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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.
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.
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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