In the early 1990s, following the collapse of communism and the dissolution of the Soviet Union, the Russian government implemented an economic reform program designed to transform the country's crumbling centrally planned economy into a dynamic market economy. A central element of this plan was an end to price controls on January 1, 1992. Once controls were removed, however, prices surged. Inflation was soon running at a monthly rate of about 30 percent. For the whole of 1992, the inflation rate in Russia was 3,000 percent. The annual rate for 1993 was approximately 900 percent. Several factors contributed to the spike in Russia's inflation rate. P rices had been held at artificially low levels by state planners during the Communist era. At the same time there was a shortage of many basic goods, so with nothing to spend their money on, many Russians simply hoarded rubles.

After the liberalization of price controls, the country was suddenly awash in rubles chasing a still limited supply of goods. The result was to rapidly bid up prices. The inflationary fires that followed price liberalization were stoked by the Russian government itself. Unwilling to face the social consequences of the massive unemployment that would follow if many state-owned enterprises quickly were privatized, the government continued to subsidize the operations of many money-losing establishments. The result was a surge in the government's budget deficit. In the first quarter of 1992, the budget deficit amounted to 1.5 percent of the country's GDP. By the end of 1992, it had risen to 1 7 percent. Unable or unwilling to finance this deficit by raising taxes, the government found another solution-it printed money, which added fuel to the inflation fire. With inflation rising, the ruble tumbled in value against the dollar and other major currencies. In January 1992 the exchange rate stood at $1 = R125.

By the end of 1992 it was $1 = R480 and by late 1993, it was $1 = Rl,500. As 1994 progressed, it became increasingly evident that due to vigorous political opposition, the Russian government would not be able to bring down its budget deficit as quickly as had been thought. By September the monthly inflation rate was accelerating. October started badly, with the ruble sliding more than 10 percent in value against the U.S. dollar in the first 10 days of the month. On October 11, the ruble plunged 21.5 percent against the dollar, reaching a value of $1 = R3,926 by the time the foreign exchange market closed! Despite the announcement of a tough budget plan that placed tight controls on the money supply, the ruble continued to slide and by April 1995 the exchange rate stood at $1 = R5,120.

However, by mid-1995 inflation was again on the way down. In June 1995 the monthly inflation rate was at a yearly low of 6. 7 percent. Also, the ruble had recovered to stand at $1 = R4,559 by July 6. On that day the Russian government announced it would intervene in the currency market to keep the ruble in a trading range of R4,3000 to R4,900 against the dollar. The Russian government believed that it was essential to maintain a relatively stable currency. Government officials announced that the central bank would be able to draw on $10 billion in foreign exchange reserves to defend the ruble against any speculative selling in Russia's relatively small foreign exchange market. In the world of international finance, $10 billion is small change and it wasn't long before Russia found that its foreign exchange reserves were being depleted. It was at this point that the Russian government requested MF loans. In February 1996, the IMF obliged with its second-largest rescue effort ever, a loan of $10 billion.

In return for the loan, Russia agreed to limit the growth in its money supply, reduce public-sector debt, increase government tax revenues, and peg the ruble to the dollar. Russia also rebased the value of the ruble, making one ruble equivalent to 1,000 old rubles. Initially the package seemed to have the desired effect. Inflation declined from nearly 50 percent in 1996 to about 15 percent in 1997; the exchange rate stayed within its predetermined band of 4.3 to 4.8 rubles per dollar; and the balance-of-payments situation remained broadly favorable. In 1997, the Russian economy grew for the first time since the breakup of the former Soviet Union, if only by a modest half of 1 percent of GDP. However, the public-sector debt situation did not improve.

The Russian government continued to spend more than it agreed to under IMF targets, while government tax revenues were much lower than projected. Low tax revenues were in part due to falling oil prices (the government collected tax on oil sales), in part due to the difficulties of collecting tax in an economy where so much economic activity was in the "underground economy," and partly due to a complex tax system that was peppered with loopholes. In 1997, Russian federal government spending amounted to 18.3 percent of GDP, while revenues were only 10.8 percent of GDP, implying a deficit of 7 .5 percent of GDP, which was financed by an expansion in public debt.

CRISIS Dismayed by the failure of Russia to meet its targets, the IMF responded by suspending its scheduled payment to Russia in early 1998, pending reform of Russia's complex tax system and a sustained attempt by the Russian government to cut public spending. This put further pressure on the Russian ruble, forcing the Russian central bank to raise interest rates on overnight loans to 150 percent. In June 1998, the U.S. government indicated it would support a new IMF bailout. The IMF was more circumspect, insisting instead that the Russian government push through a package of corporate tax increases and public spending cuts to balance the budget. The Russian government indicated it would do so, and the IMF released a tranche of $640 million that had been suspended.

The IMF followed this with an additional $11.2 billion loan designed to preserve the ruble's stability. Almost as soon as the funding was announced, however, it began to unravel. The IMF loan required the Russian government to take concrete steps to raise personal tax rates, improve tax collections, and cut government spending. A bill containing the required legislative changes was sent to the Russian parliament, where it Cases 413 was emasculated by antigovernment forces. The IMF responded by withholding $800 million of its first $5.6 billion tranche, undermining the credibility of its own program. The Russian stock market plummeted on the news, closing down 6.5 percent. Selling of rubles accelerated. The central bank began hemorrhaging foreign exchange reserves as it tried to maintain the value of the ruble. Foreign exchange reserves fell by $1.4 billion in the first week of August alone, to $17 billion, while interest rates surged again. Against this background, on the weekend of August 15-16, top Russian officials huddled to develop a response to the most recent crisis.

Their options were limited. The patience of the IMF had been exhausted. Foreign currency reserves were being rapidly depleted. Social tensions in the country were running high. The government faced upcoming redemptions on $18 billion of domestic bonds, with no idea of where the money would come from. On Monday, August 1 7, P rime Minister Sergei Kiriyenko announced the results of the weekend's conclave. He said Russia would restructure the domestic debt market, unilaterally transforming short-term debt into long-term debt. In other words, the government had decided to default on its debt commitments. The government also announced a 90-day moratorium on the repayment of private foreign debt and stated it would allow the ruble to decline by 34 percent against the U.S. dollar. In short, Russia had turned its back on the IMF plan. The effect was immediate.

Overnight, shops marked up the price of goods by 20 percent. As the ruble plummeted, currency exchange points were only prepared to sell dollars at a rate of 9 rubles per dollar, rather than the new official exchange rate of 6.43 rubles to the dollar. As for Russian government debt, it lost 85 percent of its value in a matter of hours, leaving foreign and Russian holders of debt alike suddenly gaping at a huge black hole in their financial assets. AFTERMATH In the aftermath of Russia's default on government debt, the IMF effectively turned its back on the Russian government, leaving the country to fix its own financial mess. With no more IMF loans in the offing, the government had to find some other way to manage its large public-sector deficit. The government took a twopronged approach; first, it slashed government spending, and second, it reformed the tax system.

With regard to the tax system, the government of Vladimir P utin ignored the advice of the IMF, which wanted Russia to raise tax rates and focus on tougher enforcement. Instead, the government replaced Russia's complex income tax code, which had a top marginal rate of 30 percent, with a 13 percent flat tax. Corporate tax rates were also slashed from 35 percent to 24 percent, and the tax code simplified, closing many loopholes. Paradoxically, the cut in tax rates led to a surge in government revenues as individuals and corporations decided it was easier to pay taxes than go to the trouble of avoiding them, which they had long done.

In addition to these government actions, a sharp rise in commodity prices, and particularly world oil prices, helped the Russian economy enormously. Russia is now the world's largest oil exporter, ahead of even Saudi Arabia. In addition, it exports significant amounts of natural gas, metals, and timber, all of which have seen sharp price increases since 1998. The country now runs a large current account surplus with the rest of the world (in 2004 it hit $46 billion). As a result of these changes, the Russian economy grew at an average annual rate of 6.5 percent between 1998 and 2004. Foreign debt declined from 90 percent of GDP in 1998 to about 28 percent in 2004, while foreign reserves increased tenfold to $120 billion. The government has been running a budget surplus since 1999.

In 2004 it took in some $13.1 billion more than it spent. Moreover, in January 2005 the Russian government repaid its entire obligations to the IMF ahead of schedule. Despite these positive developments, the Russian economy still has numerous structural weaknesses. The country is now very dependent on commodity prices, and if they should fall, the economy will suffer a sharp pullback. The banking system remains weak, the manufacturing infrastructure is poor, the country is still rife with corruption, there is widespread mistrust in the institutions of government, and foreign investment is relatively low

Case Discussion Questions

1. What were the causes of the surge in inflation in Russia during the early 1990s? Could this have been avoided? How?

2. What does the decline in the value of the ruble against the dollar between 1992 and 1998 teach you about the relationship between inflation rates and currency values?

3. During the mid-1990s, the IMF wanted Russia to raise tax rates, close loopholes in the tax system, and cut public spending. Russia was unable to do this. Why?

4. In the early 2000s Russia cut tax rates for individuals and corporations, and government tax revenues surged. Why? Does this result suggest that the IMF policy prescriptions were wrong?