When I taught public management, I always devoted a session to crisis management, which gave me an opportunity to concoct a plausible military, economic, environmental, or epidemiological crisis scenario. When the Eurozone seemed on the brink of dissolution, I imagined that Spain announced on New Year’s Eve that it was leaving, creating its own currency (la Peseta Nueva?), and defaulting on its Euro-denominated debt. The problem for my students was that one of the big six Canadian banks had made such a huge investment in “attractively-priced but safe” Spanish sovereign debt that the default would make the bank insolvent. Some time afterwards the exercise found its way into the hands of a Canadian public servant who had been involved in bank regulation, and he began our conversation with the words “If you only knew.”

Twenty-five years ago, the hedge fund Long Term Capital Management (LTCM) was using the ideas of two Nobel Prize-winning economists, Myron Scholes and Merton Miller, to speculate on bond prices. In 1998, these boffins predicted that spreads between certain bonds would revert to their historical averages. They were spectacularly wrong when Russia defaulted. LTCM was so highly leveraged that its imminent bankruptcy would have led to unsustainable losses for the financial institutions that lent it money. To avoid systemic failure, the Federal Reserve had to bail out and wind down LTCM. (At least Scholes and Miller lost all their equity in the firm.)

To Russia with Risk

Today Russia is once again at the heart of financial market instability. A second-order consequence of the economic sanctions being levied against Russia is that Russian assets are being sharply devalued or rendered worthless. The holders of these assets outside Russia are incurring losses and may indeed be forced to write them off completely.

Most Russian commercial aircraft are owned by overseas aircraft leasing firms. The Russian airlines will fail to make their payments and the lenders will try, likely unsuccessfully, to recover planes that are parked on Russian tarmacs. The Russian Government may then seize the planes, nationalize the airlines, and try to continue operating them as long as it can find replacement parts.

The Russian Government has stated that it will make interest payments on its sovereign debt in non-convertible rubles, which is tantamount to a default. Russia has $150 billion US in sovereign debt, which is apparently widely held by western banks and pension funds. They will likely have to write off their Russian debt. Hopefully, no overseas investor (unlike the unlucky Canadian bank in my hypothetical case) will have gone so heavily into Russian debt that its losses would be unmanageable.

Western firms that are leaving Russia are running the risk that their assets may be seized by the Russian government and nationalized. These firms too would have to write off their investments in Russia.

The one major financial institution that has not withdrawn from Russia is Deutsche Bank, which suggests that it is deeply involved in the Russian economy. Deutsche Bank has shown itself to be accident-prone in recent years (and decades), so that would not be surprising.

My overall point is that the sanctions against Russia will create pain for overseas investors in Russian debt and business in Russia. Hopefully, the aggregate size of the investments is small enough (a mere $150 billion in sovereign debt) and the investments are spread widely enough that the situation will not create systemic failures in the global financial system. This is not an argument against the sanctions, but rather a call for bank regulators and finance ministries to anticipate and respond to the second-order effects.

Rebuilding Ukraine and Suing Russia

Ukraine is also suffering financial devastation, but that is a result of Russian military action. Destroying housing will likely impose losses on Ukrainians themselves rather than foreign investors. We can expect that when the war is over its allies as well as the Ukrainian diaspora will provide financial support to rebuild Ukrainian infrastructure.

When the war is over, many Russian assets may have changed hands and the new owners will attempt to make money employing assets they purchased at fire-sale prices. Purchasers of defaulted sovereign debt will sue the Russian Government to repay the debt at prices below face value but nevertheless highly profitable (a strategy that worked in recent years for speculators in defaulted Argentinian sovereign debt). Perhaps Russian oligarchs will buy up Russian businesses and commercial assets, hoping that Putin or his successor will allow them to operate profitably. Or, if the Russian Government nationalizes assets now, it may have to return them as the price of rejoining the global economy.

As Keynes well knew, wars have economic consequences.