The tit-for-tat US-Russia sanctions – combined with Cold War-era warnings over Russian military escalation in eastern Europe – will inflict substantial casualties if the financial-market warfare continues to escalate.
While markets have largely taken the tensions in their stride – banking that Russia won’t escalate the conflict militarily further – the risks for Russian borrowers and financial intermediaries loom large while the economy faces the prospect of a technical recession this year, say analysts.
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Underscoring fears over Russia’s declining creditworthiness, following Standard & Poor’s move last week to downgrade its BBB outlook to negative from neutral, Moscow has hit back, warning Kiev of its litany of debts. This includes an $11 billion burden for gas, according to a 2009 agreement, the $2 billion owed to Gazprom and $3 billion for Russian-backed sovereign bonds.
According to Timothy Ash, head of emerging market (EM) research ex-Africa at Standard Bank: “Russia’s attempt to pursue Ukraine for past gas debts, and to disrupt broader economic ties/relationships with Ukraine, could well be viewed as escalation from Washington.”
In this scenario, the US has made it clear that sector-specific sanctions, including on energy, services and financials, are measures that could follow.
It’s not about tanks or aggressive military spending in this Cold War re-awakening. Instead, the US, and to a less extent the EU, are looking to undermine Russia’s place in the international financial system, say analysts.
According to Steven Englander, global head of G10 FX strategy at Citi: “The Russia/Ukraine crisis may be the first major political conflict that is played out in international financial markets. One advantage using finance as a weapon is that it can be scaled up or down as needed, and is much more reversible than military actions.
“It is also quicker than traditional trade sanctions to have an impact, and arguably is more likely to hit decision-makers and those who have access to them than trade sanctions, which often hit the poor and almost always create profit-making opportunities for the well-connected in sanctions-running.”
Both sides have weapons and vulnerabilities. Short of asset freezes, the US has plenty of ammo. Lawyers say bankers are looking closely at their know-your-customer (KYC) due-diligence practices to ensure end-user Russian exposures are sufficiently transparent.
Ash says the US SEC and the US Department of Justice could signal to “US-based banks that their full and total compliance with the existing Foreign Corrupt Practices Act is expected and will be subject to extensive audit ... In effect, such moves by the US authorities would produce very significant compliance by a large weight of the global financial system.”
He adds: “Second, and perhaps similarly, the US/west might look to express concern over Russian compliance with the FATF [Financial Action Task Force on money-laundering and terrorism financing], and pressure perhaps for Russia to move onto the grey watch-list of ‘needing to do more’, and potentially then onto the black list. FATF black-list status would prevent global banks from dealing with their Russian counterparts.”
And then there’s the contentious issue of Russia’s UST holdings.
The BBC’s Robert Peston revealed last week that the former US Treasury secretary Hank Paulson was informed by Beijing that Russian officials had lobbied the Chinese government to jointly dump US securities in a bid to weaken the US in the post-Lehman maelstrom.
Citi’s Englander say Russian officials might be similarly tempted to sell USD assets to inflict financial pain, but any perceived benefits are unlikely to prove durable.
“For the Russians, the temptation may be to try to sell USD assets in order to disrupt US asset markets, but the leverage may be temporary,” he says. “Their reserves are almost $470 billion but they have been actively diversifying away from USD for years. Relative to the size of any market they might be tempted to disrupt, the USD holdings are small.
“Moreover the sense that the price was being driven down by politically motivated selling would likely attract buyers on the view that the effects would be limited. Were they to convince other countries to join them, the impact would be more longer lasting and more disruptive, but it is a little bit like letting your own home run down because it will lower the property value of a neighbour you dislike. The damage you do to yourself is more than you can expect to do to your neighbour.”
While the Russian holdings of dollars are “probably enough” to inflict short-term pain, it’s not clear that associated dollar weakness would be negative for economic or financial markets, though it would clearly underscore the geopolitical risks of the US as a reserve issuer, say analysts.
While there has been much speculation over the security challenges of large-scale EM holdings of US treasuries, it’s not clear the US Treasury harbours any fears over the prospect, given the associated damage to the Russian economy.
In any case, substantial tightening of external financing for Russian corporates is now expected. At the end of 2013, Russia had gross external debt liabilities of around $732 billion, with $155 billion due to mature in the third quarter of this year. Russian borrowers have increased their exposures in international markets in recent years.
According to Dealogic, Russian hard-currency bond issuance hit a record $45 billion in 2013, compared with $27.6 billion in 2010, while Russian syndicated loan issuance in dollars also hit a record $44.9 billion in 2013 compared with $32 billion in 2010.
According to Renaissance Capital, net capital outflows by banks and corporates increased to $33 billion in the first two months of the year, driven by Fed tapering, a weaker rouble and the Ukraine conflict.
Says Standard Bank: “[As] the financial pressure from the west tightens – going through the gears of increased KYC to actual asset freezes – Russian banks and corporates will find it increasingly difficult to finance themselves in international markets, and to roll-over debt liabilities.
“And, even if they can refinance, it will likely be at a much higher cost which will ultimately feed back into lower real GDP growth in the broader Russian economy.”
The external financing crunch would be exacerbated by the acceleration of resident outflows – which is a structural problem facing the Russian economy, given the weak investment climate – say analysts.
The size of Russian non-gold reserves at around $450 billion means Russian authorities could, in theory, provide full refinancing facilities for this year’s FX maturities, say analysts.
According to Credit Suisse, however, this intervention is littered with risks. “To prevent a much steeper drop in reserves, the CBR [Central Bank of Russia] would have to either sharply curb FX interventions (politically difficult because of large-scale RUB devaluation and a surge in inflation) or resort to some sort of currency controls (eg re-introducing a high FX surrender requirement for exporters),” it states.
Instead, Credit Suisse suggests an array of policy measures are available, including loan extensions, sub-market rates for loans, expansion of eligible collateral for central bank financing and lower bank capital requirements.
A weaker rouble, declining business confidence and consumption, and higher interest rates could cause a recession in Russia, reckons Credit Suisse. However, Renaissance Capital still reckons the economy will expand 1.6% this year, helped, in part, by a compromise in the conflict and tight labour markets.
Given the small share of Ukraine in Russia’s trade – 4.6% of exports and 5.2% of imports – the “direct impact” of the conflict on Russia’s economy would be manageable, reckons the Institute of International Finance, forecasting a possible 7% to 8% hit to Russian exports in the short-run. Instead, sanctions, a fall in capital flows and plummeting business confidence will weigh on Moscow in the medium-term.
Ash remains the most bearish sell-side analyst. “I would argue that this is the biggest challenge to the Russian credit story since 2008 – when it suffered a one-to-two-notch credit downgrade, and lost more than one third of FX reserves [more than $200 billion].”
Most EM analysts reckon there will be limited contagion. However, Russia, as a high-beta proxy for EM risk, is an essential bellwether for EM sentiment with and a vital component of EM bond indices.
As of the end of January, according to Standard Bank, the allocation of real-money funds in Russia was 10.1% in local and 10.8% in credit, while Russia stocks amount to a sizeable 5% of the EM equities index (MSCI). While many sell-side analysts remain underweight Russia on Monday, Bank of America Merrill Lynch reckons the rouble is fair value.
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| Source: Standard Bank |