If Russia Pays Its Debt In Rubles, Is It Still A Default?

Among the many economic sanctions imposed on Russia by the U.S. is a ban on dollar payments through the global payments system and a freeze on the assets of the Central Bank of Russia.

That sounds draconian (it is) and possibly even effective (it isn’t), but it begs the question of who bears the loss. If I’m a debtor and you tell me I’m not allowed to pay my debts, I might say, “Thank you, that’s a relief.”

In those circumstances, the loser is not the debtor. It’s the creditor who was expecting to be paid and now finds that’s impossible.

Russia has about $100 to $150 billion of dollar-denominated debt, about half of which is owned by investors outside of Russia. If only part of that defaults, it could be $50 billion or more in direct financial losses to ETFs, mutual funds, and even smallholders in 401(k)s who may not know what’s inside the products that Wall Street cooks up.

Mega-asset manager BlackRock has already lost $17 billion of its investors’ money with bad Russian stock and bond bets, as explained in this article. Still, Russia is trying to pay.

The head of the Central Bank of Russia is Elvira Nabiullina, who is one of the smartest central bankers in the world and perhaps the only one who understands how to do her job. As reported in this article, she is trying to pay the debt in rubles even if she is not allowed to pay in dollars. Despite the sanctions, she still controls Russia’s ruble printing press and could create enough money to pay the debt.

Still, if this ruble workaround does not work, we are looking at massive losses for Western investors. The damage does not stop there. In addition to outright bondholders, there are billions of dollars of derivatives that track the bonds as well as credit default swaps that pay the holder if the bonds default.

This means that actual losses can be many times the losses on the bonds themselves. This is exactly what happened in the subprime mortgage crisis in 2008. There were about $1 trillion in subprime mortgages at the time. A 20% default rate, which is sky-high compared to usual default rates of less than 5%, implied $200 billion in losses.

That’s a huge loss, but manageable in the financial system. What most analysts missed is that there were $6 trillion of derivatives written on the $1 trillion of subprime mortgages. This meant that actual losses were more on the order of $1.2 trillion than $200 billion once derivatives were taken into account.

Something similar is at play with regard to Russian bonds. There is some ambiguity about whether a ruble payment on a dollar-denominated bond is a default; (probably, yes).

The exact identities of the holders and the scope of derivatives are almost completely opaque. No one really knows how far the financial distress may spread. The best advice is to expect the unexpected.

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