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Possible Credit Consequences Of Escalating Russia-West Tensions Over Ukraine And Further Sanctions Against Russia

This report does not constitute a rating action.

Here, S&P Global Ratings presents its views about the potential credit impact of a further escalation of geopolitical tensions involving the West, Russia, and Ukraine and a potential increase in sanctions against Russia. We examine the potential effect of such sanctions on the credit quality of the Russian and Ukrainian sovereigns, their banks, and corporate issuers. The evolving nature of the situation makes precise forecasts difficult. Therefore, as the situation changes, we could revise the macroeconomic and credit assumptions we use in rating Russia and Ukraine sovereigns, and issuers operating in these two economies.

Tensions between Russia and members of the North Atlantic Treaty Organization (NATO) over Ukraine have been increasing since late 2021.   Russia (BBB-/Stable/A-3) has warned it is prepared to use military-technical means to defend what it believes are its national security interests. The U.S. and the EU have threatened to apply an array of potentially debilitating sanctions. We understand that these, among other steps, could impinge upon Russia's access to the global economy by preventing Russian state banks from engaging in dollar clearing as well as excluding them from the Society for Worldwide Interbank Financial Telecommunications (SWIFT) messaging service, a decision the U.S. could influence, as it did in the case of Iran, and which would curtail (though not eliminate) Russian banks' ability to monitor and conduct financial transfers. Another potentially strong sanction might be a U.S. and potentially European ban on investors' secondary holdings of Russian government domestic debt. Even if the extreme scenarios are avoided, the persistent risk of the imposition of tough sanctions would likely constrain Russia's long-term growth prospects and potentially render the Russian economy less investible in the medium to long term, further weakening its integration into the global economy. Even with less drastic sanctions, whose consequences may be manageable in the short run, Russia's creditworthiness could come under pressure due to the potential depletion of its fiscal and foreign exchange buffers, should sanctions last for a protracted period of time.

Whether or not a conflict escalates over the next several weeks, it seems likely that disagreements between Russia and NATO about security concerns will persist.   With certain exceptions, relations between the U.S. and Russia have been on a downward path for almost the last two decades. Moreover, the U.S. Senate's determination in 2020 that Russia intervened in the 2016 presidential elections has redoubled support in both parties for a strong response to any perceived interference in the U.S. electoral process. In short, even a welcome de-escalation of the situation on Ukraine's border may prove to be only a temporary pause in worsening relations.

Geopolitical tensions between the U.S and EU and Russia have been part of our baseline macroeconomic and sovereign rating scenarios for Russia for over half a decade.  Since 2014, the conflict over Ukraine and the broader disagreements between Russia and the West have resulted in several rounds of sanctions against the Russian economy and its financial system. Russia is a net lender to the rest of the world. It has run uninterrupted current account surpluses since the late 1990s. Beginning in 2014, the Russian authorities adopted even more conservative macroeconomic policies to protect the economy and public finances from oil price swings, including the introduction of a fiscal rule as well as flexible exchange rate and inflation-targeting regimes. Coupled with strong buffers and public finances that are anchored into the government's oil price assumption of just slightly over $40 per barrel, these factors underpin Russia's improved resilience to shocks. Indeed, Russia's net external asset position of some 40% of GDP and the government's net debt position of around 5% of GDP are among the strongest among all the 137 sovereigns we rate. These strengths helped support our sovereign ratings on Russia even in the face of the multiple and sometimes synchronized distress episodes. These included large bank failures in 2017, collapsing oil prices in 2020, and international sanctions on private-sector entities as well as on Russia's sovereign primary debt issuance (see "Russia ‘BBB-/A-3’ Foreign Currency And ‘BBB/A-2’ Local Currency Ratings Affirmed; Outlook Stable," July 16, 2021).

But this time, tensions appear more acute, the sanctions currently under consideration in the U.S. and EU far tougher, and their macroeconomic consequences potentially more severe.   The present tensions now appear to carry a more global dimension, including the risk of an interruption in gas exports to Europe, the world's third-largest economic area, as well as broadening geopolitical sticking points between two of the world's nuclear powers. The rhetoric of all parties has escalated, with the U.S. and EU governments apparently preparing to roll out a more coordinated response regarding sanctions in case of a significant escalation of the conflict. The sanctions menu now includes potentially restricting foreign participation in secondary-market trade in the debt of the Russian sovereign, constraints on Russia's energy and mining sector as well as sanctions on large Russian financial institutions, which could disable their access to the global financial system (see infographic).

Chart 1

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Sanctions on sovereign debt

Potential restrictions on the nonresident holdings of Russia's sovereign debt in the secondary market could push up the government's implicit financing costs but their impact on fiscal and macroeconomic stability will initially likely be moderate.   We believe that the moderate impact is primarily because government debt is low, while government's financing plans in the next three years are modest at an estimated 1.6% of GDP (in net terms) annually. The government expects to run a headline fiscal surplus in 2022 and maintains an ample liquidity buffer, including, but not limited to, liquid assets in the National Wealth Fund of 7.3% of GDP. Nonresidents have already been leaving Russia's government securities market, while domestic residents hold over 80% of government bonds (see chart 1). We also understand that sanctions would most likely be applied to the holdings of newly issued and traded debt (that is, debt issued after the imposition of sanctions), which could limit the increase in Russia's financing costs should they be imposed. Secondly, after some capital outflows in recent months, the current stock of ruble-denominated debt held by nonresidents stands at around RUB3 trillion (about $39 billion or 2% of GDP), which represents less than one-tenth of the Russian central bank's gross reserves (some $640 billion at end-January 2022). Still, there is a risk of larger forced selling, for example, should sanctions on all secondary market holdings cause U.S. financial entities to lower Russia's weighing in global bond indexes. Also, if sanctions persist for long, fiscal and government financing pressures could build, possibly requiring revisions to the government's currently stringent fiscal framework.

Chart 1

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Sanctions on financial institutions

The negative effects of potentially stronger sanctions on the Russian banking system will also likely be broadly manageable.   In our view, Russia's banking system is more resilient than in the past and has largely adapted to operating under sanctions, since most large state-owned banks have been under sectorial sanctions since 2014. Accumulated capital and liquidity buffers, a solid and stable domestic funding base, as well as the tested commitment and ability of the Central Bank of Russia (CBR) to provide liquidity support to the sector to preserve financial stability are the factors that allowed Russia's banks to withstand macroeconomic and sanctions-related shocks in the last few years. What's more, domestic confidence neither tarnished at the peak of COVID-19-related uncertainly in March 2020 nor following the period of elevated geopolitical risks over the past few months, with depositors showing little willingness to convert domestic deposit into foreign currency or withdraw them from the banking system. In our view, the CBR has a wide array of tools and adequate capacity to provide emergency support to banks that might be affected by sanctions and to contain broader financial stability risks to the system ("Banking Industry Country Risk Assessment: Russia," published Nov. 17, 2021). Given accumulated capital cushions in the system, this also suggests that Russia's possible fiscal costs of supporting effected banks could be contained. We also note that Russian authorities have developed their own domestic payments and messaging systems, which could conceivably facilitate domestic payments should banks be cut off from international financial infrastructure such as SWIFT. At the same time, the longer-term impact of protracted and severe sanctions is more difficult to estimate, if buffers dry up and more public resources are needed to support affected banks.

The overall impact of possible sanctions on selected Russian banks, corporate sector and/or sovereign debt on the banking systems in Western Europe should be limited.  The earnings of international banking groups operating in Russia through their subsidiaries or those that provide banking services to large Russian corporate businesses may experience negative impacts from weaker performance of their subsidiaries in Russia or a reduction in business volumes from transactions with Russian clients. These impacts may include a deterioration in currently fairly good asset quality indicators and negative impact on capital in case of severe depreciation of the Russian ruble. However, we believe that the total exposure to Russia and Russian businesses is limited and therefore should be manageable for European banks.

However, sanctions on Russia's large financial institutions could have a detrimental effect through cross-border payment and foreign trade channels.  Restricting the access of the major Russian banks to the U.S. and eurozone financial systems could disrupt Russia's foreign trade and undermine its ability to settle cross-border payments--including on debt service. Even though exporters would eventually find a workaround, for example, settling trade in currencies other the U.S. dollar or euro, at the initial stages the fallout on Russia's export receipts, budget revenues, and the broader economy could be meaningful.

Impact on the energy and commodity markets

The scenario of large-scale disruptions to Russia's exports will almost certainly impact the global energy markets and energy supply to Europe.   Given Russia's position as the second-largest oil-producing country in the world, Iran-type sanctions on Russia's oil exports would likely cause a global energy crisis with prices going well above $100 per barrel and disruption to global supply chains. (Note that our current baseline oil price assumption for 2022 is $75 per barrel). In addition, given the crucial role of Russia as a supplier of natural gas to the EU (see charts 2 and 3), a complete shutdown of gas supply could well result in a systemic energy crisis in Europe with significant spillover to global markets. A systemic energy crisis in Europe is not part of our base case rating scenario.

Chart 2

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Chart 3

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A reduction in Russia's gas supplies to Europe will be difficult to replace.   With record-low gas stocks (only 39% full by Jan. 31, 2022, well below historical averages), a decade of declining domestic gas production, and still sticky gas demand, Europe is increasingly dependent on gas imports. Indeed, some 90% of Europe's natural gas needs comes from imports, with up to 40% coming from Russia. The mandatory phaseout of coal and nuclear power plant closures in Germany have left little alternatives to gas in Europe at least for the next several years. While the recent increase in liquefied natural gas (LNG) flows to Europe, combined with mild weather in both Europe and Asia, may help to offset the ongoing reduction in Russian gas exports for the coming weeks, the overall gap in gas supplies is too large to plug without affecting the global gas markets or triggering indirect consequences for other sectors (for example, via margin calls on hedges). On the other hand, Russia benefits from its profitable gas exports and cannot easily redirect gas flows from its major fields to other markets, leaving little economic incentive for an export ban. S&P Global Ratings' base case is that gas supplies continue under most scenarios.

Similarly, very harsh sanctions on selected Russian commodity exporters could have an equally destabilizing global effect, which makes their likelihood low.   The year 2018 showcased the extent of possible global spillovers from such restrictions, when the U.S Treasury imposed sanctions on Russia's UC Rusal – one of the world's largest aluminum exporters -- resulting in an immediate price rally in the global aluminum market and a shock to several large sectors, including global car manufacturing. For this reason, we believe that disruptions of Russian commodity exports will be against the interests of both commodity importers and Russia.

Sanctions implication for the Russian corporate sector

Extreme scenarios aside, the credit quality implications for Russian companies will largely depend upon potential sanctions against them, their shareholders, the country's largest banks, or the sovereign.   As shown by the previous round of sanctions, large Russian companies managed to address their routine refinancing needs by refocusing on domestic financial markets, so it is unlikely that most large or midsize Russian companies would face immediate liquidity issues if their access to the international financial markets is hampered. A global turmoil will likely boost commodity prices and put pressure on the Russian ruble exchange rate on the back of capital outflows – both positive for the credit quality of Russia's exporters. We believe that the Russian corporate sector used its experience from 2008-2009 and 2014, significantly reduced their exposure to international capital markets, and to foreign exchange risk, and would be less impacted by most types of liquidity constraints. Because S&P Global Ratings cannot predict which companies could be subject to sanctions of any kind, our ratings on Russian companies are currently not affected by this hypothetical risk.

Sanctions unrelated to entities, such as technology transfer restrictions, will unlikely meaningfully impact the operations of the Russian companies, in our view.   Since 2014, Russian companies have focused on reducing dependency on technology imports and developing domestic technological capabilities. As a consequence, we don't expect any immediate operational disruptions from restrictions on technology transfers. Still, a significant deterioration in business conditions would impact corporates (many of which are government-related entities), even though it is not our base case. Many international companies have significant exposure to Russia. BP, Total, and Fortum/Uniper have large equity stakes in large Russian energy companies. For many global companies in the fast-moving consumer goods sectors (such as Coca Cola, Unilever, and McDonalds), Russia accounts for a visible share of their sales. Many European companies, such as Anadolu Efes, Renault or Carlsberg have meaningful cash flow exposure to Russia. At this stage, we see no signs of a potential business impact on these companies in Russia from a degradation in business conditions.

Constraints on Russia's long-term economic growth

Even if the existing tensions subside, we believe the risk of new escalations remains elevated. One implication of this could be lower long-term growth for Russia.   While a scenario of de-escalation would ease risks of a global energy price shock, the respective gaps between the national security positions of the U.S./EU versus Russia will likely to remain wide. Even if harsh sanctions are avoided this time around, the likelihood that they are considered after another potential dispute in the future is substantial. Uncertainty about the timing and nature of future sanctions will likely deter investments in Russian public and private assets, undermining the government's export diversification and pro-growth measures. If anything, despite a strong economic recovery in 2021, Russia's modest real GDP per capita growth rates are one of the key constraints on our sovereign ratings at present.

The Impact on Ukraine's sovereign quality

Ukraine's macroeconomic policy framework is stronger than before, but the significant escalation of the current geopolitical conflict could present a major shock.   Our current 'B' sovereign rating on Ukraine, which carries a stable outlook, factors in the country's low income levels and developing institutions as well as stronger macroeconomic management, augmented foreign exchange reserves, and access to concessional fundings. Improved policy flexibility and likely financial support from international financial institutions should help Ukraine to avoid disorderly macroeconomic adjustment in the event of a moderate escalation. However, a more extreme scenario involving a growth shock, disruptions to infrastructure and exports, fiscal pressures, and financial instability could put pressure on the sovereign.

The impact on Ukraine's corporate and financial sectors

Our corporate and infrastructure ratings in Ukraine, which are relatively low, depend more on each company's unique situation and liquidity.  In a hypothetical scenario of significant escalation, we don't rule out particular effects on Ukrainian exporters of metallurgical and agricultural products, which use Ukrainian ports and railways located close to the area of most instability. For companies operating further away from eastern Ukraine, we don't expect any such operational impact but will focus on whether the companies adjust their financial policies and capital expenditure plans. Looking to the geographical footprint of the key agricultural companies we rate, the credit profile of those with assets in the eastern part of the country could weaken under extreme scenarios. In addition, as we learned from the previous military conflict in eastern Ukraine, companies with a nationwide infrastructure, such as Ukraine Railways, generally continued operating, although with temporary disruptions. In the hypothetical extreme scenario, we would expect increased pressure on the country's financial sector and significant risks to financial stability (for more detail on Ukraine's banking system see "Banking Industry Country Risk Assessment: Ukraine," published on Nov. 22, 2021).

For media queries, please contact Michelle James (michelle.james@spglobal.com) or Ekaterina Povlova (ekaterina.pavlova@spglobal.com).

This report does not constitute a rating action.

Additional Contacts:Financial Institutions EMEA;
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Insurance Ratings EMEA;
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