Streetwise Professor

July 18, 2014

Sanctions: Pinprick or Sledgehammer Blow, With Little In Between

Filed under: Commodities,Derivatives,Economics,Energy,Military,Politics,Russia — The Professor @ 11:27 pm

Before the massacre over Donetsk, the big Russia-related story was the new sanctions imposed on Wednesday. Although those sanctions were overshadowed by yesterday’s atrocity, the wanton destruction of MH17 raises the possibility that more intense sanctions will be forthcoming. Therefore, it is worthwhile to examine what the US did Wednesday to see what would be necessary to impose truly crippling costs on Russian companies and the Russian economy generally. (Forget what the Euros did. That is so embarrassing that it should be passed over in silence.)

The sanctions imposed Wednesday are very weak beer. (Here is an FAQ from the Treasury outlining them.) They were different than previous sanctions in that these were directed at companies, rather than individuals. Moreover, some of the targeted companies are on the commanding heights of the Russian economy: Rosneft, VTB, Gazprombank, and Novatek. (Notable absences: Gazprom and Sberbank.)

Under the sanctions, “US Persons” (which can include US subsidiaries in foreign countries) are prohibited from buying new debt from or new making loans to these companies with maturities of 90 days. (Existing loans/bonds are not affected.)  US persons are also precluded from buying “new” equity from the financial firms: they can buy new equity from Rosneft and Novatek.

Since US banks are major lenders to foreign companies, this might seem to be a major impediment to the affected companies, and indeed  Rosneft’s and Novatek’s stock prices were both down more than 5 percent on the news. But in my opinion, this reaction is more related to how the announcement raised the likelihood of more severe sanctions in the future, rather than the direct effects of these new sanctions.

That’s because although the sanctions will constrain the capital pool that Rosneft and the others can borrow from, other lenders in Europe and Asia can step into the breach. The sanctions do make it more difficult for the sanctioned companies to borrow dollars even from foreign banks, because although the sanctions do not bar foreign banks and investors from accessing the US dollar clearing system for most transactions, they could be interpreted to make it illegal to process the banned debt and equity deals:

U.S. financial institutions may continue to maintain correspondent accounts and process U.S. dollar-clearing transactions for the persons identified in the directives, so long as those activities do not involve transacting in, providing financing for, or otherwise dealing in prohibited transaction types identified by these directives.

Some have argued that this is a serious constraint that will effectively preclude the sanctioned companies from borrowing dollars other than on a very short-term basis. This is allegedly a big problem for Rosneft, because its export revenues are in dollars, and borrowing in other currencies would expose the company to substantial exchange rate risk.

I disagree, because there are ways around this. A company could borrow in Euros, for instance, and  sell the Euros for dollars. It could then deposit, invest, or spend the dollars just like the proceeds from dollar loans because it would have access to the dollar clearing system. Alternatively, the companies could borrow in Euros and immediately swap the Euros into dollars. This is because derivatives transactions are not included in the sanctions, and the payments on those could also be cleared. This would add some expense and complexity, but not too much.

The sanctions even permit  financial engineering that would allow US banks  effectively to provide credit for the sanctioned firms because derivatives on debt and equity of the sanctioned firms are explicitly exempted from the sanctions. For instance, a US bank could sell credit protection on Rosneft to a European bank that would increase the capacity of the European bank to extend credit to Rosneft. Syndication is one way that US banks can get credit exposure to Rosneft and reduce the amount of credit exposure that foreign banks have to incur, and even though the sanctions preclude US banks from participating in syndicates, the same allocation of credit risk could be implemented through the CDS market. This would permit foreign banks to increase their lending to the sanctioned firms to offset the decline of US direct lending. (This would still involve the need to convert foreign currency into dollars if the sanctioned borrower wanted dollars.)

Unlike real super majors (who can borrow unsecured, or secured by physical assets), Rosneft is unusually dependent on prepaid oil sales for funding, and these agreements are almost exclusively in dollars. This has led to some debate over whether the sanctions will seriously cramp Rosneft’s ability to use prepays.

There are a couple of reasons to doubt this. First, after the initial round of sanctions raised the specter of the imposition of sanctions on Rosneft, many prepay deals were re-worked to include sanctions clauses. For instance, they permit the payment currency to be switched to Euros, or to another currency in the off chance that the Europeans grow a pair and shut Rosneft out of the Euro payment system. Again, as long as access to the dollar system is not blocked altogether, those non-dollar currencies could be converted into dollars.

Second, there is some ambiguity as to whether prepays would even be covered. The sanctions specify the kinds of transactions that are covered:

The term debt includes bonds, loans, extensions of credit, loan guarantees, letters of credit, drafts, bankers acceptances, discount notes or bills, or commercial paper.

It is not obvious that prepays as usually structured would fall into any of these categories, and prepays are not specifically mentioned. A standard prepay structure is for a syndicate of banks to extend a non-recourse loan to a commodity trading firm like Glencore, Vitol, Trafigura, or BP. The trading firm uses the loan proceeds to make a prepayment for oil to Rosneft. In return, the trading firm gets an off take agreement that obligates Rosneft to deliver oil at a discounted price: the discount is effectively an interest payment.

The banks lend to the trading companies, not Rosneft. But (except for a small participation of 5-10 percent by the traders) the banks have the credit exposure. So this does not fall under any of the listed categories, except for perhaps “extension of credit.” Insofar as the trading firm is the borrower who faces the banks, it’s not clear the banks fall afoul of the sanctions even though that banks bear Rosneft’s credit risk. What about the trading firm? It’s not a US person, and a prepayment is not explicitly listed as a type of debt under the sanctions: again, this would turn on the “extensions of credit” provision. Under prepays, payment is usually with an irrevocable letter of credit, but these generally have maturities of less than 90 days, so that’s free of any sanctions problem.

So, there’s a colorable argument that prepays aren’t subject to the sanctions. But there is a colorable argument that they are. Economically they are clearly loans to Rosneft, though done via a trading firm acting as a conduit. But whether they are “debt” legally under the sanctions definition is not clear.

But especially in this regulatory environment, bank (and trading firm) tolerance for ambiguity is  pretty low. So the FUD factor kicks in: even though they could make a plausible legal argument that prepays fall outside the definition of debt under the Treasury rules, the risk of having that argument fail may be sufficient to dissuade them from doing dollar prepays. This is especially true in the post BNP Paribas world. So it is likely that future prepays may be in currencies other than the dollar, and as long as dollar clearing is open to it, Rosneft will just have to convert or swap the Euros or Sterling or Swiss Francs or whatever  into dollars if it really wants to borrow dollars. Again, an inconvenience and an added expense, but not a major hurdle.

All this means that the most recent round of sanctions are  sound and fury, signifying not very much. Indeed, by deliberately avoiding the truly devastating sanction, this round signifies a continued reluctance to hit Putin and Russia where it really hurts. Someone like Putin likely interprets this as a sign of weakness.

What would the devastating sanction that was deliberately avoided be? Cutting off altogether access to the dollar clearing system. Recall that the just-imposed sanctions say “U.S. financial institutions may continue to maintain correspondent accounts and process U.S. dollar-clearing transactions for the persons identified in the directives.” Change that to “U.S. financial institutions are prohibited from maintaining correspondent accounts and processing U.S. dollar-clearing transactions for the persons identified in the directives” and it would be a whole new ballgame. This would mean that the sanctioned companies could not receive, spend, deposit, or invest a dollar. (Well, they could if they could find a bank insane enough to be the next BNP Paribas. Good luck with that.)

I discussed how this would work in a post in March, and the Banker’s Umbrella provided a very readable and definitive discussion about that time. Basically, every dollar transaction, even one handled by a foreign bank, involves a correspondent account at a US bank. Cut off access to those accounts, and the sanctioned company can’t touch a dollar.

This would close off the various workarounds I discussed above. The sanctioned companies would have to restructure their operations and financing pretty dramatically. This would be particularly challenging for Rosneft, given that the currency of choice in oil transactions is the USD. This would be like the sanctions that have been imposed on Iran and on Sudan.

This would represent the only truly powerful sanction. And that’s one of the issues. Anything short of cutting off all access to the dollar market is at most an irritant to the sanctioned companies. Cutting off all access imposes a major cost. There’s not much in between. It’s a choice between a pinprick and a sledgehammer blow, with little in-between.

But if a Rubicon hasn’t been crossed now, with the murder of 298 people and continued battles in places like Luhansk waged by Russian-armed rebels, it’s hard to imagine it will ever be. If Putin and Russia are going to pay a real price for their wanton conduct, the sledgehammer is the only choice.

 

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22 Comments »

  1. This tragedy was caused by the Stasi android’s pusillanimity. Had he declared East Ukraine a no-fly zone a few months back, none of this would’ve happened (no-one is bombing anyone in Crimea). Of course the junta could have taken the wind out of the separatists’ sails by promising federation, Russian as another official language, not burning people alive in Odessa… But this what-if is like a “Hitler not hating Jews” what-if. Pointless.

    Comment by So? — July 19, 2014 @ 2:33 am

  2. Yes, Putler himself essentially told as much: if Ukraine had only surrendered to Russian occupation, his thugs would not need to shoot down passenger jets. It’s high time the “understanders” understood that Terrorussia won’t stop until someone bothers to stop it.

    Comment by Ivan — July 19, 2014 @ 4:49 am

  3. “the wanton destruction of MH17 raises the possibility that more intense sanctions will be forthcoming.”

    Another possibility, not easily dismissed:

    The Ukrainian integrated air defense system, while equipped with capable systems, has recently had difficulty distinguishing civilian airliners:

    http://www.telegraph.co.uk/news/worldnews/europe/ukraine/1359353/Ukraine-admits-it-shot-down-Russian-airliner.html

    http://en.wikipedia.org/wiki/Siberia_Airlines_Flight_1812

    Comment by wanderer — July 19, 2014 @ 5:15 am

  4. Say toughest sanctions are imposed, Russia at least in the initail period ignores them as it has healthy financial cushion and goes on almost allout conflict with Ukraine. What other means west would have after that ?
    For sanctions to achieve crippling effect it would take 10 ot more years, Iran is a good example.
    So its not so easy with sanctions, dont blame Obama, he is doing right :)

    Comment by erik — July 19, 2014 @ 11:47 am

  5. An unexpectedly sensible op-ed from WaPo:

    http://www.washingtonpost.com/opinions/downed-airliner-shows-the-us-needs-to-get-firmer-with-mr-putin/2014/07/18/e442738a-0e9b-11e4-8c9a-923ecc0c7d23_story.html

    @erik re 10 or more years – you must be kidding. Russia is already in recession, it is already dipping into pension money to finance the war and annexation. Russia is a cleptocracy rather than a teocracy, so Iran is not a good example. The average brainwashed Russians can follow their NoKo brethren’s path indefinitely, that’s true, but the man-eater rats from Putin’s closer circles will be jumping off the ship and/or jumping at each other’s throat in no time.

    Comment by Ivan — July 19, 2014 @ 12:08 pm

  6. Ivan, even if Russia is in recession, in which its not actually yet doesnt mean country is in collape, people mostly live poorly, compared to europe of course, so not much to lose. In this limbo state it can wobble for rather long.
    I can give another example, USSR was actually sanctioned, embargoed etc but lasted for so long.
    Putin more cares about brainwashed russians then his inner circle as his high rating saves him from trouble at home.

    Comment by erik — July 19, 2014 @ 12:32 pm

  7. @erik…10 minutes is more like it. When Igor Minioligarchy finds out his dollar balance at his bank is frozen, he and his many comrades spend no time setting fire to vlad. There are no intermediaries, no institutions of intermediation. For anecdotal paralells, just watch Russian dashcam video on youtube. Russians don’t lodge protests nor seek judicial relief. They run you down then back up over you. You haven’t lived until your Moscow driver drives over an island and goes the wrong way on a icy one-way street at high speed. Such is the rule of law in Russian culture.
    Muscovites denied their dollar balances would make instant viral videos. Russian has two words for ‘retire’:. One is to retire upright, another is to retire horizontally., implying unwillingly. Vlad would be retired quickly.

    Comment by Richard Whitney — July 19, 2014 @ 1:00 pm

  8. Richard Whitney, i live in Moscow so know crazy traits that you refer to. I’m antiPutin avid protester, and in my opinion he has passed that stage when he would have cared had his cronies got assets freezed. That would have been so like 5 to 10 years ago but now he is on nationlistic agenda and sticking to power as long as possible. Problems of his billionare friends willn’t derail him.

    Comment by erik — July 19, 2014 @ 1:24 pm

  9. Erik, the Soviet Union survived because it was a country outside of the world markets. Neither its elites nor its proles really enjoyed the modern benefits of Western civilization but in the last 10 years or so they have. Cut of Russians from their dollars, expel them from London and the same situation that led to the overthrow the Gorbachev — the dissatisfaction of mid-level officers who saw their own future wealth disappearing in the maws of the gerentocracy will overcome the new generation of FSB scum who are counting down the days until they are finally bosses and really cash in.

    Comment by d — July 19, 2014 @ 11:37 pm

  10. Precisely. Not to oversimplify complex processes, but the crucial accelerator of soviet collapse was the dissatisfaction of the nomenklatura who gradually realized they were nowhere near Western living standards despite the vast number of slaves they were able to exploit. These days they will realize it much faster, just let them see a Cartier clerk cutting their “platinum” card in half.

    Comment by Ivan — July 20, 2014 @ 1:34 am

  11. Plus the ordinary Russians can be squeezed far harder than previously. The post-Soviet generation has gotten used to easy foreign travel (let’s see if Malaysia still gives Russians visa-free entry after this), overseas work opportunities, imported cars and other goods, and easy (albeit expensive) credit.

    Comment by Tim Newman — July 20, 2014 @ 1:43 am

  12. I think the point of harsh sanctions (applying to Russia provisions of “Trading with the Enemy” act?) is not to make people there poorer – that would only be an unfortunate side effect. The point is to make the Russian state much poorer, so it simply has no means to maintain modern military, powerful intelligence and propaganda machine and cause trouble, pretty much like it was in the nineties.

    Given the dynamics of Russian internal politics, we may have to keep Russia in that sorry state for long, long time.

    Comment by LL — July 20, 2014 @ 5:12 am

  13. Syrian rebels are good. Donetsk rebels are bad.
    Turkish Kurds are terrorists. Iraqi Kurds are (were?) freedom fighters.
    Kosovo separatism good. Ossetian separatism bad.
    etc..

    Comment by So? — July 20, 2014 @ 6:26 am

  14. LL, i doubt that its possible by sanctons, Putin is pragmatic and wouldnt overburden budget by military expenses, and why should he with such huge nuclear arsenal. Should understand that Putin’s politics is purely defensive , even in Ukraine he is on defensive however strange that may sound. Intellegence+propoganda dont make much of expenses.
    One of the most powerfull tools that is left out is propoganda by west, just like in old cold war times. If RT can broadcast in english in USA , Europe why cant for example CNN, BBC do the same ? Plus the radio similar to Voice of America.
    Russia needs dearly independent and free media, in this case foreign as Putin effectively stifled all local free media

    Comment by erik — July 20, 2014 @ 6:30 am

  15. Precisely. Not to oversimplify complex processes, but the crucial accelerator of soviet collapse was the dissatisfaction of the nomenklatura who gradually realized they were nowhere near Western living standards despite the vast number of slaves they were able to exploit. These days they will realize it much faster, just let them see a Cartier clerk cutting their “platinum” card in half.

    And this is precisely why the Resource Federation has not had an independent foreign policy since 1991. Putler is just another comprador. If you don’t like something, complain to his handlers.

    Comment by So? — July 20, 2014 @ 6:33 am

  16. Extrapolating So?’s other publicly expressed opinions, the real problem is that Putin and his mercenaries are too soft-hearted. They could easily have shot down many more passenger jets, but they only did a flimsy single one. That’s why the West always gets the better of Russia: Russians are too merciful.

    Comment by Ivan — July 20, 2014 @ 6:38 am

  17. >> even in Ukraine he is on defensive however strange that may sound

    It does not sound strange, it sounds like someone with this idea of “defensive” must be kept in a much smaller cage than he currently is.

    Comment by Ivan — July 20, 2014 @ 6:41 am

  18. Russians are too merciful.

    Correct. Had the Soviet Union not been such a pacifist pussy post-WW2 ala France post-WW1, it would have still been around. But that’s what happens to all countries that win the last war at tremendous cost. They meekly surrender the next time.

    Comment by So? — July 20, 2014 @ 6:46 am

  19. >> Had the Soviet Union not been such a pacifist pussy post-WW2 ala France post-WW1, it would have still been around.

    And So? would sit in some comfy KGB office on Lubyanka and decide who to shoot and to send to Siberia, rather than having to work for a living in the hated West. What a geopolitical tragedy.

    Comment by Ivan — July 20, 2014 @ 6:57 am

  20. And So? would sit in some comfy KGB office on Lubyanka and decide who to shoot and to send to Siberia, rather than having to work for a living in the hated West. What a geopolitical tragedy.

    “Putin!”, “KGB!”. Pavlov’s dogs were smarter than that.

    Comment by So? — July 20, 2014 @ 7:14 am

  21. >> “Putin!”, “KGB!”. Pavlov’s dogs were smarter than that.

    Probably. Better as persons for certain. Unfortunately, Pavlov’s dogs are not ruling Russia, Putin and the KGB are.

    Comment by Ivan — July 20, 2014 @ 7:33 am

  22. Actually, it was Vneshekonombank (VEB) that was sanctioned, not Vneshtorgbank (VTB).

    Comment by TJK — July 23, 2014 @ 7:39 am

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