Russia Suspends Bond Auctions: Could Putin Default?

[00:00:00]As we explained in a previous video, Russia's public finances aren't in great nick at the moment. Despite a relatively low debt-to-GDP ratio, Russia's bond yields, that is the interest rate that Russia has to pay on its debt, have surged in recent months thanks to a combination of sanctions, inflation, and a generalized anxiety about the Kremlin's direction of travel.

[00:00:19]Nonetheless, there was a consensus that even if yields were up, Russia would be able to make ends meet, and this wouldn't fundamentally change Putin's strategic calculus. That was until earlier this week when the Kremlin announced that they had been literally unable to find anybody to buy their latest issuances of bonds, and so were suspending bond auctions for the foreseeable future. So, in this video, we're going to explain what this announcement actually means and why it's genuinely bad news for Putin.

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[00:01:12]So, to understand this story, you need to understand a little bit about how government borrowing actually happens.

[00:01:17]In short, when governments borrow money, they do it by issuing bonds. Bonds are essentially defined by three things: the face value, that is how much the bond costs in the first place, the coupon, that is the annual interest rate that whoever owns the bond receives, and the maturity, that is when the bondholder is paid back the face value of the bond.

[00:01:37]To give an example, the US Treasury might issue a bond with a face value of a thousand dollars, a coupon of 5%, and a maturity of 10 years. If you bought that bond off the Treasury, you would basically lend the US a thousand dollars. The Treasury would pay you $50 a year for the next 10 years, and after 10 years, they'd return the whole 1,000 dollars. By the way, this market where the Treasury sells bonds directly to buyers is known as the primary market.

[00:02:03]Importantly, however, the effective annual interest rate or yield on a bond can change if markets decide they don't want to pay the face value. So, for instance, if I try to resell that bond I just bought to someone else into what's known as the secondary market, but I could only sell it for $900, whoever bought that bond would effectively be paid a higher yield. After all, $50 is more than 5% of $900. It's more like 5.5% and after 10 years, this new bondholder would also get an extra $100 because the Treasury would pay back the full $1,000 face value. But, this new bondholder only bought the bond for $900.

[00:02:41]This means the effective yield would actually be over 6%.

[00:02:45]Now, the important thing to understand here is that when governments want to borrow more money by selling bonds into the primary market, the way this actually happens is that the government in question first looks at effective yields on already issued bonds in the secondary market and then offers effectively the same rate in the primary market. So, for example, if the US Treasury wants to issue more 10-year bonds, it'll take a look at how bonds maturing in 10 years are trading in the secondary market and then offer basically the same coupon or slightly higher on any new 10-year bond.

[00:03:17]Now, usually this process is pretty smooth and these days, even if some of them have to offer pretty hefty coupons, most governments don't struggle to actually find buyers for their debt.

[00:03:28]The UK is a good example. While the UK's public finances aren't in great shape and its bond yields are pretty high by international standards, it doesn't actually struggle to find buyers for new debt. It just has to offer an annoyingly hefty coupon.

[00:03:41]In fact, the last time the UK really struggled to find buyers for its debt was way back in the '70s, back when bond markets were way less developed and had way less money sloshing about in them.

[00:03:52]The exception to this norm, however, is apparently present-day Russia.

[00:03:56]Earlier this week, the Russian Finance Ministry announced that it would be halting its regular weekly auctions of fresh government bonds after a series of failed auctions with no indication as to when sales will resume.

[00:04:08]This came after four consecutive failed auctions. On June 24th, they had to cancel an auction after receiving no bids for their new bonds. On July the 1st, they were only able to sell 10.3 billion rubles worth of bonds out of a planned 110 billion rubles worth. And then two further auctions on July the 8th and July the 15th also had to be canceled due to a lack of demand.

[00:04:30]This means that in all, the Kremlin has only been able to raise about 10 billion rubles of the 1.5 trillion rubles it hopes to raise in the third quarter.

[00:04:40]So, why is this? Well, we see at least three reasons. First, and as we detailed in a previous video, Russian bonds are selling off aggressively at the moment, largely because Russia's deficit keeps on coming in way above forecast.

[00:04:54]This means it's hard for the Russian Finance Ministry to find the right price because by the time the Finance Ministry actually gets its new bonds to auction, the markets are often already demanding even steeper coupons.

[00:05:06]Second, Russia's bond market just isn't very liquid. In other words, there just aren't that many people selling or more pertinently from the Kremlin's point of view, buying Russian bonds.

[00:05:17]This is largely a consequence of sanctions which have locked foreign investors out of Russia's bond market.

[00:05:23]But this state of affairs has been exacerbated by the fact that the most obvious domestic buyers are Russian banks who have suffered an unprecedented outflow in recent weeks, which means they have less cash on hand to buy up Russian government debt.

[00:05:37]Third, last month, Russia's year-on-year inflation rate, which had previously been falling, ticked up to 6% and is expected to rise further in the coming months.

[00:05:46]This is largely a consequence of Ukraine's strike campaign against Russian energy infrastructure, which has pushed petrol prices up by 25% year-on-year.

[00:05:56]The reason this has been bad for the Kremlin's bond auctions is because high and rising inflation will probably force the Russian Central Bank to raise interest rates, which have been coming down for the past year or so.

[00:06:07]Risk-averse domestic investors, who might otherwise be interested in government bonds, are thus waiting to see where the Central Bank goes. Because if they decide to raise rates, these risk-averse investors might decide to just store their cash in a savings account to take advantage of these higher rates.

[00:06:24]All in all, this is genuinely bad news for the Kremlin. When no one wants to buy your debt and everyone knows this, it can spark a vicious cycle as everyone desperately tries to sell to the few remaining would-be buyers, pushing prices down and thus encouraging even more people to sell.

[00:06:40]The last time the UK experienced a buyer strike, for instance, we ended up asking the IMF for a bailout. Unfortunately for Putin, it's not clear who, if anyone, could bail out the Kremlin.

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