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.

Sovereign Debt Default: Learning Lessons From Argentina

In recent weeks and months, page one news for most of the world's major (and minor) newspapers and media outlets has been the debt crisis facing the Eurozone, most particularly Greece and, most recently, Italy.  It has certainly been a roller coaster ride for the world's bond and stock markets which fluctuate on a daily basis, solely based on that particular day's perception of whether or not a given nation will default on its debt.  In light of that, I thought that it would be prudent to take a look back at the largest sovereign debt default which took place back in 2001.  Please excuse me in advance for the length of this posting, but I wanted to ensure that the entire story was told.

After several years of recession which was accompanied by social unrest, Argentina's government imploded and stopped payments on its debt.  The default on $100 billion worth of debt that was owed to both domestic and foreign investors, was the largest sovereign default in history.  The world's experience with Argentina's default serves as a laboratory for what might lie ahead for an ever-increasing number of debtor nations who simply will not be able to service their existing and future debt loads.  The major difference between what happened in 2001 and what is happening today is scale; government debt for debtor nations today is far higher in both nominal and real terms than the issues that faced Argentina back in 2001.  Let's take a look at what happened and what is still happening as Argentina reinvents itself in the eyes of the investment community.

Back in 1989, Argentina fell into a period of hyperinflation with inflation peaking at 84 percent in 1991 that threatened to destabilize their economy.  The IMF introduced a "Convertibility Plan" in April of 1991 to stabilize the economy through a measure that fixed the peso to U.S. Dollar exchange rate at one-to-one at the same time as Argentina's central bank was restricted from printing endless supplies of paper which they had historically been prone to do (does this sound at all familiar, Mr. Bernanke?).  For the next several years, the Argentine economy stabilized and actually grew at an average annual rate of 6 percent through 1997.  Inflation dropped from its hyperinflationary peak in 1991 to a low of 0.1 percent in 1996.  Unfortunately, external debt grew from $62.3 billion in 1991 to a peak of $146.3 billion in 2000, largely due to debt rollovers.  The halcyon days of the early to mid-1990s ended with a sudden jolt in August/September 1998 when Russia defaulted on its own sovereign debt followed by the devaluation of Brazil's real in January 1999.  This triggered a severe recession in Argentina that did not correct itself, resulting in a loss of confidence in the quality of Argentina's debt, a concern that eventually became self-fulfilling.  It also became apparent that the "Convertibility Plan" had an unforeseen weak spot; because it fixed the USD to peso exchange rate, it prevented Argentina from devaluing the peso which compounded the drop in exports.  Oops!  By late 2000, Argentina was having an increasingly difficult time accessing capital resulting in a very sharp rise in the spread between United States Treasuries and Argentine bonds as shown on this graph:

Does the trend on this graph look familiar to anyone?  Here's a graph showing the yields on Italy's 10 year bonds for the past 3 years:

Here's the same 3 year graph showing the yield on Greece's 10 year bonds:

By the second quarter of 2001, capital was flying out of Argentina at light speed, necessitating even further IMF intervention as I will show later.  Runs on the local banking system resulted in a partial freeze and finally, after (belatedly) deciding that Argentina was no longer in compliance with the conditions of the IMF-sponsored program, the IMF decided to withdraw its support and suspend disbursements.  When Argentina defaulted, it owed private investors $81.8 billion, the Paris Club countries $6.2 billion and the IMF $9.8 billion.

 It is interesting to note that Argentina's debt problems escalated in an extremely short period of time.  In late 2001 around the time of the default, Argentina's debt-to-GDP ratio sat at 53.7 percent, what would appear to be a very comfortable level compared to today's sovereign debt transgressors.  Following default and devaluation of the Argentine peso, the country's debt-to-GDP soared to 166.4 percent in 2002, still relatively reasonable when compared to many debtor nations today.  What led to this crisis?  According to a 2010 report by the Congressional Research Service's J.F. Hornbeck entitled "Argentina's Defaulted Sovereign Debt: Dealing with the Holdouts";

"Argentina’s 2001 debt crisis resulted from many factors. For the most part, Argentina fell victim to its own economic policies, but these were compounded by questionable lending and policy advice by the International Monetary Fund (IMF), a global recession, and international credit markets determined to chase high-yielding debt with inadequate regard to risk. Together, these factors propelled Argentina toward a position of unsustainable debt that ended in an unprecedented default and restructuring scheme." (my bold)

Well, look at that!  The IMF compounded Argentina's debt problem by offering questionable lending and policy advice.  Apparently, global credit markets continued to loan money to Argentina even when the country's debt rose to worrisome levels.  Does this story sound familiar to anyone other than me?  Accompanying the additional loan facility was assurances by both investment banks and credit agencies that overstated Argentina's strengths.  Once again, a familiar story.  As if all of that was not bad enough, between 1991 and 2001, the IMF agreed to numerous lending arrangements to the Argentine government that were based on promised changes to Argentina's policies that were either overly optimistic, unrealistic or a combination of the two.  The IMF compounded the problem with lax supervision and ended up lending too much for too long into a situation that was quite clearly untenable.  Here's an interesting quote from the IMF's Independent Evaluation Office (IEO) report on the role of the IMF in Argentina between 1991 and 2002:

"Argentina was plunged into a devastating economic crisis in December 2001/January 2002, when a partial deposit freeze, a partial default on public debt, and an abandonment of the fixed exchange rate led to a collapse in output, high levels of unemployment, and political and social turmoil. These events have raised questions regarding the country's relationship with the IMF because they happened while its economic policies were under the close scrutiny of an IMF-supported program. Furthermore, the IMF had been almost continuously engaged in Argentina since 1991, when the "Convertibility Plan" fixed the Argentine peso at parity with the U.S. dollar in a currency board-like arrangement. While Argentina experienced strong growth and very low inflation for much of the 1990s, it fell into a deep recession in 1998 and, partly because of the strictures of the convertibility regime, became increasingly constrained in its ability to use standard macroeconomic policy tools to engineer a recovery. As the economy slowed and international investors became nervous, the country's already high external debt service burden grew to a point where the debt became unsustainable....While ultimate accountability for a member country's economic policy must rest with its national authorities, since the crisis, a number of observers have raised questions about the effectiveness and quality of financing and policy advice provided by the IMF. Some critics have argued that the IMF's main fault lay in providing too much financing without requiring sufficient policy adjustment, while others have alleged that the policies recommended by the IMF actually contributed to the crisis. In either case, the eventual collapse of the convertibility regime and the associated adverse economic and social consequences for the country have, rightly or wrongly, had a reputational cost for the IMF." (my bold)

I'd say rightly...so why is it that governments around the world continue to support the IMF and allow it to step in to “rescue” debtor nations?

Here's a graph from the IEO report showing the massive ramping up of monies disbursed to Argentina in the year of default and the rapid growth in debt (credit outstanding):

As a result of the default, Argentina's economy contracted by 20 percent from the onset of the recession in 1998 to the end of 2002.  This led to massive unemployment and further social unrest as one can well imagine.

Let's briefly address what has happened since Argentina's default in 2001 - 2002.  Following the default, there was a very lengthy and unsuccessful attempt to find a mutually acceptable solution between the creditors and the Argentine government.  The most pressing issue was that Argentina was simply in no fiscal position to repay its $98 billion debt.  By January 2005, Argentina had only reached agreement with 76 percent of its creditors and had accrued an additional $21.4 billion in past due interest on top of what it owed back in 2001.  Of the $81.8 billion of debt held by the private sector, $62.2 billion worth was exchanged for $35.2 billion of new bonds, a 56 percent recovery rate (or a 44 percent haircut).  The problem arose with the 24 percent of creditors who did not accept the offer along with the accrued past due interest as well as the arrears to the Paris Club and the poor, old IMF.  To get out from under the heavy hand of the IMF, in 2006, Argentina paid back the full $9.8 billion owing.  As of January 2010, Argentina still owed $29 billion of bond principal and past due interest to private investors and $6.2 billion to the Paris Club countries.  One would have to think that this is a perfect example of attempting to get "blood from a stone".  Here is a chart showing the current status of Argentina's sovereign debt:

Interestingly, nearly $500 million is owed to the United States which has frozen $105 million of Argentina's Central Bank reserves at the Federal Reserve Bank of New York and another $2 billion of global bonds backing loans are on hold at the Depository Trust Company.  This has meant that, under United States law, various U.S. agencies are prohibited from lending to Argentina because it is in arrears on its debt.

Argentina's economy has done remarkably well since the default; GDP growth rose to 8.8 percent in 2003 and averaged 8.5 percent annually until 2008.  Public debt-to-GDP has dropped from a peak of 166.4 percent in 2002 to a low of 48.8 percent in 2008 and the country has had a primary surplus of 2.8 percent or higher until recently.  On top of all this feel good data, Argentina's international reserves have risen from $10.4 billion in 2002 to $47.5 billion in 2009. 

Now let's summarize.  Looking at the issues facing Argentina during the onset of its debt default crisis, one has to wonder what was going through the learned minds at the IMF with their 11th hour, hail Mary dumping of credit into Argentina when it was so apparent that failure was eminent, particularly given the fact that Argentina's central bank loved to print its way out of trouble?  It begs the question, "Will the bailout of the offending Eurozone nations turn out any differently or is the agony just being prolonged?"  I've said it before and I'll say it again; apparently, economics is NOT a science!

The more things change, the more they stay the same.  Unfortunately, some lessons are learned in a very, very hard way, particularly by the world's central bankers and the IMF.  It will be interesting to see if history repeats itself on the east side of the Atlantic Ocean this time.