Two key ingredients to make the sanctions on Russia work
Two ingredients are needed for an effective offensive on the Russian economy. The main one is zero imports of Russian energy. The enabling one is full political unity among Western allies.
While the Ukrainian army is stepping up its counteroffensive, Western sanctions on the Russian economy are leveling off. To understand why and how to strengthen the sanctions, several questions are in order. How did the war affect the Russian and Ukrainian economies? Which factors are responsible for the meager effect of sanctions? And how can the West expand the counteroffensive on the economic front? My analysis points to four conclusions:
- The Ukrainian economy was hit many times more by the Russian military attack than the Russian economy was hit by the Western sanctions.
- The main reason for Russian economy’s resiliency is continued payments for Russian energy in the wake of high energy prices. Additional reasons are Russia’s investment in independent payment systems and the support of China.
- To impose a tangible economic cost on Russia, the West should phase out the Russian energy imports. The political will to do so relies critically on the unity between the EU, the US, and NATO countries.
- Stepping up the economic sanctions can aid Ukraine in future peace negotiations, but it won’t stop the Russian aggression. To effectively aid Ukraine, the West must provide military aid.
38 days into the war, what is the state of the Russian vs Ukrainian economies, and what are the forecasts?
Many financial news outlets have pointed out that Russian economy has turned out surprisingly resilient in the face of sanctions: the ruble recovered to almost pre-war levels, the stock market stabilized after the initial plunge, and GDP is up 5% year-on-year as of March 26th.
The Central Bank of Russia managed to prop up the value of the ruble with a mix of monetary policy measures (rate hike from 9.5% to 20%) and strict capital controls (all Russian exporters should convert 80% of their foreign currency earnings to rubles). On top of that, the recent Putin’s demand that European gas importers pay in rubles effectively means that 100% of EURs spent on Russian gas will be converted into rubles. Europe imports 40% of its natural gas and 27% of oil from Russia, with annual payments for these imports worth EUR 99 bn in 2021.
Granted, the black market exchange rates differ from the official ones. The difference seems to be larger in Russia than in Ukraine, suggesting some degree of artificial “price flooring” in rubles, due to capital controls among other things. For comparison, one can buy 1USD at the price of 132 RUB in one of the informal chat groups in Moscow (as of end of March), compared to Central Bank rate of 83.3 RUB. In Ukraine, one can exchange 1USD for 32 UAH (also as of end of March), compared to Central Bank rate of 29.5 UAH per 1USD.
The stock market performance is harder to gauge, given that Russian market only reopened on March 23rd, after 5 weeks’ suspension in trading. MOEX, the ruble-denominated index of 50 largest Moscow-listed companies, closed 2.6% higher on Friday (April 1st), with most of the gains coming from Banks (notably VTB and Sberbank) and Energy companies(Gazprom, Rosneft, Lukoil, among others). The Ukrainian stock market remains closed.
The Economist estimates that the Russian economy grew by 5% relative to the same time last year (as of March 26th), not least due to higher energy prices. At the same time, during the first month of war, 50% of Ukraine’s production capacity was shut down, and Ukraine is projected to lose up to 35% of its GDP in 2022, according to the IMF forecast.
Ukraine’s Economics Ministry estimates the total loss from war at USD 560 bn as of March 28, including USD 119 bn in infrastructure damage, USD 112 bn in unproduced goods and services, USD 90.5 bn in destroyed civilians’ property (houses, cars, and food), USD 80 bn in corporate losses, USD 54 bn in direct investments, and USD 48 bn in state revenue loss.
Which factors are responsible for the meager effect of sanctions on the Russian economy?
Sanctions is one of the pillars of Western support for Ukraine, along with military aid. While sanctions alone can’t defeat Russia, they do create leverage in peace talks, according to Ukraine’s foreign minister Dmytro Kuleba: “[Russian negotiators] feel the pressure of sanctions. Almost every tenth sentence they say is about sanctions.”
At the same time, the current package of sanctions has multiple loopholes allowing Russia to evade them. First, the arguably most potent sanction — freezing of $300 billion of Russia’s $640-billion gold and forex reserves — came into effect with enough delay to allow Russia’s Central Bank to still spend around $38.8bn in reserves between 18 Feb to 25 March. Second, the cut off seven Russian banks from the SWIFT messaging system only sanctions 50% of all Russian banks by assets. This creates a giant loophole, as any Russian firm can open an account in an unsanctioned bank and continue business as usual. Third, sanctions on Russian oligarchs have left half of Russia’s 20 richest billionaires not sanctioned.
The inconsistencies and loopholes in the sanctions regime can all be traced to the same root cause: Western (mostly EU’s) dependence on the supply of certain key commodities: from oil and gas to nickel. The Bloomberg report finds, for example, that “Many leading unsanctioned billionaires are active in vital global commodity sectors and own significant stakes in major companies that supply Western nations.” Similarly, banks that were spared the sanctions are those that process EU payments for the Russian gas.
The research on sanctions effectiveness points to rather limited scope of goals that prior economic sanctions managed to achieve. Among cases cited as success is the sanctions on Iran, which arguably brought Iran to the negotiation table and resulted in restriction Iran’s nuclear program in 2014. In most other cases (e.g, Cuba, North Korea earlier, and Russia after the 2014 invasion of Ukraine), sanctions contributed to the economic isolation of the sanctioned countries. In case of Russia, the current economic resilience is in part the result of Russia’s “fortress economy” approach to cutting itself off from the dependence on Western supplies of anything from physical inputs to payment systems.
What is needed from the Western governments and firms, on the sanctions front?
Still, sanctions remain important. At a minimum, bans on microchips and high-tech supplies to Russia limit the production of military equipment and therefore Russia’s ability to sustain the war effort. Also, sanctions can contribute to the domestic unrest in Russia and serve as a catalyst for the regime change. That is why stepping up the sanctions, closing the loopholes, and adopting a unified approach to the sanctions package across the Western allies remain high priority.
For sanctions to deliver the necessary effect —exhausting Russia’s ability to continue the war — they must target the core of the Russian economy: oil and gas industry. So far, only the Baltic states (Latvia, Lithuania and Estonia) stopped buying Russian gas. Other EU states (most notably, Germany) refuse to do so for fear of harm to domestic economies. However, the case is not clear cut that even an immediate cessation of Russian gas would harm the German economy anymore than the covid-19 pandemic did. Germany lost 4.5% of GDP due to covid-19, while some economists argue that immediately ceasing gas imports from Russia would lead to a 3% drop in GDP, according to The Economist. Furthermore, abandoning energy imports from Russia (gas, oil, and coal) has the potential to speed up Europe’s green energy transition.
Firms’ proactive cutting of ties with Russia can also contribute to the effectiveness of sanctions. Any companies paying tax in Russia finance the war effort, hence exiting the Russian market helps curtail the war effort. But even more important is Western firms cutting Russia off access to Western technologies in high-tech, cloud computing, and manufacturing. A full audit of firms’ cash flows and supply chains can help identify and phase out any capital flows to Russia.
Limitations of the economic sanctions and the need for military aid
Ukraine has been highly effective in its military strategy, managing to defend the capital, Kyiv, and to launch a counteroffensive on the Russian forces. The German Finance Minister Christian Lindner reportedly thought Ukraine would collapse within an hour of the Russian invasion. Instead, the Ukrainian army has proven well-positioned to yet deliver a victory over Russia. For that victory to materialize, the unified military support by the EU and NATO is paramount.
The Russian massacre of Ukrainian civilians in Bucha, Mariupol, Irpin’, Gostomel, Kharkiv and many other cities should leave no doubt of the extent of war crimes by the Russian forces in Ukraine. Ultimately, too much depends on the outcome of military action on the ground for the West to keep withholding military supplies for Ukraine.
