US debt default: Russia's experience holds a lesson

Policymakers considering the consequences of a US debt default might be well served by looking at Russia's experience 15 years ago.

"Default" is one of the scariest words in the economist's lexicon, conjuring up images of government paralysis, financial panic, currency collapse, and social turmoil.

The United States may be peering into the abyss, but Washington might be well served to also look at what happened in Russia 15 years ago, when Moscow suddenly defaulted on its treasury bonds, valued at around $40 billion, much of it owed to foreign investors.

Within weeks, many banks shut down, wiping out depositors' savings. The ruble lost almost 80 percent of its value, the stock market went into freefall and Russia's fledgling middle class was plunged into poverty just years after the Soviet collapse all but destroyed the country’s economy.

Russian economists, looking at what many insist is a very different situation currently unfolding in the US, argue that nobody ought to wish such a financial death spiral upon themselves. Having said that, most admit that their 1998 crisis set the stage for an economic rebound in Russia by purging unsustainable government debt, slashing the overvalued ruble to make Russian business more competitive, and clearing away obsolete industry and infrastructure.

"I think the 1998 default was a lesson, that's the best you can say about it," says Sergei Dubinin, who was head of Russia's Central Bank at the time. "Both elites and business, as well as the population, can draw conclusions from it. They are that you cannot go on accumulating debts, the budget has to be balanced and taxes have to be paid.

“Yes, it was a good lesson, but the price was too high. Even today we suffer from a lack of trust in investing in Russia.... We have not overcome the negative impact to this day," says Mr. Dubinin, who is today chairman of the supervisory council of Russia's state-owned VTB bank.

Russia's troubles in the late 1990s stemmed from an incomplete transition from the Soviet economy, a financially ruinous war in Chechnya that cost the Russian government around $6 billion, a culture of tax evasion, and the rising costs of state borrowing.

By mid-1998, the Russian government was forced to pay 150 percent interest on new government bonds, known as GKOs.

According to Dubinin, Russia's crisis also featured political gridlock between President Boris Yeltsin and his opposition-dominated legislature, the State Duma, which he blames for bringing the country to the verge of default.

"The Russian budget was a hostage of political passions, first of all passions in the State Duma," Dubinin says.

"The forces in the State Duma did their best to increase budgetary expenditures, trying to look well in the eyes of their voters. It was pure populism, [and it took place amid a generally unfavorable economic situation in which] unemployment was on the rise and there was a fall in production," he says. “People in the State Duma didn't want to listen to reason.”

Massive official corruption was another likely factor that dragged the Russian government inexorably toward bankruptcy. The country’s former chief prosecutor, Yury Skuratov, was suspended by Mr. Yeltsin for alleging inner-Kremlin corruption. He also told journalists following the crisis that a nearly $5 billion loan made to Russia by the International Monetary Fund in July 1998, intended to prop up the faltering ruble, was actually handed out to insider banks to bolster their own bottom lines.

According to Dubinin, in the summer of 1998, state finances flew out of control in Moscow.

"Foreigners, who made up about 40 percent of the GKO market, began withdrawing their money, and the market reacted with falling rates and decreasing prices," he says.

"It became impossible to use [bonds] as a means to replenish the budget deficit. We lacked money to refinance the state debt.... The IMF did help, but it was too little too late. People began to withdraw money and convert rubles into dollars," he says.

Following the crash, however, Russia's economy rebounded far more quickly than most gloomy assessments predicted at the time.

"We should not underestimate the great social damage that we suffered. People were deeply disillusioned," says Yevgeny Gontmakher, deputy director of the official Institute of World Economy and International Relations in Moscow.

"But in the subsequent years we experienced profound economic growth. Part of that is due to ruble devaluation, which strengthened domestic industry and made our exports much more competitive. It's true that the economic boom of Vladimir Putin's first two terms in office owe much to rising global prices for oil and gas, our main exports, but some of it was also the rebound effect," he says.

Mr. Gontmakher says Russia is now at an economic plateau, and there hasn’t been any similar bounce since the 2008 economic crisis.

"In summary, I'd have to say that financial crashes are bad things, to be avoided if you possibly can,” he says.