Russia is on the cusp of a unique kind of debt crisis which investors say would be a first time a major emerging market economy is pushed into a bond default by geopolitics, rather than empty coffers.
Until the Kremlin launched an attack on Ukraine on Feb. 24, few would have entertained the possibility of Russia defaulting on its hard currency bonds. Its strong solvency track record, bumper export revenues and an inflation-fighting central bank had made it a favourite of emerging market investors.
But the US Treasury’s decision not to extend a licence allowing Russia to keep up debt payments despite wide-ranging sanctions, have set Moscow on the road to default.
The Russian finance ministry has wired some $100 million in interest payments on two bonds due on Friday to its domestic settlement house. But unless money shows up in foreign bondholders’ accounts, it will constitute a default by some definitions.
And even if funds go through this time, payments of nearly $2 billion are due by the end of the year. One in late June is mandated to be settled outside Russia – a task experts predict will be impossible without the US waiver.
Emerging market debt crises are nothing new — Russia itself reneged on its rouble bonds in 1998. Geopolitics too have spilled into the debt sphere before, forcing defaults in Venezuela and Iran for instance.
Yet in Iran’s case, small amounts of loan debt were hit by US sanctions after its 1979 revolution, while Venezuela’s economy was already on its knees before US curbs in 2019 pushed $60 billion in sovereign and sub-sovereign debt across the brink.
Russia meanwhile continues to rake in oil and metals earnings. Even with half its $640 billion reserves’ war chest frozen by sanctions, the central bank has enough cash to repay the $40 billion outstanding in sovereign hard currency debt.
“This is a completely different crisis from other emerging market crises, it’s not about ability or willingness to pay, they technically cannot pay,” said Flavio Carpenzano, investment director at Capital Group, an asset manager that – like many others – was exposed to Russia before war erupted.
The impact is amplified by the fact this would be Russia’s first major foreign bond default since just after its 1917 Bolshevik revolution. Sanctions on Russia and its own countermeasures have effectively severed it from global financial systems.
Comparisons with recent defaults such as Argentina in 2020 are inappropriate because most countries’ finances are strained when defaults happen, said Stephane Monier, chief investment officer at Lombard Odier.
“This would be the first externally and politically driven default in emerging markets’ history,” Monier said.
The Treasury license expiry means creditors may be unable to receive payments anyway, which Daniel Moreno, head of global emerging market debt at Mirabaud Asset Management, likened to “turning the world upside down.”
“Me, the creditor, is now not willing to accept the payment,” he added.
NO GOING BACK
Russia’s international bonds, most of which started the year trading above par, have dropped in value to between 13-26 cents on the dollar. They have also been ejected from indexes.
A key difference with past defaulters such as Argentina or Venezuela is that Russia’s attack on Ukraine — which it calls a special operation — has made it a pariah in many investors’ eyes, probably for years to come.
“There is a huge stigma in actually holding these bonds, with emerging markets asset managers under pressure from their clients asking them not to invest in Russia and to liquidate their positions,” said Gabriele Foa, portfolio manager for the Algebris Global Credit Opportunity Fund.
For now, a potential default is symbolic because Russia cannot borrow internationally anyway, nor does it need to. But what comes further down the line is crucial.
Regime change in Russia could at some point end Western sanctions and allow it back into the fold.
But first, creditors face a long and costly process to recover money, for instance by exchanging defaulted bonds with new ones.
A default stigma would also raise future borrowing costs.
By defaulting “you increase the cost of funding and it’s very likely this will happen to Russia too. They will need to pay a premium,” said Capital Group’s Carpenzano.
The White House expects a default to have minimal impact on the US or global economy but Carpenzano reckons events around Russia are forcing a re-assessment of geopolitical risks in emerging markets.
“Geopolitical noise has increased and investors would like to be compensated for this higher risk,” he said, citing China’s hefty investment outflows in recent weeks.