1998 Russian financial crisis

• 1. Introduction

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  On the 17th of August 1998, the Russian government did something that would have seemed unthinkable just a year earlier. It devalued its own currency, defaulted on its domestic debt, and declared a moratorium on repayment to foreign creditors, all in a single joint statement. The ruble, which had been trading at 6.29 to the dollar just three days before, would lose two-thirds of its value within a month. The questions that follow are not simply about one nation's financial misfortune. They are about what happens when a country tries to build a modern market economy on a foundation that was never designed to bear that weight, and about why decisions made in Moscow left workers in Kazakhstan, Kyrgyzstan, and Moldova unable to cover their national expenses. What were the warning signs that went unheeded? Who made the fateful choices in the months before August? And how did a country that looked to be in recovery by mid-1997 end up appealing for international humanitarian food aid just over a year later?

• 2. Seeds of Collapse

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  In the first half of 1997, Russia's economic supervisors had genuine reason for optimism. Inflation had finally come to a standstill after years of post-Soviet turbulence, and output was showing early signs of a rebound. That cautious confidence did not last long. Two external shocks arrived in close succession, starting with the Asian financial crisis that erupted in 1997. As demand for crude oil and nonferrous metals fell sharply in its wake, Russia's foreign exchange reserves took a direct hit. Russia depended on those commodity exports to service its debts, and when commodity prices fell, the arithmetic turned brutal.

  Running underneath that external pressure was a structural problem that had never been resolved. The dissolution of the Soviet Union had left Russia with an obligation to provide assistance to the former Soviet states, and it met that obligation largely by importing heavily from those countries. Foreign loans financed the domestic investments that were supposed to modernize the economy. When those loans came due, Russia lacked the means to pay them back, and the ruble came under immediate pressure.

  The Chechnya war made everything worse. By early 1995, the conflict was estimated to be costing Russia close to $30 million per day. When hostilities ceased in 1996, the total bill was estimated at $5.5 billion, and the resulting budget deficits had climbed to nearly 10 percent of GDP. That deficit did not disappear when the shooting stopped. It became a permanent drag on a government already struggling to collect enough tax revenue to cover its basic obligations.

• 3. The Political Earthquake

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  On the 23rd of March 1998, Boris Yeltsin moved suddenly and without public warning. He dismissed Prime Minister Viktor Chernomyrdin and his entire cabinet, then named Sergei Kiriyenko, the energy minister, as acting prime minister. Kiriyenko was 35 years old at the time. The appointment sent a signal of instability through financial markets at precisely the moment Russia needed to project confidence to foreign investors.

  Yeltsin had appointed Boris Fyodorov as Head of the State Tax Service on the 29th of May 1998, but the political machinery was working against reform at every turn. On the 15th of July 1998, the State Duma, then dominated by left-wing parties, refused to adopt most of the government's anti-crisis plan. The government was left with no option but to rely on presidential decrees to push through economic measures.

  Then, on the 29th of July, Yeltsin abruptly cut short his vacation in the Valdai Hills region and flew back to Moscow. The sudden return prompted immediate speculation about a cabinet reshuffle. In the end, he made only one change: replacing the Federal Security Service chief Nikolay Kovalyov with Vladimir Putin. The political turbulence reinforced what investors were already beginning to believe, that no coherent reform program was coming.

• 4. The Defense of the Ruble

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  Russia's Central Bank had committed itself to what it called a floating peg. The bank would keep the ruble-to-dollar exchange rate within a defined band, intervening by buying rubles with foreign reserves whenever the currency threatened to weaken below the lower boundary. In the year before the crisis, that band ran from 5.3 to 7.1 rubles per dollar. If the rate threatened to breach 7.1, the bank bought. If it threatened to fall below 5.3, the bank sold.

  It was an expensive promise to keep. Between the 1st of October 1997 and the 17th of August 1998, the Central Bank spent approximately $27 billion of its US dollar reserves defending that band. The mechanism became self-defeating: every time the bank spent reserves to prop up the ruble, investor confidence eroded further, which put more pressure on the ruble, which required more reserve spending.

  Kiriyenko tried to break the cycle in June 1998 by hiking interest rates on GKO short-term government bonds to 150 percent, hoping to attract capital back into the country. By that same month, monthly interest payments on Russia's debt had risen to a figure 40 percent higher than its monthly tax collections. A $22.6 billion rescue package from the International Monetary Fund and World Bank was approved on the 13th of July 1998. But even that emergency support could not close the gap. It was later revealed that approximately $5 billion of the funds provided by international lenders were stolen upon arrival in Russia on the eve of the meltdown.

• 5. The Strike and the Brink

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  Coal miners walked off the job on the 12th of May 1998. Their grievance was unpaid wages, and their protest was unmistakable: they blocked the Trans-Siberian Railway. The strike was a visible symptom of a dysfunction that had spread across the entire economy. By the 1st of August 1998, approximately $12.5 billion in wages was owed to Russian workers across industries.

  The exchange rate on the 14th of August 1998 still showed 6.29 rubles to the dollar, a surface-level calm that masked what was coming. Three days later, the joint statement arrived. The ruble-dollar trading band expanded from 5.3-7.1 RUB/USD to 6.0-9.5 RUB/USD. Certain state securities, including GKOs and OFZs, were to be restructured into new instruments. A 90-day moratorium was placed on bank obligations, covering certain debts and forward currency contracts.

  From the 17th through the 25th of August, the ruble fell steadily on the Moscow Interbank Currency Exchange, moving from 6.43 to 7.86 rubles per dollar. On the 26th of August, the Central Bank suspended dollar-ruble trading on the exchange entirely, and no official rate was published that day. On the 2nd of September, the bank abandoned the floating peg altogether and let the ruble float freely. By the 21st of September, one US dollar bought 21 rubles, down from a value that, less than a month earlier, had been more than three times higher.

• 6. Inflation, Banks, and Farmland

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  Russian inflation reached 84 percent in 1998, and welfare costs grew considerably as the purchasing power of wages and savings collapsed. The banking sector took immediate and severe damage. Three banks named in reports at the time, Inkombank, Oneximbank, and Tokobank, closed as a result of the crisis.

  Bankers Trust, which had accumulated a large position in Russian government bonds, suffered major losses during the summer of 1998. It avoided collapse only by being acquired by Deutsche Bank for $10 billion in November 1998. That transaction elevated Deutsche Bank to the fourth-largest money management firm in the world, behind UBS, Fidelity Investments, and the life insurance fund operated by the Japanese post office.

  Russian agriculture felt the pressure through a different channel. Federal subsidies to the agricultural sector fell by roughly 80 percent in real terms compared with 1997. Regional budgets partially cushioned the blow, but subsidies from that level fell as well, just less sharply. By the 9th of October 1998, Russia, which was also dealing with a poor harvest, formally appealed for international humanitarian aid, including food.

• 7. Political Reckoning

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  Yeltsin fired Kiriyenko on the 23rd of August 1998, less than a week after the default. He announced his intention to restore Chernomyrdin, the prime minister he had removed just five months earlier. The move was welcomed by powerful business interests who feared that further reforms might cause leading enterprises to fail. The Communists also welcomed it, though for different reasons.

  The legislature blocked him. The State Duma rejected Chernomyrdin's candidacy twice, and Yeltsin, his domestic support visibly eroding, had no choice but to withdraw the nomination. He turned instead to Foreign Minister Yevgeny Primakov, who was approved by the State Duma by an overwhelming majority on the 11th of September 1998. Primakov was seen as a compromise figure capable of bridging the rifts between Russia's competing factions, and he came into office with genuine popular support.

  Primakov made his priorities clear from the start: payment of wages and pensions would come first. He invited members of the leading parliamentary factions into his cabinet. Even so, the political pressure continued. Communists and the Federation of Independent Trade Unions of Russia staged a nationwide strike on the 7th of October 1998 and called for Yeltsin's resignation. Boris Fyodorov was discharged from his position at the State Tax Service on the 28th of September, one more casualty of the political turnover the crisis had set in motion.

• 8. Recovery and Unexpected Gains

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  Russia's recovery from the August 1998 crash came faster than most observers had predicted. Rising world oil prices during 1999 and 2000 drove a large trade surplus in both years, restoring the foreign currency flow that the country had been unable to generate during the crisis. Domestic industries also benefited in an unexpected way: the ruble's collapse made imported goods steeply more expensive, which gave local producers, particularly in food processing, a competitive advantage they had not previously enjoyed.

  A structural quirk of the Russian economy also dampened the damage. Much of the economy was already running on barter and other non-monetary exchange rather than through the banking system. When the banking system collapsed, large segments of economic activity continued operating because they had never fully depended on it. As enterprises gradually cleared their backlogs of debt in back wages and taxes, consumer demand for domestically produced goods began to recover.

  The crisis also triggered changes beyond Russia's borders that its own officials had not planned. Economist Anders Aslund credits the 1998 crisis with delivering the decisive push toward genuine market reform in Romania and most of the post-Soviet states, which until then had liberalized only slowly and partially. Romania's first major privatization took place in November 1998, in the direct aftermath of the Russian crisis. The first privatization of a state-owned Romanian bank followed in December of the same year, closing a chapter that the crisis, for all its damage, had helped force open.