The West vs. Russia: The Unintended Consequences of Targeted Sanctions

Editor’s Note: The following is the third of a series of articles from the Center for the National Interest’s new report: Costs of a New Cold War: The U.S.-Russia Confrontation over Ukraine. You can read the full report here.

Russia’s relations with the West entered a new and less-than-happy chapter earlier this year. U.S. and European economic sanctions are the defining and consistent feature of this new chapter, though Russia’s actual and potential responses are becoming increasingly important.

So far, Russia’s “internal diseases” have harmed it much more than Western sanctions. Likewise, the sanctions do not undermine the stability of the Russian political regime. On the contrary, the “personal” sanctions contribute to the Putin-driven soft nationalization of the elites, and the state can more than make up for financial losses sustained by certain individuals and companies. For the elements of Russian society already dissatisfied with the Russian government, such sanctions are a “bonus” of sorts that adds to their satisfaction over the Crimea annexation—Russia gets Crimea and despised elites are punished too.

Nevertheless, new sanctions on Russia’s financial, energy, and defense sectors in July and September will have growing costs for key companies and the overall economy over time. Moscow’s retaliatory ban on certain Western agricultural imports shows that Russia is ready to engage in a tit-for-tat economic conflict—even though Russian officials recognize the economic asymmetries between their country and the West.

Most importantly, beginning a new chapter is not the same as ending one—and it by no means preordains the final pages of the book. Perhaps ironically, the harder the West tries to isolate Russia, the more Western actions will strengthen forces inside the country that welcome isolation. This will make it increasingly difficult to find necessary cooperative solutions to current differences, and it is likely to increase costs on all sides.

Russia’s Economy

To start, it is necessary to understand the nature of the present-day Russian economy. In 2013, Russia posted 1.3% growth, the worst performance over President Vladimir Putin’s fifteen years in power except in 2009, when Russia faced the effects of the global financial crisis. As most are aware, Russia’s economy depends on commodity exports, which account for more than half of the nation’s fiscal revenues. This has created an institutional environment featuring excessive regulations, pervasive corruption, rent-seeking, and exploitation of administrative barriers. The Russian government addresses economic problems through micromanagement; this is known inside Russia as “manual control”—direct personal intervention by the President or other top leaders. Small- and medium-sized enterprises occupy an insignificant and precarious position in the economy, where high administrative barriers limit their growth. Private property rights lack adequate protection.

Against this background, a tide of social challenges is rising on a national scale. One is the threat of depopulation. Russia’s Ministry of Economic Development expects Russia’s able-bodied population to decline by at least 8-9% by 2020. Labor’s poor geographic mobility exacerbates the labor shortage problem. Most experts comment on the poor quality of and diminished access to health and education; the growth of geographic inequality in terms of development standards and quality of life; and depletion of the nation’s natural capital.

Despite sustained high oil and gas prices, the Russian economy has effectively been stagnant. GDP growth has consistently declined in recent years, from 4.3% in 2011, to 3.4% in 2012 and to 1.3% in 2013. For quite some time, numerous sources (including Russian officials) have been projecting, with some concern, that the economy could soon experience a recession. In recent years, inflation has fluctuated in the 6.1-6.6% range. Though tight monetary policies pursued by the Ministry of Finance and the Central Bank have admittedly been fairly successful, promoting quality growth requires keeping inflation below 3%.

Finally, efforts to open up the country for adequate investment have failed. Russia has seen pre-crisis capital inflows ebb away as capital instead fled. In 2010, capital outflows stood at $33.6 billion, with $80.5 billion in 2011, $56.8 billion in 2012, $59.7 billion in 2013, and $75 billion in the first half of 2014.

Western Economic Sanctions

Currently, the IMF expects Russia to grow at 0.2% in 2014, while the OECD expects a growth rate of 0.5%. The European Bank for Reconstruction and Development (EBRD) assumes zero growth, while the Russian Ministry of Economic Development offers a number of scenarios: 0.5% growth if the Ukrainian situation turns out favorably, or a decline of 0.2% to 0.3% in the worst-case scenario.

As for the sanctions, the Economic Development Ministry believes that Russia has sufficient reserves to make up for the resulting losses in the short term. Top Russian officials believe this too. Still, over the longer term, economic officials recognize and acknowledge that strong sanctions could destabilize the fiscal system and constrain technological modernization, due to restrictions on technology imports, investment, and application of best practices.

In March, Moody's, Standard & Poor's, and Fitch revised Russia’s ratings because “elevated geopolitical risks and prospective sanctions … might reduce potential investments, increase capital flight, and further weaken the already declining economic performance.” Moody's put the long-term ratings of Russia’s public debt on a downgrade watch list. Standard & Poor's revised its outlook for Russia’s sovereign ratings from stable to negative, and Fitch similarly revised its outlook for long-term default ratings of Russia’s debt in foreign exchange and domestic currency while also downgrading major Russian banks.

In late April, Standard & Poor's downgraded Russia from BBB to BBB-, the lowest investment grade, with a negative outlook. Next, Standard & Poor's similarly revised the investment ratings of Moscow, St. Petersburg[1], a number of major Russian companies (including Gazprom, Rosneft, LUKOIL, and Russian Railways), and banks (VEB and VTB). In the cases of Alfa-Bank and Promsvyazbank, Standard and Poor’s only revised the outlook downward. The agency justified its decision by stating, “these companies would be unlikely to withstand a sovereign default, considering their significant dependence on Russia from the operational and financial perspective.”[2] During the summer, the three ratings agencies reaffirmed their negative outlooks for Russia.

Some politicians and experts have suggested that the ratings downgrade was itself a sanction. However, most believe that the sanctions simply hastened rating agency decisions that would have happened anyway, as the grounds for such actions arose prior to this spring. While “somewhat politically motivated,” the downgrades represented a “response to actual deterioration of our macro situation” according to Alexey Ulyukaev, Russia’s Minister for Economic Development.

Experts believe that a perceptibly higher cost of any external funding for Russia represents a major negative effect of even the “softest” sanctions regime. Foreign loans have been very popular among major Russian businesses to date, given their lower rates and “debt service costs.” According to Bank of Russia statistics, such facilities have accounted for almost nine-tenths of Russia’s aggregate external debt (i.e., $653 billion out of $732 billion).

Likewise, there has been a marked deterioration of the environment for new initial public offerings and Eurobond placements against a generally livelier IPO scene in Europe and Asia. In early March, London Stock Exchange flotation of Lenta, a major Russian retailer, precipitated a dramatic drop in its share price. Promsvyazbank, TKS Bank, Bashneft, and Detsky Mir postponed scheduled offerings.

As president of the All-Russian Insurers’ Union, I continuously monitor this sector of the domestic financial market. So far, the sanctions have yet to become the primary concern for Russian companies. Ruble depreciation, declining capitalization, and reduced corporate budgets (leading to cuts in insurance costs) have clearly damaged market players in the insurance sector. However, I believe we would still be tallying losses in this area even if Crimea had not happened.

Nonetheless, potential downgrades of Russian insurers' international ratings and, going forward, new limits on assumption of Russian reinsurance risks do pose a serious challenge for us. The relatively shallow Russian insurance market is heavily dependent on international reinsurers. So far, corporate insurance remains the only consistently profitable market segment. Difficulties in obtaining reinsurance indemnity from Western partners and resultant bankruptcies of Russian insurers would deal a very heavy blow to the domestic market.

The “sanctions regime” is also suspending various processes and postponing decisions crucial for promoting Russia's economic interests. As early as March, the European Commission de facto froze a decision that would have exempted the OPAL gas distribution system in eastern Germany—it transports imported Russian gas southward from the Baltic Sea—from some regulations in the EU’s Third Energy Package. The South Stream project is running into ever-greater obstacles, and Bulgaria has announced the project’s suspension, pending approval by the European Commission.

Despite some differences in their approaches to sanctions, the United States and Europe have both imposed tight restrictions on any business operations involving Crimea. Although the annexation of Crimea creates mainly local economic challenges for Russia, those challenges are nevertheless exceedingly difficult. Baseline conditions in Crimea, which used to be at least as good as they were across Russia, dramatically worsened in March 2014. Nowadays, Crimea means worn-out infrastructure, a lack of natural resources, dependence on Ukraine for both, inability to raise Western investment, plus vulnerable and tenuous summer tourism that serves as the key pillar of the regional economy and of the livelihoods of a majority of local residents. At the same time, major Russian companies cannot enter the Peninsula directly without risking a Western response.

Russia’s development plan for the new Crimean Federal District keeps getting costlier with every successive iteration. At this point, the Russian government has fixed spending at about $20 billion through 2020, but the actual amount of spending will doubtless keep growing. For instance, the estimated cost of the bridge across the Kerch Strait has risen from $3 billion to $4.3 billion to nearly $6 billion. During the design and engineering phase, and during potential construction, the cost will probably escalate again more than once.

Economic losses from Russia’s damaged relationship with Ukraine have further tilted the balance.  Kiev’s “European choice” made some losses unavoidable, but Moscow has done its best to maximize such losses. Clearly, Ukraine’s own losses will be much more serious, given the different scale of the two economies and the nature of their relationship. However, Russia will also lose a lot—e.g., a major source of raw materials, rolled steel, and machinery components, including defense items.

Russian assets in Ukraine, worth at least $30 billion, are now at risk. In late April, a court seized an Odessa refinery that the Russian bank VTB had obtained by way of loan recovery from Sergiy Kurchenko, a fledgling Ukrainian oligarch and ally of former President Viktor Yanukovych who is now a fugitive. Mass-scale asset divestment will probably not happen, but many businesses will find it harder to operate. Ukraine’s role as an interim transportation link between Russia and Europe (and, via the Black Sea ports, other global regions) will probably weaken as well.

Since the tragic crash of Malaysian Airlines Flight 17, European leaders have substantially reconsidered their attitudes toward sanctions against Russia. The dominant viewpoint in the United States and the EU is that while separatists are directly to blame for the downing of MH17, the Kremlin is the main culprit. The EU’s subsequent adoption of limited, so-called sectoral sanctions, the third and most painful round of sanctions, signals that the conflict between the West and Russia has gained considerable momentum.

As a result, Russia faces U.S. and EU economic machines comprising 800 million people on both sides of the Atlantic who together produce half of the world’s wealth. Accounting for just 2% of global GDP, Russia can hardly win such a boxing match—particularly since more than 50% of Russia’s trade turnover is with the European Union. Taxes on the EU’s energy imports make up almost half of Russia’s federal budget.

Now, Russian state banks, energy monopolies, and defense companies could be seriously hurt. Refinancing state companies’ $200 billion in debt will already create a serious problem; according to estimates from former Vice Prime Minister Kudrin’s think tank, underinvestment and capital flight caused by the sanctions scare will deprive the Russian economy of another $200 billion. Russian economic experts believe we risk losing up to one-third of our annual budget next year due to international sanctions, in the worst-case scenario.

Still, Russia can live with sanctions for the short term. Oil exports still guarantee us a relatively steady flow of income, and hard currency and gold reserves remain at around $500 billion. But the sanctions will eventually hit hard. Both domestic forecasts and estimates from the International Monetary Fund and the World Bank put Russia’s GDP growth at 0.2%, with a probable recession looming. Restrictions on much needed Western investments and technology is a serious impediment.

Meanwhile, the sanctions have also solidified Russia’s new and unfavorable position in the system of Western-dominated international, political, and economic relations. Though Russia is not yet considered a rogue nation, many in the West clearly see it as a problem country and an unhelpful actor. Such positioning contributes to worsening conditions on the domestic economic front.

Russia’s Responses

Notwithstanding the increasing impact of sanctions, President Putin is not likely to change his policy approach under pressure. As Russia’s officials see it, the Iran sanctions and Cuba embargo demonstrate that such a situation can persist for quite some time, especially since Russia is a relatively large and wealthy country. With this in mind, the Putin government will not give in to Western sanctions, but will instead look for ways to minimize their impact on Russia and to ensure the survival of the current political and economic system in Russia.

Domestically, Putin will try to rally the Russian elite and population around his idea that “Russia is a besieged fortress.” Although it may seem strange to Americans and Europeans, this may actually become an easier sell for Putin as sanctions become more severe, for two reasons.

First, tough sanctions will do real damage to Western-oriented internationalists inside Russia. Although there is a new generation of Russian business leaders and so-called global Russians who find Western values to be highly compatible with their mode of life, this group was relatively weak even before the Ukraine crisis. Sanctions have further reduced their voice in debates over Russia’s internal affairs. To stage a comeback, they will have to have some breathing space—something impossible under sanctions that reduce economic opportunities and distort Russia’s political climate. Under harsh and continuing sanctions, this new generation will become weaker and weaker. Russia’s Western-oriented economic elite cannot thrive in isolation from the rest of the world, and Western officials should take note of this.

Second, the isolationists around Putin who do not see their future in the wider world are already numerically and emotionally stronger than are modernizers and progressives—and this problem will get worse the longer the sanctions last. That is why the actions already taken by the West have caused a surge of enthusiasm among Russian isolationists. Kremlin efforts to mobilize their support in order to strengthen the political order will further empower them.

Neo-conservative Russian isolationists are already influential around President Putin. In the absence of any visible carrots from the West, using the stick endlessly will only strengthen the neo-conservative segment of the Russian elite and population. Russia today is far from the Iranian situation, where the supreme leader decided to avoid selecting a belligerent president to make negotiations possible. In Russia, the current situation can persist for a relatively long time, although the country already feels a strain on its budget and public expenditures.

Internationally, the sanctions regime has forced Moscow to look more intensely for new markets and new lenders. The Russian President's recent visit to China is evidence of this. Deeper cooperation with China will have costs for Russia—energy experts quickly discovered the secret price per cubic meter of Russian gas deliveries to China, and it was not what Moscow hoped for in the past. The political price for Russia of current and future Russian-Chinese agreements is anyone's guess.

The incumbent Russian leadership is unlikely to have any immediate interest in becoming too dependent upon China. However, it may perceive it as the lesser of two evils, as traditional sources of “stability,” the highest value of social life in present-day Russia, are gradually drying up. This forces the government to look for new sources of stability. Russians are already debating the scenario of “Russia as a Chinese political satellite and economic periphery” in earnest, even if most are not yet prepared to accept it.

Russia’s recent restrictions on agricultural imports from countries that have imposed sanctions show that Moscow is ready to retaliate economically against the West; beyond this, Prime Minister Dmitry Medvedev has now threatened to restrict access to Russia’s airspace. What are the Russian options if the confrontation over Ukraine continues to worsen?

One of the most visible proposals is the Glazyev plan, prepared by Sergey Glazyev, a Russian presidential advisor on economic matters who has been responsible for Russia’s integration plans vis-à-vis Ukraine. Mr. Glazyev has proposed a series of steps to increase Russia’s independence from Western economies and to attempt to damage these economies in the process. His proposed measures included the following:

·  move government assets and accounts denominated in U.S. dollars and Euros from NATO countries to neutral nations;

·  sell NATO nations’ bonds;

·  return state-owned property to Russia;

·  stop exports of precious metals, rare earths, and other strategic metals and minerals;

·  execute currency and credit swaps with China to finance critical imports;

·  build a SWIFT-like domestic system for interbank information-sharing within the Commonwealth of Independent States, along with a domestic payment system;

·  work to introduce a capital flight tax;

·  gradually transition to domestic currency settlements vis-à-vis trade partners;

·  radically reduce the share of U.S. dollar instruments and debt of other pro-sanctions nations as a percentage of Russia’s foreign currency reserves;

·  replace U.S. dollar and Euro-denominated loans of state-owned corporations and state-owned banks with ruble-denominated loans; and,

·  transfer offshore-registered titles to strategic enterprises, and transfer mineral rights, real estate, and other property back to domestic jurisdiction.

Russia’s neo-conservative isolationists generally support these measures, which would seek to move Russia’s assets and transactions away from dollars and Euros toward other currencies, develop a parallel international financial system, force Russian businesses and their assets and investment to return to Russia, and keep “strategic minerals” in the country.

Sophisticated Russian economic experts, such as former Deputy Prime Minister Alexei Kudrin, have opposing views. They argue that retaliatory measures like these would immediately cause greater losses to the Russian economy and to Russian consumers. However, they say, the best “retaliation” is a “pivot to Asia” and to other emerging economies. The goal of this pivot would be to increase Russia’s finance and trade ties with sovereign funds and public companies from Asian, Latin American, and Arab countries willing to expand their exposure to Russia. Work in this direction has already begun, though it will be difficult to replace the 80% of foreign direct investment in Russia that comes from countries imposing sanctions.

Russia also has some other options. First among them is economic retaliation against Ukraine, which Moscow is already doing as part of a wider effort to destabilize that country. Russia has halted trade of more than one-hundred agricultural commodities and industrial products. Moscow has also frozen oil and gas deals and started to look for substitutes for military equipment imported from Ukraine in the past. Russia could still do much more.

Ukraine is highly vulnerable because its financial outlook is tragic. Its budget deficit and external debt service require nearly $30 billion. Covering development and recapitalization and addressing structural imbalances in the economy will take almost $200 billion through 2018 due to long-term underinvestment, according to some expert views.[3] These gigantic amounts are simply unavailable to the European Union, Russia, and Ukraine, even if the United States had the political will to assist. But if nothing is done, the “black hole” of Ukraine’s economy in the center of Europe will drag down the country’s westward and eastward integration and will constitute a long-term economic threat to all. In order to overcome the crisis and the fractures in Europe, it is necessary to create a new platform for cooperation. Both the EU’s Eastern Partnership and Russia’s Eurasian economic integration require serious correction.

This may sound unrealistic in the current political environment, but there is no alternative. Moreover, saving Ukraine could actually be the best project to transform the “sanctions regime” back into a “cooperation regime,” something much healthier for the European and global economy. Of course, this will not be possible until governments on all sides—not only Russia—are prepared to adjust their policies.

Russia’s most serious economic weapon—restricting oil and gas deliveries to Europe—is a double-edged sword. There is no easily available buyer of this product in Asia because new pipelines or railway deliveries will take years to build. Likewise, export facilities for liquefied natural gas are also pretty scarce. At this point, nobody in his senses openly speaks in favor of cutting off gas supplies to Ukraine, which might take away up to one-quarter of Russia’s federal budget revenues directly or as collateral damage. Nevertheless, Russia could still do this if the conflict deteriorates enough to make the Kremlin’s alternatives look even worse. From this perspective, it can be very dangerous to put too much pressure on Russia.

So far, most Russian experts have expressed concern that the Russian Federation cannot respond to Western sanctions without exacerbating the economic damage caused by them. Any actions taken by Moscow to curtail economic and technological cooperation, and any restrictions imposed on Western businesses in Russia would entail immediate losses to the nation's citizens, domestic businesses, and government. Nevertheless, if Russia’s isolationists gain sufficient political influence, these experts may no longer have significant input into policy formulation.

Russia has not yet reached this point. In late May, President Putin used the St. Petersburg Economic Forum as a platform for direct dialogue with Western businesses. He clearly intimated that, so far, the Kremlin does not view an isolationist program as a serious option. Putin insisted that, even in the new environment, Russia intends to follow the motto of “partnership for global development.” Speaking of sanctions, he lamented that “inability to find compromises, unwillingness to take into account partners’ lawful interests, and blunt use of pressure only add to chaos and instability and create new risks for the international community’s continued development.”

As he spoke to established Western investors in Russia, Putin asked rhetorical questions. Why do “successful businesses have to suffer losses and relinquish to competitors this huge market and the positions they had built up?” Further, “Does anyone gain from disruptions to regular cooperation between Russia and the European Union? Does anyone gain from seeing our joint work come to a standstill on what are important issues for everyone such as nuclear safety, fighting terrorism, trans-border crime, and drug trafficking, and other priority issues? Is this supposed to make the world any more stable and predictable? Surely it is clear that in today’s interdependent world, economic sanctions used as an instrument of political pressure have a boomerang effect that ultimately has consequences for business and the economy of the countries that impose them.” These pronouncements were completely devoid of any pro-isolationist enthusiasm.

The primary effect of international sanctions is partial or complete isolation of the sanctioned nation. Russia is too big to isolate completely, however, and partial isolation is likely to have unintended consequences that contradict U.S. and European intent in imposing sanctions. Should the West strengthen isolationist forces in Russia and provide incentives for Russia's “pivot” away from the West toward China, Latin America, and Africa? This is up to Washington and Brussels.

Igor Yurgens is President of the Institute of Contemporary Development, President of the All-Russian Insurance Association, and Vice President of the Russian Union of Industrialists and Entrepreneurs, one of Russia’s largest trade associations. In addition, he serves on a Russian presidential council on human rights and as a professor at Moscow’s respected Higher School of Economics. He is a leading authority on Russia’s economy and its international economic relationships. He holds a doctorate in economics.

[1] In June, the Russian regions' movement on the Fitch scale was mixed.

[2] In June, S&P slammed lesser players in the Russian financial market; more than half of them (18 out of 32) saw a downward outlook revision.

[3]Kulik S., Spartak A., Vinokurov E., and Igor Yurgens, “Two Integration Projects in Europe: Dead End of Struggle,” INSOR, a summary of a report commissioned by the Civic Initiatives Committee, Moscow, June 2014

Source: The National Interest