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The Russian financial crisis (also called 'Ruble crisis') hit Russia on 17 August 1998. It was exacerbated by the Asian financial crisis, which started in July 1997. Given the ensuing decline in world commodity prices, countries heavily dependent on the export of raw materials, such as oil, were among those most severely hit. (Petroleum, natural gas, metals, and timber accounted for more than 80% of Russian exports, leaving the country vulnerable to swings in world prices. Oil was also a major source of government tax revenue.) The sharp decline in the price of oil had severe consequences for Russia. However, the primary cause of the Russian Financial Crisis was not the fall of oil prices directly, but the result of non-payment of taxes by the energy and manufacturing industries
Prior to the culmination of the economic crisis, the GKO bonds issuance policy was described as similar to a pyramid scheme or Ponzi scheme (Hyman Minsky 1992), with the interest on matured obligations being paid off using the proceeds of newly issued obligations. Note however this scheme is used in the issuance of currency through a central bank but is limited by Fractional-reserve banking practices.
Declining productivity, an artificially high fixed exchange rate between the ruble and foreign currencies to avoid public turmoil, and a chronic fiscal deficit were the background to the meltdown. The economic cost of the first war in Chechnya that is estimated at $5.5 billion (not including the rebuilding of the ruined Chechen economy) was also a cause of the crisis. In the first half of 1997, the Russian economy showed some signs of improvement. However, soon after this, the problems began to gradually intensify. Two external shocks, the Asian financial crisis that had begun in 1997 and the following declines in demand for (and thus price of) crude oil and nonferrous metals, also impacted Russian foreign exchange reserves. A political crisis came to a head in March when Russian president Boris Yeltsin suddenly dismissed Prime Minister Viktor Chernomyrdin and his entire cabinet on March 23. Yeltsin named Energy Minister Sergei Kiriyenko, aged 35, as acting prime minister. On May 29, Yeltsin appointed Boris Fyodorov Head of the State Tax Service. The growth of internal loans could only be provided at the expense of the inflow of foreign speculative capital, which was attracted by very high interest rates: In an effort to prop up the currency and stem the flight of capital, in June Kiriyenko hiked GKO interest rates to 150%. The situation was worsened by irregular internal debt payments. Despite government efforts, the debts on wages continued to grow, especially in the remote regions. By the end of 1997, the situation with the tax receipts was very tense, and it had a negative effect on the financing of the major budget items (pensions, communal utilities, transportation etc).
A $22.6 billion International Monetary Fund and World Bank financial package was approved on July 13 to support reforms and stabilize the Russian market by swapping out an enormous volume of the quickly maturing GKO short-term bills into long-term Eurobonds. This had started to be implemented with some success by July 24, yet the Russian government decided to keep the exchange rate of the ruble within a narrow band, although many economists, including Andrei Illarionov and George Soros, urged the government to abandon its support of the ruble. On May 12, 1998 Coal miners went on strike over unpaid wages, blocking the Trans-Siberian Railway. By August 1, 1998 there were approximately $12.5 billion in unpaid wages owed to Russian workers. On August 14 the exchange rate of the Russian ruble to the US dollar was still 6.29. Despite the bailout, July monthly interest payments on Russia’s debt rose to a figure 40 percent greater than its monthly tax collections. Additionally, on July 15 the State Duma dominated by left-wing parties refused to adopt most of government anti-crisis plan so that the government was forced to rely on presidential decrees. On July 29 Yeltsin interrupted his vacation in Valdai Lake region and flew to Moscow, prompting fears of a Cabinet reshuffle, but he only replaced Federal Security Service Chief Nikolai Kovalyov with Vladimir Putin.
At the time, Russia employed a 'floating peg' policy toward the ruble, meaning that the Central Bank at any given time committed that the ruble-to-dollar (or RUR/USD) exchange rate would stay within a particular range. If the ruble threatened to devalue outside of that range (or 'band'), the Central Bank would intervene by spending foreign reserves to buy rubles. For instance, during approximately the one year prior to the Crisis, the Central Bank committed to maintain a band of 5.3 to 7.1 RUR/USD meaning that it would buy rubles if the market exchange rate threatened to exceed 7.1 rubles per dollar.
The manifest inability of the Russian government to implement a coherent set of economic reforms led to a severe erosion in investor confidence and a chain-reaction that can be likened to a run on the Central Bank. Investors fled the market by selling rubles and Russian assets (such as securities), which also put downward pressure on the ruble. This forced the Central Bank to spend its foreign reserves to defend the ruble, which in turn further eroded investor confidence and undermined the ruble. It is estimated that between October 1, 1997 and August 17, 1998, the Central Bank expended approximately $27 billion of its U.S. dollar reserves to maintain the floating peg.
It was later revealed that about $5 billion of the international loans provided by the World Bank and International Monetary Fund were stolen upon the funds' arrival in Russia on the eve of the meltdown.
On August 13, 1998, the Russian stock, bond, and currency markets collapsed as a result of investor fears that the government would devalue the ruble, default on domestic debt, or both. Annual yields on ruble denominated bonds were more than 200 percent. The stock market had to be closed for 35 minutes as prices plummeted. When the market closed, it was down 65 percent with a small number of shares actually traded. From January to August the stock market had lost more than 75 percent of its value, 39 percent in the month of May alone.
