Russia 1998 - A Currency Devaluation and Sovereign Debt Default Case Study

Russia's collapsing currency and rapidly rising interest rates have been front page news in the media over the past month.  Here is a chart that shows what has happened to the yield on Russia's 10 year bonds:

The yield on ten year bonds is in excess of 16.5 percent compared to 10.2 percent during the last week in November 2014.  While these levels are high, they are nothing compared to what happened during the Russian crisis of 1998 and you will see.

Here is a chart showing what has happened to the value of the Russian ruble over the past month:

The ruble has fallen from 45 to the U.S. dollar during the last week of November 2014 to a low of 77.5 to the U.S. dollar in mid-December 2014.

While all of this is interesting to watch from outside of Russia, such dramatic moves in Russia's interest rates and currency exchange rates is not unprecedented.  

In 1998, Russia's economy experienced a currency crisis that resulted in a forced devaluation and a default on both public and private debt.  A study by Abigail Chiodo and Michael Owyang at the Federal Reserve Bank of St. Louis provides us with an interesting history of the 1998 Russian crisis and how it developed.

Let's look at the definition of a currency crisis.  A currency crisis is created when there is a speculative attack on a currency that occurs when currency traders decide to buy a country's currency by selling the currency of another country, for example, in Russia's case, currency traders have elected to sell rubles and buy other currencies such as the euro and U.S. dollar. A crisis can occur for several reasons:

1.) investors fear that the government will attempt to finance its debt and deficits through the printing.

2.) investors fear that the government will reduce its debt by devaluing its currency because the country either cannot afford to support the value of its currency or chooses not to support its currency.  If the government is unable to buy its own currency (i.e. prop it up) with its foreign reserves (i.e. by creating demand for its own currency), the value of the currency will drop.  This will result in the price of domestic goods and services becoming cheaper relative to foreign goods and services but will likely result in higher levels of inflation.

Let's look at Russia's public finances over the period from 1995 and 1998 giving us a sense of the magnitude of the problem in 1997 and 1998:

Government debt includes both domestic and foreign debt.  Note that interest payments on the debt reached a high of 43 percent of total government revenues in 1998. To put these numbers into perspective, according to the Central Bank of Russia, Russia's foreign debt in June 2014 was $731.204 billion U.S. dollars.

After the end of the Communist-era in the Soviet Union, Russia moved toward a free market economy.  In April 1996, Russian officials began to negotiate the payments for the debt that it had inherited from the USSR.  By 1997, it appeared that the Russian economy was on the mend with a better trade balance between both imports and imports as shown on this figure:

There was also a significant improvement in the nation's inflation rate as shown here:

Inflation had fallen from 131 percent in 1995 to 11 percent in 1997, a trend that reversed during the currency crisis.  

In 1997, oil was selling at $23 per barrel, a rather high price given that prices during the 1980s had fallen as low as $10 per barrel.  At that time, oil revenues made up 45 percent of Russia's main commodity exports.  Moves by the IMF and the Paris Club that were negotiating with Russia kept the ruble trading between 5 and 6 rubles to the dollar.  At that time, analysts predicted that Russia's credit rating would improve and Russia's government was counting on 2 percent economic growth in 1998.  On the downside, real wages were only half of their level in 1991 and only about 40 percent of the workforce was being paid on time.  Tax collection was also a problem, resulting in a high public sector deficit.  One of the biggest problems that was glossed over during the negotiations was the value of the assets held by Russia.  One-quarter of Russia's assets were loans that the USSR had made to Cuba, Mongolia and Vietnam.  

Unfortunately, during late 1997, the Asian currency crisis caused a speculative attack on the ruble, resulting in this:

The Central Bank of Russia (CBR) was forced to defend the ruble, spending $6 billion of their foreign exchange reserves.  At the same time as the ruble was under attack, the price of oil and non-ferrous metals began to drop, reducing Russia's hard-currency earnings by two-thirds.  

By early May 1998, the Chair of the CBR, Sergei Dubinin, began to warn Russia's government that there would be a debt crisis within the next three years.  Reporting on the warnings were misinterpreted to mean that the CBR was considering a devaluation of the ruble.  This resulted in a significant decline in investors' perceptions of Russia's economic stability.  By May 18th, 1998, government bond yields had increased to 47 percent.  Investors and depositors became increasingly unwilling to purchase Russia's bonds because of concerns that they would not be repaid.  This resulted in a decrease in the amount of cash that commercial banks had to keep them afloat.  In response to the crisis, the CBR increased the lending rate to 50 percent and spent $1 billion of its already strained reserves to defend the ruble.

Oil prices continued to decline, hitting $11 per barrel resulting in a loss of $4 billion in revenue.  The oligarchs who were controlling Russia's oil and gas industry strongly suggested that the CBR devalue the ruble, a move which would have increased the ruble value of exported oil and gas.  In response, the CBR raised its lending rate to 150 percent as shown here:

Here's what happened to real short-term interest rates in Russia between January 1995 and August 1998:

The high short term rates dropped after Boris Yeltsin was elected in July 1996 but rose as the crisis developed, killing off any hope of a Russian economic miracle.

Despite these efforts, the knowledge that billions of dollars worth of corporate, bank and government debt were coming due in the fall of 1998, necessitated the intervention of the IMF.  The IMF approved additional assistance of $11.2 billion in July 1998, however, approximately $4 billion in capital had fled Russia between May and August of 1998, putting an additional strain on the economy.

On August 13, 1998, the Russian stock, bond and currency markets collapsed on fears that the government would default on its debt, devalue its currency or both.  The annual yield on ruble denominated bonds rose to more than 200 percent and the stock market dropped by 65 percent on very light volumes (it had fallen 39 percent in the month of May alone). 

On August 17, 1998, Russia's government floated its exchange rate, devalued the ruble, halted payments on ruble-denominated debt and declared a 90 day moratorium on payments by the banking system to foreign creditors, a devaluation and debt default double header.

As a result of the crisis, this is what happened to Russia's economic growth during the period from 1995 to 2001:

By 2000, the Russian economy was growing at 8.3 percent, much of which can be attributed to an increase in the price for oil.

At the time of the default, Russia announced a forced restructuring of its ruble debt obligations that were falling due at the end of 1999 with a face value of $45 billion at the exchange rate prior to the crisis.  Not only were there problems with Russia's debt, but Moscow-based private banks collapsed as well, forcing depositors to transfer their deposits to Sberbank, the state-owned savings bank.    

Right now, many are speculating that Russia's current crisis has been brought about by sanctions imposed over the Ukrainian issue and by falling oil prices since oil forms a key part of Russia's government revenues.  In Russia's 2014 budget, it called for total revenues of $409.6 billion and spending of $419.6 for a deficit of $10 billion or 0.4 percent of GDP ($2.5 trillion), a tiny fraction of the deficits run in most developed nations.  According to calculations by Forbes, assuming oil prices of $111.76 per barrel for crude oil (the year-end price in 2013) and natural gas prices of $66 per fuel oil equivalent barrel, Russia's annual oil and natural gas revenues for 2014 would be $662.3 billion or 25 percent of GDP.  If oil drops in price to $80 per barrel, Russia would see its oil and natural gas revenues decline by $120 billion.  Obviously, this would push up Russia's deficit for 2014.

What is being ignored is the interconnectedness of the world's economy.  As became apparent during the Asian crisis and the Great Depression, when one part of the world's economy suffers, the suffering has a strong tendency to spread to the most unexpected quarters.  In the current case, while low oil prices will have a strong impact on Russia's economy, they will also have an impact on any nation that relies heavily on oil revenues to achieve some semblance of fiscal balance and any nation that trades with Russia.