More than a year has passed since the U.S. and EU began imposing sanctions on certain Russian and Ukrainian entities in response to former President Viktor Yanukovych’s flight, the annexation of Crimea and a separatist rebellion in the Donetsk and Luhansk regions. Although a shaky ceasefire was implemented in February 2015 with the signing of the Minsk II Agreement, the fact that almost none of its objectives have been entirely fulfilled ,and that violence continues relatively unabated near and within the separatist-held regions, means that the U.S. and EU may find themselves pressed to continue or possibly escalate their coordinated sanctions policy this summer.
Sanctions are about as far as the U.S. and EU can go without escalating and further inflaming what still remains a relatively localized conflict on the periphery of Europe. Given Russia’s importance on the world stage, both in political and economic terms, the U.S. and especially the EU have been reluctant to apply sanctions that could have especially detrimental consequences for American and European businesses interests. Moreover, the EU and U.S. have been equally cautious to make sure that their respective, yet coordinated, sanctions do not directly affect (negatively) the average Russian citizen, fearing that such a move would rally Russians against the West (which has happened nevertheless). The U.S./EU sanction regime, in this respect, is designed to apply targeted pressure on Russian business and political elites, as well as on major state companies and institutions that produce revenue for the Russian government. The hope is that sanctions will hit state pocketbooks, as well those of the elite close to the Kremlin, who would pressure President Putin to change course in Ukraine. Prompting a broad economic crisis in Russia was never the intent of U.S./EU sanctions, especially since the economies of Russia and the EU are quite significantly intertwined. Russia’s economy, nevertheless, is in complete crisis-mode, suffering from negative GDP growth and high inflation.
There is no doubt that sanctions contributed to the economic crisis in Russia. By cutting off access to Western capital markets for major state corporations and instituting trade restrictions on strategic technology (i.e. offshore drilling), among other restrictions, the Russian government’s ability to finance its budget, especially in the midst of a major military upgrade, has already taken a hit. However, oil prices and a dearth of foreign investment, both of which began affecting the Russian economy in 2013 (in which the economy only grew by 1.3%, compared to 3.4% in 2012), are the main culprits of the current economic crisis afflicting Russia, with sanctions only making remedying the crisis ever more difficult.
The Crisis Begins
Today’s Russian economy is in shambles, although less so than what many analysts expected directly following December 16, 2014 – dubbed “Black Tuesday” – which saw the ruble fall from around 60 to 80 per dollar in one day before strengthening to a still paltry 68. To put it in perspective, a year prior (December 2014), the ruble was trading at around 32 to a dollar, meaning that by the worst hours of Black Tuesday the ruble had devalued against the dollar, year-on-year, by almost 60%. The Central Bank of Russia quickly intervened, raising interest rates to 17% from 11.5% and implementing a ruble buyback program. The Central Bank spent nearly US$40 billion in foreign reserves to stabilize the national currency against investor panic and sell-off between December 2014 – January 2015, and $60 billion between December 2014 – April 2015, when reserves reached their lowest point. By April 17, 2015, Russian foreign exchange and gold reserves stood at US$350 billion, down nearly $160 billion from January 2014 when the Ukraine crisis began in earnest. Standard & Poor’s knocked Russia’s credit rating on January 26 from BB+ from BBB-, stripping it of its investment grade. Moody’s followed in February, downgrading Russia’s credit rating to junk grade to Ba1, which is one level below investment grade. Fitch, however, has been a bit more conservative than its peers, knocking Russia’s credit rating down to BBB-, which is still a level above the “junk” grades that Moody’s and S&P had assigned to Russia’s foreign currency credit rating. All three credit agencies, however, predicted a negative economic outlook for Russia, citing the sharp fall in the oil price and Western sanctions.
Recovery and Stagflation
As of late June 2015, however, the economic situation in Russia looks far less dire – at least sufficiently enough for President Putin to claim, at the 2015 St. Petersburg International Economic Forum that Russia has “stabilized the [economic] situation.” The ruble is 2015’s best performing currency, the Russian Central Bank is restocking on foreign currency reserves, reversing its policy of selling its foreign currency to bolster the ruble, and the World Bank has revised its GDP forecast, forecasting that the Russian economy will resume growing – albeit by .07% – by Q1 2016 (this is up from a forecasted .03% contraction in GDP). Russia is still plagued by structural problems in its economy stemming from deep and widespread corruption and reliance on energy commodities, but economic indicators are nevertheless looking much brighter than they were back six months ago, even given that Western economic sanctions are still in place, with the EU planning to extend their own by another six months.
Sanctions do – and have had – an economic effect on Russia, but they have had nowhere near as large an impact as the drop in oil prices. Russia, which has the largest natural gas reserves in the world and which was only until recently the world’s top oil producer (the U.S. eclipsed Russia in this respect in 2015), relies on energy exports, primarily oil and gas, for more than 50% of its federal budget, which, before the crisis, relied on oil standing at more than US$100/barrel. Comparing the RUB/USD rate and the price of Brent oil in 2014 to early 2015 shows a rough correlation between the price of oil and the value of the ruble, with the December 16, 2014 ruble sell-off coinciding with a historic low in oil prices. With Brent crude currently hovering in the low US$60’s per barrel, which constitutes a nearly 35% increase since its low of around $47 in January 2015, the Russian government is better able to weather its financial crisis. Nevertheless, Russia remains at the mercy of oil prices, definitively more so than Western sanctions. Moreover, the US$60/barrel figure is not enough for Russia to fill its budget with enough funds to finance its ambitious defense spending while simultaneously investing in general infrastructure projects throughout the country without incurring a sizeable deficit. However, as long as oil prices continue to strengthen, or at least hold off against falling back to the lows that were seen in December 2014 and January 2015 in particular, the Russian government will be able to more easily weather the economic crisis.
However, Russia’s ability to weather the most acute stage of the crisis should not belie the reality that it is entering into a period of economic stagflation, marked by high inflation and an economic slowdown, although unemployment remains artificially low at 5.6% (“artificially” because many Russian workers have been moved to part-time schedules, especially in factories). Foreign investment is also drying up, with only 178 (worth US$13 billion) foreign investment projects set up in 2014, down from 396 in 2013 (worth US$23 billion), according to FDI Markets, a service from The Financial Times. The Russian government has publicly indicated that it will do very little to make up for the lack of foreign investment, with Russian Finance Minister Anton Siluanov on June 5, 2015 noting that the government spending commitments that the Russian government had pledged when oil was hovering at around US$100 barrel are currently “unmanageable.”The Russian federal budget deficit is expected to grow to 3.7% of GDP in 2015, up from 0.5% in 2014. While financing this deficit is manageable given Russia’s reserves, budgetary constraints caused by inflation (pensions and other social expenditures will need to be indexed), the government’s desire to eliminate the deficit, and massive amounts of military spending, will inevitably require further budgetary cuts for internal investment projects. Hit by inflation and falling domestic and foreign investment, Russia’s long-term economic situation looks precarious, as former Finance Minister Alexei Kudrin remarked at the 2015 St. Petersburg International Economic Forum: “It is already practically the case that from 2012 to 2018, the time of [President] Vladimir Putin’s last term, the average growth [of the Russian economy] will be 1.4 percent per year. This means that by 2020, Russia’s share in the global economy will stand at 2.7 percent.”
The Real Effect of Western Sanctions on the Russian Economy
In January 2015, Siluanov said that Russia would suffer a US$180 billion shortfall in revenues due to the drop in oil prices, adding that sanctions would create a shortfall of between US$40-60 billion. The oil shortfall is understandable, especially given the Russian federal budget’s reliance on energy exports; but what are sanctions in particular doing to create its own adverse effect on the Russian economy?
An immediate effect of U.S./EU sanctions, particularly sectoral sanctions that placed restrictions on major Russian state banks and energy companies from raising capital in the West, is a credit crunch for banks and other companies, primarily those operating in the energy sector such as Rosneft (sanctioned by the U.S. and EU) and Gazprom (only U.S.). In the Russian banking sector, the government acted swiftly, especially given that the currency crisis had prompted many Russians to begin withdrawing funds from their accounts, thereby reducing the working capital of many Russian banks. Gazprombank, the third largest bank in Russia, a subsidiary of Gazprom, and a target of U.S./EU sectoral sanctions that prohibit U.S. and EU persons from dealing in its new debt and equity, reported in December 2014 that the Russian government had purchased RUB39.95 billion (around US$700 million) in preferred shares in the bank using money from the Russia’s National Wealth Fund (NWF). Earlier, in August 2014, the Russian government acquired shares in VTB (the second largest bank in Russia) and Rosselkhozbank, both of which are under U.S. and EU sectoral banking sanctions, in exchange for outstanding debt of RUB239 billion (US$6.6 billion). VTB is currently set to receive the first tranche of a US$2.5 billion bailout in order to increase its capital for loans and businesses. In the energy sector, Prime Minister Dmitry Medvedev approved the allocation of RUB150 billion (around US$2.5 billion) from the NWF to continue the development of Yamal LNG, an LNG project spearheaded by Russia’s largest independent natural gas producer Novatek, which is also subject to U.S. sectoral sanctions restricting its ability to raise financing in the West. Government-owned Rosneft, which is also the largest publicly traded petroleum company in the world, was targeted by U.S. economic sanctions (imposing restrictions on U.S. persons from dealing in newly generated Rosneft debt) in July 2015, and then by similar EU sanctions in September. Although burdened with foreign debt of nearly US$40 billion, half of which was due in Q1 2015, the Russian government has so far only provided the company with US$5 billion out of the requested US$25 billion in government funds.
While U.S./EU sanctions are forcing the Russian government to spend more out of its reserves to support the afflicted banking and energy sectors, it is causing foreign and private domestic investors to spend considerably less, which, in the long run and taking into account the Russian government’s reluctance to spend public money on anything besides the military, will hurt Russia’s growth prospects. In an article published in Bloomberg, Jeff Nassof, a vice president at Freeman & Co, a New York-based consulting firm, noted that 2015 is “currently on pace to be the worst year for Russian investment banking since 2001.” According to data compiled by Freeman, banks collected US$70 million in fees advising on Russian mergers and securities sales in the first half of 2015, compared to US$178 million in the first half (through to May 31) of 2015. Deutsche Bank AG has only made US$1 million in fees this year, compared to US$16 million during the same period last year, while prominent foreign investment banks such as UBS, Goldman Sachs and Citigroup have billed next to nothing. In addition to being blocked out of equity and debt transactions for key state-owned companies, and restricted completely in dealing with a number of other Russian companies and prominent businessmen, foreign investment banks are also faced with the fear of dealing with Western regulators. The US in particular has a track record of imposing massive fines on leading banks for international sanctions violations. This fear is not only felt by Western banking and finance entities, but also by those based in China, which, according to Yuri Soloviev, the first deputy chairman and president of the management board of VTB Bank, have refused to carry out interbank transactions with their Russian counterparts and have curtailed trade financing transactions in the wake of U.S./EU sanctions.While Chinese investment in Russia has indeed increased year-over-year in response to the flight of Western investors, Russia’s reliance on Eastern foreign investment to substitute Western investment may not quite be enough to make-up for the shortfall. Chinese banks with U.S. or EU operations are also subject to their sanctions policies and generally have little experience, especially compared to Western banks, in operating in the Russian financial sector.
Despite reports to the contrary, the European Union remains relatively unified with respect to its sanctions regime against Russia, as evidenced by its June 22 decision to extend economic sanctions, imposed on the Russian banking/finance and energy sectors, by another six months. The United States has continued the line that its sanctions, including its economic sanctions, will remain in place (they do not expire and are not up to periodic review like EU sanctions) until the provisions of the Minsk II Agreement are fulfilled. Given that fighting between the Ukrainian Army and separatists from the Donetsk and Luhansk regions of Ukraine continues unabated, the likelihood that U.S./EU sanctions against Russia will be mitigated or removed in the short-term decreases by the day. The implication of this is that the Russian economy will continue to be subject to the doubly negative and external forces of Western sanctions and low oil prices for the long-term.
Although President Putin and other prominent Russian political figures paint the economic crisis as a speed bump on the path to development, with an exit from recession expected by the end of the year, those with intimate knowledge of the Russian economy provide a far different picture. At the St. Petersburg International Economic Forum this year, the CEO of Sberbank, Russia’s largest bank and lender, noted that the “acute phase of the crisis has passed, but that does not mean we have passed through the crisis itself. Defaults and bankruptcies are still ahead.” The Central Bank of Russia recently warned that if oil prices remain at where they are – currently hovering at around US$60/barrel – Russia’s economy would contract for a second year in a row in 2016. Kudrin, speaking earlier in June, flatly rejected official claims that the worse was over, remarking that Russia was still in a “full-fledged crisis.”
For ordinary Russians, the economic crisis has already hit close to home. The number of Russians living in poverty increased to 16.1 million from the Putin-era low of 15.4 million in 2012. Year-on-year retail sales fell in May 2015 by 9.6%, while wages fell year-on-year by 7.3%, and inflation stood at 15.8%. Russians are increasingly seeing their purchasing power wither due to inflation (especially when it comes to food products, which on comprise 50-60% of the average Russian’s monthly income) and the volatile ruble, both of which have already deterred many Russians from traveling abroad, especially to Europe, where entire markets are suffering due to the lack of Russian tourists.
In short, the Russian economy is heading towards a long-term recession caused by the over-reliance of the Russian state budget on high oil prices, which, as far as any economist is concerned, will certainly not reach US$100/barrel levels in the short- to medium-term, and perhaps even in the long-term as advanced economies move towards more sustainable fuels. Where sanctions have a part in contributing to Russia’s economic quagmire is in restricting access to Western markets for targeted entities, all of which are main drivers of the Russian economy, and create increased risk in dealing with other, un-listed Russian entities for both Western companies directly subject to U.S./EU sanctions, as well as for companies based in other countries, but that are still subject to U.S./EU sanctions by virtue of having operations in either jurisdiction. Even as Russia looks East to China for access to capital markets and technologies, it will find partners hesitant to undermine Western sanctions, especially given that both the EU and the United States are both much larger trading partners with China than Russia – in fact, in 2014 Russia was China’s ninth largest trading partner, whereas the EU and U.S. were first and second, respectively. The fact of the matter remains that as much as sanctions are frustrating element to the Russian economy’s ability to cope with the current crisis, the crisis itself has been caused by Russia’s inability to create a diversified federal budget able to withstand shocks in oil prices.