A ‘Severe Meltdown’

The headlines for Vladimir Putin’s Russia were ominous on Thursday.

“The West is trying to destroy Russia’s economy. And analysts think it could succeed,” read one. “The end of the oligarch era nears with Putin’s miscalculation in Ukraine,” said another. Still others touted the success of finance as a “weapon of war.”

Fitch and Moody’s followed S&P in cutting Russia to junk. The multi-notch downgrades were accompanied by what it was fair to call dour color on the outlook. “The scope and severity of the sanctions announced to date have gone beyond [our] initial expectations and will have material credit implications,” Moody’s said, adding that,

Severe and coordinated sanctions imposed on Russia together with its retaliatory response in recent days have materially impaired its ability to execute cross-border transactions, including for sovereign debt payments. Russia’s prohibition on transfers of foreign currency outside of the country in response to the sanctions, which appears at this stage not to apply to repayments of legacy debt, undermines Russia’s track record of willingness to service its debt and leaves debt servicing flows highly vulnerable to further intervention.

The significant concerns around Russia’s willingness to service its debt are a reflection that Russia’s institutional strength has very materially weakened with increasing evidence that the executive faces few checks and balances. This, in conjunction with the higher complexity and technical restrictions that Russia now faces to execute cross-border payments as a result of the sanctions, are commensurate with a sovereign rating no higher than B3. The imposition of severe and co-ordinated sanctions, together with the financial ramifications from the potential delays to sovereign debt repayments, raise the probability of sustained disruption to Russia’s economy and financial sector that impairs access to Russia’s financial reserves that were built to withstand adverse shocks.

You’ll pardon the lengthy excerpts. I wanted to convey the scope and severity of the problem. It’s increasingly likely that Russia will experience some manner of credit event.

In their own rationale, Fitch said “the severity of international sanctions in response to Russia’s military invasion of Ukraine has heightened macro-financial stability risks, represents a huge shock to Russia’s credit fundamentals and could undermine its willingness to service government debt.”

Fitch continued, noting that recent developments “will weaken Russia’s external and public finances, severely constrain its financing flexibility, markedly reduce trend GDP growth and elevate domestic and geopolitical risk and uncertainty.” They also noted that “President Putin’s response to put nuclear forces on high alert appears to diminish the prospect of him changing course on Ukraine to the degree required to reverse rapidly tightening sanctions.”

Read more: Russia Risks Default As Financial System Paralyzed

The media is no longer mincing words or dancing around the issue. “With decades of integration into the global financial system snuffed out in days, Russia is now at risk of its first debt default since 1998,” Bloomberg wrote Thursday, calling the financial and economic situation a “severe meltdown” that may already be beyond repair. It’s possible, the linked piece suggested, that Moscow won’t have any motivation to service its debt. That general sentiment pervaded the assessments from Moody’s and Fitch.

To say uncertainty is high would be an understatement. There’s no telling how long it would take for Russia to confirm or deny a default and apparently, it’s not even clear whether some OFZs have the standard 30-day grace periods, although one assumes holders of ~$30 billion in local bonds have at least a vague conception of what’s in the fine print.

As for regular people in Russia, the situation is deteriorating. Media reports described a kind of fatalistic despondency. Not panic, exactly. Just resignation. The initial bank run totaled around $14 billion (figure below) according to the Bank of Russia.

Needless to say, hiking rates to 20% and imposing capital controls isn’t anyone’s idea of a “solution.” The solution, in this case, is to cease and desist from attempting to forcibly seize Ukraine.

Russia’s economy is smaller than Italy’s. People are fond of making comparisons to China while attempting to make the “resiliency” case for Putin. China’s economy is 10 times the size of Russia’s. And China prints a kinda/sorta reserve currency (for lack of a better way to describe the yuan during its ongoing internationalization phase).

The idea that Putin can somehow inoculate Russians from a global effort to engineer hyperinflation and a deep recession is (forgive me) laughable. Imports are restricted, FX pass-through inflation is likely to be brutal and, in an ominous sign, the country’s largest food retailer said it’s stockpiling months of staple items. The co-founder of Data Insight, which describes itself as the first Russian research agency specializing in the e-commerce market, told Bloomberg that prices for electronics and other imports are up as much as 30% in the space of a single week.

Some Russian banks are offering huge interest rates for ruble deposits, and APYs on dollar deposits that are around 16 times the highest rate an American depositor could receive in one of those online savings accounts. Again: That kind of thing isn’t a sign of “resilience.” It’s a sign of desperation.

Why anyone has to keep saying as much is beyond me, but the likes of Ray Dalio continue to insist that because people in Russia (and China) are used to suffering, they can triumph over the West — or at least in a hot war. “Those who are most likely to win hot wars aren’t the most powerful,” Dalio wrote this week. “They are the ones who can endure the most pain for the longest amount of time [and] in this regard the Russians and the Chinese are stronger than the Westerners.”

Maybe, Ray, but this isn’t a hot war yet. It is in Ukraine. And so far, the Ukrainians seem to be more adept at enduring suffering than their invaders. As for financial sanctions, nobody wants to see the value of the money they have depreciate by 30% overnight. It isn’t a matter of anyone’s capacity to endure suffering. It’s a matter of extreme irritation and, if it doesn’t abate, anger. And not directed at any Western nations, either. But at the country’s leaders. You can’t have hyperinflation. You just can’t. Either people will revolt or else the country will backslide into frontier market status. Dalio should know that.

MSCI and FTSE decided to boot Russian stocks from their indexes late Wednesday. MSCI called them “uninvestable” and will remove them from key EM benchmarks next week. FTSE Russell will delete Moscow-listed equities in its indexes at zero on March 7. The London Stock Exchange suspended all Russian depositary receipts.

Meanwhile, Volodymyr Zelenskiy effectively advised Putin to cut his losses. “Go home,” he told the Russian troops attacking his country.