Lessons from the Russian Crisis of 1998 and Recovery

1. Lessons from the Russian Crisis of 1998 and Recovery Brian Pinto, Evsey Gurvich and Sergei Ulatov Draft Chapter for: Managing Economic Volatility and Crises: A Practitioner’s Guide Edited by Joshua Aizenman and Brian Pinto

2. Related papers • Pinto, Vladimir Drebentsov, Alexander Morozov: “Give macroeconomic stability and growth in Russia a Chance: Harden budgets by Eliminating Nonpayments”, Economics of Transition, vol 8 (2) 2000, 297-324. • Homi Kharas, Pinto and Ulatov: “An Analysis of Russia’s 1998 Meltdown: Fundamentals and Market Signals”, Brooking Papers on Economic Activity, 1:2001, 1-67. • Joshua Aizenman, Kenneth M. Kletzer and Pinto, “Sargent-Wallace Meets Krugman-Flood-Garber, or: Why Sovereign Debt Swaps Don’t Avert Macroeconomic Crises.” NBER WP 9190.

3. Key Dates and Events • July 1995 3-year stabilization program agreed with IMF • July 1996 Yeltsin re-elected in second round • Early 1997 GKO/OFZ market liberalized, “DREAM TEAM” • Oct 1997 Chronic tax problem prompts IMF to hold up disbursements • July 13, 98 $22.6 billion package announced • August 17 Ruble devalued, emergency measures announced • September 2 Ruble is floated • September 9 Exchange rate reaches 21 R/$ compared to 6.29 R/$ on August 14

4. The Economic and Political Costs of the Crisis • GDP minus 4.9% • 12-month inflation 84% - target was 8% • Pensioners/ wage earners suffered • FX resources used up between Oct. 1997 and the Sept. 2, 1998 float $30 billion. $16 billion incurred in the last 10 weeks before the meltdown • Reformist government of Sergei Kirienko was dismissed

5. Four-Part Framework • Fundamentals and Liquidity • Market Signals • Crisis Triggers • Moral Hazard

6. (1) d public debt/GDP ratio, t time subscript (in years) pd primary deficit/GDP ndfs non-debt financing sources/GDP r composite real interest rate g real growth rate Public Debt Dynamics These are captured by the standard equation (1):

7. Public Finances and Economic Growth

8. w share of domestic currency debt in total debt r real interest rate on domestic currency debt d r real interest rate paid on foreign currency debt (e.g., interest f rate paid by government on US dollar borrowing adjusted for US inflation) r % change in dollar-ruble real exchange rate (r > 0 means a real appreciation) Public Debt Dynamics (cont’d) This brings us to equation (2), which contains an expanded version of the composite real interest rate, r: (2)

9. Why were growth expectations in Russia consistently belied? • Macroeconomic environment: high real interest rates and an appreciating real exchange rate • Serious structural problems (the non-payments problem)

10. Real Exchange Rate (RER) • Was real appreciation an equilibrium phenomenon? • Current Account Balances vs. Sargent –Wallace • RER movements = f (oil prices, capital flows, stabilization strategy • Stabilization Strategy was the main influence on RER

11. What is the non-payments problem? • Curious phenomenon unique to Russia and the FSU • Consisted of two parts: (i) arrears/overdue payments and (ii) growing use of non-monetary exchange • Became entrenched because of high interest rates • Killed growth and locked-in the fiscal deficit • Rational economic explanations • Enveloped the entire economy • Linked to PDD • Linked to growth

12. Market Signals • Foreign Currency Debt (FCD) • Domestic Currency Debt (DCD)

13. Foreign Currency Debt

14. Spread difference on the Russian and Indonesian 10-year eurobonds • June 10, 1998 -100 bps • June 25, 1998 0 • July 24 (completion of debt swap) +160

15. Domestic Currency Debt (DCD) Yields on one-year GKOs were decomposed using equation (3) to get the sovereign or default risk premium (SRP) and devaluation risk premium (DRP) as a residual. (3) id = if + SRP + (dx/x)* + DRP

16. GKO yield SRP DRP May 15 39.3 4.8 23.0 July 13 102.3 8.5 82.3 July 14 58.2 8.1 38.6 July 24 66.4 10.0 44.9 August 10 99.0 20.0 67.5 August 14 144.9 23.8 109.5 SRP and DRP Selected Dates

17. Timing of the Crisis Three factors played a role: • International liquidity • Balance and off-balance sheet exposures of banks • GKO-Eurobond swap and IFI liquidity injection

18. S max. cutoff spread 940 837.5 min. spread 4.4 Market Value of GKOs tendered ($ bn.) The Outcome of the Swap Bid Spread (basispoints) S 0

19. Why didn’t the swap work as anticipated? • No free lunch with market-based swap • Interaction effects with existing asset portfolio • Implications for size of devaluation needed to restore government’s inter-temporal budget constraint balance

20. Moral Hazard • There are many ex-post studies showing MH is not a factor • What matters is how MH affects behavior by changing expected returns • MH is a particularly costly issue when you have unsustainable PDD and low liquidity

21. Post Crisis Developments • Hard budgets and RER • Liquidity and PDD • Macro policy stance (RER, Fiscal Adjustment) • Debt Restructuring • Social Impact

22. So, What’s the Bottom Line?Lessons Learned • Extremely difficult to deal with unsustainable PDD and low liquidity simultaneously. • Inflation reduction at the expense of fiscal and growth fundamentals will simply not work. • Real appreciation with deteriorating enterprise performance and PDD is unlikely to be sustainable EVEN if CA in balance.

23. Lessons Learned (Cont’d) • Liquidity – appropriate measures. • Why financial engineering will not help. • Social safety net lessons. • Politics

24. Do Svidania!