The financial crisis of summer 1998
The Russian financial crisis of the summer of 1998 shared many features of other financial
crises in recent years. Each of these crises can be partly explained in terms of problems specific
to the country affected, in Russia’s case the shortcomings of its fiscal system described above
being particularly important. But recent episodes of financial crisis - and Russia’s was no
exception - typically involve the attraction of capital inflows associated with an interest rate
differential, generally resulting from tight monetary policy introduced for macroeconomic
balance, and a currency regime designed to stabilize the exchange rate. The inflows are facilitated
by relatively liberal rules for capital-account transactions and deregulation of the financial sector,
which leave banks free to borrow abroad, thus benefiting from international interest rate arbitrage
but building up foreign exchange exposure.
The resulting dependence on foreign capital flows
leaves the economy vulnerable to their reversal which can be triggered by unfavourable changes
in domestic or external conditions (or both). The outflow of capital following the reversal is likely
to cause a devaluation which leads to capital losses on the balance sheets of banks and other firms
carrying unhedged currency exposures. The subsequent surge in the demand for foreign
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2 Ponzi financing denotes the use of additional borrowing to meet interest obligations (which are thus
capitalised as part of a borrowers’ liabilities).
3 A repo or repurchase agreement is a contract between a seller and a buyer of securities (usually those issued
by a government) under which the former repurchases them from the latter at a higher price some time in the future.
These contracts are used in many financial markets as a vehicle for short-term financing of inventories of securities,
where the securities being financed serve as collateral for the loans.
4 The most frequently quoted estimate of the value of forward contracts affected by the 90-day moratorium
is about $10 billion. According to an estimate of Fitch IBCA, the international credit rating agency, which is cited
in J. Thornhill, J. Grant and T. Corrigan, “Stakes high in talks to restructure debt”, Financial Times, 24 August 1998,
the notional value of outstanding forward contracts sold by Russian banks is $40-50 billion.
exchange generated by attempts to cover these losses can create a free fall in the country’s
currency and a hike in interest rates, producing widespread bankruptcies.
As part of its efforts to achieve macroeconomic stabilization, as explained above, the
federal government had made increasing use of the issuance of GKOs. As can be seen from table
1, of the government deficit (excluding off-budget funds) as much as 50 per cent was due to
interest payments, and under the new policy the resulting obligations were financed in Ponzi
fashion by sales of new government paper.2
Much of this paper was bought by Russian banks
which financed their purchases by borrowing from foreign banks through repo contracts,3
in the
process exposing themselves to substantial currency risk. But an important part of the debt was
also purchased directly by foreign investors, non-resident holdings of GKOs being estimated at
about 30 per cent of the total in mid-1998.
Currency risks associated with their investment were
offset through the purchase of forward contracts from Russian banks (payments under which,
as explained below, have been frozen under a 90-day moratorium on selected external
obligations).4
As Russia’s current account deteriorated from a position of surplus in 1997 (table 1) to
a deficit now forecast at 1.5-2 per cent of GDP for 1998 as a whole, the rouble came under
pressure and monetary policy was tightened with the result that the interest rates on GKOs
reached levels of more than 100 per cent (more than 40 per cent above those on dollardenominated instruments with similar maturities). The consequent decline in the value of
government securities led to calls by the foreign creditors of Russian banks for additional
collateral for their repo loans. Russian banks thus came under pressure to raise additional funds
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5 Of the approximately $19 billion of external liabilities at the largest Russian banks in mid-1998 about $16
billion had a maturity of one year or less; see J.P. Morgan, Global Data Watch, 21 August 1998, p. 7.
6 Margin calls are the calls for additional monies from Russian banks due to unfavourable changes in various
categories of their foreign-currency exposure owing to falls in asset prices (of which those for government securities
used as collateral in repo loans mentioned above are an example).
at just the time when the central bank was draining liquidity from the market as part of its attempt
to defend the exchange rate. With the repo market in disarray owing to the falls in the value of
government securities, banks’ efforts to borrow were transferred to the interbank market which
proved unable to sustain these extra demands for funding and eventually ceased to function.
These difficulties signalled the liquidity squeeze on Russian banks to international lenders, and
increased their fears of widespread insolvencies in the country’s financial sector. At the same
time the government faced increasing difficulties over borrowing to meet the interest obligations
on its debt. The banks had no alternative to closing their repo positions by repaying their
borrowing in dollars
,5
and these repayments put further downward pressure on the exchange rate
and international reserves, thus leading to additional monetary tightening and falls in the prices
of government securities.
The package of international loans from the IMF, the World Bank and Japan arranged in
July was to provide Russia with funding of $17 billion during the remainder of 1998 and 1999
(which was in addition to financing from the IMF and the World Bank of more than $5 billion
during this period made available under earlier decisions). However, the attempt to defend the
exchange rate which followed (and which cost approximately $4 billion in a month) was
eventually abandoned, and a wider band for the rouble/dollar exchange rate was introduced in
the third week in August around a new central rate corresponding to a rouble depreciation of
more than 25 per cent from the previous level of 6.1 roubles to the dollar. This decision was
accompanied by other emergency measures including a 90-day moratorium on obligations on
selected private foreign debts with a maturity of more than 180 days and on those due to margin
calls6
and foreign exchange contracts, other capital controls such as a ban on purchases by nonresidents of domestic bonds with a maturity of up to one year, and guarantees for private bank
deposits. The government also announced a moratorium on its own debt which is to precede an
eventual forced conversion of GKOs and other bonds maturing in 1999 into longer-term debt
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7 See J. Thornhill, “Gerashchenko holds the key to market’s long term future”
, Financial Times, 17 September
1998. Before the devaluation Russian banks’ foreign exchange liabilities amounted to almost 70 per cent of their
equity. Thus a 10-per-cent depreciation of the rouble reduced their equity by about 7 per cent; see J.P. Morgan,
Global Data Watch, 2 October 1998, p. 14. In early September (after the abandonment by the central bank of the
new band for the rouble/dollar exchange rate) the rouble lost half of its value against the dollar.
8 C. Harris and J. Grant, “World’s exposure exceeds $200 billion”, Financial Times, 28 August 1998.
9
J.P. Morgan, ibid., p. 42. Exposure in the form of official export credit insurance for the financing of
Russian import was also relatively large for Germany but small in relation to the country’s government budget; see
J.P. Morgan, Global Data Watch, 4 September 1998, p. 40.
instruments (a step which followed a largely unsuccessful attempt earlier in the year to persuade
investors to exchange their holdings of GKOs for longer-term dollar-denominated debt).
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