Welcome to Finance and Fury. Will a Russian debt default cause a global financial collapse?

  1. There are some major concerns amongst financial pundits at the moment in relation to debt defaults from the Russian gov – But is Russia defaulting on their debts something new? And if they do default, will this sort of economic collapse effect the rest of the world’s financial markets?
  2. Financial markets take debt defaults pretty seriously – think about Greece in 2011 – Russia has an economy about 8 times larger than Greece
  3. So in this episode – We will look at this question in isolation – the global economic markets are a complex system – so there is no way to tell for sure if this event is the catalyst for another financial collapse or simply another blimp on the radar – but we will look at the ramifications from a Russian debt default and what this could mean for global financial markets

What is a debt default?

  1. When talking about a country/Government – this is known as a sovereign default – this is a failure of a government to honour some or all of its debt obligations – for governments this is in the form of repayments of the face value of the bonds that they have issued at maturity – bonds are a debt instrument that governments use to borrow money
  2. How Government bonds work – A government issues a debt security known as a bond to raise funds to spend –
    1. Every time there is a fiscal deficit reported in a budget – that is being funded by investors purchasing a government issued bond –
    2. The promise is that by the time the bond matures, the government will pay the investor back the face value of the bond – being the initial money that was spent to purchase it – in addition, the government needs to pay the investor a coupon payment along the way to compensate them for lending the
    3. As an example – say the Aus Gov needs $100, they then go to the market of investors and an investor buys a bond off them worth $100 – they transfer this $100 in cash to the gov so they can spend this – the investor gets the bond (in the form of a certificate) and gets an income of $4 p.a. – in 10 years’ time when this bond matures, the Gov pays back the $100, and the bond ceases to exist
    4. Normally to raise the funds to repay these bonds, in this case the $100, governments issue new bonds to raise the capital – But it is incredibly rare to find a government fiscally responsible enough to bank enough cash away to repay their bonds – so to get this $100 the Aus government would simply issue a new bond for $100 – then use these funds to repay initial investor – unironically very similar to a Ponzi scheme where government debt markets are held up by their ability to sell net debt to repay their old debt – this is where QE came into the picture to help governments beat the market and continue to issue cheap debt
  3. In Russia’s case – if they don’t have the money to cover the debts, which is likely they don’t due to having to fund war expenses, plus due to sanctions, your Central banks and government have been cut off from investment markets normally willing to purchase newly issued debts – now they are incredibly limited from issuing more bonds
    1. In addition, the Ruble has collapsed – making it more expensive to cover any non-Ruble denominated debt
    2. Downgrading of credit – increasing the yields on the existing debts – i.e. increasing the costs of holding this
  4. Therefore – a government in this situation may have no choice but to default –
    1. There are concerns right now that Russia is on the cusp of defaulting on up to US$150 billion of foreign currency debt it owes global investors, including many large Western institutions – this could amount to one of the largest emerging market defaults in history
    2. Whilst not overly common – many countries have defaulted on their debts in the past
  5. For Russia – this is not the first time – The last time was during The Russian financial crisis – which occurred in 1998 in which the Russian government and the Russian Central Bank devalued the ruble and defaulted on their debts.
    1. This event did have severe impacts on the economies of many neighbouring countries – as well as some emerging markets
    2. What caused this – Russia was coming out of the USSR – being communist style economy – their output was struggling – plus they were trying to maintain a high fixed exchange rate between the ruble and foreign currencies, particularly the USD to avoid public turmoil through rampart inflation
      1. If your country needs to purchase goods from foreign markets – if your money is worthless it costs more to import goods – so domestically prices rise
    3. Plus – The economic cost of the first war in Chechnya took a significant toll on the Russian economy – costing them around $30 million per day from the start at the end of 1994 to 1996 – in total, this war cost Russia $5.5 billion, close to 1.4% of their GDP. 
    4. In the first half of 1997, the Russian economy showed some signs of improvement – two external shocks emerged – the first was the Asian financial crisis that had begun in 1997 and the next was the following declines in demand for crude oil and minerals (such as copper, nickel, lead, etc.) – severely impacted Russian foreign exchange reserves
  6. In an effort to prop up the currency and stem the capital flight the Russian Government bond interest rates to 150%
    1. A $22.6 billion International Monetary Fund and World Bank financial package was approved on 13 July 1998 to support reforms and stabilize the Russian market by swapping out an enormous volume of the quickly maturing Russian government short-term bills into long-term Eurobonds.
    2. I wont go through all the details – but some of this money was stolen, there were strikes over unpaid wages, civil unrest and economic conditions worsened –
    3. In the end – in August 1998, the Russian government devalued the ruble, defaulted on domestic debt, and declared a freeze on repayment of foreign debt.
    4. Russian inflation in 1998 reached 84 percent – due to declining ruble – September, the exchange rate reached 21 rubles for one US dollar, meaning it lost two-thirds of its value of less than a month earlier when it was around 6 rubles per USD
  7. Recovery – Russia bounced back from the August 1998 financial crash with surprising speed. Much of the reason for the recovery is that world oil prices increased rapidly during 1999–2000 and Russia ran a large trade surplus in 1999 and 2000. Another reason is that domestic industries, such as food processing, had benefited from the devaluation, which caused a steep increase in the prices of imported goods – increasing the reliance on Russian food and fertilizer exports to the rest of the world – particularly the EU
    1. Also, since Russia’s economy was operating to such a large extent on barter and other non-monetary instruments of exchange, the financial collapse had far less of an impact on many producers than it would had have if their economy had been dependent on a banking system.

What happens if Russia does default – And Who is left holding the bag

  1. To start with – A Russian Debt default may not be as catastrophic due to the level of debt that is up for default – as well as where it is owed –
    1. The amount of Russian debt – About US$117 million in interest is due on Russian US dollar bonds this week which Russia will only pay in rubles – on the contract to these bonds – failing to service this debt in US dollars will trigger 30 day default timetables on bonds issued by the Russian state and state sponsored companies such as Gazprom and Lukoil
      1. About $120 billion of the current outstanding government and company debt is denominated in US dollars – so the equivalent payments to cover this in rubles have jumped
    2. This level of Debt is up to $150bn in total – but Russia’s debt to GDP is at about 19% – being the highest level in years
      1. Why Russia has low debt to GDP ratio? Not many investors were willing to lend due to their default in 1998
      2. Comparing this to Greece – Greece hit a government debt to GDP of 180% – and needed to be bailed out for $172bn of debt in 2012
    3. Where the IMF and governments, such as Germany were the ones that restructured the Greece debt crisis – large institutional investment company are holding the bag for the Russian debt – and are presumably sweating on the potential outcome
      1. These include BlackRock and PIMCO – But it’s not likely to be limited to these giant funds. Because much of Russia’s debt was rated investment grade just weeks ago, the securities were pervasive across global fixed-income portfolios – within people super/pension accounts as well as personal investments
      2. Institutionally, this level of default doesn’t warrant any concerns for financial collapse – through creating large enough losses to bankrupt companies – for instance Blackrock – has FUM of $9.5 trillion – where BlackRock funds exposed to Russia fell by more than 90% after the invasion, and investors now have less than $1 billion invested, down from about $18 billion at the end of January
  • PIMCO has $2.2 trillion – It has around $1.5bn in Russian debt, and also placed $1.1bn of credit default swaps on Russian debt at the end of 2021. According to the report, Pimco sold credit-default swaps to investors through at least four of its funds. The firm will be forced to pay out these investors, if Russia defaults on its debt – So about 0.1% of their FUM in losses which can be easily shrugged off
  1. While many Russian bonds were trading above 100 cents in the dollar before the conflict broke out, most have lost as much as 80% of their value with credit default swap markets implying a circa 70% chance of default – so a default is highly likely
  1. Global financial markets – those being share markets – are currently moving into long positions in Russia and China because the companies located in these regions appear superficially cheap
    1. Many of these have suffered significant declines in the past month or two – so the equity side is looking bullish
  2. when the Russian government defaulted on its debt to foreigners in 1998 – this was initially triggered by external financial consequences – such as the Asia currency crisis –
    1. This time around – the default is due to the ruble declining to the point it is not affordable for Russia to repay these loans – or they just may not be willing to do so – either way there is a high chance that they may default
  3. First – the amount of debt being defaulted on is not monumental enough to send ripples throughout the global financial markets – it is less than Greece in 2011 and it is primarily large institutional investment firms, translating into individual investors who will lose out
  4. The main risks from this come down to being another rung of a ladder of collapse or not
    1. The global economy was already in a fragile position – government policies have done a lot of damage to the supply chain over the last 2 year
    2. With rising interest rates – already materialising in the US – the valuation for investments, including shares and bonds have declined – but the risk to say the ASX from a Russian debt default are minimal
    3. In 1998 the ASX was up by 9% by the end of the calendar year – there was a decline in the year, but after 12 months it was still positive

In summary – Debt defaults are nothing to shrug off in the world of interconnected economies – but in this case, compared to the other risks of government policy overcorrections or monetary policy mistakes – it is the lessor of two evils

  1. Russian Debt defaults of this scale are likely nothing to worry about on their own – but this could be another additional risk added onto the pile of mounting risks – where you have higher inflation rates from supply chain issues – sanctions in Russia and declining production from Ukraine could spell even worse shortages of foodstuffs – crop yields could suffer from a declining yield due to fertiliser shortages –
    1. Major shortages in consumer goods are a possibility – covered a few weeks ago where grain production was at risk for this growing season – this has a potential major impact for your daily life to afford food – but for financial markets this can be shrugged off as the costs can be passed onto consumers –
  2. The main risk to markets at the moment still come from higher interest rates and lower economic growth – declines in markets can be blamed on the Russia conflict – but remember that most of the market decline occurred in Jan and Feb – before the conflict kicked off

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