Paradigm Lost: The Euro in Crisis

Reflecting on the depth of its crisis, several experts have counseled Greece to restructure its debt and leave the Euro area. In 1998, when I was deputy governor of the central bank and in charge of IMF relations, Russia successfully dealt with a severe fiscal crisis using those tools. Helped by rising oil prices, the country recovered quickly and eventually repaid its debts. Russia’s situation in 1998 differs greatly from Greece’s today, but the experience nevertheless offers three lessons for Greece and the Euro area more broadly: always beware of large macroeconomic imbalances, avoid piecemeal solutions because only comprehensive plans work, and know that the size of the external support package is central to the success of the recovery plan.

Origins of the Russian Crisis

Twelve years ago, in mid-1998, Russia found itself with a debt-to-GDP ratio of 57 percent and a fiscal deficit of around 5 percent of GDP. While neither imbalance is staggering, and both are only a fraction of what Greece exhibits today, the situation was severe. Since the beginning of reforms in 1992, Russia had failed to implement proper tax administration, and the government had been running fiscal deficits for years. A rapid fall in oil prices, which began in January 1998, compounded the already-poor fiscal situation. By the summer, oil prices had dropped to $12 per barrel (equivalent to production costs), down from $20 per barrel twelve months earlier, sharply decreasing tax revenues from the oil and gas sector. Revenues gathered through July were enough to finance only about two-thirds of government spending for the year; borrowing was needed for the rest. The price shock also significantly weakened the current account.

IMGXYZ5034IMGZYXFurthermore, much of the ruble-denominated debt—equivalent to approximately 18 percent of GDP (high inflation had reduced the value of previous debts)—was short-term. The high inflation, which had exceeded 20 percent from 1994 (when the government first offered bonds) through 1997, had prevented the Ministry of Finance from selling long-term bonds. As a result, the government was forced to repay about $1 billion of principal each week from June through December—the equivalent of 1.3 percent of GDP each month (based on a pre-default exchange rate); this was clearly unsustainable. At about 1.8 percent of GDP, Greece’s financing requirement each month is even higher.

In addition, having committed in November 1997 to continue managing its exchange rate within a band, Russia found itself bound to a nearly fixed exchange rate. Having adopted the euro, Greece today finds itself even more constrained in that regard.

The replacement of Prime Minister Chernomyrdin, who had been in office since 1992 and was expected to win the 2000 elections, with Sergey Kirienko, a relative unknown, in May further aggravated the crisis. Growing tensions between the parliament and the executive branch dragged out the approval process for the new prime minister, and the weak government structure further hurt market confidence and slowed negotiations with the IMF in June.

The Government and IMF Response

In mid-July, the IMF decided to provide $20 billion in credit to Russia, with a first tranche of $4.8 billion. This credit represented 6.7 percent of Russia’s GDP,1 in contrast to today’s 110 billion euro package for Greece, which represents 46 percent of Greece’s GDP. Not surprisingly, the IMF package for Russia failed to appease markets and did little to slow the crisis.

On August 17, 1998, Russia declared that repayment of ruble-denominated debt would be frozen until the end of 1999 and began negotiating a restructuring of the short-term debt. It also banned repayment of external debts by residents until the end of 1998 and announced a widening of the exchange rate band. Ten days later, the band was abandoned altogether and the ruble was allowed to float; it quickly plummeted to one quarter of its previous level.

Even without access to financial markets, the government managed to eliminate the deficit by mid-1999—one year before oil prices began to recover. Though there were no haircuts and the debt was eventually repaid, maturity on much of it was extended, sharply reducing the debt servicing and refinancing needs for the period over which the adjustment took place. In addition, tax revenues rose as raw material exporters saw profits grow amid the ruble’s massive devaluation. High annual inflation also increased revenues in nominal terms while the government followed a rigid spending policy and refused to index public wages and pensions.

This approach covered all of the country’s weak points: the debt burden (both interest and repayment) was reduced and the exchange rate was allowed to float. Furthermore, at the beginning of September, the new government, headed by Yevgeny Primakov—Yeltsin’s opponent at that time—gained the support of the parliament, thus enabling it to implement several austerity measures.

Though extremely painful for the economy and the population, these policies appear, in hindsight, to have been the right ones. Starting in November 1998, industrial production began to grow rapidly as sharp devaluation not only made exports much more profitable, but also benefited many industries selling goods in the domestic market. The automobile, food, and light industries, mechanical engineering, and metallurgy started to grow at annual rates above 10 percent.

Lessons for Greece and the Euro Area

1. Imbalances matter. While a favorable combination of factors can fool governments into thinking that monetary and fiscal policy can be loosened with little negative effect, practice shows that any long-term imbalance tends to result in a serious shock sooner or later. In 1998, a history of macroeconomic imbalances led to an overload of short-term debt in Russia. In 2010, Greece is experiencing the consequences of sharply escalated government debt, much of which is also short-term, increased unit labor costs, and consumption financed via external borrowing. Though this lesson comes too late for Greece, which has had to learn it the hard way, it is still of value to other exposed countries in the Euro area who are being too timid in tackling their deep-seated problems.
 
2. Only comprehensive solutions work and the country in crisis must do its job. The Russian experience shows that, when battling a crisis, policy makers must identify all of its origins and address each, never assuming that any one will resolve itself. Investors understand the problems just as well as government ministers do, and so are prepared to give policy makers some time—but they are not prepared to believe in miracles. In the case of Greece, the EU–IMF package buys time but does not solve the problem. Greek authorities now have a window during which they can modernize their economy and regain competitiveness—changes that must come from Greece itself and address the underlying structural problems as well as the fiscal and debt issues. Nevertheless, it is very hard to imagine how Greece can improve its competitiveness without control of its exchange rate. Wage reduction (if it occurs) is not likely to be enough, as Greece’s main competitors—Spain, Portugal, and Italy in the case of tourism, which accounts for one-third of Greek exports—have implemented similar measures.

3. The size of the rescue package matters. IMF assistance to Russia was unable to calm markets and give policy makers sufficient time to restore budget discipline. As a result, Russia was only able to address its problems by rescheduling its debt and breaking out of the exchange rate band. This time, IMF assistance is several magnitudes larger, providing the countries in trouble with more opportunities and perhaps avoiding the most extreme outcomes. It should be clear, however, that a failure to restore Greece’s competitiveness within a reasonable time span may force the country to abandon the euro and devalue; in that case, default will be inevitable, as devaluation will greatly increase the already staggering debt-to-GDP ratio. That means Greece will need not only debt rescheduling, but also significant debt forgiveness. In Russia’s case, the much smaller size of the foreign-currency–denominated debt enabled the country to avoid debt forgiveness.

Sergei Aleksashenko, former deputy minister of finance of the Russian Federation and former deputy governor of the Russian central bank, is a scholar-in-residence in the Carnegie Moscow Center’s Economic Policy Program.


1. This percentage is calculated using the average exchange rate for the whole year. Based on the annualized GDP from the second quarter of 1998 and the exchange rate by the time the credit was approved, it represents less than 5 percent of GDP.