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The impact of sanctions
And what's really going on with the Russian economy?
Muscovites queue at the autarkic version of McDonald’s named Vkusno-i-tochka, after the US company sold its restaurants and left Russia
The West has helped Ukraine in its war against Russia in two main ways – through military assistance to Ukraine and economic sanctions against Russia. Over the last few months the pace of deliveries of weapons and ammunition has been stepped up in preparation for a new Ukrainian offensive on which much now depends. There are anxious questions about the state of Ukrainian air defences and artillery, and how well infantry fighting vehicles and tanks will fare against entrenched Russian defences. This was discussed in my previous post. We will start to get some answers soon enough.
As for the other part of the strategy – economic sanctions – that appears to have been taken about as far as it can go. There have been ten rounds of sanctions since 2014 and so the big moves have been made. Another round of sanctions is under discussion but with each new stage consensus becomes harder to find on harsh new measures. The Group of Seven (G7) countries are due to meet in Japan on 19 May to discuss the next round of sanctions. The US has proposed that that all exports to Russia be banned, with only some limited exemptions, but this has met stiff resistance from Japan and the EU. The most likely outcome is that the next round will largely tie up loose ends and close loopholes. The economic effects of these sanctions on the Russian economy have not been negligible but their political effects are generally held to be disappointing.
If we recall the build-up to the war the threat of sanctions was presented as a deterrent to the aggressive action that Russia eventually took. When deterrence failed, their implementation was intended to confirm Russia’s isolation and hurt its ability to prosecute the war, putting the Kremlin under intense pressure to reverse course.
It is not surprising that the threat failed as a deterrent. Russia had been under a variety of sanctions since it annexed Crimea in March 2014 and these had made no appreciable difference to its behaviour. If Moscow had succeeded with the short sharp war it intended, the subjugation of Ukraine would have been a done deed before the sanctions could be organised. The message to Western policy-makers would have been that there is little point in any tough measures because these will hurt their countries while making little difference to Russia.
The Intended Impact
In the event Moscow was not only surprised by the tenacity of Ukraine’s resistance but also the severity of the Western response. Checking on the Castellum.AI dashboard, we can see that so far there have been 12,616 sanctions put in place since the invasion, in addition to the 2,695 that were already there from 2014. The majority (9,843) are against individuals. The most consequential restrict Russian gas and coal exports and seek to impose a price cap on oil exports. There are also restrictions on the sale of luxury goods, professional services, access to IMF and World Bank Funds, sovereign debts, and Russian banks use of the SWIFT international payments system. Some $300 billion of Russian assets have been frozen. The sanctions have been implemented by the US, EU, UK, Switzerland, Canada, Australia, New Zealand, and Japan, but not, notably, those many countries that come under the heading of the ‘global South.’
At first the economic hit was expected to be substantial. Here is the US Government’s ‘fact sheet’, from 24 March 2022:
‘The ruble has depreciated substantially, and is expected by markets to weaken further. The Moscow Stock Exchange closed for weeks. The Central Bank of the Russian Federation has doubled interest rates to 20 percent and companies are being forced to turn over foreign exchange for rubles to provide the Russian Government hard currency. The economy is forecast to contract as much as 15 percent or more in 2022. This economic collapse of Russia’s GDP will wipe out the past 15 years of economic gains in Russia, according to the Institute for International Finance. Inflation in Russia is already spiking, with analysts projecting it to rise up to 15 percent on a year-over-year basis, and the Russian Government has been downgraded to “junk” status by major credit rating agencies. More than 400 multinational companies have left Russia in a mass exodus by the private sector.’
All this was perhaps not enough to force a fundamental reappraisal of Moscow’s war strategy but at least, Western governments hoped, sufficient to have an impact on its fighting capacity, drain public support as conditions deteriorated, and so encourage compromise when it came to peace negotiations.
The actual impact
Yet the ruble soon recovered from its steep fall after the invasion and, in the event, the Russian economy coped far better than expected. If anything it became healthier because the conflict triggered much higher oil and gas prices and so the state’s revenues shot up. This enabled debts to be repaid and the currency propped up, helping to limit inflation. Because the sanctions were not backed by the United Nations most non-Western countries felt under no obligation to take much notice while Russian technocrats showed some ingenuity in managing the economy efficiently. For much of the Russian population, at least those not directly affected by the fighting, life could go on as before. While many Russian banks are no longer part of SWIFT some retained access for oil and gas payments to be made, and elsewhere trade is increasingly in Yuan.
A key feature of these sanctions is the number of individuals who can neither visit Western countries nor gain access to their possessions and wealth held in them. There was always some uncertainty as to whether this was a way of punishing those close to the regime, culpable in some way for its aggression and criminality, or to put pressure on the regime, because these people had real influence and their upset about their degraded lifestyles would lead them to demand an end to the war. Not only has the impact been limited, as individuals make do with Dubai as a holiday destination and transfer assets to friends and family, but the effort probably always reflected an exaggerated belief in the importance of the ‘oligarchs’ in Russian decision-making.
As always with sanctions, smuggling and new partners have replaced some of the old trading relationships. As the Economist has noted, Russia imports almost as much as it did before the invasion, with new trading partners replacing the West.
‘“Parallel” imports—unauthorised sales from the West to Russia via a third country of everything from fizzy drinks to computer chips—have soared. In 2022 imports from the EU to Armenia mysteriously doubled, even as Armenian exports to Russia tripled. Serbia’s exports of phones to Russia rose from $8,518 in 2021 to $37m in 2022. Shipments of washing machines from Kazakhstan to Russia rose from zero in 2021 to nearly 100,000 units last year.’
The IMF Assessment
By the time of the first anniversary of the invasion, last February, there were a number of articles lamenting the failure of sanctions. Too many ways had been found to evade them. Harvard economist Ken Rogoff observed: ‘it is clear that the current sanctions regime has failed to devastate the Russian economy, as Western leaders had hoped.’ His point appeared to be underlined recently when the IMF (where Rogoff was once chief economist) upgraded its forecast for the Russian economy, from a modest 2% fall last year to 0.3% growth this year and 2% growth in 2024. The IMF observed that the strong fiscal measures taken by Russia had allowed it to maintain ’quite a bit of momentum in the economy’.
Such assessments matter because they reinforce the view that Putin can cope with a long war. On this reading not only is Russia not collapsing under the weight of sanctions but is managing sufficiently well to keep going whatever the setbacks in the military sphere. It points to an underlying resilience that means that the economy can be sustained even as Russia replenishes and reconstitutes its damaged armed forces. When combined with a crackdown on internal dissent (as always it is worth following Sam Greene on this) Putin can continue to pursue this calamitous and futile war for as long as he thinks necessary. These are the sort of concerns that add to the pressure on Kyiv as it prepares its next military moves. President Zelensky knows that if the situation on the ground remains much the same as today in a few months’ time the pressures on him to agree an unsatisfactory compromise will grow.
Even as this narrative around the failure of sanctions has been developing some analysts have argued that it misses essential aspects of the situation, suggesting that Russia’s economy is suffering more than is superficially apparent, that its long-term prospects are bleak, and that even in the shorter-term shortages and budgetary pressures will affect its military capabilities.
The IMF is on the high end of the current range of forecasts, above even the Bank of Russia, which forecasts a contraction of 1.1% for 2023. The World Bank’s forecast is of a 0.2% contraction and the OECD’s a 2.5% contraction A high-powered group from Yale University has accused the IMF of ‘flying blind,’ because so much essential data has been withheld by Russia, and of failing to engage with alternative data sources. Alexei Bayer has described available Russian statistics as a ‘collection of lies and distortions,’ intended ‘to convince people at home that their economy is chugging along despite the war, and people abroad that Western economic sanctions don't work and therefore should be rescinded.’ He notes for example that the statistics show inflation at 11%, only a couple of points higher than before the invasion, when in practice it is probably closer to 30%.
The only sector booming in the Russian economy is the military. This is estimated to have gone up from around 4% of GDP in 2021 to 7% last year. It is likely to be even higher in 2023. The consequential costs of the war, for example the promised pay-outs to bereaved families and disabled veterans, will add to the bills. On the Finance Ministry’s own figures Russia's federal budget balance sank to a deficit of 2.4 trillion rubles ($29 billion) in the first quarter of the year as Moscow spent heavily and energy revenues fell. (In the same quarter of 2022 Russia posted a surplus of 1.13 trillion rubles.)
Oil and Gas
The reason for the growing deficit is not only the costs of the war but also the fall in oil and gas prices, leading to tax revenues being almost halved. Despite past efforts to diversify the economy, and encourage manufacturing, which has taken a heavy blow because of sanctions, Russia remains highly dependent on energy exports. Their performance is at the heart of every assessment about the state of the Russian economy.
Here we have a paradox in the politics of sanctions. So important is the energy sector that both sides saw it as a way to coerce the other. The Russians had seen how Germany remained keen to persevere with the NordStream 2 gas pipeline even after the annexation of Crimea. Even though the German government abandoned the project after the invasion it was not hard to discern the anxiety in Berlin and elsewhere in Europe about where the logic of sanctions might lead. The Kremlin therefore saw Europe’s dependence on its gas as one of its vital levers in persuading the West to abandon Ukraine. Just as Europe was trying to coerce Russia by denying it revenues, Russia was trying to coerce Europe by denying it energy supplies.
For Russia there was a sweet spot in the market where cutting gas supplies pushed the prices up to cause the maximum hurt to Europe while allowing it to maintain or even increase its revenues. Thus, as Nick Butler noted in his March post, it was Russia that initiated the cuts in the supply of gas, first to those countries refusing to pay in rubles and then later by reducing the throughput of NordStream 1 to 40 per cent of the normal level. Then in September, in time for winter, it suspended supplies completely, ostensibly because of maintenance work.
As an act of coercion this failed: instead of persuading Europeans to rethink their support for Kyiv the effect was the opposite. Urgency was injected into the search for energy saving measures and alternative sources of supply. Gas prices fell and with them Russian revenues. Attempts to develop alternative markets for Russian gas are hampered by the lack of gas pipelines heading east and south.
With regard to oil, the jump in prices after the invasion was the result not so much of shortages as market panic. Late last year the West agreed on a scheme to prevent Russia selling oil above a price of $60 per barrel. Europeans no longer buy Russian oil and so the bulk of its crude exports are now going to India and China. But this does not mean that they have been successful in getting the prices they need. Even to willing buyers Russia is still having to sell at just above $60. Russia was helped by the April decision of the Organization of Petroleum Exporting Countries (OPEC), in which it participated, to lower output targets by 1.6 million barrels per day (bpd). For this decisions to have its intended impact all countries must stick to their lower outputs. The price must move appreciably higher to sustain the lower volumes, so that they can earn more by selling less. After going above $66 per barrel just after the OPEC announcement, the price of Urals crude has dropped back to $63. At its peak last summer it was over $93.
Putin has at times spoken of as autarchy as a desirable end state for Russia, although for the moment the logic of the situation is to make his country increasingly dependent upon China. It is true that many companies are still operating in Ukraine, but large numbers have pulled out. There is little investment in its non-military sector, where industrial production is shrinking by about 8% a year. By contrast military orders have jumped by over a third.
Some 1,000 companies have left Russia, depriving the country of future investment in oil and technology. Another serious issue, with short-term consequences and dire implications for the long-term, is the declining population. There have long been problems with a declining birth rate and a high mortality rate. Covid took a heavy toll. Many have been killed or badly wounded in action. Others have fled the country. With the military still trying to find new recruits to replaces its losses there are reports of severe labour shortages elsewhere in the economy, especially in information technology. In this sector 10% of workers left Russia last year, confident of being able to gain employment elsewhere.
The other key question about the impact of sanctions is whether they have interfered with Russia’s ability to replace the thousands of items of destroyed or damaged equipment. Russia is following expedients from scavenging what is still left in Russia, even in museums, and holding back on meeting export orders (which has been a big business for Russia in the recent past). In terms of new production it is hampered by a lack of components that were imported in the past, including microchips. Recently Forbes has reported, drawing on a CSIS study, about Russian problems getting hold of modern optics and high quality ball bearings. These are essential for tank and armoured vehicle production. The shortages initially were so great that factories had to close. Production continues to be far below demand. Ball bearing shortages also have an impact on trains, essential to Russian logistics.
All this suggests that while the early claims that sanctions might oblige the Russians to give up on Ukraine were far too optimistic, the more recent pessimism about Russia’s ability to cope with the economic headwinds might have gone too far in the other direction. The prospect is still one of short-term difficulties and long-term decline, even though the economy has not fallen off a cliff-edge and is unlikely to do so.
How much does this matter for the coming months of the war? The Economist offered an interesting assessment when it judged that while Putin ‘should be able to maintain the war effort for some time to come. Expanding it, however, is another matter.’ There no evidence to suggest that Putin is content with a stalemate based on the amount of Ukrainian territory currently occupied. If he was he would not have tried to take more in Russia’s own recent offensive. Putin has not achieved even his minimum war-aims. If the prospect is only of resisting the next Ukrainian offensive rather than Russia mounting one of its own then the gloom in Moscow will only grow.
We can grasp the potential consequences should Ukraine’s offensive fail to make much progress, but we have little knowledge of deliberations inside the Kremlin as there continues to be so little to show for recent military exertions. That does not mean that debates are not underway and that the attitude is complacent. There is a complex interaction between Russia’s military and economic performance, which could lead to increased pressure to find a way out if both continue to move in the wrong direction for Moscow. It may be as mistaken to assume that the economy is strong enough to sustain Russia come what may as it was last year to assume that it would soon bring Putin down.
How to end sanctions
This leads on to another issue worth considering with sanctions, although it is not one that needs to be addressed yet. As with wars, once punitive economic measures are launched they are hard to end. This is in part because of the uncertainty as to whether they are a form of international virtue signalling, reflecting a desire to have as few relations as possible with countries that engage in obnoxious practices at home and abroad, or a means of persuading those countries to abandon some of these practices.
If it is about changing behaviour then how much has to be changed before the sanctions can be lifted? If efforts to stop the fighting fail to get much beyond a cease-fire there would seem to be few grounds for any relaxation, especially if swathes of Ukrainian territory are still in Russian hands. But suppose Russia agrees to withdraw back to the borders of 23 February 2022, with the Donbas enclaves and Crimea still held, should that be rewarded with some easing? And even if Russia goes further what about all the issues of reparations and war crimes? And in the unlikely event that these can be resolved can we still imagine going back to previous levels of business with Russia while Putin is still in power?
We’ve been here before with the sanctions on Iraq that were imposed because of the invasion and occupation of Kuwait in August 1990. Even after Kuwait was liberated they were maintained to ensure that Saddam Hussein abandoned weapons of mass destruction, terrorism, and claims to Kuwaiti territory. There was also the suggestion that they would stay until Saddam went. Over time they became criticised for the effects on the Iraqi people, notably child mortality, and the way that the regime used them to strengthen its position, blaming the West for the country’s woes while controlling the smuggling and rationing that allowed it to cope. Gradually their effectiveness declined with increasing numbers of exceptions and evasions.
The sheer range and complexity of the sanctions imposed on Russia, with their many layers and evident gaps, creates scope for a progressive unravelling according to how Russia behaves. This is more likely than an abrupt lifting of all measures. I realise this is doing what I always warn against –getting too far ahead of ourselves when there are important matters to be resolved in the short term that will shape the long term options. But these are critical issues that are bound to arise in one form or another especially if serious negotiations ever do begin on a long-term peace treaty.
Perhaps Russia is settled in for the indefinite future without regard for the inadequacy of its military efforts and the damage to its economy. For now we must back Ukraine’s offensive and toughen sanctions where possible. There may yet come a time when Moscow might start to consider how to get out of both the military and economic holes it has dug for itself. When they do the future of sanctions will soon loom large as an issue.
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