Ghost of Pre-Default Bonds Returns to Haunt Russia Decades Later

  • Siluanov says Russia can't borrow its way out of fiscal crisis
  • Cheaper oil squeezed budget, pushing government into deficits

GKO: three letters is all it took for Anton Siluanov to get across what he really thinks about Russia’s budget impasse.

By summoning the ghosts of the 1998 debt debacle, when the government defaulted on zero-coupon treasury bills known as GKOs, Russia’s finance minister signaled that borrowing its way out of the country’s fiscal woes isn’t an option. After warning he may be exaggerating the situation, Siluanov said at a conference in Moscow this week that “it’s possible to end up with GKOs.”

A scare tactic or not, the reminder illustrates the predicament facing Russian fiscal policy, which has lately been reduced to playing for time and waiting for the price of oil to go up. With a parliamentary ballot due this fall, Vladimir Putin’s biggest electoral test since he returned to the presidency in 2012, the government’s choices for financing the second year of deficits are narrowing as it dawdles over amendments to the budget, still based on an average crude price of $50 a barrel.

“GKOs have a bad reputation in Russia,” said Dmitry Postolenko, a money manager at Kapital Asset Management in Moscow. “It’s more logical for us to buy corporate debt for six-month terms rather than government debt.”

1998 Default

That investors are discussing the merits of GKOs is enough for the hearts of many Russians to skip a beat. The abbreviation, which stands for “short-term government bonds,” is synonymous with the worst financial crisis in Russia’s modern history. The securities, ranging in duration from three months to one year, became the Finance Ministry’s go-to instrument for funding the budget deficit in 1998. Their yields exceeded 100 percent by August that year and the government defaulted.

Putin, who became prime minister a year later before being elected president in 2000, has prided himself on turning Russia’s finances around. Its state debt was near 10 percent of gross domestic product in 2015 compared with 90 percent in 1999, according to Morgan Stanley. Putin said during his annual call-in show on Thursday that the government’s two wealth funds will last another four years if they’re tapped at last year’s pace.

Imbalances have crept back into the budget, however, made worse by the crash in oil prices and sanctions over Ukraine. Limiting the room for maneuver, social outlays and spending on security and defense now account for almost 60 percent of the total.

Privatization, Eurobond

With this year’s target for the budget deficit at 3 percent of economic output, the government faces the challenges of selling state assets or borrowing abroad while penalties introduced over the Ukrainian conflict are still in place. It’s at risk of exhausting one of its two sovereign wealth funds by withdrawing 3.8 trillion rubles ($57 billion) to plug the deficit in 2016.

That’s pushed the Finance Ministry to increase borrowing on the domestic market, where it pays 9 percent to 10 percent to sell ruble bonds, which Siluanov has called “expensive.” It hasn’t ventured onto the international debt capital market since 2013.

In the first three months of the year, Russia came the closest to reaching its quarterly fundraising target in five years, meeting more than 99 percent of its 250 billion-ruble plan. The Finance Ministry aim to sell 270 billion rubles of bonds this quarter. It will also consider increasing domestic borrowing in the second half of the year and plans to make the decision based on the budget performance in the first six months, according to Konstantin Vyshkovsky, the head of the Finance Ministry’s debt department.

As cheaper oil squeezed government income, the cost of servicing bonds reached 8.6 percent of budget revenue last year. That compares with less than 2 percent before 2008, according to Alexander Ovchinnikov, a co-founder at Movchan Advisers in Moscow. At the end of last year, maturing debt exceeded the volume of new bonds by 343 billion rubles.

Something New

“For the first time in the new history of the local government bond market, spending on servicing debt was more than the amount raised,” Ovchinnikov said by e-mail.

Rather than crimping demand for medium-term debt by selling shorter notes, a better option would be to sell long-dated bonds while the market situation allows, according to Postolenko. Two-year government notes yielded 30 basis points more than the 10-year securities on Friday, near the biggest gap since January.

Under normal circumstances, longer-dated bonds pay higher yields to compensate investors for being exposed to future consumer-price acceleration. When the curve is inverted, it points to inflation decelerating over time and shows traders expect the cost of money to become cheaper.

GKOs Return?

The government has floated the idea of selling short-term ruble bonds before. In November 2014, Siluanov said securities of up to three years may appeal to investors. Deutsche Bank AG analysts said at the time that the notes might be sold once or twice a year to meet social obligations to the tune of 600 billion rubles.

GKOs haven’t been sold since 2004, according to data compiled by Bloomberg.

“We’re still a long way off talking about GKOs, as debt payments to budget revenue remain small, ” Ovchinnikov said. “That means the Finance Ministry can afford to increase borrowing.”

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