Back From the Brink With Oil and Reforms

It was exactly one month before the ruinous 1998 financial crash that Boris Nemtsov, then deputy prime minister, said he knew for sure that the country was headed for an economic meltdown.

On that day, July 17, 1998, President Boris Yeltsin's government announced that it would officially bury the remains of the last tsar, Nicholas II, 80 years after his execution by the Bolsheviks. It was a symbolic moment of national catharsis and a big step for a country still struggling to come to terms with its past.

"We decided to hold the [memorial service] in the Peter and Paul Cathedral, so we had to do it up. The cost was $2 million," Nemtsov said in a recent interview.

But when he called the Finance Ministry to ask for the money, Nemtsov was told that the government accounts had been frozen by the Central Bank.

"I understood then - it was the end," he said.

Thirty-one days later, on Aug. 17, after teetering close to disaster for months, the government unleashed a debilitating economic double-whammy on the country - simultaneously devaluing the ruble and defaulting on its spiraling debt.

The subsequent fallout sent the banking system toppling and wiped out savings, investments and confidence in the Russian economy. The crash also left millions of Russians unemployed.

A decade later, the very thought of the Russian state scrambling around for $2 million seems almost laughable - and the crisis, chaos and trauma of 1998 feels to most people like a distant memory.

On the back of sky-high oil prices, the government's coffers are now brimming, its sovereign debt is paid off, investment is flowing in and the economy is booming.

Russia has now become, in the words of Finance Minister Alexei Kudrin, "an island of stability."

But for many, the ghost of 1998 still looms large. Although the collapse was the result of an almost unrepeatable economic storm of a shrinking economy, rising debt, low oil prices, capital outflow and mismanagement - the fallout from that August has shaped the reform process and political landscape in the country over the past decade and even proved a key catalyst for the current economic success.

Now, with the shock waves of the U.S. financial turmoil reverberating around the world, the lessons of that dark period for Russia -- what has been put right and what still needs to be done - appear more pertinent than ever.

Just as the crisis scarred the whole country, interviews with leading government and Central Bank figures from that time show that -- whether they seek now to justify, explain or exculpate themselves -- the trauma also left an indelible mark on them as well.

"Ten years after the crisis it is still painful for me to analyze the details," said Alexander Potemkin, who was then the deputy head of the Central Bank.

"It was one of the biggest macroeconomic catastrophes in Russia's history - that is the short way to describe it," said Potemkin, who is now president of MICEX Group, the parent company of the MICEX stock exchange.

Roots of the Crisis

Major players in the drama at the time don't dispute the major cause of the crisis. The Russian state was spectacularly broke and up to its eyeballs in debt.

After years of the economy shrinking and the government running a budget deficit, the shock waves from the 1997 Asian crisis sent oil prices plummeting as low as $8 per barrel, robbing the state of its major income crutch.

"It's difficult to imagine that 10 years ago there were months when Russian oil was under $10 a barrel," Potemkin said.

As oil prices soared to record highs under Yeltsin's successor, Vladimir Putin, the possibility of a repeat of the 1998 crisis faded.

"There won't be another default on government finances in the near future, that's for sure," Nemtsov said.

Nemtsov, like some of those in charge during the 1998 crisis, argues that the good fortune of high oil prices has masked the need for reform.

"Over the past 10 years, gross domestic product has nearly doubled and people's standard of living has gone up - you can't argue with that. But the problem is people could live a lot better in Russia if the reforms had been carried out," said Nemtsov, who is now a trenchant liberal critic of Kremlin policy.

"If oil was at $10 per barrel now, then they would string up Putin, they'd overthrow him in 15 minutes," said Nemtsov, who oversaw the natural resources sector in 1998.

Despite the catastrophe, some of the former government officials said they saw the seeds of Russia's current prosperity as starting on that bleak day in August 1998.

"If we are talking about the 1998 crisis, then these steps were difficult for some categories of people," said Mikhail Zadornov, the then-Finance Minister, who now heads VTB-24, a leading retail lender. "But the devaluation of the ruble and the balancing of the budget gave an impetus for economic growth in Russia over the last 10 years."

Nemtsov agreed, saying the 1998 crash marked the beginning of the turnaround for the country's economy.

"Crisis and opportunity are the same [thing]," he said.

Putin's supporters argue, however, that there was still a hell of a lot to do to turn around the economy when he became prime minister a year after the crash.

It was only by managing to find consensus with the State Duma and drawing the country around him that Putin could move quickly to balance the budget and steady the ship, they said.

But to understand how far Russia has come since 1998, prominent officials from that time said it was crucial to understand the long-term systemic flaws that led to the crisis - and the reforms that have followed.

Putin's Liberal Reforms

"There was no death of liberalism in 1998," Zadornov said. "The ideas behind the economic policy during Putin's first term were really liberal ideas."

In 2000, the government rolled out a liberal economic program under the stewardship of then-Economic Development and Trade Minister German Gref.

Many of the targets for reform were obvious and longstanding.

Throughout the 1990s, the country's tax system was cumbersome and inefficient, with nonpayment rife by everyone from major state companies to private individuals.

In 2000, in a move that even Putin's opponents applaud, he implemented existing plans to restructure the countries tax system - most importantly, slashing the income rate to a fixed 13 percent.

"It was incredible thing to do so soon after the crisis, but he took that decision," Potemkin said.

A further litany of liberal reforms - from agricultural reforms to a liberalization of registration and licensing for businesses - followed.

"Financial management has been a strong suit," said Yevgeny Yasin, who was a minister at the time of the 1998 crash. The crisis left prudence as an ingrained instinct of those in charge of Russia's economy, he said.

"In general, financial management has been well-handled," said Yasin, who is now head of studies at Moscow's prestigious Higher School of Economics. "The biggest success has been the handling of the [international] reserves and the creation of the stabilization fund."

As of last week, the government's international reserves stood at $597.5 billion, the Central Bank said Thursday. The government's oil stabilization funds had accumulated $162 billion by Aug. 1, the Finance Ministry said.

But progressive economic reform was not limited to Putin's first few years in office, Potemkin said.

Other major reforms in recent years were the scrapping of currency controls, a step that drew Putin into conflict with some in his own government, and the decision to let Gazprom shares float freely on the stock markets, Potemkin said.

More crucial, however, in contrast to the mid-1990s, Russia now has full autonomy over its economic future.

Although Zadornov, the former finance minister, denied that Russian economic policy had been set in Washington, the country was cajoled by the IMF as part of its 1995 stabilization plan into adopting an ill-fitting ruble corridor to curb the three-digit inflation of the immediate post-Soviet period.

As Yeltsin's government abandoned soft inflationary policies for monetary rigidity, inflation fell dramatically.

But as the government raised money through the treasury bills, or GKO, system, the country locked itself into a fiscal straitjacket that turned into a grand pyramid scheme when things started to go wrong.

New Political Model

While the economic reforms of Putin's first term continued some of the liberal agenda of the 1990s, the new political model of greater authoritarianism and centralization of power was also born out of 1998, some argued.

Following the 1996 presidential election, Yeltsin faced a pro-Communist, leftist State Duma bent on populist policies, rather than the austerity measures needed to rescue the country, the former officials said.

This situation changed under Putin, as power shifted away from the Duma and opposition voices were progressively sidelined or silenced.

Potemkin said that although opponents criticized the current political system for its lack of liberalism, "we can see now that after consistent and robust development, Russia has in fact found its own model."

"I don't want you to think that I support tough government, but after years spent during the 1990s dealing with instability, it is good to have a system that is at least quite predictable," he said.

If Yeltsin was constrained politically by the left, he was also hamstrung by his reliance on a coterie of billionaire oligarchs, centered on the powerful semibankirshchina, the powerful group of seven bankers said to control half of the country's economy.

These seven - Boris Berezovsky, Mikhail Khodorkovsky, Vladimir Gusinsky, Vladimir Potanin, Alexander Smolensky, Vladimir Vinogradov and Mikhail Fridman - threw their resources behind Yeltsin in the 1996 presidential election in an effort to block the front-runner, Communist leader Gennady Zyuganov.

In return for their support, Yeltsin pushed through the infamous loans-for-shares scheme, under which oligarchs lent the government money in return for buying prized state assets cheaply in rigged auctions. A key result was that the government was robbed of much of the income it expected from the privatization process.

"[They] created a lot of commitment from the government and from the president for their support," Potemkin said. "And the price of that support was too high."

Putin's subsequent rewriting of the rules between the Kremlin and the oligarchs, which resulted in the departure into exile of Gusinsky and Berezovsky, plus the jailing of Khodorkovsky and the dismantling of his Yukos empire, arguably grew out of the damaging influence wielded by the oligarchs at the time of the crash.

But some critics insist that Putin has simply swapped one camarilla of wealthy backers for another, this one drawn from his pool of St. Petersburg and security services acquaintances.

Rather than being a thought-out reaction to the challenges of the 1990s, Putin's creeping authoritarianism is a result of his background in the security services, Nemtsov said.

"It is complete nonsense to say that Putin analyzed the lessons of 1998 and came to the conclusion that the security services had to control everything," Nemtsov said. "His doctrine bears no relationship to what happened in 1998. [It] comes from what he learned at the KGB school."

Zadornov argued, however, that it was the elasticity inherent in the democratic system of the 1990s that helped the country avoid social revolution and find a way out of the 1998 crisis.

"If that political system, with a real distribution of power, gave the country the possibility to develop and grow through these crises, then my conclusion is that the political system was workable," Zadornov said.

House of Cards

In the wake of the August crisis, default and devaluation sent the Russian banking sector toppling like a house of cards over the next few months.

Leading banks, such as Smolensky's SBS-Agro and Vinogradov's Inkombank, fell into bankruptcy, while state-run Sberbank and VTB only just limped on with the help of government handouts.

The central reason for the fragility of the banking system, many say, was a simple one.

Russian banks lacked capital, and opaque accounting practices meant that even when they declared cash surpluses, they were in reality often mired in debt.

Short of cash, banks in the 1990s had to scramble aggressively for profit - pumping money earned into trying to create more profit, rather than building up their liquidity. Added to this, oligarchs owners preferred to pump their money into other ventures rather than into their nascent banking empires.

And as foreign investors looked to hedge their bets, the IMF tied Russian banks into pushing forward contracts on their ruble debts, meaning that should the ruble fall, the banks would go into the red.

Now the banking sector is far more robust, Zadornov said, with the real capital of banks standing at about 8 percent of GDP - still small by the standards of developed markets, but a big step forward.

"There is a new level of supervision in the banking sector," Zadornov said, adding that new requirements for low performance loans and risk management systems have been put in place.

In a bid to stop a 1998-style run on the banks by depositors, the government has crucially introduced a state guarantee system for private deposits, covering 95 percent of the total number of deposits, Zadornov said.

As the government has tightened up the banking system, the number of banks has fallen from almost 2,000 to around 930.

Zadornov said 900 banks was still too many.

"There are hundreds of banks that are in reality not banks, they are something like money-laundering enterprises," he said. "The work of cleaning up the banking sector is not yet finished."

Despite the greater capital and stability, there are still a number of systemic risks facing small and medium sized banks - especially amid the current global credit crunch.

Many Russian banks still have very limited capital, a small client base and no real risk management systems, Zadornov said.

More worrying in the short term is the reliance of many banks on wholesale borrowing, which leaves them exposed to foreign markets as a source of loans, he said.

"For them, a credit crunch on Western markets is a big challenge, both this year and next," he said.

The FIMACO Scandal

If the banking sector in 1998 was mired in questionable practices, then a culture of opacity seemed to stretch up to the very apex of government and the Central Bank.

In the wake of the crisis, one scandal seemed to sum up the lack of transparency at the top rungs of the financial system: the FIMACO affair, which took its name from the Central Bank's Jersey-based subsidiary,

It came to a head when the first $4.8 billion chunk of a planned $17 billion IMF loan was delivered to Russia just before the crisis. For years, the Central Bank had apparently been parking money offshore in subsidiaries such as FIMACO to prop up the GKO T-bills system. In the wake of the 1998 default, accusations swirled from inside trading to embezzlement or disappearance of the IMF loan.

Over the past decade, the subsequent furor has led to a string of accusations and investigations, at times implicating Central Bank figures such as its then-head, Sergei Dubinin, the then-deputy finance minister in charge of external debt, Mikhail Kasyanov, and Boris Yeltsin's daughter, Tatyana Dyachenko.

A decade later, the accusations over FIMACO still smart.

Potemkin, the former deputy head of the Central Bank, denied categorically that the IMF money had disappeared, been stolen or misspent.

The FIMACO scheme was a system of legal "accounting tricks" the Russian government resorted to in order to help it meet IMF demands for government net assets, he said. Nowadays, with no external demands from international institutions such as the IMF, the government has no need for such tricks, he said.

Despite the rights, wrongs or lingering recriminations of this murky chapter, the central issue of transparency at the Central Bank has since been resolved, former officials and bank analysts said.

"All the operations of [the Central Bank] and the government are much more transparent than 10 years ago," said Zadornov, who co-authored recent legislation governing the Central Bank.

A standardized treasury system and new budget code now make government and finance ministry operations more open, and a new supervisory council scrutinizes the work of the Central Bank, Zadornov said.

"Such a situation as FIMACO is simply impossible [now]," he said. "There can be mistakes or wrong steps taken by the management, but they cannot do anything that is [hidden from] society."

Richard Hainsworth, CEO of RusRating, agreed that a change of guard at the Central Bank and a raft of reforms after the 1998 crisis had ushered in greater transparency.

"There's been an evolution within the Central Bank and an understanding about the benefits of transparency and working in a clear environment," Hainsworth said. Reforms pushed through by the late Central Bank first deputy chairman, Andrei Kozlov, who was assassinated in 2006, have made a repeat of the FIMACO affair unlikely, he said.

Question of Confidence

As he lurched between his hospital bed and the bottle, Yeltsin's leadership was never predictable, but early 1998 saw a political surprise that many commentators blamed for precipitating the crisis.

In April 1998, Yeltsin replaced political heavyweight Viktor Chernomyrdin with fuel and energy minister Sergei Kiriyenko, a 35-year-old economist from Nizhny Novgorod.

Kiriyenko, Yeltsin argued, had the youthful vigor to take on a teetering economy, but for many investors, the appointment smacked of desperation.

Along with a series of government gaffes, it further stoked fears of instability and contributed to plummeting confidence.

In the days following the crisis, Kiriyenko's Cabinet was dismissed, as Yeltsin appeared to admit his error and turned back to Chernomyrdin.

Some commentators, however, pointed to the fragility of worldwide confidence after the Asian crisis, while others saw the slump as a natural re-evaluation of Russia's fundamentals after a miniboom in 1997.

Under Putin, years of stability have fostered greater confidence. The carefully stage-managed handover to President Dmitry Medvedev reassured investors that Russia had finally outgrown the unpredictability of the 1990s.

But over recent weeks, the image of stability seems to have cracked, as investors have re-examined how stable the current system really is. Amid a confluence of slipping oil prices, Putin's attack miner Mechel, worries over state pressure on BP, and the conflict with Georgia, markets have dropped in recent weeks - and the ruble has wavered.

But despite the short-term wobbles, many say long-term confidence in Russia in secure.

"If you look at the broader macroeconomic picture, you see where the major money is being invested," Potemkin said.

A Stronger Ruble

Battered by the 1998 crisis, few would have thought 10 years ago that trust in the ruble could rebound. But as confidence has grown in the Russian government, so the country's currency has seen an impressive turnaround.

"The ruble is resilient as an international currency," Potemkin said

Bolstered by record foreign exchange reserves, healthy current account and budget surpluses, and net capital inflows, indicators point to steady confidence in the Russian currency.

European financial institutions have set up ruble-denominated bonds and ruble accounts as a means of international payments.

"That is a good sign for the acknowledgement of the ruble as an international currency," Potemkin said.

State Firms Vulnerable

While financial reforms, especially in Putin's first term, might have been well handled, critics argued that longer-term threats have not been dealt with, and that aggressive nationalization has created more trouble.

Since the dismantling of Khodorkovsky's Yukos empire, the government has taken over prime assets, increased the power of the state monopolies and set up a range of new state corporations.

"They have done everything the wrong way round. They needed to create competition and a [fair] legal system; they needed to attract investment. But for the group in power, the main god is the monopoly," Nemtsov said.

Although the government is no longer mired in debt, now the state-run companies are picking up the tab for government profligacy, Nemtsov said.

"What could happen is the South Korean scenario, where the government looks OK but the state corporations go bankrupt," he said.

"Gazprom's debt is $60 billion, Rosneft's is at $27 billion, the debt of Sberbank and VTB are $100 billion," he said, estimating that total debt of state-run companies was some $400 billion.

"They are conducting themselves just like the government did in the 1990s, they are living on debt," he said.

Yasin, the former minister, said it could be years before the problems with the state corporations start to manifest themselves, but the biggest potential failure was a failure to push ahead with pensions and education reform.

As for the 1998 crisis, it was an inevitable step in Russia's problematic path from totalitarian state toward democracy, Yasin said.

"Such a crisis had to happen at some point," he said. "But the worst is behind us now."