U.S. Plays Down Russian Industry Sanctions Over Retaliation Risk

Bloomberg: 13. May 2014
U.S. Plays Down Russian Industry Sanctions Over Retaliation Risk

By Kasia Klimasinska

Russian Railways expecting German Siemens Co. to deliver eight (aditional) Velaro RUS Sapsan high-speed trains (pictured above) in 2014 as agreed in the contract signed at 2010.

Officials in the U.S. and European Union are playing down the prospect of punishing Russia with sanctions targeting entire industries, opting instead to focus on tightening pressure by targeting more individuals and companies.

Policy makers say they are concerned that broad-brush sanctions on Russia’s energy and financial sectors, the two areas mentioned as possible targets, risk provoking economically costly retaliation by Russia.

“The Europeans don’t want to have a clear, transparent move to sectoral sanctions,” said Robert Kahn, a senior fellow for international economics at the Council on Foreign Relations in Washington. “What we might see therefore is sort of creeping into sectoral sanctions through the naming of the specific firms, so it wouldn’t be necessarily the whole sector or all transactions, but it would be partial.”

Billion dollar question - How West can respond to Russia's aggression and not hurt its own interests too harsh?

Since relations between the West and Russia become more and more frosty and unfriendly, western companies that operate in the country, or companies that are trying to gain a foothold, already work under preasure and find the daily routine of running a business more and more difficult.

Here are some industries where U.S. and European companies which are heavily represented in Russia, could experience retaliation by Russia:

Energy

Russia is a hub of the international energy trade. Many western companies — from giants like Exxon Mobile and British Petroleum to small contractors like Halliburton operate in Russia. Much of the oil consumed in Europe flows from Russia through Ukraine.

Exxon Mobil Corp. XOM is one of the biggest foreign investors in Russia, according to a story in The Wall Street Journal. It has partnered with Russian firm Rosneft to explore prospects in the arctic and Siberia. And for much of the last decade, Exxon has been pumping oil and natural gas from the Sakhalin Island, which is located off Russia’s eastern coast. An Exxon spokesman did not return a request for comment. Any difficulties the country might have would not significantly impact consumers in general, but would likely hurt Exxon shareholders.

Exxon Mobil Corp. (NYSE: XOM) formed an alliance with Russia’s state-controlled oil giant Rosneft in 2011 to develop the potentially huge and totally untapped reserves on Russia's Arctic Shelf and in Western Siberia's shale oil deposits. The deal could eventually be worth as much as $500 billion. Part of the deal included exploration work in the Black Sea, but the big prize is the Arctic. Exxon was able to get Russian President Vladimir Putin to cancel taxes on oil exports from the Arctic for up to 15 years in exchange for its investments in the country.

If Russia decides to shut off the flow of natural gas and oil, Europe would be left vulnerable, although energy stockpiles would help soften the blow. Last year, Russian natural gas imports accounted for about 34% of European demand, up from 26% in 2010.

But one of the biggest risks for western companies is what could happen if a new opportunity arises in Russia, says Barclays commodities analyst Michael Cohen. “If a new opportunity presents itself in the arctic or parts of the Caspian, if relations are poor with Russia, than an Indian company or a Chinese company may find themselves at an advantage in contrast to a western company,” Cohen said.

Machinery and equipment 

Russia is one of the largest importers of cars, buying $60 billion of them last year. Renault SA is heavily invested in the market, with the company and its partner Nissan Motor Co. set to increase their stake in AvtoVAZ, Russia’s largest auto maker, to 74.5% by mid-2014, according to The Wall Street Journal. Not only do car companies export there, but large industrial firms, like General Electric GE , Siemens, Johnson Controls do, too. 

Some even have large operations there. David Nowakowski, senior director of research at Roubini Global Economics, says there’s a chance the country could try and impose quotas or tariffs on imports, or the U.S. could impose a similar limit on exports. WTO membership is an important factor in this, Nowakowski says. Russia joined the organization in 2012.

Germany based Siemens, for example, has won in 2009 a €600m order from Russian Railways (RZD) to supply eight high-speed Velaro RUS trains. The contract includes supply of the high speed trains as well as serving of the trains for the next 30 years at a cost of another €300m. In December 2013 Siemens deliverd first of eight 10-car Velaro units to Russia and has said that the all eight vehicles due to arrive in Russia by the middle of next year.

Siemens suposed to supply these trains starting from 2014 and after delivery they will be used between Moscow and St. Petersburg to meet increasing demand on the popular high speed link.

Velaro RUS trains are known as Russian Sapsan (Peregrine Falcon) and use similar technology to Germany's ICE trains, but the additional features in the train include special kit which helps the trains to withstand the Russia's harsh winter weather (temperatures from minus 40 to plus 40°C).

German Siemens Valero RUS trains on production line orderd by Russian Railways

Siemens also had signed a joint venture with the Russian locomotive producer SINARA for local production of double-section electric freight locomotives near Yekaterinburg (Urals) and own an order in May 2010 to supply 221 double locomotives worth more than €1bn. Siemens, along with Russian partner firms, had invested €200m to set up locomotive production plants to produce locomotives and regional trains. The company has earlier agreed to modernise 22 railway switching yards by 2026 and supply Russian Railways (RZD) with 240 regional trains over the next ten years.

American General Motors Co. (NYSE: GM) sold 258,000 vehicles in Russia last year, a market share of 9.1%. The company has a plant near St. Petersburg that has a current manufacturing capacity of 98,000 cars, but it is scheduled to be expanded to a capacity of 230,000 cars by 2015. GM was forced to shut its Russian plant for a full month last summer, instead of a scheduled two weeks, due to weak sales in the Russian auto market.
And, also present, Ford Motor Co. (NYSE: F) sold 105,000 vehicles in Russia in 2013 and claims a market share of 3.8% of the total of 2.8 million vehicles sold in the country. Russia is Europe's second-largest market for new vehicles, and Ford expects Russia to become the largest over the next several years. The company has a 50/50 joint venture with Russian firm Sollers that operates three manufacturing plants in the country and plans to launch a new engine plant next year. Ford is closing plants in the United Kingdom and Belgium and moving some production to Russia.

Food and Beverage

PepsiCo. PEP is heavily invested in Russia. It’s the company’s second-largest market after the U.S. It booked nearly $5 billion in profit there last year, according to The Wall Street Journal. McDonald’s MCD and other fast-food chains have also been growing market share in Russia. But Nowakowski doesn’t feel this industry will be largely impacted by the Russian crisis unless things go really downhill.

“I suppose that could happen, but they’re also presumably large employers,” Nowakowski said. “Companies could find it difficult to operate in Russia, but it’s not like it was easy before. it was already a risky environment where companies couldn’t operate independently and increasingly needed to find a Russian partner or make sure the Russian government was on its side.”

Atlanta-based Coca-Cola Co., the world's largest beverage company by revenue, is a little less exposed to Russia than PepsiCo. Still, Russia has been an important focus for Coke amid slowing sales in many more developed markets. The company spent heavily in recent months marketing its drinks as a sponsor of this February's Winter Olympics in Sochi--including accompanying the Olympic torch relay on its 123-day, 35,000-mile journey across the country. Coke's Russian beverage volumes grew 3% last year, including an 11% jump for its Coca-Cola brand and 7% and 24% increases in its local Dubriy and Rich juice brands, respectively. Coke also owns a 23% equity stake in Coca-Cola Hellenic, a large multi-country bottler with operations in Russia and Ukraine, including two plants in the latter country. Fearing for its investment, on May 8th 2014 Coca-Cola Co (KO.N) announced it is closing 2 of its 4 fruit juice plants in Russia. Allegedly "in response to falling demand", putting at risk hundreds of jobs in a business which the U.S. company had bought for $276 million four years ago.

The plants being closed are located in Novosibirsk in Siberia and in the Moscow region. Some of the unit's 1,000 staff will be offered jobs at Multon branch.

Investment banking: 

U.S. investment banks have been fighting for their share of Russia’s bustling bond issuance and IPO market. In the past week, Lenta Ltd., Russia’s second-largest supermarket chain, debuted its shares in London, with J.P. Morgan as a lead underwriter. J.P. Morgan also has a close relationship with Gazprom, and has acted as a lead underwriter on much of the company’s bond issues. A group of western banks, including Citibank, Barclays and J.P. Morgan joined with RZD Capital, a Russian bank, to help RZD Capital Plc — a Russian railroad company — issue bonds.

Investment banks are particularly vulnerable to political whims in Russia, Nowakowski said. For these banks, losing out on business opportunities doesn’t even need to happen through official channels. Powerful figures can exert authority indirectly through ‘moral suasion’ and quash a deal for a western bank.

But the flip side also applies. U.S. is weighing whether to impose sanctions on Russian banks, which Nowakowski said would certainly provoke a swift retaliation by Russia.

Largely exposed American financial organization is Citigroup Inc. (NYSE: C) which offers traditional banking and credit card services at 172 branches in its Europe/Middle East/Africa regional consumer banking operation, of which Poland, Russia and the UAE are the largest. The bank also holds $10.3 billion in aggregate assets in Russia, making it the bank's 10-largest emerging market holding. The bulk of the assets comprises $6.5 billion in loans held by the Institutional Clients Group and $1.7 billion in loans held by the Global Consumer Banking group.

Another bank giant, J.P. Morgan Chase & Co. (NYSE: JPM) reported that its exposure to Russia totaled $4.7 billion in 2013, of which $4.7 billion is in loans and $700 million is in trading and investing.

Germany alone has some 6,200 companies that have set up branches and subsidiaries in Russia in recent years. According to the German Federation of Industry (BDI), they've invested more than 20 billion euros ($28 billion). That would be seriously affected if sanctions were to spiral between the EU and Russia.

A month ago, the term "expropriation" was used for the first time in the Russian Federation Council. One member called for European companies to be expropriated without compensation. That may have been the idea of just one member, and it wasn't taken up - but the nightmare scenario has been raised and it's being thought about.

OAO Gazprom (OGZD), Russia’s gas-export monopoly, yesterday threatened to cut off supplies to Ukraine, a reminder of the power Russia wields over energy supplies to the rest of Europe. A gas cutoff by Russia would wipe out half of Ukraine’s supply and could severely disrupt supplies to the EU. The EU, Turkey, Norway, Switzerland and the Balkan countries got 30 percent of the natural gas they burned from Russia last year, according to the U.S. Energy Department.

“We have to be very careful not to hurt ourselves more than we hurt the other side,” Polish Foreign Minister Radoslaw Sikorski said yesterday in a speech in Brussels, echoing comments made last week by U.S. Treasury Secretary Jacob J. Lew.

French Warships

In a sign of Russia’s ability to use its economic clout to drive a wedge between its adversaries, France’s government said this week it will deliver Mistral helicopter carrier warships to Russia as planned, rejecting requests from its European and U.S. allies to cancel the sale.

Sectoral sanctions aren’t totally off the table: EU foreign ministers, meeting in Brussels, pledged to accelerate preparations for broad economic penalties should Russia disrupt the Ukrainian presidential election due May 25.

Meanwhile, the EU yesterday for the first time used penalties against companies, including natural gas producer Chernomorneftegaz, that were expropriated after Russia annexed Crimea. It also added 13 people to a list of individuals facing asset freezes and travel bans, including Vyacheslav Volodin, first deputy chief of the Russian presidential staff, and Vladimir Shamanov, commander of Russia’s airborne troops.

European Union foreign ministers added Chernomornaftegaz to sanctions list on May 12.

Russian stocks advanced yesterday on bets the latest penalties won’t hurt the economy. The Micex Index gained 0.3 percent to 1,375.31. while the ruble strengthened 0.4 percent to 35.1005 per dollar. Ukraine’s hryvnia fell 1.1 percent, extending this year’s slide to 30 percent.

Disputed Referendums

Tensions escalated after rebels in eastern Ukraine said they’re seeking to join Russia after disputed referendums and as the government in Kiev was handed a deadline to pay for Russian gas.

The self-styled Donetsk People’s Republic declared itself a sovereign state after saying 90 percent of voters backed breaking away from Ukraine. Separatists in neighboring Luhansk announced a similar move. Gazprom said Ukraine must pay for next month’s supplies by June 2 or face a shutoff the next day.

Russia continued to voice support for the separatists, saying the referendums “convincingly show the real sentiment of citizens in the Donetsk and Luhansk regions.”

The U.S., which is leading the global effort to force Russian President Vladimir Putin to change his actions, has blocked 45 individuals, including OAO Rosneft Chief Executive Officer Igor Sechin, a Putin associate, and 19 entities, including SMP Bank and Bank Rossiya. Rosneft is Russia’s largest oil producer.

Avoiding Retaliation

In an interview last week on Bloomberg Television’s “Political Capital With Al Hunt,” Lew stressed the need to avoid retaliation by Russia that could hurt the U.S. and Europe, even as he reiterated he has the authority to impose sectoral sanctions.

The administration of President Barack Obama has “made very clear that our goal is not to go to the maximum degree that one can to hurt the Russian economy. It’s to get President Putin to change Russia’s policy,” Lew said.

“We have been moving step by step and in a very surgical way,” he said. “The goal here is not to hurt the European economy, the American economy. It’s not to hurt the Russian people.”

Sanction Supporters

Supporters of stronger actions, such as Senators Robert Menendez, a Democrat from New Jersey, and Robert Corker, a Republican from Tennessee, favor freezing assets of Gazprom and major banks such as Russia’s largest lenders OAO Sberbank and VTB Group.

Some companies are urging caution. USA*Engage, a coalition of U.S. businesses, agriculture groups and trade associations, says the U.S. shouldn’t impose sectoral sanctions on its own.

“If sanctions are going to have any chance of achieving their intended goal, the experience has shown, they have to be multilateral,” Richard Sawaya, the Washington-based group’s director, said in an interview yesterday.

U.S. financial institutions, including Bank of America Corp. and Citigroup Inc., are already cutting exposure to Russia, while the investment unit of VTB is considering getting rid of most of its New York staff if the U.S. imposes further sanctions.

The U.S. must maintain pressure on its European allies to toughen sanctions, said Mark Dubowitz, executive director of the Washington-based Foundation for Defense of Democracies, a non-profit group that focuses on national security issues.

“There is no substitute for U.S. leadership for, without it, Europe will continue to dither,” he said. “Washington needs to continue to create a U.S. secondary sanctions architecture that increases the risk premium for international companies in their dealings with Russia. This will also force the EU to develop its own made-in-Europe sanctions that will be more timely and forceful than they would otherwise be.”