Even as India is wondering about the implications of the default of its southern neighbour, Sri Lanka, there is a much bigger default scenario playing out in the global market. Russia may be on the throes of a sovereign external default, at least that is what S&P appears to believe. The issue arose after Russian dollar debt had fallen due last week but the US had blocked the use of Russian dollar funds with US banks. This put Russia in a liquidity crunch.
As a result, Russia has offered to pay the dues in equivalent roubles deposited in the account but S&P still calls it a default. From Russia’s side, they have refused to accept it as a default since it was artificially caused by US sanctions. Russia has clarified that it is willing to pay, but its hands are tied by the sanctions. Russia is planning to pursue legal options. In this uncertain scenario, let us look at what Russian default is all about and what it could mean?
S&P lowers Russia to “Selective Default”
Among the various rating categories assigned by rating agencies, the category of “Selective Default” is rather unique. It does not speak about the ability or the solvency of the borrower to repay the principal and the interest on the loan. It talks of unique set of factors that makes it impossible for the borrower to service the interest and the principal. The likely default by Russia falls in this category. Technically, a default will kick in only after 30 days grace period, so there is still four weeks’ time for Russia to find a solution.
Russia had made arrangements to make an international bond repayment in roubles even though the payment was due in US dollars. This was after the US blocked access to Russian dollars in US banks. Significantly, Russia never defaulted on external debt in over 100 years. The last default was in the aftermath of the Bolshevik Revolution in 1917. Even the 1998 default by Russia pertained to local debt and not foreign debt. The big question is whether the decision to pay in Roubles instead of dollars would amount to a default?
Russia can pay, so it is not about ability
Let us look at a quick macro picture. It is not like Russia cannot pay. For example, their total foreign sovereign debt is about $40 billion. Against that, its total forex reserves stands at $650 billion. More than 50% of its forex reserves are still unsanctioned. That means, Russia can technically use that money, although they may want to save these funds for a rainy day. In fact, Russia was due to make a payment of $649 million to holders of two of its sovereign bonds but could not make the payment after the US Treasury blocked the transfer. This prevented Russia from using any of its frozen foreign currency reserves for servicing its debt, which had been permitted till then. As a stop-gap arrangement, Russia has placed the Rouble equivalent to bondholders in special accounts at its National Settlement Depository. The 30-day grace period expires on 04th May and by then the decision will have to be taken on whether this really constitutes a default or not.
Is it then about willingness to pay?
The argument is a lot more nuanced. Russia has the ability to pay as it receives billions of dollars in revenue from the export of oil and gas. Also, while its dollars with foreign banks may be frozen, much of its reserves in Russia and other friendly countries are still technically available. Clearly, US Treasury is trying to arm-twist Russia with a forced default, which Russia is not willing to concede; and rightly so.
The term default, itself, is loosely defined. IMF gives the closest definition by defining default as the failure to pay principal, interest or other amounts due after the grace period of 30 days has elapsed. There are also technical defaults that can be remedied and it remains to be seen if this will be classified by the courts as a regular default or technical default. However, Russia has firmly dismissed talks of default calling it an artificial creation of the US with no grounds for a real default.
What are the possible implications of a Russian default?
If you go by the pricing of Russian bonds in the global market, they are setting a high probability of default. Here are some scenarios.
a) One likely impact of a default could be credit default swaps (CDS) getting triggered. A CDS is like an insurance bought by investors against a default. The final decision will only be made after the determinations committee decides on the default and that will happen after the grace period. Currently, there are $6 billion worth of CDS contracts outstanding on Russia, which can have a spiralling effect on financial markets.
b) Another option is for Russia to unilaterally declare a moratorium; which is a freeze on all external payments. Mexico had done that in 1982 and Sri Lanka has just done that in 2022. A moratorium can also trigger CDS contract and as the global financial crisis of 2007 showed, CDS has the ability to feed on itself.
c) The S&P downgrade is based on the premise that even if lenders receive Roubles, they will not be in a position to convert these Roubles into dollars in the current situation of sanctions. Also, the fear is that things could only get worse if the sanctions intensify.
d) Currently, due to the ongoing sanctions, Russia cannot access $315 billion of its foreign currency reserves. The other half is still available but Russia may want to hold that back for a rainy day. The US wants to diminish Russia’s forex chest, something Russia is unwilling to accept at this point of time.
e) Russia is also planning to adopt the legal course, by approaching the courts with proof of their efforts to pay in Roubles. Russia calls it an artificial default since they have the dollars, the ability to pay, the willingness to repay. It is just that they are not able to access the dollars due to the sanctions.
The last word may not be said, but the Russia default could hold the global markets on tenterhooks.