24/8/18: Moscow's Fiscal Resilience in the Headwinds

Back in September 2017, Fitch (with Russia rating BBB-) estimated that the U.S. sanctions were costing Russia ‘one notch’ in terms of sovereign ratings, with ex-sanctions risk conditions for the Russian sovereign debt at BBB. Last week, Fitch retained long term debt rating for Russia at BBB- with positive outlook, noting the Russian economy’s relative resilience to sanctions.

Budgetary Resilience

Per Fitch, and confirmed by the Russian Finance Ministry analysis, Russia is looking at recording a budgetary surplus in 2018:

Fitch analysis projects the budget surplus to average 0.1% of GDP in 2018 and 0.3% in 2019, from deficits of 1.0% and 0.5%, respectively. This, alongside Russia’s strong performance in monetary policy have been noted by Fitch as core markers of the Russian economy’s resilience to external shocks, including the sanctions acceleration announced back in April 2018.

Looking forward, President Putin's RUB 8.0 trillion (ca USD127 bn) new spending priorities announced back in May will amount to roughly 7.0% of GDP over the next six years. These funds will go to support higher wages and pensions for the recipients of Federal and Local funding, as well as public investment uplift in education and core infrastructure. Per Fitch: “Due to a stronger fiscal position and a robust oil price outlook, the planned measures will not threaten the country's future budget surpluses. The government will also increase available funds by enforcing a tax overhaul and increasing [domestic] borrowing.” (see Chart below)

Policies Resilience

Resilience-inducing policies, when it comes to macroeconomic management of risks arising from sanctions regimes face by Russia include:

• Increase the Value-added Tax (VAT) rate from 18.0% to 20.0% starting in 2019, which will provide (based on Moscow estimates) ca RUB 600bn (USD 9.5bn) per annum. Social and aggregate demand impacts of VAT increases were mitigated by keeping 10% rate on certain foods, children’s goods, printed publications and pharmaceuticals, or roughly 25% of all goods and services. Some transport services will continue benefiting from 0% VAT rate.
• A phased reduction of the export duty on oil and petroleum products from 30.0% to zero and a concurrent increase in the tax on the extraction of minerals by 2024
• The combined tax rate on wages for mandatory social contributions will remain at 22%. 
• The tax on the physical capital of companies (capped at 2%), will no longer apply to moveable assets (the tax will remain for fixed capital, e.g. for buildings).
• Russia will also establish special administrative zones on Russky Island next to Vladivostok and on Oktyabrsky Island, which is part of the Kaliningrad enclave. Both will act as offshore centres where foreign-registered firms owned by Russian nationals can “redomicile” their assets. Tax advantages granted in these zones will cover taxes on profits, dividend income and different types of property.
• A recent increase in the pensionable age (men from 60 to 65, women from 55 to 63) system will lower the burden of an ageing population and a shrinking labour force, “propping up the state Pension Fund's income”

Impact on Debt Markets

Net outrun is that even faced with escalating sanctions, and having unveiled a rather sizeable macro stimulus program, Moscow's finances remain brutally healthy. Fitch research foresees “a contained uptick in government debt levels over the coming years, with the debt burden rising from 17.4% of GDP in 2017 (IMF statistics) to about 18.3% GDP by 2020.” As share of Russian debt held by external funders continues to decline, these forecasts imply increased sustainability of overall debt levels.

In it’s recent assessment of the potential impact of the ‘Super-sanctions’ (The Defending American Security from Kremlin Aggression Act of 2018 (DASKAA)) planned by Washington, the worst case scenario of all U.S.-affiliated investors dumping Russian bonds implies 8-10% decline in foreign holdings of Russian Sovereign debt, which will likely raise yields on long-dated Russian Ruble-denominated debt by 0.5-0.8 percentage points. Based on August 6 analysis from Oxford Economics, Russia will have no trouble replacing exiting Western debt holders with Ruble-denominated debt issuance.

Key Weaknesses Elsewhere

The key weakness for Russia is in structurally lower economic growth that set on around 2010-2011 and is likely to persist into 2022-2023 period (see IMF projections below):

Russian GDP growth rose from 1.3% y/y in the 1Q 2018 to 1.8% in the 2Q, with 1H growth reading 1.6% y/y. The uptick was led by faster industrial output growth (rising almost 4% y/y in 2Q) and manufacturing (up 4.6% y/y in 2Q). These are preliminary estimates, subject to revisions and, based on the recent past revisions, it is quite likely that we will see higher growth rates in final reading. 1H 2018 fixed investment rose 3% y/y. Real wages rose 8% y/y in real terms, but household disposable real income was up only 2% at the end of 2Q 2018 due to slower growth in the 'grey economy' and in non-wage income. Despite the rising household credit uptake (up 19% y/y at the end of 2Q 2018), retail sales were up only 2.5%, broadly in-line with real income growth.

All of these trends are consistent with what we have been observing in recent years and are indicative of the structurally weaker economic conditions prevailing in the wake of the post-GFC economic recession and the energy prices shocks of 2014-2017.

13/3/15: South Stream Redux: Rejecting the Hungarian-Russian Nuclear Power Deal

A pretty nasty confirmation of the overall hostile approach by the EU toward national autonomy in dealing with the energy markets by the member states came in yesterday. As reported in the FT: http://www.ft.com/cms/s/0/9a6467e2-c8c1-11e4-8617-00144feab7de.html#ixzz3UCYrZfix, the EU has blocked Hungarian deal with Russian Rosatom to develop and supply new nuclear energy facilities at Paks. The EUR12 billion, 1,200 MW facility was to be designed, built and maintained by Rosatom under a contract that is pretty bog-standard around the world and included (also standard) long term exclusive agreement to supply fuel. Paks current output accounts for 40% of total Hungarian electricity generation and the country effectively has no options other than either burn Russian gas, Polish and/or Ukrainian coal or using nuclear. Notably, Polish and/or Ukrainian coal is perhaps the dirtiest generation alternative available to Hungary.

As reported in the FT: "Many EU officials also expressed concerns that Moscow was using energy policy to divide Europe and undermine the bloc’s consensus on sanctions imposed on Russia over its actions in eastern Ukraine."

Which simply means that the EU is now arbitrarily exceeding its own sanctions and is using trade as a conduit for political influence.

It is worth noting that long-term supply agreement for fuel is a necessary part of the agreement that is part-financed (EUR10 billion) by Russian credits. Recovery of these credits is built-into the fuel supply contract.

Another thing worth noting: the EU rejection is not based on the separate concern as to the nature of procurement contract involved. Russia is not liable for the procurement procedures deployed by the Hungarian authorities that might have been in breach of the EU procurement rules.

Net impact: the EU rejection of the contract not on the basis of procurement rules violation, but simply because the EU does not like long term contractual fuel supply arrangements with Russia represents a drastic departure from the EU rhetoric of supporting free trade. Just as in the case with Nord Stream and South Stream pipelines, the EU is currently cartelising energy procurement and development policy (see earlier note here: http://trueeconomics.blogspot.com/2015/02/5215-gazproms-nord-and-south-streams.html). In addition, the EU is now clearly erring on the side of becoming completely unreliable trading partner for Russia, as even the areas not impacted by sanctions are now openly being used as a tool for strengthen sanctions impact.

The twin effect of these exchanges should accelerate Russian pivot East and South away from Europe. This pivot is costly to Russia, but it is also costly to the EU, signalling in the longer run EU's dropping out of the Asia-Pacific, Central Asian and Russian trade and investment blocks. For you may or may not be a fan of Russia or Moscow's policies, but what you cannot escape in all of this is the simple fact: EU has now fully politicised its energy markets. And if so, then who is to say it won;t do so in other markets? The ones that might be important to, say, India or China or Asia Pacific or Latin America? Who is to say that the current trade flows are a permanent and protected feature of the world that EU inhabits? And who is to say that the risk of EU politicising another sector - aviation? transport? industrial machinery? - under the pretence of creating another 'Energy' Union is a risk that the non-EU world should ignore in dealing with Europe?

2/3/15: EU Exporters: No More Than 20-30% Will Return to Russian Markets

A very interesting note reporting comments by Russia's head of Rosselkhoznadzor (organisation that certifies food imports and grants food market access to foreign exporters) on the post-sanctions regime for Western exporters into Russia. The full text is here: http://www.interfax.ru/russia/426955 in Russia.

The core point is that head of Rosselkhoznadzor expects the return of just 20-30% of EU exporters back to the Russian market once Russian sanctions on food imports are lifted. And that is 20-30% "at most". Quoting from Interfax report, the head of Rosselkhoznadzor thinks that "Products from the EU will find it difficult to return to Russian markets, because we will be forced to cut back on the number of European producers, allowing only 20-30% of previously active suppliers back into the market. The rest will be able to supply [exports to Russia] only after they restore [market] trust".

In another report (http://www.interfax.ru/business/427220), President Putin's press secretary stated today that Moscow is considering allowing imports of agricultural raw materials that serve as inputs for production of food in Russia, as long as actual production takes place in Russia. The statement relates to the President Putin's promise made in Budapest last month that Russia can expand cooperation with Hungary in food trade. According to the press secretary statement, this can only be done by relaxing sectoral restrictions as Hungary (or any other country) cannot be privileged in trade relations with the EU under the WTO rules.

Подробнее:http://www.kommersant.ru/doc/2677352

23/2/15: Russian Sanctions: Round 4 Looming?..

Big change in EU official language marks a major departure from the past diplomatic practice: https://euobserver.com/foreign/127667. Let's see if this continues, but at the very least, it lays foundations for renewed pressure on Moscow in relation to Ukrainian conflict.

Both the U.S. (see https://euobserver.com/foreign/127754) and the EU (see here: https://euobserver.com/foreign/127703) have stepped up pressure for new sanctions.

Here is my take on the prospect of the latter.

Rumours of the U.S. (and by proxy EU) sanctions extension include, once again:

• Cutting Russian bank's access to SWIFT system (spearheaded in EU by the UK and Poland back in August 2014 and backed by the EU Parliament resolution from September 2014);
• Widening sanctions against imports of Russian goods and services across broader categories and applying more pressure on the emerging markets (traditionally more important to Russian exporters of industrial machinery and capital goods) to abstain from dealing with Russian suppliers (though it is hard to see what can be added to the current list); and
• Expanding the lists of Russians banned from travel to the U.S. and Europe (which would be a weak form of response, unless it starts explicitly impacting travel for ordinary Russians - a suggestion that was floated in late 2014 by a number of former U.S. high ranking officials and analysts, with some going as far as suggesting the U.S. should ban all travel for Russian citizens, regardless of circumstances or their residency). In addition, expanding the list of sanctioned individuals to cover members of their families (to allow arrests of their property abroad, especially in those cases where such property ownership is de facto linked to the originally sanctioned officials and business leaders).

All of these proposals, at their extreme, will be firstly painful, but secondly non-reversible in the short- and medium- run.

The latter would signify that any restoration of normal relations between the U.S. (and Europe) and Russia will no longer be feasible even in the medium term and will demonstrably fail President Obama's own test of sanctions as being a tool for influencing short term policies' outcomes without directly adversely impacting ordinary Russians or sacrificing the objective of long-term normalisation.

In financial terms, cutting Russian banks off SWIFT will compound the already significant pressures on Russian corporates and banks, leading to retaliatory measures that will likely see Russian banks and companies suspending repayment and servicing of forex loans to non-affiliated entities based in the U.S. and the EU. This, financially-speaking 'nuclear' retaliation, is feasible given the downgrades of the Russian sovereign debt by Moody's and S&P: the lower the ratings go, the lower is the cost of counter-measures.

In return for this, Western lenders are likely to ask for (and easily receive) court orders to cease Russian assets abroad.

In effect, the worst case scenario here will be an all-out unwinding of Russian economic integration into the Western European and U.S. economies - a process that will make all sanctions irreversible in the medium term. The tail end of this risk is that a more isolated Moscow will face even lower future costs from taking a more aggressive stance in Ukraine or elsewhere. Economic escalation, at this stage, will most likely result in a political escalation along the lines of 'cornering Russia' into retaliation.

But beyond the Russian-U.S./EU theatre of confrontation, there looms another shadow.

In explicitly deploying economic agents and institutions in a geopolitical conflict against a significant global economic player, the U.S. is risking undermining the very foundation of its own economic power and with it, the power of the West. A long-term economic conflict with Russia is putting all emerging markets and non-Western economies on notice: the U.S. markets and institutions can be a high risk counter-parties, controlled and driven by the political considerations. Until now, targeted nature of sanctions has avoided this risk. And until now, SWIFT and its backers in Europe have made a cogent argument that excluding Russia from the system of banks payments clearance risks undermining the system itself. If Russia, in partnership with China, were forced to develop own system of parallel clearance to rival SWIFT, the West will lose control over the financial transactions pipeline that can be monitored and used to combat illicit trade, financing of terrorism and tax evasion. With time, we will also risk losing major transactions flows between other emerging markets and the West, with resultant de-internationalisation of the global financial flows and a reduction in the West's ability to tap emerging markets surplus savings and liquidity to underwrite long-term Western pensions and investment needs.

Similarly, tax evasion has been put on the declining trend by enhanced international cooperation - a process that is now driving the likes of the OECD reforms efforts in corporate taxation. This too will become more difficult to deliver if the global economic systems, largely based on Western institutions, revert toward regionalisation.

As I said, these are tail risks, but they are risks nonetheless.

Furthermore, broadening of sanctions to target explicitly Russian entities and citizens regardless of their affiliation or position vis-a-vis Moscow political regime will have another hefty long-term risk premium. The West is hoping for the sanctions to drive significant economic decline across Russia to effect a regime change, if not in terms of the physical head of Russian state, then in terms of his core policies. However, broadly anti-Russian (as opposed to counter-Kremlin) sanctions are likely to trigger more nationalist revival in Russia and any regime change in such circumstances is likely to lead to an even more bellicose stance from Moscow. Current political opposition within Russia, even theoretically capable of asserting control over power systems in the political and executive systems, is simply much more nationalistic and anti-Western than we, in Europe and the U.S., would like to believe.


None of this should override the consideration of the urgent need to restore peace in and territorial integrity of Ukraine, first and foremost. And, as I said on numerous occasions before, the onus is on Russia to act decisively to make this possible: by forcing the Eastern Ukrainian separatists to implement Minsk accord pro-actively, ahead of the Ukrainian counterparts and with fully verifiable results.

But, in the game of sanctions escalation, longer term losses for both, Russia and the West, will be significant.


It is worth noting that even Mikhail Khodorkovsky - hardly a supporter of the current regime in Moscow - has repeatedly warned against sanctions being deployed as a tool against the ordinary Russians and the Russian economy at large. See here: http://www.bbc.com/news/world-europe-27513321 and here: http://www.enpi-info.eu/eastportal/news/latest/39323/EU-needs-to-differentiate-sanctions-against-Russia,-Mikhail-Khodorkovsky-tells-MEPs.

Another prominent - and actually more important in terms of his popularity and position in Russia - opponent of the current Government, Alexey Navalny also called for strongly targeted sanctions that avoid damaging the economy and, thus, increasing nationalist axis power within the country: http://www.nytimes.com/2014/03/20/opinion/how-to-punish-putin.html although Navalny did contradict himself in some later statements (see for example a report here: http://joinfo.com/world/1001120_Alexei-Navalny-if-not-for-sanctions-Putins-army.html).

Beyond that, there has been significant enough analysts' coverage of the sanctions trap risks - the adverse impact of sanctions on the West's own objectives: the more effective the sanctions are in destabilising Russia, the more they reduce Western capacity to effect change in Russia in the longer run (see here: http://www.ecfr.eu/page/-/ECFR117_TheNewEuropeanDisorder_ESSAY.pdf).

8/9/2014: Russia's Agrifood Sector: In Need of Serious Investment

In a recent note on the state of Russian economy (http://trueeconomics.blogspot.ie/2014/08/2882014-state-of-russian-economy.html) I wrote about the need for significant increases in investment in logistics and SCM in agri-food sectors in Russia. Here is the latest Government view on the subject: http://en.itar-tass.com/economy/748513

My estimation is that to effectively develop production of substitutes for banned imports, Russia will require much more significant allocations. Production supports alone will have to rise by USD2.3 billion by Russian Ministry of Agriculture estimates starting with 2015 (Minister Nikolai Fyodorov's own estimate back in late August was for USD3.8 billion), on top of USD5.4 billion already budgeted for annual supports for 2013-2020 development. But investments in food processing, storage and transport capabilities will also be required. My estimate is that the rate of investment in auxiliary capabilities to accompany production expansion will have to run at least at 50% of the agricultural supports and this implies annual investment of ca USD3-4 billion. This comes on top of recent surveys, conducted prior to the onset of the sanctions, which put Russian logistics and SCM markets at the top of global growth curve (here is a slide on the sector potential from my earlier presentation deck):

The opportunity space in these areas is huge. And the market itself offers so much potential that faced with imports bans, producers are still attempting to maintain their long-term relations, as suggested by this article: http://en.itar-tass.com/economy/748296.

7/8/2014: Russian response to new sanctions

Sanctions tit-for-tat between Russia and the West keeps going on.

Yesterday, Canada announced new economic and travel sanctions against Russian banks and high-ranking officials to match the latest round of of the EU and the US measures (see: http://trueeconomics.blogspot.it/2014/08/282013-sanctions-v-russia-some-fallout.html).

Canadian Prime Minister Stephen Harper said that: "Export restrictions announced by the European Union with respect to military and military dual-use goods destined to Russia are already in place in Canada. We are also committed to imposing the necessary regulations to enact export restrictions on technologies used in Russia's oil exploration and extraction sector. Those will be implemented in parallel with our allies."

The Russian entities hit by the sanctions are:

• Bank of Moscow
• Dobrolet Airlines
• Russian Agricultural Bank 
• Russian National Commercial Bank
• United Shipbuilding Corporation
• VTB Bank OAO

Canada's list of sanctioned individuals excludes three business owners who are sanctioned by the US and EU, but have extensive business interests in Canada. The full list of entities and individuals impacted by Canadian sanctions is available here: http://www.ctvnews.ca/politics/canada-to-deploy-military-supplies-equipment-to-ukraine-ctv-news-1.1948163

What Russia is doing to mitigate the adverse effects of sanctions?

1) Imports substitution (long-term process) - ramping up production of components usually imported by its own defence industries to replace supplies lost due to sanctions and Ukraine trade disruption. For example:

• Sukhoi jets and other aircraft components imported from Ukraine; 
• Caterpillar & JCB sales in Russia have been falling while those of their major competitors, such as Russian Kamaz and Belorussian Belaz have been rising. This trend continues since 2008-2009. Russian manufacturers share of the domestic market rose more than 30% since 2009, but this is now likely to accelerate, rapidly; and 
• Switching to Russian-manufactured foreign equipment, e.g. Komatsu plant in Yaroslavl

2) Imports switching by substituting new longer term contracts for supply of goods and services in favour countries that are not imposing sanctions. Three examples:

• In aircraft leasing (Dobrolet and Aeroflot) contracts are being moved from Ireland to Hong Kong; 
• Turkey will be the alternative source of supply of fresh fruit and vegetables to Russia, as announced yesterday; 
• Russia has negotiated a major beef deal with Brazil and there are advanced talks on same with Argentina aiming to largely replace European shipments. Russia also announced it will switch to purchasing New Zealand dairy products, especially cheese.
• So Russia is not going for an autarchy in food markets, but rather for switching away from EU and US suppliers.

3) Longer-term exits from the markets:

• In June, Gazprombank raised EUR1 billion at 4% pa in the foreign markets via a bond sale on the Irish Stock Exchange. Gazprombank has one of the largest exposures to international funding markets of all other Russian financial institutions - it has 78 outstanding eurobond issues denominated in a number of currencies. All these will be migrating on maturity to different geographies as long as sanctions continue. It is also highly likely that even once sanctions are listed, Russian banks and corporates are likely to hold back their debt issuance in Western markets.
• Rosneft has a finance arm in Dublin : Rosneft International Finance Ltd. which placed on December 6, 2012 two bond issues totalling $3bn, the oil major said in a statement. The first $1bn issue carries a 3.15% coupon rate and is scheduled to mature on March 6, 2017. The second $2bn issue carries a 4.20% coupon rate and is scheduled to mature on March 6, 2022. The bonds were listed and admitted to trading on the Irish Stock Exchange on December 7, 2012.
• Irish law firms advise a range of Russian companies, including on Russian LPN, bond issues and ECP programmes: AHML, Federal Grid, Gazprombank, VTB, VEB, Rosneft, Uralkali, Norilisk Nickel, EDC, Borets, Metallionvest, Brunswich Railways, RenCredit, Alfa Bank, ABH Financial, Domodedovo Airport, Russian Railways, Promsvyaz and Probusinessbank.(see: http://www.arthurcox.com/practice_area/capital-markets/debt-capital-markets/).
• VTB, via its VTB Eurasia Limited (an Irish company) issued U.S.$2.25bn Perpetual Loan Participation Notes via an Irish branch.

Retaliatory sanctions

In retaliation against Western sanctions, Russian President Vladimir Putin on Wednesday signed a decree limiting the import of agricultural, raw and food products from countries that imposed sanctions against Russia. Moscow banned, for one year (mating duration of Western sanctions) imports of all meat, fish, dairy, fruit and vegetables from the US, EU, Canada, Australia and Norway.

Further sanctions are likely. These are expected to impact:

• Possible bans on breeding stock sales, biotech agricultural inputs sales, as well as
• Possible ban on drinks imports from the EU.

Irish agricultural sales to Russia (see here: http://trueeconomics.blogspot.it/2014/07/1772014-irish-bilateral-trade-in-goods.html) are

• EUR202.2 million in 2013, roughly 52% of Canada's trade of CAD563 million (EUR385 million) agricultural trade with Russia.
• Roughly 1/3 of these sales comes from coffee, tea, cocoa, and products thereof, and another 1/3 from meat & meat preparations
• Beverages - on top of the above - ca EUR12.1 million in 2013 in officially recorded exports. This excludes sales by major international brands which are predominantly imported into Russia via European subsidiaries and distributors. One example is Jameson Whiskey is now leading brand in whiskey sales in Russia since 2012. In 2012/2013 Jameson sales in Russia grew by 23% by volume (http://pernod-ricard.com/files/fichiers/Commun/Documents/RA2012_13_VGB_MiseEnLigne_28102013.pdf)

Conservatively estimating the sales via subsidiaries and distributors, Irish exports to Russia run at around EUR800 million, with roughly 1/3 of these coming from Agriculture, Food and Drinks sectors.

Some estimated 42% plus of these sales come from sectors dominated by Irish indigenous companies with roughly 50% of these accounted for Irish SMEs. There are some really brilliant examples of smaller Irish firms entering Russian markets in recent years and obtaining long term contracts to provide specialist goods and services that are provided from Ireland with zero tax arbitrage component to value added. In other words, when it comes to our trade with Russia, we have much higher indigenous jobs creation and real economic activity generation per euro of exports to Russia than from our exports to other major trading partners.

Few aside facts:

• Russia is the fifth largest (by volume) importer of food in the world (http://www.businessinsider.com/worlds-leading-food-importers-2014-8)
• Russia imported USD43 billion worth of food in 2013
• Russia is the biggest consumer of EU fruit and vegetables
• Russia is the second biggest buyer of U.S. poultry 
• Russia is one of the largest importer fish, meat and dairy in the world
• Russia bought 28% of EU fruit exports and 21.5% of its vegetables exports in 2011
• Russia purchased 8% of US chicken meat exports last year.

Chart via Business Insider:

Net conclusions: sanctions response by Moscow will cost Russian consumers through increased prices. That is beyond any doubt. But the sanctions will be supportive (in the medium term) of improved agricultural production and food sector development in Russia. This effect is similar to the one achieved in the devaluations of the ruble post-1998 crisis. Sanctions by Moscow can have a significant impact on smaller open economies of Europe, like Ireland, with this impact concentrated on smaller domestic indigenous producers. If sanctions are broadened to include drinks, there will be even more substantial declines in Irish exports. It is clear that there will be no winners from the tit-for-tat sanctions wars.