Essay: What is meant by a financial crisis?

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  • What is meant by a financial crisis?
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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.

“Who was to be held responsible for the 1998 Financial Crisis?”

The 1998 Russian Financial crisis arises due to lack of Governance and the policies that were implemented with collaboration of both Central Bank of Russia and Russian Government. Some policies were implemented with consent of both parties that led to downfall of Russian economy and Ruble was devalued.

A. The Role of Government:

In March 1998 there was increase in the series of Russian political crisis. Russian Prime Minister Viktor Chernomyrdin and his entire cabinet were dismissed by President Boris Yeltsin on 23 March 1998. Yeltsin replaced him by the 35 years old Energy Minister Sergei Kiriyenko who was being criticized a lot by the people of Russia. Boris Fyodorov was appointed as the head of tax department in the tenure of Yeltsin. Russian economy was not in so good economic condition in order to improve the economy the acting Prime Minister Sergei imposed a policy that raised GKO by 150%. GKO stand for “Gosudarstvennoye Kratkosrochnoye Obyazatyelstvo” in Russia for Short term Government Commitments also known as Treasury Bills. Other than that on 13 July 1998, $22.6 Billion loan was approved b IMF and World Bank was approved to stabilize the Russian market as well as to support reforms. To stabilize the Russian market the large quantity of the quickly swapping GKO’s were been converted into Eurobonds.

However Government keep the exchange rate of Ruble fixed .As a viewpoint of some economists they suggested that Government should have abandon its support for the Ruble .

The other event such as coal miner strike on 12 may 1998 led to increase in Russia debt owed to workers approximately $12.5 billion till the time period August 1 1998.On the other hand the exchange rate of Ruble to US Dollar was still 6.29.

Many of the Russian parties began to strike against the Sergei government and Yeltsin, which also somewhat contributed in the crisis of 1998.

B. The Role of Central Bank:

On July 29 1998 Russia Central Bank employed policy of “floating peg” on ruble in which the Central Bank of Russia would decide about the exchange rate of Ruble and its specific time.

The central bank of Russia and Government announced the joint statement on 17 August 1998 when the series of crisis was just started. The following of the policies were announced:

i. Ruble/dollar trading band was expanded from 5.3–7.1 RUR/USD to 6.0–9.5 RUR/USD. This means that the range of prices within which the currency exchange rate would controlled was increase from 5.3-7.1 to the rate of 6.0-9.5

ii. The default on short term treasury bills GKO, they announced the default on the GKO so that they can restructure the Russia economy in a better way.

iii. The 90 day moratorium on payments by commercial bank to pay its foreign creditors. A temporary prohibition was made on the commercial banks in which they were not allowed to pay theirs to debts and payments.

On 17 August 1998 at one hand Government announced that the GKO would be converted into new securities and at same time the authorities announced that they allowed Ruble/Dollar exchange rate to move freely in a wider range. From 17 to 25 August 1998 Ruble began to steadily depreciate on the MICEX i.e. Moscow interbank currency exchange rate. On 26 August 1998 Central Bank discontinue Ruble/Dollar trading on MICEX as a result the Ruble didn’t stable on that day. On 2 September 1998 the Central Bank of the Russia decided to abandon the “floating peg” policy and decided to float ruble freely. By 21 September 1998 the exchange rate reached 21 Rubles for one US dollar that shows that it lost its two third values in just three weeks. On 28 September 1998 Boris Fyodorov was discharged from the position of the Head of the State Tax Service. The 90- day moratorium imposed by the Joint Statement expired on 15 November 1998 and the Russian government and Central Bank did not renew it.

“What was the Negative Impact of the Russian Financial Crisis?”

The Russian financial crisis led to severe and disastrous effects towards the economy of Russia. Though Russia didn’t suffered a lot at time when it was made a Sovereign state but it suffered more in 1998. The foremost and direct impact was on its economy. The Russian economy contracts by 5.3% in 1998 not only this but the GDP level reaches its lowest level since its formation in 1991.

The economy and Russians suffered from the high inflation rate. Inflation rate was about 84% and the welfare of the people grew. The food prices were high which grew social unrest and people also started to migrate to other countries. This also led many banks such as Inkombank, Oneximbank and Tokobank to close down its functions.

The Agriculture sector also badly affected by the rise of crisis. There was 80% decrease in federal subsidies since 1997 though the impact on the regional subsidies was felt less. Farmers had to produce at a very large amount but their exchange was low. The Federal Government of Russia decrease the subsidies provided to farmers and other people as result the cost prices of the products grew more rapidly. On 9 October 1998 Russian also suffered from poor harvest and applied for the humanitarian aid.

The most important negative impact this event has was the political fallout. Yeltsin Government was to be held responsible for the occurrence of the panic attack. On 23 August 1998, Yeltsin fired Kiriyenko and wanted Chernomyrdin too return but the legislature didn’t accept it. Though as his replacement foreign minister Yevgeny Primakov was selected. However his appointment restored political stability but it was not up to the mark. On 7 October 1998, Communists and Russian Trade Union called a strike and demanded Yeltsin to resign.

“What were efforts made to recover 1998 Russian Financial Crisis?”

Financial crisis have serious economic results which affects both developed countries markets as well as developing countries market. These financial crises are some time hard to predict because they mostly affect the country economy slowly and gradually. The financial crisis are mostly hideous they attack the roots of economy is a disguise way so that country who doesn’t take precaution from start fall for its trap and suffer a lot. It is the foremost duty of the Government to maintain a check and balance on every sector of economy so that in near future it can avoid such crisis.

To prevent crisis Government should carry out some sensible reforms. The main cause that these crisis arises because there is the problem in the structure of the financial system. But we don’t have only problem with financial system there is also role of the political reforms of the economy to go in recession. To avoid crisis a country requires stable macroeconomic policies like low rate of unemployment, increase in the GDP growth rate, increase in the per capita income keeping the budget deficit small and current accounts feasible. Also taxation is the compulsory contribution by public to meet the expenditure so that Government can plan out according to it this is not only the source of revenue but they also bring builds gap between rich and poor.

Though Russian Financial Crisis of 1998 was severe but Russia was quickly able to gain its reputation as a strong sovereign state. The main reason in rapid growth of economy was the oil prices that rapidly rose from 1999 to 2000 as a result Russia was able to gained higher share in the oil market and the trade was in surplus. The domestic Russian industries were set back on track and the government also gave out loans to set the home industries which as a result increase the value of home produced goods rather than imports. The one of benefit Russian economy had was that Barter system was still been followed there that cause somehow less effect that it should be if it was completely running on monetary basis. The debt by the creditors were paid as a result Russian banking sector improved and started to work well and it was able to pay some share of its debt. The new Government though helped a lot in the recovery of the state as they managed to keep better control on political and social pressures. These measures helped the Russian economy to be back on track with better economic growth.

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