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
Cases 413
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.