Russian Bond Default/Ruble Collapse


Date: 1998   /   Region: EMEA
Published May 28th, 2016
Ron Rimkus, CFA

The Russian Crisis of 1998 was really an extension of the Asian Currency Crisis of 1997 (the “Asian flu”). The combination of declining economic output, falling oil prices, enormous budget deficits, and a currency pegged to the rising US dollar overwhelmed the fledgling Russian government. To maintain its peg to the dollar, Russia used its foreign exchange reserves to buy rubles. But as the country gradually depleted its foreign exchange reserves, it became clear that Russia would soon run out of reserves. At that point, the Russian government would no longer be able to maintain the ruble’s peg to the US dollar. Upon exhausting its reserves, Russia defaulted on its debt and revalued the ruble on foreign exchange markets.

Analysis and Commentary

Governments finance themselves through some combination of direct taxation of citizens, taxation of businesses, tariffs on imports from other countries, build-up and use of foreign currency reserves from international trade, issuance of debt, money printing (if possible), and seizure of property from its own citizens or from other countries (i.e., spoils of war). Setting aside extreme events such as the seizure of property, when governments remain committed to deficit spending, the difference must be made up by issuing bonds and/or printing new money. For Russia in the mid-1990s, fiscal deficits were about 9% of GDP (for context, the US fiscal deficit averaged about 2% of GDP during the mid-1990s). Such large deficits forced the Russian government to raise more and more capital via the public markets through sovereign bond auctions. Rising Russian bond yields demonstrated that investor enthusiasm for financing such bonds was waning.

As investor fears of default in Russian sovereign debt grew, the Russian ruble experienced a frenzy of selling pressure in currency markets…

Between 1996 and 1997, Russia renegotiated the foreign debt obligations the country inherited from the former Soviet Union. Inflation began falling dramatically—from 131% in 1995 to 22% in 1996 to 11% in 1997. Output began to grow slightly, and the markets began to perceive the transition to a market economy as successful, albeit bumpy. Oil was trading at about $23 per barrel (considered high back then), which helped Russia’s vast energy industry. So, even though wage levels were weak and payment of wages was notoriously slow, the transition to a market economy was taking root.

The “Asian flu” crisis in 1997 was a major catalyst for the Russian bond default. After the Asian Tiger economies (Thailand, Indonesia, South Korea, Malaysia, the Philippines, Hong Kong, and Singapore) went down one by one, global markets became increasingly concerned about other countries with similar financial profiles—namely, Russia and Brazil. Notably, those countries had exchange rates pegged to the US dollar and relied on capital markets for government funding.

To make matters worse, global energy and nonferrous metal prices were declining sharply, weakening the commodity-heavy Russian economy. Oil prices fell from a high of $23 per barrel in January 1997 to a low of $9.10 per barrel in December 1998. Low oil prices hit the Russian economy first, then hurt tax revenues to the Russian government.

It became increasingly clear that Russia could not maintain the peg to the US dollar.

Naturally, these factors escalated the pressure on the Russian government’s fiscal deficit. As the country’s financial profile worsened, investors sold Russian sovereign bonds and demanded higher interest rates. The widening fiscal deficit increased the threat that the CBR would need to print more and more rubles to make up the shortfall. Such money printing would devalue the currency, of course, and break the peg to the US dollar, which had been maintained at a band of 5–6 rubles to the dollar. As investor fears of default in Russian sovereign debt grew, the Russian ruble experienced a frenzy of selling pressure in currency markets—first, in November 1997; then, in January 1998; and then again, in August 1998. Weakness in the Russian economy caused investment capital to flee. To retain and strengthen foreign capital inflows, the CBR raised interest rates from 30% to 50% on 17 May 1998. Then, just 10 days later, on 27 May, the CBR raised rates again—to 150%. The CBR also began striking forward contracts with various foreign investors to hedge their currency risk (attempting to keep the capital in Russia). The sharp rise in interest rates further slowed the economy, which further reduced tax revenues and compounded the fiscal deficit problems.

Meanwhile, the CBR was working feverishly to maintain the ruble exchange rate to the US dollar by using its foreign currency reserves to purchase rubles. As of June 1997, the CBR had $20.4 billion in foreign currency reserves. By November 1997, reserves had fallen to $12.2 billion. By January 1998, reserves had fallen to $10.5 billion. And during the third wave of frenzied selling of rubles in the market in early August of 1998, the CBR’s foreign currency reserves were down to about $8.2 billion (for a total decline of 60% over 14 months). It became increasingly clear that Russia could not maintain the peg to the US dollar. Consequently, on 17 August 1998, Russia devalued the ruble and defaulted on government bonds. In the ensuing 18 months, the ruble went from an exchange rate of 5 rubles per US dollar to 30 rubles per US dollar, for a net decline of 83%.

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Timeline

Background

  • 1991: The Soviet Union collapses, and the now Russian Federation begins the transition to a market economy and a more democratic form of government.
  • 1993–1996: Russia generates large fiscal deficits, averaging about 9% of GDP, and struggles with tax collection and slow economic growth. Inflation, however, drops steadily.
  • 1995–1996: Russia receives $9.3 billion in aid from the International Monetary Fund (IMF) with terms that emphasize the need for the Russian government to tighten fiscal policy in order to promote macroeconomic stability.
  • January 1997: Various economic indicators are positive, including a declining inflation rate (11%) and a stable ruble exchange band (floating peg) of 5–6 Russian rubles to the US dollar. The economy shows signs of improvement through the first half of 1997. Real wages continue to sag, however, and deficits remain high.
  • July 1997: The Asian financial crisis begins. Countries with currencies pegged to the US dollar and/or managed exchange rates are hit by the market as the dollar rises. These economies slump.
  • September/October 1997: Russia reaches agreements with foreign creditors to begin repayment of Soviet debt and eases restrictions on nonresident investment in government bonds. To make scheduled debt payments, Russia will need to increase revenues through economic growth and taxes, but in late October, the IMF announces that it is withholding a $700 million loan payment to the Russian government because of lax tax collection. The Russian stock market begins to decline.
  • 11 November 1997: Selling pressure on the ruble erupts. The Central Bank of Russia (CBR) spends $6 billion of its $23 billion foreign currency reserves to defend the ruble.
  • December 1997: Falling prices for crude oil and metals puts pressure on Russian foreign currency reserves. Russia and the IMF come to an agreement in which Russia agrees to improve tax collection and reduce its spending and the IMF agrees to restart the disbursement of the $700 million.
  • January 1998: Nonresident holders of short-term Russian government bonds (GKOs) start signing forward currency contracts with the CBR to hedge against the ruble losing value. Russian bank liabilities held in foreign-owned forward contracts increase dramatically. The CBR raises interest rates; the Russian stock market experiences a sharp decline over the course of January.
  • February 1998: A new, simplified tax code is passed, but its provisions do not help increase government revenues. Russia requests additional emergency funds from the IMF.

Central Events

  • 23 March 1998: Boris Yeltsin, first president of the Russian Federation, abruptly dismisses his entire cabinet, including Prime Minister Viktor Chernomyrdin, and appoints the relatively new and inexperienced Energy Minister Sergei Kiriyenko as acting prime minister.
  • April 1998: The Russian stock market recovers and moves close to previous historical highs.
  • May 1998: Coal miners in Russia, striking over unpaid wages, block the Trans-Siberian Railway. Unpaid wages across the country amount to close to $12 billion. Stock prices begin to decline in a fall that will last for the rest of the year. The CBR continues to spend foreign currency reserves to maintain the ruble peg and raises interest rates on GKOs as high as 150% to keep capital in the country.
  • 24 June 1998: The Russian government announces plans to cut expenses and raise revenues. Kiriyenko submits a budget austerity plan to the IMF, which releases a previously held loan installment of $670 million.
  • July 1998: Disputes between the central government and the parliament (Duma) over how to implement tax and spending reforms threaten to stall IMF assistance and contribute to increasing skepticism on the part of investors and depositors about the government’s ability to maintain control of the developing crisis and meet its debt obligations. Markets are highly volatile. Dropping oil prices contribute to declining government revenues. An emergency IMF loan is barely able to offset disappearing liquidity, and a plan to swap out soon-due GKOs for long-term Eurobonds does little to stabilize the markets.
  • Early August 1998: Conflict between the central government and the Duma over the right course of action persists, and Yeltsin passes several decrees while vetoing Duma proposals.
  • 13 August 1998: Standard & Poor’s downgrades the Russian ruble. The Russian stock, bond, and currency markets collapse, and trading is halted on the stock market for 35 minutes. Bond yields climb to as high as 200%. Kiriyenko asserts that the market decline is not based on reality and that the government has the ability to pay its debts.
  • 14 August 1998: Investor exit from the Russian bond market for the week costs the CBR $1.7 billion. Yeltsin backs Kiriyenko and declares that the ruble will not be devalued. Russian markets briefly stabilize, but banks suffer from increasing illiquidity and cannot meet scheduled payments to each other.
  • 17 August 1998: Russia officially announces plans to expand the ruble-to-dollar exchange rate band, a restructuring of ruble-denominated debt, and a 90-day moratorium on the payment of various bank obligations and currency forward contracts to foreign creditors. Standard & Poor’s further downgrades the ruble—to CCC/C. Demand for dollars rapidly increases in Russia as fears of a massive devaluation mount.
  • 19 August 1998: Russia officially defaults on its short-term GKOs. The IMF and Group of Seven (G–7) refuse to provide additional loans to Russia until it meets existing promises.
  • 21 August 1998: The Duma calls for Yeltsin’s resignation, and investors flee to US Treasury bonds, causing these bonds’ yields to drop to record lows.
  • 24 August 1998: Yeltsin dismisses Kiriyenko and names Viktor Chernomyrdin as prime minister.
  • 25 August 1998: On the Moscow Interbank Currency Exchange (MICEX), the ruble has been steadily depreciating against the US dollar since 17 August—from 6.43 to the dollar to 7.86.
  • 26 August 1998: The CBR ends ruble-to-dollar trading on the MICEX, and the MICEX does not fix a ruble-to-dollar rate that day.
  • 2 September 1998: The CBR, having spent an additional $2.8 billion in reserve currency since 17 August trying to defend the new exchange band, officially abandons the floating peg exchange band and floats the ruble freely.

Aftermath

  • 7 September 1998: The chairman of the CBR resigns, and the Duma rejects Chernomyrdin’s nomination as prime minister, deepening the country’s political and economic turmoil.
  • 11 September 1998: The Duma approves Yevgeny Primakov, a compromise candidate, as prime minister, and a measure of political stability is restored.
  • 21 September 1998: The exchange rate reaches 21 rubles to the US dollar; thus, the ruble has lost two-thirds of the value it had less than a month prior.
  • 23 September 1998: The New York Federal Reserve orchestrates a $3.5 billion bailout of Long-Term Capital Management, a large US hedge fund invested heavily in Russian bonds.
  • 22 October 1998: Anticipating winter food shortages, Russia takes precautionary measures by announcing an emergency food reserve and approving an emergency spending plan whereby the CBR prints at least $1.2 billion to help pay back wages, rescue banks, and support the new emergency food program.
  • 30–31 October 1998: The IMF withholds a $4.3 billion installment of the $22.6 billion aid package it agreed to in July until Russia produces a realistic budget for 1999. The IMF mission leaves Russia.
  • 5 November 1998: Russia reaches an agreement with foreign investors to accept repayment in rubles of $40 billion of debt frozen in August but reschedules $17.5 billion of debt due in 1999. Russia also receives an $800 million loan from Japan, originally part of the IMF rescue deal.
  • December 1998: Russian inflation reaches 84%.
  • 1999–2000: Rising world oil prices results in a Russian trade surplus, Russia recovers quickly. The devaluation causes the price of foreign-made goods to rise sharply, benefitting domestic industries.

Investment Principles

Principle #1

Government finances can be very sensitive to specific industries or sectors (e.g., oil or other commodity prices).

Principle #2

Government assurances about not defaulting are meaningless.

Principle #3

Many governments would rather default on sovereign debt obligations than balance their budgets.

Principle #4

A currency peg (or collar) acts as a constraint on money printing. 

Principle #5

Foreign currency reserves act as a constraint on a country’s ability to maintain a currency peg (or collar).

Principle #6

Foreign capital inflows are an important financing mechanism for sovereign governments and can offset deficiencies in the fiscal budget for a considerable period of time.

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Sources

Central Bank of Russia. “International Reserves of the Russian Federation”.

Chiodo, Abbigail, and Michael Owyang. 2002. “A Case Study of a Currency Crisis: The Russian Default of 1998.” Federal Reserve Bank of St. Louis (November/December).

Chance, Clifford. “Chronology of the Russian Financial Crisis 1998.” American Russian Law Institute.

Dabrowski, Marek. 1995. “The Reasons of the Collapse of the Ruble Zone.” CASE Research Foundation, Center for Social & Economic Research, Warsaw (November).

Dungey, Mardi, Renee Fry, Brenda Gonzalez-Hermosillo, and Vance Martin. 2002. “International Contagion Effects from the Russian Crisis and the LTCM Near Collapse.” International Monetary Fund Working Paper WP/02/74 (April).

Fischer, Stanley. “The Russian Economy at the Start of 1998.” International Monetary Fund.

Gilman, Martin. 2010. No Precedent, No Plan: Inside Russia’s 1998 Default. Cambridge, MA: MIT Press.

Nadmitov, Alexander. 2004. Russian Debt Restructuring: Overview, Structure of Debt, Lessons of Default, Seizure Problems and the IMF SDRM Proposal. Cambridge, MA: Harvard Law School.

Odling-Smee, John. “The IMF and Russia in the 1990’s.” International Monetary Fund. 2004.

Perotti, Enrico. 2002. “Lessons from the Russian Meltdown: The Economics of Soft Legal Constraints.International Finance, vol. 5, no. 3 (November).

Pinto, Brian; Khara, Homi; Ulatov, Sergei. “An Analysis of Russia’s 1998 Meltdown: Fundamentals and Market Signals.” Brookings Institute; World Bank. January, 2001.

Pinto, Brian, and Sergei Ulatov. 2010. “Financial Globalization and the Russian Crisis of 1998.” World Bank. Policy Research Working Paper 5312 (May).

Popov, Vladimir. 2000. “Lessons of the Currency Crisis in Russia and in Other Countries.” Problems of Economic Transition, vol. 43, no.1: 45–73.

Quandl. “Europe Brent Spot Price FOB, Daily”.

Roche, Cullen. “The Russian Default – What Happened?” Pragmatic Capitalism. 12 December 2011.

Russia lets ruble fall.” 1998. CNN Money (17 August).

Russian Bonds Hit Default Levels as Meltdown Looms.” 1998. Euroweek (14 August).

The Russian Crisis 1998.” Rabobank. 16 September, 2013.

Timeline of the panic.Frontline.

Additional Reading

Horrigan, Brenda D. 1999. “Debt Recovery by Foreign Investors in Post-Crisis Russia.” European Business Journal, vol. 11, no. 2: 88–99.

Dungey, Mardi, Charles Goodhart, and Demosthenes Tambakis. 2008. “The US Treasury Market in August 1998: Untangling the Effects of Hong Kong and Russia with High Frequency Data.International Journal of Finance & Economics, vol. 13, no. 1 (January).

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