Finance

What happens when a major economy can’t pay its debts in dollars? Russia is about to show us | Adam Tooze

As of Wednesday Russia has been scheduled to pay investors holding two dollar-denominated government bonds $117m in interest payments. It will likely make the payments, but probably in roubles rather than dollars. Some of Russia’s debt contracts permit such an arrangement; the two bonds in question do not. Russia has a grace period of 30 days within which to make payments in the normal fashion. If it fails to do so, it is likely to be declared in default by its creditor.

Sovereign defaults send shockwaves through the global financial system. They signal that a debtor at the very apex of the monetary system – a government – is either unwilling or unable to meet its obligations. Since, in a modern monetary system, government debt is generally treated as the ultimate safe asset, this is a shock that goes beyond the arena of high finance. Russian defaults have rocked the global financial system twice in modern history. In 1917, the Bolsheviks repudiated the debts of the Tsarist empire, souring relations with Russia’s former allies, most notably France, for decades to come. In 1998, in the financial crisis that defined Vladimir Putin’s rise to power, Russia defaulted on its domestic debt and some Soviet-era foreign debt. The repercussions were significant enough to bring about the meltdown of the LTCM hedge fund, the world’s biggest, in New York.

The current impending default is nothing like either of those occasions. Only a few short months ago Russia was a top-rated sovereign debtor. It had only $38bn in foreign currency debt outstanding, of which only $20bn was owned by foreign investors – a tiny amount for a trillion-dollar economy. The payment that is due now, $117m, is a small fraction of what Russia continues to earn every day for its oil and gas exports. For gas alone, Russia was a fortnight ago earning more than $700ma day.

Russia will pay in its local currency not because it is unable to find $117m, or because it has unilaterally decided that these debts are odious and should not be serviced. It is not paying its foreign creditors because it is locked in an asymmetrical proxy war with the west, a struggle in which the latter has chosen to weaponise the financial system.

The defining moment came on Saturday 26 February, with the announcement of central bank sanctions. This sent the rouble plunging, and forced the closure of Russia’s financial markets. In the coming months, inflation in Russia will surge. To contain the price increases, interest rates have been savagely hiked. Russia will have a hard time getting hold of vital imports. Economists estimate that Russia’s economy could contract by 15% or more.

All of this is terrible news for Russian households and businesses. But if Iran is anything to go by, it will not lead to a total collapse of the Russian economy. Since only the US, which consumes hardly any Russian oil, has so far imposed an embargo on Russian energy exports, Russia continues to earn hard currency. Having piled up its foreign exchange earnings, it has enough foreign exchange reserves to settle its entire foreign currency debt outright more than 12 times over. Russia’s problem is not financial but political. It cannot access its hundreds of billions in foreign exchange reserves because of European and American sanctions. For its part, it has barred foreign investors from selling their Russian investments. And when it makes the $117m payment in roubles, it is not obvious that its foreign creditors will be able to set up bank accounts in Russia into which to receive them.

To treat this as a regular default is to engage in a charade: it is a tit-for-tat measure in a financial war. Given the sanctions we have imposed, it is frankly silly to expect anything less.

The losers will be the west’s private investors in Russian bonds. Their interests – not just the oligarchs’ – were sacrificed the moment sanctions were announced. BlackRock, the world’s largest fund manager, has written almost entirely off the $18.2bn in Russian assets it had at the beginning of the year. Practically every major western brand name is pulling out of Russia. Some will incur heavy losses in the process, inflicting pain both on their investors and on the hundreds of thousands of Russians who work with them. Ethics aside, it makes perfect sense from a business point of view. No one wants the reputational damage.

Foreign creditors of the Russian government are in a different position. Their interest was not in selling hamburgers or self-assembly furniture to ordinary Russians. They put their money directly towards funding the Russian state, warts and all. The prospectuses of Russia’s bonds issued since the annexation of Crimea in 2014 specifically refer to geopolitical tensions with the west and the risk of sanctions. Knowing full well what they were funding, western investors snapped them up. That bet has now gone bad.

The legal claims by Russia’s creditors may be odious but they are also powerful. If they are shameless enough to pursue their defaulted loans through the courts in London or New York, they may well be granted liens on Russian government property while the true victims of Putin’s aggression, first and foremost the Ukrainians, have no such recourse. Debt activists around the world have pushed for legislation in major creditor countries to ban vulture funds from taking advantage of distressed sovereigns. It is time for legislation in the UK and US to ensure that if anyone is able to make financial claims against Putin’s regime, it is not those who sought to profit by investing in it.

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