19/7/2014: Some Early Signs of Crimean Economy Suffering Sustained Slowdown

A very interesting data coming out of Crimea - early indicators of the cost of Crimea's incorporation into Russia: http://www.infox.sg/others/frame/krym-prishel-v-upadok/

Roughly translating some parts of the article:

Tourism is suffering in Crimea - the sector is the cornerstone of the regional economy, but over the first 6 months of 2014, number of visitors to Crimea fell ca 29.5% y/y at 1,772,000 visitors as opposed to the same period of 2013 when Crimea received 2,515,000 visitors. The issue, of course, is not solely down to Crimea's accession to Russia - given the state of civil war in Ukraine and the collapse of the country economy, there can be expected a massive reduction in the number of travellers to all parts of Ukraine. Given recessionary dynamics in Russia, there also can be expected to be fewer tourists visiting all Black Sea resorts over this summer.

According to Ukrainian estimates, overall number of Ukrainians travelling to the Black Sea resorts (including those in Ukraine proper) is projected to fall by some 30% this year due to deepening economic crisis and falling real incomes.


The collapse of tourism to Crimea is probably a temporary phenomena. And much of it is due to disruptions in transport routes. For example, ferry crossings from Russian mainland rose 2.8 times, air traffic rose 1.6 times. However rail transport numbers fell 2.8 times. Rail goes via Ukrainian mainland, so this is not surprising. There is no land connection to Crimea from Russia and ferry and airlines capacities are very limited, although they will be expanded over time. The bridge, linking Crimea to Russian mainland will likely take 2 years to build and estimated costs range from USD2 to 4 billion.

As the result, at the start of the tourism season, Crimea's resorts reported 63% vacancy rates.

In the past, roughly two thirds of visitors to Crimea were Ukrainian nationals, with one third being Russian nationals. While the former are understandably cancelling their plans to vacation in Crimea, the latter are finding it difficult to get to the resorts: majority of Russian visitors in the past opted to travel either by car or by rail - both of these routes are now firmly blocked. Meanwhile, airports in Crimea are too small to accommodate significant numbers of visitors and their capacity is now already stretched to the limit. Two major carriers Transaero and Dobrolet are reporting 100% and 98-99% loads on their flights.

While much of this suggests that the problems with tourism sector are temporary, there are some worrying parallels across all sectors of Crimean economy. Apparently, lack of compliance with certification relating to EU requirement that any exports from Crimea can be accepted only if they bear certification from Ukraine, is reducing industrial output in Crimea. And European sanctions that ban exports from Crimea are hitting the sector hard. In the past, EU accounted for over 35% of total exports from Crimea. Now this is down to USD5.9 million and accounts for just 10.2% of total exports. Largest shares of exports to EU go to Germany (4.5%) and Hungary (2.1%), while Austria, France, Poland, the Netherlands and Lithuania accounted, jointly for 3.6%. Exports were heavily concentrated in industrial machinery, chemicals and agricultural goods. Meanwhile, shipments to Russia are rising, but slower than the decline is exports to EU.

Overall, the problems in tourism sector appear to be much more significant than in the industrial and agricultural sectors but these problems appear to be linked to:

1. Temporary transport links problems;
2. Decline in travel in Ukraine and Russia due to the economic slowdown; and
3. Much more longer term issue of Ukrainian tourists switching away from Crimea.

9/5/2014: Latvian Military Report on the Lessons from Russia-Ukraine Crisis

National Defence Academy of Latvia, Center for Security and Strategic Research, recently published a hugely insightful analysts of Russia-Ukraine conflict. The paper, titled "RUSSIA’S NEW GENERATION WARFARE IN UKRAINE: IMPLICATIONS FOR LATVIAN DEFENSE POLICY" (http://www.naa.mil.lv/~/media/NAA/AZPC/Publikacijas/PP%2002-2014.ashx) achieves several things.

Firstly, it outlines step-by-step what appears to be a shift in conflict strategy adopted by Russia. This is summarised in Figure 1 below and in 10 points list on page 6 of the report.

Secondly, it outlines existent weaknesses in Nato's legal framework. In particular, these weaknesses relate to Article 5 clause operationality in the case of modern conflict that involves no formal military presence on Nato territory. De fact, the report acknowledges that Ukraine conflict to-date does not amount to a normal, legally definable war.

Thirdly, Latvian potential response to the second issue above is to attempt to address the existent and severe national imbalances that exist between ethnically Latvian population and population that is Russian-speaking (encompassing many more ethnicities other than Russians). In this, the report de facto acknowledges that there are political, cultural, social and economic disadvantages that are being placed on ethnic minorities in Latvia today.

Fascinating as this is, my focus here in on the report's coverage of the events in the conflict, contained in the first part of the paper. In this:

1) The report clearly shows that Russia's position in the region as a country with natural geopolitical interest toward neutrality and/or alliance with neighbouring states is in direct confrontation to Western European and US ambitious in that region.

2) The report also places Russian geopolitical interests in the region as ethically and legally senior to those of Western Europe and the US.

3) The report clearly identifies a major problem created by the Nato Eastward expansion during the 1990s as a legitimate threat to Russia.

4) The report also shows that Russian acceptance and endorsement of February 21st was a major concession on Russian side and that the February 21 accord was a constructive engagement for all sides concerned that could have led to fundamental change in leadership, reforms and stabilisation in Ukraine. The report clearly puts blame for violation of February 21st agreement at the feet of Maidan leaders.

5) The report clearly states that Yanukovich Government was overthrown under the threat of a coup from Maidan: "…the opposition continued to push for Yanukovitch's resignation. Speaking to the crowd from the stage on Maidan, Volodymir Parasiuk declared that if Yanukovitch did not resign by 10am on 22nd February an armed coup would occur. Police withdrew, leaving government buildings, including the President's residence, unguarded. A new coalition was created in the Ukrainian parliament, with 28 members of its members leaving the pro-Russian Party of Regions' faction."

6) The above quote clearly shows that Yanukovich's flight to Russia was carried out due to security forces withdrawal and direct threat to his life, which makes impeachment proceedings against him (based on the claim that he abandoned the seat of Government for personal reasons) invalid. It also shows that Maidan was the direct source of current interim Government - as opposed to democratic process legitimacy.

7) On Maidan snipers, the report does not endorse the official Kiev position, but gives two theories currently working their way through various media channels: "Snipers started shooting at both protesters and the police, with two versions emerging of what was happening. One, supported by Russia, was that the opposition, backed by Western countries was behind the shootings; the other, was that the snipers were from the Ministry of Internal Affairs and the SBU, acting on Soviet era type plans, with the objective of escalating the conflict, thus justifying an operation to end the protests." The problem is that, as report notes, the second version is not consistent with the outcome: "If this was true, the result was the opposite, since it gave more power to the opposition…"

8) On legitimacy of the Kiev Interim Government: "First, Russia considered Yanukovitch's impeachment to be illegal, therefore the new government was not legitimate. According to the Constitution of Ukraine, the procedure to impeach the President must observe the following procedure: a.) the President is formally charged with a crime; b.) the Constitutional Court reviews the charge; c.) the Parliament votes. The impeachment takes place only if there is a three-fourths majority." The problem is that (a) and (b) were not followed through, as far as I am aware. Crucially, there is a cooling-off period over which the Supreme Court can produce its verdict on validity of impeachment. This also was not followed through, as far as I am aware.

The report does not endorse Russian actions, but it presents the basis for them - calmly and without hysteria and subjective claims that usually accompany these in the media.


The report summarises six reasons why Russia had to act in Crimea [comment is mine]:

"Ukraine always represented a red line for Russia; therefore, it decided to act to preserve its regional interests.

• First, and most important, its military interests. Crimea has been the base of the Russian Black Sea fleet for more than 250 years. An anti-Russian government could cancel the agreement which permits Russia to have military bases there. [This is significant as it is supported by the evidence of past Ukrainian demands relating to naval bases leases and disputes the common claim that Russian bases were not subject to political threats from Kiev. They were and the only way of securing them in March 2014 was to take them over. Alternative was to withdraw from Black Sea bases and face zero presence in the Black Sea arena. Does anyone rationally expects Russia to accept such an outcome?] 
• Second, because it considers Crimea’s becoming a part of Ukraine in 1954 a mistake, since it has always been a part of Russia. [This is not an unreasonable argument from Russian side. But it does present a problem as to the previous international agreements entered into by Russia with respect to Ukraine. Of course, Moscow's response to this is that as long as Ukraine had neutral and legitimate Government, the old treaties applied. Change in the underlying conditions warrants change in treaties status and validity.] 
• Third, to give a clear message to the West that the Ukrainian issue is a real red line and it should remain in the Russian sphere of influence. 
• Fourth, to show that Russia is to be respected and considered to be of a similar stature to the United States. It does not want to be integrated into the West, but to be an independent actor. [And this status of an independent state, in Moscow's view, requires maintenance of deep territorial buffer between Nato and Russia - the buffer that shrunk from 1,600 km distance between Nato territory and St Petersburg - major Russian city - in 1989, to 160 km now] 
• Fifth, to divert public attention from Russia's own internal social and economic problems… 
• Sixth, to make clear that any attempt to split off from the Russian Federation will not be tolerated."

On Crimea operations, the report states that "…although it is true that the number of troops stationed [in Crimea before and during the referendum] increased, this is still within the limits of the bilateral agreement between Russia and Ukraine." The report does not reference legality of the troops actions in Crimea.

The report describes the outcome of the Crimean campaign as follows: "Its success can be measured by the fact that in just three weeks, and without a shot being fired, the morale of the Ukrainian military was broken and all of their 190 bases had surrendered. Instead of relying on a mass deployment of tanks and artillery, the Crimean campaign deployed less than 10,000 assault troops – mostly naval infantry, already stationed in Crimea, backed by a few battalions of airborne troops and Spetsnaz commandos – against 16,000 Ukrainian military personnel. In addition, the heaviest vehicle used was the wheeled BTR-80 armored personal carrier."

In other words, Ukrainian forces were not outnumbered by Russian forces. Nor were they overpowered. Instead, someone should ask serious questions as to whether lack of legitimacy and/or leadership from Kiev led to the situation where 16,000 Ukrainian troops in Crimea were simply unable/unwilling to engage 10,000 Russian troops and pro-Russian militias.

26/3/2014: Comment on Russia: Expresso, March 22

My comment to Portugal's Expresso on Russian economy:

24/3/2014: Russian Roulette or a Wheel of (Risky) Fortune?

What to expect this week on the Russia v the Western World stage:

1) More theatrics or threatatrics: so far the sanctions delivered amount to not much more than a buzz of a mosquito in the June midnight - weakly threatening, largely painless. In fact, current state of sanctions-for-Ukraine play is causing no impact on the real economy of Russia, although financial markets are showing their usual propensity to panic. The problem, however is that the current sanctions pretty much exhaust the list of political sanctions possible: selective travel bans and individual restrictions on two banks and a handful of banks accounts can be expanded in size, but to shift sanctions to the next level of pain will require disrupting trade flows. Thus, the EU/US are now holding their mild trump card of more broadly-based sanctions and this is weighing on the Russian markets through heightened uncertainty channel.

Given the unaltered status quo in Ukraine-Russia relations, compounded by the fact that President Obama and G7 are about to start series of week-long deliberations in Europe, as well as physically in Kiev, we can expect more sabre rattling this week. I expect the threats of further sanctions, isolation and financial ostracising against Kremlin to  intensify in the next 3-4 days, but die out thereafter. The key to this timing is that the US and EU have already explicitly drew the line in the sand - status quo of weak sanctions will remain in place, assuming Russia stays out of Eastern Ukraine. The only two unknowns here are:

• Will Russia stay out of Eastern Ukraine? My view here is that it will. We are more likely at the end of the game, than in the opening rounds.
• Will Eastern Ukraine stay calm with no acceleration of currently rather subdued protests by pro-Russian groups? My view is that this is the key threat and that despite the West's firm belief to the contrary, the Kremlin has little control over the situation on the ground when it comes to the pro-Russian protesters. Thus, the real uncertainty here is whether or not Eastern Ukrainian opposition and Kiev Government will be able to refrain from forcing Moscow's hand.

2) Over the next few months, assuming no escalation in the conflict, we can expect gradual reduction in political risks and a swing in markets pricing of risks. Currently, markets price risks asymmetrically, to the upside. This means that any adverse newsflow will trigger a broad sell-off in Russian indices. If there are any signs of political normalisation, especially tied to bilateral risk declines on both Ukrainian and Russian sides, the markets will start pricing risk to the downside and indices can rally even on weaker news. The next two points discuss the catalysts for such switch in risk pricing.

3) Ukraine is about to start dealing with the problems of state and economic collapse. This will involve, first and foremost, the discussions with the IMF, EU and US on the financial bailout. Given the role Russia plays in this (Ukraine owes Russia significant amounts against Government borrowings and gas arrears, Ukraine is hugely dependent on Russian markets for supply of energy and major inputs into industrial production, and demand for its exports) this process is bound to start drawing Ukraine into more cooperative mood vis-a-vis Russia. Russia also holds a major trump card against Ukraine in the form of gas prices. Comes April 1, Ukraine will lose its gas discounts from Gasprom and will be facing a tariff of some USD480-500 per mcm of gas from current pricing around USD268 per mcm charged since January 1. Kiev has already warned that Ukraine's domestic retail prices for gas will have to rise some 40% in order to fulfil conditions for the IMF bailout. All of this means that any bailout talks will have to involve Kremlin. And this, in turn, means that bailout talks can act as a catalyst for enhanced cooperation and de-escalation of both the conflict and the sanctions rhetoric.

4) Second stage is longer duration - as it involves political normalisation in the Ukraine. The core catalysts here will be presidential (May 25th) which may drag out into the second round (less likely) and possible late 2014-early 2015 Parliamentary elections. Given the size of the political risks discount on Russian markets, May elections should be a catalyst for the upside, although volatility will remain through the summer as new Presidential administration in Kiev starts re-asserting its role over the current Government and as the discussion on the future of presidential powers will start building up.

All above considered, my view is that we are nearing the bottom-fishing grounds for Russian equities, subject to two caveats:

• No further crisis escalation, and
• Strong investor stomach to weather incoming volatility. 

Am I alone in this call? Not exactly. Current valuations multiples on Russian stocks are at the levels last seen at the height of the 2008 crisis. By CAPE (price to 10 year average of earnings ratio), Russian equities are currently second lowest valued, after Greece. Russian core indices currently trading at around 4.8 times earnings, just over 1/3 of Indian markets valuations and just over 1/2 the P/E ratios for Brazil’s Ibovespa.

Weaker ruble favours stronger current account surplus and higher domestic earnings for companies, meanwhile high oil prices alongside the said weaker ruble favours stronger fiscal performance, giving upside to the probability of the federal government stepping in with a stimulus. Of course, ruble is probably set to lose some more ground on the USD and Euro, but it is hard to see it moving much more down.

On the economy side: growth is slowing, with 2013 coming in at lowly 1.3% GDP expansion delivered by shocks to inventories and weak fixed investments. This year, pricing in the risks to-date and a good portion of potential risks forward, the economy should generate GDP growth of just 1.0%. A rapid rebound in H2 might push that to 1.5%. Both still shy of the late 2013 projections of 2.5-2.7% expansion. January 2014 fixed investment growth was negative 7% y/y against +0.3% in December 2013.

When you look at Russian ETFs, they too support the case for going long Russian equities. RSX, iShares MSCI Russia Capped ETF and SPDR S&P Russia ETF have been supported recently on foot of insiders buying oversold Russian equities.  Per reports in the media, Vagit Alekperov, CEO of OAO Lukoil has been buying Lukoil shares, and OAO Novatek purchased 2.5 million shares between March 11 and March 14. OAO Rosneft insiders have also been buying shares in the company. These three companies account for 18% of the RSX holdings and 21.3% of the iShares MSCI Russia Capped ETF

All you need for some of the above to start rising fast is: political risks abatement and dividends uplift. Political risks are talked-through above. So to dividends: in 2013, Russian equities were the fastest growing dividend generating market in the Emerging Markets and Putin has been actively pushing Russian listed companies to up their dividend payouts to 35% of their net income.

Buckle your seat belts (they should have been bucked already, folks)...

22/3/2014: Russian Capital Flight and Current Account: Crimea's Punch

While sanctions against Russia have been pretty much anodyne to-date in direct economic impact terms, there are indirect effects worth considering that are worrying from the economy's perspective. Some of these are boiling down to capital flight vs inflows of funds from external balance of trade.

Chart below sets the stage through Q4 2013:

While we do not have full Q1 2014 data in what we do know is that outflow of capital has accelerated on Ukraine/Crimea news. Here's one report putting full year 2014 estimates at USD130bn so far, double 2013 recorded official outflows: http://www.themoscowtimes.com/business/article/goldman-puts-2014-capital-flight-at-130bln/496228.html. And the Central Bank has so far promised not to impose controls on outflows: http://www.reuters.com/article/2014/03/18/us-ukraine-crisis-capital-idUSBREA2H0NH20140318.

On the current account side, so far, there should be little impact. Gas flows to Europe not only remained un-impacted by the Crimean crisis, but through March 10th, these actually averaged a rise month-on-month, from around 440 thousand cubic meters per day in 2013 to around 476-477 thousand cubic meters. But the problem is that much of shipments via Ukraine is currently accumulating in the arrears account, which is hard to close in the environment of a crisis. Should Ukraine default on payments to Russia or delay these significantly, the current account side of the above funds flows will be hammered. In 2013 alone, absent the standoff in Crimea, Ukraine's unpaid arrears to Gasprom stood at USD3.3 billion. This was partially covered by a payment of USD1.28 billion made on February 14th, with current arrears of USD1.99 billion still outstanding for the balance on 2013, plus January-February 2014.

The overall arrears on Naftogaz (Ukraine's state gas imports agency) are a problem and are likely to feature in the IMF funding deal to be struck before the end of this month. Whether or not the IMF forces Ukraine to default (partially or fully) on its gas imports-related arrears is unknown, but there is some possibility this might happen.

However, as is (above chart), since 2013, Russian current account surplus already no longer covers capital outflows, which explains much of the rouble weakness in 2013 and ongoing weakness in 2014.

So what is the possible impact of the risks to gas and oil trade from Russia on Russian economy? Here are some points:

1. Gas is far less important to Russian Government revenues than oil: Gas accounts for just around 20-22% of budget revenues. Russian Federal Budget is balanced at oil price of USD115/bbl, which is falling as rouble depreciates, and now probably set around USD110/bbl.
2. Balance of payments is under a greater threat from Ukraine crisis: gas accounts for 14% of Russian exports against 50% for oil and petroleum products.
3. Russia's oil exports are only about 8% exposed to Ukraine's transit (Druzhba pipeline) and shipments are declining (2013 transit of 15.6 million tonnes against 2014 planned transit of 15 million tonnes).

Mitigating factor to all of this is the South Stream pipeline which is scheduled to ship 63 bcm of gas cutting Russian exports transit dependence on Ukraine to roughly 50 bcm and is set to become operative around 2015.

Either way, the problem for Russia in the short term is capital flight. If Estimated losses of capital in Q1 2014 are to run at USD60-70 billion (note: Capital Economics forecasts the latter figure), given stagnant or declining current account surplus, monetary authorities have three tools at their disposal:

• Allow further devaluation of the rouble (chart below shows why that is unlikely to provide much of a cushion, given already massive devaluation to-date)
• Raise rates (current rates already biting hard into economy, with further uplifts risking to push economy into a recession)
• Capital controls (politically hard thing to swallow in the current investment environment: see second chart below) 

Which means that all three measures will be tried, with primary emphasis on devaluation. This in turn means that the investment case for Russia is still weak, despite a significant fall-off in equity valuations. Bottom fishing is some time off for investors.

18/3/2014: Crimea's Fate Sealed, It's Time for Risk-on on Russia

Key takeaways on today's news from Crimea, so far:

• Crimea is now fully legally incorporated into the Russian Federation and this makes the region's split from Ukraine and accession to Russia irrevocable, no matter what sanctions are being put forward.
• President Putin's address to joint meeting of Russian Duma and Federation Council raised a number of very strong geopolitical points. The main one being the role played by the Nato expansion over the last 20 years in triggering the latest crisis. Despite this, President Putin clearly extended a proverbial olive branch to Nato and positioned this offer of continued cooperation on the shared interests footing (mutual respect and coexistence with recognition of the legitimacy of Russian 'Near Abroad' sphere of influence).
• The Crimean crisis was from the start largely a Russia-Ukraine issue. Thus, Western engagement in it became excessively overbearing on the one hand (starting with the EU pushing forward its own Neighbourhood policies toward Ukraine without having any respect for or consideration of the country's massive economic, demographic, cultural and political links with Russia and without engaging constructively with Russia on bilateral basis) and strategically weak and indecisive on the other (with EU offering no constructive platform for a dialogue with either Ukraine or Russia since November 2013).
• Overall, President Putin's speech was yet another signal to the West that he is ready to consider more constructive engagement and dialogue, and that Russia is not interested in any serious acceleration in the confrontation. The latter point was very clear from the onset of the Ukrainian crisis, not just during the Crimean crisis.
• President Putin is correct that the Crimean crisis was resolved without any loss of life, in contrast to Bosnia, Kosovo, etc.
• Putin's speech, by bringing Russia back on track to seek normalisation of its ties with Ukraine and the West, means that Europe and the US are once again being left without any visible strategic alternatives and puts Moscow one step ahead of them in this geopolitical game. Effectively, the US is now firmly stuck in the proverbial corner: it cannot de-escalate vis-a-vis Russia and it cannot accelerate current sanctions to anything more meaningful. Instead, it is now more likely the US will focus its resources on trying to salvage the current Government in Kiev.

Most significantly, Putin can now set out a number of contrasting and legitimising points to the accession of Crimea:

1. The referendum on Sunday stands in stark contrast to the lack of referenda when Crimea was 'gifted' to Ukraine in 1954 and when Ukraine and Russia (alongside with Belorussia) agreed to dissolve the USSR back in 1991.
2. Crimean accession was carried out on the request of the Crimean government that had effectively no less legitimacy than Kiev government has today. It was created on foot of a popular revolt by the democratically-elected parliament (although in the case of Crimea, as far as I am aware, opposition was present at the vote, unlike in the case of Ukraine).
3. Officially (and that is not to say that this is a complete truth, which we may know one day) Russian military presence in Crimea did not exceed the contractually allowed 22,000 troops. Hence, technically, there was no violation of sovereignty. There was no opposition from the Ukrainian army, further confirming the above point (even if this lack of opposition was driven by the confusing orders from Kiev). The role played by militias (subject to the first caveat above) is no different from the role Maidan forces played in Kiev... etc, etc… All of which (not to justify the events that took place) goes to confirm that there is very little difference (at this point in time) between what happened in Crimea and what happened in Kiev.
4. Whilst Ukrainian constitution does not recognise secession referenda held in a single region as valid, it is worth reminding that the same legal reasons for rejecting the Crimean independence were also raised in the event of secession of Ukraine (and Russian and Belorussia) from the USSR in 1991. It is, therefore, kind of hard for Kiev to have the old the cake and still keep it at the same time.

So today's news put the score at Russia 2: West 0. And with it, Russian markets should be shifting into a 'risk-on' mode over the near future.


Note: as I said before, my preference was and remains for the territorial integrity of Ukraine to remain intact. But setting aside my own preferences (and controlling in the above arguments for my imperfect knowledge of the events and facts on the ground), the current outcome is a new status quo. There is absolutely nothing anyone can or should do about it.

10/3/2014: Crimean Crisis: NewstalkFM podcast

There was a very robust and interesting discussion of the Ukrainian crisis (including Crimea) last night on NewstalkFM Marc Coleman's show. Podcast http://russianireland.com/index.php/home/news-mainmenu/politics/7791-2014-03-10-08-52-48

Very good panel (excluding my small contribution).