On Wednesday, Russia was required to pay $117 million in interest on two dollar-denominated sovereign bonds, the first time since the outbreak of the Russo-Ukrainian war.
However, the Russian government may be on the verge of defaulting on its international debt for the first time since 1917 because of the restrictions on the means of payment due to the sanctions imposed on Russia by Western countries.
Some say this could be the most talked about government debt payment since Greece defaulted on its debt, and could even trigger a new “Lehman crisis” if the shock spreads.
An “artificial” debt default
Russia has issued a total of 15 international bonds, each with a total face value of about $40 billion, about half of which are held by international investors.
The first payment Russia needs to make is the March 16 coupon, which is linked to bonds listed in 2013 and payable in U.S. dollars, with Citi as the paying agent.
In addition to this Wednesday’s coupon, Russia has $615 million in coupon payments due for the remainder of the month. In addition, Russia’s first bond principal payment will occur on April 4, when $2 billion of bonds will mature.
Originally, Russia relied on its nearly $650 billion in foreign exchange reserves to have fully adequate debt servicing capacity. However, after the outbreak of the Russia-Ukraine war, more than half of Russia’s overseas reserves are now frozen due to Western sanctions.
According to S&P, the freezing of most of Russia’s foreign reserves has weakened the Russian central bank’s ability to act as a lender of last resort and Russia’s credit strength. To mitigate the resulting high exchange rate and financial market volatility, and to preserve the remaining foreign exchange buffer, the Russian government has introduced capital controls, a move that may impose restrictions on non-resident government bondholders receiving interest and principal payments on time.
Russian Finance Minister Siluanov already said on Monday that the country’s finance ministry is prepared to repay some of its foreign currency debt, but if the sanctions make it impossible for banks to repay the debt in the currency indicated when the bonds were issued, then Russia will pay through rubles.
Such statements have added to market concerns. Although some of the bonds and coupons to be paid next in succession have a clause in the notes that they can be paid in alternative currencies, including rubles. However, the coupon-linked bond due on Wednesday does not have such a clause, which means it can only be paid in U.S. dollars.
According to bond rules, if Russia does decide to pay these dollar-denominated coupons in rubles on Wednesday, it would still mean a default. And given that there are multiple coupon and debt payments to come, that means a string of defaults could follow.
What’s next?
Technically, there is a 30-day grace period for the coupon payment due on Wednesday, which means that if Russia can pay the coupon in U.S. dollars by April 15, it could also avoid default.
To recap, there are three possible scenarios that could happen next.
One, Russia chooses to pay the full amount of the coupon directly in U.S. dollars, meaning default fears disappear for now.
Both Gazprom and Rosneft have made payments on the international bonds in the last 10 days, so it is possible to avoid the risk of default if the Russian side feels this option is in its interest.
Second, if Russia chooses not to pay, then a 30-day grace period countdown will open. If Russia is still unable to pay the coupon in full in U.S. dollars until April 15, that would constitute a default.
Third, Russia chooses to pay in rubles, which would still amount to a default under the bond’s legal terms and could still constitute a default after the 30-day grace period.
Guido Chamorro, manager of Pictet’s emerging markets portfolio, said, “There is never a clear answer about default, and this is no exception… There is a grace period, so we won’t really know if this is a default until April 15, and anything can happen during the grace period. ”
What will happen if there is a default
In fact, the market is now widely expecting a Russian default as a probable event, and it is for this reason that the latest Russian bonds are already trading at only 10 to 20 percent of their face value.
“I think the market now expects Russia not to repay (the bonds),” said Jeff Grills, head of emerging market debt at Dutch global life insurance group (Aegon) Asset Management, adding that this would be one of the few emerging market events that could actually disrupt global markets.
So what will be the impact if a debt default occurs?
First, the rating agencies would downgrade the bonds in default and Russia’s long-term foreign exchange rating, meaning Russia would not have access to international capital markets. But given that Russia is now effectively excluded from the global financial market system, the impact of this article may not actually be that obvious.
Second, it would lead to potentially severe financial losses for many large global fund managers. Since most of Russia’s debt was rated investment grade just a few weeks ago, most fund managers have exposure to Russian bonds in their global fixed-income portfolios and benchmarks, including BlackRock and Pacific Investment Management (PIMCO). This means that this shock wave of defaults could spread to pension funds, school funds and foundations, among others.
Third, it could trigger Russian debt default insurance, namely credit default swaps (CDS), resulting in losses for some banks. JPMorgan Chase estimates that there is approximately $6 billion of outstanding CDS to be repaid.
Fourth, in addition to international institutions and banks, Russia’s own banks and investment institutions will also suffer losses. Not only do international asset managers have exposure to Russia’s foreign debt, but Russian banks could also get into trouble because of the bonds, which are part of their capital buffers, said Yevgeny Suvorov, an economist at the Central Credit Bank in Russia.
Many Russian investors have bought such bonds through their accounts at Western banks,” he said. There is a general suspicion that the holders of Russian sovereign foreign debt are primarily Russian investors.”
Jonathan Prin, a portfolio manager at hedge fund Greylock Capital Associates, warned that this would be a huge default, and in terms of market impact, it could be the broadest emerging market debt default to hit since the 1998 Russian debt crisis.
However, the International Monetary Fund president Kristalina Georgieva is relatively optimistic, arguing that the event is unlikely to trigger a large-scale financial crisis because the $120 billion exposure of global banks to Russia “is not systematically relevant.
