Russian Default: Fool Me Twice…

Rating agencies have downgraded Russia’s debt to junk status, and Russia has issued its latest coupon payment on dollar-denominated bonds in rubles. Should Russia default on its sovereign debt, can we expect contagion throughout emerging markets similar to that seen after the Russian crisis in 1998? Beyond former Soviet republics whose economies are closely linked to Russia’s, which countries’ sovereign and corporate debt would be most vulnerable?

Contagion to a Russian debt default would likely be limited as it has been well-signaled, Russian outstanding debt volumes are moderate, and overall contagion risk to individual country details have waned. The most vulnerable countries are those who themselves have weak balance sheets and are suffering from rising food and fuel prices – these include some frontier markets in Sub-Saharan Africa, and North African countries like Egypt (though GCC support may partly offset this). Overall, rather than default, the externalities of the war (rising food and fuel prices) and Fed normalization are the bigger risks to EM debt sustainability. These will be a source of differentiation, with commodity exporters like Brazil outperforming importers like Turkey.

Russia need not default on its debt. It can simply pledge to allocate interest payments to an escrow account and commit to bond holders these payments after sanctions are lifted and it is allowed to pay. This isn’t a true insolvency, as it is not an inability to pay, but rather a technicality preventing payment. There are no similarities to the 1998s default, as that period was the world’s first experience holding Russian debt, and it took place during a market phase where many global bond investors raised allocations to EM debt for the first time, and their allocation to Russia was a misunderstanding of the economic fundamentals post-Soviet collapse and privatization. Therefore, the unexpected default led to greater contagion. EM portfolios holding Russian debt now are mature hands.

Most emerging markets are susceptible to capital outflows due to their increased governmentindebtedness relative to the pre-COVID era and the upcoming interest rate hikes in the US. But the Russian downgrade and highly likely upcoming default is unlikely to trigger a contagion throughout emerging markets similar to the 1998 crisis. First and foremost, Russian decoupling from world markets is a truly unprecedented and idiosyncratic event. Russia has the reserves to pay all its debt. It is not about its “capability”, it is about its “ability” to make those payments. Beyond former Soviet Republics, the countries that are most vulnerable to Russian trade, Russian contracts, and Russian tourists are Turkey, Hungary, Baltic Countries (Latvia, Lithuania and Estonia), and secondarily Czech Republic..