As Russia is cut off from international trade and financial markets, its sovereign debt seems increasingly risky. What impact could a Russian default have on the US economy and financial institutions?
Key Points
Russian debt owed abroad was $490 billion at the start of 2022
Russia's partial default in 1998 sparked a crash in US equities and required Federal Reserve intervention on behalf of the era's largest hedge fund, Long Term Capital Management.
Similar risks could exist today from levered funds, as evidenced by the fallout from Archegos' collapse in March 2021.
Despite a vice-grip from sanctions squeezing nearly all Russian finance out of global markets, investors in USD-denominated Russian sovereign debt have reported coupon payments scheduled for March 16 are trickling into their accounts at Western banks. Many have taken this as a sign that even in the face of near complete economic and financial isolation Russia’s external liabilities are not a cause for concern, and foreign-denominated Russian bonds which had been trading at 20% of par have more than doubled in value since. But this optimism is misplaced, as these commentators are ignoring the ripple effects that a default or late payment could have across international markets, despite being contained to a relatively modest asset pool (outstanding Russian debt owed abroad was $490 billion at the end of 2021).
A Russian default has shaken US markets in the (not so distant) past
There is a historical parallel in Russia’s 1998 partial default, which sparked a crash in US equities and forced the Federal Reserve to organize the rescue of the era’s largest hedge fund, Long Term Capital Management. Then, as now, the Ruble had depreciated violently (dropping 65% against the dollar from August to September 1998 cf. 50% from February to March 2022), FX reserves were unavailable for bond repayments (they’d been spent on stabilizing the Ruble), and the nature and scope of risk was unclear. In late September it emerged that LTCM had massive leveraged exposure not just to Russian sovereign debt but also in related derivatives positions, potentially landing their bank creditors with enormous losses. To avert a potentially “systemic collapse” the New York Fed convened a bank consortium to bail out the fund. As word of the crisis spread markets reeled, with the yield curve inverting, the S&P 500 dropping 15%, and small- and mid-cap US equities dropping 25%.
There are reasons to believe similar risks are latent in the financial system
Key to righting the market and stabilizing the economy was the Fed’s ability to cut rates three times between September and November 1998, from 5.5% to 4.75%. With US inflation soaring to nearly 8% in February, and the Fed’s target policy rate still at just 0.5%, there simply isn’t policy room to respond the same way. And as recently as last year we witnessed an eerily similar scenario: a large, opaque private fund roiling markets and causing huge losses for bank creditors. Like LTCM, Archegos Capital Management was able to secure high degrees of leverage from their prime brokers and engage in aggressive derivatives trading with little or no supervision or disclosure requirements. Like LTCM, the fund’s bank counterparties couldn’t effectively risk-manage their exposures to Archegos because they could only see their bilateral positions, not the fund’s aggregate risk profile. When its bets on a range of US and Chinese stocks soured in March 2021, creditor banks were again on the hook, losing over $10 billion and suffering double digit stock declines.
Strain from a Russian default could spread to the corporate sector and real economy
The impact of Archegos’ collapse ultimately fell short of systemic importance, but it shows that market structures are still in place which allow for the buildup of risks that could be transmitted to the real economy. The revelation that a large fund with leveraged Russia-linked exposures was under strain could produce another crash in equities and spike in risk premia. This would result in a sharp rise in corporates’ cost of capital, jeopardizing their dynamism in a rapidly changing operational landscape. To mitigate this risk, companies with a thin cash buffer could consider a preemptive capital raise while capital markets are relatively benign.
Alternatively, the triggering of a rash of credit default swaps could put an insurer under strain. Estimates put outstanding CDS tied to Russian debt at $40 billion – it cost the Fed $85 billion to stabilize AIG in 2008 when its CDS issuances triggered en masse. Such strain in insurance markets could lead to steep increases in companies’ premiums across insurance products. To mitigate this risk, companies could consider options for locking in existing premiums for extended terms or negotiated pre-payment of premium obligations. While experts are largely ignoring these scenarios, dismissing risk from Russia’s foreign liabilities could be costly for businesses.