Russian Financial Crisis (1998)

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Topic 3: Russian financial crisis (1998)

1.0 Introduction
Affected by the Southeast Asian financial crisis, Russia suffered from the financial crisis in May 1998 followed the crisis in October 1997. The crisis initially reflected on currency market and security market. As a result, foreign capital about one-third of the total amount of Russian national debts faced large-scale capital flight; exchange rate depreciated and stock market suffered a large setback; re-lending interest rate once reached up to 150%. Stock market, bond market and currency market basically fell into halts, and banks were incapable to handle residents’ withdrawals. (Desai, 2000) In brief, the operation of the whole financial system and economy was almost paralyzed. In August 1998, the Russian government decided to let Rouble free float and announced that it would implement one-sided moratorium for Rouble-dominated internal debts and some external debts, and prohibit banks cash foreign exchange commitment. (Feridun, 2004) From then on, the financial crisis full-blown erupted. Because the Russian government made some wrong political decisions, the public distrusted it so as to create the financial crisis.

The purpose of this report is to analyze Russian financial crisis 1998 mainly from inflation, international trade and capital flows. First of all, it will explain why the high Russian inflation was putting pressures on the value of the Russian Rouble, will identify how the government responded to this situation and then will summarize implications for Russian companies involved in international trade and capital flows. Secondly, it will discuss the relationship between the effect of Russian inflation on the decline of the Rouble’s value and the theory of purchasing power parity (PPP). Thirdly, it will elaborate if the prices of Russian goods will be equal to the prices of US goods from the perspective of Russian consumers. Fourthly, it will analyze how US importers of Russian goods will be affected by the Russian inflation and the decline in the Rouble. Finally, it will make a conclusion based on previous analysis and discussions.

2.0 Government response and implications for Russian companies under the situation of high Russian inflation and low value of the Russian Rouble According to the scheduled plan, the Russian government lowered the inflation rate to 10% in 1998. However, the inflation rate after the crisis increased substantially. The inflation rate has reached up to 15% in August while it has climbed to 40% in September. In order to deal with the crisis, one approach was to issue currency, which would lead to the continual rise of inflation rate. If the banks kept the exchange rate at 20 Rouble for one dollar, the inflation rate would rise by 240% to 290% at the end of 1998. (Feridun, 2004) High inflation rate means the currency depreciation (Ball, 2007). Therefore, Rouble’s value declined sharply facing high inflation. According to the statistics, Rouble depreciated by 48% within one month after August 17, which became the world’s most devalued currency in 1998. (Malleret, Orlova and Romanov, 1999)

Under this circumstance, the Russian government mainly employed the following three countermeasures. First of all, the government improved the interest rate for maintaining Rouble’s value. It was reported that the Central Bank regulated the discount rate from 30% on May 19 to 150% on May 27. The bank rate ever declined to 60% on June 4, but soon it again regulated to 110%. (Feridun, 2004) At the same time, the bank unloaded dollars intervention exchange rate so that the foreign exchange reserves decreased to 15 billion dollars from 20 billion dollars at the beginning of 1998. (Malleret, Orlova and Romanov, 1999)

Secondly, the government turned to raise external debt from raising internal debt. Russia paid a cost for offsetting financial deficits by issuing national bonds from 1993 to May 1998. To be specific, the finance...
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