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Jan 21, 2014 | 11:03 GMT

Russia's 1998 Financial Crisis in the Regions: A Case Study

Russia's New Crisis: Regional Debt
Stratfor
Summary

Editor's Note: The following is the second installment of a three-part series on growing debt for Russia's regional governments.

Traditionally, Russia's regions have reacted against federal authority in times of economic crises, such as the so-called Ruble Crisis of 1998. The crisis serves as an example of how economic instability could add to the Kremlin's problems in managing the country, particularly since Russia is already dealing with divisions along social and ethnic lines.

In 1997, the Asian financial crisis began to ripple throughout the world. Russia was still reeling politically, socially, economically and financially from the fall of the Soviet Union just six years before. Russia's industrial and service sectors had collapsed, and capital was leaving the country rapidly. Additionally, the price of the one thing bringing in money to Russia — energy — was dropping rapidly.

Russian Ruble Exchange Rate

Russian Ruble Exchange Rate

By 1998, interest rates in Russia skyrocketed by 150 percent. The Kremlin attempted to counter the destabilization of the Russian ruble by using a "floating peg" system in which Russia's central bank would keep the ruble-to-dollar exchange rate within a certain range — and as close to the U.S. dollar as possible. Whenever the ruble fell to the end of that range, the Russian Central Bank took action, such as selling foreign reserves to create demand for the ruble, to pull it back up.

But the Kremlin was running out of cash to stabilize the currency, and energy prices were continuing to decline. In August 1998, the Kremlin could no longer pay to maintain the peg and enacted a mass devaluation. Russian stocks, bonds and currency markets all collapsed as the stock market fell 75 percent. The Russian government defaulted on $40 billion of domestic debt.

Russia's Inflation Rate

Russia's Inflation Rate

The Russian people saw all their ruble savings become worthless. Inflation soared 84 percent while the cost of imports rose more than 400 percent and food prices increased more than 100 percent. The majority of businesses stopped paying their workers. The crisis pushed about 43 million people or 30 percent of the Russian population below the poverty line of 522 rubles ($25 in December 1998 terms) per month.

Crises in the Regions

The 1998 crisis affected each of the Russian regions differently. Industrial production was already in decline, falling 60 percent between 1992 and 1998 (in comparison, the United States' Great Depression saw a 47 percent fall). Regions such as Sverdlovsk, Chelyabinsk, Vologda, Kemerovo, Krasnoyarsk, Orenburg, Volgograd, Omsk and Lipetsk were hit the hardest, because they depended on industry for the majority of their economies.

The agricultural sector was also declining — production was down 50 percent from 1992 — due to delays in land reforms after the fall of the Soviet Union and a lack of investment in agricultural equipment and fertilizers. Massive food shortages were seen in Sakhalin, Kamchatka, Dagestan, Kaliningrad and other areas. There were reports that the food shortages in Chukotka were so bad that the residents resorted to hunting whales for food. By October, mass protests filled the streets across the country. In most of the regions, leaders and governments broke with the Kremlin's plan to counter the crisis and started to look out for their own regions' interests.

In Kemerovo, Tatarstan and Altai, the governors banned the export of food from their regions to other regions and hoarded goods, which is banned by federal law. In Vladivostok, rationing was implemented, restricting food and medicine to the cities and leaving the countryside abandoned. Starting in Krasnoyarsk and then spreading to 30 other regions, governments capped price increases on goods to 10 percent, against federal orders.

Many regions, like Kaliningrad and Khakassia, refused to pay taxes to the federal government. Others, like Nizhny Novgorod, refused to pay salaries, instead shutting down municipal and regional services. Some regional governments took control of local assets; Rostov took over agricultural producer Rostelmash, while Bashkortostan's government took control of all energy assets in the region.

Many regional governments decided to set up their own parochial banks to replace the collapsed federal banking system. In some cases, the regions interlinked their banks to be able to support and swap currency. In other cases, regions refused to help each other, such as when Yekaterinburg's Severnaya Kazna refused to exchange currency with Moscow's Inkombank.

In addition, many areas reached out for financial help abroad — something strictly against federal law at the time. Regions such as St. Petersburg and Novgorod sold land and other assets in their territory to foreign investors. Tatarstan, Komi and Sakha all borrowed money on the international market from banks like Bank Societe Generale and Schweizerischer Bankverein. Those loans soon fell into the cycle, however, as regions borrowed internationally to cover their current debts then defaulted on those loans.

Federal Reactions to the Regions' Actions

By the end of 1998, the federal government had almost entirely lost the ability to control how the regions were operating. The Justice Ministry reported that nearly two-thirds of the regions had enacted unconstitutional measures, procedures and laws. This lawlessness was one of the factors that contributed to Putin's rise. In July 1998, Russian President Boris Yeltsin named Putin as head of the Federal Security Services (the successor to the KGB), and in October he was earmarked for the Security Council. One of the tasks given to Putin at the time was to rein in the rebellious territories.

Putin's plan was simple: Purge the leaders who did not comply, and if they refused to go, then deploy the military. Military units all over Russia were put on stand-by, signaling to the regional leaders that this new power in the Kremlin was not to be defied. By the start of 1999, 46 of the then-89 regions signed power-sharing agreements with the Kremlin to recentralize their legal system under federal control. One-third of the then-directly elected regional leaders reportedly resigned, while many others were imprisoned.

The recentralization of the Russian regions under Kremlin control continued to intensify when Putin became president. He abolished direct regional elections, his political party dominating each region. Putin's recentralization — not just of the regions but of the entire country economically, politically and in the realm of security — combined with a global economic recovery brought a decade of relative strength and stability to Russia.

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