Default is not necessary. But it could happen
March 5, 2022
In recent days, many experts have started talking about the possibility of Russia defaulting on its debts. They have even begun to name the date—March 16—when the Russian Ministry of Finance is due to pay the coupon on its Eurobonds maturing in September 2023. The argument is simple and straightforward: The currency accounts of the Ministry of Finance and the Bank of Russia are blocked, which will prevent the Ministry of Finance from delivering money to bondholders, even if it wants to do so.
The three leading rating agencies, S&P, Moody’s, and Fitch, severely downgraded Russia’s sovereign rating. The most negative comment came from S&P:
“The downgrade of Russia’s ratings follows the introduction of measures that we believe could significantly increase the risk of default. The military conflict in Ukraine has triggered a new round of sanctions by G7 countries, including on the Bank of Russia’s FX reserves. This makes a significant portion of the reserves inaccessible, which will negatively impact the Central Bank’s ability to serve as a lender of last resort and undermines what until recently was the basis of Russia’s creditworthiness—its net foreign exchange position.”
Let me say straight away that in my view, there is no need for default; there is nothing to prevent the Ministry of Finance from making the payment on time; the Ministry of Finance will find the money to pay.
1) There is no need for a default. The volume of the Eurobond issue is $3 billion, the coupon rate is 4.875%, and the amount to be paid by the Ministry of Finance is $73.125 million. As soon as the Ministry of Finance fails to pay, a technical default is declared, resulting in a full default in 30 days. After that, holders of all Eurobonds of the Russian government will be entitled to submit them for early redemption (so-called cross-default). All Eurobonds issued by Russia amount to $67 billion. Put yourself in the shoes of the Finance Minister and tell me, would you have to save $73 million to get a $67 billion bill? When the Ministry of Finance assets are locked up, it would not be challenging to find them. And I do not doubt that a court in London would quickly decide to pay the Eurobond holders out of the blocked assets.
2) Nothing prevents the MoF from transferring the coupon amount for distribution to investors. The fact is that the MoF does not communicate with investors directly but uses its agent, Vnesheconombank, to do so. This practice was established in the Soviet Union when VEB made all foreign exchange transactions with the outside world. It was not destroyed after the collapse of the Soviet Union because VEB was the borrower and holder of all information on the debts of the USSR, which were restructured, and the creditor on the obligations of other countries to the Soviet Union. In short, part of VEB became a dedicated division of the Ministry of Finance, which kept records of debts and did the technical work of transferring debt service funds (interest and principal.) This is well known to the U.S. Treasury, which, when imposing sanctions on VEB, issued a particular clause that allowed all payments related to debt service. The exact position is taken by analysts at Fitch Ratings, who wrote, “We believe that U.S. sanctions prohibiting transactions with the Russian Ministry of Finance will not interfere with servicing Russia’s sovereign debt.” True, this phrase has a sequel whose meaning I could not understand: “...but it is unclear, and the risk of such a harsh measure has increased markedly.”
3) Although the foreign currency accounts of the Russian Ministry of Finance are blocked, this measure works only outside the Russian Federation. Moreover, all of the Ministry of Finance’s foreign currency accounts are held at the Central Bank, which does not have to comply with the U.S. Treasury’s request to freeze accounts and transactions with the Ministry of Finance, as the Bank of Russia is not a U.S. resident. Although the Bank of Russia’s accounts outside Russia are blocked, this does not prevent it (and all other sanctioned banks) from conducting foreign exchange transactions within Russia. For this purpose, the banks use mutual correspondent accounts, which are not visible to U.S. banks. The use of such accounts allows the Bank of Russia to freely purchase foreign currency from banks not subject to sanctions and transfer it to VEB’s accounts for debt service using funds from the Ministry of Finance. High oil prices (even considering the significant discount that has appeared in recent days as an additional risk premium) and the inevitably reduced demand for foreign currency for import purposes will keep Russia’s current account balance positive. This means that the Bank of Russia will not have any market problems buying foreign currency for the Ministry of Finance.
In addition to foreign currency debt, the Russian Federation has ruble-denominated debt, the so-called OFZs. On July 20, the Ministry of Finance is due to redeem an issue of 293bn rubles (appr.$2.5 bln.). Undoubtedly, some part of those bonds belongs to non-residents, who would face severe problems if the recent bans imposed by the Bank of Russia were in place at that time. Let me remind you that the Bank of Russia banned depositories and registrars from crediting income on securities to non-resident accounts and banned banks from transferring funds from non-residents from the 43 countries that joined the sanctions regime and major offshore jurisdictions to their accounts abroad.