Too much trouble
Can investors profit from the impasse between Russia and Ukraine?
by Kateryna Arriaga Frias and Peter Barišić
I
n times of crisis, the political situation gains
more and more importance. States can use
the economy as an instrument of foreign
policy and impose sanctions, which then initiates boycotts from the opposite side. This is
happening at present in the ongoing geopolitical crisis in Ukraine, in which Russia and
Ukraine are key players. The consequences of
the troubles in eastern Ukraine are going well
beyond that country’s borders and are having
This is the latest in a series of articles on eastern Europe
that bulwiengesa AG is writing for The Letter – Europe.
Further articles will focus on the remaining countries and
groups of countries in the region. Together, these articles
will provide a comprehensive insight into eastern Europe
and the environment for real estate investors.
an impact both on world politics and on the
international financial markets.
Ice Age — but no new Cold War
The current crisis in Ukraine has seen the
United States and the European Union impose
tighter sanctions on Russia and prominent Russians. These measures are directed primarily
at the Russian financial, energy and defence
industries. Banks were defined as a particular
target. Russia’s financial institutions have to be
prepared for a disconnection from international
capital markets, which will make refinancing
more difficult. This, in turn, will limit the ability
of the banks to finance the Russian economy.
As a result of the limited access to western markets for fundraising, the Russian rouble could
Copyright © 2014 by Institutional Real Estate, Inc. Material may not be reproduced in whole or in part without the express written permission of the publisher.
The Letter – Europe | 1 | October 2014
come under further pressure and short-term
interest rates might have to be raised further.
How much the Russian economy depends
on international capital markets cannot be said
for certain. However, London and Vienna would
be particularly affected by additional sanctions,
as they are considered to be centres for Russian
financial transactions in Europe and the United
States. Conversely, however, lots of western
money is deposited in Russia. Among the individual banks, the biggest lenders are France’s
Société Générale, Italy’s Unicredit, Austria’s Raiffeisen Bank, Hungary’s OTP Bank and the Scandinavian Nordea Bank. The same applies to the
foreign direct investments of western companies
in Russia.
In the event of further sanctions against Russia, a recession there is inevitable. The reasons
for this are the sanctions by the United States
and the EU, the flight of capital from Russia
and the low investment rate. Even before the
Ukraine crisis, the Russian economy was weakening. The times when annual economic output
grew by 5 percent or more disappeared with the
global financial crisis — in 2013, GDP growth in
Russia was down to 1.3 percent and the forecast
for 2014 is for growth of only 0.2 percent.
Another inhibiting factor is the withdrawal
of foreign money from Russia. According to the
Russian Central Bank, around $75 billion (€57
billion) was taken out of the country in the
first half of 2014, twice as much as in the same
period last year. By the end of the year, investors
may have taken some $150 billion (€114 billion)
out of Russia.
Investors in international financial markets
are primarily guided by sentiment. The current situation on the Russian market is tense.
The Russian Central Bank recently raised its key
interest rate by half a point to 8.0 percent in an
effort to reduce the capital outflow.
Sanctions will not solve the conflict
In contrast to the Russian financial crisis of 1998,
this time Russia is much better prepared: today,
for example, the country has enormous gold
reserves. In addition, it has a low level of debt
and can fully finance its expenditures from its
revenues. Russia is one of the largest owners of
gold in the world, has a stable state budget and
is economically independent of the West; that
cannot necessarily be said of western countries
in relation to Russia. In this context, the EU’s
dependence on Russia’s oil and gas should be
mentioned.
Unlike many other countries, Russia stores
its own gold; there is, after all, plenty of room.
In addition to its enormous gold reserves, Russia
has huge amounts of foreign currency reserves,
especially US dollars. Only four countries in
the world hold more foreign currency reserves
than Russia. These are Japan, China, Saudi Arabia and Switzerland. In addition to large foreign
exchange reserves, Russia also holds US Treasury bonds; however, this holding was recently
reduced by about a quarter within a year.
This shows Russia’s clear-cut course to
reduce its relationship with US dollars and Treasury bonds and to enter into new agreements
with Asian currencies such as the Chinese yuan
or the Hong Kong dollar to protect itself from
the western sanctions. This trend symbolises an
increasing orientation toward China: one longterm effect of the crisis in eastern Ukraine may
be a loss of lucrative business in Russia by western companies to Asian competitors.
Another advantage that Russia has is relatively stable household finances in comparison
to the United States and the euro zone. In 2013,
Russia’s government debt ratio was only about
14.0 percent (United States: 101.5 percent, euro
zone: 92.6 percent). Similarly, the budget deficit was only –1.3 percent (United States: –4.1
percent; euro zone: –3.0 percent), although the
country spent billions of euros on the 2014 Winter Olympics in Sochi (and is preparing to spend
billions more on the 2018 FIFA World Cup).
About two-thirds of the Russian economy
is dominated by the oil and gas business. At
the same time, Europe is heavily dependent on
these raw material supplies, and this, in turn,
emboldens Russia to escalate its actions with
impunity over time. Recently, a natural gas supply agreement worth almost €300 billion was
signed with China, starting in 2018 and featuring
a contract period of 30 years. Thus, Russia is
Principal data for Ukraine, 2008–2016
2008 2009
2010
2011 2012 2013 2014f 2015f
2016f
GDP growth (%)
2.3
–14.8
4.1
5.4
0.2
0
–6.7
–1.2
0.7
Inflation rate (%)
25.2
15.9
9.4
8.0
0.6
–0.3
10.2
9.1
5.6
6.4
8.8
8.1
7.9
7.5
7.2
8.4
8.3
8.1
Current account balance (% of GDP)
–7.1
–1.5
–2.2
–6.0
–7.9
–8.7
–5.6
–4.8
–4.6
State fiscal balance (in % of GDP)
–3.2
–6.3
–5.8
–1.7
–3.5
–4.2
–7.1
–6.6
–6.0
Government gross debt (in % of GDP)
20.5
35.4
40.5
35.1
35.4
38.8
46.2
51.3
54.9
Unemployment rate (%)
f = bulwiengesa AG forecast, July 2014
Source: bulwiengesa AG
The Letter – Europe | 2 | October 2014
Photo by Kateryna Arriaga Frias
The Opera House in Odessa, the third largest city in Ukraine, with a rich history dating back to the Ottoman and Russian empires
reducing its dependence on demand for energy
from Europe.
Currently, the limitations of the West’s efforts
to influence Russia’s behaviour can be seen in the
attempt to oppress Russia with sanctions. In fact,
the western countries are inflicting damage on
themselves. The immediate harm to Polish agriculture will amount to around €500 million. The
Polish Central Statistical Office has announced
that Polish exports to Russia slumped by 10.7
percent in the first half of 2014. Furthermore,
the Russian economy can benefit from the commodities market as well as major infrastructure
projects such as the preparations for the FIFA
World Cup in 2018, the construction of a bridge
to the new state territory of the Crimea and the
expansion of the Trans-Siberian Railway.
On the verge of economic collapse
Ukraine’s economy is going through a difficult
period, due to the unpredictable geopolitical climate and the current military activity in the east
of the country. Moreover, the decision to row
back on the economic relationship with Russia is considered to be fatal for Ukraine. In this
Europe-oriented situation, Ukraine is likely to
become just the next huge marketplace for primarily western goods. At the same time, Ukrainian goods are unlikely to be hugely attractive to
European companies and consumers. However,
Ukraine’s economy is still somehow being kept
afloat, principally through the use of remaining
reserves. But how long these will suffice …
The road to nowhere
A sharp decline in people’s incomes and social
benefits in Ukraine, as well as the introduction
of new taxes, such as the new 1.5 percent “military” tax, aimed at reinforcing the state budget
and to continue sponsorship of the anti-terrorist
operations in eastern Ukraine, are leading to
higher unemployment levels and worsening living standards.
The newly-elected government is not coping well with the crisis. Heavily indebted and
almost in a state of civil war, Ukraine finds itself
in the worst situation ever. Conflict has gripped
precisely those manufacturing and heavy industrial areas that have acted as the economic locomotive of the country: Donetsk and Lugansk.
The United States and the EU, of course, have
announced financial assistance for Kiev. This
financial support may just be enough to pay off
the debts, but no more. Especially now that the
Ukrainian government is spending all its funds
on the needs of the Ukrainian army rather than
on the country’s economic recovery.
Democracy for the poor
Ukraine’s prime minister Arseniy Yatsenyuk
recently presented the updated forecast of the
Cabinet of Ministers; according to this, the inflation
The Letter – Europe | 3 | October 2014
Principal data for Russia, 2008–2016
2008
2009
2010
2011
2012
2013
2014f
2015f
2016f
GDP growth (%)
5.2
–7.8
4.5
4.3
3.4
1.3
0.2
1.4
2.1
Inflation rate (%)
14.1
11.7
6.9
8.5
5.1
6.8
7.0
5.9
5.3
Unemployment rate (%)
6.4
8.4
7.5
6.5
5.5
5.5
5.7
5.6
5.5
Current account balance
(in % of GDP)
6.2
4.1
4.6
5.1
3.6
1.6
1.3
1.1
1.0
State fiscal balance
(in % of GDP)
4.9
–6.3
–3.4
1.6
0.4
–1.3
–1.2
–0.8
–0.4
Government gross debt
(in % of GDP)
7.9
11.0
11.0
11.7
12.5
14.0
15.6
16.2
16.6
f = bulwiengesa AG forecast, July 2014
Source: bulwiengesa AG
rate for 2014 will be 19.5 percent, the reduction in
real wages will be –6.5 percent and the fall in GDP
will be –6 percent. New utility tariffs and the 50
percent devaluation of the hryvnia should also not
be forgotten. The current administration is managing to divert the attention of Ukrainians away from
its dubious achievements, shifting responsibility
on the deposed government and on Russia.
However, the start of the next heating season
is likely to bring a new wave of social dissatisfaction. The problem with the gas transit system
of Ukraine remains unsolved and inadequate
supplies of gas in the country is threatening all
Ukrainians with spending the coming winter in
unheated apartments. The question of who will
control the gas transit system of Ukraine — local
oligarchs or western investors — remains open.
The 1.5 percent “military” tax took effect at
the beginning of August. Moreover, all tax rates
on hydrocarbon production, oil, gas and ore as
well as excise taxes on cigarettes without filter
were increased. In addition, from 1 August, a
15 percent tax on income from savings deposits
was introduced. All these innovations were necessary for Ukraine in order to obtain the next
tranche of financial aid from the IMF and the
World Bank.
Once again, the government found a compromise and redistributed the budget in favour
of the army and the oligarchs, simultaneously
tightening the belt of public sector employees. Thus, it is just a succession of temporary
plugged gaps, but the ship is still sinking …
“Waiting for a miracle”
The situation with the real estate market in Ukraine
is rather ambiguous. On the one hand, the crisis
has not spared the real estate market from adverse
effects, and on the other it can become a platform
for new opportunities. Market participants are
now actively working on the development of the
property sector and attracting investors for new
projects. The only exception is in the eastern part
of Ukraine, where the anti-terrorist operations are
being carried out and are resulting both in severe
damage to infrastructure and superstructure and in
significant dislocation and loss of life.
The current crisis is having a rather peculiar
impact on the commercial property market. The
devaluation of the national currency, the sharp
decline in the purchasing power of the population and, consequently, lower retail sales have
negatively influenced the property market as a
whole. Some retailers were not able to stand the
pressure of the crisis and the local competition,
and left the market. This is evidenced by the
exit from the Ukrainian market of the German
retailers OBI and Praktiker, as well as the Baltic
retail group Baltika Group. International investors could take advantage of this and begin to
implement an expansion strategy in Ukraine. But
for this they would need to feel that Ukraine is
starting to implement measures to overcome the
crisis — and considering the current situation in
eastern Ukraine, it does not seem likely that the
conflict can come to a speedy resolution.
Ukraine was not at the top of international
investors’ property shopping lists at the beginning
of the crisis. The most active players on the Ukrainian real estate market were always Russian investors. The current conflict with Russia is worsening
the already unfavourable investment climate in
Ukraine. Investors need to see positive steps to
a stabilisation of the political and economic situation in the country and an improvement in relations with Russia. Moreover, important measures
in attracting foreign capital should be investment
by the state in infrastructure and transport systems, the development of high-quality residential
assets that prospective tenants actually want to
live in, the introduction of legislation on the protection of investor rights, and an increase in the
transparency of the market. v
Kateryna Arriaga Frias (arriagafrias@bulwiengesa.de)
and Peter Barišić (barisic@bulwiengesa.de) are
research analysts at bulwiengesa AG, based in
Munich.
The Letter – Europe | 4 | October 2014