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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 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, “SargentWallace Meets Krugman-Flood-Garber, or: Why Sovereign Debt Swaps Don’t Avert Macroeconomic Crises.” NBER WP 9190. 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 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 Four-Part Framework Fundamentals and Liquidity Market Signals Crisis Triggers Moral Hazard Public Debt Dynamics These are captured by the standard equation (1): (1) d pd ndfs r g d t d t 1 ( pd t ndfst ) (rt g t ) (1 g t ) d t 1 public debt/GDP ratio, t time subscript (in years) primary deficit/GDP non-debt financing sources/GDP composite real interest rate real growth rate Public Finances and Economic Growth Table 1. Public Finances and Economic Growth, 1995-98 Units as indicated Primary Interest Payments Government Real deficit debt GDP (percent Percent Percent Billions Percent Growth Year of of GDP of of of GDP (percent GDP) a year) revenuesa dollars 1995 2.2 3.6 28 170 50 -4.0 1996 2.5 5.9 47 201 48 -3.4 1997 2.4 4.6 38 218 50 0.9 1998 1.3 4.6 43 242 75 -4.9 Sources: Ministry of Finance, Goskomstat, and internal IMF reports a. Cash plus noncash basis. b. Domestic plus foreign, end of period. Public Debt Dynamics (cont’d) This brings us to equation (2), which contains an expanded version of the composite real interest rate, r: (2) r wrd (1 w)( r f r ) w share of domestic currency debt in total debt rd real interest rate on domestic currency debt rf real interest rate paid on foreign currency debt (e.g., interest 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) 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) 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 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 Market Signals Foreign Currency Debt (FCD) Domestic Currency Debt (DCD) Foreign Currency Debt Table 7. Yield Spreads on Russian Eurobonds upon Issue, 1997-98 Units as indicated Maturity Yield spread Face value Issue date a date (basis points) (billions of dollars) June 26, 1997 2007 375 2.40b June 4, 1998 2003 650 1.25 c June 18, 1998 2028 (2008) 753 2.50 July 24, 1998 2005 and 940 6.44 d 2018 Source: Ministry of Finance a. Over U.S. Treasury securities of similar maturity. b. Of which $0.4 billion was settled on October 28 at a yield spread of 334 basis points. c. Issued as a thirty-year bond with a out-at-par option after ten years. d. Seven-and twenty-year bonds issued as part of the GKO-Eurobond swap. Spread difference on the Russian and Indonesian 10-year eurobonds June 10, 1998 June 25, 1998 July 24 (completion of debt swap) -100 bps 0 +160 Domestic Currency Debt (DCD) Yields on one-year GKOs were decomposed using equation (3) to get the sovereign or default risk premium (SRP) and devaluation risk premium (DRP) as a residual. (3) id = if + SRP + (dx/x)* + DRP SRP and DRP Selected Dates GKO yield SRP DRP 39.3 4.8 23.0 July 13 102.3 8.5 82.3 July 14 58.2 8.1 38.6 July 24 66.4 10.0 44.9 August 10 99.0 20.0 67.5 August 14 144.9 23.8 109.5 May 15 Timing of the Crisis Three factors played a role: International liquidity Balance and off-balance sheet exposures of banks GKO-Eurobond swap and IFI liquidity injection The Outcome of the Swap Bid Spread (basis points) S max. cutoff spread 940 837.5 min. spread S 0 4.4 Market Value of GKOs tendered ($ bn.) 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 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 Post Crisis Developments Hard budgets and RER Liquidity and PDD Macro policy stance (RER, Fiscal Adjustment) Debt Restructuring Social Impact 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. Lessons Learned (Cont’d) Liquidity – appropriate measures. Why financial engineering will not help. Social safety net lessons. Politics Do Svidania!