Soft war – when finance becomes continuation of politics by other means

(Business New Europe – bne.eu – PERSPECTIVE – Roland Nash of Verno Investment Research – March 27, 2014) As the conflict between Russia and the West for influence in Ukraine unfolded, finance has found itself in the unfortunate position of sitting squarely in the front line. From the acceptance by Viktor Yanukovych of a $15bn loan from Russia to the freezing of oligarch bank accounts in the US and Europe, finance has been used as a tool to push the political agenda of both sides.

The immediate consequence has been a fall in the value of Russian assets, the latest of many that have plagued Russia over the last 20 years. If a market correction is the only impact, recent weeks will prove little more than another example of how Russian markets have a tendency to overreact to newsflow. But there could well be a more far reaching impact – and perhaps with rather different consequences than those intended by the US and EU.

In the 14 years that Vladimir Putin has dominated Russian politics, arguably the biggest threat to his authority was the 2008 financial crisis. By suddenly facing the removal of access to financing, Russian businesses and the elites that controlled them found they were unable to meet obligations – not just to the West, but to each other, the Russian public and the Russian government. The equity market lost a $1 trillion in value in the space of three months, western banks threatened to take control of Russian industry in lieu of debts, and the economy declined by 8% in 2009 – the biggest recession of any major country globally. While Putin had created a highly successful power-vertical in Russia, it transpired the whole edifice of the Russian economy could be threatened by what was little more than collateral damage from decisions taken in the US and Europe to support their own economies.

By the same token, the crisis also demonstrated the soft power of western finance in Russia. It is one of the great ironies of Russia’s post-Soviet experience that one of the events that did most to restore the influence of the state across the Commonwealth of Independent States (CIS) was a financial crisis in the West. With the removal of sources of external private finance, businesses, banks, oligarchs and even governments had no choice but to turn to the Russian state for liquidity. Into the vacuum left by western finance walked the only entity that had been saving during the 10-year post 1998 economic boom, the Russian state. Through Sberbank, VTB and VEB, the state provided liquidity and in return gained influence.

The experience of 2008 was a lesson that appears to have been learned by both the West and Russia. From the western standpoint, finance has been chosen as one of the few mechanisms available to apply pressure on Russia in response to events in Crimea. Targeted asset freezes and restricting certain Russian companies’ access to finance are measures that appear to be viewed as a surgical way of directly pressuring those making decisions related to Ukraine. Rumours of the threat of wider sanctions abound, with the effect of artificially creating the circumstances that so impacted Russian economic stability in 2008. Actual concrete decisions are not always necessary – rumour alone can be highly destructive.

From the Russian standpoint, just as the lesson from 1998 was not to let government finances ever become over-exposed to the West, so the lesson in 2008 was to limit private sector exposure. Companies and banks have been encouraged to increase domestic borrowing and decrease reliance on the West. Oligarchs have been far more reluctant to leverage their individual holdings through western banks. From a policy standpoint, the Central Bank of Russia has floated the ruble and the Kremlin has been vocal about its awkwardly titled policy of “de-offshorization”.

Both sides are manoeuvring. Russian stocks are particularly vulnerable to geopolitics because so much of the free float is owned by foreigners, creating the opportunity for considerable value destruction if holders become nervous of deteriorating politics. Of the 18% fall in the equity market so far in 2014, at least half can be directly attributable to the impact of events in Ukraine, which would imply a $60bn cost to Russia.

But equally, a collapse in Russian valuations hurts foreign funds disproportionately because they own so much of the market. Indeed, Russian corporates are looking at lower valuations as an opportunity to buy back their stock from foreign holders. A similar trend is underway in debt markets. Companies that borrowed in western financial markets at 5% are now able to buy back their debt at yields several hundred basis points higher.

In Ukraine itself, finance is likely to play a key role as military tensions subside. The West’s arsenal of multilateral lenders is likely to be deployed to prop up the Ukrainian economy and persuade of the advantages of looking west. In Crimea, Russia is likely to want to illustrate the merits of stronger ties with the homeland and, given the smaller scale of the project and the relative priority of policy, could well prove to be the more successful.

In the longer term, the costs to Russia are likely to prove more substantive. Partly this will reflect a lower availability of financing at a time when Russia needs to be investing. But it’s the quality of financing rather than the quantity that may have the bigger impact. Russia is only capital constrained because such a large proportion of domestic savings are exported abroad. Financial markets are global, and if the West is not prepared for political reasons to provide financing, then other sources are likely to take advantage of any improved economics. Organizations like the Russian Direct Investment Fund have already proved successful at both raising and deploying institutional funds in Russia. But if, as is likely, capital deployment in the absence of the West involves greater state involvement, then there could well prove to be an efficiency loss that will cost Russia over the longer term.

From the West’s standpoint, financial engagement has been one of the major successes of the integration of Russia into the global economy since the break-up of the Soviet Union. Incentivizing Russian organizations to adopt the standards and the disciplines that most effectively ensure access to western finance encourages many of the trends that the West should, in their own interests, be working to achieve. Disincentivizing western finance from engaging with Russia may indeed damage Russian growth, but it will also undermine some of the most encouraging trends of the last decade.

There is a feeling in Moscow that the model of finance that has developed in Russia over the last 20 years may have been permanently changed by the reaction to events in Ukraine. This, like other crises before it, will undoubtedly create opportunities for capital deployment. But it may also change attitudes that will have unintended costs for both sides.