Russia Risks Default As Financial System Paralyzed

When you’re in a hole, the first step is to stop digging. But not if you’re Vladimir Putin.

On Monday, amid a collapse in the ruble, a slow motion bank run and an emergency hike from the central bank (among other measures), Putin effectively ordered Russians to voluntarily default on nearly a half-trillion in external debt.

Technically, it’s a prohibition on hard currency transfers abroad, but it includes debt service payments. It takes effect tomorrow and could imperil nearly $500 billion in liabilities (or assets, depending on which side of the equation you’re on). As Bloomberg noted, “it wasn’t clear if the new rules applied to sovereign debt and if they constituted default.”

It probably doesn’t matter what they “constituted.” Some kind of default seems inevitable. CDS spreads approached 1,200 basis points (figure below), although now, sellers have apparently switched to demanding upfront payments in addition to premiums.

Five-year swaps implied around a 56% chance of default. On a one-year horizon, the implied probability was 40%.

Russia was cut to junk last week by S&P, on the following straightforward justification:

The downgrade follows the abrupt escalation of Russia’s military intervention into Ukraine, which has prompted a series of stringent economic and financial sanctions from the U.S., EU, and U.K. governments, among others. In our view, the sanctions announced to date could carry significant negative implications for the Russian banking sector’s ability to act as a financial intermediary for international trade.

Apart from the immediate disruptions to economic activity that the sanctions could cause, second-round effects on domestic confidence could also be substantial. Some of these might be difficult to contain even in the face of Russia’s currently strong public and external balance sheets, as well as its conservative macroeconomic management. Under some scenarios, escalating geopolitical tensions could also trigger countermeasures from the Russian government that could worsen the impact. We believe the uncertainty surrounding the extent of the military conflict poses additional risks. Continued military escalation could result in a new round of strong sanctions. Under some scenarios, this could disrupt part of commodity trade or undermine the Russian government’s technical ability or willingness to ensure timely debt service.

Do note that latter bit, which alluded to the prospect that the Russian government might simply choose to default.

As a “countermeasure,” Putin’s latest decree is mostly meaningless in the face of the body blows inflicted on Russia’s financial system over the past 72 hours. The US Treasury stepped things up another notch on Monday. OFAC barred all transactions with Russia’s central bank, the country’s wealth fund and the ministry of finance, a move Treasury described as “effectively immobiliz[ing] any assets of the Central Bank of the Russian Federation held in the United States or by US persons, wherever located.”

“The unprecedented action we are taking today will significantly limit Russia’s ability to use assets to finance its destabilizing activities, and target the funds Putin and his inner circle depend on to enable his invasion of Ukraine,” Janet Yellen said. Essentially, the US has succeeded in paralyzing around half of Russia’s $630 billion in reserves.

While none of this is likely to result in any kind of mass upheaval in Russia (yet), everyday people are “starting to pay the price,” as Bloomberg’s Anthony Halpin wrote, from Moscow. “For ordinary citizens, millions of whom have already seen their wages stagnate for a decade, the unprecedented measures translate into more pain as prices of goods jump and the cost of servicing loans soars,” Halpin wrote, adding that “airspace closures mean middle-class Russians can’t travel to favorite European spots any more.”

TD on Monday wrote that “the private sector will need assistance from the CBR in sourcing hard currency,” which in turn depends on energy exports. “If Russia is able to continue to export oil and gas, the $200 billion of revenues here should be enough to cover our estimate of around $80 billion in short-term hard currency needs of the banking sector and government,” Rich Kelly and Cristian Maggio said.

They also delivered a straightforward assessment of what, exactly, the West is trying to accomplish with the measures targeting the central bank. This might be helpful for readers who’ve expressed incredulity over the last 24 hours regarding how powerful Western sanctions actually turned out to be.

“Sanctions against the central bank are meant to remove the power of the lender of last resort to intervene in two key areas  — defending the currency from depreciation and backstopping domestic banks with hard currency needed to meet foreign financial obligations,” Kelly and Maggio wrote.

So, yes, folks. The US (in this case acting in concert with the EU and UK) has the power to effectively strip a foreign central bank of its lender of last resort status vis-à-vis the capacity to protect its own currency and provide its banks with hard currency. This is what the “de-dollarization” crowd and the Kremlin propaganda didn’t tell you. The US can 1) engineer a currency crisis in an emerging market, then turn right around and 2) unilaterally impede the central bank’s capacity to stop the crisis.

That’s the reality facing Putin’s Russia. As for the country’s gold, TD noted that, “they would likely find it extremely difficult to find a counterparty willing to do a location swap with gold located in a Russian vault… leav[ing] physical delivery in a way which isn’t sanctioned as the next outlet.”

Good luck with that.