take up the basic weaknesses of the economy and build trustworthy public institutions into the country.

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Table 1. Federal budget execution in 1992－1997 (IMF definition, bill Rub.).

1992 1993 1994 1995 1996 1997

Expenditures % to GDP －including cash

Revenues

% to GDP －including cash

Deficit

% to GDP Primary deficit

% to GDP

11.2 58.9

2.8 14.7

8.5 44.2

49.1 28.6

22.3 13.0

26.8 15.6

137.4 22.5

72.5 11.9

64.9 10.6

283.2 18.4

196.5 12.8

86.7 5.6 37.2 2.4

474.3 22.1 376.2

296.3 13.8 198.2

178.0 8.3 53.6 2.5

485.2 19.2 426.3

311.0 12.3 252.1

174.2 6.9 56.4 2.2

Total

External Tied credits Non-tied credits Eurobonds Principal debt payments

Internal Central bank

Direct credit Purchases of government securities NMR reductions

GKO-OFZ Other

Structure of deficit financing (%) 100.0 28.4

71.6 64.5 61.8

2.6 0.0 7.1

100.0 12.1 13.7 3.0 0.0 －4.5

87.9 79.9 75.5

4.4 0.6 7.4

100.0 0.3 7.4 0.9 0.0 －8.1

99.7 92.4 80.3

12.1 11.0 －3.7

100.0 －3.6 9.7 3.1 0.0

－16.4

103.6 27.7 0.0

27.7 53.0 23.0

100.0 7.3 5.0 7.4 3.1 －8.2

92.7 27.0 0.0

27.0 60.1 5.6

100.0 27.2 7.8 10.2 15.1 －5.9

72.8 17.5 0.0

17.5 52.6 2.7

Source: Russian Ministry of Finance.

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Table 2. The Stock of Federal Debt and Debt Service

1994 1995 1996 1997 1998

Federal Debt, bill.rubl.

Domestic debt, bill.rubl.

－ GKO-OFZ, bill.rubl.

External debt

bill.rubl.

bill. US$

－debt of USSR

－debt of RF

353.6

88.4

10.6

265.2

119.9

108.6

11.3

739.4

191.2

76.6

548.3

120.4

103.0

17.4

1059.9

365.6

237.1

694.3

125.0

100.8

24.2

1276.8

499.6

384.9

777.2

130.8

97.8

33.0

3706.3

520.0

387.1

3186.3

154.3

95.0

59.3

Federal debt service, bill.rubl. External debt service, bill.US$

－schedule

－fact

20.2

5.6

28.0

20.2

7.1

44.6

18.7

7.7

42.1

13.6

7.5

129.6

9.9

First line reserves, bill US$ －currency reserves

Export, bill US$.

GDP, bill.rubl.

6.5 4.0

75.3

610.7

17.2 14.4

94.1

1541

15.3 11.3

103.5

2146

17.8 12.9

102.2

2522

12.2 7.8

87.7

2685 Source: Russian Ministry of Finance, Goscomstat, OECD

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Table 3

The GKO-OFZ market.

1993 1994 1995 1996 1997 1998/ 7m

1.The volume of issue 2.The volume of underwrighting 3.The volume of sale revenues 4.Rasing of budget revenues 5.Ratio of Raising of budget revenues to the volume of issue,% (4:1)

0.2 0.2 0.2 0.2 100

20.5 17.5 12.9 5.7 27.8

171.0 140.4 106.2

11 6.4

479.0 399.7 297.3 15.3 3.2

605.5 449.2 386.5 6.9 1.1

353.5 225.4 169.6 －39.8 －

Source: CBR, Goscomstat

Table 4

Currency Reserves and Base Money

June 1995

June 1996

June 1997

June 1998

Currency reserves, bill. US$. 10.1 12.8 20.4 11.2 Base money, bill.rubl.

99.0 158.1 205.5 193.8

Source: Goskomstat of Russia, CBR