Photographer: Andrey Rudakov/Bloomberg

Russia Braces for Debt Blowback If U.S. Stiffens Its Sanctions

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Russia is prepared for higher borrowing costs in the market as a result of concerns about possible U.S. sanctions, although the budget fallout would be limited, according to Deputy Finance Minister Vladimir Kolychev.

Investors are growing uneasy before a report by the U.S. Treasury, due next quarter, on the possible effect of sanctioning Russian sovereign debt. While local bonds are among the best performers in emerging markets this year, yields have been rising since mid-October. The bid-to-cover ratio at last week’s auction of ruble debt known as OFZs dropped to the lowest since July.

“The Finance Ministry is ready for growth in yields because of concerns over sanctions,” Kolychev said in an interview in Moscow. Still, “the cost of debt servicing for the budget will rise insignificantly.”

The expansion of penalties to local debt not only raises the prospect of a selloff in the bond market but also poses risks to the ruble. Facing few options to address the threat, top Russian officials have been brushing off worries about the severity of any impact. The Finance Ministry, which largely relies on debt to cover the budget shortfall, is seeking to borrow 1.05 trillion rubles ($18 billion) domestically in 2018, more than a third less than this year’s plan.

Yields have lured investors from abroad, with foreigners increasing their OFZ holdings in August to 32 percent of the total outstanding, a record high. That, in turn, makes the ruble bond market ever more sensitive to a sudden shift in global sentiment.

Fitch Ratings, alone among major credit assessors to deem Russia’s debt worthy of investment grade, has warned that the possible extension of U.S. sanctions to target state bonds is delaying a credit upgrade for the government. 

‘Investor Uncertainty’

It’s a view shared by S&P Global Ratings. A bill codifying the penalties, adopted by the U.S. in August, “adds to existing investor uncertainty,” according to S&P.

“The codification of sanctions by the U.S. adds additional barriers to their removal,” it said in September. “There is a lack of clarity on how the bill will be implemented, which sectors of the economy it will affect, and what Russia’s response will be. ”

For now, Russia’s Finance Ministry doesn’t anticipate the need for extraordinary measures to control the currency market, Kolychev said. Last month, he said the government is considering legal changes to allow for the quick imposition of emergency measures to stabilize the ruble in the event of a major financial crisis.

“Demand for foreign currency rises and falls,” Kolychev said in the interview. “Our currency market is liquid enough to absorb such situations. We don’t expect any effects that would lead to financial instability and would require the regulator’s involvement.”

Praising the ruble’s decreasing sensitivity to oil as a result of the ministry’s foreign-exchange purchases, Kolychev pointed to the Russian currency’s relative stability in October despite a rebound in crude prices.

After the Finance Ministry on Friday announced it would step up its purchases of foreign currency in November by 65 percent from the previous month and the dollar gained, the ruble’s 30-day correlation with Brent plunged into negative territory for the first time in three years.

Sanctions are less of a threat for Russian bonds than the risk of spillover from a selloff in emerging markets and crises unfolding from Saudi Arabia to Venezuela, according to Richard Segal, a London-based credit analyst at Manulife Asset Management.

“Perhaps we’re too complacent about Russia, but for now anyway there are bigger worries,” he said.

— With assistance by Evgenia Pismennaya

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