13 min read

Offers you can refuse

Russia's coercive signaling is about Zelensky, not US sanctions
Offers you can refuse

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Well, to everyone’s surprise, the recommendations from within OPEC+ to hold production down till September were amended, reportedly after a conversation between Mohammed bin Salman and Putin. The plan now is to lift production quotas by 350,000 barrels per day (bpd) in May, then 450,000 bpd in June followed by another 450,000 bpd in July. What’s more, Saudi Arabia will unwind its voluntary additional 1 million bpd cuts from February alongside the reduction in OPEC+ quotas by 250,000 bpd in May, 350,000 bpd in June, and 450,000 in July. We’re looking at a flood of new production relative to where demand is likely to be at the moment, though it’s always possible demand surprises towards the upside. To many, it’s completely incoherent to propose a 2 million bpd output increase after announcing a 300,000 bpd demand growth reduction for the year. All we know is that Putin and MbS supposedly talked about everything — green energy and climate change too, not just oil — and MbS opted to push for a big output increase afterwards. It’s a confidence game. Oil prices recovered all ground lost since the Suez Canal closure and new lockdown announcement in France hit:

The market is now more convinced of a demand recovery because OPEC+ doubled back on its own forecasts and urge for caution and is betting on a stronger demand recovery, at this point largely down to the US stimulus and hopes that come summer, a lot of people with cabin fever and some savings take more flights and so on. The other factor that’s fairly obvious on the Russian end is that they need to slowly step up output to improve domestic industrial orders and get more people spending again given the overall bad underlying data from 1Q that does not herald a strong recovery. It’s important to note that all the real action right now on the oil market driving price shifts is in the US asa refineries are getting back to solid utilization rates and shifting their runs. Gasoline stocks are being drawn down while distillate stocks linger, a reflection of adjusting output to maintain production for middle distillates i.e. diesel used by trucking, marine diesel, or extra light heating oil — demand was relatively unaffected by COVID — shifting to gasoline as driving picks up once more:

Expect the US oil & gas lobby to frantically lobby Congress not to kill their subsidies over the next 3 months as the infrastructure bill rollout moves forward. API, one of the industry’s biggest groups with lots of lobbying pull, came out in support of carbon pricing on March 25. If they’re smart, they’ll try to argue to keep subsidies in exchange for a carbon tax to raise those same revenues. If Congress is smart, it’ll work with them to do so. Raising extraction costs significantly will destroy lots of existing union or else well-paying skilled labor jobs that geographically would be moved around, costing lots of families in the process. Taxing the externality first before rolling back subsidy support lengthens the runway while still achieving the same ends. Putin and MbS may pull off an expansion of their market share, but even if US drillers cede ground with a $60-70 price band, a carbon price suddenly means the US has to use border adjustment to better balance imports and exports and then we’re off to the races.

What’s going on?

  1. The bargain with regions over their debts was simple — the center would restructure them in exchange for that money going right into new projects intended to maintain investment levels across the country and economy. So far, 49 of 69 regions have are using the restructuring measure, but only to the tune of 98 billion rubles ($1.29 billion) vs. the intended 420 billion ($5.5 billion). The government is hoping that they take up the full volume of credit support by the end of the year because of Putin’s executive order to do so. According to MinEkonomiki, about half of the sum to be spent so far is going to projects authorized by the ministry after review with the rest at the “last stage” of the process. This comes on top of the 200 regional projects that have been marked for 1 trillion rubles ($13.15 billion) under the current infrastructure initiative to get building. Per MinEkonomiki’s accounting of the spending that’s being done now, that 98 billion ruble figure is meant to draw in 1.3 trillion rubles of investment in total from private sector sources and end up creating 64,000 jobs. These are simply unbelievable figures that can’t have any basis in reality. They read like a McKinsey report upselling a host government on some green zone fantasy in a country rebuilding from war. The Kommersant writeup suggests spending levels will rise over the year, and I agree with that. But to suggest they’ll be spent effectively, especially when there’s such weak effective demand within the economy and infrastructure spending is working off such a relatively low base that the multiplier effect, while real, would seem to be limited in my view and unlikely to materially change revenue problems at the regional level.

  2. Russia’s begun the process of establishing a legal framework to integrate small solar generation at homes and stores onto the grid, paving the way for future disruptions to the price stability promised to leading energy firms without some care. The following graphic shows up a bit small from the space constraints but compares generation (salmon) with demand (black) for homes in Adler and stores in Rostov-on-Don on a monthly basis:

    The basic lessons is that for homeowners, we’re talking about 5ish months of the year where generation capacity matches or exceeds demand levels, something that never happens for stores based on the assumptions here. Grids still matter a great deal and it’s not going to necessarily undermine the earnings of large power companies, especially since it’s expected there may be shortfalls of generating capacity after 2025. The law in place now states that there are no limits on home generating capacity, but only 15KWh can be sold to the grid. Rosset’ is worried about low quality generation i.e. instability for output so and the fear of system instability from a rising share of renewables is definitely one that seems likeliest to help Rosatom in the long-run for domestic investments. Overall, the real development should this process get underway is to change the pricing dynamics for power markets in Russia as more flexible supply traded at spot prices comes on-grid and challenges the arrangements that frequently pay state-guaranteed fixed rates up to a certain level of generation provided to the grid, only after which contract mechanisms and spot prices matter. The national market isn’t designed for spot pricing, and spot pricing poses problems when you look at the massive distances often involved for transmission and limited local demand once you’re outside of well-settled European Russia. It’s still going to have to shift the more local generation like solar panels on homes comes into play, particularly with the currently lackluster investment levels for plant modernization expected to trigger power price inflation above 5-6% annually post-2025.

  3. Andrei Belousov’s efforts to improve the investment climate led to the creation of a unified system to determine levels of support for regional projects that includes a few ‘steps’: 1) an investment declaration laying out regional development goals and the means to stimulate investment 2) a set of investment rules that offer a “step-by-step algorithm” for investors in differing situations, including connecting to regional utilities networks receiving permission and 3) a digital investment map dynamically providing info on projects and the region 4) regional investment commissions that address problems as they arise. The fact that 1, 2, and 4 count as progress should be alarming and 3 is just an out-growth of the current hunt for data to ease all decision-making, topped off with a registry tracking all major projects. All of these things are meant to be uploaded to the unified information system for which Sber wants the contract. To be blunt, this effort is laughable. The real drag on investment nationally is the constantly shifting legal environment and lack of legal guarantees protecting investors, which then is worsened by poor infrastructure or financial conditions/returns and investors who have limited means of verifying if what they’re being told locally is actually true or going to pan out. Unstated in the coverage, my sense is that Belousov’s solution is another case of trying to expand the government’s capacity to gather data as needed, and then apply pressure to businesses to spend money. It’s more a mobilization tool for capital than an actual fix to the problems facing investors. The easiest way to get ‘de-risked’ money into infrastructure to improve investment — one of the two pillars of the strategy per government orders — then the state should just build it. The latter half — simplifying investment procedures — is a polite way of suggesting it’ll be easier to sell a bridge if some paperwork is cut. Nothing’s been substantively changed. We’ll see if anything comes of it later this year, though.

  4. In the wake of the CBR’s initial rate hike in March, private banks are scrambling to raise deposit rates and compete to hold more savings. Broadly, deposit rates are moving into a 5.5-6% band that will only rise in the months to come. It’s a logical balancing response as costs for bank borrowing rise. Perhaps more crucially, these increases will face more pressure the longer that inflation stays higher, less because the rate of return vs. inflation is abysmal but rather because people will be withdrawing more cash to pay for basic needs unless incomes rise as well. Overall, deposit rate hikes are set to outstrip key rate hikes. Where it gets a little more interesting is that state banks are slow-rolling these changes by comparison because of their earnings on lending and other factors affecting profitability. This dynamic is one to watch given that Rosstat found no slowdown for price inflation in March — the rosy predictions that inflationary pressure would peak by the middle of the month were salesmanship and not serious. Vegetables are now up in price 16.7% year-on-year, and I don’t think everyone wants to live on shchi. Savings rates have been going up, but how much of that reaches bank deposits if price inflation keeps pace is an open question. I’ll probably have to come back to this with CBR data in a few weeks’ time.

COVID Status Report

8,792 new cases reported alongside 400 deaths. Vitaliy Zverev, a virologist from RAN, thinks the pandemic in Russia will be over come August with the potential incoming 3rd wave a reflection of seasonality and not a substantive change in the national situation. The latest treatment breakthrough appears to be an immunoglobulin meant to treat COVID-19 made using plasma gathered from people who recovered from the virus. That’s really good news, and likely important as a supplement to the vaccine given ongoing skepticism. It doesn’t look like the state plans on taking COVID passports seriously at the domestic level for good now that they can cite fears of inequality between those who’ve been vaccinated and those who haven’t. The geography of infections is relatively static since February, as the case decline has plateaued:

Speak loudly, carry a big stick

Russian deployments of troops to Crimea and territories neighboring Donbas set off the usual firestorm of speculation that Moscow is threatening to significantly escalate the conflict. What’s crazy to contemplate is that a net deployment of 4,000 troops with tanks in tow is seen as enough to significantly alter the balance of a fight that’s locked into relatively entrenched positions on a front about 450 kilometers long resembling something more akin to trench warfare than open maneuver. The US government has leapt into the breach with Secretary of State Tony Blinken reaffirming the United States’ “unwavering support” for Ukraine. Of course, the situation is still dynamic and further deployments could well shift the picture on the ground. I defer to Michael Kofman on military matters, given that most of my understanding is cobbled together from reading military history and logical inference based on the logistics of military action, but I also agree with the political implications of his take on the current situation:

The question is why the coercive display of force now? There’s the take that somehow this aligns with an incoming US sanctions decision:

This makes no sense to me. Russian military decisions in Ukraine have never corresponded to sanctions risks and bear little relation to NS2.  If this is true, then why isn’t Moscow aiming its efforts at Germany? The real answer is that the domestic political outlook in Germany is shifting and there’s not much Moscow can do at this stage save hope that Biden’s team opts for a deal.

When arguments cite the effectiveness of western sanctions as having halted further Russian advances, the likelier explanations come from the fog of war and, eventually, Ukrainian military reforms only later buttressed by the post-Obama expansion of lethal aid. The most famous case is Russia’s failure to retake Mariupol in September 2014. The proof that sanctions risks stopped a further Russian advance hinge entirely on a rather generous interpretation of assumptions about being cut off from SWIFT that don’t align with what the Obama administration had communicated as of September 2014 as well as a host of assumptions about issue salience and the momentum of military operations once they’re underway. In effect, the source here from this IISS report by Nigel Gould-Davies — a great overview for how to think about the efficacy of sanctions on Russia — is an argument founded on causal inference without much to go on. It’s supported by what didn’t happen, which retrospectively is over-determined. Even if Russian forces can maintain escalation dominance, commanders have to know where the enemy is and what they have available. It’s hard to imagine that a field commander thought to himself “we won’t press the advantage now, they might deny us access to SWIFT…” no matter whether the military was briefed about the risks of excessive escalation (this assumes a huge amount about issue salience and military/political goals in the conflict).

Kyiv and the separatist governments in Donbas were blaming each other of escalation 3+ weeks ago, yet Washington and Brussels were largely silent on the matter. Ukrainian forces were identified by Russians as moving heavy weaponry and logistical support into position about a month ago. My claim isn’t that Ukraine escalated this situation, but that there’s been a broader buildup this year that almost certainly reflects the political interests of both Zelensky and his government as well as the local actors in Donbas and now Moscow. The question is what comes next. I don’t have much insight into what to expect on the ground, but I can’t see any reason to believe that the current escalation is anything other than a signaling exercise. Canada’s now pressuring Zelensky to further military reform to ensure complete civilian control of the military as a means of encouraging further support from NATO. NATO defense attachés have reaffirmed NATO support for Ukraine’s territorial integrity. Signaling exercises beget signals in response. The irony is that coercive signaling conceivably encourages the Biden administration to be more aggressive in adding sanctions onto Russia’s sovereign debt, which undermines the whole point unless Russia is willing to bear the costs of a military action that would have been far less costly in 2014. It’s incoherent logic and the kind that may reflect the more conspiratorially minded in Moscow or elsewhere, but is a gross miscalculation if so.

I’ve been pretty clearly of the mind that such sanctions would create a significant shock and political risks via capital outflows and risk premiums, but that overall, Russia can mostly finance its needs. My friend Max Hess argues for Riddle that setting aside the limited macroeconomic impact, if the US were to sanction trading on secondary markets of sovereign debt, it would drastically hinder Russian efforts to reprofile its debt and create pressure among creditors to Russia who want their money. In effect, sovereign debt sanctions would become the first order problem to be addressed in bilateral relations, only after which other issues could be managed. These are really important points to acknowledge and address and I highly suggest reading the piece in full. My main response in light of events in Donbas is that there is as yet no evidence Biden intends to sanction trading on secondary markets, with a sanction on primary issuances much more likely if the step’s taken, but more importantly, it’s a bit odd to think that sovereign debt sanctions would become the unmovable sticking point in bilateral relations when Crimea and the related sanctions already play that role. If the assumption is that the market’s reaction has hinged on ‘insider knowledge’ of intense sanctions to come, I assure you that information would be leaking in Washington and out in the open because the US government would want to provide more of a runway for US investors to unload their holdings as well as assure allies there won’t be secondary sanctions. That’s not to say there might not be harsher than expected action. It’s just remarkably difficult to keep major policy initiatives secret for long and to suggest that a declaration of war on sovereign debt would be the real final nail in the coffin in bilateral relations blocking progress elsewhere understates the extent to which Crimea became that issue for Moscow and the 2016 election became that issue for US policymakers.

The result is saber rattling without any proper means of ascertaining what is intended by any given signal. I don’t mean to suggest that a military standoff between the US and Russia is inevitable. There’s just no way to read the current escalation as a shock move from Russia, though unannounced and unscheduled it may be. Rather it denotes just how unwilling Washington is to take Ukraine to task over the risks it faces and its domestic political incentives to increase tensions, particularly if it’s the best way to get NATO and the West to through more resources at integration processes that the EU has ultimately failed to deliver on despite the continued majority of the population supporting eventual EU accession. Biden isn’t being tested. This isn’t a test, so far at least. It’s a reminder that Ukraine shouldn’t stick its neck out too far. Fortunately for both sides, moving front lines in trench warfare differs greatly from mechanized warfare moving quickly. The downside is obvious: it’s easier to signal with larger deployments like this without significantly changing the balance on the ground because of the level of numerical superiority needed to storm positions in this type of combat. Hopefully cooler heads prevail. Just don’t assume sanctions will have much to do with that.

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