Essay: What is meant by a financial crisis?

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  • Subject area(s): Finance essays
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  • Published on: July 28, 2019
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“A situation in which the value of financial institutions or the value of their assets drops rapidly.” A financial crisis is often associated with a panic or a bank run that may collapse whole financial system of economy. The investors sell off assets or withdraw money from savings accounts with the expectation that the value of those assets will drop if they remain at a financial institution. Financial crisis means downfall in the value of the country currency and financial institutions or market mechanism as a result country may suffer from recession.

‘Financial Crisis’:

A financial crisis can come as a result of institutions or assets being overvalued, and can be worsened by investor behavior.

One example of a currency crisis occurred in Russia in 1998 and led to the devaluation of the ruble and the default on public and private debt. Currency crises such as of Russia’s may emerge from variety of economic conditions, such as large deficits and low foreign reserves. These crises may have effect on one’s country at times when its neighboring countries are experiencing financial crisis.

THE RUSSIAN DEFAULT: A BRIEF HISTORY

After six years of economic reform in Russia, privatization and macroeconomic stabilization had experienced some limited success. Yet in August 1998, after recording its first year of positive economic growth since the fall of the Soviet Union, Russia was forced to default on its sovereign debt, devalue the ruble, and declare a suspension of payments by commercial banks to foreign creditors.

“What caused the Russian economy to face a financial crisis after so much had been accomplished In April 1996”? Russian officials began negotiations to reschedule the payment of foreign debt inherited from the former Soviet Union. These negotiations were a major step toward restoring investor confidence. Apparently 1997 seemed poised to be a turning point toward economic stability.

The following positive effects were on economy:

• The trade surplus was moving toward a balance between exports and imports.

• Relations with the West were promising:

• The World Bank was prepared to provide expanded assistance of $2 to $3 billion per year and the International Monetary Fund (IMF) continued to meet with Russian officials and provide aid.

• Inflation had fallen from 131 percent in 1995 to 22 percent in 1996 and 11 percent in 1997

• Output was recovering slightly.

“What led to Russian financial crisis?”

1) The failure to restructure the economy

Russia’s economic situation was bleak for a long time. Even before it was to be made a sovereign state, the USSR economy was in decline. The transition in Russia did not get rid of the macroeconomic legacy of the socialist era. After the crash of communism, the combination of both soft budget and administrative reforms led to undesirable results in the economy. The inadequacy of market mechanism led to a persistent decrease in tax collection and increase in borrowings of Russia. Russia had to rely on its exports especially “OIL” but it was on fragile situation as the world prices of oil were fluctuating thus this may to Russia industry being weak. On the other hand, increasing borrowing requirement forced Russia to pick up dollar-denominated debt, leaving the country vulnerable to the swings in the exchange rates.

2) High government debt and over-valued currency

The main causes of Russia’s crisis included unsustainable public debt dynamics and the overvalued real exchange rate. Russia was unable to raise high tax amount and IMF also prohibited borrowing from Central Bank of Russia during period of 1995 to 1997 as a result Russia had to increase GKO’s (short-term bills) and OFZ’s (long-term bonds). In order to attract more funds, the annual interest rate on Russia’s government securities was much higher than the other countries, approximately 30 percent. The high interest rate dried up Russia’s limited revenue. Whereas these high-cost debts were never implemented to restructure weakness in economy.

3) The Asian Crisis and the oil price The Asian Crisis brought speculative attack to Ruble on November 1997. The decrease of oil and nonferrous metal prices also hit Russian economy heavily. The Asian crisis seemed to be the “last straw” to Russian economy and began to cut off the capital inflow of Russia. When the contagion of Asian Crisis spread to other Asian “tigers” known as “Singapore, Thailand, South Korea and Taiwan” and South America, Korean and Brazilian investors primarily exited their domestic currency assets. The first bout of instability coincided with the decision of IMF that its loans would hold up disbursements at the end of October in 1997. With liquidity pressures at home and high interest rate, enormous investment began exiting the GKOs (short-term government bills) .This marked the ruble start to under speculative attacks. Meanwhile, non-resident holders of the GKOs signed forward contracts with the CBR for foreign currency, because they anticipated that the ruble, like the other Asian currencies, would lose value. On the one hand, these forward contracts enabled the investors to hedge exchange rate risk. On the other hand, Russian commercial banks had to burden much more currency risk in the future. A substantial amount of liabilities of these banks were consisted of forward contracts.

“What were the ‘Consequences’ of the event?”

On 17 August 1998, the Russian government defaulted on its GKO Treasury Bonds, imposed a 90-day moratorium on foreign debt payments, and abandoned the ruble exchange rate corridor. Within the next couple of weeks, the Russian Central Bank announced that it would stop selling U.S. dollars, suspend trading of the ruble on main exchanges, abandon the exchange rate band, and allow the ruble to float.

These events led Russia’s international reserves to fall by $13.5 billion and to the dissolution of the government. One month later, the value of ruble fall to its lowest point. These events signaled the onset of the Russian financial crisis, which had its roots in the fundamental problems in the Russian economy but was triggered in part by the continuing financial crises in emerging markets in Asia and around the world.

The Russian economy has severe structural problems that were the primary cause of the crisis: fiscal deficit, banking sector problems. the IMF and the problems with the international financial system, claiming that moral hazard problems led investors to underestimate the risk of investing in emerging markets such as Russia, and that unregulated short-term investment flow led to downfall of Russian economy.

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