Risk of huge US$150 billion Russian debt default with consequences for investments in China...

Christopher Joye

Coolabah Capital

Russia is on the cusp of defaulting on up to US$150 billion of foreign currency debt it owes global investors, including many large Western institutions, in what could become one of the biggest emerging market defaults in history. And if China consents to reports of Russian requests of military support for its invasion of Ukraine, the Middle Kingdom would almost certainly be slapped with similarly harsh global sanctions. Our central case remains that a heavily chastened Vladimir Putin will seek a negotiated off-ramp, or exit, from the Ukraine crisis in the coming months, with the risk skewed to him agreeing to a deal in the very near term (ie, in days or weeks). 

According to the FT, China has signalled its willingness to provide weapons to Russia, which beggars belief: this would only further reinforce the profound economic ostracisation, or decoupling, China has suffered in response to its relentless efforts to force the liberal-democratic world to bend to its Communist will under President Xi's zealously ideological leadership. Back in June 2020 we predicted that Chinese decoupling from the West was set to markedly intensify.

Last year we repeatedly advised investors that they should adopt our unique "democratic criterion" as part of their ESG overlays, which prevents us from allocating any capital to non-democratic states like Russia and China. We explicitly warned the NSW government that it should immediately stop lending hundreds of millions of taxpayer dollars to Russia and China because doing so failed this important ESG test. 

This is not just a moral or ethical issue: it should be patently obvious that if you cannot have confidence in the rule of law, property rights, and the enforceability of contracts in countries run by despots and dictators, then you cannot invest in equity or debt instruments issued by them (or by companies based in these nations).

Global markets clearly have had large lazy longs in Russia and China because assets located in these regions appear superficially cheap. But is impossible to monetise these opportunities when the country in question unilaterally appropriates your assets, bans investors from exiting, as both Russia and China have done (in 2015 in China's case), and/or Western states force you to dispose of these assets at precisely the time that there is no durable bid for them.

Scores of large offshore and local institutional investors are presumably sweating on their horrific Russian losses and wondering which country could be next. Well, if President Xi does indeed attempt to forcibly unify with a resistant Taiwan, as he has promised during his term in office, we will see the West applying exactly the same playbook, albeit with even greater force. The West has arguably much more at stake with Taiwan.

This is starting to precipitate an exodus of capital out of China as the uninvestable nature of non-democratic states dawns on investors (witness the enormous decline in Chinese tech stocks and huge increases in credit spreads on Chinese bonds).

Russian default looms

About US$117 million in interest is due on Russian US dollar bonds on Wednesday, which Russia says it will can only pay in roubles due to the impact of global sanctions. Failing to service this debt in US dollars will trigger 30 day default timetables on bonds issued by the Russian state and oligarch-controlled companies such as Gazprom, Lukoil and Sberbank. Bloomberg reports:

Signs of looming financial damage are becoming apparent at many of the world's biggest money managers, including BlackRock Inc. and Pacific Investment Management Co. But it’s not likely to be limited to these giant funds. Because much of Russia’s debt was rated investment grade just weeks ago, the securities were pervasive across global fixed-income portfolios and benchmarks, meaning the impact could ripple across pension funds, endowments and foundations.
“This will be a monumental default,” said Jonathan Prin, a portfolio manager at Greylock Capital Associates. “In dollar terms, it will be the most impactful emerging-market default since Argentina’s. In terms of broader market impact, it’s probably the most broadly felt emerging-market default since Russia itself in 1998"...

While many Russian bonds were trading above 100 cents in the dollar before the invasion, they have since lost as much as 80% of their value with credit default swap markets implying a circa 70% chance of default. Some rating agencies believe a default is imminent. Bloomberg continues:

Russia’s late-1990s default was on domestic debt, so a foreign-currency default would be the first since the aftermath of the 1917 Revolution, when the Bolsheviks refused to recognize the czar’s debts.
At Franklin Resources Inc., one fund marked down its Russia bond holdings by more than half to $194 million as of Feb. 28. BlackRock funds exposed to Russia fell by more than 90% after the invasion, and clients now have less than $1 billion invested, down from about $18 billion at the end of January. The decline probably reflects a range of factors, from writedowns to client redemptions since the war began.
Others with major exposure to Russia include Ashmore Group, an emerging-markets specialist, while Capital Group and Fidelity are among the top holders of Russia’s dollar bonds, according to data compiled by Bloomberg.
About $120 billion of the current outstanding government and company debt is denominated in dollars, with the bulk of the remainder in euros, according to data compiled by Bloomberg. Roughly $25 billion was issued by Gazprom, the state-owned natural-gas giant.
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Christopher Joye
Portfolio Manager & Chief Investment Officer
Coolabah Capital

Chris co-founded Coolabah in 2011, which today runs over $8 billion with a team of 26 executives focussed on generating credit alpha from mispricings across fixed-income markets. In 2019, Chris was selected as one of FE fundinfo’s Top 10 “Alpha...

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