Investors into Russian stocks, bonds and the ruble are holding their breath, waiting to see how bad the widely expected US sanctions on Russia will be. But the growing consensus is that the US sanctions will be light and merely symbolic.

Reuters reported on March 2 that two US government sources said on condition of anonymity that the United States was expected to act under two executive orders: 13661, which was issued after Russia’s invasion of Crimea but provides broad authority to target Russian officials, and 13382, issued in 2005 to combat the proliferation of weapons of mass destruction.

Both orders let the US freeze the US assets of those targeted and effectively bar US companies and individuals from dealing with them, but they would only be used against a total of 10 officials. No oligarchs, state-owned companies or managers will be targeted, nor will the “nuclear option” of sanctioning Russian private companies or sovereign debt be the focus of sanctions.

A decision on sanctions could be released as soon as March 2. If the reports prove to be correct then they tally with a growing consensus amongst analyst that investors have over-reacted and discounted Russian assets more deeply than necessary.

Sanctions in the pipeline

There has been little doubt that some sort of sanctions are coming. What has been unclear is how harsh they would be. US President Joe Biden used his first foreign policy speech to threaten Russia and the Kremlin didn't take it well. Clearly some sort of clash is in the works.

Responding to President Biden’s comment “We will not hesitate to raise the cost on Russia”, Kremlin spokesperson Dmitry Peskov said: “This is very aggressive, unconstructive, rhetoric, to our regret. Any hints of ultimatums are unacceptable to us. We have already said that we won’t pay attention to any lecturing announcements.”

Russian Foreign Minister Sergei Lavrov responded a week later by laying out new rules of the game at a joint press conference with the European Union's top diplomat Josep Borrell, humiliating him by ordering the expulsion of four European diplomats while Borrell was sitting in front of the wily old Foreign Minister. Lavrov followed up a few days later by threatening to break off diplomatic relations with the EU if any sanctions “that damage our economy” are imposed.

In essence, Russia is saying it is fed up with Western double standards where Brussels and Washington now automatically impose sanctions on Russia for any perceived infraction or abuse, but refrain from even criticising each other for their own respective flaws. From the Russian point of view, it is no longer an emerging market and wants to be treated as a global peer – and it is prepared to break off ties with the West completely, throwing in its lot with China, if the West doesn't respond.

The EU has already succumbed. While it was relatively quick to impose personal sanctions on three dozen senior Belarusian officials, and Belarus' self-appointed President Alexander Lukashenko himself, following the outbreak of mass protests last summer in the wake of a disputed presidential election on August 9, Brussels was a lot slower to respond to the arrest and jailing of anti-corruption activist and opposition politician Alexei Navalny.

In the end the EU sanctioned only four officials that were directly involved in Navalny's arrest and incarceration – almost the least it could do.

The EU remains highly conflicted over Russia. Many of its largest firms are heavily invested in Russia – especially in the retail and heavy engineering sectors – and Russia is both the major supplier of energy and raw materials as well as the biggest, and highly profitable, consumer market in Europe. Trade turnover between Russia and the EU has fallen by about €100bn a year since 2014, but there is still over €250bn of trade between the two sides, and Germany, for example, remains a top three trade partner with Russia for both imports and exports.

 

On the other hand, the US has little direct involvement with Russia and indeed, they have become rivals on the international oil and gas markets. While a bne IntelliNews investigation into the origins of Russia’s foreign direct investment (FDI) found that actually the US is the single biggest direct investor into Russia, as most of this investment is routed through third countries it is difficult for the Kremlin to identify the investors or cut them off. The money earned by American companies doing business in Russia doesn't show up on the radar and no one really wants to talk about it, so there is little political pressure on the Capitol by US business to leave Russia alone.

And for the Americans Russia has become an especially useful whipping boy for both sides of the aisle. In the same way that Putin used the “enemy at the gate” narrative following the annexation of the Crimea in 2014 to rally national sentiment behind him, in the US the Russian bogeyman is often employed by US politicians for purely domestic political ends. Biden himself ran a youtube fund-raising campaign ask for $25 donations which he would use to “combat Russia.”

“All parties in Congress are united in their wish to hit Russia again,” said Chris Weafer of Macro Advisory. “This is one of the few issues that unites both parties in Congress – that Russia is to blame (for most problems facing the US) and that new sanctions should be applied. There are several bills (such as DASKA and Deter) which have been floating around Capitol Hill for more than one year, and a new bill, HRAMAA, has recently been introduced. This latter bill mentions the murder of Boris Nemtsov (assassinated on February 27, 2015) and seeks to link this event with the Kremlin. Nemtsov has nothing like the political baggage of Navalny and would be an easier emotional sell in Washington.”

If new sanctions are a shoe-in, why are they taking so long? Despite the tough man rhetoric, Biden is treading cautiously. It is easy to shout at the bear from the safety of the Beltway, but prodding it with a stick is an altogether more serious undertaking. And he has his arms control agenda to worry about, and Russia’s co-operation is needed in solving several international headaches, including Syria, Libya and China to name just a few.

After taking office Biden ordered a review of the Russian problem by his intelligence agencies and for them to come up with recommendations. At the same time, the White House has reached out to the European capitals to co-ordinate its actions with Brussels and beyond. The intelligence report is due in March when some sort of decision by the White House is anticipated.

While the US has little skin in the Russian economy, Biden’s desire to repair the damage former US President Donald Trump did to trans-Atlantic relations means that European concerns and desires will have to be taken into account and will serve to limit the US action on Russia. Which relation is more important – US-Brussels or US-Moscow – remains to be seen.

In the meantime, investors are left guessing what will happen next. And it could go either way. Well-respected analyst and head of the Moscow Carnegie Centre Dmitri Trenin summed it in a recent comment: “Europe is at a tipping point.” Harsh US sanctions could seriously disrupt the balance and trigger what would look like a new Cold War if extreme measures are imposed.

That is holding back investment into Russia, although investment into EMs has already begun. Equity markets started a relief rally in November after the first vaccines were approved and investors included Russia in their choices, sending the price of stocks soaring, and bond holdings swelled to pre-crisis levels and beyond. Likewise, there has been a noticeable rally on the commodity markets where the prices of iron and copper are at nine-year highs, sparking talk of a new super-cycle, while oil prices are back above $60 and said to be headed to $75 or more after falling into the $20s in 2020.

But the rising tide lifting EM boats has not lifted Russian assets as high as most of the other BRIC countries. This is most apparent in the ruble-dollar exchange rate: despite the rise in oil prices the ruble has to a large degree de-coupled from the oil price and has remained stubbornly at RUB74 to the dollar despite an almost $10 increase in the price of oil.

What is actually decided will depend to a large degree on what is in the intelligence services report.

“There is no indication as to what the substance or target for the next sanctions will be. It depends on whether the report to the president casts doubt on some allegations or supports some/all of the allegations against Russia. In addition, since Biden ordered the report, there have been calls for additional actions to punish Moscow for jailing Navalny,” says Weafer.

The options could be mild, such as:

• Replicating the actions taken by the EU last year and targeting individuals in the government blamed for the Navalny poisoning;
• Adding several high-profile oligarchs to the list of sanctioned individuals – accusing them of being part of Putin’s so-called inner-circle;
• More diplomats expelled and a further reduction in embassy services.

Or moderate (base case), such as:

• In addition to the actions above, targeting individuals in the administration and targeting diplomats;
• Many more oligarchs, their families and business associates – but not including their publicly listed assets or any asset deemed important for the global economy;
• Tighter restrictions on investments in energy investment and co-operation, further tightening of restrictions against the Russian financial sector and in technology transfers.

Or severe, such as:

• All of the above, plus:
• A prohibition on US investors buying Russian domestic (ruble) debt;
• Blocking the listing of Russian companies on the US stock exchanges.

“All of these sanctions would be applied to EU states and investors because of the secondary sanctions introduced in the CAATSA legislation of August 2017,” says Macro Advisory.

After the EU was called on to sanction Russia and blinked in the face of Lavrov’s threats there is a camp that believe the US will put more weight on fixing its relations with Europe than punishing Russia for jailing a dissident that is actually not that popular with the people in the first place.

If this is the case, then the sanctions discount placed on Russian assets is too large and the market will rally once a mild new sanctions regime is announced, argues Evgeniya Sleptsova, an economist with Oxford Analytics.

“In our view the new sanctions are unlikely to have a meaningful impact on the Russian economy or its sovereign debt, and thus we believe the risk premium is exaggerated. We estimate the ruble is 5%-7% undervalued, and we expect it to appreciate to 72.3 RUB/$ by year-end,” says Sleptsova.

Biden knows Eastern Europe better than most American politicians. He was Obama’s point man on Kyiv following the EuroMaidan revolution in 2014 and travelled there several times. He was also vocal in condemning Lukashenko’s power grab in Belarus, sending tweets using the Belarusian version of the transliterations of the opposition leaders' names, not the Russian versions, that shows a depth of understanding on the political mores of the country that are simply lost on most of his countrymen.

Given his well-known stance of pro-Ukraine, anti-Russia, the market has been pricing in a serious clash with Russia that some analyst don't think will transpire. Biden’s phlegmatic progress on imposing sanctions also argues for the milder versions, although most investors are still taking a wait-and-see approach.

“More recently, pressure on both the US and the EU to act has increased following the poisoning and arrest of opposition leader Alexey Navalny. Although the pressure has not translated into a renewed, persistent weakening of the ruble, it has prevented the currency from benefiting from higher oil prices,” says Sleptsova. “At a meeting of Europe’s foreign ministers on February 22, the EU agreed to draft new sanctions, but made it clear they will be targeted at key officials implicated in Navalny’s poisoning and will be co-ordinated with the US. As we don’t expect US sanctions to be tougher than the EU’s, we think the impact on the Russian economy and asset markets will be negligible.”

Oxford Economics says their research shows that 70% of the ruble-dollar exchange rate is driven by one of three factors: oil prices; risk premiums on Russia’s dollar debt; and 10-year local bond yields. The remaining 30% is driven by “other factors” that include the imposition of major sanctions. And Sleptsova concludes that the current drag on the ruble’s strengthening that should accompany the rising oil prices is mostly accounted for those “other” factors.

“Assuming that demand for Russia’s local debt is likely also closely correlated with sanctions sentiment, then the size of the sanctions premium would be even higher, closer to 9%,” Sleptsova says.

“In real effective terms, we found that the ruble has significantly deviated from its “fair value” (estimated using terms of trade, EM risk premiums, real interest rates and broader dollar movements) at times of meaningful sanctions-driven market moves. These include: the 2015 Ukraine-driven sectoral sanctions; the 2016-2017 “Trump rally”; the 2018 unravelling of that rally as a series of “draconian” laws were introduced by Congress (CAATSA, DASKA and others); and, finally, the Biden risk premium during 2020,” says Sleptsova.

 “Biden’s recent tough talk on Russia may result in some new measures, but we don’t believe they will be significant enough to hurt the broader Russian economy,” says Sleptsova.