03 09 2014

Will sanctions hurt Russia?

The short answer is yes, very much so. And much more than it will hurt the EU or the US. Post-Soviet Russia is mainly a producer and exporter of oil, gas and raw materials. Just as Canada, Australia, Brazil, Chile and Venezuela. It has gone through a de-industrialisation after the dissolution of the Soviet Union and is now heavily dependent on imports of almost everything. It is the world sixth biggest economy, but it is too small to survive isolated. So sanctions will hurt a lot. But they may also have unintended consequences. Some of them could actually be quite interesting.

US and NATO have – at least for now – decided that a war with Russia is too dangerous. So for now they relay on sanctions. The aim is to defend the sovereignty of Ukraine, an independent country being bullied, and now – according to NATO – invaded by Russia. Is there a genuine problem with a Russian minority in the Don-bass Area wanting autonomy? According to NATO, no. Only local gunmen (terrorists) armed by Russia and reinforced with disguised Russian soldiers, trying to take over part of the country. So this is a replay of Munich in 1938, and we have to stand up to them.

So, short of a military conflict, we go for sanctions.

A quick view of the economic relations between Russia and the EU-US makes it clear that the sanctions will hurt Russia very hard. But what about the other way round? There are two main ways, in which sanctions can affect the economy: cutting off trade and stopping direct investments.

In the case of the US, trade with Russia is minimal. In 2013 US exported for 11 billion USD to Russia. That sounds as a lot, but it is less than 1 % of total US exports. The main items were aircrafts and cars. The import from Russia is also minimal and consists mostly of oil products. So if trade with Russia is cut off, it will have a negligible effect on the US.

For the EU, the impact is bigger. The EU export to Russia was in 2012 132 billion USD, and its import from Russia was 213billion USD. That is, almost 10 times the US trade with Russia. No wonder there is more hand-wringing in the EU than in the US. As a percentage of total trade, Russia takes around 7% of EU's exports and covers around 12% of its imports. The trade pattern is the same as with the US: Russia sends mainly oil, gas and raw materials to the EU, and getsback consumer goods, machinery and food products. Russia is the EU's second most important partner when it comes to imports (after China, followed by the US), and fourth when it comes to exports (after the US, Switzerland and China). So obviously, a break down in trade will hurt the EU much more than the US.

Regarding investments, it is a bit more complicated. The statistics on foreign direct investments are murky, as the main flow of foreign investments comes from tax havens such as Cyprus and Virgin Islands. Much of this money is probably from Russian oligarchs, capital that has fled the country and then has been reinvested it in Russia after being whitewashed. With the extra benefit that the owners can get protection as foreign investors. This money goes mainly into real estate and finance. When it comes to investments, the US has the largest number of projects in Russia in the period 2007-11, followed by Germany, UK, France and Finland. The largest number of projects are in the automotive industry (most of the main car producers have production in Russia), followed by food processing, and machinery and equipment. So here a host of large multinational firms stands to lose, if sanctions go as far as a freezing of assets (as in the case of Iran), as this necessarily will be a two-way process. You grab my assets, I grab yours.

Then there is the financial sector. Russia's external public debt is low, and it has very big foreign reserves. Around a quarter of these are placed in a sovereign investment fund, which principally is holding low-risk Western government bonds. In case of an asset freeze, Iranian style, this capital would be lost. So it would be a tempting way to punish Russia. But it would also send a shiver through other countries holding this type of assets, among these China, probably pushing these to try to get of out of this type of dubious assets. That would not be funny for debt dependent US or for debt ridden EU countries So it will be probably be a measure of last resort, short of open war.

Another way to punish Russia could be banishing its access to the system for international financial transactions and settlements, as it is done in the case of Iran (and unilaterally by the US in the case of Cuba). The UK is presently advocating for the exclusion of Russia from the SWIFT payment system, used to make transfers between banks. As the international financial settlement system is completely dominated by Western financial institutions, and in particular US institutions, this really hurts. It makes financial transactions with other countries extremely complicated, as the Cubans and Iranians will tell you. Another less extreme measure is to close the international credit card system to Russia, as was done for a short period by Visa and Mastercard.

So in conclusion, the Western countries have a lot instruments that can be used to punish Russia, where it really hurts. But there are some drawbacks:

1. Cutting off trade. This would hurt Russia much more than the West. But in the short to medium term it would give serious problems with the gas supply to several European countries. In the medium term this can be solved by alternative energy sources, among these liquefied gas from the US shale gas fields, renewable energy and converting back to coal. It will of course be considerably more expensive than at present, but everything has a cost. On the Russian side, they will have to diversify their gas export, and that means mainly selling to China. The effect of the sanctions has already been that a mega gas export deal that the two countries have been discussing for around a decade, suddenly has been concluded. However, this will only help Russia in the medium term, as it takes time to get the project on stream. It is clear that the main winner here will be China, and Russia will be forced into an uncomfortable dependency of China.

2. Cutting off all hi-tech trade. This would make it very difficult for Russia to develop its industry, and in the short term Russia would have to find alternatives in domestic production or imports from BRICs countries, if they exist. That will not be easy. Again, China will be the main beneficiary.

3. Cutting off exports of oil and gas equipment. This would mainly affect the more complicated oil and gas fields, e.g. deep drilling and drilling in the Arctic. However, an important part of the imported equipment can probably be partially substituted by domestic equipment.

4. Excluding Russia from the international payment system. This would hurt Russia, but the unintended consequence is that it may also constitute the first step to bring the existing Western monopoly to an end, as new systems for settlement of international payments would necessarily have to be set up to make possible the trade between Russia and in first hand the BRICS countries. Russia and China have already done that for the bilateral trade, and the BRICS countries have in principle agreed to do so also on a broader scale. That will take time, but the process will undoubtedly be speeded up.

5. Exclude Russia from the international credit card systems. Incredibly, Russia is at present dependent on Visa and Mastercard even for domestic payments and cash withdrawals. It has now belatedly decided to set up a national system (as most developed countries already have), but that will take time. In the meantime, the Chinese Union Pay, the world biggest by number of users, is expanding rapidly in Russia.

6. Confiscate Russia's holding of Western Government bonds. It appears that Russia's central bank is already trying to diversify its holdings, getting out of these bonds and into Chinese Yuan and gold. So it has to be done fast for it to really hurt. And as mentioned, it will probably trigger a much broader selling of these bonds by other countries also. So it will hurt both ways – difficult to say, who will be hardest hit.

Another unintended consequence could be within Russia itself. Russia is a very unequal society, almost as unequal as the US – and that is bad. Unlike the US, where the local oligarchs are quite popular and admired, the local oligarchs are not particularly popular in Russia. If the Russian people shall be convinced to shoulder the hardship that a prolonged economic war with the West will entail, not to mention a real war, the Russian government will probably have to do something about it. Clamp down on corruption, confiscate the fortunes of some of the most corrupt oligarchs and civil servants, and even put some of them into jail, start taxing the rich, improving living conditions for the broader population - in short, take policy measures that in old times would be called social-democratic, but nowadays is called populist. That would be really interesting to watch.

We are waiting with interest.

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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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