The markets have been spooked by the threat of “crushing” new US sanctions on Russia this autumn that could include Russian debt. If the US goes through with a ban on owning or trading Russian debt the effects will be dramatic and widespread.

It is not clear what debt the sanctions will target. Both Russia’s primary sovereign Eurobonds and its ruble denominated treasury domestic bonds, the so-called OFZs, are in the crosshairs.

The ban on Russia’s circa $70bn worth of Eurobonds would be unpleasant but not that damaging. By international standards Russia has tiny external debt of some 15% of GDP and doesn't rely on external markets to fund the budget. There are some $7bn worth of Eurobond issues in the budget each year, but these bonds are more of a benchmarking exercise to determine a sovereign yield curve so Russia’s corporate bonds can be priced properly. Russia issues sovereign Eurobonds more as a public service than to raise cash.

But sanctions on the OFZs would be a lot more damaging as these are the Ministry of Finance’s workhorse debt instrument and a key source of funding for the budget.

President Vladimir Putin’s May Decrees have called for approximately RUB2 trillion of new spending on top of the circa RUB16 trillion of spending each year in the federal budget to “transform” Russia’s economy. In next year’s budget the Ministry of Finance has raised its issue target of OFZ issues by about half to RUB1.4 trillion each year for the next three years.

And foreign investors, including Americans, make up a big part of the holders of OFZs; until April foreign investors owned a third (34%) of all the OFZs outstanding or some $30bn.

But the mere threat of sanctions has panicked the market, which has been dumping OFZs. By July the share of foreign ownership was down to a quarter (27%) and will continue to fall. And the yield curve has risen dramatically, up 40-105bp (depending on maturity) in August alone, rising another 30-50bp in just the first week of September as tensions between Moscow and Washington rose further.

The volatility on the market has become so bad that the Ministry of Finance cancelled its regular OFZ auction in the first week of September, and where it used to pay 7.1% on short term OFZs at the start of this year, investors are demanding 9% for the same bond now.

The outflow of money from the OFZ bond market is already hurting the currency, as investors convert their rubles to hard currencies on the way out of the door. The ruble broke through the psychologically important RUB70 to the dollar and RUB81 to the euro marks on September 10, dropping to its lowest level in two years. All in all the ruble has lost at least 17% to the US dollar since the start of this year and could lose more, despite the much higher than expected oil prices, which should push the value of the ruble up.

The knock on effect is that whereas the Central Bank of Russia (CBR) has been easing its monetary policy with a series of cuts in interest rates this year, it is likely to hike rates for the first time in a year at its next meeting on September 14, to contain the fall of the ruble. The falling ruble also started to feed through into inflationary pressure, which ticked up in August to break above the 3% level for the first time in a year. Inflation was expected to rise towards the CBR target of 4% anyway, helped along by those higher oil prices, but it is rising a lot faster than it was supposed to now.

“The ruble is plummeting by the staggering weekly pace of 3.4%, headline inflation is notably accelerating (from 2.5% y/y in July to 3.1% in August), people’s inflation expectations are starting to edge higher (from 9.7% in July to 9.9% in August for the one-year-ahead gauge) and there’s a multitude of other risks around. With that said, we feel the CBR will not haste to deliver such a decision as early as the September 14 MPC meeting,” Yuri Tulinov and Phoenix Kalen, analysts with Societe General, said in a recent note.

A rate hike and the end of the CBR’s easing cycle would be unwelcome news for the government that is working hard to boost growth. The Ministry of Economy recently downgraded its GDP growth forecast for this year for a second time to 1.8%, which is, for an emerging market, a stagnation level of growth. Russia’s economy has been recovering but with growth stuck at around 2% for the foreseeable future Russia will slowly fall behind the rest of the world, which is growing faster, and the relative gains of the last decade will be lost.

Indeed the Kremlin is well aware of the problem as amongst the many demands made by Putin in his state of the nation speech in April is that Russia’s growth should be raised to well ahead of the global average by 2024. The May Decrees are supposed to provide the impetus, but with the OFZ sanctions it becomes unclear how the Ministry of Finance will be able to fund the dozen gargantuan national projects in the programme.

Moreover the CBR’s attempt to support the ruble with a rate hike will be less effective than usual as none of the factors driving the ruble down — investors dumping OFZs on sanction fears, higher petrol prices following oil prices upwards, a weaker harvest, a recent 2% hike to VAT rates — are monetary factors and all of them are out of the central bank’s control so hiking interest rates won’t help solve any of these problems.