Germany may get a black eye if Russia moves to erase a black mark from its international standing by paying off Soviet-era debt to other members of the Paris Club of creditor nations. The Paris Club meets this week and the question of Russia's early repayment of any or all of its $43.1 billion in debt is thought to be at the top of the agenda. Last July Germany, which is Russia's largest creditor. faced a gaping hole in its budget and used an innovative debt offering to help plug it. Germany magnetised $5 billion worth of the Paris Club bilateral debt owed to it by Moscow into what are now called Aries bonds. These bonds bear interest costs higher than plain vanilla German government debt. One issue is whether Aries bonds will become a high yielding German government debt if Russia pays off its Paris Club obligations.
Another is whether Germany allows Russia to pay off the debt in total. Unless Russia defaults on Paris Club debt, Germany still has to pay out on high-yielding Aries bonds. In case of default, Germany pays out just 20 percent.
Aries bonds have become, on a relative value basis, more expensive than the Russian Federation's own sovereign bonds. Some investors believe Aries bonds will only get dearer if a deal is struck because they see them becoming a German liability.
"If you assume my scenario, I think there is a strong possibility that the entire stock is going to be retired .... so essentially bond holders are left with German risk (rather than Russian)," said Tim Ash, emerging markets analyst at Bear, Stearns & Co in London.
Ash estimates that by 2008, Russia will have $90 billion in its oil stabilisation fund, the source of cash for repayments.
"Owing Paris Club debt to Germany looks bad. It is kind of a black mark in terms of your credit," he added.
But some investors believe if a deal is struck between Russia and the Paris Club, it would be better to simply hold Russian bonds outright and dump the 'too richly priced' Aries. "We feel that at current market prices it is overestimating the probability that at some point in the future Aries becomes effectively German government debt," said Marc Balston, emerging market debt strategist at Deutsche Bank in London. "I would recommend exchanging them for Eurobond debt."
The bilateral debt with Germany, estimated to be 14 billion euros in total, was incurred by the former Soviet Union in the form of commercial credits and loans.
Deutsche Bank argues Germany is unlikely to accept full repayment because it would need the underlying Paris Club debt payments from Russia to fund the interest costs of Aries.
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