The Physics of Sanctions
Vladislav Inozemtsev on the threat of ‘radical sanctions’ against sovereign debt for Russia
The article by Sergey Glandin, recently published on Riddle, thoroughly discusses the likely developments with regard to sanctions against Russia that may be imposed in the near future by the U.S. government and the EU. The author provides a detailed explanation of the mechanism and the legal framework for such measures and concludes that the consequences for Russia could be grave. One of his arguments is that the likely ban “prohibiting US banks, residents, and companies from purchasing Russian sovereign debt, regardless of the currency used for the transaction or whether it is on the primary or secondary market” could deal a serious blow to the budget, which would lose access to a significant share of borrowings. This view is being voiced by many experts today, which is why we should dwell on this claim for a while and assess how much damage such sanctions could do to Russia, and how likely they are to be imposed.
Let us begin by saying that there are no formal obstacles to the establishment of this kind of sanctions regime: it is permitted under the Chemical and Biological Weapons Control and Warfare Elimination Act of 1991. This very Act is invoked by Biden’s administration. As readers will remember, in 2019, after the poisoning of Sergei Skripal and his daughter in the UK, the U.S. Treasury Department already imposed restrictions barring U.S. banks from participating in initial public offerings of Russian Treasury securities denominated in U.S. dollars. This measure was among the softest interpretations of the actions the administration was obliged to take when Russia did not respond to demands to repent of the use of chemical weapons and to open access to production sites of such weapons.
The impact of the sanctions introduced in August 2019 has been negligible (Russia successfully placed its last $3bn issue of dollar-denominated Eurobonds in the spring of that year, with U.S. companies buying more than 20% of the issue). Since that time, the Russian Ministry of Finance started issuing euro-denominated debt on the Eurobond market (in 2020, a total of two issues were placed, with a nominal value of €2bn). The situation on the domestic market has not changed at all: the U.S.-based Blackrock Inc., Legg Mason Inc. and Vanguard continue to be among the largest holders of Russian federal loan bonds. But what will happen if the toughest possible sanctions are introduced, prohibiting all transactions involving Russian debt for American (and possibly European) banks as well as other legal entities and individuals?
Let us try to reconstruct the possible scenario. Today, the Russian sovereign debt is represented by Eurobonds denominated in foreign currencies, placed under market conditions (as of 1 January 2021, they totalled $21.2bn, according to Bank of Russia’s statistics) and federal loan bonds denominated in roubles, issued in the domestic market (with a total value of 13.7 trillion roubles as of the same date). Let us assume that foreign entities hold 100% of the Eurobonds (although the exact figure is unknown since entities controlled by Russian beneficiaries may be among the customers of those banks) and 23.3% of federal loan bonds (with U.S. and UK companies being the largest holders, with a total of 13.8%). The combined nominal value of these assets is approx. 4.76 trillion roubles ($44.5bn), or less than 4.5% of Russia’s GDP. By all standards, this is a negligible amount (the latest stimulus package alone, passed in the USA, increased sovereign debt by 9.1% of GDP). The Russian authorities control the National Wealth Fund (with 13.6 trillion roubles), which can be easily used to redeem foreign-owned federal loan bonds. The Bank of Russia, which manages $456bn worth of foreign currency reserves, not counting monetary gold, is also unlikely to remain passive. It will be very easy, and perhaps even pleasant, for it to transfer part of its reserves from the securities issued by foreign governments into those of the Russian government.
Even if we imagine that both the National Wealth Fund and the Central Bank of Russia stand aside, it must be remembered that the requirement to get rid of the Russian obligations—either immediately or within certain period—will automatically lead to their sell-out, with a corresponding decline in prices and increase in profitability. At present, the weighted average yield of the federal loan bonds is 5.6% per annum if placed for three years, reaching 7.3% for 20-year securities whereas the yield offered on long-term deposits by most Russian banks falls within the range of 3.8–4.2% per annum. An attempt to sell about one third of the free floating securities on the market will result in a short-term yield increase to 7–9% per annum, which would make them an extremely interesting deposit instrument. As readers may recall, the balances on private current accounts and deposit accounts with Russian banks amounted to 32.8 trillion roubles as of 1 January 2021, which was ten times as high as the volume of federal loan bonds in foreign hands. Even without resorting to any help from the government and without any governmental orders, Russian banks will easily acquire any amount of securities coming onto the market. Furthermore, one should not forget that federal loan bonds are a permanent component of the Bank of Russia’s Lombard list, and any bank which buys them may pledge them to the Central Bank to obtain the required funds at the historically lowest bank rate.
The situation with Eurobonds is roughly the same, although in this case the involvement of the Bank of Russia seems almost inevitable. Most of those bonds were issued by Russia in 1997–2011 with a 30-year maturity and high coupon values (for instance, the coupon on dollar-denominated bond XS0088543193 due on 24 June 2028 stands at 12.75% per annum with a current yield of 2.4%, which has enabled it to be traded in the range of 160% to 175% of nominal value over the last 12 months). Should the need arise to sell the securities quickly, one can presume an increase of the yield by 175–300 basis points and a decline in the price to 135–140% of the nominal value, which would entail a direct loss to all holders of Russian Eurobonds in the range of $3–7bn, based on the total value of the outstanding liabilities. The same holds true for the reduction of the market prices of federal loan bonds by 5–10 percentage points and an even greater reduction in their currency value due to the short-term weakening of the rouble triggered by the sanctions (foreign investors will lose $3.5–6bn in that market if they close their positions). In other words, Russia will be able to buy back its debt at a significantly lower cost than it would have done if redeeming it at maturity, whereas foreign holders of debt instruments will incur net losses.
Special attention should be paid to the widespread argument that the introduction of ‘radical sanctions’ against Russian sovereign debt will prevent the government from borrowing money to balance the budget. This claim seems unfounded. The amount borrowed, estimated at 4.5 trillion roubles (approx. 4.2% of GDP) by 2022, is low and if the government is forced to act in an emergency, those securities could easily be placed on the market through authorised banks, which would become their nominal holders by pledging them at the Central Bank. If this scenario materialises, virtually all income paid by the Ministry of Finance to banks will go to the Central Bank and generate profit, and 75% of that profit will be transferred to the federal budget in the year following the reporting year, as provided in Article 26 of the Federal Act No. 86-FZ “On the Central Bank of the Russian Federation (Bank of Russia).” This means that the government will borrow money approximately three times more cheaply than today. The issue of 2.5–3.5 trillion roubles within one year that could potentially follow such a step will not shake the financial system (in 2019–2020, the Central increased the M2 money supply by 6–7 trillion roubles per year, which did not even prevent inflation from declining).
The nervousness among the expert community and some Russian officials about the possible sanctions against Russia’s sovereign debt stems from the erroneous identification of this measure and sanctions against the financial sector (and state-owned banks), both which can indeed cause enormous damage to any country, as was the case, for instance, with Iran. However, one should bear in mind that in the Iran’s case the issue was related, firstly, to the suspension of settlements with many financial institutions and, secondly, the sanctions were not imposed by the United States government, but by the UN Security Council, which ultimately forced Tehran to change its attitude towards international coordination of its nuclear programme. However, it is impossible to tear the Russian economy to pieces by restricting access to international credit markets: that is because the Russian sovereign debt is very low in relation to the GDP and the federal budget, and also (much more importantly) because Russian companies and banks, including those with some state-owned interests, have successfully borrowed money on world markets for a long time (in 2017–2020 they placed more than $55bn worth of Eurobonds alone, or 4.6 times more than the Ministry of Finance). To cover the budget deficit, the Russian authorities can use domestic market debt instruments and the National Wealth Fund, the opportunity to increase rouble revenues from foreign economic activity by devaluing the rouble, and many other methods (not to mention the fact that oil at a price of $70 per barrel will help the budget break even).
A total ban on transactions involving the Russian foreign debt and the extension of that ban to the U.S. allies will only result in serious losses for the Western financial institutions following the sell-out of this type of assets, and the Russian authorities will restructure their liabilities, making considerable savings on debt servicing. Moreover, the Russian authorities will receive additional arguments for their rhetoric where Russia is set in opposition to the Western world. While Russia does have multiple vulnerabilities in the economic, industrial and technological areas, sovereign debt is not one of them. It would be no exaggeration to say that sovereign debt operations in recent years have been a kind of ‘tribute to trends’ rather than an important element of financial strategy. Therefore, by dealing a blow against Russian sovereign debt Western politicians will not inflict much damage to Russia’s finances. Given the cost of the measure to Western investors themselves and the brutal ‘physics’ of the problem, no amount of subtle ‘chemistry’ will be likely to force the Americans and Europeans to take such a step.