Five Hits but Greater Self-Sufficiency Brings Opportunities

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There is no doubt that economic sanctions are no good for anybody, especially if the target country has the ability to strike back. The first round of Russia retaliatory sanctions is already hurting some individual exporters of food products and regions in the EU, which had built up capacity to serve the large and growing Russian market. Additional sanctions would broaden the impact to other industries and increase the cost to western countries. Whether that happens or not will be as a result of currently unpredictable military and political actions. But the retaliatory marker has now been firmly planted and is now part of the equation for the EU in particular.

So much for the local commercial. The fact is, despite some sharing of the pain, sanctions are already weighing on the local economy and the situation will continue to deteriorate until they are lifted. That is not to say that Russia is in any danger of economic collapse or defaulting on debt. It is not. Even the rouble, historically very sensitive to any hint of economic turmoil, looks relatively immune from a further significant devaluation. Fiscally Russia is in good shape to ride out the sanctions period, i.e., making the three assumptions that the sanctions period does not last much beyond a 12-24 month period; the government does not waste all of its accumulated savings in ill-advised investment or support operations; the price of oil does not collapse below $85-$90 per barrel.

But while supported with a good balance sheet, the pace of economic growth will not be able to avoid further weakness over the next 6-12 months. Sanctions hits growth in five main categories; the first hit is to the domestic credit market. Because of the restrictions placed on state banks accessing western debt markets, which we know has been extended by most western institutions to most Russian enterprises on a voluntary basis, the local debt market is already tightening and interest rates are rising. It means that businesses are focusing on debt management rather than investment and households are spending a larger share of income on debt servicing. The second hit is to inflation and inventories. The ban on imported food items will lead to higher prices this autumn and winter. We have already seen this with the ban placed on imported pork earlier this year; domestic prices rose sharply and the product is hard to find in restaurants and on super-market shelves. We will see that effect replicated across more food items in the coming months, as alternative supply sources will take months to be integrated. Rising inflation will also force the Central Bank to keep its Key Rate high and maybe even to raise it further by year-end. That will exacerbate the first problem mentioned.

The third hit is to the supply-chain serving domestic manufacturers. Sanctions, and the anecdotal evidence of widespread self-sanctions as western suppliers and risk managers adopt a cautious approach to all Russia exposure, could seriously disrupt the supply of key parts to local industry. For example, auto-manufacturers import almost 50 per cent of the components needed to build a new car. The problem is that these have to be ordered well in advance so any disruption today may have a legacy impact lasting beyond the sanctions period. The fourth hit to the economy is from declining domestic confidence. It is no surprise that a majority of people have reacted to sanctions with defiance. But as prices rise and some items become scarce, the reaction will inevitably become more cautious. That means preserving cash and avoiding new expensive debt. In July, sales of new vehicles, one of the main discretionary purchases, fell by more than one-fifth compared to the same month last year. The fifth hit is to inward investment, which has almost dried up as investors wait to see what happens next ‘on the ground’ and to get a better assessment of the sanctions impact. The longer this avoidance of Russia risk lasts the longer, and deeper, will be the damage to long-term growth prospects.

That’s the bad news. And before we talk ourselves into a spiral of depression, let’s look at the positives. The first point to make is that if ever there was a good time for a period of sanctions, it is now. The country has $180 billion of ‘reasonably’ disposable cash split between the Reserve and Wellbeing funds. That money may be used to substitute for the block on access to western capital markets and to support banks and industrial groups as they seek alternatives in Asia. Some of the money may also be used to cover additional budget spending, which the government is expected to announce later this year to try and stimulate investment spending and raise demand for domestic goods. Russia’s key advantage is the high price of oil which, in combination with the Central Bank’s flexible rouble exchange rate policy, meant that the federal budget reported a surplus equal to 1.9% of GDP for the first half of this year. Given the legacy of wars in Libya and Iraq, it certainly does not seem as if the risk premium in the oil price is in danger of falling any time soon.

A well-worn cliché states that every crisis is also an opportunity. Russia is the largest country on the planet and yet it still imports almost 20 per cent of its food. The country is a net importer of most meat and, for example, only produces three out of every four carrots sold in supermarkets and restaurants. That is a result of a couple of decades of under-investment and neglect. President Putin complained about this at the time of the disastrous draught in August 2010 and one can’t help but make the connection that focusing Russia’s initial sanctions response in this industry may also be partly motivated by a wish to force investment into agriculture and food production. And by no means is this the only sector of the economy which used to be, and is theoretically capable of, being self-sufficient.

Time and time again we see that policy planning in Russia translates very slowly into meaningful actions. This is, of course, not unique to this country but is a common trait across most emerging economies. More often it requires a crisis to focus resources and effort to fixing a problem. Sanctions present that opportunity. There is no question that, for the reasons already mentioned, Russia is facing a period of hardship in the economy. But if that is paralleled with a serious effort towards greater self-sufficiency in such industries as food, pharmaceuticals, machinery and technologies, then what started out as a crisis may become a long overdue turning point. Foreign companies willing and able to make the transition from suppliers into Russia to investors in Russia will be the best placed to not only survive but thrive.