Russia-Ukraine: Return of the Prometheans

(Business New Europe – bne.eu – Chris Weafer, Macro Advisors – March 24, 2014)

“Taking a new step, uttering a new word, is what people fear the most”
Fyodor Dostoyevsky, Crime and Punishment

The threat is more important than existing sanctions. The sanctions announced so far do not directly cause any material disruption to the economy. But the actions taken by the US/EU bring Russia to the outer limit of the “inconvenient” sanctions. Any additional sanctions are likely to cross into the trade and economy disruption category. It is that threat which is now of greatest concern to investors/business community.

Political rhetoric will get worse this week. The assumption is that moving to more serious sanctions is now linked to Russian actions elsewhere in Ukraine. Moscow continues to play down that risk but the political rhetoric from the US/EU is expected to ratchet up much further this week as the G7 leaders hold a series of meetings in Europe and, most importantly, in Kiev.

The risk premium is staying high. Politics and the threat of next stage sanctions will keep markets nervous again this week. The dollar based Russian indices are already in a bear market in 2014. Sentiment is super sensitive to any comments or actions from either side. That backdrop of political nervousness may not change until the election processes are completed in Ukraine later this summer. But, any sign of political cooperation will cut the risk premium and send indices up at least 10% in a knee-jerk move.

Talks about a Ukraine bailout have to start soon. Assuming the political risk calms this week the focus will soon have to revert to the bailout. Every week that passes increases the size of the cheque required and the difficulty in reviving the economy.

Russian market is important. Moscow has said that it will revert to the old gas tariff from April 1st which, without the naval base discount, means that Ukraine would pay close to $500 p/’000 cm, i.e. the highest in Europe. Russia’s share of Ukraine exports is 25% and despite the new trade deal with the EU, it will not be able to replace that market for years. Bailout talks will have to include a Russia input.

Insiders have started to buy equities. One theme which is starting to emerge in Russian equities is share buybacks by companies and share buying by existing core shareholders. We review a list of shares (below), many of which are well supported with a high dividend yield, which may see share buybacks or core shareholder support.

Revised top DR picks. The list of our Top Russian stocks is revised later in this note to reflect long term investment opportunities opened up by the stock indices collapse. (tables below). In particular we highlight Novatek, Megafon and CTC Media which have been hard hit because of ownership risk. We rate all three as buys for investors who can suffer short-term volatility.

Situation update

Sanctions have targeted individuals and two banks. Both the US and the EU expanded their sanctions lists last week but have refrained from imposing any sanctions which directly impact the Russian economy or external trade. The sanctions announced so far only impose travel bans and asset freezes on named individuals and two banks with no meaningful role in external trade. The big threat, however, is that we are now close to the boundary between these “inconvenient” sanctions and the more serious “economy disrupting” sanctions. Hence the concern is not what was signed last week but what may be signed this week.

President Obama starts a weeklong trip to Europe this week and included is a meeting of the G7 in Kiev. This is, therefore, a much more dangerous week for Russia as the threat of additional and damaging sanctions will be on the agenda every day and will likely feature prominently i n the media headlines. Investment sentiment is already very sensitive to news headline and will certainly continue to be this week.

Companies are nervous. Foreign companies are equally nervous that the sanctions list may be expanded to affect their activities or even their presence in Russia although, thus far, that remains only a threat rather than current. Our view is, as it has always been, that a move up to the more dangerous sanctions is still unlikely unless Russian forces actually move into another part of Ukraine. Several EU leaders made that clear over this weekend and that message is expected to be front and center this week. The caveat of course is that situation like this are very unpredictable and so many vested interests, on all sides, are involved. So a very cautious position is clearly prudent until the actual threat level becomes clearer.

The backdrop will remain nervous for months. In reality the threat of more serious sanctions will remain in place until some form of political dialogue is restored between Moscow and Kiev or between Moscow and the EU concerning Ukraine. That may not happen until after the May 25th presidential election and maybe not until the RADA elections are held. So far no specific date has been set for that latter election other than a vague “mid-summer”. The specific threat is of violence in east Ukraine during both elections if people, who previously mostly supported Yanukovich and the Party of the Regions, are disenfranchised. Reports of instability during these election periods, i.e. assuming nothing escalates before then, will keep market sentiment firmly in the nervous category for months to come.

Both hope and threats are rising. The recent statements from Moscow plus the linking of trade/financial sanctions to any further incursion into Ukraine by Russian forces by several EU leaders over the weekend, offers the hope that a political escalation can be avoided, albeit a greater inten sity to the statements from western leaders in absolutely inevitable. That would then mean that, by the end of this week, the focus should start to re-fix on the trend in the economies of both Ukraine and Russia. We will not get a proper view of the trend in either the Ukraine or Russian economies until mid-April or mid-May when the data covering the March escalation is known and the impact on ongoing activity better assessed. Meantime we are sticking with a current year GDP growth forecast of +1.0% for the Russian economy and a contraction of 2.0% for Ukraine until a proper review can be completed. Both numbers will almost certainly change by mid-year.

The impact on the economy is yet to be calculated. For Russia the big issue is the impact on domestic consumer and business confidence and what that is doing to activity. The concern is also about the damage to inward investment flows and rising capital outflows. For Ukraine the problem is much more basic; the country needs a huge bailout and quickly. So far all that has been signed is a political cooperation agreement between Ukraine and the EU and a $1 bln loan guarantee from the US. The government actually needs hard cash. The talks may switch to the bailout this week when the G7 meets in Kiev. Investors are certainly expecting that as the longer the issue is avoid the larger will be the cheque required and the longer it will take to revive the economy.

Note: We will review the current macro indicators for the Russian economy in the next issue of Macro Monthly, due early next week.

Russia is still important for Ukraine’s economy. The Ukraine economy is the one factor which might encourage an earlier dialogue between Ukraine, EU and Russia. An update on the issues concerning both is later in this note. But two factors are worth pointing out;

1. Russia has said that it will revert back to the higher gas tariff from April 1st. This will push the price charged to Ukraine from the 1st Qtr price of $286 per 1,000 cubic meters (cm) to almost $500 p/’000 cm. That is $100 p/’000 cm higher than Ukraine paid previously because Russia no longer has to offer the Navy base discount. The revised price is the highest in Europe and Ukraine cannot afford it. Negotiating either a new contract or offering a new compensating discount is one of the two aces Moscow holds.

It is assumed that the Prime Minister’s comment about possibly looking for a back tariff of $11 bln is not a realistic proposition but has been mentioned to emphasise that Moscow does still have an important role in its neighbors economy. Neither the IMF nor the EU will be keen to pick up the tab for such a high gas tariff nor to have to pay off the $2 bln that Ukraine owes under existing contract terms. This should at least open the way to bring Moscow to somebody’s table to discuss the issue.

If Ukraine repudiates the gas contract terms and there are no talks to resolve the is sue, Gazprom may well turn off the as flow to Ukraine again. The last time, 2009, this happened Ukraine simply tapped into gas intended for Gazprom’s EU customers and that led to the pipeline being fully closed. It could happen like that again but is unlikely. Ukraine has now moved close to the EU and would not want its first action being to siphon off gas. In any event, Ukraine has said it has a reserve supply for many months.

2. Even though Ukraine and the EU have now signed a cooperation agreement which will make it a lot easier for trade to flow west. But that is a long term proposition and meantime almost 25% of Ukraine exports have been flowing to Russia and a larger percentage through Russia. If the border were to be closed to Ukraine trade this would make the cost of the IMF/EU bailout larger and reviving the economy would take many years longer.

So called “Odious debt repudiation is not realistic. There has been some discussion by academics last week th at Ukraine has a case to make that the $3 bln loan advanced by Russia to the previous government in December plus the gas debt may be repudiated under the precedent of “Odious Debt”, i.e. debt acquired to fund or prop a previous regime rather than for genuine economic purposes. That course is most unlikely to be adopted by the Kiev government for the two key reasons cited above.