Russian Financial Crisis Triggers Devaluation, Near Default
The Luck Ran Out
By Steven J. Norton and Lynda L. Maillet

At times, it seems that Russia specializes in the production of crises. This has been a particularly good year, with both political and economic crises in multiple episodes. Beginning in the spring, the long-serving (if only modestly effective) government of Viktor Chernomyrdin was removed by President Boris Yeltsin; in its place, Mr. Yeltsin nominated a government led by a reformist political newcomer, Sergei Kiriyenko. Mr. Kiriyenko put together a cabinet heavy with reformers, but not long after its stormy parliamentary confirmation his government was confronted with the beginnings of a financial crisis that would stretch throughout the summer. Finally, on 17 August, the Russian authorities announced both a devaluation and a unilateral debt restructuring in an attempt to stop the hemorrhage of foreign currency reserves and give the government some breathing room to meet its obligations. Six days later, Mr. Kiriyenko was out, and Mr. Yeltsin called upon Mr. Chernomyrdin once again to put out the domestic political fires and cope with the crisis. But Russia’s financial difficulties stem from a combination of international and domestic problems that will not yield easily to any solutions, especially not those which might be palatable to any large portion of Russia’s political spectrum.

Path dependence
The stage for the financial crisis was set in the early years of Russian independence. In an effort to battle the hyperinflation then ravaging the country, the Russian government shifted away from printing rubles as a way of financing the central budget deficit to issuing government debt instead. Because prices were still rising rapidly, and the economy was extremely shaky, investors were only willing to accept bonds with very short maturities. Halting the uncontrolled money emissions was a critical step, but the government’s heavy dependence on ruble-denominated debt with maturities of less than one year forced it to constantly refinance that debt -- so the burden of debt service could balloon rapidly. (The Russian government also issued dollar-denominated bonds with longer maturities, but they represented a smaller proportion of the total debt.) Interest payments equaled 5.7% of GDP in 1996, 4.5% in 1997, and 5% in the first quarter of 1998; but the debt burden continued to grow since the government budget continued in deficit even excluding interest payments -- by 2.2% of GDP in 1996 and 2.5% in 1997 (and this with accumulating payments arrears).

Also important to our story is the fact that as much as one third of the short term debt (mostly bonds known by the acronym GKO) was held by foreign investors interested in the attractive interest rates and short-term commitments. Most of the rest was held by Russian private banks, whose assets were largely tied up in GKOs and currency trading operations. In contrast to banks in the west, the major Russian private banks performed little retail banking and instead served mostly as financial intermediaries for the “financial industrial groups” (and the business tycoons) which owned them. Not only were most of these banks’ assets tied up in GKO and currency contracts, they often used the bonds as collateral to obtain foreign loans....

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