The high probability that the Russian government will stop paying its international debts is well down the list of things to worry about as the tragedy in Ukraine unfolds. But this risk should certainly be somewhere on that list – as the fallout from past defaults has shown.
We have been here several times before. Moscow also defaulted on Soviet-era dollar debt in 1998, exacerbating a sell-off across all emerging markets which had begun a year earlier in Asia. This contributed to the near-collapse of a huge US hedge fund, Long-Term Capital Management, which had to be bailed out to prevent a worldwide meltdown. This rescue came too late to save many other investors from large losses.
Ten years later, apparently isolated problems in the US mortgage market did cause a global financial crisis. For LTCM read Lehman Brothers, which was allowed to fail. (If it hadn’t been Lehman’s, it might just have been someone else.)
Rolling on to today, some form of Russian default is almost inevitable. Western financial sanctions mean that the country is finding it much harder to make international payments – as well as to receive them. This is a problem both for debt denominated in US dollars and for rouble debt where the holders are based overseas.
What’s more, Moscow itself has imposed capital controls. These have prevented foreign investors from receiving interest payments on some local currency bonds.
There was another twist on Wednesday (16th March) when Moscow was due to pay $117 million in interest on a tranche of dollar-denominated bonds. The Russian Finance Ministry says it has made the necessary payment (in dollars) to the right Western bank, but it is uncertain whether this money has actually reached the bond holders.
This is a very unusual situation. Russia still has more than enough cash to cover this and future payments (international reserves were $643 billion as of 18th February). Moscow could reasonably argue that there is only a problem here because of financial sanctions. There is also a standard 30-day grace period to sort this out. Nonetheless, the bottom line is that creditors are not being paid.
So, how worried should we be? There are many good reasons to think that a Russian default would not be a big deal, and the contagion should be limited.
For a start, Russia doesn’t actually have much debt of any type, thanks to years of huge oil and gas revenues. Prior to the invasion of Ukraine, gross government debt was less than 20 per cent of national income. Foreign-currency debt amounts to $38.5 billion, with just $20 billion held by overseas investors.
According to data from the Bank for International Settlements, the exposure of foreign banks to Russian entities was estimated at around $105 billion (on a ‘guarantor basis’) in the third quarter of last year. That might sound like a lot, but in the context of the global financial system, it really isn’t. This only represents about 0.1 per cent of the total assets of reporting banks.
A Russian default would hardly be a surprise, either. Government debt has already been downgraded to ‘junk’ status by international rating agencies, and sizeable losses have been priced in. If Moscow does default on its bonds, it would simply be catching up with the reality visible for all to see in the Russian equity and currency markets.
Many western companies have already written off a large part of their investments in Russia, too. The world’s largest asset manager, BlackRock has taken a $17 billion hit, though this is just a drop in the ocean of its total global assets (more than $11 trillion).
BP might have to write down as much as $25 billion following the decision to dump its holdings in the Russian energy company Rosneft. But even this hasn’t made much of a dent in BP’s share price.
The global financial system is also in better shape than in 2008, partly because the global financial crisis itself has led institutions, rating agencies and regulators to take a more cautious approach. In the case of Russia, many Western investors had already begun to pull back in 2014 following the annexation of Crimea. Even before the current collapse, Russia only accounted for about 3 per cent of global GDP.
And yet, one lesson from past crises is that, in an ever more interconnected world, ripples in what might appear to be one small pond can cause a tsunami of losses in unexpected places. For example, Russia has begun to seize aircraft leased from Western companies, valued at around $10 billion.
Even where direct exposure to Russia is small, a sustained period of risk aversion could also prompt a flight out of all emerging markets – and some more developed ones too. Managers could be forced to sell ‘good’ assets as well as bad, in order to reduce risk and cover redemptions. Investors might also start to rethink their exposure to much better credits – such as Chinese government bonds – for fear these might be next.
In short, a Russian default should be just another small part of this ongoing story. There is no obvious reason why it would trigger another global financial crisis, mainly because the sums are relatively insignificant, and losses are already priced in. However, similar arguments have been made before…
This is an updated version of an article which was first published by The Spectator on 14th March 2022