Default - what is it in simple words, the default situation of 1998 and its lessons

What is default in simple words

First, let's talk about what the word default means in simple words.

Default is the inability to pay one's obligations. In simple terms - bankruptcy.

The term is most often applied to states or large national companies. In this article we will talk about government defaults.

Default almost always leads to a large-scale economic crisis. It becomes more difficult for countries only in the post-war period, when everything is destroyed.

How does default threaten the economy?

The economy has 2 indicators that directly affect the exchange rate of the national currency: GNP (domestic national product) and money supply (the amount of money in circulation). Their ratio forms the inflation rate.

If the increase in GNP is significantly less than the increase in the money supply, then we have an increase in inflation rates. If we see an increase in GNP and an increase in the money supply in approximately equal proportions (the increase in money will always be greater, with rare exceptions), then the inflation rate will be stable.

GNP, in very simple terms, is the power of the economy. The value of all goods and services that were produced by residents of a country, regardless of territory. And the money supply is the amount of all money in circulation, both paper and non-cash.

Default, in fact, does not affect these indicators. They remain unchanged. But here the third indicator comes into play - investment attractiveness and confidence in the national currency. This is where the main blow comes. Let me explain with an example:

You are a smart businessman. You understand that with the help of loans you can take an enterprise to the next level and actively use the funds raised, while paying off long-term obligations at the expense of profits. But if at one point all creditors demand repayment of debts, you will have to close the company. Simply because the money has already been spent, and the profit with which to pay has not yet appeared. We will have to sell property at a lower price, reduce turnover, cut salaries and fire people. In fact, demands from all creditors to repay loans will lead to the fact that your company will go down the drain, no matter how profitable it may be.

And the same thing happens with the state, only on a larger scale. Foreign investors who previously trusted the state and its policies immediately cease their activities, withdraw money from the budget, convert it into another currency and leave the market. This is the first rate jump. Then the first jump is followed by the second - ordinary citizens, who, in fact, were deceived by the state with their papers, transfer assets to other currencies in order to protect themselves. And after two jumps, general panic begins, and this is the third and final jump, after which it is difficult for the huge, clumsy “machine” to recover.

If we talk about economic indicators, then before the first jump there is a decrease in GNP - they sell shares in companies, which means they practically close them or deprive them of part of the profit. Then comes the second decrease in GDP, when the confidence of national investors, who transfer their money to other assets abroad, is lost.

And as a result, we see the following: GDP is significantly less than it was before the default, but the money supply indicator is increasing. After all, the state needs to stabilize the situation through something. All this is followed by colossal inflation, a depreciation on the world stage and a catastrophic outflow of investment.

How to protect savings from default?

Here are the standard safety rules:

there must be a cash reserve , and in foreign currency;
If you are not going to give up bank deposits in your country, open them in different institutions . It is advisable that their size remains within the insurance limits. First of all, work with state banks; if the state defaults, they will work until the last minute;
You can open an account in a foreign bank . The profitability will be extremely low, but this is a means of protecting capital, a small percentage is more of a bonus and not the main goal. Even if there are restrictions on cash withdrawals, you will still be able to withdraw cash at the bank's branches in your country. One of the popular options for opening accounts abroad is a Swiss bank; read the link for information on how to open an account in a Swiss bank;
invest in defensive assets. Gold can become an analogue of foreign currency for insurance against possible default. Using protective assets, do not limit yourself to bullion or OMS (unallocated metal accounts), you can invest in securities of gold mining companies, gold CFDs, gold ETFs;
Get into the habit of investing at least part of your funds in the stock market , create a diversified portfolio. Securities provide higher returns compared to a bank deposit;
less debt market . If you are investing in the debt market of a country whose condition is causing concern, reduce the share of these securities to a minimum.

These steps will reduce the impact of economic default on your well-being to a minimum.

What is the essence of default?

Now let's talk from a more everyday point of view. After all, we are not interested in macroeconomic indicators. Let's look at default from the point of view of an ordinary citizen. What will be the consequences of the state's refusal of obligations?

Problems with work. The most obvious factor. Jobs are cut, companies close, and if not, wage delays inevitably arise. It doesn't hit top management as hard, but ordinary workers suffer from it.

The amount of money is becoming less and less. And it is unknown when all this will end - when work will appear again, when salaries for December will be paid, although it is already April.

Problems with government funding. In budgetary institutions everything is even worse. There is a shortage of teachers and educators in schools and kindergartens; there is simply nothing to feed the children. The quality of service in clinics is deteriorating; most specialists are leaving.

Budgetary institutions are being hit the hardest. So, small funding, which also ends up in the pockets of management, is generally cut.

Constantly rising prices. To somehow compensate for economic problems, stores are forced to raise prices. And the population's income is declining. At the same time, the quality of products inevitably decreases, because costs are being cut on all fronts.

All this leads to a colossal increase in prices even for food and essential goods.

Panic. This is the toughest, uncontrollable and very negative factor. We saw an example of such panic quite recently, at the end of 2014. Because of the sanctions, the ruble exchange rate went down, and almost everyone decided to buy, buy, buy, so as not to buy something even more expensive later. It doesn’t matter whether it’s necessary or not, useful or not useful at all - you have to buy it.

If there was no general panic, most crises and difficult situations would go much smoother. But we have what we have.

All these factors add up to one very simple picture: there is no work, and if there is, then wages are delayed, prices are rising like a snowball, there is a shortage of personnel and money in government agencies, and there are fewer and fewer goods on store shelves.

Reasons for default

Let's consider the fundamental causes of defaults in different countries, incl. and in Russia. Let's figure out what leads to such a huge economic crisis.

1 reason for default: protracted economic crisis . This is when the country has driven itself into a situation where it is impossible to pay off its debt obligations.

Example. In 2010, a real economic crisis began in Greece, which the whole world tried to solve. As a result: huge loans and the inability of the state to pay bills, a default for the country.

Reason 2 for default: incompetent capital management. Default most often occurs due to misuse of credit. For example, the state was given a loan to stabilize the economic situation; you need to “throw” money into production, into the real sector and, through taxes, make a profit in the long term. This is done through banks and lending incentives. But incompetent management can easily lead to the issuance of loans for something else, and as a result, instead of an increase in production, we get an increase in consumption, and then a rise in prices -> crisis -> default, since there is no money, there is a crisis after all.

3rd reason for default: theft and waste of public money. Almost all governments of countries that have been in default are guilty of this. Instead of using loan money for stimulus, it is simply funneled through privately controlled entities.

A trivial scheme: bypassing the direct issuance of money to a government institution, an agreement is concluded with a private bank. The bank issues the loan minus interest, and then receives the full cost of the loan. As a result, govt. the money is in the hands of a private company, and the budgetary institution does not receive funds.

In fact, the most common cause of default is poor management and theft of public money. Instead of developing the country's economy, figures close to the Government decide to waste money, having previously said that they are bankrupt.

Consequences

Lenders no longer trust a borrower who has entered into default. Having failed to repay a loan once, it is difficult to get a new loan. There is an increase in investment risks; obtaining money is only possible at high interest rates. This increasingly worsens the debtor’s financial situation.

There are also positive aspects of declaring a default. Non-payment of payments on external debt allows the borrower to invest in improving its financial condition and get out of the crisis situation. For this reason, in the event of a corporate default, before the debtor is declared bankrupt, crisis managers are sent to the organization to restore the borrower’s solvency.

State insolvency leads to particularly serious consequences:

the authority of the country and domestic business has been undermined. Cheap loans become unavailable to the government and corporations;
the national currency is devalued, imported goods become more expensive;
When the economy is heavily tied to foreign supplies, the purchasing power of money decreases. The population becomes poorer and is unable to purchase goods in the same volume;
When demand for goods decreases, production suffers. The sales market is shrinking and costs are rising. The crisis has a particularly strong impact on companies that use imported raw materials. Many corporations face ruin in such a situation;
To reduce costs, enterprises are laying off employees and reducing wages, which is fraught with even greater impoverishment of citizens and increased unemployment;
negative impact on the banking sector of the economy. With the outflow of investment, the inability to receive international assistance and the depreciation of reserves, the financial system collapses.

A sovereign default negatively affects both the bankrupt state and creditor countries. This could cause a financial market collapse and an international economic crisis. As a result, not only citizens of a country that does not pay debts suffer, but also the population of other countries.

At the same time, default contributes to the mobilization of state reserves, and budget funds are used more efficiently. Creditors do not want to lose everything, so they restructure debts, that is, they agree to a longer payment period or waive interest.

Weak enterprises cease to exist, strong ones survive (natural selection occurs). The depreciation of the national currency increases the competitiveness of domestic producers. So, default is a painful but necessary tool to help improve the economy.

Types of default

There are 2 types of default: technical and sovereign.

A technical default is a situation where a government is currently unable to pay its debt obligations, but may do so later. A trivial example: the state issues OFZs with a maturity of 3 years. This is done to attract funds to the budget. But after 2.5 years, a total economic crisis begins, and the state is not able to repay the OFZ. This means that they are extended for another 3-4 years, with interest rates remaining the same or increasing, and after that they are repaid.

A sovereign default is the bankruptcy of a state when a country cannot pay its own obligations at all. Such a default leads to a decrease in the value of the national currency, catastrophic inflation rates, and the state’s debts are repaid by other countries.

A technical default does not mean that everything is too bad. But it often leads to the fact that the national currency rate rapidly flies down. A sovereign default, on the contrary, shows that everything is critical, and unless there is outside help, the situation cannot be solved.

What will happen to the loan if there is a default?

The overall picture immediately after the default depends on the currency in which the loan was opened. The worst situation will be for those who received a loan in dollar or euro terms. Due to the resulting difference between the exchange rate of national and foreign currencies, new monthly payments and the debt balance will increase significantly. In this case, no compensation is provided from the bank.

It will be easier for those who took out a loan in Russian rubles. The bank management cannot raise the interest rate and the balance of debt, and therefore there will be no significant difference. In both cases, you can ask the bank to restructure the debt.

This is especially necessary for borrowers who took out a foreign currency loan. In this case, the bank will either increase the term of the agreement to reduce the monthly payment, or reduce the interest rate. In any case, it will be easier for the client to cope with payments.

Also, do not forget that due to a complete revision of policy after a default or crisis, the rate of inflation in the state greatly decreases or increases. For example, in Russia after the 2014 crisis, inflation decreased to its lowest historical value - about 4% per year. As a result, banks were forced to adapt to such indicators: there was a wave of reduction in loan interest rates.

In such a situation, it is necessary not only to restructure the debt, but also to refinance it, i.e. refinance. Then you can get a new loan on more favorable terms - for example, with a significantly lower interest rate.

As a last resort, you can declare bankruptcy. Since 2015, a bill has appeared in Russia that regulates the right of any Russian citizen to declare himself bankrupt. The procedure requires going to court, providing evidence of your insolvency, as well as the reasons for your inability to pay the debt.

How many defaults were there in Russia?

In total, there have been 2 defaults in Russia over the past century. And both were very difficult for the country:

Default in 1918.
Default in 1998.

The first default in our country occurred due to the change of Government and the formation of a new state. When the Communist Party came to power, the country was in ruins, war and with debts behind it. After carefully weighing the consequences, a strong-willed decision was made to refuse to pay the debts.

We all know the result very well. The Entente begins to sponsor the white movement, civil war and complete devastation in the country.

The default in 1998 followed a different scenario. Due to the actions of the country's leadership, which led to the collapse of the economy, it was decided to refuse real payments on government securities.

We also know the result very well. A severe economic crisis, a huge debt to external borrowers and a change of government.

This distinguishes economic crises from real defaults. The first can last several years and hit the economy quite hard. But during a default, all consequences increase several times.

Default in Russia in 1998

The fundamental reason for the default in '98 was quite simple: emerging market markets were overheated with investment. And no matter how much we would like to say the opposite, Russia has been and remains a country with a developing economy.

Let us roughly reconstruct the chronicle of events that led to this:

After the collapse of the USSR, the country urgently needs injections of foreign capital. Russia receives huge loans from abroad.
In 1997, the collapse of the national currency and the stock market in Thailand began.
Following this, confidence in emerging markets is rapidly declining.
The global crisis is growing, the consequence of which is a fall in the value of Russian government bonds, and through them the country covers debts to other states.
At the end of 1997, the Government decided to artificially inflate the ruble exchange rate. Expenses exceed income by more than 120 billion rubles.
In January 98 they increase the refinancing rate from 28 to 42% per annum. Loans and deposits are becoming more expensive. The government is trying to avoid devaluation.
The IMF approves a $700 million loan to Russia and agrees on the entire payment schedule for the year.
In May 1998, the chairman of the Central Bank openly said that Russia was facing a new crisis, and the state would not be able to pay off its obligations.
On May 18, trading opens with a 10% drop in Russian securities.
The yield on issued bonds doubles, up to 50% per annum.
Western investors are no longer believing in Russia's solvency.
There is no buyer for Rosneft, at the expense of which they wanted to pay off the debts. The yield on securities soars to 70 - 80% per day.
The heads of the largest companies declare that the ruble needs to be devalued, otherwise the market will do it itself, and the consequences will be terrible.
Government bond quotes are falling. The yield on securities soars first to 100, and after some time to 140% per annum.
The State Duma rejects the tightening of policy and the list of anti-crisis measures. The IMF is issuing a loan to stabilize the situation.
On August 1, a loan is used to buy back GKOs and stabilize the ruble exchange rate. There is an apparent balance.
On August 10 and 11, Western banks demand the repayment of loans secured by government bonds. The reassessment of the solvency of Russian banks has led to the fact that it is already clear that the state will not be able to repay its own bonds.
There is a massive purchase of currency. Everyone is convinced of the impending crisis. Due to the artificial maintenance of the currency corridor, the Government lost huge amounts of money.
On August 12, the Central Bank limits foreign exchange transactions to the 25 largest banks. The money was transferred to stabilize the situation with the exchange rate.
On August 13, trading on the stock exchange was practically stopped. Russian banks have stopped issuing loans, and they are on the verge of ruin.
George Soros officially declares that Russia is at the last stage of the crisis, and devaluation is inevitable. Yeltsin at the same time says that there will be no devaluation. Firmly and clearly.
August 15 The government realizes that it can no longer pay off government bonds. The first words about debt restructuring have begun.
On August 17, a default was declared.

After the open declaration of default in the country, everything began to happen even faster: a month later there was an official statement that the majority of Russian banks were practically bankrupt. Next comes the revocation of licenses from small and medium-sized banks. Then the toughest event was the introduction of crisis management at Inkombank, a TOP-5 bank. As a result, the ruble depreciated 4 times, extra zeros were removed from the currency, and many companies simply disappeared.

This was due to 5 reasons:

The first reason was the global crisis in emerging markets. Too much money was invested in them, which was used for other purposes. The overheating of the Thai economy and the subsequent collapse became the first alarm bell about the riskiness of investing in developing countries, which includes Russia.
Credit pit. In fact, all of Russia developed exclusively through borrowed funds. We took out loans from the West and issued government securities to repay Western loans. And such a connection would sooner or later be interrupted by any small storm.
Frankly incompetent management. When top economists who wanted to prevent a default proposed measures to tighten policy and increase taxes, which would at least somehow cover the gaps and not lead to such a full-scale crisis, the head of the country refused over and over again and pretended that everything was normal.
A huge cut of funds. Of course, this is unofficial. But in fact, judging sensibly, one can easily understand that thanks to huge investments from the West, Russia has not acquired anything in its own economy. It’s just that state-owned enterprises passed into private hands, and profits were funneled through people close to the Government in order to cut taxes. As a result, expenses far exceed income.
And the final blow was a reassessment of investment prospects and demands to pay off debts. In fact, this was to be expected. The government itself created a soap bubble with these rotations of loan funds and changes to the budget, where expenses were much higher than revenues.

If the Government had wisely approached investing in its own economy, even through the use of natural resources and raising taxes, such a full-scale crisis would have been stretched out for 5 to 10 years, and the situation would not have been much different from our current one. And so, we got a default and a lot of problems.

There were many consequences:

Job cuts.
Salary delays.
Price increase.
Panic among the population.
Dismissals in the government apparatus.

The default in 1998 is a real full-scale economic failure of Russia on all economic fronts. No measures were taken to overcome the crisis, no problems were solved.

Defaults in other countries

Now let's talk about examples of global defaults.

The last default in the global economy was the technical default in Greece in 1515. The protracted economic crisis that began in 2010 led to it. Then the Government tried to stabilize the situation with the help of external loans, but by 15 everything turned out to be too bad. Urgent re-election of the head and statements that Greece requires restructuring/debt write-off led to this:

The exchange rate of the national currency fell sharply, confidence in the state in the foreign market disappeared, and part of the state assets, which had previously been taken from private investors, went to foreign buyers. As a result, by transferring the lion's share of strategic companies into the hands of foreign investors, Greece somehow got out of the hole.

Technical default in Ukraine in 1998. Then the state just issued Domestic State Loan Bonds for a period of 3 years. But due to the difficult economic situation, it was not possible to repay them on time. At the same time, it was repaid later, and the paper holders received additional interest for increasing the terms.

Nothing particularly terrible happened here. There was simply a drop in trust in the state, plus a decrease in the value of the national currency.

Argentina's sovereign default in 2001. This is the most severe case of default. The government issued government bonds to attract money to the budget. But when the bonds expired, the hole in the budget did not disappear; they had to reissue securities with a lower interest rate and a long term. But these papers did not save the economy. The next step was to confiscate funds from private pension funds. As a result, all this led to the collapse of the peso, the state abandoned all its foreign debt and fell into a huge economic hole.

Due to the fact that the peso exchange rate was legally tied to the dollar, 1:1, the crisis hit the currency too hard. A rapid decline in the value of the national currency, a decrease in GDP, unemployment and hyperinflation. Almost a post-war situation, when the price can change several times a day.

Historical reference

In one form or another, crises leading to a default state of the economy occur regularly. Over the past 25 years, the following have failed to meet their obligations:

Mexico, 1994. The reason for the depreciation of the national currency (peso) was the issue of short-term government bonds. They were denominated in pesos, but depended on the dollar exchange rate. After political assassinations in 1994, trust in the state was lost, and investors began to withdraw money from Mexico. The government was forced to increase borrowing rates and cancel the dollar peg.
Russia, 1998. The country's position, which seemed stable after the reforms of the early 90s, was precarious. The crisis in Asia has led to a drop in prices for raw materials, mainly oil. The state lost the ability to pay obligations on short-term bonds, which was announced on August 17, 1998.
Argentina, 2001. The economic decline of the late 1990s led to an erosion of faith in the Government and a subsequent flight of capital. Individuals and corporations preferred to keep their savings in dollars. The authorities responded by banning the withdrawal of large sums from accounts - a decision that led to mass outrage. The last pre-default mistake was the introduction of a free exchange rate for government bonds. The state was unable to fulfill its obligations.
Uruguay, 2003. The crisis was a response to the situation in Argentina. After Buenos Aeros introduced restrictions on withdrawals, 38% of deposits were withdrawn from Uruguay's two largest banks (which were controlled by Argentine investors). The consequence was devaluation and the subsequent inability of Uruguay to meet its obligations. The government made a request to defer the payment of bonds for 5 years, to which the consent of 93% of creditors was received.
Greece, 2020. In January 2020, the country held elections for a new Government, which stated that it intended to conduct a dialogue on the restructuring of external debts. But after Athens’ June refusal to make another transfer, the International Monetary Fund suspended negotiations on refinancing. On June 28, 2015, the Government stopped the work of all financial institutions until July 6 (the goal is to curb the outflow of money from Greece) and introduced a limit on withdrawals from ATMs. On July 1, the country announced the inability to pay obligations.

Is it true that there will be a default in Russia in 2020 - 2020

Now let's talk about the ruble default today. Will it happen, why did the assertion that everything is bad come about, and what to expect in the next couple of years.

Talk about a default in Russia in the coming years began with statements by Bank Of America, the World Bank and George Soros. All three emphasized one thing:

Against the backdrop of a stronger dollar, emerging market markets are lagging significantly. It is quite possible that foreign investment will flee from the markets of developing countries and a repeat of the crises of 98-99.

The original text from which Bloomberg drew its conclusions, the trend of which was picked up by publications from Russia, is generally like this:

Decoupling in the US (in the context of a stronger dollar), a flattening yield curve and collapsing emerging market markets (in the context of unprofitability for investment). That's all. No default predictions.

At the same time, the head of the World Bank generally spoke in the following vein:

The world market shows the same trends as in 97-98. A new period of crisis is possible, since the economy is cyclical.

But Russian publications followed the path of “circum-truth.” Here's the news you can see:

Mk.ru makes a big headline. The US predicted a Russian default: “It will happen after 2020.”
The free press echoes. Bank of America: Crisis and default are already on the doorstep.
Pravda.ru publishes an article with the headline “The tragic forecast of an impending default has been confirmed.”

All near-economic publications heard “The crisis is like 20 years ago” and deduced from this “The default of money, like in ’98.” But there are no true opinions from truly top economists. There are two expert opinions:

Gref and the Kremlin claim that there will be no default.
The opposition claims that a default can happen, but a whole chain of factors is required: oil to $35, new sanctions in the form of disconnection from the global settlement system, freezing of gold and foreign exchange assets in Western banks. This is an almost unrealistic scenario, but purely theoretically everything is possible.

Of all the sources that I looked at, not a single person, except for a couple of publications, speaks unequivocally about whether a default is expected in Russia.

What happens in case of default

Judging by all macroeconomic indicators, there should not be a default. But if the Government suddenly decides to take a very strange and winding path, it is purely theoretically possible. So let's look at what the default threatens.

Real inflation of 2-3-4 times is what will be faced within a few days of the announcement of the inability to pay debt obligations. In the first few days, prices will skyrocket 2-3 times, and it will be approximately the same as in 98: “We woke up in a different country.”

Job cuts and bank closures. This should not be confused with what is happening today. Now there is a global cleansing of the banking market, which is overheated with garbage. If everything goes according to the most negative, purely theoretical, scenario, then:

1 - 3 banks from the TOP 10 will close. Deposit rates will increase to 50% per annum. Banks from the TOP-100 and below will close after one.

It will be much the same with jobs. Companies will begin to close simply because they will no longer make a profit. There will be less money, but prices will rise. As a result, we will end up with a completely stalemate situation that cannot be corrected without an artificial injection of funds.

Denomination. Again, as soon as the inflation rate hits the ceiling, there will be a denomination immediately behind it. Now there are already a lot of zeros on the currency, and if the same jump occurs, it means that the extra ones will simply be erased. True, reducing real incomes even more - but this cannot be avoided.

More stringent lending conditions. Getting a loan from a bank is very difficult. During a default, this is almost impossible to do. How to convince the bank that you will be able to return it on time and will it be profitable for them? As a result, there will be no borrowed money left.

Everything will unfold approximately according to this scenario. But this, again, is purely theoretical. In fact, there are no real prerequisites, as there were in 1997.

Consequences of default

If we talk about the consequences of a default for the entire economic system, then first of all we should focus on the decline in the standard of living among the entire population, as well as on the subsequent outflow of capital from the country.

A state-level default automatically entails the collapse of the banking system and leads to the bankruptcy of companies that do not have an appropriate level of financial stability.

In turn, the deterioration of the political situation and rising inflation are fraught with street rallies and popular discontent. In order to normalize the situation, each individual case should be considered individually.

The consequences of this economic phenomenon may vary in severity. Restoring the system will require direct intervention by the international community.

It should be noted here that default is not a disaster, the consequences of which cannot be completely eliminated. This is a negative factor in economic development, which can safely be positioned as a recovery and subsequent strengthening of the financial sector. After all, this creates the opportunity to revise the terms of cooperation between the borrower and the lender.