Russian sanctions: an historic turning point for investors and the dollar?

By Stéphane Monier Chief Investment Officer Lombard Odier Private Bank

Spooked by the Trump administration’s sanctions on Russian individuals and companies, investors are struggling to value Russian assets. While the most immediate turmoil has been as predictable as the Russian government’s reaction is unforeseeable, we believe that it’s more important to step back and look at the historic implications.

On 6 April, the US Treasury added seven Russian oligarchs, 12 companies that they own or control, and 17 government officials to its Specially Designated National List, effectively banning US companies and individuals from doing business with them. After initially underreacting to the US government’s sanctions announcement, the rouble fell nearly 12% between 9 and 10 April. Wary investors, unsure which targets may be next and keen to avoid penalties for violating sanctions, sold off Russian assets. The cost of insuring Russian debt, measured by five-year credit default swaps, widened to 162 basis points, their broadest level since July last year.

With all Russian companies potentially at risk, the impact is substantial. And the greater unintended consequence, however, may be that the sanctions change the nature of risk by undermining the market’s infrastructure.

Let’s be clear, the US measures are not only the most aggressive retaliation since economic sanctions after Russia’s Crimean annexation in 2014, they are also the first time that companies’ outstanding debt has been targeted. Bond clearing and trade facilitation are now directly affected, creating new material risks for bondholders who can neither trade nor settle. Among those hit were United Co. Rusal, the world’s second-biggest aluminium producer, which could end up in technical default on its credit obligations, after warning that it may be unable to physically transfer coupon payments on its dollar-denominated bonds.

The sanctions show an unprecedented lack of regard for investor interests. While the Treasury probably expected and encouraged a sell-off, it probably also expected that the market infrastructure and its mechanisms would continue to function. In the event, faced with the impossibility of pricing risk and the danger of opening themselves to eventual US sanctions, investors were temporarily paralysed. 

Meanwhile the US Treasury continues, in line with its advice in January, to caution against banning the purchase of Russian sovereign debt for fear that it may destabilise markets globally.
 

Ripping up the social contract

This market paralysis in the face of illiquid assets points to an even more fundamental fall-out. The sanctions have torn up the social contract underpinning the relationship between investors and the market. While everyone knows that investments may go down as well as up, no one imagined you could get stuck with an otherwise-healthy asset till-death-do-you-part. There was always supposed to be someone further along the road to take it off your hands. No longer. The world of investing is waking up to the idea that the few clearing houses handling debt denominated in the US currency can stop managing payments, and with that, shut down the market for a security.

Of course there have always been assets that no one wants. We need only think back to the financial crisis ten years ago. Yet this is the first time that we have seen illiquidity without any fundamental change in the underlying asset. Russian companies are still creditworthy. They still have the ability to pay their debts, they may just lack the mechanisms to be able to do so.
 

The challenge to dollar dominance

Beyond the short-term turmoil, the knock-on effects of this in the longer run may be significant for the dollar. Appetite for the US currency may be compromised as investors understand that dollar-denominated assets come with strings attached. And that those strings have now been pulled.

There are some early, tentative signs of a shift away from the dollar with China’s launch in March of the first yuan-denominated oil futures on the Shanghai International Energy Exchange. The latest US sanctions will only accelerate this trend as investors reevaluate their dependence on the dollar and companies look to issue debt in an alternative currency. This can only help the development of emerging markets, especially the offshore yuan market.
 

Conclusion

Five years from now, the short-term disruptions of the US sanctions may be forgotten. What will almost certainly remain lodged in investors’ memories is the feeling of holding a bond, and then being lumbered with it.

The immediate challenge for investors is to price a binary political risk, which will either evaporate or escalate. While that persists, market infrastructure risk and the liquidity risks threaten the efficient functioning of the market and are the most important elements to watch.

In the shorter run, a liquidity premium should apply to the affected companies that goes beyond the immediate action on particular companies and individuals. Yet since there is no change to the credit fundamentals nor the underlying business, and while the market remains in price discovery mode, the best strategy is to wait for signs of stabilisation before adjusting risk allocation in portfolios.