The line between government and private debt has practically disappeared thanks to German officials who previously resisted this move more than anyone else

Vladimir Rzhanitsky

On August 26th, Minister of Finance Alexei Kudrin announced to journalists that Russia is ready to offer the Paris Club an exchange of its debt for market securities. This initiative to securitize debt came in response to the untraditional move on the part of the German Finance Ministry. The Germans decided two months ago to place credit notes among private institutional investors tied to Russia’s repayment of its Paris Club debts to Germany.
Russian officials off the record expressed their dissatisfaction with the German’s deal, which came as a surprise to Moscow. They made it clear that they would do everything in their power to prevent other lender countries in the Paris Club from conducting similar operations with Russian sovereign debt. A flood of debt obligations related to Russia could make it difficult for both the Russian government and Russian corporations to enter international markets. There is demand among international investors for Russian risk, and in this situation it is more advantageous for Russia to place its own securities and not secondary ones.

Aries: no one saw it coming

In June the German Finance Ministry literally shook the financial world by announcing an innovative deal to securitize Russian repayment of old Soviet debt to the Paris Club. To service this repayment, a specially created organization issued three tranches of bonds (called Aries on the market) maturing in three, five, and ten years. The proceeds, totaling around five billion euros, went into the German budget as income from privatization. In other words, the Germans preferred to get the money from years of future payments on part of Russia’s debt immediately.
The deal provoked dramatic reactions on the market due to several circumstances. First of all, the deal meant that several billion dollars in securities related to Russian risk were thrown onto the market at once, which no one expected. This unanticipated injection would predictably lead to a serious decline in quotes for all Russian hard-currency bonds, both state and corporate. And this is exactly what happened, to the great disappointment of everyone with Russian securities. In addition, for a definite period of time, the market performance of Russian companies’ new debt issues also worsened notably. Secondly, Russia’s previous requests to government creditors for a more flexible and mutually beneficial solution to debt repayment always came to nothing with the Paris Club because of Germany’s absolute refusal to consider repayment (including to other countries) in any other form than according to the originally agreed-upon schedule.
What motivated the German government, which had never before exhibited the slightest interest in financial innovation, to make such an extraordinary deal?

Winners and losers

Necessity is the mother of invention. Economic stagnation in Germany drags on, the central government’s budget deficit has crossed the three-percent threshold for the third year in a row, and by the end of this year state debt is expected to exceed the EU-set limit of 60% of the GDP. These factors have put Germany, recognized economic leader of Europe, in a very uncomfortable position and are forcing the country to seek unusual solutions, including those that before seemed unthinkable.
In addition, the operation had talented co-authors, the investment banks that organized the issues. To all appearances, their pressure and lobbying became a major driving force behind the deal. They were able to convince German officials that privatizing Russian debt was to their advantage.
However, the privatization was highly unusual. From a legal point of view, Germany is still Russia’s biggest creditor (and retains its political clout), and Russia is still in debt to Germany for the same amount. However, a significant portion of the risk is now being handed over to investors. Should Russia default on its Paris Club debt, the German government guarantees only 20% of face value.
For this reason, these bonds were given a rating two levels below the current Russian sovereign credit rating. Naturally, this meant an additional 1-2% annual premium for additional risk, which naturally investors have a right to demand, but apparently the Germans were absolutely convinced they were doing the right thing and/or they absolutely needed money.
Let’s summarize the short-term effects:

The winners:
- the issuing organizations: banks earning a nice commission (36.5 million euros);
- the main potential Aries buyers: hedge funds and other risky investors who were never very high in the German authorities’ favor. These investors bought Russian debt cheap and now have a new instrument to play with. The fact that the German government sold too low is obvious: The decline in Aries yield has outpaced the recovery of Russian Eurobonds maturing in 2030 after the initial shock to the market.

The losers:
- Germany, which sold Russian debt too cheaply (as well as its “firm principles”). This has already had serious political implications, and both German conservatives and the usually extremely cautious Bundesbank expressed their strong disapproval of the deal;
- Other countries lending to Russia, which have long been willing to take far less radical approaches to Russian debt privatization and are now deeply offended;
- The EU financial agencies, which know perfectly well that this type of maneuver, while improving current budget figures, will not solve serious long-term problems and could even exacerbate them.
- Russia, whose securities and market image have suffered and whose debt burden remains the same. The Russian Ministry of Finance did not hide its annoyance at the form and results of the deal;
- Investors in Russian securities, who face losses due to falling quotes;
- Russian corporations, which will have to pay more to borrow on the market due to the significant increase in securities related to Russian risk in circulation.

The final balance is bleak. But could good tidings be waiting around the corner?

“Official” capitulation
The consequences of the deal don’t stop there. Without a doubt, it could have a long-term impact on the financial world far beyond the bounds of Russo-German debt relations. There is every reason to believe that Aries could become more than an experiment. It could become a model changing the structure of today’s financial markets.
The previous, rare securitizations of sovereign debt were generally not public, and the best known public precedents (the sale of Poland’s debt to France) were fairly cautious and limited. In this particular case, neither the banks nor Germany are ruling out a repetition of the operation. They merely promise to wait another six months after Aries.
It has long been thought that the so-called quota for swap operations in Paris Club agreements, which at most equals 20%, was the strict limit for state debt securitization. The fact that Germany is selling off a third of its Soviet debt without a second thought serves as a resonant precedent for all other countries facing deficits and various other financial problems. Russian authorities’ promise that the German securitization will be the only one is hard to believe. It will be hard to explain to Berlusconi or Chirac why Schroeder can, but they can’t.
In the end, the moment the market acquires enough experience transforming sovereign debts, no one will ask anyone’s permission. Any reasonably up-to-date financial expert can easily arrange the type of operation today that will be a done deal both in terms of legality and international politics. The financial result of this operation will be similar to the Aries deal.
Investors are happy to take on higher risks (of course, for the right price). As any textbook will tell you, financial markets exist merely to repackage payment and risk.
Thus, the limits on securitization have now disappeared and the wall between public and private debt has practically been torn down. Nothing was sacred for the market, and now even the taboo on international debt is gone. State debts will remain legally the same thing they are today, strategic tools of political influence, but their financial essence will circulate completely independently on the market. It cannot be ruled out that very soon, a country in default on its international loans will not only have to deal with direct creditor countries, but also with a myriad of private organizations that do not follow diplomatic etiquette. This will likely make future restructuring negotiations more difficult, and we should also expect regular rounds of frozen accounts, grounded planes, and the end of discussions of sovereign immunity.
The glorious Paris Club (and also the IMF, which seems to have lost its place in the world permanently) is irrevocably approaching its demise. The interest of creditors in the Club as a monitoring tool and as a means of securing equal rights for all members is doomed to decrease. In this context, Kudrin’s statement regarding the exchange of Russian debt for eurobonds, which demonstrates the minister’s intention to halt what is already in progress, sounds tough but remains somehow unconvincing. Kudrin’s proposal asks the Paris Club to officially sign and seal its own death warrant.

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