Gulf Air, the national carrier of Bahrain, announced the launch of direct services to Moscow in early August. The new route, to open in October, is intended to support the strengthening trade, investment and tourism ties between the Gulf and Russia.

What would usually be considered a fairly straightforward new route launch has been made far more significant by the timing of the agreement, coming just as Russia acutely needs to forge new alliances as the pressure of sanctions imposed by Western powers intensifies. It coincided with news that Russian low-cost carrier Dobrolyot, operated by Aeroflot, suspended flights after its airline leasing agreement was cancelled under EU sanctions because it flies to Crimea.

Diplomatic ties

In recent weeks, Russia has been actively carving out stronger diplomatic and economic ties in the Middle East and North Africa (Mena) region. It signed a preliminary multibillion-dollar oil deal with Iran in August, which would see Moscow buy thousands of barrels of oil a day in exchange for goods.

Egypt’s newly elected president, Abdul Fattah al-Sisi, met Russia’s President Vladimir Putin in Moscow on 12 August to boost trade and military cooperation. A food import deal was also discussed in the wake of Russia’s decision to ban certain products from Europe in retaliation to sanctions. Putin said Moscow would welcome more imports of Egyptian oranges, potatoes and other agricultural products.

In June, the UAE Economy Minister Sultan bin Saeed al-Mansouri met his Russian counterparts in Moscow to discuss an economic cooperation agreement, pledging to increase trade between the two countries.

The latest wave of sanctions from the US and Europe were imposed shortly after the downing of a Malaysian passenger jet in July, allegedly shot down by pro-Russian rebels in Ukraine. The embargoes specifically target Russia’s state-owned banks and ban European and US banks from doing certain kinds of business with these financial institutions.

This could create a significant funding challenge for Russia in the medium to long term, with the country’s banks and corporates having traditionally tapped the European debt markets for billions of dollars of financing.

Emerging markets, such as the Middle East, therefore could offer Russia not only new diplomatic, economic and trade alliances, but could provide the country with an alternative source of funding.   

EU sanctions

The latest EU sanctions specifically target Russia’s major state-owned banks. They are barred from accessing Europe’s capital markets for bonds, equity or other financial instruments with a maturity of more than 90 days. Loans are excluded from the sanctions.

The blacklisted banks include Sberbank, VTB Bank, Gazprombank, Vnescheconombank (VEB) and Russian Agriculture Bank.

The US followed the EU’s steps by also barring US banks from dealing with several Russian banks. But it is the European sanctions that will bite the hardest, given the high volume of debt Russian banks typically raise on European markets.

Although the EU sanctions do not prohibit all business between European banks and selected Russian banks, the legislation has sent ripples of fear through the financial centres of Europe, with many banks scaling back or halting all Russian banking activity.

With large-scale penalties for breaking sanctions being handed out to international banks on an increasingly regular basis, such as those linked to Iran, bankers do not want to be caught out if sanctions against Russia become even tougher.

A funding crisis

Russia’s banking sector will not immediately plummet into chaos, with its central bank and the government having enough funding to prop up the sector if needed in the short term.

Currently, state-owned banks are in a relatively healthy position, with VTB Bank issuing a statement in August in response to media speculation, saying it had not sent Moscow a request for state support and that it is not experiencing any liquidity problems.

Analysts say Russia’s strong foreign exchange position will not create any immediate exchange funding problems. State-owned banks currently have $33bn-worth of short-term debt due over the next 12 months.

The potential problems lie in the long term and depend on how long the sanctions will last.

If EU-Russia negotiations are successful, sanctions may be short-lived, but if they drag on, a lack of access to external capital markets could hinder long-term funding plans for banks and corporates alike.

Sanctions will also place pressure on the central bank and push up the cost of funding for state-backed banks, which in turn will push up costs for Russia’s private banks and corporations.

The central bank, which has reserves of $480bn, has already hiked its rates, and further increases are likely.

“The cost of credit in Russia will increase sharply, particularly as state-owned banks account for over half of banking system assets,” read an economist note from London-based investment firm Schroders.

There will be a point when it might be cheaper for Russian banks and companies to raise money in markets unaffected by the sanctions.

“Russian state banks have started exploring other markets,” says Grigory Marinichev, partner at Morgan Lewis law firm, based in Moscow.

“If you cut them off from European and US markets, there are three alternatives available. They can get funding from the government, local funding from deposits from Russian companies and individuals, or you go to other markets such as Asia or the Middle East,” he says.

A Middle East solution

It is still too early for any major Russian-Middle East financing deals to be signed since the sanctions were imposed.

Yet there have been some preliminary investigations by Russian bankers about the potential of the Middle East, particularly the Gulf market.

“We are, in fact, starting to look East in light of the recent events. I have been to Dubai a number of times recently as we look to work with that region,” says one source from a privately-owned Russian bank.

Marinichev adds: “Given the high liquidity in the Middle East, and the trend among the Middle Eastern governments to diversify markets, this could be considered as an open alternative for Russian banks and corporates.”

Strengthening Middle East and Russian banking relations predate the recent sanctions, but the current situation is encouraging greater ties.

Russian investment bank, Renaissance Capital, is set to open a new office in Dubai this year and has made several new hires to support its expansion in the Mena region. 

Qatar has existing investments in Russia, with its Qatar Investment Authority (QIA) being one of three sovereign wealth funds to acquire stakes in VTB Bank during its share sale last year.

The Russian Direct Investment Fund has also been signing billion-dollar agreements over the past few years with all the major Gulf sovereign wealth funds. This includes a $2bn deal signed in May with the QIA, which will see the Qatari entity invest in Russian projects.  

Islamic finance

Russia is also eyeing opportunities to raise money in the Islamic finance market, which will inevitably involve the many Islamic banks headquartered in the Middle East.

In August, a lobby group representing Russian banks wrote to the central bank in Moscow asking for the promotion of the Islamic finance market, calling for the introduction of new legislation to govern this segment.

The letter concludes that the development of a regulated Islamic finance market would not only be of benefit to Muslims living in Russia, but also attract foreign investment from the Middle East and Southeast Asia.

This is not a short-term solution to Moscow’s immediate financing needs, but is a long-term option to lessen the country’s reliance on European markets.

Asian competition

Middle East market is not the only alternative market for funding for Russia, with Asia, particularly Hong Kong, potentially proving to be a more attractive prospect.

Russian banks and corporates have already made more concrete inroads into this market than the Middle East.

Indeed, one Dubai-based banker remarks that the Gulf could end up just “being a place for Russian oligarchs to park their money”, rather than seeing any significant growth in Russia-Gulf banking business.

One reason the Russian banks might see Hong Kong and other Asian finance hubs as their first port of call is due to the range of currencies they can access.

“It is more likely that Chinese financial markets and investors, having a broader basket of currencies available to spend, are in a better position to offer euros than investors in the Middle East,” says Antonio Timoner-Salva, senior economist at risk consultancy IHS, based in London.

Apostolos Bantis, a credit analyst for Germany’s Commerzbank, based in Dubai adds: “The prospects for these markets to develop are a lot higher than developing banking ties with the Middle East. It is definitely an option – but I think it will be a lot more difficult.”

Already in April, there were reports of Russian companies and banks such as Sberbank and Gazprom meeting Asian investors, discussing raising debt in currencies such as the Singaporean dollar or raising ‘dim sum’ bonds, which is debt provided in Chinese yuan, but sold outside China, often in Hong Kong.

Debt requirements

Yet, both the Gulf and Asias have limits on their capacity and there is a question mark over whether even these markets combined could provide enough liquidity to support Russia’s debt requirements.

Neither the Middle East nor Asia will be a panacea for Russia’s potential funding problems, but they will provide a stop-gap in the absence of any immediate reconciliation with the West.

More importantly perhaps than a provider of funding, the Middle East is also set to be useful economic and political ally for Russia.