Source: Carnegie

The International Economy, July/August 2000, pp. 38-39.

On August 17, 1998, the Russian government devalued, defaulted on its domestic debt, and declared a ninety-day moratorium on foreign payments. Russia was devastated, and the world could feel it. Within a week, President Yeltsin sacked the Prime Minister Sergei Kirienko government and the leadership of the central bank. The exchange rate plummeted three times. Russian output moved toward a free fall, and inflation approached hyperinflation. An old-time, communist-heavy government came to power, and the reform efforts appeared to come to a final halt.

Within a year, however, Russia had surged to an annualized 8 percent growth rate, and remarkably it maintains that level. During the first four months of this year, investment in fixed assets soared by 13 percent. The Russian budget is balanced, while Russia had a trade surplus of $33 billion last year.

The conventional wisdom is that these splendid new developments merely result from high oil prices and the large devaluation, prompting import substitution. But this view is no longer tenable. Russia's recent growth bespeaks a fundamental qualitative change. We also need to revise our thinking about the Russian financial crash.

The financial crash of August 1998 delivered the shock that the Russian elite needed, but the reformers had failed to impose. It altered the economic thinking of both the elite and the government. Reforms that were legislated just before the crash have only become effective in its aftermath.

In analyzing the causes of the crash, various analysts emphasize either the over-valued exchange rate or the excessive budget deficit. The exchange rate was undoubtedly too high, and a gradual devaluation beginning in the late summer of 1997 would have been preferable to the crash in 1998. However, nobody thought of that at the time, as the trade surplus was so palpable. And by early 1998, it was too late. Half the banks would have collapsed because of their skewed currency balances.

The fiscal deficit had long hovered around 8 percent of GDP, but in October 1997 Prime Minister Viktor Chernomyrdin made a compromise with both the Communists in the Duma and business tycoon Boris Berezovsky that allowed for the boosting the budget deficit rather than cutting it. In late October 1997, the Asian financial crisis hit Russia. But since the government had used up so much good favor in the recent compromise, it would take months before any re-thinking was politically possible.

A third cause of the crash was also significant: the increased barterization of the Russian economy, analyzed by Cliff Gaddy and Barry Ickes. The share of barter transactions in industry peaked at 54 percent in August 1998. A group of World Bank economists have estimated that the total level of government subsidies to enterprises in 1998 amounted to no less than 16 percent of GDP, and most of those implicit subsidies have been made through barter and nonpayments. Little wonder that it was politically impossible to reduce the budget deficit!

However, these loose fiscal policies would not have been possible if the Russian government had not had access to ample Western financing. Contrary to popular perception, the International Monetary Fund (IMF) gave little - $4 billion in 1996, and little in 1997 - since Russia did not comply with the IMF conditions. Instead, Russia obtained no less than $46 billion in private portfolio investments from foreigners in 1997 alone - that is, ten percent of GDP. These portfolio investments, primarily in domestic government bonds, were the key cause of the August 1998 crash. They prompted the high exchange rate and they financed the budget deficit, rendering further reforms politically unfeasible.

In hindsight, the developments in 1998 make a lot of sense, but each step occurred too late. Of course, President Yeltsin was right to sack Prime Minister Viktor Chernomyrdin, who was directly responsible for this crisis. In June and July of 1998, the new Kirienko government and the IMF worked out a substantial reform package, minimizing the fiscal deficit. The proposed tax reforms were fine, improving the profit tax and the value-added tax as well as introducing a full tax code. A new good bankruptcy law had already been adopted. The IMF, the World Bank, and Japan offered impressive financing of $22.6 billion. This was a serious and balanced package, giving Russia a fair chance.

However, the Duma blew this chance by listening to strong vested interests who hoped to continue living on state largess. It refused to transfer any regional government revenues to the federal government, leaving the federal deficit bloated. Most of these marginal regional revenues were spent on socially harmful enterprise subsidies.

As the Kirienko government only managed to push part of its program through the Duma, the IMF cut its financing short and made only one disbursement of $4.6 billion in July 1998. It then dropped Russia like a hot brick. This was the right policy. The IMF and the Kirienko government had drawn up the necessary fiscal reform plan. Part of it had been legislated, which would help in the future. But the IMF clarified that even Russia faced a hard budget constraint in international finance. The August 1998 crash taught the Russian establishment the limits of state financing the hard way.

Arguably, the Kirienko government should have resigned after July 20, as the Duma had in effect declared its lack of confidence in it. From that date, it was clear that Russia's financial situation was untenable, and it had to devalue or default. A devaluation was inevitable because of declining reserves, and it was better to devalue early on while reserves were still substantial. So this was done. The GKOs (domestic treasury bills) were primarily held by state banks and foreign investors, and a default on the GKOs would have the least negative social effects. Their legal base was flimsy, which facilitated such a default. Without a default on the GKOs, the devaluation would have been all the greater, and aroused near-hyperinflation. In a financial panic, some cooling is needed. The ninety-day moratorium was imposed for that purpose. The Russian government and central bank could hardly have acted better in the given situation. And they did so early enough to salvage some $10 billion of international reserves.

The financial crash was frightful. It devastated half the Russian banks and the savings of the burgeoning middle class, and international investors over-reacted. The lesson to the Russian society, however, could not have been clearer. And it has been learned: The budget has been balanced; enterprise subsidies of all kinds have been sharply reduced; real arrears have fallen by three quarters; barter has declined by nearly half as a share of payments; federal revenues as a share of GDP have skyrocketed from 11 percent of GDP in 1998 to 18 percent of GDP so far this year; and Russia registered almost 10,000 bankruptcies last year.

Most importantly, Russian society and business have experienced a fundamental change in mentality, evident in many areas. Even the Communist Party revoked its anti-market stand before the parliamentary elections last December, and [cut] a new reform consensus has emerged. Therefore, Russia's annualized growth of 8 percent in the last six months is [cut] a natural consequence of the financial crash and the reforms prepared just before it.