Russia is on the verge of not being able to pay its debts despite the sanctions imposed by the West after Vladimir Putin’s invasion of Ukraine.
World Bank chief economist Carmen Reinhart warned on Thursday that Russia and its ally Belarus were “strongly close” to default.
A key test will come on Wednesday next week, when the Russian state will have to make a payment of $117m (£89m) on some of its US dollar-denominated debts. While Russia has relatively low debts and its financial system is less integrated with the rest of the world than that of other countries, some analysts warn that an imminent Russian default could have unintended consequences.
What happens in the event of a defect?
A default occurs when a borrower fails to make agreed payments on their debts.
The Bank of Canada and the Bank of England, which track global sovereign defaults, estimate that the total value of government debt in default worldwide was $443.2 billion in 2020, or about 0.5% of global public debt.
Among the governments that have recently defaulted are Argentina, Belize, Ecuador and Suriname, with the countries generally failing to keep up with payments denominated in foreign currencies. Some have strong track records, especially in the US and UK. However, both have been lacking in the past – including Britain in 1672 during the reign of Charles II and the United States in 1862 during the American Civil War.
Russia must make two regular coupon or interest payments on March 16. However, it will have a 30-day grace period, meaning a default wouldn’t officially occur until at least April.
When was the last time Russia defaulted?
Russia has failed before, notably during the 1917 revolution and in 1998, when the country’s economy remained weak after the collapse of the Soviet Union and the costs of the war in Chechnya prevented it from meet the repayment of its debt. However, even then Russia continued to pay in dollars.
The so-called ruble crisis has caused severe damage to neighboring economies and sent shockwaves through the global financial system, including huge losses for US hedge fund Long-Term Capital Management.
What’s at stake
Russia has strengthened its financial position in recent years in response to Western sanctions imposed after the annexation of Crimea in 2014, with the government running budget surpluses and reducing its reliance on the US dollar.
According to the Institute of International Finance (IIF), Russia’s external debts – money owed to creditors by the government, businesses and households – have fallen from around $733 billion in 2014 to around $480 billion. dollars. Of this amount, $135 billion must be paid to creditors within one year.
However, the amount owed by the government itself is relatively small. The state holds about $40 billion in foreign currency bonds denominated in dollars and euros, which is tiny compared to the size of its economy and many comparable countries. Foreign investors also hold $28 billion of ruble-denominated Russian debt.
However, the scale of the problem is greater for Russian companies, with just under $100 billion in international bonds outstanding.
Investors in Russian debt include hedge funds, which prefer to take risky bets, and major global asset managers. According to the Financial Times, US fund manager Pimco, one of the world’s biggest investors in the bond market, has amassed a $1.5 billion position in Russian sovereign debt.
Why could Russia default?
Western sanctions against Russia’s central bank and the country’s biggest lenders are disrupting financial transactions. Moscow has also imposed capital controls in response, including suspending the transfer of sovereign debt coupon payments to foreign investors.
The Russian Ministry of Finance has declared that it will ensure the full and punctual servicing and payment of sovereign debts. However, Putin said that Russian entities can pay their foreign currency debts in rubles at exchange rates set by the Russian central bank to residents of “countries that engage in hostile activities”.
While Russia would have had enough foreign currency to cover debt payments, having amassed $630 billion in reserves, the US, UK and EU freezing its central bank assets returned a large part of this inaccessible sum.
Rating agency Fitch downgraded Russia’s sovereign debt rating to its second-lowest level earlier this week, saying a default was “imminent”.
What could be the consequences for Russia?
Defaults make borrowing more difficult and more expensive in the future, given reputational damage. However, Russia is already isolated on the world stage after the invasion of Ukraine. Western governments have also prevented the Russian state from raising new funds in capital markets, especially in London and New York.
According to the IIF, sanctions that increase the cost of funding are likely to affect the government’s financial situation, potentially forcing Moscow to cut spending or raise taxes.
Which could the consequences are elsewhere?
Targeting the Russian financial system aims to inflict economic hardship inside the country, although there may be indirect effects on the entire global banking system.
However, many economists, including Andrew Bailey, the Governor of the Bank of England, have suggested that Russia’s financial ties to the rest of the world are weak and not systemically important.
Foreign banks have about $121 billion in exposure to Russia, mostly in Europe, according to data from the Bank for International Settlements. The IIF estimates that foreign banks play a minor role in the country, holding only 6.3% of total assets.
The country’s corporate sector mainly depends on loans for funding from public banks. Foreign participation in the Russian sovereign debt market currently stands at 20% of total debt outstanding, with political uncertainty since 2014 discouraging foreign buyers.
The World Bank’s Reinhart told Reuters the fallout had been limited so far, but risks could still emerge.
“I worry about what I don’t see,” she says. “Financial institutions are well capitalized, but balance sheets are often opaque… There is the problem of Russian private sector defaults. We cannot be complacent.