The rise in interest rates had two effects. First, it exacerbated Russia’s revenue problems. Its debt grew rapidly as interest payments mounted. This put pressure on the exchange rate because investors feared that Russia would devalue to finance its non-denominated debt. Second, high government debt prevented firms from obtaining loans for new capital and increasing the interest rate did not increase the supply of lending capital available to firms. At the same time, for eign reserves held by the CBR were so low that the government could no longer defend the currency by buying rubles.
Three components fueled the expectations of Russia’s impending devaluation and default. First, the Asian crisis made investors more conscious of the possibility of a Russian default. Second, public relations errors, such as the publicized statement to government ministers by the CBR and Kiriyenko’s refusal to grant Lawrence Summers an audience, perpetuated agents’ perceptions of a political crisis within the Russian government. Third, the revenue shortfall signaled the possible reduction of the public debt burden via an increase in the money supply. This monetization of the debt can be associated with a depreciation either indirectly through an increase in expected inflation or directly in order to reduce the burden of ruble-denominated debt. Each of these three components acted to push the Russian economy from a stable equilibrium to one vulnerable to speculative attack.
In this paper we investigate the events that lead up to a currency crisis and debt default and the policies intended to avert it. Three types of models exist to explain currency crises. Each model explains some factor that has been hypothesized to cause a crisis. After reviewing the three generations of currency crisis models, we conclude that four key ingredients can trigger a crisis: a fixed exchange rate, fiscal deficits and debt, the conduct of monetary policy, and expectations of impending default. Using the example of the Russian default of 1998, we show that the prescription of contractionary monetary policy in the face of a currency crisis can, under certain conditions, accelerate devaluation. While we believe that deficits and the Asian financial crisis contributed to Russia’s default, the first-generation model proposed by Krugman (1979) and Flood and Garber (1984) and the second-generation models proposed by Obstfeld (1984) and Eichengreen, Rose, and Wyplosz (1997) do not capture every aspect of the crisis. Specifically, these models do not address the conduct of monetary policy. It is therefore necessary to incorporate both the first-generation model’s phenomenon of increasing fiscal deficits and the third-generation model’s financial sector fragility. We conclude that the modern currency crisis is a symptom of an ailing domestic economy. In that light, it is inappropriate to attribute a single prescription as the prophylactic or cure for a currency crisis.
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