Why Not Default?
A journalist called today to discuss the Russian sovereign bond situation. Whether the Russian Federation indeed defaulted on its Bonds due 2026 and Bonds due 2036 by instructing a USD payment that got stuck in Euroclear’s account with the sanctioned Russian National Settlement Depository (NSD) and never reached the relevant bondholders, comes down to the legal interpretation of the term “non-payment” under the bonds. It is for a court to decide whether there can be a non-payment under the relevant bonds if a correct payment instruction was made and the funds left the sphere of the issuer timely.
The far more interesting political economy question is, why did Russia try to avoid a sovereign default in the first place? The unprecedented sanctions issued by the United States and the European Union made clear that the Russian Federation was to be shut out of the international bond markets in the foreseeable future. Why not default right away if any payments on maturing bonds and on coupon due were sunk cost in any case?
Here are some educated guesses that I caught in the City.
On an optimistic note, Russia may have assumed that a limited number of access channels to the international bond markets would remain open and therefore may have made an effort to comply with its obligations under the outstanding bonds. For example, the expectation may have been that a special arrangement would be accommodated for, similar in style to the arrangement that permits euro payments rather than rouble payments for Russian gas deliveries to European customers as long as the payments are made to Gazprombank, which has not been sanctioned by the EU. However, U.S. and EU authorities have made it utterly clear that the approach pursued following the annexation of Crimea in 2014, has been replaced with a more rigid regime. In making this decision, these authorities will have considered that only approximately 50% of the aggregate amount of approximately USD 40 billion in Russian sovereign bonds are held by non-Russian investors and that a sovereign default will likely have only marginal impact on global financial stability, if at all. Historically, foreign holders of Russian sovereign debt are hedge funds—not exactly a “protected class” in the current economic climate.
Russia may have complied with its sovereign bond payments to maximize its flexibility, reduce its dependency on any third party, and keep Russia’s borrowing cost low. For example, reliance on China or India to raise or transfer funds will likely have its own cost, at least in the long-term. Strategically, if it maintained access to the international bond markets, at least in a limited fashion, Russia may prevent third parties from extracting a bargain from it and enjoy a certain degree of flexibility in the emerging multilateral global order.
The underlying assumption of both above educated guesses is that Russia at some point will have to return to the capital markets and borrow. Is this assumption realistic given the recent unprecedentedly high oil and gas prices, which have led to huge money inflows for Russia?
Separately, or in addition to the above, there may also be a law and order type moral argument that kept the Russian Federation at servicing its debt. As someone pointed out to me, this argument is addressed to an external and an internal audience. Taking the long-term view, Russia addresses its external audience, international creditors, and let’s them know, “We are honourable people, we make due on our debt regardless of international politics. Pacta sunt servanda. We will be back in the market as soon as possible and, we are aware, our conduct today, will then be a pricing consideration.” From the perspective of an internal audience, continuous debt service may be crucial in upholding the image of lawfulness and normalcy and may as such be conducive to ensuring internal support and stability for the Putin regime. Default cannot be justified in a regime that insists on its ability to weathering the (financial) sanctions well. Assuming that ordinary citizens would notice if there was a sovereign default, flooded with cash, debt service as a means to simulate “normalcy” and to prove a point may not only be the cheapest but also the most obvious and rational of all ways out.
Maria C. Schweinberger
Some Resources:
List of Russian Sovereign Bonds outstanding as of March 31, 2022
Russian Federation US$2.5 billion 12.75% Bonds due 2028