The Russian Default of The Russian Default of 19981998

A case study of a currency A case study of a currency crisiscrisis

Francisco J. Campos, UMKCFrancisco J. Campos, UMKC10 November 200410 November 2004

What’s a currency crisis?What’s a currency crisis?

It can be defined as a speculative It can be defined as a speculative attack on a country’s currency.attack on a country’s currency.

It can lead to forced devaluation and It can lead to forced devaluation and debt default.debt default.

It might happen when investors fear It might happen when investors fear that the government is going to that the government is going to devalue the domestic currency.devalue the domestic currency.

What’s a currency crisis?What’s a currency crisis?

A devaluation occurs when there is A devaluation occurs when there is market pressure to increase the market pressure to increase the exchange rate because the country exchange rate because the country cannot or will not be able to support cannot or will not be able to support its currency.its currency.

In order to maintain the exchange In order to maintain the exchange rate peg, the central bank must rate peg, the central bank must intervene in the FX market buying up intervene in the FX market buying up its currency with foreign reserves. its currency with foreign reserves.

Currency crises: what does macroeconomic theory suggest?

Macroeconomic models

First-Generation Models Second-Generation Models Third-Generation Models

First-Generation ModelsFirst-Generation Models

Causes of a currency crisis: Causes of a currency crisis: government debt and inability to government debt and inability to control the budget.control the budget.

• People believe financing the debt People believe financing the debt becomes the government’s major becomes the government’s major concern.concern.

• People expect the monetization of People expect the monetization of the fiscal deficit. the fiscal deficit.

Second-Generation ModelsSecond-Generation Models

They suggest that a devaluation in They suggest that a devaluation in one country affects the price level or one country affects the price level or the current account of the countries the current account of the countries around it.around it.

• Economic events, such as war or oil Economic events, such as war or oil price shocks.price shocks.

• Expectations.Expectations.

Third-Generation ModelsThird-Generation Models

They suggest that a currency crisis is They suggest that a currency crisis is brought on by a combination of factors:brought on by a combination of factors:

• High debtHigh debt• Low foreign reservesLow foreign reserves• Falling government revenuesFalling government revenues• Increasing expectations of devaluationIncreasing expectations of devaluation• Domestic borrowing constraints Domestic borrowing constraints

(increasing the interest rate reduces the (increasing the interest rate reduces the amount of loans)amount of loans)

The Russian default: A brief history The Russian default: A brief history 1996 and 1997 1996 and 1997

In 1997, Russia seemed to be turning In 1997, Russia seemed to be turning toward economic stabilitytoward economic stability

The Russian default: A brief history The Russian default: A brief history 1996 and 19971996 and 1997

The trade surplus was moving toward a balance between The trade surplus was moving toward a balance between exports and imports.exports and imports.

Inflation had fallen from 131% in 1995 to 11% in 1997.Inflation had fallen from 131% in 1995 to 11% in 1997.

The Russian default: A brief history The Russian default: A brief history 1996 and 19971996 and 1997

The exchange rate was kept between 5 and 6 The exchange rate was kept between 5 and 6 rubles to the dollar.rubles to the dollar.

The Russian default: A brief history The Russian default: A brief history 1996 and 19971996 and 1997

Output was recovering slightly. Russia ended up Output was recovering slightly. Russia ended up 1997 with a 0.9% growth.1997 with a 0.9% growth.

The Russian default: A brief history The Russian default: A brief history 1996 and 19971996 and 1997

Annual Percentage Change in GDP for Russia (1990-2004).

The Russian default: A brief history The Russian default: A brief history 1996 and 19971996 and 1997

Structural problems still remained.Structural problems still remained.• Real wages were less than half of what Real wages were less than half of what

they were in 1991. Only about 40% of they were in 1991. Only about 40% of workers were paid in full and on time.workers were paid in full and on time.

• Per capita direct foreign investment was Per capita direct foreign investment was low.low.

• Privatization of public enterprises was still Privatization of public enterprises was still difficult due to internal opposition within difficult due to internal opposition within the government.the government.

• Low tax collection Public Sector DeficitLow tax collection Public Sector Deficit

The Russian default: A brief history The Russian default: A brief history 1996 and 19971996 and 1997

In November 1997, the ruble suffered In November 1997, the ruble suffered its first speculative attack.its first speculative attack.

The CBR spent nearly $6 billion of its The CBR spent nearly $6 billion of its foreign reserves to defend the ruble.foreign reserves to defend the ruble.

In December 1997, the price of oil In December 1997, the price of oil began to drop.began to drop.

The Russian default: A brief history The Russian default: A brief history 19981998

With some many uncertainties in the With some many uncertainties in the economy, investors turned their attention economy, investors turned their attention toward Russian default risk.toward Russian default risk.

The government increased tax collection, The government increased tax collection, lowering bank’s and firm’s liquidity.lowering bank’s and firm’s liquidity.

The CBR responded by increasing the The CBR responded by increasing the lending rate to banks, first from 30% to lending rate to banks, first from 30% to 50%, and finally to 150%. 50%, and finally to 150%.

The price of oil was as low as $11 per The price of oil was as low as $11 per barrel barrel

The Russian default: A brief history The Russian default: A brief history 19981998

In June 1998, the ruble came under attack for the In June 1998, the ruble came under attack for the second time.second time.

In July the IMF approved assistance of $11.2 In July the IMF approved assistance of $11.2 billion, of which $4.8 was given immediately.billion, of which $4.8 was given immediately.

By August, $4 billion had left Russia in capital By August, $4 billion had left Russia in capital flight.flight.

The final attack happened on August 13, 1998. The final attack happened on August 13, 1998. The Russian stock, bond and currency markets The Russian stock, bond and currency markets collapsed as a result of investor fears that the collapsed as a result of investor fears that the government would devalue the ruble, default on government would devalue the ruble, default on domestic debt, or both = DEVALUATIONdomestic debt, or both = DEVALUATION

How the theory explains the How the theory explains the Russian crisisRussian crisis

Fiscal deficits and debt

expectations

A fixed exchange rate

monetary policy and interest rates

How the theory explains the How the theory explains the Russian crisis: Russian crisis: Exchange rateExchange rate

The CBR was willing to defend the The CBR was willing to defend the exchange rate peg.exchange rate peg.

The first two speculative attacks The first two speculative attacks depleted Russia’s foreign reserves.depleted Russia’s foreign reserves.

Once depleted, the government had Once depleted, the government had no choice but to devaluate following no choice but to devaluate following the August attack.the August attack.

How the theory explains the How the theory explains the Russian crisis: Russian crisis: Fiscal deficitFiscal deficit

High debt and low revenues. Causes:High debt and low revenues. Causes:• Low output.Low output.• Competition between local governments to Competition between local governments to

attract firms.attract firms.• The decrease in the price of oil.The decrease in the price of oil.• Large amount of short-term foreign debt Large amount of short-term foreign debt

due in 1998.due in 1998. Under a fixed exchange rate, Russia was Under a fixed exchange rate, Russia was

unable to finance its deficit by printing unable to finance its deficit by printing money.money.

How the theory explains the How the theory explains the Russian crisis:Russian crisis:

Monetary policy and interest ratesMonetary policy and interest rates

The rise in the interest rate had two The rise in the interest rate had two effects:effects:

• It increased revenue problems and It increased revenue problems and debt.debt.

• It did not increase the amount of It did not increase the amount of loans available to firms. loans available to firms.

How the theory explains the How the theory explains the Russian crisis: Russian crisis: ExpectationsExpectations

Three aspects increased Three aspects increased expectations of devaluation:expectations of devaluation:

• The Asian crisis.The Asian crisis.• Public relations errors.Public relations errors.• Low revenues.Low revenues.

ConclusionsConclusions

Factors of risk for a currency crisis: a fixed Factors of risk for a currency crisis: a fixed exchange rate, fiscal deficits and debt, the exchange rate, fiscal deficits and debt, the conduct of monetary policy and conduct of monetary policy and expectations of default. expectations of default.

Under certain conditions, contractionary Under certain conditions, contractionary monetary policy can accelerate monetary policy can accelerate devaluation.devaluation.

First and Second-Generation models First and Second-Generation models explain fiscal deficits; the Third-Generation explain fiscal deficits; the Third-Generation model, financial sector fragility.model, financial sector fragility.

Questions?Questions?