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Russia & CIS

Mixed Signals from the US and Europe Keep Russia in Sanctions Limbo

Lack of unity on the US government’s future policy towards Russia, coupled with similar divisions growing in the EU, complicate Russian risk and leave an air of uncertainty hanging over increasingly attractive Russian credit.

Jan 17, 2017 // 5:08PM

In his first post-election interview in the UK, Donald Trump stayed true to his headline-grabbing rhetoric, declaring NATO “obsolete,” accusing Angela Merkel of the “catastrophic mistake” of allowing in refugees, and praising UK for the Brexit vote.

Yet one quote largely eclipsed by the US president-elect’s more sensational remarks is sure to attract the attention of Russia’s president Vladimir Putin.

“They have sanctions on Russia — let’s see if we can make some good deals with Russia," the Republican president-elect told The Times.

“For one thing, I think nuclear weapons should be way down and reduced very substantially, that’s part of it. But Russia’s hurting very badly right now because of sanctions, but I think something can happen that a lot of people are going to benefit [from].”

While Trump’s policy hints need to be taken with a pinch (or a spoonful) of salt, his latest comments certainly opened new possibilities in a complicated and convoluted space: Western and US sanctions against Russia.

Putin has not been so close to having the sanctions lifted since their implementation – and yet the mixed signals sent from the US and Europe on the subject also mean any potential relief could still be far away, which suggests the Russian economy could continue to suffer.

In order to understand the potential impact of a Trump Administration-driven “thawing” of US-Russia relations, it is important to first make a distinction between various sets of measures introduced by the US, EU, and various other states and organisations, against Russia.

The Saga So Far

The initial sanctions imposed against a number of Russian individuals and state officials were introduced prior to the Ukraine conflict, in 2012 as part of the Magnitsky Act. It was a is a bipartisan bill passed by the U.S. Congress and signed by President Obama in November 2012, intending to punish Russian officials responsible for the death of Russian lawyer Sergei Magnitsky in a Moscow prison in 2009.

In response to the Act, Russia announced a range of countermeasures, including banning of some US officials from travelling to Russia as well as introducing a ban on adoptions of Russian children by US families. The list of sanctioned individuals has since been expanded by the US, but its targeted approach meant that the overall impact on the Russian economy was minimal.

The main set of economic sanctions was imposed on Russia by the US, the EU, and its allies in 2014, in the aftermath of the Crimea annexation and the conflict in Donbass – sanctions that were expanded and prolonged on at least two occasions.

The measure targeted a number individuals, businesses and officials from Russia and Ukraine that were either involved in or supported, financially or rhetorically, the ongoing conflict in the East of Ukraine between the country’s military and Russian-backed rebels.

The list eventually came to include a number of state-owned banks, corporates and their senior executives. It also included restrictions on the issuance of and trade in certain bonds, equity or similar financial instruments on a maturity greater than 90 days by sanctioned entities. But because the sanctions did not apply retroactively, existing Russian sovereign and corporate bonds did not suffer, while loopholes allowed them to refinance debt and sell state assets (the sovereign stake in Rosneft recently being sold to Glencore and the QIA, for instance).

Finally, a new range of individual sanctions targeting some of the high-command in Russia’s security and intelligence communities, as well as persons accused of carrying out the alleged hacking of the Democratic Party during the US election, was enacted by president Obama’s presidential decree in the first week of January. These, like the Magnitsky Act, also had minimal impact on the country’s economic stability.

The sanctions package that followed the Ukraine conflict, along with Russia’s response to them – a unilateral embargo on Western goods and products – put a big dent in the country’s economy, which was already under strain from deflated commodities prices.

In fact, some analysts, including Russia expert and chief economist for the EBRD Sergei Guriev, suggested that international sanctions had only a limited role in precipitating the recession, which was largely a result of low oil prices and Russia’s lack of exposure to international capital markets.

“Now, as oil prices recover, we are seeing some growth in the Russian economy and the recession ease. But two of the other factors are still in play – a lack of economic reforms and lack of access to international capital markets – so this growth is subdued,” Guriev was quoted as saying in an interview with a Russian newspaper.

Furthermore, a new bipartisan bill, led by Republican senators Lindsay Graham and John McCain, aims to punish Russia for its alleged involvement in the DNC hacks. The proposed legislation would take the Crimea-related sanctions even further by ordering sanctions on investments going towards Russia’s oil and gas industries of US$20mn or more.

Most significantly, and with a clear nod to the Rosneft-Glencore deal, it would impose mandatory sanctions on US and other companies that help Russia privatise state-owned assets.

Many observers believe the new administration will find a way to gradually phase out the sanctions, whether through agreeing a “trademark” Trump deal, or by simply not extending the current measures when they expire next year.

Despite Russia’s increasing economic isolation, it has remained fairly robust, with the rouble recovering up to 21% of its value last year, after collapsing to nearly 75 against the US dollar in the immediate aftermath of the Crimea annexation. The banking sector clean-up was also seen as a major success by international observers, with the CBR chief Elvira Nabiullina winning much of the credit for the Bank’s adoption of key macroprudential measures.

Against that backdrop, Russia’s corporate and sovereign bonds have been some of the best performers over the past 12 months, attracting investors with juicy yields in a relatively risk-free environment. According to Iain Stealey, managing director of the JPMorgan Asset Management Fund, Brazilian and Russian debt returned 4.9% and 2.3% respectively, with Russia’s 10-year notes yielding as much as 8% this year.

Others, however, were less optimistic.

“On the one hand, Trump’s soft rhetoric on Russia is encouraging, on the other – it is also very inconsistent. Similarly, Tillerson, the former head of Exxon, was seen as an ally of Russia, but his response in his confirmation hearing suggest a more “hawkish” position. So I would say that overall, the new administration is not going to be a “gift” for Russia,” said Sergei Dergachev, Senior Portfolio Manager and Lead Manager for Union Investment Privatfonds.

Indeed, one of the main sources of uncertainty around continuation of the sanctions regime – and therefor Russia’s short-to-medium term prospects on the capital market – is that it is conditioned on a number of factors.

No End in Sight?

While it is possible that Trump would be able to roll-back Obama’s presidential decree and the sanctions resulting from it, the move would attract more negativity from those in the US and abroad concerned about the new administration’s alleged ties with the Kremlin. Some observers noted the timing of Obama’s latest move as particularly significant because it puts Trump at a pivotal crossroad on future Russian policy days before the inauguration.

“And even if Trump’s positive attitude towards Russia turns out to be sincere, as a businessman, he is likely to use the current sanctions as leverage to make a bargain with Russia. Trump is not going to give the Kremlin a handout, he will want something in return,” Dergachev added.

Furthermore, if the new punishing measures are approved by Congress, even the president would not be able to remove them – as with Iran and Cuba, such Congress-imposed sanctions could last for years, even decades.

The bipartisan bill to expand sanctions against Russia, currently under discussion in Congress, would directly target any US or international corporates that conduct business with Russian state entities. That is a major shift from past measures, which targeted only Russian individuals. Some analysts put the chance of it passing at 50%, Dergachev says.

The danger for Russia is that with a much more comprehensive package that targets the country’s bond market, the impact on the economy and investment climate could be disastrous.

“International investors hold around RUB1.4tn of Russian government debt. Were they to suddenly flee, driven away by the new restrictions, borrowing rates for the state would skyrocket, and we may well see the local currency collapse again,” a Russian based academic and economist Yakov Mirkin told a local newspaper. “As dollars and Euros poured into rouble-denominated assets at the currency’s lowest value, they can now be taken out as the rouble strengthens. This financial instrument has been used in the past to bring down countries’ economies.”

The impact on other, non-US companies, however, could also be damaging – and could motivate lawmakers to water down the bill in its current iteration.

“The problem with lifting the sanctions is that the anti-Russian lobby in Congress remains very powerful. And Russia’s “pivot to the East,” possibly issuing yuan-denominated bonds, complicates things further. It means that Asian, particularly Chinese, companies working in Russia could be hit. That could potentially impact the US-China relations, which are already quite tense,” Dergachev speculated.

Europe is another source of anxiety. Even with Trump and Congress on board, other countries, particularly Germany and Eastern Europe, may be hesitant to lift sanctions, as relations with Russia remain chilly.

While the British government has so far worked towards building a tight relationship with Trump and his cabinet, Germany’s leader has been far less keen to “cozy up” to the president-elect, raising questions about countersanctions – which largely target EU goods and produce.

Avoiding the Debt Trap

Shifting market sentiment poses the biggest risk for the country’s markets. While the economy has performed relatively well under stress, an expansion of sanctions would inevitably raise the risk-factor and could tip it over the edge. The second impact would be increased geopolitical uncertainty – particularly if the US chooses to impose the new regulations more strictly than before, perhaps even targeting European corporates that do business in Russia.

Still, with Trump there is now a better chance of the two countries drawing closer, after years of drifting apart. If some of the sanctions are rolled back it would improve Russia’s investment potential and provide a boost to the stagnating economy.

At the same time, Dergachev warned, Russia should be wary of falling into the “debt trap”, where corporates that until now have been starved of foreign capital go on to borrow uncontrollably, leading to an overleveraged corporate sector; in 2014 Russia’s external debt was as high as US$750bn, and bringing it down to just over US$500bn this year has been one of the government’s most impressive achievements.

For now, though, assessing Russia’s short-term prospects and investment outlook involves a lot of guesswork and political speculation.

“The main conclusion we can draw from recent weeks is that there is a lot of uncertainty emanating from the US – that includes relations with Russia, but other countries too,” concluded Dergachev. “We are entering an interesting period in history.”

Russia & CIS Policy & Government

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