Russia is close to defaulting on its debts due to 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 are “extremely close” to default.
The key test will come next Wednesday, when the Russian state will have to pay $117m (£89m) on some of its US dollar-denominated debt. While Russia’s debt is relatively low and its financial system less integrated with the rest of the world than other countries, some analysts warn that an imminent Russian default could have unintended consequences.
What happens by default?
A default occurs when a borrower fails to make agreed payments on its debts.
The Bank of Canada and the Bank of England, which track global sovereign defaults, estimate the total value of government debt in the event of default globally in 2020 at $443.2 billion, about 0.5% of global government debt.
Recent governments that have defaulted include Argentina, Belize, Ecuador and Suriname, with countries generally unable to honor payments denominated in foreign currencies. Some of them have a good track record, including the US and the UK. However, both countries have defaulted in the past – including Britain in 1672 during the reign of Charles II and the US in 1862 during the American Civil War.
Russia is due to make two coupon or regular interest payments on March 16. However, it will have a 30-day grace period, which means that a default will not technically occur until at least April.
When was the last time Russia defaulted?
Russia has defaulted before, including during the 1917 revolution and in 1998, when the country’s economy remained weak after the fall of the Soviet Union and the costs of the war in Chechnya left it unable to repay its debts. However, even then Russia did not lag behind dollar settlements.
The so-called ruble crisis has severely damaged neighboring economies and triggered turmoil in the global financial system, including huge losses for US hedge fund Long-Term Capital Management.
What’s at stake
Russia has bolstered its financial position in recent years in response to Western sanctions imposed after the annexation of Crimea in 2014, when the government ran a budget surplus and reduced its reliance on the US dollar.
According to the Institute of International Finance (MIF), Russia’s external liabilities — money owed to creditors by governments, companies and households — have fallen from about $733 billion in 2014 to about $480 billion. Of these, $135 billion must be paid to creditors within one year.
However, the government’s own debt is relatively small. The state has about $40 billion in foreign-currency bonds denominated in dollars and euros — negligible compared to the size of its economy and several comparable countries. Foreign investors also own $28 billion worth of Russian ruble-denominated debt.
However, the scale of the problem is larger for Russian corporations, which have just under $100 billion worth of international bonds in circulation.
Investors in Russian debt are risky hedge funds and major global asset managers. US fund manager Pimco, one of the world’s largest bond investors, has amassed $1.5 billion in Russian sovereign debt, according to the Financial Times.
Why can Russia default?
Western sanctions on Russia’s central bank and the country’s biggest creditors are disrupting financial transactions. In response, Moscow also imposed capital controls, including suspending the transfer of coupon payments on sovereign debt to foreign investors.
The Russian Ministry of Finance has stated that it will service and pay sovereign debts in a timely manner and in full. However, Putin said that Russian entities could pay their foreign-currency debts in rubles at the exchange rate set by the Russian central bank for residents of “countries that engage in hostile activities.”
While Russia would have had enough foreign exchange to pay off its debt, having accumulated $630 billion in reserves, the US, UK and EU have frozen their central bank assets, making much of that amount unavailable.
Earlier this week, ratings agency Fitch downgraded Russia’s sovereign debt rating to the second-lowest level, saying default was “inevitable”.
What could be the consequences for Russia?
Debt defaults make it harder and more expensive to borrow in the future, given the reputational damage. However, Russia is already isolated on the world stage after the invasion of Ukraine. Western governments have also blocked the Russian state from raising new money in the capital markets, including in London and New York.
According to the IIF, sanctions that increase the cost of funding are likely to hit the government’s financial position, potentially forcing Moscow to cut spending or raise taxes.
What could Will the consequences be elsewhere?
Targeting Russia’s financial system is intended to cause economic damage domestically, although this may have indirect consequences for the global banking system as a whole.
However, many economists, including Governor of the Bank of England Andrew Bailey, believe that Russia’s financial ties with the rest of the world are small and not of systemic importance.
According to the Bank for International Settlements, foreign banks have about $121 billion in relation to Russia, mostly in Europe. The IIF estimates that foreign banks play a minor role in the country, owning only 6.3% of all assets.
The country’s corporate sector mainly relies on loans for financing from state-owned banks. Foreign participation in the Russian sovereign debt market currently stands at 20% of total outstanding debt, and political uncertainty since 2014 has been deterring foreign buyers.
Reinhart of the World Bank told Reuters that so far the effects have been limited, but risks could still arise.
“I worry about what I can’t see,” she said. “Financial institutions are well capitalized, but balance sheets are often opaque… There is a problem of Russian private sector defaults. You can’t be complacent.”