International rating agency Fitch downgraded Russia's sovereign rating to “imminent default” on March 8 and said that a default is “inevitable.” Is Russia going to repeat its default of 1998?

Russian e-commerce giant Ozon appears to be the first victim, announcing on March 10 that it was delisting 1.875% convertible bonds due in 2026, after trading in Ozon shares did not resume on NASDAQ on March 8. Given the delisting, the bondholders have the right to require the convertible shares redemption to be at par plus accrued interest. The current bond principal outstanding is $750mn.

At the end of 2020 Ozon pulled off a hugely successful IPO on Nasdaq, raising $1.2bn – more than twice the initial $500mn it had been asking for.

Concerns that Russia being hit harder than it was expecting by sanctions will lead to a default are building fast after sanctions on the Central Bank of Russia’s gross international reserves (GIR) on February 27 and the leading state-owned banks were excluded from SWIFT.

Russian President Vladimir Putin has built a fiscal fortress over the last 14 years but after the CBR lost half its reserves and now the West is attempting to make it hard for it to even sell its gold that makes up nearly half of its remaining reserves, investors see a default as very likely. US lawmakers tabled a bipartisan bill this week to apply sanctions on any firm or bank that helps Russia transport or sell gold.

Russia has a $117mn bond redemption payment to make this month and several billion in other payments throughout the rest of this year. Morgan Stanley said in note this week that Russia faces a “Venezuela-style default” very soon.

Scrambling to keep order, the CBR has already ordered exporters to surrender 80% of their hard currency earnings to keep the system functioning and on March 9 it announced new regulations capping withdrawals from banks to $10,000 and limiting access to the some $280bn of foreign exchange deposits held by companies and the people in banks.

“The very word "default" causes Russians to instantly associate it with August 1998 – the collapse of the ruble, the collapse of the banking system and the loss of savings,” The Bell reports.

“The analogy is hardly applicable to 2022: in 1998, the default became the direct cause of the crisis, and today it will become just one of its consequences. You should not be afraid of the default itself – all the worst market events have already occurred, and the income of Russians will not collapse because of it, economists say,” The Bell said.  

The sanctions have already caused a liquidity crunch and on March 5, Russian President Vladimir Putin signed a decree on the temporary procedure for paying off foreign debt that allows for paying foreign currency debts to creditors from states that have committed "unfriendly actions" against Russia in rubles, through special accounts in Russian banks. The Ministry of Finance still has the right to pay foreign debt in foreign currency, but the decree allows everyone else to use rubles instead.

Switching to rubles for a debt denominated in, say, dollars is a technical default. By definition, default is the default by the borrower of its debt obligations, both in terms of paying interest and repaying the principal debt, on time and in full in the currency specified in the documents for issuing debt obligations.

Redemption schedule

The first key date to keep an eye on is March 16, when Russia has to pay external creditors about $117mn in coupon income on sovereign bonds maturing in 2023 and 2043, Bloomberg calculated, not a large amount.

On March 31, the Ministry of Finance will have to make another payment of $359mn on Eurobonds maturing in 2030. And on April 4, Russia had a third payment of $2bn due on more Eurobonds, Reuters reports.

Coupon payments on some Russian Ministry of Finance ruble-denominated OFZ treasury bills denominated in foreign currency can be made in rubles – but specifically for these issues, Russia does not have such an option, the newspaper notes. \

Russian bonds have a built in grace period of 30 days to make payments (that is, until April 15), after which, if the payment is not made, they are considered to be in default.

Bonds have been singled out by the US sanctions on Russia announced last month and US investors (which is effectively a global ban) are no longer allowed to buy any new debt issued by the Russian government. Importantly, there are no restrictions on buying or trading in debt issued before the sanctions were imposed, nor is there any ban on receiving coupon payments from these bonds.  

As of January 1, 2022, non-residents owned approximately $20bn of Russian government Eurobonds (51% of all outstanding) and $40bn of the Russian Ministry of Finance ruble-denominated OFZ treasury bills.

These bonds are another drain on Russia’s reduced hard currency reserves, as they have to be serviced but can no longer be rolled over. However, for the last five years Russia has been issuing bonds with a clause in the covenant that allows them to be settled in rubles and not hard currencies if it becomes impossible to pay in those hard currencies. About $15bn worth of bonds have this clause.

Another quirk of Russian bonds is normally the covenants offer waivers to the “state immunities act” that means states can never be sued from or by another country. The lack of this waiver means if the Russian government walks away from a bond there is very little the foreign investors can do about it. Although the covenant is nominally governed by English law, Russia has explicitly refused to submit to the jurisdiction of any court, foreign or domestic.

Analysts at Morgan Stanley told The Bell that it might be possible to settle these bonds using the CBR money that has been frozen in foreign banks by the sanctions if the investors take the Russian government to court. Judges in the UK could assert that despite Russia’s sovereign immunity, the UK court has jurisdiction anyway and “seize” the CBR’s money in the UK to meet Russia’s obligations. Nevertheless, this is still a default.

And the estimate of the amount of CBR money seized by the sanctions is going upwards slowly and was $380bn based on June 30, 2021 data, the latest data available.

The big difference between the 1998 default when the government of Boris Yeltsin walked away from over $40bn of the so-called GKO treasury bills and this default (if it happens) is that in the 1990s the government was almost entirely dependent on external financing to fund the budget and this time it is not.

Analysts believe that Russian President Vladimir Putin will try to avoid default if he can, as it permanently damages the country’s reputation and increases the costs of borrowing, even from its friends that will still do business with it. In 1998 the government technically didn't default but “restructured” the GKOs, delaying payments by five years. Special “S” accounts were created to hold the bonds and make the coupon payments and restrictions were placed on these accounts to control investors' ability to withdraw money that were gradually eased. One of the work-arounds introduced was the cash in the S-accounts could be used to buy equities, which helped fuel a stock market boom in the second half of the noughties and actually made a lot of investors a lot of money.

Corporate debt

Redeeming Russian bonds is going to be hard but getting back money lent to corporations will be even harder. In a note, Capital Economics' Liam Peach warned there could be a wave of corporate loan defaults in the works as well.

Russia’s non-financial corporations owed a total of $1.4 trillion, or 81% of GDP, at the end of the third quarter of last year, according to the Bank for International Settlements, often called “the central bankers’ central bank.”

“A detailed breakdown is not easily available but we’ve done our best to piece together the jigsaw and the key facts are as follows: loans amounted to 91% of all debt ($1.2 trillion or 74% of GDP) and debt securities (i.e. corporate bonds) the remainder ($118bn or 7% of GDP). We estimate that 73% of all debt is denominated in rubles and that 81% of debt is owed to residents in Russia,” Peach said in a note. “Of this domestic component, we estimate that 90% ($1 trillion or 59% of GDP) reflects loans provided by all domestic financial institutions.”

Of all this debt, foreigner creditors play a significant role but it is the Russian creditors who are in the firing line; non-residents creditors are owed a total of $258bn, or 15% of GDP and 18% of the total corporate debt.

The manufacturing sector is the biggest user of corporate debt, as Russia’s economy has actually been growing well in the last few years (apart from a pause in 2020 due to the pandemic) and accounts for a quarter of the total outstanding debt.

“This probably reflects the many SMEs in Russia that depend on bank loans for their finance. Domestic loans to the mining sector account for just 6% of all corporate loans,” Peach said.

Corporate bond issuance is heavily concentrated among Russia’s largest companies and that is also concentrated in the extractive industries, including oil & gas, construction, metals and mining companies, that account for three quarters of all outstanding corporate bonds, according to Capital Economics. In 2018, state-owned oil major Rosneft accounted for 40% of all corporate debt issuance by itself according to ACRA ratings. Other major issuers include Russian Railways, Transneft and Gazprom – all owned by the state.

However, despite the size of corporate debt the exposure is mainly borne by Russian creditors and so remains under the control of the government as domestic banks and credit institutions hold three quarters of corporate debt. Practically all of the $118bn of corporate bonds is held domestically in Russia too, most likely by financial corporations, according to Peach. Non-resident creditors hold only $5bn of corporate, or less than 5% of the total outstanding corporate securities.

“Foreign banks have sizable claims on Russian corporations through loans, with those in Europe (particularly Austria, and to some extent Italy and France) most exposed,” Peach says.

Capital Economics are expecting a lot more Russian companies to follow Ozon into default on their debts. The dollar bonds of the Russian government and some large corporates are already trading in distressed territory and the main ratings agencies have downgraded Russian debt by multiple notches; Fitch Ratings downgraded Russia's Long-Term Foreign Currency Issuer Default Rating to “imminent default” on March 9 and S&P downgraded Russia to the pre-default rating of CCC- a day earlier.

“Russian corporate external debt repayments over the next six months (March to August) amount to around $23bn, half of which includes intercompany lending and most of the rest includes loans,” says Peach. “We consider it likely there will be more corporate defaults.”