abrdn: Russia default hits pensions and portfolios worldwide

April 13, 2022

By Andrew Stanners, Investment Director, abrdn

As the Russian invasion of Ukraine continues, Russia is now at serious risk of defaulting on its debt.

It’s been 24 years since the country’s last rouble-based default, which triggered a crisis that shocked the financial world. The rouble collapsed, inflation in Russia hit 86% and more broadly, the default contributed to the failure of a number of highly-leveraged hedge funds. Perhaps most significantly though, the crisis also ushered in the resignation of Boris Yeltsin and the succession of his prime minister, Vladimir Putin.

As the Russian invasion of Ukraine continues, Russia is now at serious risk of defaulting on its debt. It’s been 24 years since the country’s last rouble-based default, which triggered a crisis that shocked the financial world. The rouble collapsed, inflation in Russia hit 86% and more broadly, the default contributed to the failure of a number of highly-leveraged hedge funds. Perhaps most significantly though, the crisis also ushered in the resignation of Boris Yeltsin and the succession of his prime minister, Vladimir Putin.

The sanctions imposed on Russia over the invasion of Ukraine risk not only a rouble-based default, but also a foreign-currency default. The last time this happened was in 1917, when the new Bolshevik government was refusing to accept responsibility for the tzar’s debts. Before the Ukraine conflict, Russia was an investment grade country with low debt and high gold reserves. As such, a default will undoubtedly impact pensions and portfolios around the globe. It will also lock Russia out of financial markets and push the country into a deep recession and likely economic crisis.

Corporate debt defaults might have an even bigger impact than government debt defaults. Sanctions are tightening with international reserves being the main target. There’s an increasingly restrictive stance on bond payments from any Russian reserves held at American banks and sanctions are preventing Russian companies making payments of coupons to bondholders.

Indeed, the UK foreign secretary claimed recently that Russia can no longer access 60% of its enormous $604bn in foreign currency reserves. There is still some way to go to fully restrain the Russian economy especially with the complexity in disentangling Europe’s oil and gas relationship, but be in no doubt, if the conflict continues, the technical challenges for Russian companies and the sovereign to pay bondholders will be extremely high. Indeed, rating agencies such as S&P have foreign and local currency ratings at CC “high vulnerability” to debt non-payment.

Looking back to 1998, the Russian economy, reeling from war in Chechnya and the 1997 Asia crisis, was unable to stave off huge capital flight and rising debts, despite the help of the IMF and the World Bank. The government tried a limited devaluation of the rouble but this led to loss of confidence and a full-scale devaluation. Inflation quickly rose to 28% in 1998, then 86% the next year, leading to social unrest. It was a rise in the global oil price that helped Russia to recover. The default had a considerable ripple effect across emerging markets leaving many investors reluctant to embrace such a volatile asset class.

A great deal has happened in the emerging-debt universe since then: the number of eligible countries has expanded; indices have been introduced for local currency sovereigns, emerging corporate bonds, frontier markets and ESG. The success of the EM debt asset class post-1998 was really built around its attractive yields and its low correlation to risk markets.

From the early 2000s through to 2008, this was an asset class that performed year after year, but was still perceived as risky and as such, was under owned by most asset allocators. Its low correlation to mainstream risk markets made it an attractive diversification tool. The Global Financial Crisis of 2008 and the subsequent demand for yield was what pushed EM debt into the mainstream.

There’s no doubt that the return of a Russian debt crisis, 24 years later, should be a wake-up call for investors of the asset class. With the interconnectivity of global economies, EM debt cannot continue to be viewed as a niche, uncorrelated asset class in a portfolio. Recognising this, a small number of investment houses have started to adapt, as the lessons and experience in how to manage risk in highly correlated developed markets is starting to feed through to EM.

Total return strategies aim to maximise the attractive yield and returns the asset class can offer, but also to reduce the associated risk and volatility that comes with it. Free from the shackles of benchmarks, these strategies are able to use different techniques to dampen asset class risk. The pioneers of credit default swaps in Russia could have had little idea that 24 years later, these would help total return EM debt strategies to protect clients’ assets against default risk.

The future of this conflict remains unclear, but the financial costs will be considerable. Sanctions are notoriously difficult to roll-back, so it seems likely that Russia will remain excluded in part from the global economy for some time to come. Ukraine will also face considerable challenges to rebuild post conflict, with estimates from the Ukraine prime minister Denis Shmygal in March at $565bn, at the same time as managing its own debt responsibilities.

On the face of it, with the prospect of a new Russian default, history might seem to be repeating itself, but the innovation of total return strategies within EM means past performance may not necessarily be repeated.