The EU and US governments have opted for a targeted strategy when trying to force Russia out of the Ukraine conflict. Unlike Russia, they have not chosen wide restrictions on imports and exports. The initial sanctions attempted to restrict travel of senior Russian corporate leaders close to Putin. Recently, they have focused on restricting selected Russian companies from using European and American capital markets.
Restricting access to capital markets for some firms is not a one-dimensional operation. Capital markets consist of a wide variety of financial institutions and entities. Sanctions imposed by the governments of the respective countries have to be executed by those financial institutions. In practice, this means that financial institutions are prohibited from providing investment or brokering services to the selected Russian companies. One could easily see a problem in this strategy. By attempting to hurt the Russian economy, the Western governments are also hurting their own financial markets.
Serious trouble for Russia in the short run
Russian companies, like companies from all over the world, need funding to operate. Although these funds can be acquired from various sources, large companies usually resort to international capital markets. The vast amounts of capital required for their operations can only be acquired against reasonable conditions on this platform. The current sanctions imposed on Russia thus present these companies with a huge problem.
Under the sanctions, the selected companies are unable to acquire any new finance from EU or US capital markets. Finance includes both equity and debt financing. Of most immediate concern is the restriction of debt financing. New debt does not just include any additional level of debt the company wants to acquire to expand its operations. It also includes new debt to replace old debt that is due. Companies, and countries for that matter, often use debt to pay off debt. In the process, they are able to adjust their interest rates and the maturity of the debt.
Usually, this is a straightforward action that does not cause any problems. Every so often, this is not the case. A prime example in recent history involves the financial crisis in the EU. Interest rates on loans for various southern European countries rose above acceptable levels. Greece used to have interest rates for long-term debt of 4 to 5% prior to the crisis; this increased to close to 30% at the height of the European crisis. This means Greece would have to replace their debt issued at 4% by new debt issued at 30%, a huge increase in interest costs for a country already in trouble. Greece was effectively shut out from capital markets, like the Russian companies, and forced to lend money from the IMF and Western European countries.
The Russian companies face a similar problem. They too have to pay off their debt, and preferably with new debt. There are several alternatives to using new debt. One is the use of cash, which has its limits and reduces the liquidity of the company. Illiquidity in itself is perceived as a market risk, increasing the risk levels for the company, and as a result increasing required returns. Another option would be to replace debt by equity, which is also not an option under the current restrictions. It seems only sensible that Russian companies are looking for alternative markets for funding, being shut out from the Western markets. Those markets will not be easy to come by; one does not easily replace a financial hub like London.
The short-term impact for the Russian economy will no doubt be severe. Even if the companies are able to meet their debt obligations, it will come at the cost of cash balances and new debt at worse conditions. Russian companies currently not affected by the sanctions will be readjusting their debt levels and sources in anticipation of possible new sanctions. This readjustment could mean higher financing cost and lower investments, implying a possible stagnation of the Russian economy.
The West will face the consequences in the long run
In the long run, it seems the sanctions imposed by the Western countries are bound to hurt the same Western countries the most. Already, Russia is looking for alternative ways of funding for their companies. Within Russia, they have the option to use government funds or insurance funds, along with funds from Russian financial institutions. Externally, the Russians will look for countries not participating in the current sanctions battle. Specifically, they will be looking at the Chinese financial markets to fill the gap.
Like the Russian companies, Western financial institutions will lose out in the short run. They are simply not allowed to serve the Russian companies, at the cost of huge fines. At the moment, the debt obligations of these Russian companies are spread across a great number of financial institutions. Of much greater concern is the long run impact of not serving these customers. Russian companies now facing the difficulties and costs of finding alternative ways of funding will not fall into the same trap twice. Looking at the future, they will make sure their funding is more diversified and, importantly, much more focused on partners the can rely on. The current sanctions prove that Western financial markets are not necessarily a reliable means of funding. Rather, they can be used in a political battle. As a result, Russian companies will always consider the risk of losing access to the capital markets in the EU and the US. And they will act accordingly.
Companies are always looking for the cheapest, or – more accurately – most cost-efficient way to fund their activities. The size and depth of capital markets in the US and EU will not suddenly cease to be attractive to companies. Looking at the difficulties Russian companies have in reacting to the sanctions, proves the point that a replacement is not easy to come by. But for Russian companies, the sanctions will have increased the risk in Western financial markets. Risk is a cost. It is a cost for Russian companies, as well as a cost for the Western financial markets. So far, we have considered Russian companies and losing their business. However, there is every reason to be just as worried about the reactions of Chinese companies or companies in the Middle East. They too will look closely at the current situation and assess what the possible consequences could be for them. They too will see that the financial markets are used as a political instrument in the West and start looking for alternatives.
Financial markets in the West have been taken on an insecure road by their governments. Just recovering from a financial crisis, strengthening their balance sheets and decreasing their exposure to risk, the last thing they need now is insecurity. Political leaders in the West have seen it fit to impose sanctions on Russia for the situation in Ukraine. It seems the current sanctions are effective in the short run, but are self-damaging in the long run. Using the financial markets as a political instrument will be a clear message to any country that does not consider itself an immediate ally of the West. The longer these sanctions are in place, the more damage is done to the credibility of financial markets in the West. As a result, the sanctions force the Western countries to reach an agreement with Russia as soon as possible. Although that sounds positive in the spirit of peace, it weakens the negotiation position of the West. The West may think it is hurting Russia, but it is probably more accurate to say they have done Russia a favor.