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18 September 2017

Sanctions Therapy?

Sanctions are effectively remodeling Russia's financial relations within the country at the same time as it redraws its financial links with the outside world

When the U.S. Congress recently pushed through a fresh round of sanctions on Russia, which President Donald Trump then signed into law, it meant imminent bad news for a long list of Russian companies. This round of sanctions involved a longer list of companies and individuals than the 2014 round, and the result will be restrictions on access to capital, not just for those on the list, but also for the wider Russian economy. Western investors will once more be on their guard when it comes to apparent opportunities in Russia, for fear of losing out if sanctions get stepped up yet again.

While access to Western capital will not be impossible (no sanctions regime could or would ever try to be completely comprehensive) Russian companies will now lobby hard for the Russian government to improve the availability and reliability of domestic finance, at least for large-scale investment projects. A limited “pivot to Asia” in the form of financial cooperation with China  (and to some degree with Japan) is also already gradually getting underway, and now looks set to continue. In short, sanctions are effectively remodeling Russia's financial relations within the country at the same time as it redraws its financial links with the outside world.

However, to make the nascent model of those relations sustainable, the various deep structural problems of the Russian financial system will inevitably need to be overcome. So sanctions, after initially wounding the economy in the short term, could possibly prove to be an unlikely stimulus for vital reforms that have eluded Russian policy makers for the last 25 years.

Endless struggles with long-term finance

Long-term finance has been problematic in the Russian economy ever since the collapse of the Soviet Union in 1991. Companies wanting to invest in long-term projects were frequently forced to incur credits abroad. There is plenty of data to illustrate this trend: Russian foreign private debt, for example, since the mid-2000s has been approximately as high as the volume of the Russian Central Bank's (RCB) reserves - or even higher (amounting almost up to $500bn).

Financial sanctions imposed by the US and the EU on Russia aimed at exactly this weak point of the Russian economy. Those restrictions have targeted state banks such as Sberbank, Vneshtorgbank or Vnesheconombank, prohibiting their access to Western credits for any time period longer than 30 days. Sanctioned state companies such as Gazprom, Rosneft or Transneft (and many others) could borrow in the West only for the marginally longer period of up to 90 days. Credits from Western banks for financing investment projects are therefore impossible to obtain for those companies.

Concerning the new American round of sanctions, they are imposed in particular on companies related to the business of building pipelines, such as Transnefteprodukt, Giprotruboprovod, Chernomorskie Magistralnye Nefteprovody, Transneft-Druzhba, Transneft-Sibir. According to the Directive 2 of the sanctions document issued by the US Office of Foreign Assets Control, those companies are not allowed to have transactions with US persons involving financial instruments with the maturity over 90 days. Here again, large-scale projects are thus excluded from financing by Western banks. Overall, new sanctions are likely to reinforce the financial blockade of the Russian economy. Western banks have become even more cautious when it comes to lending to any Russian companies, as they may be formally or informally connected to sanctioned subjects.

The reasons for the Russian banking sector's difficulties in providing long-term finance? There are almost too many to mention. In general, the Russian financial system is fairly underdeveloped. The volume of domestic savings in Russia is low (except for state savings and savings provided by the richest 1% of the population) and most bank deposits can be taken out on any day, which restrains banks' capability of credit creation. Time deposits are relatively rare; only about 17% of the Russian populations have them. The RCB has not established a full-fledged system of refinancing credits of domestic banks and assuring their liquidity by the same token. Moreover, the level of inflation in the Russian economy tends to be high, usually about 10%, even though it currently amounts to 4%. Despite its success in battling inflation, the RCB keeps its key rate at 9 %, increasing the cost of finance.

As for other reasons for the relative lack of long-term finance in Russia, the level of risk in the Russian economy as a whole is high. Informal and even criminal practices abound. Russian banks would thus incur significant risks when issuing long-term credits. In general, the risk premium makes credits to Russian companies cost up to 25%. All those institutional deficiencies were discussed in Russian policy-making circles during the 2000s and 2010s and creative policy ideas to improve them were plentiful. The accumulation of substantial financial reserves, including revenues from the export of oil, made experts wonder why and how there is such a deficit of long-term finance in Russia.

The rigid monetary and financial policy was the main focus of expert criticism. Pragmatic liberal economists who were engaged in policy-making - such as Alexei Vedev, Yuri Danilov, Oleg Solntsev, Vladislav Inozemtsev - and also statist economists like Ruslan Grinberg and Sergei Glaziev, all argued that high interest rates on credits motivate entrepreneurs to raise prices. Entrepreneurs have to do so, they argued, because only then could they make a profit and pay back their credits before high interest rates forced them into a cycle of unsustainable debt. The monopolistic and oligopolistic structures of the Russian economy, against which too few policy measures were taken, enables companies to do it. In general, in these experts' view, the policy of money scarcity is not conducive to investment and development, as it reduces the amount of available funds and raises the cost of finance.

Those economists, as well as the pro-Kremlin national-conservative circle around the business weekly “Expert” and the association “Delovaya Rossiya,” advocated “financial sovereignty” for Russia. They were in favour of a policy of developing the domestic financial system to be able to meet the various credit needs of domestic entrepreneurs, in particular small and medium-sized ones. Some of their policy recommendations were fairly sensible. However, in spite of approving of state sovereignty and the sovereignty of the Russian economy in principle, the ruling elites undertook few measures to improve the availability of finance for Russian companies.

Economic policy discussions led nevertheless to the emergence of a series of development institutions. Those banks and funds were to issue credit for the economy at more affordable rates than those of private banks. In 2006-2007, the former Soviet foreign economic affairs bank Vnesheconombank was transformed into the Russian Development Bank. Moreover, a bank for crediting small and middle-sized enterprises MSP-Bank was created as well as the Investment Fund. After the global financial crisis of 2008-2009, the development frenzy resumed and new institutions such as the Agency for Strategic Initiatives, the Fund for Development of the Russian Far East, and the Russian Fund for Direct Investment were all set up.

Yet all those institutions did not radically improve the availability of finance in the Russian economy. First of all, most of those institutions lend money to large-scale investment projects with state support. Second, they are risk-averse and therefore credit projects with high expected profits, paying less attention to their contribution to socioeconomic development. Third, though the cost of finance obtainable from those institutions is less than that of private or even state banks credits, it is still higher than abroad.

Overall, the emergence of multiple state banks and funds is consistent with the growing role of the state in the Russian economy. The actual financial market has very low depth and instead the state plays an increasingly important role in distributing resources. The four biggest banks are state banks. Overall, state-controlled banks account for more than the half of the Russian financial system. In a state capitalism of this sort, the financial system serves first and foremost the needs of state corporations. Development banks and funds are financing state companies that receive state orders and pursue large-scale investment projects. Small and middle-sized enterprises, on the contrary, have limited resources and often have a hard time trying to leave the informal, grey economy.

A surprising remedy?

Financial sanctions inadvertently address this structural insufficiency. They focus on the very enterprises that had most relied on Western finance - that is, on state companies. Western banks and investors did not fear lending to Russian state enterprises before 2014, as they expected the Russian state to be a lender of last resort. The Russian Development Bank and state banks Sberbank and VTB that could partly replace missing funds are equally on the sanctions list.

However, Russia has found various ways to deal with difficulties posed by sanctions. The example of the investment project YAMAL LNG of the sanctioned company Novatek (run by President Vladimir Putin's friend Gennady Timchenko) shows how the Russian economy copes with a shortage of capital. This liquefied natural gas plant is expected to cost $27 billion. Out of the project cost, Russian banks Sberbank and Gazprombank, as well as the National Welfare Fund put forward about $5.6 billion. A further $0.4 billion is being lent by the Japan Bank for International Cooperation and a further $12 billion is being lent jointly by the Chinese financial institutions Export Import Bank and the Bank for Development. The rest is covered by project shareholders – the French Total, the Chinese CNPC and the Chinese Silk Road Fund. As this example shows, Chinese development banks and funds are ready to finance Russian flagship projects. As state institutions with little exposure to the global economy, they are willing to accept more risks, however they also offer more expensive credits than global financial players. In contrast with those state banks, Chinese private financial institutions de facto stick to Western sanctions. Russia's pivot to Asia therefore has its limitations.

In general, restrained access to international credits has an ambivalent impact on the dynamics of the Russian financial system and of the Russian economy. Western financial sanctions in fact do force Russian authorities to develop domestic financial institutions, but the latter will not be able to satisfy the investment needs of a growing economy for a long time, even within state capitalism. It is nevertheless likely that sanctions will have a different effect in the medium term than they were meant to. They provoke a change in the model of domestically financing economic development, which might potentially, eventually, prove beneficial for the Russian economy.

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