Russian external sovereign debt is relatively small at around USD40bn

The US hedge fund LTCM incurred massive losses and had to be rescued and the Fed was forced to ease policy dramatically. It was not called a Russian crisis for nothing! Twenty-four years on could we be looking at a similar scenario? Of course, twenty-four years is a very long time in the history of Russia, the rest of the world, and of financial markets. This means that there’s notable differences today from events back in 1998, but there are also some similarities as well and these should not be ignored. In what follows we will discuss these in order to try to answer the question we posed above.

There are a number of reasons to expect that a default this time around won’t have the same global ramifications as the one back in 1998. For one, the Russian crisis came not long after the 1997 Asian crisis which started with Thailand’s devaluation and rapidly spread to other countries. This crisis left many investors nursing losses and the Russian crisis might have just been the straw that broke the camel’s back, at least where LTCM was concerned. Fast forward to today and the pandemic has taken something of a toll but asset prices recovered strongly after the hit in Q1 2020 and hence investors appear to have been in better shape going into the Russian invasion.

A second factor is that Russian external sovereign debt is relatively small at around USD40bn. In essence what Russia has tried to do is to ensure is that it is not vulnerable to the whims of external creditors or international governments. Its international debts have not been growing, it has built up a robust balance of payments position, hefty FX reserves and all, presumably, so it could withstand the sort of sanctions war that has been levied against it since the invasion of Ukraine. Of course, the jury is still out on whether it can endure this but it does seem that foreign creditors have also taken note. For while the lure of strong commodity prices had pushed foreign ownership up to around four fifths of the stock market, debt holders account for only around one fifth.

Another factor is that it will be hoped that investors in Russian assets do not prove to be as vulnerable as LTCM was all those years ago, given that LTCM adopted a highly leveraged strategy, holding assets four times larger than that of its nearest rivel by the time of its collapse.

What of the more pessimistic arguments? One is that the economic spillover from Russia-Ukraine crisis will be much larger this time around because it has led to surges in food and energy prizes. Hence, even if Russian default does not directly hit the investment community hard and spark possible contagion effects, there are many other investments around the world that have been hit hard by this crisis and the cumulative effect on investors such as hedge funds could still be substantial. If we add in the hit from the slump in Russian stocks as well the damage to many investors could be significant, but whether it would be sufficient to prompt some sort of systemic crisis like 1998 is hard to say.

Another point is that the relaxation of the Volker rules on proprietary trading and hedge fund stakes by large banks could have increased risks should holders of Russian debt and equity come under pressure. And we should not forget that if financial market tension ratchets higher the Fed is not in a position to ease, unlike 1998.

It won’t be a big surprise should Russia default on its debt. That might give the market confidence that there won’t be any wider contagion risk. But we’d be wary of being so optimistic about the possible ramifications. As the IMF put it recently, what we can see appears to be OK, but what we should be worried about is what we can’t see.