The Russian financial crisis

“What Were The Causes Of The Russian Financial Crisis Of 1998? What Role Did The IMF Play In Solving The Problem?”

Introduction:

The Russian financial crisis hit Russia on August 1998. The situation in Russia was exacerbated by the global recession during that time. This recession had its roots in the Asian crisis of 1997. In this paper, the reasons that were behind the financial crisis that hit Russia are outlined. I will try to analyze why the devaluation of the ruble and the financial crisis were inevitable and I will also look into the role that the International Monetary Fund (IMF) played into solving this problem for the Russians. The most important year in this analysis is 1998 during which most of the incidents were very significant. So, it would be very useful to start talking about the political and financial situation that Russia was in during that period. Russia’s economy, during the last decade of the 20th century, was in transition after the fall of communism in the late 1980’s. Boris Yeltsin was the President of the Russian federation, serving from 1991, and leading the Russian federation through this difficult period of transition. It is much more interesting and important for the following analysis to focus on the period from 1996 to 1998 in order to better understand the situation of the Russian federation. During the late 1996 and the early 1997, the Russian economy showed some signs of improvement and as the OECD survey revealed “the Russian economy appeared stronger than at any previous time during the transition period” ( OECD Economic Surveys, Russian Federation, March 2000, OECD Publications, p.34). This statement was supported after indications of the stabilization of output, the positive sign of the annual GDP growth and a rather tight monetary policy that was implemented by the Russian government. All these leaded to the stabilization of the inflation and the exchange rate thus making them more predictable for the investors. Adding up to all these, the living standards of the Russian population started to recover after being very low during the first years of the transition period. So, based on these improvements the Russian government wanted to try and fix things in the financial sector. This effort involved the elimination of the government’s debt and the control of the government’s fiscal imbalances. This was a very natural reaction by the Russian authorities but the main flaw in this effort was that it was based on the assumption that the relatively low interest rates that were achieved at that time would be kept at the same low level. In other words, the Russian government took the strong inflow of capital for granted and that proved to be a terrible mistake. This is how the situation stood until the November 1997. At that time Asia was hit by a financial crisis and this financial crisis affected the expectations of the investors as the export prices increased. So, the increase of the export prices and the decline in their demand caused the elimination of Russia’s current account surplus.

The Causes Of The Russian Financial Crisis:

Up until now, we have seen that the Russian economy was showing some important signs of improvement. But, the Asian financial crisis proved to be really significant for Russia’s economic situation. It is true that the Russian government has based its whole economic plan on keeping the interest rate relatively low and on attracting a strong capital inflow from investors. But the Asian financial crisis made these goals to appear rather ambitious for the government of Boris Yeltsin. Russia’s economy was heavily dependent on the export of raw materials such as oil, natural gas and metals that accounted for more than 80% of Russian exports. This was indicative of the vulnerability of the Russian economy to the swings in world prices. So, the Asian crisis had a great impact on the Russian economy. The world prices for metals and generally raw materials had increased and so did the prices of Russian exports. This led to the fall in the demand for Russia’s exports.

Apart from that, Russia suffered another major hit in the effort to attract some capital from investors. In late 1997, Russian stock prices suffered a major blow and the prices started falling. However, there was a period of time during which the prices of the stock market started increasing but this proved to be a “bubble” as the prices fell even more. So, after the fall of the stock market prices and the increase of the export prices in Russia, investors started questioning the situation of the Russian economy and doubting the profitability of their investments. So, many of them stopped investing in Russia as there was significant proof of instability and of a forthcoming crisis. This was a major blow in Russia’s economy as the government expected that the inflow of capital from investors would continue. These were the effects of the Asian crisis on Russian economy during the late 1997.

Apart from that, another major problem arose in early 1998. President Boris Yeltsin was handled with disbelief from both the Russian public and the western countries. In an attempt to correct this impression and promote the notion that he is still under control, Boris Yeltsin brought some political changes into effect. He appointed Sergei Kiriyenko as the new Prime Minister succeeding former Prime Minister Viktor Chernomyrdin. In addition to that, Boris Fyodorov was appointed deputy Prime Minister and was also named Head of State Tax Service. With these political changes taking effect in mid-1998, Yeltsin tried to regain the lost confidence of the investors and generally the western countries. This was not feasible though because Russia was in a very difficult position at that time. In May 1998, the situation got even worse. Kiriyenko acknowledged that the major problem to be faced by the government was the financial situation. But, the financial situation of the country did not leave him with many options. During that time, the government’s budget was very low and as a result the government was unable to pay wages and pensions. This happened because the majority of the government’s income was going to payments for foreign and domestic debts. This caused the great strike of workers on the Trans-Siberian railway by blocking it. This contributed to the worsening of the situation because the prices of exports increased once again and the export of oil, natural gas and metals not only stopped being profitable but the even helped to raise Russia’s debt.

This leads us to the most important period of the financial crisis in Russia. In June, Russia was found in a critical point. The cost of imports was higher than the profits gained from exports leaving the government with a negative balance of trade. Moreover, industrial production was even lower than that in 1997 and real income of Russians was 10% lower than before. Under all these conditions the devaluation of the ruble and the calling off of debt repayments were inevitable for the Russian government. But, this was avoided temporarily by a $4 billion credit from the International Monetary Fund. The IMF delayed the approval of the loan claiming that the Russian government was not putting too much effort in the collection of taxes. This is when Yeltsin appointed Chubais as the Russian representative in talks with the IMF trying to gain some confidence from the Western World. Chubais set his goals in getting a substantial loan from the IMF which according to the Russian government would help them escape the crisis. So, the Russian government asked for an additional loan, substantially higher this time than the previous one, in order for Russia to escape the financial collapse. Meanwhile, Yeltsin’s appointment of Chubais was met with content by the Western powers and as a result Chubais convinced them to invest in Russia. As Medvedev wrote: “Chubais’s trip to the IMF headquarters in Washington had been successful and dollars started to flow into the Russian Central bank” (Roy Medvedev, Post – Soviet Russia: A Journey Through the Yeltsin Era, 2000, Columbia University Press, p.303). But, this plan only helped the Russian government for a few weeks as Russia was in a very poor state financially. Therefore, the Russian government tried to implement an anti- crisis plan by raising the taxes but this was of no substantial help as it was really late for Russia to escape the crisis. Every reserve of the Russian central bank was spent in order to keep the exchange rate of the ruble at 6 American dollars but the reserves were not enough to support such an action for a long time. On the other hand, the loan of the IMF was now approved and Russia got nearly 23 billion of American dollars with a view to help them avoid a possible financial collapse.

In August, the reserves used by the Russian government to keep the exchange rate relatively low were exhausted and as a result the demand for American dollars was increased since the government was failing to keep the exchange rate in a low level. Also, the ministry of finance had no more ruble reserves and this left the country in a very bad situation. Furthermore, Russian markets started collapsing with the most significant to be the currency, the bond and the stock market. It is important to highlight here that the Russian stock market fell by 75% during the previous year and this was clear evidence of the worsening of the situation. At last, all these factors left the government with no option. The devaluation of the ruble was unavoidable and the inability of the government to pay its debts was a clear indication of its failure to face the situation. So, Russia went bankrupt in August 17, leaving a new exchange rate that was up to 9.5 American dollars per ruble. At that point, the government denied calling this result a devaluation of the currency saying that this new exchange rate is part of the “New” foreign exchange policy for the defense of the ruble. But, the government could not drive away the public disbelief as the ruble continued its free fall and the government and the Central Bank had no more reserves in order to defend the national currency and maintain somehow its value. This left the country in a tragic state facing an exchange rate of 20 American dollars per ruble in early September.

The Role Of The IMF In Solving The Problem:

The International Monetary Fund is an international organization that has three goals. Firstly, it aims at the surveillance and the monitoring of economic and development policies. Secondly, the IMF has the ability to lend money to countries that face difficulties in their balance of payments and finally it provides technical assistance to countries that need it in the areas of training and research.

In the Russian case of 1998, the IMF was lending money to the Russian government in order to help them escape a financial collapse. This was the only help that the IMF gave to the Russians during that period of time. In this point of the essay I will try and assess the help given by the IMF to the Russian government. As stated before, Russia was in a really difficult financial position during 1997 and 1998. The loan by the IMF was approved in June 1998. At that point, there wasn’t much that the Russian government could do in order to prevent the financial disaster that was coming. Even if there was time, approving a loan to be given in a country that faces difficulties in its balance of payments is not the best solution somebody could suggest. It is a short-term measure that will not cure the problem but it will only make it less significant for a short period of time. That is exactly what happened in Russia. The IMF was willing to provide monetary help to the Russians but the situation was already out of control. The Russian government held no reserves of currency. There was nearly no budget in the government and they were unable to even pay the workers and the pensioners. In other words, the collapse was inevitable at that time that the loans were approved. On the other hand, suppose that the monetary aid was given to Russia in 1997. That raises a big question. Would it make any difference if the Russians received the IMF loans earlier? The answer to this question is clear. Definitely not. In order for a country to cure its financial problems and to escape from a difficult situation, it takes not only a financial aid but a plan to do that. As Vladimir Mau wrote: “The crisis was a result of the irresponsible financial and monetary policy of the post-Soviet period” (V. Mau, From crisis to Growth, The Centre for Research into Post-Communist Economies, 2005, p.80). The IMF provided a loan to a country that definitely needed it. But there is no point where we can believe that the Russian government had a plan with a view to escaping the crisis. Boris Yeltsin had lost control of the situation long before it reached a crucial point. This is proved by the fact that only 5 months before the collapse of the Russian economy, Boris Yeltsin was busy replacing the staff in his government. This is definitely not indicative of the Russian government having a plan to face the crisis. So, the IMF did approve the loan to the Russians. But this raises a very important question right here. Why did the IMF loan money to a government that didn’t have a plan on how to use it? The answer to that is simple. The IMF did what had to be done in order for the Russians to escape the crisis. But, the time that the help was given to the Russians was not right. It was late for them to recover from such a significantly difficult position. And what makes it worse is that such a corrupted government could never allocate the money effectively in order to avoid the collapse of the economy.

Conclusion:

The causes of the Russian financial crisis were mainly coming from the political and the economic sector of Russia’s government. The Asian crisis played a very important role in causing it as it was responsible for the fall of the demand for Russian exports and also for the sharp increase in their prices. Also, the government played an important part in letting the situation getting out of hand. The Russian government failed to come up with the plan that would help Russia avoid the financial collapse of 1998. In fact, the only plan that the Russian government came up with was base on two assumptions. The first is that the inflow of the capital by investors would continue to flow in the country and the second is that the interest rates would be kept in a relatively low level. Both assumptions failed to come true so the plan of the Russian government failed from its roots as it was full of flaws.

The IMF did help the Russian Federation at that time but it was late and apart from that the Russian government did not have a plan of how to use the money that they got from the organization. So, the help of the IMF would have solve the problem temporarily, as it did for a few weeks, but giving financial aid to a country that is on the edge of falling bankrupt is not a substantial way to help cure the problem. It is only a short-term injection that should be accompanied by a very well-organized plan on how to face the crisis. And apparently, the Russian government of Boris Yeltsin did fail in this task.

Bibliography:

OECD Economic Surveys, Russian Federation, March 2000, OECD Publications

Roy Medvedev, Post – Soviet Russia: A Journey Through the Yeltsin Era, 2000, Columbia University Press

Vladimir Mau, From crisis to Growth, The Centre for Research into Post-Communist Economies, 2005.

www.imf.org