There’s been little progress resolving the Ukraine crisis, and Russia’s pain from sanctions could be just beginning. Russian President Vladimir Putin and Western leaders are trading blame over continued bloodshed in Eastern Ukraine. And German Chancellor Angela Merkel said Friday that sanctions against Russia would stay in place.
The real pain for Russian companies is still coming, Jorge Mariscal, chief investment officer of emerging markets at UBS AG said in an interview with Risk & Compliance Journal. Over the next year or two, continued sanctions would chew into Russian profits and cause a spiral of decline in the country’s economy, Mr. Mariscal said. “People believe Putin is this chess master,” he said. “But they underestimate Russia’s vulnerabilities.”
– What are the medium term risks that Russian sanctions pose for companies and investors?
Mr. Mariscal: E.U. and U.S. restrictions prevent Russian firms under sanction from borrowing for more than three months. But they can borrow in the short term. Right now it’s O.K. because the cost of borrowing is very low right now. The interest rates are very low.
But that’s not a smart thing to do on an ongoing basis because the companies under sanction will be exposed to interest rate risk as the Fed starts tightening some time next year. Short-term financing will expose them to higher financing costs.
So right now, a lot of these companies are doing relatively O.K. because they have cash in their balance sheets. They can also borrow in local currency to the extent that their operations allow it and they don’t need foreign exchange. But over time, if these sanctions aren’t lifted they are going to run into a tighter and tighter predicament. We estimate they are O.K. until the middle of next year or late next year. Much longer than that they are going to begin to see pressure. As interest rates start to move up then their cost of funding will increase and profitability will suffer.
They can borrow within Russia in rubles, but if these companies want to import, they need dollars or euros, not rubles. A U.S. exporter is only going to accept dollars. And if they borrow in Russia they are going to have much higher interest rates. Interest rates in Russia are around 9% right now, it’s much more costly.
The government could make dollars available through the central bank. They have resources to do so. But that would impact the perception of risk on Russia because then the foreign exchange reserves in the country would be coming down, leading credit agencies to downgrade further and increasing concerns about Russia’s ability to service debt. That’s going to squeeze economic activity even further.
– Are we starting to see any of these effects right now?
Mr. Mariscal: Capital flight has been increasing in Russia. The estimates vary as to how much. They have lost a fair amount of reserves. They had a recent peak of $537 billion in March of 2013. And today Russia has $435 billion in reserves. They still have a fair amount, $435 billion is not peanuts, but the rate of depletion is quite alarming. In the last month, they lost $30 billion.
– What does capital flight tell you?
Mr. Mariscal: Number one, it’s a reflection of a poor business environment. The overall incentives to invest in Russia are quite low right now. But it also tells you the ruble is likely to depreciate against the U.S. dollar, which makes it more expensive for companies that import things into Russia. A weaker ruble ends up reflecting higher customer prices and tighter monetary policy. If the central bank is forced to raise interest rates to stave off some degree of the decline in the ruble and capital flight, that only slows down the economy further and makes the cost of funding local companies more expensive. So you create a vicious circle.
– What are the risks to U.S. and European companies?
Mr. Mariscal: The risks are not large enough to worry economies broadly. The impact is that Russian companies are going to be short on dollars to conduct transactions, so you could see less funding to buy imports from the U.S. or Europe.
But in many cases these imports have already been banned. So even if Russian companies have the funding for sophisticated oil equipment, they have been banned. Sophisticated military equipment has already been banned.
You look at the overall trade of the U.S. or Europe with Russia it’s relatively small. If a company made its business in buying or selling equipment for oil exploration with Russia, then obviously it’s going to be hurt. But this business represents a relatively small percentage of the U.S. and EU economy. That’s not a significant impact, even in the medium term, if this continues.
The one wild card is Russia might retaliate, which they’ve threatened to do. But they have not yet done anything that really bites. For awhile, they threatened to freeze assets of Western companies operating in Russia. But the bottom line is Russia is very vulnerable right now, so they would be shooting themselves in the foot by imposing sanctions on foreign entities.
The real sanction they could impose back on the West would be to curtail gas supplies into Europe. That would hurt. That could send Europe into recession and rattle global financial markets in a meaningful way. But rattle is the word for what would happen to the U.S. and Europe. It would be a disaster for Russia. The country would go into deep recession. It would hurt Russia a lot more. Almost 60% of Russia tax revenues are oil and gas. They’d be shooting themselves in the foot.
Whether even the mild recession this would produce in Europe would be tolerable is a question mark. The Europeans have so far not been willing to go all the way with blanket sanctions, partly because they don’t want to force Russia into a corner where they’d have to impose gas rationing. It’s also the fact that they want to continue to have ammunition, in case Russia does something crazy. If they go all the way to blanket sanction, then what’s left? The only thing left is military action. And that’s unthinkable.
