Wednesday, July 30, 2014

Understanding the Russian Sanctions

By Roy C. Smith and Ingo Walter

The latest tightening of the US and EU sanctions on Russian business and finance will provide an interesting lesson in international political, economic and military affairs. Here are some key issues to think about:

These Financial Sanctions Can Be Very Potent

They deny Russian access to capital markets in the US and Europe, which is to say global capital markets. Asian markets are not included but they are not significant enough to matter much.  This is the most important sanction imposed on Russia so far, since Russian banks and businesses have been obtaining about half of their total funding requirements from these markets over the past three years, according to the FT. 

Between them, Russian non-financial state-controlled companies ($41 billion), state banks ($33 billion), private banks ($20 billion) and non-financial private companies ($67 billion) will have $161 billion of foreign debt maturing in the next 12 months. The sanctions prohibit these borrowers from rolling-over this debt.

Where’s the Re-funding Money Going to Come From?

The Russian borrowers will have to obtain funds from sources other than the capital markets to avoid default.  The logical main source of refinancing is the Russian central bank, which can draw upon the country’s $500 billion or so of foreign currency reserves.  Russia has the means to absorb the effects of the sanctions for a few years, at least, but the effects on economic performance will certainly be meaningful. It could have the effect of shutting down Russia’s internal credit generating capacity.

If Russia fails to refinance its maturing debt, the borrowers will have to default – and since many of the borrowers are state-controlled, this will turn into a “sovereign” default. Default makes all outstanding foreign debt become immediately due and payable.

This will trigger all sorts of additional denials of credit to Russian banks and businesses, which would deepen the isolation of the Russian economy, reduce the value of its currency, increase interest rates and inflation and curtail domestic growth, which is now forecasted at about 0% for 2104. 

Adding to the pressure is the recent ruling of the international Court of Arbitration in The Hague that the Russian state misappropriated assets of Yukos several years ago and must return $50 billion to shareholders of the company. Russia does not want to pay this claim, but it is an obligation of the government and surely will involve default litigation if not paid.

Default most likely would trigger a rush by foreign creditors to impound Russian assets abroad (think of Lukoil’s gas stations and Aeroflot aircraft “arrested” at JFK Airport), plus certain foreign currency receipts - including (possibly) those related to sales of oil and gas and other commodities.

Some may not believe a default would have that much of an impact. Russia says it can become more self-reliant. But just ask Argentina about its economic track record since 2001, when it undertook the world’s largest default, compared to how the country would have done otherwise. Now that Argentina in on tenterhooks again after 13 years in default, stay tuned. Russia tried a debt “moratorium” in 1998, and learned to regret it. The key to avoiding default is the ability and willingness to service foreign debt. Russia may be able but unwilling.

The Other Announced Sanctions are Meaningful - But Longer-Term

They also include prohibitions on the access to oil and gas industry technology that is crucial to Russia’s ability to develop its energy reserves in the future, and limit transactions in the armaments industry. The effects of these sanctions are much more structural and will only be felt over the years, but they are important nonetheless.

The Sanctions Are Enforceable.

As we saw in recent US litigation of major European banks engaged in sanctions-busting, violations of the rules related to the enforcement of sanctions can involve very meaningful penalties. These rules are now not just American rules, but have been adopted and will be enforced in Europe also.

Economic Sanctions Can Replace Military or Diplomatic Moves

The Russian sanctions are the first set of US and European economic  “blockades” that have been applied to a major country with serious military capability. They may have a chance because of the increased globalization of the Russian economy which brought with it growth and increased prosperity for its people. Sanctions can result in a serious drop in Russia’s domestic economic welfare and possibly cause pressure on the government to change its behavior in Ukraine in order to avert domestic discontent.

But don’t bet on it. Russia is far from democratic. Russians are nationalistic and Putin at least temporarily is at the top of his game. He thinks Russians are stoic and suffer well – invoking World War II and decades of stagnation under Communist rule. His oligarchs and cronies are certain to squeal under the sanctions, but he can pick them off one at a time. And he can point to the spotty record of sanctions imposed on countries like North Korea, Cuba Iraq, Sudan and Iran in changing offending policies.

But whatever he says, these sanctions are going to be painful and reduce growth and economic opportunity for all the Russians. It will be an interesting time. Fasten your seat belts.

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