South-Western College Publishing - Economics  
Russia's Economy Gets Two "D's"
Subject International Finance
Topic Devaluation
Key Words Devaluation, Default
News Story

The Russian government announced two dramatic measures to attempt to avert a collapse of its financial markets - devaluation and default. The value of the Russian currency will be allowed to float as low as 9.5 to the dollar by December. The ruble was trading at 6.3 to the dollar before this announcement. The default occurred because the government decided to permanently close its domestic bond market, restructure its debt and delay payments for 90 days on foreign debt owed by its banks and domestic firms. These measures were undertaken after months of chaos and uncertainty in Russia's financial markets that appeared to be heading towards a collapse and financial panic.

The devaluation will increase the prices of imported goods and lead to higher inflation and possibly social unrest. Moscow now relies on imports for over half of its food supplies. Devaluation will help exporters especially in oil and natural gas. The devaluation was a major change in strategy for President Yeltsin, who had declared only three days ago that there would be no devaluation.

Russia's decision to impose a 90-day moratorium on the repayment of foreign debt was an attempt to protect the Russian banking system from a chain of bankruptcies. The moratorium would allow banks to renegotiate debts in hard currencies. Russia tried to assure investors that it would repay all of its obligations. International rating agencies such as Standard and Poor's have substantially downgraded their assessment of Russia's creditworthiness.

The government also decided to close its domestic bond market and restructure existing domestic debt. These bonds, known as GKOs, had been part of the government's fiscal problems because it often was forced to pay interest rates in the order of 150 percent on them. Details of the restructuring have not been announced.

In the past few weeks, Russia's stock market has plummeted, foreign capital has been leaving and confidence in the stability of the financial sector was evaporating. The abrupt moves initiated by the government are an attempt to restore stability and confidence. The cost of these moves may be even more chaos, inflation, and social unrest. (Updated September 1, 1998)
Questions
  1. What happens to the value of a country's currency in a devaluation?
  2. What happens to its exports and imports as a result of a devaluation?
  3. What happens to a country's exchange rate when domestic interest rates increase?
  4. What happens to the exchange rate when "foreign capital leaves" and there is a "loss of confidence"?
Source David Hoffman, "Russia Devalues the Ruble to Prop Up Banking System," The Washington Post, August 18, 1998.

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