Russia Watch: Violent conflict in Ukraine ... default delayed for now — why?

Further hardening rather than easing signals dominate in the Ukraine war. In the economic sphere Russia is still trying not (yet) to be forced into a (technical) default (for corporate bonds technical defaults on external debts are mounting) — preserving a minimum degree of economic rationality. Meanwhile, an ultra-strong RUB can be sold as a policy success domestically. We remain on alert regarding further (Western) steps of "economic warfare" ahead (e.g. asset seizures, enforced external sovereign default).

Creeping further hardening and preparation of further escalation steps

Currently, all indications are pointing to a further hardening of positions in war in Ukraine on the ground as well as in regard to the geopolitical positioning in the background and in the days and weeks to come. Meanwhile, we see preparations for additional steps of "economic warfare".

  • Diplomatic/peace talks between Russia and Ukraine got completely off track in recent days with no indication for a further continuation near terms. Ukraine remains committed to diplomacy on a Presidential level only. The fate of the Azov Steelworks fighters remains unclear, but they are more likely to face war crimes tribunals in the occupied territories or in Russia than a mere prisoner exchange.
  • In eastern Ukraine, it looks like Russia now wants to achieve further military sub-goals with all its vehemence and determination. Following the ultimate capture of Mariupol local territorial gains are taking place in Eastern Ukraine. A certain lack of speed should not obscure from the fact that, according to official indications (such that of the Russian Defense Minister) Russia is setting itself up for a long conflict despite unprecedented pressure of sanctions. Meanwhile, it seems that the military strategy of Russia in other parts of Ukraine also aims at destroying key economic infrastructure and facilities. Moreover, there are indications that Russia (despite current official denials) may prepare for further votings on joining Russia or recognition of new People's Republics either on Ukraine territory and/or in other occupied territories (e.g. South Ossetia).
  • At the same time, the conflict or polarization between the West and Russia continues to intensify. Russia is currently even being actively accused by the West of deliberately causing a global hunger, poverty and refugee crisis ("using food supplies as a weapon" like with energy). Russia blames the West and its sanctions policy for the emerging global food and poverty crisis, while the West probably also wants to support Ukraine with weapons systems (e.g. anti-ship missiles) that could help break the naval blockade. At the same time, further logistical support for Ukraine is being worked on. The EU is (still) calling on Russia to engage in dialogue on these issues and unlocking Ukrainian food exports. An escort of cargo vessels by Western navies could lead to direct conflicts with Russia. Moreover, the last few days have again brought clear signals of diplomatic support for Russia by China (see, for example, joint military drills in Asia in the middle of US diplomatic activities there).
  • Within the EU, public calls for the confiscation of frozen Russian state and private assets are gaining significant momentum in policy circles. Some EU countries (the three Baltic countries plus Slovakia) are currently actively advocating for such a move, while European Commission Chief von der Leyen confirmed the EU is looking at making use of frozen Russian assets (CBR assets & private assets). Legislative measures are also being prepared currently (at least for private assets), while some EU officials remain highly cautious on confiscating Russian state assets.
  • Meanwhile, the EU has not managed to agree on an embargo on Russian oil yet, while this was possibly the assumption on behalf of Russia. It remains to be seen whether the EU will manage to broker a political solution in the coming days or if single EU countries will move on their own going forward.

The Ruble Conundrum - a sign of strength?

In some ways, Russia can claim (supposed) success on financial markets. The USD/RUB exchange rate has even broken through the 60 mark to the south on the local market in recent days, trading much stronger compared to pre-war times. The local currency remains supported by FX market restrictions and enforced conversion. Moreover, short-term market technicals like tax payments and conversion of payments for gas into RUB also play a role. Therefore, the RUB is among the best performing global (EM) currencies in turbulent markets YTD (currently leading the pack), while the analyst community (incl. us) do see the fundamental value at much lower levels. However, capital controls and dysfunctional markets are not supporting any (short selling) positioning against the RUB. Therefore, the exchange rate continues to trade at ultra-strong levels, while sovereign and corporate default topics do remain with investors (see next paragraph). Currently, the RUB might be already at too strong levels from a local perspective as indicated by the decrease of mandatory FX sales for exporters in recent days.

Exchange rates vs. USD (%, YTD)
Refinitiv, RBI/Raiffeisen Research

Russian sovereign default – a rehash of the topic or material change?

Since the launch of sweeping Western financial sanctions Russia has been seen already few times on a cusp of an external (technial) sovereign default, though so far making good on foreign obligations. This week, however, sees another landmark change in the sanction landscape as the U.S. Treasury is said to not roll over the special waiver (license) allowing the Russian FinMin to service external debt, hence making the technical default a matter of time. A non-renewal was decided, possibly also because Russia was probably too optimistic and pronounced that the USA would not "dare" to take this step. Perhaps minding that the license expires on 25 May, the Russian FinMin took care of the two Eurobond coupons worth ~USD 100 mn (2026 USD and 2036 EUR) falling due on 27 May already last week.

Respectively, a formal non-payment might not occur as yet, though few nuances should be noted. Both Eurobonds in question were issued through the domestic financial infrastructure and bear "RU" ISINs. This means the funds are distributed via the National Settlement Depository (NSD), which makes it less clear how smooth can be the transfer to foreign investors given the sanctions-driven disconnect between NSD and Euroclear/Clearstream. At the same time, both issues may be serviced in "alternative currencies" (EUR, GBP, CHF — for the 2026 bond; USD, GBP, CHF or RUB — for the 2036 bond) if principal or interest cannot be paid in the originally agreed currency for “reasons beyond control” of the Russian government. In fact, almost 70% of Russia’s sovereign Eurobonds outstanding (by principal amount) are equipped with the “alternative payment currency” clause, where around a half contain an option to pay in RUB (including for all EUR-denominated issues).

RU Eurobond payments due in 2022*
* in USD mn equivalent for sovereign issues; Source: Refinitiv, RBI/Raiffeisen Research
RU Eurobonds outstanding*
* principal amount for sovereign issues; Source: Refinitiv, RBI/Raiffeisen Research

In other words, with the OFAC waiver expiring, the risk of a missing payments for foreign creditors is disproportionately higher on Russia’s plain vanilla dollar bonds (no legal option to pay in RUB), where the nearest coupons are due in June (~USD 400 mn) having also a formal 30-day grace period on top. Having said that, we do not expect the Russian government to declare bankruptcy — rather, in case of technical (compliance) issues with money transfers it would pay in roubles and on local NSD accounts regardless of the bond documentation, i.e. in line with the established counter-sanctions regulation. A payout of the credit protection would be the base case here, however further litigation strategies for creditors might prove limited in the current sanctions environment given also additional challenges related to sovereign immunities.

A lack of creditors' initiative to claim bond payments we also see in the corporate universe where already about twenty Russian companies have fallen overdue with their Eurobond coupons because of the sanctions-driven restrictions since March. In total, these embrace around USD 14 bn of bonds principal amount that is now in technical default but prompting no legal action by creditors that we would be aware of. We note that the issuers' strategy varies here, as some companies pay in roubles (e.g. Sber, VTB, VEB) while others apply for an exemption (license) that would allow them transacting in hard currencies for the purpose of debt service (none has been granted so far to our knowledge).

All in all, it seems that at some point in time in the coming months Russia cannot avoid a "default" label being pretty much forced into a technical non-payment event. One may question the rationale of this move from the U.S. side, since it does not change much Russia's (locked-out) position on the international financial market while scrapping a legit tool to deplete its fresh FX revenues and putting U.S. holders of Russian debt in the line of fire. However, this will still count as a strong political statement and escalation in the sanctions pressure. From the Russian side, it seems rational to delay this step as long as possible, as it could certainly entail some imponderables (such as how non-sanctioning countries can act with Russia). However, we remain skeptical that in a few weeks or months the circumstances will be such that a technical (external) state default — induced by Western sanctions — can really be avoided.

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Gunter Deuber is heading the Economics and Financial Analysis division (Raiffeisen Research) at Raiffeisen Bank International (RBI) since 1 January 2021. Since 2011, Gunter Deuber has held leading positions in RBI's Economic and CEE Research and has continuously expanded the cooperation with his research colleagues in RBI’s subsidiary banks in CEE. Since the early 2000s, he has been analysing economies, banking sectors and market topics with a focus on CEE and EU/euro area topics for RBI in Vienna, but also in the international (investment) banking context in Frankfurt. He regularly presents the views of Raiffeisen Research and his research team at meetings with investors and clients. He is a well sought-after speaker at landmark events in the finance and banking industry and a guest lecturer at several universities/teaching institutions. In 2019, he was nominated for the US State Department's IVLP (International Visitor Leadership Program). Gunter has published several edited volumes on Euro/EU crisis issues and published various articles in professional journals and industry magazines. Outside the office, Gunter enjoys travelling with his family and long-distance running.

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Ruslan Gadeev is a Senior Financial Analyst in the Fixed Income team at Raiffeisen Research and a CFA Charterholder covering banking markets in the CEE space. Before joining the Research division in 2017, Ruslan had spent five years in the corporate risk management and credit analysis roles in Citigroup and RBI. Outside the working hours, Ruslan’s family is a priority, though in the rare minute of free time he might enjoy playing guitar or a game of chess.