Can Russia's Deficit Spending Save Russia's Economy?

In a world that is not lacking for large and contentious issues, small and mundane matters frequently slip by unnoticed. For example, Russia’s Duma (their legislative body, akin to a parliament) yesterday passed the initial draft of the Russian budget.

While the Kommersant reporting on the legislative action gives precious little detail about the budget, one word comes up again and again in the translation: “deficit” (emphasis mine).

After that, the deputies moved on to questions. Vladimir Kashin (KPRF) was interested in why, with a budget deficit, “tens of trillions of rubles flow past the country’s cash desk”: “Offshores, arrests of gold and foreign exchange reserves, a resource-based economy - everything is built today to please the oligarchy. At the same time, our progressive tax laws, the monopoly on alcohol are not accepted, as well as social laws, for example, on children of war. When will we see the victory budget, the development budget?” Anton Siluanov calmly replied that he had read the proposals of the Communist Party of the Russian Federation and, in his opinion, they would only lead to an increase in inflation, which would “eat up all our investments and social spending.”

It would seem that the Russians share the West’s addiction to deficits and sovereign debt.

What makes the Russian version of debt addiction noteworthy is Russia’s seeming reliance on government bonds with a variable rather than a fixed coupon interest rate.

According to the chief analyst of Sovcombank Mikhail Vasiliev, this year the budget deficit will amount to 1.5-2 trillion rubles. and will be closed mainly at the expense of the NWF. “Next year, the budget deficit is expected to be about 3 trillion rubles, and the Ministry of Finance is going to attract 2.5–3.5 trillion rubles on the debt market,” he points out.

To cover such holes in the budget, the funds of large market participants, primarily banks, are needed. However, as Mikhail Vasiliev notes, they do not show much interest in classic OFZs with a constant coupon, as they are not ready to take on interest rate risk in the face of increased uncertainty due to the conflict with the West, a likely global recession, and budget deficits in the coming years. Floating rate floaters carry no interest rate risk and are not subject to negative repricing. “The placement of floaters for the Ministry of Finance is now beneficial in the expectation that rates will decrease in the medium term. When placing classic OFZs, the ministry is forced to fix the current high rates for the entire period of circulation of the bonds,” notes Dmitry Monastyrshin, chief analyst at PSB.

In the Russian government’s most recent debt sale, demand for “floating coupon” rather than fixed coupon (variable interest rate rather than fixed interest rate) exceeded the demand for fixed coupon securities by a multiple of 3 at least.

Demand for seven-year OFZs with a constant coupon turned out to be three times lower (76.5 billion rubles), but the Ministry of Finance cut off most of the applications, placing papers for 20.7 billion rubles. at an average yield of 9.87% per annum. The largest application accounted for 5 billion rubles, and in total, applications with a volume of more than 1 billion rubles. accounted for 55% of the placement. But even to achieve this result, according to Mr. Yermak, the Ministry of Finance had to provide a yield premium of 11 bp. which is more than double the average premium at the beginning of the year.

To get investors to purchase fixed coupon securities, the Russian government had to offer a substantial premium to the prevailing yields.

While it would be speculative in the extreme to comment to any great detail on Russia’s variable interest rate securities, given the derivative exposures to rate hikes in Western economies, the question has to be asked what happens to Russia’s floating coupon debt in a market environment where yields surge unexpectedly?

If yields rise, could Moscow be faced with its own extremely awkward margin call, or worse? Much like ARMs in the mortgage industry, a variable interest rate debt instrument seems too much like a shortcut and not enough like a stable prudential investment option.