Transcript An Analysis of Russia`s 19998 Meltdown Fundamentals and Market

Lessons from the Russian Crisis of 1998
and Recovery
Brian Pinto, Evsey Gurvich and Sergei Ulatov
Draft Chapter for:
Managing Economic Volatility and Crises:
A Practitioner’s Guide
Edited by Joshua Aizenman and Brian Pinto
Related papers
 Pinto, Vladimir Drebentsov, Alexander Morozov: “Give
macroeconomic stability and growth in Russia a Chance:
Harden budgets by Eliminating Nonpayments”, Economics
of Transition, vol 8 (2) 2000, 297-324.
 Homi Kharas, Pinto and Ulatov: “An Analysis of Russia’s
1998 Meltdown: Fundamentals and Market Signals”,
Brooking Papers on Economic Activity, 1:2001, 1-67.
 Joshua Aizenman, Kenneth M. Kletzer and Pinto, “SargentWallace Meets Krugman-Flood-Garber, or: Why Sovereign
Debt Swaps Don’t Avert Macroeconomic Crises.” NBER WP
9190.
Key Dates and Events
 July 1995
3-year stabilization program agreed with IMF
 July 1996
Yeltsin re-elected in second round
 Early 1997
GKO/OFZ market liberalized, “DREAM TEAM”
 Oct 1997
Chronic tax problem prompts IMF to hold up disbursements
 July 13, 98
$22.6 billion package announced
 August 17
Ruble devalued, emergency measures
announced
 September 2 Ruble is floated
 September 9 Exchange rate reaches 21 R/$ compared to 6.29 R/$
on August 14
The Economic and Political
Costs of the Crisis




GDP minus 4.9%
12-month inflation 84% - target was 8%
Pensioners/ wage earners suffered
FX resources used up between Oct. 1997 and the Sept. 2,
1998 float $30 billion. $16 billion incurred in the last 10
weeks before the meltdown
 Reformist government of Sergei Kirienko was dismissed
Four-Part Framework
 Fundamentals and Liquidity
 Market Signals
 Crisis Triggers
 Moral Hazard
Public Debt Dynamics
These are captured by the standard equation (1):
(1)
d
pd
ndfs
r
g
d t  d t 1  ( pd t  ndfst ) 
(rt  g t )
(1  g t )
d t 1
public debt/GDP ratio, t time subscript (in years)
primary deficit/GDP
non-debt financing sources/GDP
composite real interest rate
real growth rate
Public Finances and Economic Growth
Table 1. Public Finances and Economic Growth, 1995-98
Units as indicated
Primary Interest Payments
Government
Real
deficit
debt
GDP
(percent Percent Percent Billions Percent Growth
Year
of
of GDP
of
of
of GDP (percent
GDP)
a year)
revenuesa dollars
1995
2.2
3.6
28
170
50
-4.0
1996
2.5
5.9
47
201
48
-3.4
1997
2.4
4.6
38
218
50
0.9
1998
1.3
4.6
43
242
75
-4.9
Sources: Ministry of Finance, Goskomstat, and internal IMF reports
a.
Cash plus noncash basis.
b. Domestic plus foreign, end of period.
Public Debt Dynamics (cont’d)
This brings us to equation (2), which contains an
expanded version of the composite real interest rate, r:
(2)
r  wrd  (1  w)( r f  r )
w share of domestic currency debt in total debt
rd real interest rate on domestic currency debt
rf real interest rate paid on foreign currency debt (e.g., interest
rate paid by government on US dollar borrowing adjusted
for US inflation)
r % change in dollar-ruble real exchange rate
(r > 0 means a real appreciation)
Why were growth expectations in
Russia consistently belied?
 Macroeconomic environment: high real interest rates
and an appreciating real exchange rate
 Serious structural problems (the non-payments problem)
Real Exchange Rate (RER)
 Was real appreciation an equilibrium phenomenon?
 Current Account Balances vs. Sargent –Wallace
 RER movements = f (oil prices, capital flows,
stabilization strategy
 Stabilization Strategy was the main influence on
RER
What is the non-payments problem?
 Curious phenomenon unique to Russia and the FSU
 Consisted of two parts: (i) arrears/overdue
payments and (ii) growing use of non-monetary
exchange
 Became entrenched because of high interest rates
 Killed growth and locked-in the fiscal deficit
 Rational economic explanations
 Enveloped the entire economy
 Linked to PDD
 Linked to growth
Market Signals
 Foreign Currency Debt (FCD)
 Domestic Currency Debt (DCD)
Foreign Currency Debt
Table 7. Yield Spreads on Russian Eurobonds upon Issue, 1997-98
Units as indicated
Maturity
Yield spread
Face value
Issue date
a
date
(basis points)
(billions of dollars)
June 26, 1997
2007
375
2.40b
June 4, 1998
2003
650
1.25
c
June 18, 1998
2028 (2008)
753
2.50
July 24, 1998
2005 and
940
6.44
d
2018
Source: Ministry of Finance
a. Over U.S. Treasury securities of similar maturity.
b. Of which $0.4 billion was settled on October 28 at a yield spread of 334 basis points.
c. Issued as a thirty-year bond with a out-at-par option after ten years.
d. Seven-and twenty-year bonds issued as part of the GKO-Eurobond swap.
Spread difference on the Russian
and Indonesian 10-year eurobonds
 June 10, 1998
 June 25, 1998
 July 24 (completion of debt swap)
-100 bps
0
+160
Domestic Currency Debt (DCD)
Yields on one-year GKOs were decomposed using
equation (3) to get the sovereign or default risk
premium (SRP) and devaluation risk premium (DRP)
as a residual.
(3)
id = if + SRP + (dx/x)* + DRP
SRP and DRP Selected Dates
GKO yield
SRP
DRP
39.3
4.8
23.0
July 13
102.3
8.5
82.3
July 14
58.2
8.1
38.6
July 24
66.4
10.0
44.9
August 10
99.0
20.0
67.5
August 14
144.9
23.8
109.5
May 15
Timing of the Crisis
Three factors played a role:
 International liquidity
 Balance and off-balance sheet exposures of banks
 GKO-Eurobond swap and IFI liquidity injection
The Outcome of the Swap
Bid Spread (basis points)
S
max. cutoff spread
940
837.5
min. spread
S
0
4.4
Market Value of GKOs tendered ($ bn.)
Why didn’t the swap work as
anticipated?
 No free lunch with market-based swap
 Interaction effects with existing asset
portfolio
 Implications for size of devaluation needed
to restore government’s inter-temporal
budget constraint balance
Moral Hazard
 There are many ex-post studies showing MH
is not a factor
 What matters is how MH affects behavior by
changing expected returns
 MH is a particularly costly issue when you
have unsustainable PDD and low liquidity
Post Crisis Developments
 Hard budgets and RER
 Liquidity and PDD
 Macro policy stance (RER, Fiscal
Adjustment)
 Debt Restructuring
 Social Impact
So, What’s the Bottom Line?
Lessons Learned
 Extremely difficult to deal with unsustainable PDD
and low liquidity simultaneously.
 Inflation reduction at the expense of fiscal and
growth fundamentals will simply not work.
 Real appreciation with deteriorating enterprise
performance and PDD is unlikely to be sustainable
EVEN if CA in balance.
Lessons Learned (Cont’d)
 Liquidity – appropriate measures.
 Why financial engineering will not help.
 Social safety net lessons.
 Politics
Do Svidania!