Russia has defaulted on its international debts for the first time in a century. It has left Vladimir Putin into a humiliating blow and it further isolated his nation from the Western financial system.
Russia failed to pay $100 million of coupons on bonds due last month, for which a 30-day grace period ended on June 26. Since beginning an invasion of Ukraine in late February, Russia had already come close to going into default multiple times.
Russia has the ability and inclination to pay its obligations but was unable to do so because the White House’s decision to restrict avenues to creditors in the West effectively prevented payment. A previous domestic debt default occurred in 1998 when the country faced a post-Soviet economic transformation.
According to Russia, the US allegedly staged the default as a ruse. Last week, it announced that it would pay off its debt with roubles, a plan that creditors have already rejected. The scenario has been referred to as a “farce” by finance minister Anton Siluanov.
Siluanov said anyone can declare whatever they like. But anyone who understands what’s going on knows that this is in no way a default.
A default would be declared by one of Wall Street’s ratings companies, likely S&P, Fitch or Moody’s. But European Union sanctions have forced the firms to withdraw their coverage of Russia.
However, the bonds on which the payment was missed allow their holders to declare a default if 25% agree non-payment has occurred. Documents attached to the debt instruments give three years for a claim to occur – meaning some investors may wait to see whether Russia is rehabilitated into the global financial system during that time.
If they do take action, doing so through the legal system could prove difficult because Russia has said it will reject the jurisdiction of any foreign court.
Foreigners held about $20 billion of Russian eurobonds at the start of April. Several payment deadlines have now passed, so it is possible Russia will soon be deemed to have defaulted on multiple debts.
Why did Russia not make the payment?
The default was not for lack or willingness or means on Russia’s part. The country runs a huge trade surplus predominantly because of lucrative oil exports. it exported goods and services worth $58.2bn more than the value of its imports in the first quarter of 2022, according to the Central Bank of Russia. It also has relatively low debt levels.
However, Russia’s coupon payments were rendered impossible by the United States. The Office for Foreign Asset Control – the branch of the US Treasury Department that deals with financial sanctions – had allowed Western investors to continue to receive debt payments as part of the initial volley of sanctions at the start of the war in Ukraine. That exemption was allowed to lapse last month, meaning payment became effectively impossible.
What would it mean for Russia?
Recovering from a default can be a slow and arduous process and may be even more complicated for Russia given it is being squeezed out of the global financial system.
The reputational damage can also be heavy. Many investors are bound by covenants preventing them from investing in countries deemed to be in default. If it cannot rebuild its reputation as a borrower, Russia may find there is limited interest next time it tries to tap international markets, although it isn’t expected to do so for some time.
The process will be unusual in this case. Countries usually default because they are destitute. That isn’t the case for Russia. Its fiscal strength means investors may be very willing to rehabilitate Moscow when, or if, it returns to Western markets.
The bigger impact may prove to be on Russia companies, which are more reliant on international funding. Some investors may rule out lending money to such companies as a result of the state-level default.
Who else will be affected?
At the time of the invasion of Ukraine, Russia had $39.7bn of outstanding external debt – comparatively small compared to the US which paid out almost $140bn on sovereign debt in 2020 alone. About half is held by foreigners. Another 3 trillion roubles of domestic debt is held by foreigners, according to pre-war data.
Most of that is held by financial institutions: banks, pension funds, asset managers and hedge funds.
Data from the Bank for International Settlements shows French banks held about $4.5bn of Russian government bonds as of last year, while US lenders held $3.8bn, Austria’s had $3.2bn and Italians $2.6bn. UK banks had just $520m of exposure.
A debt default is typically followed by a period of restructuring, when investors usually lose money. Moody’s estimates investors can expect to receive up to just two-thirds of the bond’s value. Some could respond with legal challenges, although these would face difficulties because Russia will not recognise the jurisdiction of foreign courts.
The documents for the bonds Russia has defaulted on say holders have three years to make a claim following non-payment. Some investors may be tempted to wait it out and see what happens.
Russia’s economy to shrink by 15%
A global banking lobby group said that Russia’s economy will shrink 15% this year and 3% in 2023. The downfall will be because of western sanctions, an exodus of companies, a Russian brain-drain and due to collapse in exports wipe out 15 years of economic gains.
In its report on the Russian economy following its invasion in Ukraine on February 24, the Institute of International Finance (IIF) said it did not expect a ceasefire in the war and that it was likely sanctions would be expanded and tightened in the coming months.
Western sanctions following the invasion had triggered the full disintegration of 30 years of investment, Elina Ribakova, the Institute of International Finance’s (IIF) deputy chief economist, told reporters during a media briefing.
“What is the number you are going to put on ripping apart 15 years of value chains, adding that should Europe wean itself off Russian energy exports, the economy would be hit even harder in the medium-term, she said.
The United States, European countries and other allies have imposed sweeping sanctions aimed at punishing Russia and at impeding Moscow’s ability to fund its war machine.
While Russia’s economy is slowing sharply and its people’s spending power is shrinking, a surge in oil and gas prices — major Russian exports — have lifted the country’s current account surplus to record levels in recent months.
Ribakova said that the surplus, as well as a rebound in the rouble after an initial crash, should not be mistaken for thinking Russia’s economy was holding up better than expected.
Russian banks were flush with foreign exchange reserves as imports collapsed, she said, but Russian businesses and consumers had nothing to spend it on.
Instead, the impact of sanctions would hit harder with time, especially if Europe cut oil and gas imports significantly, although she noted this would take months if not years.
The IIF forecasts that Russian gross fixed capital formation will contract 25% in 2022, imports 28% and exports 25%.
“Despite the meaningful steps taken since late February, we are far from the top of the escalation ladder,” the IIF authors said in their report.
“Additional measures, such as those related to the financial system and/or key Russian exports (and imports), would be possible and could lead to dramatic consequences for the Russian economy, as well as the government’s ability to continue its war effort in Ukraine. However, the costs of such actions could be significant for the sanctions-imposing countries as well”, the IIF authors added.
Ribakova, just back from a trip to Kyiv, also said that while much attention was being paid to reconstruction costs, Ukraine was on the verge of a balance of payments crisis as the war hammered its economy.
Russian stock market experiencing fifth worst crash in history
According to Bloomberg analysis the benchmark MOEX Russia Index closed 33% lower in Moscow, erasing $189 billion in shareholder wealth. That’s the fifth most brutal one-day selloff among 90 global equity indexes.
This is the first time since 1987 that a selloff of this magnitude has hit a market worth more than $50 billion. In the aftermath of the Black Monday crash that year, Hong Kong’s Hang Seng Index tumbled 33%. The worst single-day drop over the past century in any market of any size was Argentina’s 53% slump in January 1990, when the country was battling hyperinflation and a mounting economic crisis.