Russia is on the brink of a unique type of debt crisis

Investors believe this would be the first time that a major emerging market country is forced into a bond default through geopolitics rather than empty coffers.

Few would have imagined Russia defaulting on its hard currency bonds if the Kremlin attacked Ukraine on February 24. Its solid solvency record, high export revenues, and inflation-fighting central banking made it a favourite of emerging market investors.

Moscow is now on the brink of default due to the U.S. Treasury’s refusal to grant a license allowing Russia to continue debt payments despite broad-based sanctions.

Russian finance minister wired $100 million in interest payments to its domestic settlement office for two bonds due Friday. However, if the money doesn’t show up in foreign bondholders’ accounts, it will be considered a default according to some definitions.

Even if funds are approved, payment of almost $2 billion is due by the end of the year. One is required to be settled in Russia by June 30, according to experts.

Emerging market debt crises do not happen often — Russia reneged in 1998 on its rouble bonds. Geopolitics has also gotten into the debt sphere, causing defaults in Venezuelan and Iranian for example.

However, Iran had only a small amount of loan debt hit by U.S. sanctions following its 1979 revolution. Venezuela’s economy was already in ruins before U.S. restrictions in 2019 forced $60 billion in sovereign debt and sub-sovereign debt across to the brink.

Russia continues to earn oil and metals profits. Despite having half of its $640 billion war chest frozen by sanctions the central bank still has enough cash to pay the $40 billion in outstanding sovereign hard currency debt.

Flavio Carpenzano is an investment director at Capital Group. He said that this crisis is different from other emerging market crises. It’s not about the ability or willingness of Russia to pay.

This would be Russia’s first major foreign bond default in over a decade since the 1917 Bolshevik revolution. Russia’s sanctions and countermeasures effectively cut it off from the global financial system.

Stephane Monier (chief investment officer at Lombard Odier) said that it is inappropriate to compare recent defaults like Argentina in 2020. Most countries are financially stressed when defaults occur.

Monier stated that this would be the first-ever externally and politically driven default in the history of emerging markets.

Creditors may not be able to receive payments if the Treasury license expires. This is what Daniel Moreno (head of global emerging market debt, Mirabaud Asset Management) likened “turning upside down” to.

He added, “Me, creditor, are now unwilling to accept the payment.”

No Return

Russia’s international bonds have fallen in value to 13-26 cents per dollar, despite most of them trading above par. They were also removed from the indexes.

One key difference between past defaulters like Argentina and Venezuela is that Russia’s attack against Ukraine, which it calls “a special operation”, has made it a pariah for many investors, likely for many years.

Gabriele Foa, portfolio manager at the Algebris Global Credit Opportunity Fund, stated that there is a stigma associated with holding these bonds. Clients are putting pressure on emerging market asset managers asking them to not invest in Russia and to sell their positions.

A potential default is symbolic at the moment because Russia can’t borrow internationally and doesn’t need to. However, what happens further down the road is critical.

Russia’s regime change could end Western sanctions and bring Russia back into the fold.

First, creditors must face a lengthy and expensive process to recover their money. This could include exchanging defaulted bonds for new ones.

A default stigma could also increase future borrowing costs.

It is very likely that Russia will experience the same thing. Russia’s defaulting on funding increases the cost of funding. They will have to pay a premium,” stated Carpenzano, Capital Group’s CEO.

While the White House believes that a default will have little impact on the U.S. economy or global economy, Carpenzano thinks that events in Russia are forcing us to reassess geopolitical risks in emerging market markets.

He said that geopolitical noise had increased and that investors would like to receive compensation for this higher risk. He cited China’s recent large investment outflows.

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