Russia will benefit in the long term from the German government’s unprecedented decision to resell Russian sovereign debt

Ekaterina Shokhina

In late June, Germany’s Ministry of Finance announced its intention to convert some of Russia’s sovereign debt into bonds and sell these papers on the market. Germany expects to sell $2.4 billion in Russian debts from a total of $20.3 billion. This operation is not a direct securitization of Russian debt: Germany intends to issue its own securities – credit notes with the yield linked to Russian debt payment.
The German authorities had to make this decision, unprecedented among the Paris Club, to reduce its state budget deficit, which has exceeded the 2% limit set for EU member states for the past three years. The German government doesn’t dare to reduce the deficit by cutting spending. It has failed to increase revenue. Therefore, the government had to this crucial step. “Germany’s decision is the result of talks over the last one and a half years between Russia’s Ministry of Finance and the Paris Club on conversion of our debts into market instruments. Under Paris Club rules, twenty percent of all debts can be converted using such procedures, and in exceptional cases, the figure can amount to thirty percent,” says Boris Kheifets, Chief Research Associate at the International Economic and Political Research Institute, or IMEPI, of the Russian Academy of Sciences. “We were aware of this operation,” says Sergei Kolotukhin, Director of the International Financial Relations, Public Debt, and Public Financial Assets Department at the Russian Finance Ministry. “It is in line with the public debt control strategy approved by the Russian government regarding securitizing debt and increasing its market component. Therefore, we don’t see anything unusual in this operation.”

Short-term losses

However, the market proved sensitive to the German financial authorities’ decision. Quotes on Russian eurobonds have dropped noticeably, since investors see the new German notes as an additional supply of Russian securities to the market. “The logic is simple: Russian bond supply is being increased considerably when demand for them is stable. As a result, prices fall,” explains Alexander Kudrin, an analyst at Troika Dialog.
The higher yield on securities issued by Germany will be another factor reducing investor interest in Russian eurobonds. Moreover, they will be partially insured. “According to the data made public, the yield on 5-year issues of the new bonds will amount to 7.75-8 % p.a. and 9.75-10% on 10-year bonds, whereas the yield on similar Russian eurobonds ranges from 6.5-6.6% on average. For the German bonds, the rate on circulating issues will amount to 150-200 basis points, while on Russian bonds it will be from 100 to 150. As a result, one cannot rule out the possibility that investors will shift money from existing Russian eurobonds to the new bonds, which could mean a further drop in eurobond quotes,” says Vladimir Malinovsky, a senior analyst at Web-Invest-Bank. “The new securities will also attract investors because they come with an interesting guarantee. Germany will pay 20 cents on the dollar and euro in the event of Russia’s default,” adds Nikolai Kashcheev, an analyst at Trust Bank. “We don’t have such a commitment on any of other debts.”
There is another factor making investors lose interest in Russian securities. The market is concerned that other Paris Club member-countries experiencing problems with budget deficits, will follow Germany’s example. The matter involves first and foremost Italy (Russia owes $5.4 billion), Japan ($3.6 billion), and France ($3.2 billion). Russian Finance Ministry officials flatly deny such a possibility, though. “We have always emphasized that the German operation is exceptional in nature, and we would not be pleased if other Paris Club creditors issue such securities,” states Sergei Kolotukhin.

Long-term benefits

Despite the fact that the market’s initial response to the German Finance Ministry’s decision was negative, Russia stands benefit more than Germany itself.  The first benefit for Russia from the securitization of part of its debt lies in the possibility to recoup foreign debt more advantageously and in a shorter period of time. “It’s difficult for the state to redeem debts directly because of the high cost, and it takes time to boot,” says Boris Kheifets from IMEPI. “The German bonds enable us to buy up our debts virtually without interest.”
The Ministry of Finance will be able to redeem the sovereign debt through corporate or partially state-owned banks like Vneshtorbank, Sberbank, or Vneshekonombank. “Via arrangements with Russian business, the state can implement different conversion options or in other words use a more flexible approach to repaying the debt,” Boris Kheifets believes.
One can also see the increase in the volume of the circulating Russian debt as a positive side of the deal. In theory, this is bound to attract more investors and thus increase the liquidity of eurobonds issued by Russian companies as well. “With time, the situation will stabilize and value of Russian eurobonds will increase,” believes Nikolai Kashcheev from Trust Bank. “Even if there are a lot of German securitized papers, the drop in prices for Russian eurobonds won’t be catastrophic, in only because Russia’s credit rating is expected to rise, and this will inevitably increase demand for Russian securities.” 

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