What happens if Russia defaults?

Well down the list of things to worry about as the ghastly Ukrainian tragedy unfolds is the high probability that the Russian government will stop paying its international debts. But this risk should certainly be somewhere on that list – as the fallout from past defaults has shown.

We have been here several times before. Moscow also defaulted on its debt in 1998, exacerbating a sell-off across all emerging markets. It led to the collapse of a huge US hedge fund, Long-Term Capital Management, which had to be bailed out to prevent a worldwide meltdown. This came too late to save many other investors from large losses. Ten years later, apparently isolated problems in the US mortgage market did cause a global financial crisis. For LTCM read Lehman Brothers, which was allowed to fail. If it hadn’t been Lehman’s, it might just have been someone else.

Rolling on to today, a Russian default is almost inevitable. A large amount of Moscow’s debt is financed by bonds issued in US dollars and the country is finding it much harder to access foreign currency. This could come to a head as early as Wednesday, when Russia is due to pay $117 million in interest on a tranche of dollar-denominated ‘eurobonds’.

The authorities surely still have enough cash to cover this payment, if they want to. A default might be seen as a sign of weakness and a blow to national prestige. Nonetheless, Moscow may still decide not to make the payment as retaliation for western sanctions. Or it might choose to pay in heavily-devalued rubles, which would be a technical default. Indeed, Moscow has already failed to make payments to foreign holders of local-currency bonds.

So, how worried should we be? There are many good reasons to think that a Russian default on international debt would not be a big deal, and the contagion should be limited.

For a start, Russia doesn’t actually have much debt of any type, thanks to years of huge energy surpluses. Prior to the invasion of Ukraine, annual government borrowing and the stock of debt were both relatively low (gross government debt was less than 20 per cent of national income).

According to data from the Bank for International Settlements, the total exposure of foreign banks to Russian entities was estimated at around $105 billion late last year. That might sound like a lot, but in the context of the global financial system, it really isn’t. This only represents about 0.1 per cent of the total assets of reporting banks.

What’s more, the UK’s direct exposure to Russian financial institutions is much smaller than many EU members – notably France, Italy and Austria.

A Russian default would hardly be a surprise, either. Government debt has already been downgraded to ‘junk’ status by international rating agencies and sizeable losses have been priced in. If Moscow does default on its bonds, it would simply be catching up with the reality visible for all to see in the Russian equity and currency markets.

Many western companies have already written off a large part of their investments in Russia, too. The world’s largest asset manager, BlackRock has taken a $17 billion hit, though this is just a drop in the ocean of its total global assets (more than $11 trillion).

BP might have to write down as much as $25 billion following its decision to dump its holdings in the Russian energy company Rosneft. But even this hasn’t made much of a dent in BP’s share price.

The global financial system is also in better shape than in 2008, partly because the global financial crisis itself has led institutions, rating agencies and regulators to take a more cautious approach. Last but not least, the degree of exposure to Russia is generally well-known, and central banks still have some firepower left to limit any collateral damage.

And yet, one lesson from past crises is that, in an ever more interconnected world, ripples in what might appear to be one small pond can cause a tsunami of losses in unexpected places. Even where direct exposure to Russia is low, a sustained period of risk aversion could prompt a flight out of all emerging markets – and some more developed ones too.

Managers could be forced to sell ‘good’ assets as well as bad, in order to reduce risk and cover redemptions. Investors might also start to rethink their exposure to much better credits – such as Chinese government bonds – for fear these might be next.

In short, a Russian default should be just another small part of this ongoing story, and there is no obvious reason why it would trigger another global financial crisis. However, similar arguments have been made before...