1. The Russian Default of 1998 A case study of a currency crisis Francisco J. Campos, UMKC 10 November 2004

2. What’s a currency crisis? It can be defined as a speculative attack on a country’s currency. It can be defined as a speculative attack on a country’s currency. It can lead to forced devaluation and debt default. It can lead to forced devaluation and debt default. It might happen when investors fear that the government is going to devalue the domestic currency. It might happen when investors fear that the government is going to devalue the domestic currency.

3. What’s a currency crisis? A devaluation occurs when there is market pressure to increase the exchange rate because the country cannot or will not be able to support its currency. A devaluation occurs when there is market pressure to increase the exchange rate because the country cannot or will not be able to support its currency. In order to maintain the exchange rate peg, the central bank must intervene in the FX market buying up its currency with foreign reserves. In order to maintain the exchange rate peg, the central bank must intervene in the FX market buying up its currency with foreign reserves.

4. Currency crises: what does macroeconomic theory suggest? Macroeconomic models First- Generation Models Second- Generation Models Third- Generation Models

5. First-Generation Models Causes of a currency crisis: government debt and inability to control the budget. Causes of a currency crisis: government debt and inability to control the budget. People believe financing the debt becomes the government’s major concern. People believe financing the debt becomes the government’s major concern. People expect the monetization of the fiscal deficit. People expect the monetization of the fiscal deficit.

6. Second-Generation Models They suggest that a devaluation in one country affects the price level or the current account of the countries around it. They suggest that a devaluation in one country affects the price level or the current account of the countries around it. Economic events, such as war or oil price shocks. Economic events, such as war or oil price shocks. Expectations. Expectations.

7. Third-Generation Models They suggest that a currency crisis is brought on by a combination of factors: They suggest that a currency crisis is brought on by a combination of factors: High debt High debt Low foreign reserves Low foreign reserves Falling government revenues Falling government revenues Increasing expectations of devaluation Increasing expectations of devaluation Domestic borrowing constraints (increasing the interest rate reduces the amount of loans) Domestic borrowing constraints (increasing the interest rate reduces the amount of loans)

8. The Russian default: A brief history 1996 and 1997 In 1997, Russia seemed to be turning toward economic stability

9. The Russian default: A brief history 1996 and 1997 The trade surplus was moving toward a balance between exports and imports. The trade surplus was moving toward a balance between exports and imports. Inflation had fallen from 131% in 1995 to 11% in 1997. Inflation had fallen from 131% in 1995 to 11% in 1997.

10. The Russian default: A brief history 1996 and 1997 The exchange rate was kept between 5 and 6 rubles to the dollar. The exchange rate was kept between 5 and 6 rubles to the dollar.

11. The Russian default: A brief history 1996 and 1997 Output was recovering slightly. Russia ended up 1997 with a 0.9% growth. Output was recovering slightly. Russia ended up 1997 with a 0.9% growth.

12. The Russian default: A brief history 1996 and 1997 Annual Percentage Change in GDP for Russia (1990-2004).

13. The Russian default: A brief history 1996 and 1997 Structural problems still remained. Structural problems still remained. Real wages were less than half of what they were in 1991. Only about 40% of workers were paid in full and on time. Real wages were less than half of what they were in 1991. Only about 40% of workers were paid in full and on time. Per capita direct foreign investment was low. Per capita direct foreign investment was low. Privatization of public enterprises was still difficult due to internal opposition within the government. Privatization of public enterprises was still difficult due to internal opposition within the government. Low tax collection Public Sector Deficit Low tax collection Public Sector Deficit

14. The Russian default: A brief history 1996 and 1997 In November 1997, the ruble suffered its first speculative attack. In November 1997, the ruble suffered its first speculative attack. The CBR spent nearly $6 billion of its foreign reserves to defend the ruble. The CBR spent nearly $6 billion of its foreign reserves to defend the ruble. In December 1997, the price of oil began to drop. In December 1997, the price of oil began to drop.

15. The Russian default: A brief history 1998 With some many uncertainties in the economy, investors turned their attention toward Russian default risk. With some many uncertainties in the economy, investors turned their attention toward Russian default risk. The government increased tax collection, lowering bank’s and firm’s liquidity. The government increased tax collection, lowering bank’s and firm’s liquidity. The CBR responded by increasing the lending rate to banks, first from 30% to 50%, and finally to 150%. The CBR responded by increasing the lending rate to banks, first from 30% to 50%, and finally to 150%. The price of oil was as low as $11 per barrel The price of oil was as low as $11 per barrel

16. The Russian default: A brief history 1998 In June 1998, the ruble came under attack for the second time. In June 1998, the ruble came under attack for the second time. In July the IMF approved assistance of $11.2 billion, of which $4.8 was given immediately. In July the IMF approved assistance of $11.2 billion, of which $4.8 was given immediately. By August, $4 billion had left Russia in capital flight. By August, $4 billion had left Russia in capital flight. The final attack happened 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 = DEVALUATION The final attack happened 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 = DEVALUATION

17. How the theory explains the Russian crisis Fiscal deficits and debt monetary policy and interest rates expectations A fixed exchange rate

18. How the theory explains the Russian crisis: Exchange rate The CBR was willing to defend the exchange rate peg. The CBR was willing to defend the exchange rate peg. The first two speculative attacks depleted Russia’s foreign reserves. The first two speculative attacks depleted Russia’s foreign reserves. Once depleted, the government had no choice but to devaluate following the August attack. Once depleted, the government had no choice but to devaluate following the August attack.

19. How the theory explains the Russian crisis: Fiscal deficit High debt and low revenues. Causes: High debt and low revenues. Causes: Low output. Low output. Competition between local governments to attract firms. Competition between local governments to attract firms. The decrease in the price of oil. The decrease in the price of oil. Large amount of short-term foreign debt due in 1998. Large amount of short-term foreign debt due in 1998. Under a fixed exchange rate, Russia was unable to finance its deficit by printing money. Under a fixed exchange rate, Russia was unable to finance its deficit by printing money.

20. How the theory explains the Russian crisis: Monetary policy and interest rates The rise in the interest rate had two effects: The rise in the interest rate had two effects: It increased revenue problems and debt. It increased revenue problems and debt. It did not increase the amount of loans available to firms. It did not increase the amount of loans available to firms.

21. How the theory explains the Russian crisis: Expectations Three aspects increased expectations of devaluation: Three aspects increased expectations of devaluation: The Asian crisis. The Asian crisis. Public relations errors. Public relations errors. Low revenues. Low revenues.

22. Conclusions Factors of risk for a currency crisis: a fixed exchange rate, fiscal deficits and debt, the conduct of monetary policy and expectations of default. Factors of risk for a currency crisis: a fixed exchange rate, fiscal deficits and debt, the conduct of monetary policy and expectations of default. Under certain conditions, contractionary monetary policy can accelerate devaluation. Under certain conditions, contractionary monetary policy can accelerate devaluation. First and Second-Generation models explain fiscal deficits; the Third- Generation model, financial sector fragility. First and Second-Generation models explain fiscal deficits; the Third- Generation model, financial sector fragility.

23. Questions?