Time is a Commodity: the impact of sanctions on Fortress Russia

Over the past weeks, the EU and Western allies have ramped up financial and economic sanctions against Russia in response to the invasion of Ukraine. As a result, Russia has now become the most heavily sanctioned country in the world (Figure 1). Understanding the impact on Russia’s financial flexibility is thus key to assess the role of sanctions as a short-term deterrent.

Our analysis suggests Russian finances will be eroded by sanctions, but the economy may continue to run a net financing surplus, especially when we account for the increase in commodity prices.

Russia closed 2021 running a current account (CA) surplus close to 10% of GDP. The war induced a spike in commodity prices and a crash in the ruble, which will ultimately push the CA higher. Commodity demand is arguably inelastic, while a deep devaluation will cause import to collapse. The country may thus be forced into large trade surpluses that partially balance out sanctions-induced weaknesses.

According to our calculation, recent changes in commodity prices and FX would mechanically lead to a $200bn current account surplus for 2022. This is more than 2.5 times short-term debt amortizations. In other words, Russia may service its financial obligation even if global demand for its output shrinks by a half and without having to resort to its (reduced) international reserves.

The financial channel is not the only one via which sanctions will affect Russia. Lower trade, higher interest rates and weaker currency will generate a deep recession and high inflation – the early signs of which are already visible. The full impact on the economy will however take a few months to materialize, while the financial channel has an immediate effect. In fact, the ruble has depreciated by 50% in just one week since the invasion began – pricing Russia’s increased economic isolation.

Our conclusion is that the quickest macro effect of the war may be an increased ‘dollar surplus’ which would allow Russia to pay its external debt coming due in 2022 despite USD reserves being now largely unavailable. The “self-sanctioning” role of global players in relation to Russian energy may thus play an important deterrent role, as the current sanctions themselves are not enough to generate a dramatic drawdown of dollar flows towards Russia. If the US, EU, UK and Canada were to cooperate and impose an embargo on Russian oil and gas, that would effectively wipe out the ‘dollar surplus’ from the commodity price increase and accelerate the depletion of Russian FX reserves. At the same time, it is a measure that would have high economic and political costs for the countries involved – and demand a strategic approach, which we have discussed in our latest Green Leaf issue here).

Central Bank Sanctions

The most powerful set of sanctions imposed so far are targeting the Central Bank of Russia (CBR), by prohibiting any transactions pertaining to the management of CBR’s reserves and assets. These sanctions undermine the key tenet of the “Fortress Russia” strategy – i.e. the idea that Russia would be able to withstand prolonged economic isolation thanks to its massive international reserves.

Russia has around USD 640bn in international reserves. After invading Crimea in 2014, the CBR has progressively switched reserves away from Europe and the US, and into gold (which is held in Russia) and Yuan. Yet, the freezing of the CBR’s assets and accounts in all G7 countries means that the CBR has lost access to ~65% of its reserves and can now freely access only the portion that is held in gold and Yuan, i.e. around USD 277 billion. Both gold and Yuan are useless for maintaining stability in the domestic foreign exchange market – and the CBR has indeed explicitly recognized this newfound inability to manage the level of the ruble exchange rate. Gold and Yuan reserves also do little in terms of allowing Russia to pay its external debt – which is largely denominated in euros and dollars.

As a response, Russia has introduced tight capital and currency controls. Russian exporters have been ordered to sell 80% of all their foreign exchange earnings (in all currencies) for rubles, and Russian residents are prevented from sending FX loans and transfers abroad, or to leave the country with more than USD 10,000 in cash. Surcharges between 12% and 30% have also been imposed on FX purchases. Brokers are banned from executing foreign sell transactions and Russian entities are not allowed to service their debt in foreign currencies from domestic resources, meaning that debt payments on Russian bonds and loans to non-residents would need to be paid either from accounts the borrowing entity holds abroad or in Rubles domestically. Meanwhile, the rubles tumbled by 30% on February 28^th – despite the CBR hiking rates from 9.5% to 20% – and trading on Moscow Stock Exchange is suspended.

SWIFT Blockade

On top of the freeze of international reserves, the EU cut seven Russian banks off SWIFT – a secure financial messaging service used to execute international transactions among banks, currently counting 11,000 members. Prior to that, the US and UK had significantly reduced the ability of selected Russian banks to perform international payments by preventing them from opening and maintaining a correspondent account or payable-through account with US banks.

Banning a bank from SWIFT curtails its ability to transact with the rest of the world – including for making payments on imports and receiving payment for exports. Disconnecting Russian banks from the system they use to make customer payments can thus disrupt the flow of goods and introduce significant frictions, which will make trade more complex and expensive. Some companies whose business model rests on importing foreign goods and/or sell imported goods in Russia may come under significant strains, which might lead to an increase in defaults on Russian obligations.

Yet, the EU ban does not extend to Sberbank and Gazprombank, and the UK and US measures carve out from their blocking sanctions payments for energy, which accounts for roughly 50% of Russian exports. These carveouts allow sizable flows of dollar and euro-denominated cross-border payments to continue in and out of Russia, which facilitate Russian in paying for its outstanding external debt.

External Position

Russia sources ~56% of its imports from the EU and the US, and about 80% of that trade is settled in euro or dollars. On top of that, Russia has an outstanding external debt of approximately USD 491 bn (as at Q3 2021). About USD 80 bn of that comes due over the next 12 months. Slightly more than a quarter of that (25bn) is debt of the Russian government – the only sector in the Russian economy posting net negative external assets – and a majority (~20.5bn) is in the form of Eurobonds held by non-residents.

Russian banks and corporates on the other hand registered around USD 200bn in external liabilities for loans and deposits at the end of Q3 2021. These sectors however have significant foreign assets, and both run positive net external positions worth ~2x their debt redemptions coming due between now and Q3-2023, although the recent capital control measures make those external assets a lot more difficult to liquidate for FX.

Effect of Sanctions

Given these external constraints, how long is the Fortress Russia strategy viable, before sanctions exhaust Russia international reserves? The answer hinges on the size of the Russian current account surplus, which allows the country to replenish its reserves. The size of Russian current account surplus, on the other hand, hinges on Russia’ ability to keep exporting its key commodities (oil and gas) to the very countries that are now sanctioning it.

In a business-as-usual scenario, Russia runs a current account of approximately 7-10% of GDP, or USD 120 billion in 2021. With natural gas at EUR 160/MWh, and (Urals) oil at USD 90/bbl, every day in which the EU keeps importing Russian fossil fuel adds approximately EUR 800 million to the Russian current account surplus. Energy exports are inelastic to price: even factoring in a 20% volume reduction due to the sanction-induced risk aversion of brokers and dealers unwilling to move Russian oil, if we assume a 30% shock to gas prices and a 10-20% shock to oil prices throughout 2022, Russia will enjoy a large windfall from energy prices. At the same time, imports are very elastic to the domestic currency depreciation, so a collapse in imports by 30% would further reinforce the effect on the current account – which would reach above USD 200bn in our estimates.

This scenario assumes that volumes and prices of other Russian exports remain unchanged. That could be a conservative scenario, as almost 75% of Russian exports are concentrated in goods that are scarce globally (energy, minerals, grains, metals) and hence will likely benefit from a price windfall in a similar way as energy. On the other hand, the shock to imports from domestic devaluation could also be larger than we assume. Under these conservative assumptions, Russia would have no difficulty paying off its external debt coming due in 2022 and would be left with a “dollar surplus’” of USD 20-30 billion that would help replenish its Euro/Dollar reserves (currently made inaccessible by sanctions).

Western Self-Sanctioning

A decision from the West to unplug from Russian fossil fuels would change the scenario significantly. The US is reportedly considering imposing an embargo on Russian oil even without the participation of other countries, while the EU is set to reveal today a plan to cut its dependence on Russian gas by 80% in the space of a short period of time. An oil embargo by the US, EU, Canada, and the UK, could – according to our calculations – offset the Russian CA windfall from higher energy prices combined with the collapse of imports. Adding an embargo on gas from the same countries would force Russia to use the entire 2022 current account surplus to repay the external debt coming due during the year, with the need to start tapping into international reserves for any other external payment that may occur.

Conclusion

The Russian economy has already performed a 20-years U-turn in macroeconomic policy in the space of just a few days, with the reintroduction of capital and currency control and a move towards more economic isolation. Yet, our calculations suggest that Fortress Russia – while breached – remains a viable economic strategy as long as energy remains exempted by the current sanction environment. Skyrocketing energy prices coupled with the collapse in imports due to the fall of the ruble naturally produce a windfall that would allow Russia to pay for its external debt and replenish its FX reserves with the residual “dollar surplus”.

A decision by the US, EU, UK and Canada to enact an oil and gas embargo would significantly alter this calculation – by accelerating the depletion of Russia’s “dollar surplus” and subsequently international reserves. At the same time, as we discussed in our previous analysis, unplugging from Russian energy would be complex and expensive in the short run. As such, we argued that it would require a strategic energy plan encompassing both the absolute prioritization of energy efficiency and renewable projects, together with initiatives to reduce consumption as well as substitution of Russian gas with alternative fuels for as much as possible. The key element gluing all these pieces together should be a common EU borrowing initiative to allow countries that are most dependent on Russia and have a narrower fiscal space to weather the cost of this major geoeconomics decision. While much uncertainty still remains on the outcome of the conflict in Ukraine and its economic fallout, recent news suggest that the EU is moving in the right direction and that this may turn out to be yet another step in strengthening European integration in the face of adversity.

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Gabriele Foà – Portfolio Manager, Global Credit Opportunities

Antonio Focella – Research Analyst

Silvia Merler – Head of ESG and Policy Research

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Unless otherwise indicated, numbers are Algebris calculations based on Bloomberg or CBR data

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