Comments and Discussion

On August 17, 1998, a little more than a month after an international package of emergency financing and economic reforms was announced, Russia was forced to devalue the ruble.¹ Russia also declared its intention to restructure all official domestic currency debt obligations falling due to the end of 1999 and imposed a ninety-day moratorium on the repayment of private external debt, to aid its commercial banks. The moratorium also applied to these banks' obligations from short positions on currency forward contracts, as well as margin calls on repurchase operations (repos) with foreign banks. Less than three weeks later, on September 2, the Central Bank of Russia (CBR) floated the ruble. By September 9 the exchange rate had reached 21 rubles to the dollar, more than three times the 6.29 rubles to the dollar that had prevailed on August 14.

The free fall of the ruble and the disruption in the government's access to market borrowing were costly, with an output decline, bank failures, and a spike in inflation. Russia ended 1998 with an output contraction of 4.9 percent for the year, compared with initial expectations of slight growth. Inflation for the year as a whole was 84 percent, compared with an original target of 8 percent. On the political front, the reformist government of Sergei Kirienko was dismissed in the wake of the devaluation, leading to fears of policy reversals and a return to hyperinflation.

In an effort to avoid these economic and political costs and achieve a soft landing for the economy, a $22.6 billion international financing package to support fiscal and structural reforms had been announced on July 13. The package was designed to maintain the preannounced exchange rate band while buying time to implement what were recognized as difficult and time-consuming reforms, through an injection of liquidity into reserves and a swap out of short-term ruble treasury bills (called GKOs) into long-term Eurobonds.² The objective of the swap was to address the rollover risk from the maturing of large volumes of GKOs each week, totaling $32.7 billion over the last seven months of 1998. It was envisaged that the announcement of the package would stabilize the market, reduce real interest rates to levels the government could afford, and take the pressure off the exchange rate. Indeed, GKO yields halved the next day but remained in excess of 50 percent, far above the 8 percent inflation target. By July 24, upon completion of the GKO-Eurobond swap, GKO yields had jumped to 66 percent, and they kept rising until the August 17 devaluation.

Two factors apparently underlay the decision not to abandon the exchange rate band. First, for the Russians, the attainment of single-digit inflation in early 1998 (twelve-month inflation dipped below 10 percent from February until July) represented a major policy achievement, one that they would abandon only with great reluctance. Second, the recent East Asian experience with devaluation had been bad, especially in Indonesia. During the crises in some of those countries in 1997-98, attempts to float had precipitated free falls of the currency, damaging exposed banks and corporations as well as reducing output and raising inflation, and imposing large welfare costs. As a result, there was strong motivation in the Russian case to try and maintain market sentiment and access until fiscal and structural reforms could deliver results. This soft landing scenario implicitly underpinned the international package, which also recognized that Russia's fiscal and structural problems admitted no quick fixes.

The package did not achieve its objectives. Total foreign exchange resources, including reserves and new external borrowings, used to defend the ruble between the first speculative attack in late October 1997 and the September 2, 1998, decision to float the currency amounted to $30 billion, about one-sixth of postcrisis GDP.³ Russian-era foreign currency debt of the federal government increased by $20.5 billion over the same period.⁴ Of this, no less than $16 billion, or 8 percent of postcrisis GDP, was accumulated...