CEASE-FIRE PROCESS BRINGS SANCTIONS RISK RELIEF

FINANCIAL ANALYSIS

by Chris Weafer

Today we issue our September Macro Monthly for Russia. The breaking news from Kiev (Wednesday morning) is that Russia and Ukraine have agreed to a permanent cease-fire in eastern Ukraine. That was later amended by President Poroshenko's office to state both sides had agreed to a cease-fire process. We have reflected that news in this report but clearly there is a great deal more clarification to come in the days ahead – especially at the NATO summit in Wales (Thursday and Friday). If required we will issue a supplementary note in a few days.

Summary

• The escalation of fighting in eastern Ukraine immediately after the Minsk summit had raised the sanctions threat against Russia. The threats were expected to become even more pronounced in the days leading up to the NATO summit on 4-5 September.
• The breaking news from Kiev (Wednesday morning) is that Russia and Ukraine have agreed to a permanent cease-fire in eastern Ukraine, later amended by President Poroshenko's office to state both sides had agreed to a cease-fire process. Despite Moscow sticking with its long held position that it is not party to the conflict and therefore is not formally part of the peace deal, the news will greatly add to the optimism that the worst of the crisis has now passed. If the agreement is seen to be put into effect then optimism that the existing sanctions against Russia, and the retaliatory actions taken by Moscow, may be removed at the first review date on November 1st.

In our recent note “Ukraine: What Comes Next?” we highlighted that the Kiev government is under much greater pressure than Moscow to end the fighting in the east. The Ukraine economy is now spiraling downwards faster and the government will need to ask for additional bailout cash from the west. More immediately the Rada elections have been set for October 26th and would be much more fractious if the fighting in the east was ongoing.

The ruble and asset prices on the Russian and Ukraine bourses will undoubtedly react very positively to the news.

The appetite for further sanctions in Europe had already appeared weak as several country leaders spoke out against additional measures after Moscow’s food import ban retaliation.

The cease-fire, assuming it comes into effect and holds, will bring relief to foreign businesses in Russia. But the declining pace of economic growth will not be easily of quickly reversed. The legacy of sanctions and other economic problems, evident long before the Ukraine crisis started, will still take some time to resolve.

The Economy Ministry has cut its growth outlook and raised its inflation outlook for both 2014 and 2015, specifically blaming the accumulated impacted of sanctions and the declining level of consumer activity and investment.

The Central Bank had been expected to raise the Key Rate again at its September 12th meeting because of the recent pressure on the ruble and the high inflation rate. The rally in the ruble, which followed this morning’s peace deal news, may be enough to allow the Central Bank delay that rate decision.

Despite this morning’s rally we have cut our year-end ruble-dollar target to RUB37.5/US$. The price of Urals has again dipped just below $100 p/bbl and the Central Bank now seems content to let the ruble float more freely.

The ruble lost 4% against the US dollar in August and dropped a further 1% on 1 September (down 14% YTD ahead of this morning’s rally). Most of the weakness is a direct result of the political risk and sanctions fears, but the drop in the price of crude oil to under US$100 p/bbl in recent days and the rally in the weighted value of the dollar have also contributed to the weakness.

Protecting budget revenues is now a greater priority for the government and that is why the Central Bank pulled further back from intervening in the currency market last month.

The weaker ruble is generating some positives, e.g. in the manufacturing sectors as the price of imported goods rise, and it is compensating for the lower oil price in federal budget revenues.

The threat of referring Russia’s sanctions to the WTO seems weak as Moscow has invoked the “national security exception” clause as justification for its food import ban and would undoubtedly cite that if further sanctions were to be imposed.

The July macro data showed a further decline in activity across most sectors, with high-priced consumer goods, e.g. vehicle sales, taking a big hit.

While the crisis is clearly hurting the medium-term operating and profit outlook for businesses and investors, there is still no credible evidence that it will not pass by as others have, albeit somewhat longer and deeper. The rules of the game will certainly change, but the game itself will not. Many foreign companies face a difficult winter in Russia but good government (federal and/or regional) contacts and prudent contingency planning will leave them well positioned to benefit from changes in the investment landscape and for the post-crisis recovery.

Despite the recent oil price weakness Russia still has sufficient fiscal scope to muddle through this crisis with low growth, even in the event of a likely technical recession later this year, and it has the resources to help banks and major companies with credit substitution. The oil price outlook is, as always, uncertain but the geo-politics of the Middle East and Africa suggests the medium term downside for crude is limited this winter despite the concerns over global economic growth. 

Apart from the obvious short- to medium-term risks to growth and investment, the greater long-term risk comes from the fact that the government is boosting budget revenues by dipping into the pensions pot, as well as considering using money set aside in the Reserve and Wellbeing Funds to cover bailout costs and looking at hiking taxes in the consumer sectors. If Russia comes out of this crisis with greatly depleted investment resources, a greater oil dependency and a higher consumer tax burden then recovery will be more difficult and slower.

The one positive from the crisis so far, i.e. apart from the boost to domestic manufacturers from the weaker ruble, is the greater focus within government towards investment into industries, such as the agriculture sectors, which will permanently reduce import vulnerability. If that effort proves tangible and is sustained alongside a greater effort to advance business climate reforms, then the post crisis recovery will be much faster.

 

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Chris Weafer

Senior Partner

Macro-Advisory Ltd

Moscow