Hitting Bottom: The Default of 1998

The period between 1996 and 1999 was characterized by continued privatization, growth in the big private companies, some political maneuvering over the passing of new legislation, a few high-profile assassinations, and (very importantly) the rapid growth of government short-term bonds. The so-called GKO bonds were issued for a few months each, and typically had an interest rate just ahead of the inflation rate, to keep the public interested. Because the situation appeared to be under control, many people—including many oligarchs, key government officials, and even some representatives of reputable Western investment funds—were attracted to the GKOs in large numbers. The economic realities, however, were not at all as rosy as they seemed, and after a few months of skyrocketing yields (to attract ever more investors in what was essentially a Ponzi scheme), the Russian government started suspecting a looming default. In the absence of real economic growth, it basically had to keep raising the interest rates to attract new buyers to pay off the old bonds to bring in new cash. After replacing the stalwart Chernomyrdin with the young, inexperienced Kirienko, Yeltsin seemed to do nothing at all to deal with the situation. The default finally occurred in August 1998, partially in response to the widening financial crisis in the emerging markets in Asia. The Russian state defaulted on its ruble GKOs, and some foreign loans in hard currency. The investors fled; many banks collapsed; and the ruble plunged from about 6 to 31 against the U.S. dollar in less than 2 months.

It took about 2 years and a new Russian president, Vladimir Putin, to restore some confidence in the Russian market. To be fair, many countries with much older market economies and in better economic shape than Russia (e.g., South Korea, Brazil, Mexico, and Argentina) experienced similar problems at about the same time; even the mighty United States itself became embroiled in a major financial collapse in 2008. The default of 1998, however, made it abundantly clear that Russia's economy had indeed hit bottom. By the fall of 1998, the Russian GDP was about half of what it was in 1990—an unprecedented decline in any country in the absence of war.

When citing macroeconomic statistics, however, we need to consider the unofficial sectors of the Russian economy (thought to account for perhaps 20% of it), so the real situation was actually better than the official numbers alone portray. Also, much of the decline in the GDP was in heavy industrial production; Russian tractors, boilers, combines, and so on were of inferior quality and greatly overproduced anyway. Growth in retail trade, services, construction, and a few other consumer-oriented sectors was occurring at the same time as the big industries were faltering, and this growth partially offset the gloomy statistics. Nevertheless, particularly hard hit were some of the most consumer-oriented enterprises, such as the textile and shoe industries, where production in 1998 was a mere 20% of the 1990 level.