This year Russia will celebrate the 25th anniversary of the Belavezha Accords signed by Boris Yeltsin at the end of 1991. At that time, he declared declared the dissolution of the Soviet Union, and launched a series of painful but necessary reforms that turned citizens’ lives upside down. These reforms not only involved the basic institutions of a market economy (market prices, private property, etc.), but also the creation of Russian regulatory bodies. In particular, the Central Bank was established as a result of the transformation of the Russian department of the State Bank of the USSR into the Russian Republican Bank. The next 25 years paved the way for the Central Bank to conduct an independent policy, the main obstacles of which were numerous crises of the Russian economy and banking sector.
Hyperinflation of 1992-1994
The first challenge that Russia faced at the beginning of the reforms was hyperinflation. The only way to overcome hyperinflation was to completely refuse to cover the fiscal deficit at the expense of centralized loans of the Bank of Russia. The first efforts to avoid using them were made around the time the market reforms were launched. From January through April 1992, the Bank of Russia did not lend the government a dime (data from the annual report of the Bank of Russia for 1992). However, in August 1992, the substantial easing of monetary policy began after commercial banks became obliged to provide companies with funds for their operating activities and the cleaning up of their payable accounts; then, the Central Bank reimbursed all costs. These actions affected inflation dynamics: if from May through August, average monthly rates worked out at 12.6 %, then from September through December, they were already at 21.4%. At the beginning of July, the ruble exchange rate stood at 125.3 RUB/USD, but by the end of December, it had fallen to 414.5 RUB/USD. Subsequently, for the next two years, Russia was coping with triple-digit inflation that hit 840% (1993) and 214.8% (1994), respectively. The policy of financing the fiscal deficit at the expense of the Central Bank’s loans was to blame. Eventually, “Black Tuesday” led to the rejection of this policy; on October 11, 1994, the ruble exchange rate weakened by more than a quarter – from 2,833 to 3,926 RUB/USD. After that, the Board of Directors of the Central Bank, with Viktor Gerashchenko at the head, was dismissed.
The Banking Crisis of 1995
In 1995, the government stopped printing money to finance the fiscal deficit, and inflation dropped as a result: If in January their monthly rates were 17.8%, in July they fell to 5.4%. This led to a number of problems for a range of financial institutions, as their business models were based on the principle that the value of borrowed money diminished faster than the time of payment. Then, this money was used for FOREX and interbank operations. It was the interbank lending market collapse at the end of August that contributed to the crisis. A domino effect was triggered in the banking sector, and in the evening of August 25, 1995, more than 150 banks were unable to close their credit positions; consequently, the interbank lending market crashed. Thanks to the prompt intervention of the Central Bank, which lent 2 trillion rubles (not yet denominated) to the banks, the crisis did not affect the major players in the sector, and that was why so few people noticed it. At the same time, a range of banks were forced to stop functioning: if from 1993 to 1995 the number of commercial banks rose from 1,715 to 2,439, from 1996 to 1997 that figure skyrocketed to 2,029 (the Association of Russian Banks data).
The Default of 1998
From 1996 to 1997, banks’ investments in government bonds (called GKOs) were three times higher as usual (hereinafter “Centre of Development” Institute estimates), and they became the main source of financing the fiscal deficit. At the time of the Asian financial crisis in autumn 1997, which caused capital outflow from developing countries, GKO market rates began to rise dramatically: from September 1997 to May 1998, their fluctuation range was 30-40%; in June, rates rose to 60% and ultimately reached 120% in July. However, investors were not interested in debt securities issued by the Russian Government at such rates: During the auctions of July 23 and 30, and the auctions of August 5 and 12, the Ministry of Finance failed to raise a dime. In the second half of 1997, commercial banks reduced bond investments as a result of yield decline, and in 1998 they got rid of these bonds altogether because of the impending threat of the loss of liquidity. On the morning of August 17, the government refused to service and cover their debt liabilities.
The direct consequence of the default was the crash of the biggest banks of the time, namely “Menatep,” “SBS,” “Inkom,” “Onexim,” “Most,” and “Mosbusinessbank.” Andrey Kozlov, the first deputy chairman of the Central Bank, initiated the transfer of these institutions’ deposits to “Sberbank,” which stopped the outflow of capital. If in the third quarter these banks’ ruble deposits (Sberbank’s excluded) dropped by 46%, in the fourth quarter deposits went up by 13% compared to the first half of the year.
In addition to the government default and the bank run, the depreciation of the ruble caused serious damage to banks’ stability. From August to the end of December, the ruble weakened from 6 to 20.7 rubles per dollar. The devaluation hindered banks from repaying foreign-currency loans, and liabilities reached 8 billion dollars by August 1. Given the situation, they could only hope that their foreign creditors would agree to negotiate a debt restructuring. On August 17, the Central Bank declared a 90-day moratorium on foreign debt repayment aimed at facilitating the negotiations. The first group meeting between creditors and debtors was held in Moscow on September 2; however, it did not work out as planned, as the Board of Directors of the Central Bank went through substantial changes in the middle of September, and banks had to negotiate with their creditors one on one.
The crisis resulted in a sharp decline of bank capital: From August to September, the value of their assets decreased by more than 200% – specifically from 67 to 20 billion rubles. Overall, the default ended the period of extensive development of the Russian banking system based on either seizing a part of the state share premium (1992-1994) or generating income from investments in state debt securities (1995-1998).
The Banking Crisis of 2004
In 2004, Russian private banks went through a new crisis. In May, the withdrawal of the Sodbusiness Bank’s license triggered this crisis. For the first time in the post-Soviet period, the reason for this action was suspicion of money laundering. At the beginning of June, the bank Credittrust could not use its debt limit on the interbank market any longer, as banks suspected it of an ownership connection with the Sodbusiness Bank, and this meant that it would suffer the same fate. When the players in the interbank lending market ceased to give one another debt limits, the market collapsed.
At the end of June, it was announced that Credittrust’s license was withdrawn, and at the beginning of July the insolvency of Gutta Bank was declared. These events were followed by a bank run that was averted only when the Council of the Federation passed a law in which the Central Bank would compensate the clients of those bankrupt banks that did not participate in the system of mandatory individual deposit insurance. As a result, the Central Bank had to take on extra liabilities to the extent of 20 billion dollars, according to the estimates of then-chairman Servei Ignatyev. The Central Bank started to control commercial banks on its part, and this led to a contraction of their number from 1,329 in 2004 to 1,299 in 2005, and then 1,253 in 2006.
The Crisis of 2008
In the years before the global economic crisis, the main driver of the development of Russian banks was carry trading strategy: Financial institutions made foreign-currency borrowings at low interest rates and invested these borrowings in high-yielding assets in rubles, including corporate bonds and loans to individuals and businesses. The widespread strategy can be proven by the data from August 1, 2008: Liabilities to non-residents exceeded the value of the banks’ assets to the amount of 10.7% of the assets of the total banking system (hereinafter Gaidar Institute’s estimates are used). The banks’ external debt increased from 50.1 billion dollars in 2006 to 166.3 billion dollars in 2008. In these conditions, the depreciation of the ruble (which dropped by 25.6% from 23.4 to 29.4 RUB/USD from August to December) could possibly result in mass bankruptcy of the banks.
However, it did not happen due to the Central Bank’s assistance in decreasing the reserve ratio requirement, depositing temporarily free budget funds and the funds of state corporations, increasing the number of repurchase agreements, and offering unsecured loans. From August to December, the Central Bank provided financial support at 10.8% of the value of the bank’s assets, or nearly the amount of the bank’s foreign liabilities. Soft devaluation also played an important role: Since the ruble slumped more than 300% against the U.S. dollar between August and December 2008, the ruble lost a quarter of its value. Thanks to the actions of the Central Bank, which spent 170.3 billion dollars during the same period, the banks were not able to neutralize their currency risk.
The Central Bank’s anti-crisis package also included an increase in the banks’ capital-adequacy ratios. In October 2008, the Bank of Russia provided 750 billion rubles in subordinated loans (for 5 years and without collateral) to Sberbank, VTB, and Rosselhozbank. Moreover, in 2008-2009, the Central Bank helped to increase the capital of the largest Russian banks VTB, VEB, and Rosselhozbank by purchasing their shares for 421 billion rubles. Another action was in direct support of the banks on the brink of bankruptcy: In 2009, the government allotted 142 billion rubles to keep Svyaz-Bank afloat, 87 billion dollars for Globex, and 135 billion dollars for KIT-finance and its lender Gazprombank.
In an attempt to avoid a bank run, the government improved their refund terms for the clients of the bankrupt banks: The maximum refund from the Deposit Insurance Agency rose from 400,000 to 700,000 rubles, and now it could be made in full; earlier, if a refund exceeded 100,000 rubles, a 90% refund would be made. As a result, the number of depositors who withdrew their funds from the banks was lower than in 1998: From September to December, ruble deposits decreased by 1.13 trillion rubles, while on the contrary, currency deposits increased by 25.7 billion dollars. These anti-crisis actions helped to prevent a bank panic, but not to extend lending: From September 2008 to August 2009, banks offered a smaller number of loans. Lending only began to rise consistently from March 2010 (“Centre of Development Institute” data).
A new milestone in the development of the Bank of Russia began with the appointment of Elvira Nabiullina as head of the bank in 2013. The first change undertaken by the new chairwoman was tighter banking control. Many big banks in Russia seemed untouchable until November 2013, when the Central Bank revoked the license of Master Bank, one of Russia’s top banks in terms of assets, because it was involved in dubious transactions and false accounting. The campaign resulted in the withdrawal of more than 170 licenses in 2014-2015, which was referred to as “cleaning up” the banking sector.
The Bank of Russia implemented monetary policy in the framework of the inflation-targeting regime, and one of its main tools was the key rate. In 2014, the Russian economy faced external shocks associated with falling oil prices and international sanctions that restricted Russian companies’ and banks’ access to foreign capital markets. These shocks impeded a smooth transition to new principles of monetary policy. As a result, Russian companies and banks had to clear liabilities to foreign banks at their own expense. This sparked a great demand for currency, and the ruble finally collapsed. Between July 2014 and January 2016, corporate sector external debt dropped from 675.7 billion dollars to 484.6 billion dollars; namely, during this period, Russian companies and banks spent 191.1 billion dollars repaying their loans, and the average ruble exchange rate amounted to 38.4 USD/RUB in 2014 and 61 USD/RUB in 2015. The Board of Directors of the Central Bank understood that the bank’s massive interventions would not hinder devaluation. When foreign capital markets were closed, and prices for the main export goods dropped, attempts to defend the ruble brought nothing else but the exhaustion of international reserves and encouraged further destabilization. This was why in November 2014, the Central Bank had no choice but to announce a shift to a free-floating exchange rate, though the Bank of Russia continued to intervene in the currency market for some time. Pressure accelerated in December regarding the country’s currency, and the Bank of Russia took another urgent step and raised the key rate to 17%. Later, the regulator’s actions became the main reason for criticism from a range of experts.
Despite the complexity of the current economic situation in Russia – partially due to high rates and a sharp devaluation of the ruble – over the past two years, perhaps for the first time in contemporary history, the Central Bank managed to show a high level of independence in making decisions. Nevertheless, debates surrounding the autonomy of the Central Bank with regard to monetary policy persist among scientists and experts. A range of specialists suggested relaxing monetary policy and financing measures to promote growth in the real sector on account of issuing money. At the same time, the Bank of Russia still believed that price stability was the main priority, and their policy started to take off.
A settlement of this dispute, in our opinion, will determine the ongoing development of the Russian economy. If the Central Bank manages to maintain its current position, the most likely result will be to move toward long-term macroeconomic stability with moderate inflation and economic growth rates. Otherwise, a massive issue may accelerate the GDP growth rate in the short term, but it is more likely to result in a new wave of hyperinflation.
We believe that adherence to the principles of inflation targeting in monetary policy and the Central Bank’s independence can lead to the predictable volatility of inflation and interest rates by creating favorable conditions for long-term investment planning that is essential to the modern Russian economy.
Samvel Lazaryan – Adviser to the Director of the Financial Research Institute of the Russian Ministry of Finance
Ivan Nikonov – Economist, Financial Research Institute of the Russian Ministry of Finance