MOSCOW, August 17. /TASS/. Twenty years ago, on August 17 1998, Russia declared technical default on main types of state liabilities which triggered a grave financial crisis.
Financial situation in Russia in 1995-1997
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 (on January 1, 1998 the ruble 'cut off' three zeros, with 1,000 rubles becoming 1 ruble). 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.
"There will be no devaluation"
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.
Government takes measures
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).
Changes in the government
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.
Short-term economic consequences
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.
Long-term consequences
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.