What Would a Forced Default by Russia Look Like?

The word “default”—which became a synonym for “financial catastrophe” in Russia in 1998, when the country defaulted on domestic debt—is once again being heard with increasing frequency as Western financial sanctions against Russia make it harder and harder for Moscow to service its international debt.

The prospect of Russia’s potential default on sovereign eurobonds sounds alarming, but for now the markets are barely reacting. Russian financial regulators have operated on the premise that Russia has money, and that therefore they can conduct transactions as though it is business as usual. A big chunk of the Finance Ministry and central bank international reserves were frozen back in late February, but Russia was able to use those funds to make payments in dollars until April 4, and to use new revenues for payments until May 25.

About 72 percent of the Russia-2022 eurobond was redeemed in rubles. Russia tried to pay out the rest of the $2 billion bond using dollars from frozen funds, and when it couldn’t, it used new revenues to make the payment in late April. However, by the end of May it was unable to make the coupon payments. 

The Finance Ministry then announced a settlement scheme analogous to the one used for gas exports, but in reverse. Creditors were to open accounts at Russian banks (such as Gazprombank) and ultimately receive euros and dollars: the assumption was that most creditors wouldn’t care what currency was used behind the scenes. But this scheme required the participation of Russia’s National Settlement Depository (NSD), and it looks untenable now that the NSD is also under European sanctions. 

Nevertheless, the scale of the problem should not be overestimated. Russia has $18 billion in sovereign eurobonds, with about $1.2 billion due in coupons per year (the exact amounts depend on the dollar/euro exchange rate). About 70 percent of the outstanding bonds are held by Russian investors, which means they can be serviced in rubles or by other means that will not lead to a default. Another potential solution is a series of early buyouts at a discount. 

Of the remaining 30 percent, some bonds could be legally paid out in other currencies, leaving only about 10 percent of total Russian sovereign eurobonds vulnerable to a “real” default (i.e., unable to be serviced), which is not much. Furthermore, Russia has funds beyond the frozen assets, so the only real problem is that payments cannot be made directly. Russia is also receiving large foreign currency inflows from exports, which it finds difficult to spend. The government could, therefore, take a page from an old playbook and engineer a buyout at a discount facilitated by a friendly investor, or make payments using unsanctioned currency in a neutral jurisdiction such as the UAE, Turkey, or Israel, or possibly Kazakhstan or Armenia.

The situation with ruble-denominated sovereign bonds—federal loan bonds (OFZs), which total about $40 billion depending on the ruble/dollar exchange rate, with coupon payments of about 8 percent, or $3.2 billion—is both simpler and more complex. Settlements are being made in rubles and through special accounts, but the sanctions against the NSD prevent payments through international depositories.

It would be easy enough for Russian financial regulators to unfreeze the funds of institutions from friendly countries and allow them to acquire OFZs from nonresidents from problematic jurisdictions, or to reinvest the funds in new OFZs or corporate bonds. For example, when Russia began to unfreeze the same type “C” accounts in 2000, the funds of foreign investors that had been trapped in those accounts after the 1998 default were largely channeled into Russian corporate bonds. There will be technical challenges in determining the ownership of securities held outside Russia, but these can be solved, and the share of foreign investors who hold corporate and municipal ruble bonds is quite small. 

The fate of corporate and bank eurobonds—a segment worth about $90 billion—is more complicated. Some of these issuers have come under the harshest sanctions: banks refuse to process their payments, financial institutions won’t service their bonds, and rating agencies no longer assign them rankings. 

Yet here too there are mitigating factors. Requirements for issuers to maintain certain ratings aren’t as common today as they were in 2008, when Russia once again faced a financial crisis, and demands for early debt repayment are less likely. Furthermore, some corporations have foreign assets, which could be split off from domestic ones and paired with the foreign debts, though this may require permissions from and extra payments to foreign bondholders.

Issuers that don’t have foreign assets or that face harsher sanctions could buy out their debts through neutral jurisdictions, possibly with the support of the Russian state. A surplus of foreign currency has been making the ruble too strong, and buying out bonds would be a good way to spend excess foreign currency and support the reputation of Russian issuers. 

For many years, the Russian government has focused on keeping national debt low. Russia has one of the lowest indicators among major countries, at just 17 percent of GDP compared with triple-digit figures for many developed countries and 160 percent for Russia itself back in 1998. Russia’s national debt is also largely denominated in rubles.  

Russia is being prevented from borrowing when it doesn’t really need to borrow. The situation is very different from late 2008, when low prices for most Russian exports triggered by the global credit crunch pushed leading companies to the brink of default, and only a successful $35 billion rescue plan by the central bank and Finance Ministry saved them. There is even a difference from 2014, when falling export revenues coincided with the introduction of Western sanctions that Russia was not ready for, and foreign debt was about 40 percent higher than it is right now. The technical aspects of the payments are currently the biggest problem for Russia, but this problem can be solved, even if it entails additional expenses or the involvement of intermediaries.

The new approaches will mean more work and more money for lawyers, for bankers, and for intermediaries from neutral countries that might be willing to risk secondary sanctions for potentially profitable deals. The costs will be borne by investors and issuers, but even they will not lose everything, unless they sell Russian assets when these are bottoming out.   

As a result, Russia and Russian companies will have virtually no debts to investors from countries that imposed sanctions, and the Russian financial market will become largely isolated from global finance. Over the next few years, especially if Russia’s key interest rate is lowered, its own resources should be sufficient to cover the needs of the budget, banks, and corporations. 

After that, the situation could become more difficult. If and when sanctions against Russia are lifted and Russian issuers once again have access to capital markets, the history of sanctions will be calculated into the expected profitability of Russian securities. But other countries have returned to the market after multiple defaults. 

A default by an issuer that still has funds is very different from a true default. This is why the market reaction to the uncertainty surrounding Russian securities is tepid. However, even the prospect of the imposition of large-scale sanctions could exacerbate the balkanization of the global capital market and reduce the role of traditional financial instruments for the many developing countries that have political risks of their own.

By:

• Anton Tabakh