The risks lurking in the Russian debt market

Almost all of new Russian corporate debt has variable interest rates. Companies are betting that rates will fall soon - but they could be wrong.

In September, Russian banks and businesses issued bonds for 640 billion rubles (6.7 billion dollars) - a new record and twice the amount issued in September 2023. While the growth of consumer credit has slowed, Russian businesses seem to be almost immune to the Russian Central Bank’s very high key interest rate of 19%. As of September 1st, bank loans to the real sector were 21.4% higher than a year earlier. Notably, almost all of the new debt has variable interest rates.

A boom in credit with variable interest rates can point to hidden risks in the financial market: In the 2000s, many US homeowners accepted mortgages with variable interest rates, believing that interest rates would stay low forever. When the FED raised interest rates from 1% to 5.25% in 2004-2006, mortgage payments overwhelmed millions of homeowners - and the rest is history.

If the interest rate on a loan or bond is variable (or floating), it means that the borrower (the Russian business - or the US homeowner) takes over the interest rate risk: Wherever key interest rates go, the costs of serving their debt follow. The problem is that private households or companies from the real sector are often not really good at judging where interest rates are going in the future and regularly fail at managing their financial risks properly.

At the moment, most companies in Russia seem to expect interest rates to come down soon, making it easier to service their debt in a few years. But if interest rates stay as high as today, some companies will be in trouble.

There are good reasons why the expectation of falling interest rates in Russia is so persistent: There is the experience of the last 25 years. Real interest rates (interest rates minus inflation) are around 10%, which is extremely high by Russian standards, so high that it simply does not seem sustainable. Moreover, there was a brief period of super-high interest rates at the beginning of the full-scale invasion. When the Russian economy was reeling from the shock of economic sanctions, the Central Bank of Russia raised its key interest rate to 20%.

Chart of Russia’s key rate from 2010 until 2024, created with TradingView

Much to the delight of Russian borrowers, inflation turned to deflation and interest rates fell rapidly already in the summer of 2022. This experience of short-lived inflation and rapidly falling key interest rates shapes expectations today.

But today’s inflation is very different from the 2022 inflation. 2022 inflation was triggered by an external shock (war and sanctions), which led to a brief period of exploding import prices and mass buying of consumer durables (such as TVs or washing machines) by Russians worried about economic stability. In 2022, inflation was also not solved by super-high interest rates. The Central Bank got help from a surge in export revenues due to high oil and gas prices, which led to a very strong ruble (and cheap imports), and also by falling demand as sanctions hit some sectors and some consumers hard.

In contrast, today’s inflation is driven by war spending, a strong fiscal stimulus into an overheated economy. Unemployment is extremely low and salaries are rising fast. This type of inflation could only be solved if the economy cools down, meaning: Some businesses in the civilian part of the economy have to be forced to make layoffs, freeing up workers to feed the ever growing demands of the war machine. Achieving this takes much more time and is much more painful than the 2022 experience may suggest. Company profits will have to fall until enough businesses are underwater.

The Central Bank can hardly be happy about Russian companies’ persistent expectations of falling interest rates. It wants companies to scale back their investment plans as soon as possible in order to reduce aggregate demand and, ultimately, inflation. Like any central bank faced with an overheating economy, the CBR would like to see a soft landing, which requires a timely, but gradual and controlled response of the real sector to monetary policy.

But if the CBR can’t convince companies that interest rates will indeed remain high for many years, then companies will simply continue their borrowing spree, relying on floating rates, until they run into bigger problems. This means that the risks of the real sector overestimating what it can handle will increase, and the landing will not be soft at all. Ironically, part of the problem may be that businesses simply trust the Central Bank to solve the inflation problem as quickly as it has in the past. The CBR’s success in the past is now part of its predicament today.

But even if some companies reduce their investments, even if the tight monetary policy starts to bite and the civilian economy starts to suffer, real interest rates could at least remain elevated. Russia is simply not in a “normal” economic situation anymore, so that the experience of the past 25 years is a poor guide. Russia is a country at war, and - typical of countries at war - the government needs people to cut back on personal consumption and save.

The situation is a bit paradoxical: the Kremlin is showering trillions of rubles on Russian men willing to fight in Ukraine or work in the defense industry, but it doesn’t want the recipients of this windfall to spend all their money while the war is going on, because that would cause inflation.

Interest rates could even rise further if, for example, oil prices fall. The resulting ruble depreciation would initially help budget revenues, but it would also push up import prices, necessitating further interest rate hikes to fight inflation. Russia’s ruble is relatively strong in real terms and the key rate is at 19% today. It is not difficult to imagine a key interest rate of 25% or even 30% in the event of a significant ruble depreciation. This could make life very difficult for those companies that are borrowing at floating rates today.

A truly destructive chain reaction similar to the US financial crisis is still unlikely in the Russian debt market. In the past, when systemically important companies or banks got into trouble, the government or the Central Bank quickly stepped in to help. Many of the borrowers are primarily state-owned and have “soft budget constraints,” meaning that an insolvency situation may not be life-threatening for the company because they can expect a bailout.

But rescuing troubled companies comes at a cost. If the Russian government has to bail out those who are overleveraged, its only option to finance this may be to monetize their debt and accept higher inflation for years. In the process, it would devalue the savings of Russian citizens, which would - again - be quite typical for a country at war.