Russia Defaulted on Debt It Could Have Printed Money to Pay
In 1998 Russia defaulted on domestic currency obligations and devalued simultaneously. Defaulting on debt in your own currency is a choice, and the reasoning is worth understanding.
The Event
In August 1998 Russia devalued the rouble, defaulted on domestic currency denominated government debt, and declared a moratorium on certain payments to foreign creditors.
The default on local currency debt is the analytically interesting part, because it was not strictly necessary in a technical sense.
Why Local Currency Default Is a Choice
A government borrowing in a currency it issues can always meet nominal obligations by creating money. The obligation is denominated in something the government controls.
The cost of doing so is inflation, and potentially severe inflation if the amounts are large relative to the economy. So the choice is between defaulting on the debt and effectively defaulting on the currency, which imposes losses on everyone holding money rather than only on bondholders.
A government with its own currency chooses who bears the loss. Default hits bondholders. Printing hits everyone holding the currency.
The Situation
Several pressures combined. Fiscal revenues were weak, with substantial difficulty collecting taxes. Oil prices had fallen sharply, which mattered enormously for an economy dependent on energy exports.
The government had been financing deficits with short term rouble denominated instruments carrying very high yields, which created a rolling refinancing requirement at punishing rates. A currency peg was being defended, which constrained monetary policy and consumed reserves. Contagion from the Asian crisis had reduced appetite for emerging market risk generally.
Defending the peg while rolling short term debt at extreme yields was not sustainable, and abandoning both simultaneously was the outcome.
The Global Consequences
The effects extended far beyond Russia. Investors reassessed emerging market risk broadly and withdrew capital indiscriminately.
The most consequential transmission ran through Long Term Capital Management, whose relative value positions depended on liquidity premiums normalising. The flight to safety triggered by the default moved every one of those positions adversely at once, and the resulting near failure required intervention organised by the Federal Reserve Bank of New York.
An emerging market default therefore threatened the stability of major American financial institutions through a hedge fund's positions, which was a novel demonstration of how leverage transmits shocks across unrelated markets.
What It Established
The episode reinforced that local currency debt is not risk free simply because it can be paid nominally. Willingness to pay is distinct from ability, and governments do weigh inflation against default.
It also demonstrated that defending a currency peg while running fiscal deficits and short term debt rollovers is a combination with limited endurance, since each element constrains the response to the others.
The Bottom Line
Russia could have printed and chose not to, judging inflation the worse outcome. Local currency debt carries the risk that a government prefers your loss to everyone's.