By Sergei Gorbunov, Ph.D., CFA
On 29 July, the European Union joined the United States and announced a further, much tougher package of sanctions against Russia. This targeted the energy and defense sectors as well as state-controlled banks. The measures, which took effect on August 1, are limited to future contracts and will not be applied retroactively. But we have to ask, what has been done, and what does it mean for the near future?
Here are the details of the sanctions:
The Natural Gas Sector Is Untouched
- EU exports of oil exploration technology and drilling equipment for deepwater oil exploration and production, Arctic oil exploration or production, and shale oil projects are now banned.
- A ban on energy equipment applies only to the oil industry, whereas the natural gas sector is unaffected as the EU depends on Russia for roughly one-third of its gas imports, and Russian gas delivered through pipelines is less flexible than crude imports.
- The defense sector is also subject to sanctions. Exports of weapons systems and dual-use technology are not permitted.
The Financial War Is on
- The most important measure agreed to imposes constraints on new financing.
- Sanctions on the financial sector affect all of Russia's large state-controlled banks: Sberbank (OTCPK:SBRCY), VTB Bank, Gazprombank, Vnesheconombank (VEB), and Russian Agricultural Bank (Rosselkhozbank).
- New equity and bond issues of these banks are banned on European markets. Unlike the United States, the EU did not ban syndicated bank loans with maturities of more than three months.
- EU subsidiaries of the targeted Russian banks are excluded from the ban, but they are prohibited from raising funds for their parent companies.
In its turn, the United States matched the EU move by adding three more Russian state-controlled banks: VTB Bank, Rosselkhozbank and Bank of Moscow to the US sanctions list released on 16 July.
Initially, it contained several of Russia's leading companies and banks including oil major Rosneft (OTC:RNFTF), independent natural gas producer Novatek (OTC:NOVKY) and Gazprombank, the financial arm of Gazprom (OTCPK:OGZPY). All these entities are off limits for debt financing longer than three months. The U.S. may limit derivatives trading and short-term loans with Russian companies if further escalation of sanctions is considered necessary. Unlike the EU sanctions, the US sanctions do not target the biggest Russian state-controlled bank, Sberbank.
Dependence on Foreign Funding Is Rather High
Foreign financing is very important for the Russian corporate sector, as it represents roughly 40% of total external funding. Total corporate foreign debt is close to $650 billion, or 31% of GDP and roughly 140% of foreign reserves. According to the Central Bank of Russia, Russian banks must refinance about $50 billion of foreign debt this year and next, whereas companies' refinancing needs stand at around $100 billion.
The restrictions on access to US and EU capital markets pertain mainly to state-controlled entities. Nevertheless, the whole corporate sector of Russia will be negatively affected through reduced access to external funding and rising funding costs in all markets because of elevated political risk premiums and poorer prospects for economic growth due to the sanctions.
Alternative sources of external financing will likely be insufficient to offset the closure of Western capital markets. Non-Western capital markets are not that deep. Moreover, local financial institutions may be reluctant to provide funding to firms under US and EU sanctions.
Financial Sanctions Are Not a Problem
In the short term, the constraints on access to external financing are unlikely to have a serious effect on banks and corporations because the fundamentals of the Russian corporate sector are relatively healthy. Also, unlike the 2008-2009 global financial crisis, the credit squeeze is not accompanied by a fall in oil prices.
The strong fiscal position of the Russian state and ample foreign reserves make it possible for Russian borrowers to be financed solely from domestic sources for at least two years. As during the financial crisis of 2008-2009, Russian authorities are likely to respond to the rapid reversal of capital flows by providing extensive liquidity facilities to keep strategic industries and banks afloat and cover external repayment obligations. This may lead to a partial reversal of Russia's integration into the world economy and further increase the state's role as major companies deleverage abroad or swap expensive external financing to government-backed lending.
Uncertainty Is on the Rise
Risks may rise if sanctions remain in place longer and/or continue to intensify. The prospect of additional sanctions may lead to a major increase in uncertainty that further affects Russian firms. Even before the sanctions, political and economic uncertainty reduced Russia's access to financing, increased its borrowing costs, and caused capital outflows to increase and fixed investment to fall.
For instance, in the second quarter of 2014, foreign bank lending to Russian companies fell 42% from a year earlier. And the spread on loans rose to 287 bps from 194 bps. The latest round of sanctions will likely further amplify that uncertainty as neither side appears ready to back down on the crisis or look for some compromise.
Foreign Investor Sentiment Is Fading
It is also worth noting that the latest round of sanctions is a blow to foreign investor sentiment, which had taken the risk of sanctions rather lightly. Now, it seems realistic that the Russian asset market will remain shut down for some time to Western institutions. Reflecting the changing investor mood, as well as geopolitical tensions around Ukraine, two major stock index providers, MSCI and Standard & Poor's (S&P), are considering removing Russian companies from their gauges.
MSCI is launching a new series of composite indexes that will exclude Russia for investors who want to avoid exposure to Russian assets. MSCI also is considering removing VTB ruble shares from its Russia index. Another option is to maintain VTB Bank in MSCI Russia Index until the first issuance of new shares. In its turn, the S&P is asking clients whether it should remove sanctioned firms from its indexes. S&P is also considering whether a firm sanctioned by a specific country should be treated as sanctioned in all jurisdictions. As for Russian bonds, JPMorgan said its emerging market bond index will not include any new bonds issued by sanctioned Russian firms.
These moves that look purely technical may, in effect, be more serious than sanctions themselves. They may further accelerate the exodus of foreign investors who hold almost $200 billion of Russian equities benchmarked to indexes and result in an enduring bias against investing in Russia, thereby destroying some of the core financial arteries that have been built since the early 1990s. Index reshuffling of this kind may result in many Russian equities becoming uninvestable for a large part of investor base, particularly for US institutions and those managing US money. It also raises perceptions of an impending market shutdown for foreign investors which, at least for now, is not in the offing.
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