25 08 2022

Can sanctioned countries survive?

Import substitution: As China is being increasingly cut off from buying advanced equipment from Western countries for production of semiconductors (chips), their hope is that domestic companies as e.g. SMEE will be able to fill the gap. The most advanced SMEE lithography machine SSA600 is able to produce 90nm chips, but the next model (SSA800) will produce 28nm and should be on its way. Import substitution: As China is being increasingly cut off from buying advanced equipment from Western countries for production of semiconductors (chips), their hope is that domestic companies as e.g. SMEE will be able to fill the gap. The most advanced SMEE lithography machine SSA600 is able to produce 90nm chips, but the next model (SSA800) will produce 28nm and should be on its way. From the SMEE webpage

It looks as if sanctions haven’t had the expected disastrous consequences for Russia compared to say Iran, Venezuela and Cuba, at least in the short term. But what about the longer perspective? Will the Russian economy implode or stagnate? Or will it be able to survive and perhaps even prosper? History tells us that both scenarios are possible and that the outcome to a high degree depends on how well the situation is managed and the legitimacy of the political leadership.

The world has seen dramatic ruptures of international trade before, most recently during the 1930 big depression and the following World War 2. It forced countries around the world to look inward for development and find substitutes for goods that it was not possible to import any more. This gave rise to new industries in many countries, and many developing countries, particularly in Latin America, continued to protect domestic production, also after world trade had resumed, and it was no longer a necessity. In Japan and South-east Asia protection of national industries also became common and fuelled the economic development of the so-called ‘Tiger Economies’, but unlike Latin America it was coupled with an aggressive policy to support exports of industrialized goods. However, even an inward looking country needs some imports, particularly of capital goods, and hence foreign currency to finance this import. Latin America depended on exports of raw materials and agricultural goods, and these goods went during the post-war period through a long period of declining prices compared to the imported industrial goods, creating perennial balance of payment problems (often called “external strangulation”).

As it is well-known, the South-east Asian countries were ultimately successful, while it didn’t end well in Latin America.

The biggest risk: inferior and expensive products

The main risk for a policy based on substituting imported products with domestic production is that the domestic products may turn out to be inferior or more expensive – or worse, both. This is so, because the domestic market frequently is not big enough for more than one company to reach a scale, where it can operate efficiently, so it becomes a monopoly which can sell whatever it likes at a price it can set itself. In many parts of the economy this is not a big risk, as the minimum scale for efficient production is small (say agriculture, food-processing, services and the like), but in others the minimum efficient scale of production is large (say automotive industry or production of some household goods) or research and development costs are high compared to production costs, so a high sales volume is necessary to pay back the investment in R&D (say pharmaceutical industry, software industry, heavy machinery as turbines, ship or aircraft engines, semiconductors and different machine tools and specialized machinery).

This implies of course that the policy has better chances of success in big countries than in small countries, so Russia is better positioned than say Iran, Venezuela or Cuba, and China is better positioned than all of them. But even in big countries scale often becomes a problem, and in extreme cases it is a problem even at world scale. Take the example of the aircraft industry, where only two companies, Boeing and Airbus, completely dominate the world market (a duopoly both Russia and China now are trying to break). Or the case of Dutch ASML, which is the only company in the world producing advanced lithography equipment for semiconductor (chip) production (and is forced by the US not to sell to China).

How to ensure price and quality?

What can a sanctioned country do to avoid ending up with inferior and/or too expensive domestic production – or, even worse, both plus recurrent difficulties with insufficient foreign exchange?

If the local market is too small to secure local competition, it can be required that a certain share of the products be exported, thus demonstrating that they are competitive and at the same time help reach a minimal efficient scale of production. This may of course be difficult when part of the world market is out of reach because of sanctions. Another option it to require that the products meet well-defined international industry standards and require that prices are within a range of prices of similar products on the international market (called benchmarking). This is necessarily a cumbersome bureaucratic procedure, prone to corruption, but difficult to avoid.

A common strategy is to concentrate on strategic sectors and avoid trying to produce everything domestically. In the case of Russia, reasonable quality goods can often be found in China, India and other countries not participating in the sanctions. A limiting factor can be that leading first-tier companies in these countries are unwilling to cooperate because of fear of “secondary” sanctions from the US and EU, so this may restrict the commercial interaction to second-tier companies (this is a frequent challenge for Cuba).

As the domestic market may be too small to recover substantial research and development investments, a policy of subsidies for development costs for local companies in strategic sectors is often necessary, and also a guarantee for the future sales, in case the sanctions suddenly are lifted. This seems to be one of the strategies presently followed in Russia, where development contracts are awarded to private or public companies for specific products considered essential (as for example machine tools, aircraft engines, gas turbines, large marine diesel-gas engines, and some components for the aviation and automotive industry), combined with guaranteed sales that permit the company to recover the investment.

The biggest Russian automotive company Avtovaz (which produces Lada cars) has been majority owned by Renault since 2008, but Renault has now pulled out and sold its stake to State-owned company Rostec (for one ruble). Lack of Western car parts forced production to stop for several months. It was restarted in June 2022, but without advanced features such as air-bags, air-con, navigation system and ABS brakes. According to sky-news, all these features are back by August 2022, except for ABS brakes, which reportedly will follow soon, as Avtovaz switches to alternative domestic and foreign providers.

However, there is a high risk of corruption, as the lack of discipline imposed by international competition forces the country to rely on administrative measures. Some corruption is inevitable, but it does not necessarily impede the system from functioning unless it gets out of hand.

Neoliberal governance

The biggest challenge is political governance. In countries that depend on protection of local production, everything becomes politicized and most conflicts almost inevitably involve the Government, even in a capitalist economy. Local alliances are often formed to squeeze money out of the national economy, particularly in monopolistic sectors, sometimes even involving alliances between companies and workers to raise prices and salaries in detriment of other sectors.

This political governance challenge was what finally paved the way for the neoliberal Reagan-Thatcher revolution in the eighties, and this political innovation rapidly spread to most of the rest of the globe. In face of the difficulties in governing restless and relatively egalitarian societies, market discipline was introduced by opening up to foreign competition, letting the weakest companies go bankrupt and importing cheap labour through increasing immigration to keep wages down. And it worked as intended. It led to de-industrialisation in the US and most of Europe (the famed post-industrial society), the unions were weakened to a point where they are a shadow of their former self, wage-price inflation virtually stopped and inequality increased almost everywhere, as we now know. In Latin America this new discipline was introduced through military coups in most places (most notoriously in Chile, Argentina and Uruguay), and in South-east Asia the countries were under different sort of military or other authoritarian Governments (military in South Korea and Taiwan, English Colonial Rule in Hong Kong and a restricted parliamentary system in Singapore).

Governance through legitimacy

In sanctioned societies this neoliberal governance is not an option, so governance becomes the main challenge. Because of the need to balance the pressure from the different economic stakeholders, not only between organized labour and capital, but also between capital groups and organized small enterprises, this is very far from the neoliberal minimal state, and outcomes that are considered unjust by parts of the society cannot be pushed through arguing the “necessary policy” due to international competition. If the Government is not able to reconcile the competing claims, it may either lead to turmoil or a drift towards a more authoritarian government, even if parliamentary elections continue to be held. Therefore, much depends on the population’s perception of the legitimacy of the government. As long as the economy is managed prudently, and the balancing act between the different sectors of society is not considered too unjust by the majority of the population, the Government may be able to navigate these challenges. To this comes that sanctions in themselves tend to increase the legitimacy of the Government, as the country is considered under attack from outside and problems may be alleged to be the fault of malign external forces. But if the outcome is considered unjust by broad sectors of society, or if economic chaos prevails, this legitimacy of course disappears, and political turmoil is a probable outcome.

This last outcome is what the US and its NATO allies hope for in China, Russia, Belarus, Iran, Venezuela, Cuba and other countries that are not behaving as they should.


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Thorbjorn Waagstein

Thorbjørn Waagstein, Economist, PhD, since 1999 working as international Development Consultant in Latin America, Africa and Asia.

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