The Russian Ruble Crisis and its Aftermath

PRELUDE

In the early 1990s, following the collapse of communism

and the dissolution of the Soviet Union, the Russian

government implemented an economic reform program

designed to transform the country’s crumbling centrally

planned economy into a dynamic market economy. A

central element of this plan was an end to price controls

on January 1, 1992. Once controls were removed, however,

prices surged. Inflation was soon running at a

monthly rate of about 30 percent. For the whole of 1992,

the inflation rate in Russia was 3,000 percent. The annual

rate for 1993 was approximately 900 percent.

Several factors contributed to the spike in Russia’s inflation

rate. Prices had been held at artificially low levels

by state planners during the Communist era. At the

same time there was a shortage of many basic goods, so

with nothing to spend their money on, many Russians

simply hoarded rubles. After the liberalization of price

controls, the country was suddenly awash in rubles chasing

a still limited supply of goods. The result was to rapidly

bid up prices. The inflationary fires that followed

price liberalization were stoked by the Russian government

itself. Unwilling to face the social consequences of

the massive unemployment that would follow if many

state-owned enterprises quickly were privatized, the government

continued to subsidize the operations of many

money-losing establishments. The result was a surge in

the government’s budget deficit. In the first quarter of

1992, the budget deficit amounted to 1.5 percent of the

country’s GDP. By the end of 1992, it had risen to

17 percent. Unable or unwilling to finance this deficit

by raising taxes, the government found another

solution—it printed money, which added fuel to the inflation

fire.

With inflation rising, the ruble tumbled in value

against the dollar and other major currencies. In January

1992 the exchange rate stood at $1 5 R125. By the

end of 1992 it was $1 5 R480 and by late 1993, it was

$1 5 R1,500. As 1994 progressed, it became increasingly

evident that due to vigorous political opposition,

the Russian government would not be able to bring

down its budget deficit as quickly as had been thought.

By September the monthly inflation rate was accelerating.

October started badly, with the ruble sliding

more than 10 percent in value against the U.S. dollar in

the first 10 days of the month. On October 11, the ruble

plunged 21.5 percent against the dollar, reaching a value

of $1 5 R3,926 by the time the foreign exchange market

closed!

Despite the announcement of a tough budget plan

that placed tight controls on the money supply, the ruble

continued to slide and by April 1995 the exchange rate

stood at $1 5 R5,120. However, by mid-1995 inflation

was again on the way down. In June 1995 the monthly

inflation rate was at a yearly low of 6.7 percent. Also,

the ruble had recovered to stand at $1 5 R4,559 by

July 6. On that day the Russian government announced

it would intervene in the currency market to keep the

ruble in a trading range of R4,3000 to R4,900 against

the dollar. The Russian government believed that it was

essential to maintain a relatively stable currency. Government

officials announced that the central bank

would be able to draw on $10 billion in foreign exchange

reserves to defend the ruble against any speculative selling

in Russia’s relatively small foreign exchange market.

In the world of international finance, $10 billion is

small change and it wasn’t long before Russia found that

its foreign exchange reserves were being depleted. It was

at this point that the Russian government requested

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IMF loans. In February 1996, the IMF obliged with its

second-largest rescue effort ever, a loan of $10 billion. In

return for the loan, Russia agreed to limit the growth in

its money supply, reduce public-sector debt, increase

government tax revenues, and peg the ruble to the dollar.

Russia also rebased the value of the ruble, making

one ruble equivalent to 1,000 old rubles.

Initially the package seemed to have the desired effect.

Inflation declined from nearly 50 percent in 1996

to about 15 percent in 1997; the exchange rate stayed

within its predetermined band of 4.3 to 4.8 rubles per

dollar; and the balance-of-payments situation remained

broadly favorable. In 1997, the Russian economy grew

for the first time since the breakup of the former Soviet

Union, if only by a modest half of 1 percent of GDP.

However, the public-sector debt situation did not improve.

The Russian government continued to spend

more than it agreed to under IMF targets, while government

tax revenues were much lower than projected.

Low tax revenues were in part due to falling oil prices

(the government collected tax on oil sales), in part due

to the difficulties of collecting tax in an economy where

so much economic activity was in the “underground

economy,” and partly due to a complex tax system that

was peppered with loopholes. In 1997, Russian federal

government spending amounted to 18.3 percent of GDP,

while revenues were only 10.8 percent of GDP, implying

a deficit of 7.5 percent of GDP, which was financed by

an expansion in public debt.

CRISIS

Dismayed by the failure of Russia to meet its targets, the

IMF responded by suspending its scheduled payment to

Russia in early 1998, pending reform of Russia’s complex

tax system and a sustained attempt by the Russian government

to cut public spending. This put further pressure

on the Russian ruble, forcing the Russian central

bank to raise interest rates on overnight loans to

150 percent. In June 1998, the U.S. government

indicated it would support a new IMF bailout. The IMF

was more circumspect, insisting instead that the Russian

government push through a package of corporate tax increases

and public spending cuts to balance the budget.

The Russian government indicated it would do so, and

the IMF released a tranche of $640 million that had

been suspended. The IMF followed this with an additional

$11.2 billion loan designed to preserve the ruble’s

stability.

Almost as soon as the funding was announced, however,

it began to unravel. The IMF loan required the

Russian government to take concrete steps to raise personal

tax rates, improve tax collections, and cut government

spending. A bill containing the required legislative

changes was sent to the Russian parliament, where it

was emasculated by antigovernment forces. The IMF responded

by withholding $800 million of its first $5.6 billion

tranche, undermining the credibility of its own

program. The Russian stock market plummeted on the

news, closing down 6.5 percent. Selling of rubles accelerated.

The central bank began hemorrhaging foreign

exchange reserves as it tried to maintain the value of the

ruble. Foreign exchange reserves fell by $1.4 billion in

the first week of August alone, to $17 billion, while interest

rates surged again.

Against this background, on the weekend of August

15–16, top Russian officials huddled to develop a response

to the most recent crisis. Their options were limited.

The patience of the IMF had been exhausted.

Foreign currency reserves were being rapidly depleted.

Social tensions in the country were running high. The

government faced upcoming redemptions on $18 billion

of domestic bonds, with no idea of where the money

would come from.

On Monday, August 17, Prime Minister Sergei

Kiriyenko announced the results of the weekend’s conclave.

He said Russia would restructure the domestic

debt market, unilaterally transforming short-term debt

into long-term debt. In other words, the government

had decided to default on its debt commitments. The

government also announced a 90-day moratorium on

the repayment of private foreign debt and stated it

would allow the ruble to decline by 34 percent against

the U.S. dollar. In short, Russia had turned its back on

the IMF plan. The effect was immediate. Overnight,

shops marked up the price of goods by 20 percent. As

the ruble plummeted, currency exchange points were

only prepared to sell dollars at a rate of 9 rubles per dollar,

rather than the new official exchange rate of

6.43 rubles to the dollar. As for Russian government

debt, it lost 85 percent of its value in a matter of hours,

leaving foreign and Russian holders of debt alike suddenly

gaping at a huge black hole in their financial

assets.

AFTERMATH

In the aftermath of Russia’s default on government debt,

the IMF effectively turned its back on the Russian government,

leaving the country to fix its own financial

mess. With no more IMF loans in the offing, the government

had to find some other way to manage its large

public-sector deficit. The government took a twopronged

approach; first, it slashed government spending,

and second, it reformed the tax system. With regard to

the tax system, the government of Vladimir Putin ignored

the advice of the IMF, which wanted Russia to

raise tax rates and focus on tougher enforcement.

Instead, the government replaced Russia’s complex income

tax code, which had a top marginal rate of

414 Part 4 Cases

30 percent, with a 13 percent flat tax. Corporate tax

rates were also slashed from 35 percent to 24 percent,

and the tax code simplified, closing many loopholes.

Paradoxically, the cut in tax rates led to a surge in government

revenues as individuals and corporations decided

it was easier to pay taxes than go to the trouble of

avoiding them, which they had long done.

In addition to these government actions, a sharp rise

in commodity prices, and particularly world oil prices,

helped the Russian economy enormously. Russia is now

the world’s largest oil exporter, ahead of even Saudi

Arabia. In addition, it exports significant amounts of

natural gas, metals, and timber, all of which have seen

sharp price increases since 1998. The country now runs

a large current account surplus with the rest of the world

(in 2004 it hit $46 billion).

As a result of these changes, the Russian economy

grew at an average annual rate of 6.5 percent between

1998 and 2004. Foreign debt declined from 90 percent

of GDP in 1998 to about 28 percent in 2004, while foreign

reserves increased tenfold to $120 billion. The government

has been running a budget surplus since 1999.

In 2004 it took in some $13.1 billion more than it spent.

Moreover, in January 2005 the Russian government repaid

its entire obligations to the IMF ahead of schedule.

Despite these positive developments, the Russian

economy still has numerous structural weaknesses. The

country is now very dependent on commodity prices,

and if they should fall, the economy will suffer a sharp

pullback. The banking system remains weak, the manufacturing

infrastructure is poor, the country is still rife

with corruption, there is widespread mistrust in the institutions

of government, and foreign investment is relatively

low. 1

Case Discussion Questions

1. What were the causes of the surge in inflation in

Russia during the early 1990s? Could this have

been avoided? How?

2. What does the decline in the value of the ruble

against the dollar between 1992 and 1998 teach

you about the relationship between inflation rates

and currency values?

3. During the mid-1990s, the IMF wanted Russia to

raise tax rates, close loopholes in the tax system,

and cut public spending. Russia was unable to do

this. Why?

4. In the early 2000s Russia cut tax rates for individuals

and corporations, and government tax revenues

surged. Why? Does this result suggest that the IMF

policy prescriptions were wrong?

Sources

1. S. Erlanger, “Russia Will Test a Trading Band for the

Ruble,” The New York Times, July 7, 1995, p. 1;

C. Freeland, “Russia to Introduce a Trading Band for

Ruble against Dollar,” Financial Times, July 7, 1995, p. 1;

J. Thornhill, “Russians Bemused by ‘Black Tuesday,’ ”

Financial Times, October 12, 1994, p. 4; R. Sikorski,

“ Mirage of Numbers,” The Wall Street Journal, May 18,

1994, p. 14; “Can Russia Fight Back?” The Economist,

June 6, 1998, pp. 47–48; J. Thornhill, “Russia’s Shrinking

Options,” Financial Times, August 19, 1998, p. 19;

“Russia,” The World Factbook 2005 (Washington, DC:

Central Intelligence Agency, 2005); “Change Those

Light Bulbs: The Russian Economy,” The Economist ,

February 8, 2003, p. 43; and “The Kremlin Repents,

Maybe: Russia’s Economy,” The Economist, April 9, 2005,

p. 32.