Analysis: No knockout, but new U.S. sanctions add to Russia's 'slow destruction'

For all the insouciance with which markets treated Washington's latest sanctions on Russia, its move to target Moscow's main funding avenue - the rouble bond market - has in some ways, crossed the Rubicon, potentially with far-reaching consequences.

Drawing on experiences of sanctions imposed previously, including after the 2014 Ukraine crisis and the Mueller report on Russia's alleged U.S. election meddling, money managers haven't rushed to dump Russian assets en masse.

The rouble, which fell as much as 2% at one point on Thursday, has clawed back losses and is on its way to recording its best week this year; Russian bond yields, on local as well as international markets, have fallen.

That reaction suggests Washington's ban on U.S. investors buying new Russian rouble bonds - OFZs as they are known - is being perceived as yet another annoyance for a market that's coped for years with sanctions risk.

Investors had feared "nuclear" options such as barring U.S. firms completely from rouble debt or cutting Russia out of international money-transfer systems. Those may yet come to pass. But for now, U.S. funds can buy the bonds in secondary markets, which is what most of them already do.

Yet many caution the U.S. move is an escalation from previous sanctions against individuals and Russian dollar debt.

"This is not just another round of essentially political sanctions that target a few officials or blacklist companies no one has ever heard of," said Christopher Granville, managing director at consultancy TS Lombard and a veteran Russia watcher.

"They have gone this time for real financial sanctions that are designed to harm Russia by raising its borrowing costs and weakening the rouble."

Granville reckons these will lead to Russian interest rates being 50 basis points (bps) above where they would otherwise have been.

Indeed banks such as Morgan Stanley and JPMorgan now see a higher chance of a larger-than-expected 50 bps hike next week, which could hurt Russia's expected 4% economic rebound in 2021.

Foreigners have already cut OFZ exposure to six-year lows. U.S. investors hold nearly 7% of the total. Extrapolated to the expected $37 billion worth (2.8 trillion roubles) of OFZ sales this year, the removal of U.S. buyers would remove $2.6 billion in demand.

This is an extreme figure, though, and does not account for secondary-market purchases.

Russian banks too can absorb surplus debt. But it will likely reduce market liquidity - Russian investors mostly buy to hold - while yields should rise at least at the margin.

'SLOW DESTRUCTION'

Russia has more strength than most developing countries to absorb such blows. Since the 2014 double-whammy of an oil price collapse and the first set of sanctions over its annexation of Crimea, it has built up fortress-like defences.

Its debt-to-GDP ratio of around 20% is under a fifth of U.S. levels.

The risk is of a longer-term corrosion of the economy and an erosion of Russia's presence in international markets, processes that are already in train.

"The sanctions have created a slow destruction," said Pavel Mamai, co-founder of hedge fund Promeritum Asset Management. "Every single sanction won't hurt but it's the trend. Russia is getting more marginalised."

Sanctions in 2019 made future Russian dollar debt ineligible for major bond indexes, such as JPMorgan's EMBI Global. JPM, which runs the most popular emerging debt benchmarks, may exclude newly issued OFZ too.

That means investors tracking those indexes, or using them to benchmark performance, won't feel the pressure to buy OFZs.

Russia's 4.2% share in JPM's corporate bond index is down from 5.6% in 2013. It will shrink further as many big Russian firms and banks are barred from dollar debt markets

RISK PREMIUM

JPMorgan economists, who are separate from its index team, warn of "medium-term" consequences for foreign investment in OFZs. The possibility of further OFZ sanctions mean higher risk premia are the "new normal", they wrote.

The rouble too is dogged by geopolitics - ING analysts estimate it carries a 16% discount to commodity currency peers. Its risk premium has risen 7%-10% since the U.S. elections in November, calculates Sofya Donets, Russia and CIS economist at Renaissance Capital.

Russians are already living with the consequences of sanctions, which the International Monetary Fund estimated cost Moscow about 0.2 percentage points of GDP every year between 2014 and 2018.

Rouble depreciation reduced per-capita income to $10,000 last year, from $16,000 in 2014.

Lower anticipated investment is another way the sanctions could bite. Domestic investment slumped after the 2014 and 2018 sanction rounds, while bricks-and-mortar foreign direct investment is around 1% of GDP, down from 3% before 2014, according to RenCap's Donets

($1 = 75.9000 roubles)