Why Putin Has 2006 Flash Before His Eyes After Sanctions

With the world watching if U.S. and European sanctions over Ukraine usher in a new Cold War, the showdown first risks sparking a return to capital controls in Russia after they were dismantled eight years ago.

President Vladimir Putin’s government scrapped capital controls in 2006, becoming the only one of the biggest emerging economies to allow unrestricted flows of money across borders. If the Ukrainian conflict worsens, tripwires may be set off in case the ruble weakens 15 percent or the country’s international reserves fall about $100 billion, according to Russian economic institutes that advise the government.

“Rejecting the free flow of capital is more of a political decision than one for the central bank,” said Mikhail Khromov, a senior researcher at Moscow-based Gaidar Institute. “It may be Russia’s answer to Western sanctions.”

The reintroduction of capital controls, the abolition of which was a milestone of Putin’s second presidential term, would mark a step back toward the Soviet economy that was mostly sealed off from international markets. With economic ties gradually being severed again, Russia may put up defenses of its own to halt investor flight and shield reserves, the world’s fifth-biggest.

‘Soft Measures’

The European Union followed the U.S. in putting more pressure on Russia’s financial system in an effort to force the Kremlin to end support for separatists in eastern Ukraine. The bloc said yesterday that it will prohibit Russian state-controlled lenders including OAO Sberbank and OAO VTB Bank from selling shares or bonds in the EU.

“The central bank will try to use market instruments,” Anton Tabakh, a senior economist at the Energy and Finance Institute in Moscow, said by phone. “But if there’s a sharp and systemic ruble depreciation, capital outflow and pressure on reserves, then the central bank may impose soft measures to control capital.”

In 2006, the central bank made the ruble fully convertible by scrapping currency controls and easing restrictions on investors. Before then, the regulator required the use of special accounts and depositing collateral to transfer funds.

Russia’s reserves, which peaked at $598 billion six years ago, have since declined by $126 billion and are near the lowest level since 2010. The ruble, which has weakened 8.1 percent against the dollar this year, is among the 10 worst-performing currencies, according to data compiled by Bloomberg. It lost 0.2 percent to 35.8150 by 4:14 p.m. in Moscow, heading for its weakest level in three months.

‘Serious Depreciation’

“A serious depreciation of the ruble, for example by 15 percent from the current level, may be a reason for the central bank to impose some capital restrictions,” Ilya Prilepskiy, an analyst at the Economic Expert Group in Moscow, said by phone.

Russia’s central bank, led by Chairman Elvira Nabiullina, has so far tried to combat market turmoil with three interest-rate increases, and last week pointed to “geopolitical factors” for tighter monetary conditions since March.

Russia refrained from introducing controls during the 2008-2009 financial crisis and later refrained from the measure to keep out speculative capital. With the stalemate over Ukraine showing little sign of easing, investors are heading for the exit in droves.

At $48.8 billion, Russian capital outflows in the first quarter were the largest since $132.1 billion had left the country in the last three months of 2008 after the collapse of Lehman Brothers Holdings Inc. and a five-day war with Georgia.

‘Headache Now’

Outflows from Russian assets jumped to $74.6 billion in the first half, compared with $61 billion in the whole of last year, central bank data show. The regulator estimates capital outflows won’t exceed $90 billion this year. The Economy Ministry estimates flight will reach $100 billion.

“The headache now is about what will happen with reserves in the future,” said Sergei Pukhov, a senior analyst at the Development Center of the Higher School of Economics. “If sanctions continue, the level of reserves may in the course of 2015-2016 reach a critical level equal to six months of imports of goods and services, or about $200 billion.” That amount doesn’t include the two sovereign wealth funds, he said.

Russia’s Reserve Fund fell to $86.6 billion in July from $87.3 billion the previous month, the Finance Ministry said on its website today. The National Wellbeing Fund declined to $86.5 billion from $87.9 billion in June.

Crisis Deepens

Restrictions on money flows is for now an “unlikely scenario,” according to Yaroslav Lissovolik, the Moscow-based head of research at Deutsche Bank AG. “Even capital outflow forecast at $100 billion this year isn’t enough to put the issue of capital control on the agenda.”

When the U.S. and its allies first started to impose individual sanctions in March, the Russian government held no discussions on imposing currency controls, Deputy Finance Minister Alexey Moiseev said at the time.

Since then, tensions have escalated, with the authorities in Kiev pressing an offensive against separatists in the east of the country. After a Malaysian passenger jet was downed over eastern Ukraine on July 17, the U.S. and the EU ramped up sanctions against Russia, limiting access for banks to capital financing.

If Putin reverses course, he’ll be joining other developing economies such as China, where capital controls are used to limit access to local securities. Countries from Argentina to Ukraine have imposed restrictions to safeguard reserves and halt a slide in their currencies.

‘Step Backward’

The central bank still doesn’t see any reasons for introducing control over cross-border capital flows, according to its e-mailed statement in response to questions from Bloomberg News.

A Chinese model with a fixed exchange rate and capital controls would be a “step backward” for Russia, Nabiullina said in an interview in June 2013, when she took over the central bank chairmanship from Sergey Ignatiev.

If external financing slams shut for state-owned banks and companies, the government may have to provide them with a total of $40 billion to $90 billion in foreign-currency assistance in 2014-2015, according to the Higher School of Economics in Moscow.

“That will be more than a serious burden on Russia’s foreign currency and gold reserves,” Valery Mironov and Alexei Nemchik, from the Higher School of Economics’s Development Center, said in a report.