Russia Watch – Sanctions looming

by: Nora Neuteboom , Georgette Boele

In this publication: Ruble hit by sanctions and broader EM pressures. Uncertainty on new US sanctions against Russia is at all time high. Russia is able to withstand a new round of sanctions because of strong external position. Sanction risk and inflationary pressures forced CBR to hike rates by 25bp. Growth will remain low in 2019 on the back of weak investor confidence and lower consumption growth.

181002-Russia-Watch_final-1.pdf (139 KB)

EM turmoil and sanctions hanging over Russia

The recent emerging market turmoil and the corresponding sharp drop of portfolio outflows on the back Fed rate hikes has taken its toll on Russia as well. However, Russia specific risks, such as the looming sanctions are much more pertinent. This prompted foreign investors to withdraw capital from Russia, resulting in a 14% drop of the ruble against the dollar since the beginning of this year.

Bill from hell’ – flashback from 2014?

In March 2014, the European Union (EU) and United States (US) enacted sanctions against Russia in response to its illegal occupation of Crimea and support for secessionist groups in eastern Ukraine. At first, these were individual sanctions against specific people and companies. Then in July 2014, additional sectoral sanctions were imposed that limited foreign financing for public banks and oil and gas companies, and restricted Russian oil and gas companies’ access to advanced production technologies. In response, Russia imposed an embargo on a wide range of agricultural products from Western countries in August 2014 (see also: Sanctions against Russia: the new normal). New sanctions were imposed on Russia in April this year, specifically targeting several individuals and companies (see also: New sanctions against Russia: from the US with love). Compared to 2014, this time several issues are on the table, creating much more uncertainty. A new round of sanctions may arise from the ongoing Mueller investigation in the US, the Skripal poisoning in the UK, Russian support for the Assad-regime or cybercrime allegations.

On 2 August, the US announced a draft legislation on the Defending American Security from Kremlin Aggression Act (DASKAA) (to be debated later in autumn). The newspaper Kommersant  published a full draft on 8 August. The draft legislation includes:

  1. Banning Russia’s biggest state banks — Sberbank, VTV Bank, Gazprombank, Rosselkhozbank, Promsvyazbank, or Vnesheconombank — from operating inside the United States, which would effectively prevent these institutions from conducting dollar settlements.
  2. In the energy sector, the legislation would impose sanctions on investment in any projects by the Russian government or government-affiliated companies outside Russia worth more than $250 million.
  3. Sanctions on purchases on Russian sovereign debt by US investors (which will have an impact on global financial markets as well)

Also the Defending Elections from Threats by Establishing Redlines Act (DETER Act) is still pending. This legislation would also include tough sanctions on Russia (including the banking sector) if US intelligence agencies find Russian interference in US elections.

Both legislations will probably be watered down in the months ahead. Earlier this year, the US Treasury department said that “expanding sanctions could potentially have negative spill over effects into global financial markets and businesses”. Furthermore, the US government has backtracked some of the earlier sanctions imposed on Rusal, as they caused severe panic on commodity markets. But as the language of both bills reveal, the bipartisan appetite for an aggressive response to Russia is real. It is certainly more aggressive than anything we’ve seen so far.

On 9 August, the Trump Administration has signed off on new sanctions against Russia following the nerve agent attack against former Russian spy Sergei Skripal. The sanctions include a prohibition of US companies to sell any products to Russia that may be used for military purposes or in chemical weapon production. Furthermore, if Russia does not provide reliable evidence that it is no longer using chemical or biological weapons and does not allow on-site UN chemical inspections within a 90-day period (so around the end of November), the US will impose a second round of sanctions including an almost full ban on trade, suspension of diplomatic relations, prohibition of any loans from US banks to the Russian government and ban on air travel for state-controlled airlines to and from the US.

Strong external picture mitigates the impact of new sanctions

While the prospect of new punitive sanctions have triggered capital outflows and will continue to dampen investor confidence towards Russian assets, the country’s external posi­tion looks well placed to weather these setbacks. Gross external debt has fallen from USD 668bn in December 2013 to USD 524bn by end-2017, largely due to Western sanctions since 2014 preventing Russian banks and other institutions from borrowing on international capital markets or rolling over external debts falling due. External debt to GDP stands at 33% of GDP. The external debt ratio remains relatively low by emerging market standards, while a gradual rebound in oil prices will help avert any systemic problems in the servicing of external debt. FX reserves are around USD 400bn and they cover almost 10 months of imports. That said, not all reserves are liquid. This is because part of it is situated in the National Wealth Fund, which is earmarked for deficit financing and upholding the pension system. The current account surplus is over 4% of GDP. Given the likelihood of reduced capital inflows (weak FDI and portfolio investment), the current account surplus will be the main source of foreign currency for the economy.

However, if sanctions on sovereign debt were eventually imposed, Russia could see higher capital outflows.  The large increase in non-resident holdings of OFZs (since 2015) will partly reverse. Around 1/3 of both the foreign-debt and domestic debt is held by non-residents. FDI has seen a recovery since 2017, and is currently more diversified. FDI is also coming from countries that did not impose sanctions. Meanwhile, Russia’s central bank has divested most of its US Treasury holdings, while accumulating more gold, suggesting they are preparing for the worst case scenario. Furthermore, some big Russia companies are experimenting with settling payments into foreign currencies. This could be in yuan or even gold. That said, the full implementation of the sanctions will probably result in ruble weakness which will have an upward pressure on inflation.

Ruble hit by sanctions and broader EM pressures

So far this year, the Russian ruble has weakened by 12% versus the US dollar, and by around 8% versus the euro. This weakness has been mainly the result of the announced and feared sanctions (mentioned above) but comes at times when emerging markets are under general pressure because of fears of a trade war, higher US dollar and higher US interest rates. Recently higher oil prices have been able to support the ruble. However, the most crucial driver for the ruble remains the perceived country risk, so in fact the actual sanctions. If these sanctions are watered down, we expect the ruble to recover.

Later in the year and next year we expect the oil prices to rise, the US dollar to peak, and Fed rate hikes to be fully anticipated by financial markets. Then we expect the ruble and other emerging market currencies to recover. We forecast USD/RUB 63 end of year 2018 and 60 end of 2019.

An unexpected hike

In August inflation jumped to 3.1%. Much of the acceleration reflects base effects and temporary factors such as higher food prices. However, as also noted in our latest Russia Watch: Lacklustre growth, inflationary pressures are more widespread. The increase in VAT of 2 percentage points also resulted in higher inflation. Furthermore, the tight labour market will put pressure on wages and hence raise headline inflation by the end of this year. The recent slide in the ruble will also result in imported inflation, while we expect this effect to become more apparent in September and October. Therefore, inflation is on its course to overshoot the inflation Central Bank’s inflation target (of 4%) in 2019.

In light of these factors, on 14 September the Central Bank of Russia (CBR) hiked interest rates by 25bp hike (to 7.5%). This was unexpected as the monetary policy in Russia was generally considered to be already firmly tight. The bank projected inflation at 5-5.5% for the end of 2019. It also said that it would consider the necessity of further increases, taking into account the higher inflation expectations and risks posed by external conditions. This indicates that if sanctions materialise, the CBR will be ready to act and will hike rates further. However, we think that it is unlikely that sanctions will be adopted in the current form. So our base case view is that the central bank will keep interest rates on hold (7.5%) for the remainder of 2018. Furthermore, we expect that it will resume the easing cycle carefully in 2019, and we expect the benchmark rate to be 7% end of 2019.

Looming sanctions hangs over growth outlook

Economic growth momentum increased in the first quarters of this year, by 1.3% yoy growth in the first quarter and 1.9% yoy growth in the second quarter. Economic growth was mainly driven by consumption, as low unemployment levels led to rising wages and improving consumer sentiment. Our oil analyst expects oilprices to rise further and peak in 2Q 2019 (USD 90/bbl) before declining to USD 85/bbl end-2019. We expect economic growth to be slightly lower in 2019. Higher oilprices in 2019 present an upward pressure on growth, while weak investor confidence (as a result of the looming sanctions) and lower consumption growth due the VAT increase put downward pressure on the growth forecasts (See Russia Watch: Lacklustre growth).