The administration of US President Joe Biden on April 15 released details of long-expected new sanctions against Russia, including a ban on US investors buying newly issued Russian ruble bonds that will infuriate the Kremlin.

The sanctions were imposed via an executive order in response to alleged election interference, cyberattacks and the recent aggressive build-up of Russian military forces on the Ukrainian border that have sparked invasion fears.

Without exception, all economists and investment bank analysts interviewed by Russsian newswire The Bell called the sanctions imposed by the White House against the national debt "painless" and "cosmetic" and say the market's optimistic reaction as natural.

The announcement of new sanctions comes only days after the presidents' second phone conversation this year, where Biden offered to meet Russia's President Vladimir Putin for talks in “a third country” in the near future to tackle the many points of contention between the two rivals. 

"Levying draconian sanctions on Russian bonds, arguably, would be inconsistent with Biden’s offer for a bilateral summit to ‘normalise’ relations," BCS Global Markets wrote in a note to clients on Thursday morning. "Yet tension between the West and Russia over Ukraine lingers, with uncertainty weighing on the risk trade.”  

There has been much debate on whether the White House will target Russian Ministry of Finance ruble-denominated OFZ treasury bills, as they are widely held by US investors and pension funds.

Russian Foreign Minister Sergei Lavrov warned in February that the Kremlin would not tolerate any more sanctions that cause “economic damage” to Russia in a speech where he laid out new rules of the game. Lavrov followed up a week later by threatening to break off diplomatic relations with the West if punitive sanctions were imposed. By targeting Russian debt the Kremlin may well say that line has now been crossed.

The measures expand the existing restrictions on US banks trading in Russian public debt, i.e. they prohibit US financial institutions from buying new bonds directly from the Ministry of Finance, the Central Bank of Russia (CBR) and the National Welfare Fund for securities issued after June 14.

Not the nuclear option  

The new sanctions fall short of the so-called nuclear option of banning US investors from owning Russian debt outright, which would create chaos on the capital markets. Making holding the debt illegal also makes it impossible to sell it. As happened following a similar short-lived ban on owning securities belonging to the Rusal aluminium company of oligarch Oleg Deripaska, investors would find themselves with bonds on their books they were unable to sell as their value effectively falls to zero at the stoke of a pen.

However, the Kremlin may accept the new restrictions, as in practice they are not very restrictive at all. US investors are still allowed to buy and own OFZ bought on the secondary market.

Tim Ash, senior sovereign strategist at BlueBay Asset Management, argued in an opinion piece that banning US investors from the OFZ primary market was a “no-brainer”  

“Remember here that the US Treasury has already sanctioned primary USD debt – so US institutions cannot participate in new longer-term borrowings by the Russian sovereign. But secondary trading in dollar debt has not yet been sanctioned; neither was primary or secondary ruble debt,” Ash said. “So that means there are still three gears to go through here: first sanctioning primary ruble debt, then sanctioning secondary dollar and then ruble debt. So even if the Treasury did the logical step of sanctioning ruble primary issuance, it can still further escalate down the line by sanctioning secondary dollar and then ruble transactions. I admit the latter two would be more nuclear or extreme options as they would lock in investors, as has been the case with some Venezuela actions.”  

The new measures resemble those imposed in 2019 during the second round of the Chemical and Biological Weapons Control and Warfare Elimination Act of 1991 (CBW) sanctions following the alleged poisoning of Sergei Skripal. Sova Capital noted that in that case the restrictions included only three measures: restrictions on multilateral development bank assistance, a prohibition on US banks from participating in the Russian Eurobond primary market and export restrictions on dual-use chemical and biological items.

US investors are not allowed to buy Russia’s Eurobonds on the primary market but can buy in secondary trading. These restrictions have had no notable effect on the bonds' liquidity or prices, as the bond markets are deep and liquid. The OFZ market is even bigger and even more liquid so the new restrictions should make little difference.

However, even without tough sanctions, the share of foreigners in the Russian OFZ market is not so large and is decreasing. According to the Central Bank, now their share is 19.7% of the total volume in circulation (at the beginning of 2020 it was 35%). In the primary placements in March, it is even less - 9.6%, although in absolute terms the volume of their purchases has slightly increased recently, according to the Central Bank's review.

For the Russian budget, which is partially covered by OFZ auctions, economists do not see any big problems either. In 2021, the Ministry of Finance planned to sell OFZs worth RUB2.9 trillion, of which RUB740bn rubles had already been placed.

The plan for 2021 has already been a quarter fulfilled and if the share of foreigners in new issues is only 10% going forward, the Ministry of Finance would only lose RUB200-220bn, according to the the Center for Comprehensive European and International Studies, a small amount that can easily be covered by Russian state-owned banks.

Reaction  

Given Lavrov’s belligerent speech in February the Kremlin may choose to reject even a largely symbolic set of sanctions on principle.

The announcement comes after several months of slowly escalating tensions between the two rivals. As followed by bne IntelliNews, geopolitical tensions and sanction risks have spiked under Biden, prompting a sell-off of Russian OFZ debt in March. In April renewed military tensions in Ukraine have put pressure on the ruble.

"We expect strong sell-offs on the market today and the ruble rate to weaken sharply, at least until the information about the sanctions becomes clearer," John Walsh, equity strategist at Alfa-Bank, wrote in a note to clients, as cited by the Financial Times.

Biden's administration has also expelled 10 diplomats from the US and sanctioned 32 entities and individuals allegedly linked to interference in last year’s elections in the US.

The Kremlin has been hesitant about accepting Biden’s offer of a meeting and said that it depended on how Washington behaves in the coming weeks. Biden is in a position where he needs to be seen to be tough on the Kremlin for domestic political reasons, but at the same time he does not want to provoke the Kremlin into escalating the confrontation. Investors will be watching closely to see the Kremlin’s reaction to these new sanctions.

In the initial reaction the ruble fell 2.2% to RUB77.5 to the dollar, before recovering to RUB76.9 by midday. The currency has been on a roller-coaster ride in recent weeks and rallied to RUB75 to the dollar after Biden proposed a summit. By the close of trading on April 15 the ruble had recovered to RUB76.24, up 0.3% on the day, suggesting FX traders believe Washington’s choice of sanctions is mild enough not to provoke a harsh response from the Kremlin.

The Kremlin said it would wait for official confirmation of the measures before commenting on their impact, adding that Russia would respond in kind.

“We condemn any desire for sanctions. We consider them illegal. In any case, the principle of reciprocity in this matter applies,” Dmitry Peskov, Putin’s spokesman, told reporters, as cited by the Financial Times, adding that fresh sanctions could scupper efforts to arrange the planned summit between the two leaders.

Capital Economics reported that there was a sell-off of the ruble and Russian bonds, but the consultancy said that the selling would be limited “unless sanctions are extended to all sovereign debt or Russia retaliates aggressively. Even so, we think this argues in favour of a larger 50bp rate hike, to 5.00%, at next week’s CBR meeting.”

CBR governor Elvira Nabiullina already took the markets by surprise in March with a prophylactic 25bp hike, partly in anticipation of new sanctions, suggesting the Kremlin was expecting exactly today’ actions.  

“The decision marks a major deterioration in US-Russia relations, but it is worth emphasising that the US has refrained from imposing sanctions on all debt (i.e., the primary and secondary market), often talked about as the “nuclear option”. So long as sovereign debt is subject to the same restrictions as debt of most sanctioned banks and firms, transactions in debt issued before the new sanctions shouldn’t be affected,” said Capital Economics economist Liam Peach.