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Friday, 21 March 2014

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.





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