VI. 1997–2001: Turmoil and Recovery
- James Roaf, Ruben Atoyan, Bikas Joshi, and Krzysztof Krogulski
- Published Date:
- October 2014
The latter part of the 1990s was a period of major crises in emerging markets, from Mexico in 1994–95, through Asia in 1997, and leading to Argentina in 2001. The emerging European economies were highly vulnerable in this environment, with macroeconomic stability not fully secured, nascent market institutions, and fragile financial systems. And indeed many of the countries that had progressed less in establishing robust market-based frameworks succumbed, first in a number of individual crises, and then in the wake of the systematic case of Russia in 1998. However, these crises (several of which involved calls on the IMF for financial assistance) resulted in most countries learning from the experience, and exiting the period determined to follow policies that would reduce their exposure to such risk—laying the ground for the period of growth that followed.
Source: WEO; various sources for some countries in early years.
Note: CEE average weighted by GDP, others unweighted.
Emerging Europe currency crises, 1997-98
1997: Idiosyncratic crises
The costs and risks of incomplete reform became increasingly apparent through 1997. By early in the year, Bulgaria was already in a full-fledged banking and currency crisis, which cost 14 percent of GDP in output loss and left the lev worth just a few cents of its value of a year before. Only after April 1997 was stabilization achieved, through a new program in support of a currency board arrangement (see Box 2).
Neighboring Romania suffered high inflation in early 1997 triggered by recent price liberalization, a rapidly depreciating exchange rate and a deep recession, following years of delayed reforms. The authorities managed to temporarily reduce inflation by managing the exchange rate, but the strategy was undermined by fiscal slippages and delivered considerable real exchange rate appreciation and a ballooning current account deficit—subsequently leading to a renewed currency crisis following Russia’s default a year later.
Meanwhile Albania suffered a unique crisis in 1997. In light of its earlier isolation, the country had made major progress towards a market economy. However, financial sector development had been limited, and the official banking system was moribund. Instead, an informal credit market had built up, financed via remittances. Deposit-taking companies developed in this environment, but instead of making loans to the real economy, the companies morphed into pyramid schemes, paying very high returns to depositors based on ever-increasing flows of new deposits into the scheme. By late 1996, more than two-thirds of Albanians had invested in the schemes, many selling their homes or livestock to do so. But soon the schemes started to unravel, and depositors’ accounts were frozen, leading to mass riots. By March 1997 Albania was in chaos: the government fell and some 2,000 people were killed in the violence. GDP fell by about 10 percent in 1997, the currency collapsed and inflation spiraled. However, the recovery was relatively swift, with a strong rebound in growth in 1998—due in part to the new government’s budget discipline in refusing to compensate depositors and allowing inflation to cut real public wages.1
Belarus too suffered a crisis going into 1997, though (in contrast to Albania) of a recurrent nature. The combination of inconsistent macroeconomic policies—including expansionary monetary and credit policies while trying to maintain an artificially high exchange rate—along with a reluctance to allow market forces to operate at the enterprise level, inevitably led to severe balance of payments difficulties. By the end of 1997 the exchange rate had fallen to half its level of a year earlier.
Finally the Czech Republic, under pressure from a widening current account deficit and contagion from the Asia crisis, and buffeted by a recent series of bank failures and revelations of fraud in the mass privatization scheme, was forced in May 1997 to abandon the exchange rate peg that had anchored monetary policy since early in the transition. But the impact was relatively mild compared to other cases: the exchange rate depreciated by around 10 percent, while for 1997 as a whole, GDP fell by 1 percent.
1998: The Russia crisis and its aftermath2
At the beginning of 1998, few would have guessed that the Russian economy would end the year in political and economic collapse. The general view was that macroeconomic stability had largely been achieved—with growth returning and inflation conquered—but that Russia still faced major challenges in fiscal policy, and across a broad swath of structural policies.3 What was not understood at the time was the extent and speed with which these latter shortcomings could undermine the fragile stability that was in place, and their inconsistency with maintaining Russia’s sliding peg exchange rate.
But in hindsight there were a number of warning signals already. Spillovers from Asia had raised borrowing costs, and precipitated sharp declines in oil and other commodity prices, hitting Russia’s exports and budget revenue. Maintaining the exchange rate required increasing short-term and foreign currency-denominated borrowing, and, in late 1997, heavy intervention. And the hoped-for improvement in tax collection failed to materialize.
Adverse developments piled up through 1998. Foreign financing started to dry up amid continued fiscal disappointment and a growing awareness of the exposure of the banking system to the exchange rate and short-term government debt. In May the central bank had to raise interest rates sharply to defend the currency. In July, a voluntary swap of short-term ruble debt for Eurobonds, and agreement with the IMF on a new package of official support, gave some respite. But this proved short-lived, as the parliament rejected key program measures, while the government could not finance its deficit and repay maturing debt without central bank financing. By mid-August, reserves were being rapidly depleted even with overnight rates rising close to 300 percent.
The crisis came to a head on August 17, when the authorities announced the devaluation of the ruble, a unilateral restructuring of ruble-denominated public debt, and a moratorium on private sector external debt payments. In the absence of supporting macroeconomic policies, confidence fell further, and the ruble went into freefall—from 7 to the dollar to 20 by early September. A week after the devaluation, the government was dissolved.
The combination of devaluation and effective default had a devastating impact on the banking sector, paralyzing the payments system for over a month and with bank customers losing large shares of their deposits. Industrial production dropped sharply, and GDP declined over 5 percent for the year. The effect of devaluation on foreign currency liabilities pushed debt to unsustainable levels, requiring a restructuring (completed in 2000) of legacy Soviet-era debt. Vulnerable groups—the poor, pensioners, and many public employees—were hit especially hard as devaluation and inflation wiped out savings and sharply reduced the value of wages, pensions and social benefits.
The shock from the Russia crisis reverberated both regionally and globally. In the region, it was felt most strongly through the effect of the collapse of Russian imports, which halved in the months following the devaluation. The hardest hit were the former Soviet republics, which had export shares to Russia ranging from 20–25 percent in the Baltics through Belarus and Ukraine to Moldova at over 50 percent. The last three were all forced to follow Russia with large exchange rate devaluations, and suffered sharp slowdowns in growth.
Emerging market risk premia
Source: JP Morgan.
The Baltic countries, in contrast, were determined to maintain their new currency board arrangements pegged to hard currencies—notwithstanding, in Latvia’s case, significant contagion via banking sector links to Russia. This required sharp increases in interest rates, as well as intervention in the foreign exchange market. All three countries fell into recession at the end of 1998, and unemployment rose significantly. Nevertheless, they succeeded in defending their currencies—a result which added to their resolve, and their credibility, when faced with similar pressures during the global financial crisis a decade later.
Other CEE countries, whose export shares to Russia were mostly in the region of 5 percent, were less exposed through the trade channel. But they were affected through financial markets, with pressure on exchange rates—especially Slovakia, where the crisis contributed to the decision to float the koruna in October 1998 —and increases in real interest rates. Effects on GDP were small compared with the Baltics and other former Soviet republics, however.
Globally, the Russia crisis constituted a major shock to emerging markets, with spreads widening sharply in Latin America and Asia as well as Europe, and contributing to Brazil’s currency crisis. One dramatic consequence was the collapse of the prominent US hedge fund, Long Term Capital Management, which lost $5 billion due to interest rate movements in the wake of the Russian crisis, and needed a bailout to avoid a potential market meltdown.
Box 5.IMF-Supported Programs with Russia in the 1990s—a View from the Field
In retrospect it is clear that the IMF-supported programs with the Russian Federation, spanning most of the period from mid-1992 through 2000, had some unique features. In terms of design, as with other programs, the focus was on macroeconomic stabilization with a large dose of structural policies to try to restructure the economy after eight decades of dysfunctional economic management under the Soviet regime.
However, independent Russia’s starting conditions at the outset of 1992—notably a bankrupt treasury, the collapse of the command economy, and disrupted economic relations—overshadowed initial efforts at stabilization and growth. Those starting conditions were arguably worse than those that prevailed in most Central and Eastern European countries that emerged from behind the Iron Curtain after 1989. The expectation at the time was, nevertheless, for a sustained rebound in Russia once the monetary overhang and resource misallocation under the Soviet state-control system had been addressed. But it took ten years of under-achieved programs to bear fruit.
There were important advances in structural reform, especially under the early programs. But the state seemed to lack the means to be really effective, at least until after the 1998 default. Perhaps in reaction to living under the centralizing principles of the communist regime, central authority was discredited and weak. Strong disparate forces in the regions and powerful oligarchs further undermined normal state functions. As a result, legislation had little practical effect. The civil service was demoralized, bloated and underpaid. Tax collection was inadequate to finance even a limited government function, much less the wholesale transformation required by the circumstances. Program targets for tax collection were repeatedly thwarted by a tendency first to overestimate the government’s capacity to raise revenues and then, when faced with chronic shortfalls, to resort to apparently attractive shortcuts that promised quick fixes to problems that required institution-building.
Despite the underperformance against both macroeconomic targets and the structural reform agenda, the IMF continued to support Russia with financing, with the country becoming (at the time) the largest borrower ever from the Fund. But as policy implementation fell short, internal inconsistencies were building up, which—along with the trigger from the Asia crisis—led inexorably to the 1998 crisis. The crisis was a hard lesson for the IMF, but served as a wake-up call for Russia. It proved to be the fateful tipping point in Russia’s prevarication to become a modern, market economy.Prepared by Martin Gilman, Senior IMF Resident Representative in Moscow, 1996-2001, based on Gilman (2010).
In light of the turmoil ensuing from the Russia crisis, the recovery in the region was surprisingly rapid. For the region as whole, GDP rebounded by 4 percent in 1999 and 7 percent in 2000, by which time every country in the region was growing, most of them strongly. Russia’s recovery was particularly fast, helped by improved competitiveness due to the devaluations, an improvement in commodity prices, and, once the initial period of chaos had passed, policy actions. Key measures included a much more serious effort to collect taxes than in the past, as well as advances on the labor code, deregulation, pension reform and legal reform. Elsewhere in the region countries put the crises behind them and embarked on consolidation. In hindsight, the late 1990s period overall was one of gains both in terms of macroeconomics and structural reform. By 2001, most countries in the region had current accounts, budget deficits and inflation under control. Average EBRD transition indicators also improved for almost all the countries in the sample, some quite significantly.