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At this point I thought it useful to think over some basic sanctions questions like why are sanctions being used, what has actually happened on the sanctions front, how are they impacting Russia and where I see the direction of travel now on the sanctions front.
So why are sanctions being imposed/rolled out?
Well, I guess the obvious answer is because of Russia’s invasion of Ukraine, but also before that, the annexation of Crimea, and the first Russian military intervention in Donbas back in 2014.
We can add here a whole string of Russian malign actions though, from cyberattacks, interference in Western elections, sabotage (explosions in the Czech Republic on ammo dumps), murder abroad (Salisbury, Litvinenko, et al) including let’s not forget repeated chemical/nuclear terrorism in attacks in Salisbury, Litvinenko and then Navalny.
Often there is push back here with questions as to why sanctions, why can we not try other means, such as negotiation?
Well, we tried negotiations. In the case of Ukraine, there was the Minsk 1 and Minsk 2 talks, then the Normandy format. And after February 24, there has been again the Minsk and then Antalya formats. And there have been presidential summits, with Biden sitting down with Putin in Geneva, and then again Lavrov and Blinken again in Geneva.
The reality is that negotiations failed - and US diplomats have suggested in the last-minute talks with the Russian side just prior to the February 24 invasion, that the Russian side appeared unwilling to negotiate.
A similar impression was given to those at the Antalya talks in Turkey that Lavrov had no mandate to negotiate. Rather at Geneva and again at Antalya, the Russian side read out demands and was not interested in negotiation. Putin seemed to have already decided his course of action.
Now there is a debate here about what is behind Russia’s invasion of Ukraine - the likes of Mearsheimer would argue the fault is with the West and the over-enlargement of NATO.
But surely Putin himself put paid to this argument when first in his essay published last summer he laid out the case for war, and then again in Putin’s comments at the St Petersburg Economic Forum in June this year, that for Putin this is about a land grab, and his rejection of Ukraine’s right to exist within its current borders, and Russia’s rights over land currently occupied by Ukraine.
For Ukraine what is there to negotiate over when its very existence is under threat? And therein how can the West, in the 21st century, negotiate with Putin away Ukrainian land and sovereignty?
So we tried negotiation, but that failed.
What about the military option?
Well NATO could come to Ukraine’s defense but with the risk therein starting WW3, there is an obvious reluctance on the part of existing NATO members to get fully involved.
So the military option for the West, at least in terms of direct military intervention with boots on the ground has been rejected. Obviously, we can still continue to arm Ukraine, to engage with it to help it defend itself, but that comes with risks and Putin has indeed warned NATO of potential retaliation if it continues to arm Ukraine.
Is doing nothing an option?
Assuming negotiation failed, and with limited military options, the question is what else the West could do? Could it do nothing - that would be an option. But surely the risk there is that Putin takes this as weakness and given he has himself stated that this is all about a land grab the question is where he stops. First Ukraine, then Moldova? Northern Kazakhstan?
Georgia and the rest of the former Soviet space? What about Russia pushing its influence back out to circa 1989, and the area then occupied by the Warsaw Pact?
Further expansion beyond Ukraine might seem unlikely but so was Russia seizing Transnistria, Abkhazia, South Ossetia, Crimea, and now much more of Donbas and much of Kherson and Zaporizhiya, plus still tracts of Khakhiv. Putin has developed a clear track record here for the territorial enlargement of Russia. How can he be trusted now?
So doing nothing does not seem like a great option.
But why sanctions? What is it about sanctions that might have some effect?
Sanctions are about imposing costs from Russian malign actions, and economic costs.
The assumption here is that the Putin regime cares about power, and the creation of power whether military or peddling of influence, needs economic power or wealth to sustain it.
Russian GDP, public finances, balances of payments, its FX reserve position, and Russian inc’s balance sheet, help build and project power.
Simply put, the strength of its economy helps build and maintain Russia’s military might. Russians, particularly its elites, meanwhile, enjoy the personal benefits of wealth through their enjoyment of high-end yachts, Western apartments, the best Western schools for their kids. They enjoy the lifestyle of a strong economy.
Eroding Russia’s economy might impact on Putin’s ability to wage war, but it also risks his personal popularity at home. Elites might defect or plot for his removal.
Ordinary Russians might well tire of falling living standards, high inflation, and job losses. It creates a risk of domestic political unrest for Putin.
Is it about regime change?
Well, that would be nice, but it does not have to be. It is about changing behavior, this can come with or without regime change.
But sanctions, by undermining Russia’s economy, creates political jeopardy for the Putin regime, and it might begin to question the overall benefits of territorial expansion. Sure Russians might think it’s great that Putin is expanding Russia’s territory but what is the price of that?
The answer is sanctions, economic isolation, and Russia as a result lacks the economic resources to rebuild Crimea or Donbas, or if the costs of those rebuilds are born by the population of Russia within its existing borders, that again risks weighing on the popularity of the Putin regime.
The loss of treasure comes as Russia is already suffering the loss of considerable blood. Sanctions threaten the legitimacy of the Putin regime, eventually, albeit that make take time to impact.
On their own sanctions might not be the silver bullet, but they are aimed to incrementally up the pressure on the Putin regime, and along with other factors (military casualties, diplomatic isolation) help change the overall calculus.
So sanctions are aimed at changing Russian behavior, and there has been much focus or reliance on sanctions as our options, in terms of other policy responses, are somewhat limited, unless the West actually wants to go to war with Russia and risk WW3.
So sanctions are kind of all we have got, other than doing absolutely nothing in response to Russian aggression in Ukraine and elsewhere.
What have we actually done on the sanctions front?
It’s always difficult to gauge where we are on the sanctions front. I like to try and use the scale of 1-10, with sanctions on Iran being 10 and would tend to think we are currently more like an 8.
We could more fully sanction the Russian energy and banking sector, and could FATF blacklist Russia. But let’s now forget here that before February 24, we were perhaps only a 2-3 out of 10. And part of the problem now is that Russia never took Biden’s threat of the mother of all sanctions regimes on Russia seriously when he warned as much before February 24.
And arguably Russian never expected harsh sanctions - an 8/10 - because its experience after the annexation of Crimea was that the West was always too timid. Various Western interests and lobby groups always managed to water down the sanctions response - they lobbied to prevent sanctions and then typically when weak sanctions were rolled out were the first to complain that they were not working.
But if Biden’s signaling had been believable before February 24, Putin might not have invaded after assessing the actual economic risks from sanctions now rolled out.
Hindsight is great, and we are where we are.
But the reality now is that sanctions post-February 24 have gone much further than anyone expected, beyond the usual suspects of bans on military equipment and technology, but notably extending to:
Few people expected numerous banks would be fully blocked and particularly cut off from SWIFT, albeit more can be done;
Few people expected CBR assets would be frozen, now amounting to in excess of $300bn, and talk now of these assets being confiscated and used for Ukraine rebuild costs;
Few people expected the energy sector to be included in sanctions but coal and sea-based crude oil deliveries have been sanctioned, and discussions are underway how to sanction gas;
Few people expected Russian sovereign debt to be sanctioned to the point that Russia is unable to pay its liabilities and is now in default;
Few people expected Russia to be kicked out of the main investment indices, including those covering bonds and equities.
And actually, the last category is perhaps most notable and potentially impactful as this was achieved despite the fact that holding such debt and equity securities is still not a sanctionable activity.
Russia was kicked out of the main debt and equity indices by moral suasion, and a campaign to embarrass index providers over keeping Russia in such indices. Herein is an example of something almost entirely new in the sanctions experience (not even really seen with respect to Iran sanctions), that is Western entities self sanctioning and pulling out of Russian investments because they are worried as to how this plays on their international image.
This has actually been a hugely powerful new sanctions tool - the power of ESG or morale suasion/campaigning. In this respect, we have now seen thousands of Western companies decide to exit Russia, an eventuality that could prove far more powerful and effective in hurting the Russian economy than the letter of the sanctions law.
Imagine Western insurance companies refusing to insure business in and with Russia - and many more examples of this. And why? Well first because the Putin regime went too far in Ukraine, not only by breaking international law but also in the pursuit of such brutal means of warfare - bombing civilian targets, and war crimes committed in Bucha, et al. And second the bravery and innovation of Ukrainians in fighting and fending off a far more powerful foe. They put us all to shame in their David versus Goliath battle.
If I put all this together this amounts to a pretty brutal, restrictive sanctions regime. Aside from a number of carveouts covering energy and commodities, it’s going to be difficult going forward for Western business to trade and conduct business with Russia. Russia will feel the impact of shortages of technology, key inputs, and finance. It’s become an international pariah in affect in international business.
More can obviously be done, particularly in the energy and commodities field, but as ever with sanctions regimes the art and skill is about hurting the target of sanctions more than the sanctioning country. And therein obviously there is currently a big debate about the effectiveness of energy sanctions.
And this leads us to the question of how the sanctions are impacting?
There is a consensus building that sanctions are ineffective, having little affect and indeed actually benefitting Russia by creating shortage fears across commodity markets and hence elevating prices.
I think this is a wrong interpretation and oversimplification, and we need to think about both the long term and the short term consequences. And remember that sanctions are not a silver bullet, take time to impact and that the target of sanctions - Russia in this case - a not a docile recipient of sanctions, but rather an agent that tries to subvert and get around sanctions. It is a constant battle to keep up sanctions pressure.
But let’s just look at some of the impacts.
First, both international Russian official sources suggest that sanctions are likely to crater Russian real GDP growth this year - with the consensus being a decline of 8-10% in 2022.
On a dollar GDP of $1.8 trillion, and assuming period trend growth of 2%, that’s a loss of $180bn in lost/forgone dollar GDP.
Second, Russia’s financial markets suffered a catastrophic collapse in the immediate aftermath of February 24, and the sanctions rollout. Russia’s long bond, the 47s dropped from 130 cents pre war to under 30 cents now. Russian equities, while rebounding from their lows immediately post Feb 24, are still down by around one third. Total Russian financial market losses, on assets mostly held by locals are likely to total $200-300bn. This loss is mostly suffered by Russia’s oligarchs and middle classes, but it is still a significant loss - they will be smarting, and their net wealth to be deployed now on Russia’s reconstruction will be more limited. Some might be so upset as to challenge the regime - albeit I would not hold my breath for their chances of success.
Third, Russia has had significant foreign assets frozen - at least $300bn in CBR assets, and perhaps up to $100bn in other assets. Russia is unlikely to get these assets back unless it agrees to a comprehensive peace agreement in Ukraine, and even then assets might still be confiscated and allocated to Ukraine reconstruction.
Fourth, fears of shortage have pushed oil and commodity prices higher. It’s likely the current account surplus might have reached as much as $200bn in H12022. This is evidently helping to buoy the ruble in the short term.
However, despite this apparent current account surplus, the CBR has not been able to accumulate additional FX reserves. Indeed, CBR assets have actually fallen from a peak of just over $640bn before February 24, to around $582bn as of writing. Even accepting for cross FX valuation effects, this suggests a very significant capital flight out of Russia.
And indeed, the third-country balance of payments series, in countries particularly in the former Soviet space, suggest increased capital flight via increased remittance outflows. Russians are getting their money out, despite various capital controls to defend the ruble. And this all puts FX resources beyond the control of the Putin regime despite high oil and commodity prices.
And what about the ruble and it’s remarkable move from mid 60s to 140, then back to sun-60?
Well strength here might not be as it seems, as it reflect partially recession, and also an inability of Russia to buy key imports because of sanctions. Eventually this will weigh on real GDP growth, likely hitting potential growth. And now an overappreciated ruble will further stall GDP growth.
It is also important to remember that commodity prices might stay elevated in the short term, but what is clear is that Russia is now marked out by the West as an unreliable energy and commodity partner.
Over the medium term, it will be cut out of Western commodity supply chains. Russia’s export volumes will decline, eventually more than making up for the price effect. This could be further precipitated if the G7 follows thru with its plan to impose a commodity price cap on Russia.
Total export dollar receipts will fall, as will the current account surplus, while capital flight likely will sustain and Russia will not be able to replenish FX liquidity through access to international capital markets which remain closed.
Fifth, and as already noted above, Russian access to international capital markets remains highly restricted because of sanctions. In addition, as result of the US Treasury in effect forcing Russia into default on various Eurobond debt payments, Russia will be unable to come out of default and re-access international capital markets unless the US Treasury gives creditors the green light to negotiate with Russia.
That is unlikely to happen unless Russia agrees on a peace agreement with Ukraine. So Russia will have little or no access to international capital markets likely for years to come.
Putting all the above together, Russia has suffered a sizeable loss in GDP, financial asset value, and it does not appear to be managing to bank much of the benefits from the commodity price affect through the balance of payments. CBR reserves are lower, and even then Russia has lost access to over $300bn in reserves which have been frozen.
Oil and commodity prices will not stay high forever. The West will find alternatives to Russian supply, and Russia will likely struggle to quickly divert supply elsewhere - lots of talk of energy sales to Asia, but Russia lacks the pipelines to divert gas from Europe to Asia. And it will take years for these pipelines to be built.
Sure, sanctions have not stoppped the Russian economy in its tracks. But it was never meant to - or the West always had to weigh cost to Russia against the costs to Western economies. But the shear scale of sanctions and self sanctioning will inevitably weigh on Russia growth over the longer term, its ability to finance investment, and likely the economy will stagnate. This means higher unemployment, lower living standards, capital flight and a brain drain.
This all comes as the Russian military suffered a huge loss of equipment in the war in Ukraine. Putin likely will want to rebuild that to maintain Russian military power.
And it’s not even a question of maintaining Russian military capacity but with NATO now upping defense spending in response to the Russian threat, Russia will have to increase defense spending just to maintain some kind of military balance. But with limited external financing options, and a stagnant domestic economy he will have to divert scarce resources from consumers to the military.
As with the arms race between the Soviet Union and NATO in the early 1980s, likely this will create new strains and pressures in the Russian economy, and major social and political challenges and threats. All this might not bring immediate risks to the Putin regime, but likely it will over the slightly longer term. Sanctions just make all of this more difficult.
And where are sanctions going from here?
Well, it is possible to see sanctions being lifted if Putin agrees on some peace deal with Ukraine. But is that likely? And will Putin agree to any deal which means he surrenders any territory back to Ukraine? That seems unlikely, and without the latter, it is difficult to imagine any significant sanctions moderation.
Experience with sanctions in place on Iran or Venezuela is that they are sticky and remain in place for some time. And despite all the talk of Western sanctions unity swaying, there is no evidence since 2014 of any substantial sanctions being taken off. The best here that can be hoped for by Russia is that the sanction rollout is slowed or moderated.
And while some might counter that a Trump win in the 2024 elections might bring the hope of sanctions moderation, that was not the experience of the first Trump term, and notable herein is still the bipartisan support in Congress for a hawkish stance on Russia, and near-universal support for Ukraine.
Meanwhile, the experience over the past decade or more, is of more, not less malign actions by Russia, and now with the setting of a Russia - NATO arms race, there will be more pressure in the West to crimp Russian economic capability to restrain its military rebuild. And sanctions are still one of the limited options it has at its disposal. The reality is therefore more, not less sanctions, causing ever greater harm to the Russian economy.