July 31, 2014

Economic and political pressure on Russia continued to mount in the last month and the increased scope of international sanctions is adding to the long list of challenges that the Russian economy is facing. On 29 and 30 July, the European Union and the United States stepped up sanctions on Russian banks and introduced new measure that affect other important sectors of the Russian economy.



Since the beginning of the Ukrainian crisis, the EU has been reluctant to impose stronger sanctions on Russia, fearing that sanctions targeting the oil and gas sectors would also affect the European economy. However, following the downing of a Malaysia Airlines commercial flight on 17 July by pro-Russian separatists in which 298 people died, pressure on European politicians mounted to exert more influence on Russia to withdraw its support for separatists in eastern Ukraine.



The European Union’s new measures include an arms embargo, restrictions on offshore energy exploration and curbs on Russian banks trading in European markets. By impeding access to Western capital markets, the sanctions will drive up the banks' funding costs, hurting their ability to lend and thus further cut into investment. However, some loopholes are likely to limit the impact of the sanctions on the financial sector: Many Russian banks still have access to financial markets through their EU-based subsidiaries.



Anna Bogdyukevich, economist at UniCredit Research commented on 31 July:



“The situation is far from critical yet, but the eventual outcome will depend on the pace and severity of the sanctions imposed by the West, as well as on the degree of support extended by local authorities. Some banks may seek funding in the East (…) but, in general, the need to replace USD and EUR liabilities is not going to be an easy task, in our opinion.”



As sanctions have not yet extended to Russia’s energy sector, the direct impact has been limited. That said, the Russian economy has been affected by the sanctions through deterioration in investor confidence—both foreign and domestic. In the first quarter, investment experienced the sharpest contraction since the end of 2009 and, while capital outflows moderated in Q2 compared to the massive flight seen in Q1, they continue posting worrying levels.



The Central Bank raised interest rates on 25 July, a move that many analysts have interpreted as an attempt to prepare the economy for further sanctions, to retain capital within the country, and to support the ruble. However, the rate hike will inevitably increase the cost of financing across the Russian economy, thereby deepening the current slowdown. Moreover, most political observers assume that the West will impose even harsher sanctions if Russian officials do not stop military support to rebels in the Donbas region. The ongoing geopolitical uncertainty and the threat of additional sanctions pose the greatest threat to the Russian economy. Many investment projects are being scaled down or held back until peaceful progress is made between Ukraine and Russia.



Since the beginning of the conflict in Ukraine, the economic growth outlook has deteriorated constantly. At the start of the year, panelists expected the Russian economy to expand 2.3% in 2014 and saw it accelerating moderately to a 2.6% expansion in 2015. According to the latest FocusEconomics Consensus Forecast poll, the Russian economy is now projected to grow a paltry 0.4% this year, and to accelerate to a 1.6% rise in 2015. Among the components of GDP, private investment has experienced the sharpest downward revision. While in January panelists saw private fixed investment expanding 2.7% this year, the panel now projects a 3.3% contraction, which would represent the largest drop since the 2009 crisis.