Russia's 1998 Currency Crisis: Causes and Aftermath

Introduction

Although the former Soviet Union has collapsed and lost much of its territorial possessions, Russia remains the largest country in the world, and what happens to the Russian economy can have a profound effect on the rest of the world — as was witnessed during its currency crisis in 1998. This paper reviews the relevant literature to identify the antecedents of that most recent financial crisis, compares it to previous financial crises in the country, and identifies key similarities and differences. A summary of the research and its important findings is presented in the conclusion.

The 1998 Currency Crisis: Origins and Immediate Impact

The most recent currency crisis that Russia experienced began in August 1998 (Robinson 246). As Chiodo and Owyang report, "A currency crisis can be defined as a speculative attack on a country's currency that can result in a forced devaluation and possible debt default. One example of a currency crisis occurred in Russia in 1998 and led to the devaluation of the ruble and the default on public and private debt" (7). Some indication of the severity of this episode can be discerned from its impact on Russia's gross domestic product (GDP). The Russian GDP experienced a major decline beginning in 1998 that continued through the turn of the century before rapidly increasing thereafter, and the percentage GDP growth rate was even more striking in its severity.

According to one financial analysis, "At the time, the crisis marked a turning point in the development of the Russian economy. In its immediate aftermath there was some expectation that it would be the prelude to . . . a long and painful period of insolvency and crisis [that] would lead rapidly to another, more severe, financial crisis" (Robinson 246). These dire predictions, however, did not bear out, and the Russian economy has since experienced a sustained period of growth. Rather than causing further financial crises, the period following the August 1998 episode was characterized by continued growth, disrupted only slightly by the global economic downturn in 2008 resulting from the subprime mortgage crisis in the United States (Robinson 247). As Petro and Kovriga point out, "It is widely acknowledged that the [2008] global financial crisis was triggered by a shortfall in the liquidity of the U.S. banking system. Major banks securitized highly profitable, but very risky subprime mortgages" (27).

The main origins of the 1998 currency crisis were primarily attributable to low foreign reserves and large fiscal deficits — factors that have also been responsible for financial crises in other countries, including the East Asian crisis of 1997–1998 (Hill and Jongwanich 2). Beginning in the early 1990s, foreign reserve levels in East Asia grew rapidly but began a sharp decline by the late 1990s as a result of that crisis; however, these levels rebounded after 2000 (Hill and Jongwanich 3).

Sieron also notes that other systemic weaknesses contributed to the 1998 Russian currency crisis, most notably unsustainable debt accumulation. By 1998, interest payments on Russian debt accounted for fully 43% of total government revenues (Sieron 4). External factors compounded these structural problems: the lingering aftereffects of the 1997 East Asian crisis subjected the ruble to speculative attacks that resulted in the loss of almost US$6 billion in reserves as Russia attempted to defend its currency (Sieron 4).

A chronology of events that preceded and followed the 1998 Russian currency crisis is presented below.

January 1992 – June 1, 1995: Freely falling / Dual Market. No price data exists before this date.

July 6, 1995 – July 1996: Freely falling / Dual Market. Pre-announced crawling band around the U.S. dollar for the official rate.

August 1996 – August 17, 1998: Dual Market. Pre-announced crawling band around the U.S. dollar for the official rate.

August 17, 1998 – November 1999: Freely falling / Dual Market. The band was widened on August 17 and eliminated on September 2. On June 29, 1999, the two rates were unified temporarily.

December 1999 – December 2010: De facto crawling band around the U.S. dollar / Multiple exchange rates. Band width ±2%. In principle it targeted a U.S. dollar–euro basket; the band appears to have widened to ±5% starting October 2009.

Source: Ilzetzki, Reinhart, and Rogoff, 2010

Russia's Economic Recovery After 1998

Notwithstanding the negative effects of the 2008 financial crisis, the Russian economy managed to weather the storm and even prosper thereafter. Robinson emphasizes that "The power of the Russian state has grown since 1998 and Russia has experienced a near uninterrupted economic recovery since 1999 with GDP growth averaging 6.8% per annum from 1999 to 2005" (247). Other major indicators of sustained growth include a 7% per annum increase in industrial production, a reduction in unemployment from 13.2% in 1998 to 7.7% by 2005, and an increase in average wages from $108 a month in 1998 to $301 a month by 2005 (Robinson 247). In sum, the overarching effect of the 1998 currency crisis on the Russian economy proved to be, in the longer run, surprisingly positive (Robinson 246).

The relatively sustained economic growth that followed the 1998 crisis resulted from a combination of factors, most especially the decision to allow the ruble to float freely rather than subject it to further managed devaluations. As Cassidy notes, "The Russian Central Bank, after being forced to devalue the currency during a financial crisis in 1998, no longer does this. The ruble floats" (3). The Russian leadership implemented this policy in part to avoid further devaluations that could be caused by future downturns in global oil prices, a major component of the Russian economy (Cassidy 4). Since 1998, the Russian Central Bank has also managed to accumulate a significantly larger stock of foreign exchange reserves (Cassidy 5).

Despite this progress, fundamental vulnerabilities remain, most notably Russia's heavy dependence on oil revenues. According to Sieron, "There is a significant positive correlation between [the] ruble and oil prices (which are affected to a large extent by a strong U.S. dollar)" (5). To the extent that oil prices decline in the future, demand for rubles is likely to fall as well, introducing additional pressure on the Russian government to maintain a viable exchange rate (Sieron 5). As Galbraith observes more broadly, "The distribution of economic earnings is built up in any given national economy out of deeply interlaced institutions, firms, occupations, industries, and geographic regions. That being so, consistent observation of the movement of these entities, taken at their average values and compared to each other, is often sufficient to reveal the main movements of the distribution as a whole" (30).

Although the Russian economy continues to enjoy intermittent growth, avoiding future currency crises will require the concerted effort of the Russian Central Bank (Sieron 5). As Sieron warns, "Unfortunately, after the infamous Rosneft's case, its credibility has been called into question, as investors fear that it will be printing more money to help oligarchs' banks and businesses. Without a credible monetary policy and structural reforms, the Russian economy is going to slump into recession, which will last as long as oil prices do not rise again" (6).

During the period from 1995 through 2015, the Russian GDP growth rate averaged 0.77%, culminating in a record high of 4.10% during the first quarter of 1999 following a record low of -5.40% during the third quarter of 1998 (Russia GDP Annual Growth Rate 1). The Russian GDP declined 2.01% in the second quarter of 2015 compared to the previous quarter, underscoring the economy's continued vulnerability.

Conclusion

The research shows that the Russian economy still possesses considerable strength, but there are signs that its relatively sustained economic growth may be threatened by internal and external factors, some of which were also responsible for the currency crisis of 1998. The increased military spending of Russia has been cited by numerous observers as potentially destabilizing — and such enormous investment in military might was one of the principal factors that resulted in the collapse of the former Soviet Union. In addition, corruption remains a major constraint for investors who view the rule of law in Russia as dubious at best, and many Russians have been heard to lament the loss of the stability associated with the communist era, where pay may have been low but benefits were generous and guaranteed for life. In the final analysis, it is reasonable to conclude that Russia will continue to experience relatively sustained economic growth provided that global oil prices remain stable and the government takes substantive steps to resolve the current constraints to additional foreign direct investment.

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