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Pro-Russian men guarded barricades Monday in front of city hall in Slovyansk, eastern Ukraine. The city’s self-proclaimed mayor, Vacheslav Ponomarev, wants Russia to send peacekeeping troops after a shootout at a checkpoint manned by pro-Russia insurgents near the city.

Sergei Grits • Associated Press,

The Economist: Business in Russia goes from bad to worse

  • Article by: the economist
  • April 21, 2014 - 5:57 PM

Before the current standoff between the Kremlin and the West over Ukraine, it was already clear that Russia’s economic model, of strong energy exports fueling domestic consumption, was running out of steam. In 2007, on the eve of the global financial crisis, Russia’s economy grew by 8.5 percent. Last year’s growth was a ­meager 1.3 percent.

Still, the country’s population of 144 million, its entry into the World Trade Organization, its consumers’ aspiration to a Western lifestyle and its status as the “R” in the BRICs (Brazil, Russa, India, China) have persuaded multinationals to keep investing in plants in Russia, and foreign investors to keep providing capital to Russian firms. The attitude until recently, said Alexis Rodzianko of the American Chamber of Commerce in Moscow, was that “Russia’s economy may be slowing, but my own prospects are pretty good.”

Now the outlook for businesses there is looking gloomier. With pro-Russian separatists seizing government buildings in eastern Ukraine amid talk of a full-scale invasion, firms of all kinds fear a tightening of American-led sanctions, a cutoff of foreign lending and investment, and a further fall in consumers’ confidence.

The most immediate concern, especially for Western firms doing business in and with Russia, is the curbs the United States and the European Union have imposed on dealings with certain individuals. Even the somewhat stronger American sanctions imposed so far are, on paper, “pretty limited”, says Alexander Kliment of Eurasia Group, a risk-analysis firm. But they have created a “scare factor” that is magnifying their effect. For example, shares in Novatek, a gas producer, fell sharply when the restrictions were announced, on fears it might struggle to do deals with foreign partners or raise capital abroad. That’s because Gennady Timchenko, a friend of Vladimir Putin, is named on the American sanctions list, owns 23 percent of the company and sits on its board. If Igor Sechin, the boss of Rosneft, another energy firm, is sanctioned, the effect may be similar.

Foreign firms fret that sanctions also could create openings for competitors. American firms worry that the E.U.’s softer curbs may give its companies more flexibility. The boss of Siemens, a German engineering giant, met Putin in Moscow last month. Americans and Europeans alike worry about losing out to Asian rivals. Moscow business circles are full of rumors of Chinese executives trying to peel off contracts by urging Russian companies not to depend on Western ones, given the possibility of further trading restrictions.

Russian firms and politicians, in turn, are casting around Asia and elsewhere for new customers to replace those they fear losing from the West. Russia’s deputy prime minister, Arkady Dvorkovich, said the government hopes to finalize soon a long-promised deal for Gazprom to sell gas to China. Rosneft is seeking to treble its exports of oil to China. Sukhoi, a state-owned aircraftmaker, has just struck a deal to sell a fleet of small passenger jets to a Chinese airline, hoping this will offset any loss of orders from Western carriers. But its plane, the Superjet, is chock full of key parts from American and European suppliers, and thus its production is vulnerable to any tightening of sanctions.

For domestic firms, a bigger worry than the sanctions imposed so far is the risk of losing access to foreign loans, and what that will mean for investment, productivity and growth, says Elena Anankina of Standard & Poor’s, a ratings agency.

Western lenders are likely to honor existing loan deals, but they may be reluctant to provide fresh financing. Rusal, an indebted aluminum producer, is among the Russian firms most exposed to this. Some state banks, such as Sberbank and VTB, have indicated that they are ready to fill the gap left by Western lenders. But Anankina wonders how long they will be able to do so. Indeed, some Russian banks themselves depend on Western loans. With capital flight hitting $60 billion to $70 billion in the first quarter of this year, investment in domestic production — which the spluttering economy needs most of all — will be even harder to come by.

The fallout from Russia’s annexation of Crimea and further stoking of unrest in eastern Ukraine has put downward pressure on an already weakening ruble.

On its face, a cheaper currency should be a boon to domestic producers. But thinking that a “weak ruble is the way forward” is the “wrong paradigm,” argues Deutsche Bank’s Yaroslav Lissovolik. Many Russian manufacturers, like Sukhoi, depend on imports for inputs and equipment. And in any case, many are running near full capacity and will be unable to grab market share from foreign rivals without cash to invest in increasing output.

This confluence of economic bad news will hit a few industries first and hardest: consumer goods, construction, property and banking. Demand for the roughly half of Russian steel that goes to building projects at home will drop. Car sales, dependent on the availability of bank loans, will probably fall.

Copyright 2013 The Economist Newspaper Limited, London. All Rights Reserved. Reprinted with permission.

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