Yesterday, Russia launched what amounts to a counter-sanction by mandating that all payments for Russian gas from “unfriendly countries” be made in roubles. Sadly most commentators missed what these measures amount to. And they also missed some potentially significant secondary effects, one of which may be to solidify the ties between India and Russia.

We’ll turn later to a new Dallas Fed paper that warns that keeping the Russian energy spigot turned off for the rest of 2022 will put the world in a recession.

“Unfriendly Nations” Rouble Payment Counter-Sanctions

Putin announced this move before the US and other countries were set to launch new sanctions against Russia at NATO and G7 meetings on Thursday. The gas payment counter-sanction is highly unlikely to change the West’s plans, but it might wind up superseding other discussions planned for these summits:

Recall that we said the very day that the US imposed economic sanctions on Russia, with the intent to make it unable to use dollars, that there was no point in Russia continuing to sell oil to the US under those conditions. It might as well be paying Russia with bags of feathers.

Now the US solved that problem for Russia by sanctioning all Russia energy. But the EU also sanctioned Russian banks by kicking them off SWIFT. That makes it more cumbersome to sell gas to the EU, particularly since some Russian banks had to close all their operations in the EU. It can’t have been lost on Russia that the EU could try to use its control of the payment apparatus to inflict more pain and costs.

We are calling the Putin measure a counter-sanction because it is designed to unpick a key part of the Western sanctions, which is to subject Russia to payment arrangements to the control of the US and EU. It is not a sanction because Russia is not withholding supply. And separately, both Russia and China object to the US-EU sanctions because they were not approved by the UN. So expect any additional Russian actions, even if they have the effect of sanctions, not to be structured as sanctions.¹

As we’ll explain, this counter-sanction does not amount to forcing (much) more demand for roubles (unless Russia sets an above-market rouble price for these gas buys). Russia has already imposed currency controls, including requiring major exporters to sell 80% of their foreign currency receipts and buy roubles. And contrary to popular mis-perceptions, the rouble is not collapsing. Russia reopened its financial markets earlier in March. The rouble, while still much lower than it was in 2021, has rebounded from its low as of when sanctions were imposed, as this chart from Trading Economics shows:

Let us consider how Europe is buying gas from Russia now:

EU buyer pays Euros, to say Gazprom via one of Gazprom’s banks.

Either that bank is one of the non-sanctioned Russian banks, or Gazprom transfers the funds to a non-sanctioned Russian bank to convert enough of the Euros to roubles to satisfy Russian requirements. Note that there are not enough roubles circulating outside Russia for it to be very likely that a garden-variety European bank could acquire enough roubles for Gazprom.²

So what is different now?

The EU buyer is now required to deliver roubles, not Euros, to Gazprom at an unblocked account or an unsanctioned bank. Since there is very little in the way of roubles outside Russia, the buyer will now need to open and maintain rouble accounts in a Russian bank. That means Russia controls whether or not the account is blocked on its side.

To put it more bluntly: To sell Euros, the EU needs to keep the Russian banks sanction-free, otherwise it can’t trade Euros for roubles to procure gas.

Buyers that don’t play ball don’t get Russian gas. Trying to replace it won’t be easy. From Statista, share of gas supply from Russia in Europe in 2020, by selected country:

Bosnia and Herzegovina* 100%
North Macedonia* 100%
Moldova* 100%
Finland 94%
Latvia 93%
Serbia* 89%
Estonia* 79%
Bulgaria 77%
Slovakia 70%
Croatia 68%
Czechia 66%
Austria* 64%
Greece 51%
Germany* 49%
Italy 46%
Lithuania 41%
Poland 40%
Hungary 40%

If anything, some of these figures may be low. One reader at the Financial Times said that Germany now gets 55% of its gas from Russia and Italy is the second largest customer, by volume.

Some observers contend that the Russian change is of little consequence because Qatar, one of the world’s largest LNG suppliers, agreed to send more to Europe. But Qatar already said, at the beginning of February, that it could not unilaterally fill the loss of Russian-supplied gas. Moreover, most of the world’s LNG supplies are subject to long-term contracts and thus can’t be redirected quickly. I would be curious to see more detail as to how much LNG Qatar is expected to send to Europe and how much that could increase over time.

The EU buyer can whine about it if the contract with Gazprom doesn’t allow for Gazprom to be paid in other currencies. This is a Russian edict overriding existing agreements. After the West freezing $300 billion in Russian central bank assets and the US and to a large degree the EU refusing to take oil deliveries from Russian ships already bound for various ports, the EU does not have a very firm basis for complaining about being treated badly. If you want the gas, you need to pay in roubles.

IMHO the much harder part will be agreeing on a price or price formula for roubles, particularly for any gas deliveries set under a long-term price agreement as opposed to spot prices.

Some have suggested that the Russian requirement will allow buyers to change other contract terms, like shorten the length of their agreements. If you listen to Putin’s statement, the Russian position is that it is keeping the contracts in place. So it seems very unlikely that Russia would allow other changes in terms unless Russia deemed them to be in its interest.

Around the margin, the Putin requirement does increase demand for roubles, but this isn’t a game changer, since the sales of Russian gas abroad will now go from being 80% converted to roubles to 100%. And those operators do have expenses outside, so they will presumably need to and be allowed to convert some of those roubles back into foreign currencies.

Now it is still possible that some key EU players, in a fit of cussedness, again play the “I’ll hurt myself to hurt you” game and refuse to go along with the rouble payments. Perhaps I am missing something, but that would seem to be to Russia’s advantage, since it would accelerate the onset of energy shortages, particularly in Europe, that the IEA was warning were coming over the next four months, particularly of diesel. More economic distress sooner, particularly since a sudden shock is more clearly the result of Ukraine policies, has more potential to create domestic unrest. That in turn could lead to more willingness to negotiate with Russia, rather than require them to decisively win the war to sue for terms.

There was some very good commentary on a new Financial Times article on the Russian counter-sanctions, provided you had the patience to wade though the huge number of jingoistic and low-information-value comments. From reader vlbuzz:

On top of this development:

– a RUBINR swap line is being established between Russia and India, effective as of the next week, allowing direct exchange of currencies and using bi-lateral settlement system
– Central Bank of Russia finally takes the lesson from the Fed and the ECB and engages in QE, targeting the RUB yield curve by direct purchases of government debt on MICEX from the local investors (foreign owners’ holdings are effectively frozen as of now and can not be sold in the market)
– a comprehensive set of capital controls stops the capital flight, USDRUB is down 30% from the recent post-invasion peak
– retail fuel prices are down 5-10% in RUB terms across the country as the excess export volumes of diesel go to domestic market
– export oil prices are up markedly, fully negating the Urals-Brent discounts in absolute terms, the same in thermal coal, fertilizer, wood and cellulose, copper and aluminium among others
– the heating and electricity bills for the population will be indexed by just around 8% y-o-y in nominal RUB terms (or effectively decreased by -4-7% in real terms), negating the higher food/FMCG price effects
– food inflation is rising due to increased stock-piling by the distributors and population (sugar, mostly, as widely used in home breweries to make moonshine), but the impulse buying has mostly subsided while the stocks are managed by temporary export bans for most of the agricultural commodities…

You’ll have to pay up a bit to buy a new Bentley and ship it from Azerbaijan or Kazakhstan to Moscow, but other than that, the impact on the larger part of the society is so far rather limited.

One possible partial way around the counter-sanctions would be to deepen the market for roubles outside Russia. From Financial Times reader no illusion:

This means that the buyers will need to go sell their euros in Russia and buy Rubles to pay for gas. This creates a big forex market here – with spot and derivative components.

Possibly, but the reason banks are willing to run big intra-day dollar exposures with each other that are settled out at the end of each trading day in the US is that large-dollar payments go through banks with US licenses that are on Fedwire. That means the dollar payment system is ultimately backstopped by the Fed.

It is over my pay grade to guess how much rouble trading would be done outside Russia save on a regulated exchange (with all sorts of trading limits and both trade and exchange margins required) or if OTC (which is how nearly all foreign exchange trading is done) or with a Russian central bank backstop…or with a bank in a country with currency swap lines with Russia’s central bank…which India will soon have. But I can’t see these transaction volumes being big enough to handle the very large payments that would be made for Russian gas.

One fascinating secondary effect of the rouble-pay scheme may be to increase India-Russia ties. Yet another Financial Times comment, this one from Anonymous columnist, writer:

Some days back a top forex trader and now monetary economist for HSBC Global Market remarked recently that following Russian Central Bank’s foreign currency dollar asset freeze order by US, it’s only a matter of time that the Russia would be forced to go for trading with the west in Rouble only or Rouble and Yaun/Renminbi currencies only to ensure it remains 100% risk free from sanctions and asset freezes, despite potential risk of inflationary costs at home.

India, one of the major economies and the largest democracy in the world has already been trading with Russia under Rouble – Rupee exchange agreements for many decades. Indian banking and finance lawyers privately say that India’s finance ministry along with Reserve Bank of India (RBI) and Bank of Russia is “racing against time” in exploring options to “internationalise” Russian version of the SWIFT version – SPFS, starting with India as a launch base outside Russia (being helped by the fact that India has reservations in dealing with China’s CIPS – China’s version for SWIFT – though it is ready to accept expansion of China’s UnionPay card payment system subject to restrictions).

In fact many Indian online retailers, like Israeli online retailers and service providers, have/are on the verge of setting up Russia’s Mir card payment system online to enable Russian citizens to trade with/buy products from India.

Israel has/soon to have similar arrangements in place. Turkey, Malaysia, Bangladesh, Argentina, Venezuela, Iran, Saudi Arabia, South Africa and many AU countries and of course China all have (or most already rushing to have) rouble + their respective currency exchange agreements in place.

A number of lawyers based at Indian corporate law firms in Mumbai say “they are working around the clock” like never before following the outbreak of Ukraine war, in advising number of governments of African Union countries on enabling rouble-based trades and also currently advising many of the corporations and conglomerates based in emerging markets on setting up rouble based contracts, given India’s half-a-century unsurpassed experience in trading with Russia under rouble – rupee exchange agreement/and or rouble – rupee swaps.

However, notwithstanding this, Indian corporate law firms are advising many large corporations based in the emerging markets to evaluate their governing contract and arbitration clause options and to seriously consider other major jurisdictions available as alternative to London, New York, Paris and Singapore, with the options of Dubai, Hong Kong being on the table among others.

Corporate law firms in India’s financial capital Mumbai say that government of India with the help of country’s premier members of the legal profession is also seriously considering to see current Russian-Ukraine crisis as “either or never” opportunity for India to emerge as future international arbitration centre alternative to London, Paris, New York, Singapore and Switzerland and evaluate whether it can become alternative to London and New York as governing law provider for English law or New York law respectively, by using India’s well established English common law system, though this is likely to take some time (Dubai, Singapore and Hong Kong provides a tough competition).

On another note, an Indian lawyer said they along with Hong Kong and Dubai based lawyers are advising banks in Bangladesh, UAE, Pakistan and African Union member countries alongside Bank of Russia in exploring options to consider rolling out/enable cross-border Russia’s Mir and China’s Union Pay systems in the said countries’ retail and commercial banking as well as to roll out rouble currency accounts for retail customers as FCY account options for customers wishing to open forex based rouble (or alongside limited capacity Renminbi Yua) fixed deposit schemes for the purpose of sending their children to Russia for education and medical treatments, given that Ukraine is out of the equation for many; until recently, Russia, Ukraine, Belarus, Georgia after the west, Turkey and the Far East was considered one of the most attractive cheaper alternatives for study medicine and study abroad for STEM subjects for middle class citizens from the emerging markets.

Sober Dallas Fed Forecast if Russian Energy Sanctions Persist

Even though the major financial news outlets like the Wall Street Journal and Bloomberg reported on the new Dallas Fed paper, The Russian Oil Supply Shock of 2022, seemed worth highlighting here. It is short and in large type, which worries me as a sign of the central bank’s assumptions about the intellectual level of its audience. Key sections:

In the immediate aftermath of Russia’s invasion of Ukraine in late February, early estimates suggested that perhaps 3 million barrels a day (mb/d) of petroleum production—almost 3 percent of world production—had been effectively removed from the global oil market, constituting one of the largest supply shortfalls since the 1970s…

Recent data from Energy Intelligence, however, indicate that the fall in Russian petroleum exports to date has been somewhat smaller than the initial estimate of 3 mb/d and coincided with oil price weakening after March 8.

What changed is that much of the Russian oil that continues to be exported from Baltic and Black Sea ports at steep discounts is not delivered to refiners, as is customary. Instead, trading houses are purchasing the oil and keeping it in commercial storage in Europe, from where it may be potentially resold, bypassing financial sanctions. Buying oil for storage is not prohibited under current sanctions.

Yves here. Let me stop for a second. Oil storage capacity is limited. Basically, contrary to what intuition would tell you, oil does not store very well. Hopefully readers can provide any update/correction if needed, but storage capacity relative to normal use levels back in the runup to the crisis was 51 to 55 days. That is why when speculators are stockpiling oil on a widespread basis, you read about full oil tankers wandering around like the Flying Dutchman. It’s normally easier to store oil by leaving it in the ground or by stockpiling finished product, particularly energy-dense diesel.

In other words, buying for storage has limits…but in reality, these traders are just taking oil into storage in one door and selling it out the other. I would hazard this intermediation mainly adds costs and complexity rather than amounting to meaningful stockpiling, particularly in light of the oil shortfall. Back to the Dallas Fed:

…the main reason Russian crude oil and refined product exports have been at risk since Russia’s invasion has been the refusal of financial institutions to back such transactions. In addition, oil tanker rates for Russian destinations rose to record levels, reflecting public pressure on oil companies to avoid purchasing Russian oil, fear of official sanctions on Russian energy exports at a later date and attacks on vessels in the Black Sea. This outcome was largely unanticipated, as U.S. and European Union sanctions originally deliberately excluded Russian energy exports.

Another dimension in which the current event differs from historical precedent is that the reduction in Russian oil exports was preceded by a cut in Russian natural gas exports to Europe. Natural gas is used for home heating, for power generation and in industrial production. For example, it plays a central role in the production of fertilizer. The resulting price increases to various degrees have spread across the globe through trade in liquefied natural gas.

The paper then goes through alternate suppliers, and how the Saudis and UAE (at least presently) won’t make up the shortfall or how, like US shale players, they can’t, at least not in a time frame that will have a big enough impact. Again from the article:

Thus, unless the Russian petroleum supply shortfall can be contained, it appears necessary for the price of oil to increase substantially and to remain elevated for a long period to eliminate the excess demand for oil….

…if the bulk of Russian energy exports is off the market for the remainder of 2022, a global economic downturn seems unavoidable. This slowdown could be more protracted than that in 1991.

For those of you who remember the 1991 recession, it was very nasty, hit the oil and gas sector hard (along with Citibank, which almost went under thanks to heavy exposure to speculative commercial real estate projects in the oil patch) but was short lived. The economy rebounded faster than most economists anticipated because Greenspan engineered a very steep yield curve that allowed damaged banks to repair their balance sheets fairly quickly via simple-minded “borrow short-lend long” which Greenspan made particularly profitable.

I don’t see any conjurer’s tricks for getting out of this downdraft easily if the Dallas Fed’s scenario pans out.

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¹ The conveniently timed damage to the Carpathian gas pipeline to Southern Europe and loss of supply though it for at least three weeks could fall in this category.

² Note that once Gazprom got the Euros to a Russian bank, it could presumably transfer them to a sanctioned Russian bank if it also had bank accounts there. But that wrinkle does not matter much for the big picture.