The war between Ukraine and Russia shows no signs of ending soon with Russia trying to strategically invade city after city after some early setbacks and Ukraine holding on to its fort with external support. The world is in an inflation mode but none of it seems to bother Russia. Its internal economy is in shambles with double-digit inflation and the worst economic crisis in years but nothing seems to deter its resolution to occupy Ukraine at all costs. The latest news coming in is of the Russian debt default.

Where it all started…

As soon as Russia positioned its troops on the Ukrainian border and started invading this country, the West started imposing sanctions on Russia restricting it from dealing in international trade and currency in order to cut it off from the global economy. Russia has over $600 billion worth of foreign currency and gold reserves and almost half of them are held overseas. The U.S initially allowed Russia to repurpose the funds kept in its American banks to pay off its sovereign debt obligations. But on 4 April, even this was stopped completely freezing its assets.

This was stopped completely freezing its assets.

Russia has 15 international bonds outstanding with a face value of over $40billion. In May this year, Russia was to pay coupons or interest, and payments with a combined value of over $100 million to bondholders on the two bonds denominated in dollars and euros issued by the government in 2013. Like many international bonds, it had a 30-day grace period and Russia had time until 26 June to make the payment. It sorted part of the payment through temporary procedures but some of the payment was still pending. Russia tried to pay its bondholders in dollars from its American bank reserves but was stopped by the U.S treasury department’s office of foreign assets control (OFAC) as a part of the war sanctions. The payments or the coupon haven’t yet reached the stakeholders within the grace period. This could possibly trigger a declaration of Russia having defaulted on its foreign currency debt.

Note: A further $2 billion in payments is due before this year-end. But thankfully for Russia, some of these bond contracts allow Russia to pay back in rubles or other currencies.

It’s not that Russia doesn’t have the money to repay, but it cannot convert it into dollars due to international sanctions. The Russian finance ministry said it would pay the dollar-denominated debts in rubles and offer an opportunity for subsequent conversion into dollars. But bondholders will not take the risk of accepting it in rubles and then converting it into dollars fearing a U.S secondary sanction on their financial activities.

Russia tried to service these external debts by allowing bondholders to open hard currency accounts in Russian banks in order to receive payments. The money would be channeled through Russia’s National Settlement Depository (NSD) which was not subject to sanctions by the U.S. However, in a swift move, the European Union imposed sanctions on the NSD further complicating matters for Russia. Furthermore, none of these expired bonds have terms that allow for settlement in local currency. And you can expect intensified sanctions in the coming days with Russia hampering and not honoring the terms and conditions of its obligations to foreign debt holders.

If you can recall, the last time Russia faced such a debt default situation was a century ago, in 1917, during the Bolshevik Revolution when the Russian Empire collapsed and the Soviet Union was created. Again in the 1990s, Russia defaulted on domestic debts but was able to recover through international aid.

Russia has announced that the West is trying to artificially manufacture this “force majeure” situation as it already has the money and also the readiness to pay but the West is stopping the bondholders from getting the money due to sanctions.

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When is the non-repayment of debt considered a default?

A formal default declaration has to come from a rating firm. But the U.S and European sanctions have led to Moody’s and other assessment firms withdrawing ratings on Russian entities. forward your text, images, or videos to anyone in your contact list.

Another possibility is if 25% of the outstanding bondholders agree that an “Event of Default” has occurred (as per the bond contract). If this occurs, then all other Russia’s foreign bonds go into the default mode as per the bond provision. The bondholders could then go to court to enforce payment.

Bondholders, who hold credit default swaps that act as insurance policies against default, can take the help of a committee consisting of financial firm representatives to determine if the failure to pay the debt can trigger a payout. But again, this isn’t a formal declaration of default.

The Credit Default Determination Committee, a group of banks and investment funds, told that Russia failed to pay the additional interest after making the payment but didn’t take any further action as it didn’t want to jeopardize any settlement plans.

The bondholders and the Russian government can negotiate a settlement where the bondholders get new bonds worth less than the original but at least a comparable compensation. But it is possible only when the war ends and the sanctions are lifted. By then, what the worth of these defaulted bonds will be is a question mark.

Even though the grace period has ended on 26 June, it might still take time to confirm a debt default by Russia.

How will the debt default impact the Russian economy?

If considered a default, it will have a significant impact on Russia’s ratings and market access to finance for the future. After its 1917 default, it took a long time for Russia to have access to international loans. Though this is different and it will not have the same intensity of repercussions, Russia can come out of its default if the U.S Treasury gives a nod for the bondholders to negotiate terms with the Russian creditors.

When a country is declared that it has defaulted on payments, it can be cut off from the bond-market borrowing until the default and even any legal cases stemming from it are sorted. But it again depends on the government’s ability to pay (Russia has demonstrated its willingness to clear the debt) and the investors’ confidence to reinvest in government bonds.

So far, Russia has managed to implement financial controls over its oil exports. It imposed that countries wanting oil and energy from it have to pay currency in rubles thus supporting the currency from a spiraling collapse. But European countries have already started looking for alternatives and this diversification from Russian energy and commodities will mean a collapse in export receipts in two to three years.

Even if the war ends or there is a ceasefire, no investors will be ready to lend their capital to Russia. Hence, Russia’s access to international financing will remain limited and even if available, will be at higher interest rates. If Russia looks at China as an alternative source of financing other than the West, it will still have a tough negotiation ahead with banks reluctant to look beyond the default headlines.

With no financial help in sight, Russia’s economic growth looks bleak. When lending to Russia becomes difficult, it will attract lesser investments and lower growth leading to a decline in the Russian economy.

Meanwhile, much of Russia’s military has been destroyed and Putin will need to divert more funds to rebuild the army. When the war ends, whatever the result, Russia may have to regret having entered the warzone with a collapse in the economy and a decline in its popularity. Already, Russia is treated as an economic, financial, and political pariah. The default may not impact the Russian economy immediately but will make its recovery much more difficult in the long run.