Russian August 1998 Financial Crisis:Is Asia to Blame?Galina B. Hale∗September 13, 1999AbstractThe paper shows that the crisis in Russia was not likely to resultfrom the traditional contagion spread from East Asian economies, in-stead it was the result of Russian domestic problems. Two channelsof contagion are analyzed: trade and speculaative. Neither seems tobe present in any significant way between Asia and Russia. The pa-per then argues that the crisis in Russia was the result of deep fiscalproblems and poor debt management.1 IntroductionIn July 1997 Thai baht was successfully attacked. Within next monthMalaysia, Philippines and Singapore were hit by the crisis and withinnext half a year contagion spread out to Indonesia, Hong Kong, Koreaand Japan. Currency pegs in those countries were abandoned and∗UC Berkeley, [email protected]. This is work in progress, please, do not quote.I thank David Romer, Maury Obstfeld and Barry Eichengreen for helpful comments onthe idea of the paper. I am grateful to my mother Irina Borisova for finding and sendingRussian materials. Arkadij Dvorkovich helped with undestanding Russian budgetary pol-icy issues, Julia Shvetz was extremely helpful in gathering data. The Berkeley Soviet andPostsoviet Studies Program summer research grant allowed me to gather necessary dataand meet with specialists on some of the issues, New Economic School provided researchfacilities. All mistakes are, of course, mine.1their currencies depreciation followed accompanied by the financialsystem crash and series of macroeconomic problems.A little over a year after the onset of Asian crisis, on August 17,1998, Russia announced the float of the Ruble (after two years ofsuccessful “crawling peg”) and the restructuring of its debt maturingbefore January 1, 1999. Later in fall 1998, Russia restructured moreof its debt, defaulted on some part of it, and imposed currency con-trols. Interest rates were over 100% in Fall 1998, banks were failingand prices were growing uncontrollably. Over fall 1998 real personalincome fell by 15%1, unemployment increased, rate of growth of realGDP became negative again.Many economists agree that the Russian crisis was an importantevent for the global financial network and, in particular, for emerg-ing markets. The current views are that the abandonment of Russiancurrency peg and, more importantly, the default on Russian debt re-sulted in more conservative behavior by international investors thathurt all the emerging markets and in particular Brazil. As Calvoshows in his recent papers (Calvo, 1998, 1999), the Russian crisis wasan important factor in the freezing of credit to emerging markets thatcan result in major recession in those economies. Roubini (1998) ar-gues that Russian crisis had a direct effect on the current situationin Brazil. This makes a question of what caused the Russian crisisand whether it could have been avoided important in more than justRussian context.The existing theoretical literature on the channels of contagionconcentrates around two main ways of the contagion transmission:via trade and via capital flows. I analyze these channels separatly tosee whether the contagion could be transmitted from Asia to Russia.After concluding that neither of the channels was present betweenRussian and Asia in the way that will explain Russian financial cri-sis, I turn to Russian domestic problems. The analysis of Russianeconomic development in 1995-98 shows that the main reason for thecrisis was the accumulation of budget deficits and poor governmentdebt management. These two factors lead to a debt crisis which inturn provoqued the currency crash and enhanced the banking crisis.Paper is organized as follows. In part two I investigate differentchannels of contagion in search of the way crisis could transmit from1Estimate by Business Environment Risk Intelligence.2Asia to Russia. In part three I analyze Russian domestic problems.Part four concludes.2 Was it a contagion?Throughout this paper, the term contagion is used in the same senseas in Eichengreen, Rose and Wyplosz (1996):... an increase in the probability of a speculative attackon the domestic currency which stems not from domestic“fundamentals” such as money and output but from theexistence of a (not necessarily successful) speculative attackelsewhere in the world.If we look at Russian fundamentals in 1994-98, they do not showthe signs of an approaching crisis. The inflation rate was at the lowlevel of 10% in 1997 and 5.39% in annual terms in the first half of 1998(see Figure 1) and the output showed the signs of growth. Thereforeit is reasonable to ask a question of whether Russian crisis resultedfrom the spread of the Asian contagion, which might seem plausiblegiven the timing of Russian crisis.I will consider two channels of contagion. As mentioned above, firstis the trade links between the source of contagion and the “infected”country2, second is a change of the investors’ behavior in one country’smarket as a result of the crisis in another country’s market.2.1 Trade channelBilateral trade. Bilateral trade is the obvious way for contagion tospread across countries. The crash of the currency of country A wouldincrease its export and thus increase the import of its trade partner,country B. Thus country B will develop current account deficit thatwill put the downward pressure on its currency price. If the exchangerate is pegged, Central Bank will start loosing its reserves and thecurrency will eventually crash. Gerlach and Smets (1994) presenta two-country version of Krugman (1979) classic speculative attackmodel that combines the story described above with monetary sphereand show that trade contagion makes currency crisis possible even in2direct as well as the competition on the world markets3the country with otherwise sustainable domestic policy. The reasonfor this latter to be subject to the crisis is the depletion of its reservesdue to the increase in its imports.In 1997 imports from East Asia3to Russia accounted for only3.28% of total Russian imports4. Figure 2 presents the dynamics ofthis share. Therefore Asian crisis is unlikely to create significant tradedeficit to put enough downward pressure on Russian ruble.Competition on the world markets. Another way of conta-gion to transmit is throught the competition on the world markets.The crisis in country A will make it’s exports more competitive due todomestic currency depreciation. If country B is