Impact of the Crimean Annexation and Sanctions on Russian Growth

Whatever the narrative or counter-narrative, the annexation of Crimea by Russia is in effect.  What does this auger for Russia’s economy?

Russia’s growth was already flat-lining before the Russian-Ukrainian “conflict” with concern over the greater reliance in 2014 on hydrocarbons than in 1991 AND the increasing likelihood of a narrowing current account on the Balance of Payments in the coming years.

Did the Putin team do its sums?

Cost of Transfer of Fiscal Responsibilities To Moscow

The incorporation of approximately 2 million Crimeans represents an administrative challenge that Russia will manage although the transfer of property rights will prove more taxing whilst an asset-grab of prized real-estate or businesses has already begun.

Crimea was reliant on transfers from Kiev of around 60% of its budget of approx. $0.5 bn. Add additional (and higher) centrally managed social payments (eg pensions higher than in Ukraine) that Moscow will now have to manage and the expected reduction of both cash-payments from migrants working outside Crimea and the likely collapse – at least this year – of tourism receipts means that the net back-of-the-envelope cost to the Russian budget is around $1.5-2bn per year.

Add additional Russian transfers that will be needed to keep the Crimean economy afloat – and the total bill will be $4-5bn, equivalent to less than 0.2% of GDP for the Russian Budget.  I’m sure the boys from MinFin will have provided something along these lines in their preparatory brief to Mr Putin.

Cost of Sanctions

This is the big unknown. The Russian economy is far more integrated with the rest of the world than is often appreciated.  Even excluding the gas flows that cater for 30% of European energy consumption there is a surfeit of international connections from industry to finance that affect corporates and banks.

The combination of US and EU sanctions was scoffed at by Putin and co initially. However the very inter-connectivity of Russia to the global nexus of markets is already having a marked effect – in particular following the measures announced by the US.  Global banks will be reticent to fall foul of the US’s regulatory net by touching anything associated with the Putin Inc. clan that have been shown the equivalent of soccer’s Yellow Cards.  With regulators purportedly checking bank exposures to Russia, and with recent experience of handling and containing potential contagion, the possibility of a tail-risk event such as a gradual Iran-style financial squeeze led by the US could seriously hurt Russia.

With rating agencies such already highlighting a “negative” for Russia and reports of credit lines being cut, the initial flight of hot funds may prove to be a more lasting factor than Putin’s strategists may have anticipated in their cost-benefit analysis of the Crimean blitzkrieg.

Interbank rates in Moscow have risen over a percent over the last 48 days and the US’s clever focus on Bank Rossiya and the resultant freeze on its quarter of a million credit card holders by Mastercard and Visa will have done more to hit home to the rich upper and middle classes the potential financial impact of even a modest lock-out from the international financial architecture.

Old hands in Russia from the 90s will be aware of the  risk of mini bank runs given memories of two previous Russian financial crises since the Soviet collapse in 91 but I see this less of a risk and the Central Bank will manage any liquidity crises given its oodles of reserves.

One hopes that diplomacy at least de-escalates the situation so that the threat, in particular, of harsher German-led EU economic sanctions dissipates. If not the next round of trade and financial sanctions on Russia – and its likely reaction against foreign investments in Russia by it – will unfortunately mean a greater hit on the Russian economy.

The Putin model relies on hydrocarbon revenue and the short-term risk of say the US releasing reserves on the global market will have less of an impact than imagined as supply is based on agreed forward prices.

However if such a move affects the forward curve and at the same time presages a very likely structural shift in EU energy demand for Russian gas through say a strategic “energy security pact” to import US gas and accelerate alternative LNG and from other supply sources in the Mediterranean, then this will have a harder medium-term hit on the Putin model and its economy.

Compensation for loss of State Owned Assets to Ukraine?

Murky waters and hardly mentioned so far… but assume that Ukraine,  with western assistance, is able to get safe passage out for its military personnel.

And that it seeks damages from Moscow for loss of key refineries and other assets. .. what then?

The “zero agreement” at the time of the Soviet Dissolution amicably done by the successor republics and Russia was for Russia to assume all external debt obligations but also to secure external assets – including Soviet embassies. As the takeover in Crimea is an annexation and essentially – despite Russian protestations – in violation of the Budapest Agreement it signed in 1994 that recognized Ukraine’s borders, it is highly probable that Ukraine could seek damages in almost any western country.

Summary:

1.       The nominal cost of running Crimea will be peanuts but the short term cost for Russia will reduce growth by  1/5% of GDP to around 0.5%-0.7 and lower than the 1.3% year-start forecast.

2.       Russians are feeling very proud of Mr Putin but domestic consumption will be lower as the financial squeeze from the sanctions hits home and the cost of capital rises and imported inflation rises on the back of a falling rouble.

3.       Trade will be affected – both due to the rise in country risk and delay or cancellation of cross-border projects – but also due to the significant impact on Ukrainian-Russian trade, even excluding the risk of putative economic sanctions from the EU. The Current Account could be wiped out.

4.       An escalation of tension will lead to a much higher hit on the Russian economy from the external squeeze – particularly through the financial links - but Putin's government will tap into the huge fiscal reserves to ensure growth remains at least round 0.5% of GDP.

5.       Mr Putin has in effect secured his re-election! In turn the Putin 2.0 economic model will last longer . The EU will accelerate to reduce reliance on Russian gas. Together these two factors will lower trend growth.

Ukraine, Key Political-economy Concerns and Stabilisation

There are several overarching questions and concerns that are exercising the international community, some of which include:

• How did it get to this stage with Ukraine and Russia now on the brink of war?
• What can be done to assuage Russian concerns and de-escalate the situation?
• What does it mean for the longer term for Russia’s neighbours from the Narva region in north-east Estonia through to the ‘stans in the east and even Moldova in the south-east where there are sizeable Russian populations (if not majorities as in NE Estonia)?
• And in turn for the EU that now houses several former members of the Comecon bloc and for its own energy security given the continued reliance on Russian gas and for financial centres such as London a reliable diet of Russian capital – legal or otherwise – as well as listings?
• Concurrently how can the EU utilise its very successful soft power refined during the Accession Process since the late 90s that has helped former planned economies to successfully transform into functioning, democratic, market economies?
• And the Economics: how does the putative conflict between the countries likely to affect the economies of these two countries – both over the short and medium term -  and what are the potential spillover effects onto neighbouring economies? 

As someone who has advised worked on both countries (inc. the Crimea) since the mid-90s I have my own views on these questions from first-hand experience and various writings.

In this blog entry I will focus only on the last question as it is perhaps the underlying and central cause of the current malaise. Although events over the last few months seemed to accelerate toward the end till the eventual exit of the now-former president Yanukovych, to many of us long-time Ukraine-watchers the situation had been steadily worsening with gross mismanagement of the economy and in effect a social mis-contract between the political-economic elite that are essentially the one-and-same to effectively asset-strip the state, allow rampant corruption and in effect created the disconnect and discontent that so fuelled the anger on the street.

Result: macroeconomic instability with the economy in recession since 2012 but which was buoyed previously due to demand for steel from Russia and globally, a large current account deficit, fiscal mismanagement and with FX reserves below 90-day cover.

In the last week has seen the Ukraininan currency, the Hryvna bombed and Ukrainian assets nosedived as investors rushed to the Exit doors.  The threat of bank runs has been temporarily halted through restrictions on withdrawals but the threat of meltdown remains a tail risk without external support. The necessary devaluation through an open float of the currency will push up imported inflation and further reduce real incomes and purchasing power.

Though Russia has too been hit it is sitting on a half trillion dollar reserve base inclusive of oil funds and will ride out the storm…one for another blog.

Ukraine will, however, need rapid stabilisation and to their credit the big guns in the form of the IMF and the EU are already making preparations for rapid-response loans and budget support using the experience from recent years in the Eurozone and elsewhere.

The key question beyond short term plugging of financing gaps will be whether Ukraine will be willing and able to undertake genuine reforms to ensure sustainability. This in turn will depend on how the Russo-Ukrainian spat plays out – the longer the duration, the more costly the impact and the reconstruction/redevelopment efforts.

It will also depend on political will and all the bonhomie rhetoric from some western capitals about the Ukrainian parliament being the people’s senate ignores the rather unsavoury truth  that it does unfortunately retain the reputation of being a Members Club for crooks. Whether this group in the Rada has the courage or willingness to sanction broad-based reforms remains to be seen, particularly difficult reforms to balance the fiscal books through necessary but potentially difficult political amendments to the energy deficit that has been soaking close to 8% of GDP in subsidies.  A fresh election may well be required to give the new government a genuine mandate.

The so-called Orange Revolution in 2004-05 was pyrrhic and a gross disappointment for those that saw it as a precursor of a fundamental redress of governance in Ukraine. Unfortunately, and despite significant good-will and dollops of western assistance thereafter there was little real appetite in Kiev to modify the status quo and despite some sterling efforts to kick-start reform at a regional levels.

Hopefully, the penny has dropped for many of these rent-seeking members of the elite that political stability and effective economic governance go hand-in-hand….and hopefully the sabre-rattling from Moscow will cease….and the hit on the RTS, the rouble and share prices in energy stocks in Russia may well catalyse this.

The debate on Scottish Independence and the EU

The arguments for hearts and minds of Scottish voters went into overdrive in the last few weeks, from PM Cameron’s speech, a choreographed doomsday scenario by the 3 main parties at Westminster and now the departing president of the European Commission, Manuel Barroso , putting his oar into the debate.

I have commented previously on the debate in 2012 when I looked at the country risk and macro aspects of the independence debate and pretty much all those points remain valid. The pro campaign’s economic case is on the whole somewhat weak. That said, sovereign dissolutions in Europe since the Second World War have been political in nature even though the economic dislocations were catalytic – from the dissolution of the USSR signed off by the presiding heads of the soviet republics in 1992 to the velvet divorce of the former Czechoslovakia in to the resultant Czech and Slovak republics in 1993 and the economic impact that hit and ultimately dismembered Yugoslavia.

So the debate about a currency union post-independence in Scotland, pooled fiscal policy and the like are indeed important but miss the point somewhat. Ultimately if the Scots want independence a solution will be found to these economic issues as it always is. Connoisseurs may recall the IMF’s advice to Estonia to retain the rouble in 1992 but the latter did pretty well with its Kroon that ultimately sailed into the Euro-zone in 2011.

So why my angst?

As an economic liberal I fully support the rights of the Scots for quasi self-determination that is at stake in the debate even though I don’t see the economic case for it. If the Scots gain independence and see a Norwegian style oil economy they will also suffer the boon-curse conundrum of rising real exchange rates as echoed in the 2012 blog.

And if East Germany could be absorbed into the EU through a union with West Germany despite the huge structural differences and if the Czech and Slovak Republics are now merrily back in the bosom of the EU then why cannot an independent Scotland be a successful part of the EU, of which it has been a de facto member through the UK’s membership since 1973? Does Scotland not explicitly, if not implicitly, already comply with the EU’s body of law – the acquis communautaire – which the would be accession states are busily internalising? And would an independent Scotland really not be more in line with economic convergence with the EU than say Serbia or Montenegro let alone new Member States like Bulgaria and Romania that joined in 2007?

Moreover the pro-independence waffly goal is precisely akin to the EU geek-speak of “subsidiarity” implied by granting political, economic, fiscal and administrative functions to the lowest level. So why did Mr Borosso get involved?

The on-going peace dividend following the end of the Cold War in Western Europe, at a time of increasing global technological connectivity, is seeing a part resurgence to the pre-industrial revolution sense of European regionalism over nation states – and the spectre of an independent Scotland therefore raises temperature in Madrid (fear of Catalonia saying adios to Spain proper let alone the regular feast of El Clásico football matches between Real Madrid and FC Barcelona) or the north of Italy doing the same or even the possible break off in Belgium where the EU institutions are housed.

I don’t expect the Yes-campaign to win but what chances that there won’t be demand for another one within the decade – particularly if the rest of the UK continues – at least politically if not at the street level - to project an anti EU-and an anti-Johny Foreigner mentality driven by UKIP.

The somewhat bizarre sight of Messrs Cameron and Barroso playing from the same hymn sheet is a reflection of a common political goal to stop a possible rise in demand for splitting existing EU states. Bizarre because of the Cameron-led Conservatives have been pushed by UKIP to a more antagonistic stance toward all things EU (except for the Single Market that is).

The real story in the early 21st century EU, especially post-financial crisis, will be what shape and form the EU will develop as regards further economic, fiscal and political integration – now that financial and monetary integration are so developed. And that in turn smacks of what form federalism will take, to allow so many member state countries to work as a cohesive economic group.

So one hopes the debate in October after the likely failure of the yes campaign turns to how to provide even greater fiscal autonomy in the UK, where so much remains centralized and defeats the often well-meaning structural programmes by successive governments in various sectors as there is no real incentive for reform where purse strings are almost fully based on central transfers.

And that in turn could help to invigorate the direction and vision of the EU that remains such a lodestar for the likes of those outside such as Ukraine where it – or rather the EU’s prevailing requirement of standards of democracy, governance and rule of law – remains such a beacon.

Sochi Games and Russia

There is something pyrrhic about witnessing an opening to the Sochi Winter Olympics – and the related cost of a jaw-dropping $50bn – set against the prevailing economic headwinds facing the Ruuski economy…itself set against the cyclical turbulence afflicting the emerging economies more generally.

The front cover of this week’s The Economist with Mr Putin’s face pasted onto the ice-skater with his arms aloft whilst his partner (Russia)  is on her backside was apt.

The Sochi Olympics is a showcase for a re-emerging Russia and the wonderful opening ceremony showcased the country’s history, pride and ability for grand engineering.

And yet it remains a project, a grand expensive project at that. Like the London 2012 Olympics it will no doubt inject a degree of feel-good factor in the host country. But the real feel-good driver for Russia in the medium term will remain the price for hydrocarbons that continues to fuel the Putin’s economic model.

And here we return to the fate of Mother Russia or more humbly the Russian economy. What does the Olympics signify for Russia’s ambition to be a major global player in international economics and politics?

A lot has been written about the costs and related corruption on a grand scale. Is any major tournament really that different – particularly in emerging economies? And are decisions to award say the FIFA World Cup to Qatar (without a football league and summer temperatures in excess of 40 degrees centigrade) based on a truly unbiased fair selection? The Russians will do a fab job, and with 1 squaddie for every local denizen in Sochi, it will be well-protected also.

The decision to go for a big international project is akin to a coming of age for a country and signifies confidence in itself, ability to finance the games and to organize it. Witness the World Cup in South Africa, the putative Games and next FIFA Cup in Brazil and even the slightly wonky Asian Games in India.

Mind you it will be interesting to see how many of these EM countries put their hat for such show-case events in the ring now that the US-tapering has commenced and capital has started to leave these states.

So why pyrrhic?

The success in holding an international Sports Day (or days) does not change the overall context of the challenges facing Russia and its economy.  And there are more  parallels with the Soviet Union’s 1980 Games when Russia’s predecessor USSR was in a downward economic spiral than with many of the other EMs that have seen greater structural changes and a more balanced share of wealth.

Unlike the other above-mentioned EMs (and ignoring basket cases such as Argentina and Venezuela) Putin’s Russia is more centralized, less democratic and more reliant for employment on the state when compared with the early 90s…and where the state itself is even more reliant on oil and gas revenue that account for ¾s of all exports.

Whereas the Beijing Games were genuinely regarded as confirmation of China’s return to global influence politically and economically, one hopes the Sochi Games don’t instead presage the parallels with the economic malaise that subsequently afflicted the Soviet Union.