The latest round of Western sanctions against Russia restricts the ability of Russia’s largest state-owned companies and banks to raise funds in the European financial markets. But what does this mean in practice — and what might the consequences be for the Russian banking system?

It remains to be seen if Russian banks will be able to adjust to sanctions. Photo: Kommersant 

Since March 2014 many of Russia’s largest banks - Sberbank, Gazprombank, Vnesheconombank, Bank of Moscow, VTB and Russian Agricultural Bank - have been hit by Western sanctions. Now European and U.S. debt markets (other than for short-term debt) are effectively closed to Russian financial institutions. The obvious question becomes: How will this affect the development of the Russian financial sector and what steps might be taken to limit the long-term negative impact?

Russia’s financial sector at risk

The main risk factors for the coming year are the size of Russia's foreign debt payments (owed both by banks and non-financial companies) and a potential clampdown on international settlements carried out by Russian banks. Over the long term, Russia should seek less dependence on Western capital markets in favor of Asia and the BRICS countries.

Payments on external debt (more than $60 billion by the end of 2014) have already started to put pressure on currency liquidity and, indirectly, the ruble. With the Western capital markets effectively off limits for major Russian companies, funds need to be found internally. Companies with a high share of state-owned capital will likely receive an injection of public money, while the rest will have to buy foreign currency in the market, which will inevitably weigh heavily on the ruble.

The need to support state-owned companies, combined with the pressure on the ruble, will force the Central Bank of Russia to spend part of its gold and currency reserves (GCR). If the outlay is significant, currency controls will likely be introduced. Although the level of GCR is more than sufficient to maintain financial stability for the next couple of years, this breathing space should be used to gain access to international capital markets other than the U.S. and EU markets. The need to raise capital will revive attempts to build an international financial center (IFC) in Moscow.

The trajectory of the sanctions invites the conclusion that Russian assets in the West are at risk. There is no official ban on the SWIFT (Society of the Worldwide Interbank Financial Telecommunications) payment system, but its regulators can instruct banks under their jurisdiction not to serve Russian clients that appear in the sanctions list. Such decision would de facto enable SWIFT payments to be blocked, without excluding Russian banks from the system (creating a legal minefield in the process). The actions of Visa and MasterCard set a precedent under which the threat of a ban on international payments is no longer in the realm of abstract theory, but very real.

Another consequence of the sanctions has been the return of many Russian assets abroad to Russian depositories. Perhaps the IFC project in Moscow will get a second lease of life simply because of the need to keep certain types of assets solely in Russia.

In search of global alternatives

The risks associated with the sanctions urgently require mechanisms to facilitate international settlements in currencies other than the dollar and the euro. The task is complicated, since the lack of exchange rate stability and poor liquidity outside of Russia make the ruble an undesirable contract currency for foreign buyers of Russian raw materials. The Chinese yuan is also unsuited to the role of contract currency, at least for the time being. The Hong Kong dollar, however, could be an option thanks to its hard peg to the U.S. dollar and issuing authorities outside the purview of the U.S. and the EU.

The need to raise capital in foreign markets, at the same time as Western capital markets remain closed, will stimulate the issuance of debt instruments, such as Eurobonds, but in a jurisdiction and currency other than those of the U.S. and the EU. It could ultimately result in the issue of “BRICS-bonds.”

Raising capital in the West is attractive due to the lower cost than in Russia. But the sanctions make the risk premium on this source of capital unaffordable, forcing other alternatives to be sought. The search process will not be easy. An obvious consequence will be a rise in the cost of credit inside Russia (which has already climbed above 2 percent since the start of the sanctions), and a decrease in its availability.

Both sanctions and counter-sanctions could expedite the process of import substitution. However, the first consequence thereof will be an increase in prices (and a decline in the quality of goods), which will hike inflation with all the ensuing consequences. Nevertheless, by definition import substitution cannot be achieved without restricting imports, and the current period of tit-for-tat sanctions will give Russian producers a chance. What they will do with it, however, is another question.

Among other things, import substitution will see the establishment of national rating agencies, or the assignment of such status to existing bodies. Naturally, emulating the “Big Four” will be a rocky road, but valid ratings are a must (including for the needs of regulators).

Russia’s financial system hopes for the best, prepares for the worst

For the ordinary citizen, the most obvious consequence of an attempt to protect the Russian financial system against sanctions would be the forced introduction of payment systems other than Visa and MasterCard. It could be China’s UnionPay (which is easier and faster to implement), together with a Russian system.

To make interbank settlements risk-free, it is very likely that a domestic payment system would be created, similar to SWIFT but completely independent from it. The main challenges here have less to do with creating it per se than with ensuring its rapid implementation. SWIFT’s strength lies primarily in its ubiquity. Rolling out a domestic system abroad would not be easy, but under Russian law banks could simply be obliged to serve (in addition to any other) the national payment system. And most likely the Central Bank would take such a decision.

The short-term consequences of insulating the Russian financial system against sanctions will be a reduction in liquidity (especially currency liquidity). This will lead to a marked slowdown in economic growth. The ruble could slide. In the longer run, as the country’s economic players become inured to the new realities, Russia’s financial system will be much more resistant to external shocks. The price of this stability, however, will be high.

The opinion of the author may not necessarily reflect the position of Russia Direct or its staff.