SNAPSHOT: Political risk outlook in Russia deteriorates as government considers nationalising foreign assets

SNAPSHOT: Political risk outlook in Russia deteriorates as government considers nationalising foreign assets

OVERVIEW

  • On 14 March, Russian President Vladimir Putin signed a law allowing Russian airlines to operate leased planes without a foreign certificate after Bermuda announced it would revoke the flight licences of Russian aircraft registered there. A large part of the Russian commercial aviation fleet is registered in Bermuda and the new law aims ‘to ensure the uninterrupted functioning of activities in the field of civil aviation’.
  • The new legislation will create a barrier for leasing firms seeking to recall over 500 aircraft physically present in Russia and valued at an estimated USD10 billion. Under sanctions imposed against Russia over the invasion of Ukraine, aircraft leasing firms have until 28 March to withdraw from deals with the country’s airlines.
  • Last week, reports the Russian government may be planning to seize the assets of Western companies that have left the country following Moscow’s military operations against Ukraine triggered concerns that such de facto nationalisations are imminent. Russia’s economy ministry has said it could take temporary control of companies where foreign ownership exceeded 25 per cent. Specifically, on 10 March Russia’s Prime Minister Mikhail Mishustin warned that steps could be taken to ‘introduce an external administration’ to take control of assets belonging to firms that suspended operations in the country.
  • In another major development, the Group of Seven (G7) countries said on 11 March that they would remove Russia’s ‘most favoured nation’ (MFN) status under World Trade Organisation (WTO) rules. This follows a decision by the Canadian government on 3 March to subject imports from Belarus and Russia to a 35 per cent tariff after removing the two countries from the MFN’s beneficial trade system.
  • Meanwhile, the exodus of companies from the Russian market continues, with fast-food chain McDonald’s and soft drinks manufacturers Coca-Cola and PepsiCo announcing last week they would cease operations in the country. Similar announcements were made by firms in the financial services sector, including Goldman Sachs and JPMorgan. Over 300 companies, ranging from technology to food and beverage firms, have either suspended or reduced operations in Russia since the military invasion began on 24 February.

ANALYSIS

  • Recent developments underscore the worsening investment climate for foreign firms with a commercial presence in Russia. Beyond economic sanctions imposed by the West, the emerging risk of asset seizures and potential nationalisation has dramatically altered the domestic market operating environment. Many foreign companies will perceive this new dynamic as hostile and adverse for existing investments.
  • The removal of the ‘most favoured nation’ status is significant as it means WTO members can impose tariffs on Russian goods without violating international trade rules. For instance, the UK said on 15 March that it would ban the export of luxury goods to Russia and impose a 35 per cent tariff on GBP900 million worth of imports, including vodka, metals and fertilisers. This comes as the EU formally approved a new sanctions package, including a ban on investments in the Russian energy sector, luxury exports and imports of steel, expected to impact EUR3.3 billion worth of Russian products.
  • Sanctions against Russia over the invasion of Ukraine are unprecedented both in terms of scope and because of their immediate impact on economic activity. For example, the removal of certain Russian banks, including VTB and Promsvyazbank, from the SWIFT interbank messaging system presents a practical obstacle for firms accessing funds for operational needs and receiving payments.
  • The withdrawal of independent journalists from Russia is another concerning development for foreign companies still operating in the country. Lack of independent investigative scrutiny and increased opacity will undermine the reliability of official reports on economic issues as such indicators are taken into account by businesses as part of pre-investment planning.
  • There are also important reputational considerations for foreign companies behind their motivations to leave Russia. Indeed, internal risk assessments likely concluded that it is preferable to pull out of Russia rather than risk reputational damage and regulatory repercussions. Even previously attractive investments, particularly in the extractive sectors, will now be viewed as toxic for most investors due to their high risk levels.
  • Companies are faced with the difficult choice of absorbing losses rather than risk becoming embroiled in ever-expanding Western sanctions on individuals and entities in Russia. The threat of sanctions almost certainly factored into Moscow’s pre-invasion calculus, with officials probably deeming these would not significantly differ from past punitive measures. However, the fact that sanctions have targeted political officials, prominent business figures, and financial institutions demonstrates how present measures are qualitatively different from previous sanctions imposed on Russia.
  • Ever since the fall of the Soviet Union the risk of sudden nationalisation in Europe was significantly reduced as post-Soviet states adopted free-market economic models. In Russia, large-scale privatisations in the early 1990s were then heralded by some Western economists as a permanent shift away from Soviet-style economic planning. Western investment grew and, according to data by UNCTAD, accumulated foreign investment in Russia was estimated at USD446.7 billion in late 2020.
  • The legislation approved on 14 March is notable because it may signal an intention to effectively nationalise foreign-owned aircraft. The nationalisation of foreign assets is likely to have a broad sectoral impact, with companies that recently announced they would be leaving the Russian market being especially exposed.
  • Nationalisations are likely to expand to other private spheres, impacting both domestic and foreign actors. Several mutually reinforcing statements made by Russian government officials in recent days carry weight because they outline likely intentions for more political intervention in private markets.
  • Companies operating in sectors deemed strategically and politically important, such as defence, research and energy, face a higher nationalisation risk. Beyond government takeovers of assets owned by foreign companies, domestic financial institutions impacted by sanctions may also be nationalised as part of future financial rescue or recovery plans.
  • The financial cost of nationalisation without compensation can be extremely high for some companies. On 11 March, German car manufacturer Mercedes-Benz said that EUR2 billion in assets were threatened in Russia if the government moved ahead with nationalisations.
  • Heightened political risk will also translate into greater scrutiny of foreign firms that decide to remain in Russia, especially in terms of their political positioning. In a bid to control the narrative over the invasion, information available to the public is now under near-total government control in Russia. A climate of suspicion fuelled by the Ukraine conflict and the need to bolster public support for the war effort, means more political pressure will be exerted on companies that publicly condemn the invasion or are openly critical of the government. This type of state behaviour is already more or less present in China, where in 2018-19 some foreign firms were cautioned for ostensibly taking positions on the issues regarding Taiwan and Hong Kong deemed unacceptable by Beijing. In many ways, Russia is orienting itself towards China and this is unlikely to be limited to closer economic ties unless Beijing chooses to adopt a more ambivalent policy towards Moscow’s globally disruptive policies.

OUTLOOK 

  • More companies are likely to leave Russia in the coming weeks because of the volatile economic environment, pressure from within their home countries and increasing political risks. Companies remaining in Russia should assess the vulnerability of their assets to a potential government takeover and factor this risk into strategic planning.
  • Further, investors are, to varying degrees, highly sensitive to political instability, economic risks and reputational or brand damage. A return to pre-conflict economic conditions is unlikely in the short-to-medium term, while steadily eroding trust between the Russian state and foreign corporate actors is unlikely to improve within the medium-term outlook, and probably far longer.
  • Even if Russia diverts some of its exports to other markets, such as China, this is unlikely to offset the severe economic damage inflicted by Western sanctions. Among Western allies, now more united over this issue than any other over the past three decades or more, the pendulum has shifted and put in motion a series of events with one overarching aim: the economic and geopolitical isolation of Russia, notably demonstrated by the accelerating effort from the EU to cut dependence on Russian energy supplies.
  • The impact of the invasion on the business climate in Russia will be long-term and represents a widening gap between Moscow and the West that is unlikely to narrow unless the war is brought to a swift conclusion through dialogue rather than military force. The scale of Russia’s invasion, subsequent campaign, and its initial statements that a military build-up was not intended as an act of aggression against Ukraine has dealt a permanent blow to its credibility for many foreign investors. While in the longer-term some investors may return, depending on how the war is resolved, others will not due to their own assessment or external pressures that make the risk too high.