Could a Russian default trigger an EM crisis?

Russia’s invasion of Ukraine continues to have a devastating human impact. The latest headlines have been ever more shocking, and additional Western sanctions are already being unveiled.  

As investors, we continue to weigh up the global macroeconomic and market implications of sanctions. Russia has so far been able to avoid default on its external, foreign currency denominated, government debt, in spite of the swift imposition of broad sanctions by the US and its allies.  

However, the risk of default is rising. This week the US barred Russia from using frozen central bank reserves, held with US banks, to pay bondholders. Meanwhile, the US Treasury blocked US correspondent banks from manging dollar payments from Russia; a move which forced Russia to pay holders of dollar denominated government debt in roubles. Payment in an alternate currency is likely to be viewed as a default, albeit not until a 30 day grace period has elapsed.  

Understandably, emerging market (EM) sovereign debt defaults always raise questions about contagion to other markets. After all, past defaults saw crises ripple through Latin America in the 1980s, Asia in the 1990s and Central Eastern Europe (CEE) in the 2000s; and there have been other examples of contagion such as after the Russian ruble crisis in 1998.

Are we about to see a repeat of contagion into other emerging markets?

In the first instance it seems unlikely that a default by Russia would spark a wave of other credit events. After all, any default by Russia would be due to sanctions preventing it from making payments, rather than economic problems. And it is not the case that other EM have built up external vulnerabilities in recent years like those that preceded past regional crises.

Indeed, most EM have been fairly resilient in recent months as solid external positions and proactive interest rate hikes have provided insulation to global events.

That being said, tighter global financial conditions that are a result of US Federal Reserve tightening and weaker risk appetite owing to the situation in Ukraine are likely to have some negative impact on the ability of EM to access external financing and meet outstanding obligations.

Which emerging markets are most at risk?

One way to identify those markets that might get into trouble is to look at the ratio of short term external debt (that is all debt servicing, public and private, denominated in both foreign and local currency owed to foreign investors in the next 12 months) as a share of foreign exchange (FX) reserves.

This metric helps to identify those EM where there are potential liquidity problems, usually when short term external debt exceeds the level of foreign exchange reserves.

When looking at the chart above, a couple of points stand out.

First, Russia is at the far right of the chart. Up until its reserves were frozen and sanctions imposed, Russia had an extremely strong external position. Short-term external debt accounts for only about 10% of FX reserves, while Russia’s total external debt is only 75% of reserves.

Second, there are a few countries where short-term external debt exceeds the level of FX reserves and these are vulnerable to default in the current environment. Sri Lanka clearly has the worst external debt dynamics when viewed through this lens, followed by Tunisia and Belarus – the latter which may also fall foul of sanctions.

And the bad news is that fragile external positions are likely to worsen as high commodity prices cause trade balances to deteriorate. Sri Lanka and Tunisia are already in negotiations with the IMF to secure financial support, and it is possible that others may be forced to follow.

Why investors should not be concerned

The good news from an investment perspective is that these countries are relatively small frontier markets and that defaults are at least partially priced into markets.

For example, by assuming a 40% recovery rate, spreads on hard currency bonds already price in a 20-40% chance of default in many frontier markets.