Two sides of sanctions: how they will affect the economy of Russia

ICU
ICU
Aug 22, 2017 · 6 min read

Alexander Valchyshen for European Pravda, in Ukrainian, August 03, 2017

The US has finalized the introduction of new sanctions against Russia, Iran and North Korea.

This initiative is promoted as a profoundly new step towards undermining the Russian economy. Is this interpretation accurate? How America’s new sanctions will actually affect Russia’s economy?

Sanctions still weak

In my view, the latest package of sanctions remains too weak as an instrument to punish aggressive international behavior of Russia’s leaders.

For instance, the financial sector will see a certain reinforcement of last year’s restrictions and sanctions against the use of America’s financial system. This can make it more difficult for the Russians to use financial innovations in order to show the international community that they are doing great.

Some examples of such financial innovations include complex international transaction schemes: the biggest one was implemented by the Russians in the recent “privatization” of a 19.5% stake in Rosneft.

At that point, the financial press was surprised to find out that VTB bank, an entity under sanctions, was part of the international consortium (with the Swiss company Glencore, Qatar Sovereign Wealth Fund and the Italian bank Intesa) in the sale of a state-owned stake that ended up in the hands of undeclared private investors.

Another step to counter the sanctions was the issuance of sovereign eurobonds by the Russian government that generate significant interest among international investors but are based on the local (Russian) financial infrastructure. Once again, the VTB Capital investment bank, an entity under sanctions, is engaged.

Even though the current sanctions do not prohibit American investors to buy Russian government debt or trade with VTB, the mere actions of placing sovereign bonds among American investors is presented by Russia’s government as a sign of weakness of the sanction regime.

The new package of sanctions allows the introduction of a ban on investment in Russian sovereign debt, including “the full range of derivate products”, by American citizens and financial institutions. This ban is not introduced automatically after the law takes effect. It may (!) come into effect after the Congress’ public discussion of the joint report by the US Department of the Treasury, Department of State and Director of National Intelligence.

This is not a critically fatal blow to Russia’s economy. It can create a new brief wave of volatility on the foreign and domestic market of Russian sovereign bonds.

However, the strategic vector in the development of the Russian economy is to use the domestic financial system. Therefore, sanctions will only boost transition to it.

It is important to recall the history of the eurobond market, or something known today as the international debt market. It appeared in the 1960s and was largely based on what remained of the Soviet government’s deposits in the American bank system in US dollars. One of the key impulses leading to the emergence of this market, a serious innovation in itself, was the desire of the Soviet government to avoid control by the Federal Reserve while retaining continued revenues. Moscow Narodny Bank, the Soviet bank based in London (hereinafter referred to as MNB), played the leading role. Eventually, more players got involved in the market turning it into a full-fledged element of the international financial system.

Thus, the Russian financial engineering has a good tradition of adapting and finding bypasses when faced with pressure from external restrictions.

In the 1960s, the geopolitical situation was no less complex than it is now: 1962 saw the Cuban Missile Crisis and 1968 saw Soviet invasion of Czechoslovakia. America responded with sanctions back then too: it froze the US dollar-denominated assets stored at deposits at the London-based MNB and opened in the American financial system.

This was a serious step: the MNB was the major (if not the only) settlement bank in the trade with the West for the Soviet Union and other states of the socialist block. The equivalent today would be the freezing of Russia’s foreign currency-denominated reserves deposited in the US.

At that point, Soviet financiers managed to solve this difficult situation partly by flirting with other developed countries that were trying to tame aggressive geopolitics through more active development of economic ties between the West and the East.

This time, American sanctions do not freeze Russian accounts in the US financial system, yet they create a threat for Russia’s sovereign debt and its derivative products on the domestic and international markets.

In my view, a stricter sanction regime would be a combination of freezing the accounts and banning transactions linked to Russia’s government debt.

It is possible that a new wave of sanctions will be viewed by the Russians as an incentive to turn to financial innovations through Asian financial centers, strengthening cooperation with China.

It looks like the international financial system has a natural feature: its participants adjust to changes through innovations, especially when there is demand for them.

Early political impact

Realistically, the sanctions, old and new, play in the hands of Russia’s political leadership both in short- and long-term prospect.

In the short run, they encourage further consolidation of the majority of people around the Russian leader in the run-up to the presidential election. In the long run, they give Russia an opportunity to blame the West of all the problems faced by the Russian citizens as their country’s economy changes inevitably.

The presidential election campaign has effectively kicked off in Russia already. There is no doubt about who will enter the presidential office for the next term. However, the Kremlin’s task is to turn the process into a show aimed at legitimizing the newly elected president through higher voter turnout and a high share of votes in support of the “leader”.

The Russian media have been talking about the “70/70 strategy” implemented by the Russian Presidential Administration since last year. It aims at getting a 70% turnout and 70% of votes given to Vladimir Putin in the elections.

The election rhetoric about the West that is “acting with special cynicism” will work to prop up this strategy.

A new model for Russia’s economy

It is for this reason that the efficiency of sanctions should only be viewed in the context of their mid-term prospect. What can they deliver?

Russia’s economy is currently in an unsatisfactory state both in the eyes of the citizens, as poverty rises, and in the eyes of the country’s leadership. Yet, even in this situation, Russia’s government has long (and fervently) adhered to the orthodox economic formulas of the IMF and the World Bank.

For instance, the Russian government essentially uses the language of the IMF when it designs and fulfills the state budget aiming at a rapid shrinking of deficit. The same trend can be seen in the monetary policy with the floating exchange rate and inflation targeting introduced and accomplishing its goal of consumer price inflation at 4% this year.

The key advantage of the Russian economy today is its ability to quickly establish price controls which is a sign of stability in the eyes of average Russians. However, it has its flaws.

Today’s Russian economy model overlooked the global financial crisis of 2008 and brought forth the problem of inequality (including in the developed countries, not just in Russia). Moreover, it led to an internal economic problem in Russia in 2012–2013. The leadership decided to mend it with a hasty solution of a complex geopolitical game under the “Crimea Is Ours” and “Ukrainian Crisis” slogans.

Western analysts and Alexei Kudrin’s economic doctrine say that sanctions will continue to prevent investment from going into Russia’s economy. In their words, this will prevent the economy from growing at the desired 4%. In my opinion, this approach has certain flaws.

The Russian economy had been working under Kudrin’s doctrine until 2014, too. Yet it found itself in a state of crisis long before sanctions had come in place.

Therefore, Russia’s economy will try to diversify from oil and dependence on foreign money as much as possible within the next six years.

If it succeeds, western sanctions will no longer be a crucial factor affecting Russia’s economy. If it doesn’t, the sanctions will have served their purpose.

The sanction story leads to two key conclusions. One is that they can hamper technological development of Russia’s economy and its key industries, while also allowing the current government to implement changes in the economy from a more comfortable position as it exploits these sanctions to its benefit (at least, in the short-term prospect).

The success of the sanctions depends on whether Russia succeeds in transforming its economy.

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ICU

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ICU

ICU is a Kyiv based financial services group that provides securities trading, IB & AM for both private & institutional investors. http://icu.ua

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