By Levon Kameryan, Senior Analyst, Sovereign and Public Sector Ratings

The cumulative impact of existing and potentially stronger future sanctions is a concern for the country’s credit outlook.

A comprehensive package of sanctions has the potential to disrupt Russian exports, further discourage foreign and domestic investment, which the country needs for sustainable economic growth, and push up government borrowing costs – at least at the margin.

Agreement among the Western allies to cut Russia off from the SWIFT international payments system would be potentially the most damaging action. Such a move would have severe consequences for Russian investment and exports despite Russia’s increased resilience through reduced dependence on the dollar and foreign funding in recent years, as it has coped with existing sanctions.

Russia has reduced exposure to the dollar amid fresh sanction risks

Source: Bank of Russia

Russia is heavily reliant on SWIFT, as most Russian oil is still traded in dollars. The share of Russia’s exports of goods and services sold in USD accounted for 54% of the total in Q3 of 2021 (see chart), albeit down from near 70% during 2016-18. Russia currently conducts more trade with China in euros than in dollars, with EUR being the settlement currency for around half of Russian exports to China, compared to one-third for USD.

Another measure under consideration is US sanctioning of secondary trading in Russian government bonds. This would have a more tangible impact on Russia’s room for financial flexibility than the April 2021 sanctions on primary market debt issuance of the state. This would make it more difficult for state-owned Russian banks to substitute for lost US and non-US foreign demand on the primary market and sell Russian government bonds on to foreign banks on the secondary market. The share of non-resident holders of Russia’s treasury bond market is still sizable, at around 19%, despite recent reductions.

Such a move would also further discourage foreign investment. Inbound foreign direct investment fell from an annual average of USD 55bn over 2010-13 to around USD 20bn over 2018-21.

One knock-on effect might then be an acceleration in local private capital outflows, which already rose to USD 72bn in 2021 in net terms, from USD 50bn in 2020, as well as further sale of Russian bonds by non-resident holders. High oil prices might not be able to fully offset such capital outflows, especially if foreign investors and Russian corporates start to factor in more adverse scenarios related to the conflict over Ukraine.

Higher energy prices are cushioning Russia from the economic impact from the diplomatic crisis and any future sanctions – at least in the short term, even without the new Nord Stream 2 gas pipeline in operation. The government has budgeted for an oil price of USD 62/barrel in 2022. The average price of Urals oil was around USD 86/barrel in January.

But regardless of the design of any new sanctions, geopolitical tensions have helped push energy security further up the policy-making agenda in the EU, Russia’s biggest trading partner, whose imports of Russian oil and gas and related products is worth around EUR 90bn a year. We will likely see acceleration in EU efforts to diversify sources of oil and gas, which could reduce European demand for Russia’s energy exports longer-term.

To be sure, there is plenty of uncertainty surrounding the application and design of any future sanctions. A new status quo of heightened geopolitical tensions without further escalations, and thus no justification for additional sanctions, could also emerge. Even if the crisis worsens, it is not yet clear what mix of measures the US and EU might then impose.

Sanctions are also not cost free for the US and EU. Exemptions to allow energy transactions with Russian banks, even in a scenario of sanctions involving SWIFT, could thus be a possibility. Similarly, sanctions could also accelerate Russia’s reliance on domestic financial markets in potential conjunction with partners such as China, thereby limiting longer-term financial damage.

Over the longer term, however, sanction risks significantly cloud the outlook for investment and growth in Russia. Even excluding the potential impact of additional sanctions, the economy’s moderate medium-run growth potential is estimated around 1.5-2.0% a year, despite comparatively low per capita incomes and a significant economic catch-up potential. This remains a key credit constraint.

Contributing Writer: Matthew Curtin