Sanctions Pushing to Decline?

23 september 2014

A New Reality for the Russian Economy

Alexei Portansky is a professor at the School of World Economics and World Politics at the National Research University–Higher School of Economics; senior researcher at the Institute of World Economy and International Relations, Russian Academy of Sciences.

Resume: Creating substituting production capacities, operating a semi-isolated financial system, spending resources to overcome trade barriers and looking for new markets will require enormous and unjustified expenditures, which will inevitably affect the competitiveness of Russia’s national economy and lead to the impoverishment of the population.

Since the economic crunch of 2008, experts, analysts and economists have offered a variety of short- and medium-term scenarios and forecasts for the development of the Russian economy. But, clearly, none of them could envision such a factor as economic sanctions, for it was not possible to anticipate the events that happened in Ukraine in 2013-2014 and, above all, their consequences. In March and April 2014, in a move designed to condemn Russia’s policy with regard to Ukraine and particularly the incorporation of Crimea, the United States and the European Union announced sanctions against a number of Russian citizens and companies. The former were restricted in travelling to the United States and the European Union and their bank accounts there were frozen. The latter will have to face restrictions in international markets.

Moscow condemned the policy of sanctions as counterproductive and leading nowhere, while at the same time tried to persuade the general public inside and outside of the country that it did not fear any serious impact on the national economy and, on the contrary, expected the sanctions to give a badly needed boost to Russian enterprises by encouraging them to develop and increase their own production. However, earnest independent economic analysis  provides a different picture: even initial sanctions cannot but affect the Russian economy and if further restrictions are imposed, the effect may be more serious and perilous.

WHAT SANCTIONS COULD BE LIKE

Let us clarify what kinds of sanctions are used in international practice in general and which of them can cause the biggest damage to Russia at this point. There can be trade, financial, travel, scientific, cultural and sport, diplomatic, and procedural sanctions. Practically all of them have already been applied to Russia. But these are not international sanctions which can only be imposed by the U.N. Security Council or the International Court. In our case sanctions have been announced by individual countries.     

The most tangible and active measures have been taken against government officials and entrepreneurs. On March 17, the United States introduced sanctions against high-ranking Russian politicians forbidding them to enter the country and putting a freeze on their assets and property abroad. On the same day, EU foreign ministers approved sanctions against Russian and Ukrainian government officials who they believe are responsible for “undermining the territorial integrity of Ukraine.” The sanctions were imposed for six months. Later, on March 20-21, their list was enlarged to include more Russian government officials, parliamentarians and entrepreneurs. On April 11, the United States announced sanctions against the Crimean company Chernomorneftegaz and Crimean officials. On April 28-29, Washington and Brussels expanded them. On May 12, the EU foreign ministers added another 13 persons to the list for destabilizing the situation in Ukraine.

While officials might not have experienced serious inconveniencies and no damage was done to the country in general, Russian scientists, including nuclear physicists, were very strongly affected by American restrictions on travel and participation in major conferences. 

As for procedural sanctions, it would be worth mentioning that the steps taken in the spring of 2014 included the interruption of the talks on Russia’s accession to the OECD, the suspension of Russia’s de facto membership in the G8 and New Zealand’s initiative to halt the free trade area talks, as well as the pressure on the Russian delegation to the PACE with a threat to silence it. In other words, Russia’s positions have worsened in a number of international organizations.

Naturally, the most harmful sanctions for any country are trade and financial ones. These sanctions have a long history and are known to have been used even in Ancient Greece. Sanctions against Russia date back to the late 15th century when the opposing Livonian cities had stopped supplying copper, lead, pig iron, canons, mail armor, and saltpeter. In the early 16th century, the Grand Duchy of Lithuania, the Hanseatic cities (the Steads) and the Livonian Order jointly agreed to suspend the export of non-ferrous and precious metals to Russia, a ban that lasted until 1514. 

The best known example of trade sanctions in the 19th century was the continental blockade of England by Napoleon. His firm position that all European cities should strictly enforce the blockade became the cause of the war on the Iberian Peninsula and deteriorating relations between France and Russia, which subsequently led to the war of 1812. The continental blockade spurred the development of certain French industries (mainly iron and steel, and processing enterprises) but at the same time adversely impacted the economies of other European countries that historically had had commercial relations with Great Britain and for that reason was constantly broken. The main purpose of the blockade declared by Napoleon – demise of Great Britain – was not achieved. 

In the 20th century, trade and financial sanctions were used most often by the United States. In July 1941, when Japan invaded Indochina, Washington froze all Japanese assets. Great Britain and the Dutch East India (now Indonesia) followed suit. The sanctions proved quite effective as they had cut off Japan from the main international trade operations, causing it to lose 90% of its oil import. And yet, Japan did not withdraw its troops from Indochina and responded with the attack on Pearl Harbor.   

In 1996, the United States adopted two sanctions laws. One, D’Amato-Kennedy Act, was aimed against rogue states, namely Iran and Libya, for suporting international terrorism, attempting to acquire weapons of mass destruction and opposing the peace process in the Middle East. The law imposed  a ban on investments, by any country or individual, in the Iranian and Libyan oil and gas sectors in excess of $40 million. But the Cuban Liberty and Democratic Solidarity Act of 1996 (Helms-Burton Act), passed in the same year, was even harsher as it extended and increased the American embargo on Cuba and provided penalties for foreign companies that maintained trade relations with Cuba.

Russia’s ban on the import of wine, juice and mineral water from Georgia in 2006 was also regarded by the international community as trade sanctions even though officially Moscow explained it by sanitary considerations. 

Economic sanctions against Iran were imposed by the U.N. Security Council in 2006, 2007 and 2009. The United States and the European Union stepped them up further with trade, financial, energy and technology restrictions and a ban on insurance and reinsurance services by EU companies. These measures are believed to have achieved the goal by forcing Iran to curtail its military nuclear program.  However not all sanctions have been lifted up to date as Tehran was found to be in breach of some of its obligations.  

The history of sanctions against the Soviet Union shows that the West can impose them even to its own detriment, which proves wrong those who say that the United States and its allies will not increase the sanctions against Russia as this would be harmful to their own interests. In 1930-1933, the only commodity the West agreed to buy was grain, while in the United States its own grain crop was destroyed in great amounts. In 1932, England refused to accept gold, wood, ore, coal and oil, which it so much needed at that time, as payment for machine-tools supplied to the Soviet Union and only agreed to take grain which it could buy at much lower prices in the United States. In 1980, despite the oversupply of grain on the domestic market, Washington banned its sale to the Soviet Union which was experiencing its shortage at the time. Partial sanctions imposed through COCOM in 1960-1980 in most part did not benefit economic interests of Western countries but were diligently enforced against Moscow.  

After the disintegration of the Soviet Union, the West contemplated financial sanctions against Moscow at least on two occasions: in 1998 when Russia was unable to pay debts to foreign creditors, a freeze on its Central Bank’s assets abroad was considered quite seriously; and in 2008 after the war in Georgia when the West was pondering a similar measure against the bank accounts of Russian government officials and entrepreneurs.

WHAT CAN SANCTIONS DO?

How can the economic consequences of the sanctions imposed in 2014 and of potential new ones be assessed? It is generally believed that the sanctions have not had any serious impact on the Russian economy thus far (at least as of the middle of June 2014). This may be true only  for now. The attitude to Russia and its business activities is changing and this change may become much more pronounced already by the end of the year.

The first change that has already taken place is the dwindling trust in Russia and the resulting capital flight and worsening investment climate that was never particularly good. As Finance Minister Anton Siluanov said in April of this year, “the continuing capital flight reduces opportunities for investment and economic growth thus creating the risk of budget imbalances. And the main reason for capital flight is the geopolitical uncertainty.” As a result of the sanctions, more capital left Russia in the first three months of 2014 than in the whole of last year. Forecasts indicate that $100 billion may be taken out of the country by the end of the year. This will put additional pressure on the ruble and spur inflation.     

Unfortunately, there are a great many examples of capital flight from Russia. In April of 2014, some Japanese banks such as Sumitomo Mitsui Banking Corporation and the Bank of Tokyo announced they would scale down their operations in Russia. The former withdrew from the deal to finance export operations for Metalloinvest and for some time froze credit lines for the oil trading company Gunvor. Several American banks have cut investments in Russian assets: in the first three months of the current year Citigroup slashed them by 9%, JPMorgan Chase by 13%, and the Bank of America Merrill Lynch by 22%. Also in April, a leading American investment fund got rid of its stake in Russia’s major agricultural company Rusagro while sustaining tangible losses. Some Chinese companies have also refused to do business in Russia. In May 2014, the Chinese company Beijing Interoceanic Canal Investment Management Cо (BICIM) withdrew from the project to build a deep-water port in Crimea following its incorporation into Russia.

Former Finance Minister Alexei Kudrin believes that with the current level of official and unofficial sanctions Russia’s losses will amount to 1-1.5% of GDP and will not be disastrous for the economy. At the same time, at the beginning of the year he and some other Russian economists warned that the sanctions could create risks for the Russian corporate sector which had drawn more than $700 billion worth of loans from Western banks. And this is indeed a serious problem. 

In the previous years, major Russian companies did not return short-term debts, preferring to draw new loans from Western banks to repay the previous ones. They are hoping to do the same this year or they will have to pay a huge amount of about $100 billion. However, practically no new loan transactions have been made between Western banks and Russian companies since spring when Crimea joined Russia. And Western banks will be more than likely to refuse to issue new loans at the end of the year or they may charge exorbitantly high interest rates. Both scenarios are extremely negative but almost unavoidable.   

In fact, everything will depend on the position of Washington which effectively controls the international financial sector and has actually tightened its grasp lately. Penalties for cooperation with entities “black-marked” by the American Department of the Treasury may be very large. In 2013, HSBC had to pay $1.9 billion fine. In the whole of last year, the United States penalized six major EU banks for $7 billion for having overlooked their clients’ dealings with Iran, Cuba and other such countries. All fines were paid for fear of being cut off from U.S. dollar settlements. The recently adopted FATCA (Foreign Account Tax Compliance Act) further increased control over the flow of funds.

FATCA is an American tax law which requires non-resident financial organizations to provide information about the accounts of American residents and persons under their control and act as tax agents in transactions whereby income is paid in the United States. In other words, the law requires disclosure of foreign accounts for the purpose of taxation. After its adoption, most countries signed interstate agreements with the United States and have been exchanging information with the tax services. However, following U.S. sanctions, Washington stopped FATCA accession talks with Moscow, and the Russian Ministry of Finance had to propose a bill allowing banks to share client information with the foreign tax authorities directly. By June 1, 2014, more than 500 Russian banks, including Sberbank, had registered in the U.S. Internal Revenue Service (IRS) in order to comply with FATCA.

If banks do not sign the agreement with the United States, they will face sanctions. A 30-percent tax will be levied on all payments made in their favor using correspondent accounts in American banks. Subject to the tax will be only passive income at first but eventually, from 2017, it will also be applied to incomes from the sale of securities and transit payments. And if a bank wants to continue its business in the United States, it will have to comply. If a bank gets blacklisted by the U.S. Department of the Treasury, it will simply be excluded from the international financial system. For Russian companies this can mean that they may not be able to find a bank that will agree to lend them money bypassing American rules. 

Many have not realized yet how all-pervading the American financial system is. If, for example, a Russian government official or an entrepreneur wishes to buy some real estate abroad, he will need the services of a bank to transfer the money. But each financial institution has to be linked to a correspondent bank in the United States in order to be able to make settlements. Therefore such a payment can be blocked.   

There is also the threat of sanctions against concrete Russian companies that will be affected most seriously. The Americans are considering stopping the purchases of Russian RD-180 engines which they use for orbiting civilian and military satellites. In this case they themselves will sustain big losses as there is no adequate replacement for the Russian engines. And yet, the issue is under consideration. Should this happen, Russia’s engine manufacturer Energomash will essentially be left without means of existence, as only 60 of 101 engines have so far been delivered under the contract effective until the year 2020.    

Western sanctions have also impacted Russian-Ukrainian economic ties, specifically in the defense industry, and this can entail serious losses for Russia. For example, the Yuzhnoye Design Bureau in Dnepropetrovsk continues to exercise technical oversight and extend the service life of Russia’s most powerful silo-based SS-20 (Voivode or Satan by NATO classification) missiles which make up 70% of the country’s land-based ICBMs and are the main element of our nuclear shield. The control system for the rocket was designed by Ukraine’s Elektropribor in Kharkov. Engines made by the Zaporozhye-based Motor Sich Company are used practically in all Russian combat and transport helicopters. Antonov planes cannot be made without Ukraine as all know-how belongs to Ukraine’s Antonov Design Bureau. The overall volume of military supplies from the Ukrainian south-east to Russia is estimated at about $500 million a year. It’s hard to imagine how these cooperative ties can be severed. However, as Ukrainian Deputy Prime Minister Yerema has said, this has been demanded by Kiev’s partners in the West. On June 16, Ukrainian President Petro Poroshenko ordered a halt to all military-industrial cooperation with Russia.

HOW TO RESPOND TO SANCTIONS?

The wish to respond to the Western sanctions has generated both rational and irrational scenarios. The latter include the so-called “anti-sanctions” such as de-dollarization of the Russian economy proposed by the president’s economic adviser. He suggested major changes in the financial operations carried out by both the public and private sectors and even the population. The government has to withdraw all euro- and U.S. dollar-denominated assets and accounts from NATO states to other jurisdictions and promptly sell NATO countries’ bonds. Parallel to that, the Central Bank will have to reduce the number of its U.S. dollar instruments and get rid of the bonds issued by the governments that supported the sanctions. 

He also proposed that the Central Bank organize a special-purpose issue of ruble banknotes to finance the projects of state-owned corporations and banks. Financial losses from such moves can hardly be estimated, and the latter of them can send inflation spiraling beyond a double-digit mark.

No less harmful would be a proposal, articulated in government circles, that major Russian companies whose securities are trading abroad should list them on the Moscow Stock Exchange. One does not have to be a professional to understand that a mass buyout of one’s own shares in foreign markets for subsequent placement at home is a knowingly loss-making operation a reasonable company will hardly agree to undertake.  

Another “anti-sanction” is the project to create a national payment system. After Visa and MasterCard had stopped servicing Russian banks affected by Western sanctions, they were required to make security deposits at the Central Bank to be used as compensation for damage incurred by their possible refusal to service cards again. However, as the initially proposed size of such deposits by far exceeded Visa’ and MasterCard’s earnings in Russia, they wandered if they should stay here at all. Fortunately, the Russian authorities gave up the initial harsh scenario and the latest version of the Law “On the National Payment System” drafted in May will be revised to delete all provisions concerning specifically the size of the security deposits, their deadlines and the rules of deducting fines from them. All this will be regulated by the government in coordination with the Central Bank.

And the last example of “anti-sanctions” I would like to mention is the proposal to turn off base GPS stations in Russia. This can hardly hurt the Americans, but Russian surveyors, geologists, builders and the local authorities will most likely sustain real losses.   

Along with import substitution, rational responses to the sanctions could also include the use of WTO mechanisms. In the middle of April, Minister of Economic Development Alexei Ulyukayev said that Russia could take legal action at the WTO against the United States for its sanctions against the bank Rossiya. Moscow believes that Washington is in breach of its obligations under the General Agreement on Trade in Services, one of the basic WTO documents. These obligations forbid actions that can adversely affect the rights of Russian companies which provide services in the United States or sell services in partnership with American companies. GATS expressly forbids any restrictions on international money transfers and current payments related to the U.S. specific commitments.

According to Western officials, the European Union and the United States can use so-called sectoral sanctions against Russia, which means arbitrary restrictions on the import of Russian goods. In this case, Ulyukayev says, Moscow will make maximum use of the WTO mechanisms to protect its trade and economic interests. There is such experience. After the adoption of the Helms-Burton Act by the United States in 1996, the European Union considered its trade interests infringed upon and filed a claim at the WTO, stating that this act ran contrary to several articles of the GATT-94 agreement. In the long run, the European Union got what it sought. 

Sectoral sanctions against Russia would be a gross violation of numerous WTO rules and regulations which forbid export bans unless there is a threat to people’s health and security or these are temporary measures allowed by the WTO rules if these rules have been broken. Claims that can be filed by Russia in this case can create tensions within the WTO and become a test of strength for the organization. Clearly, WTO members are not looking forward to that. 

When this article was still being written, it was unclear how to assess the probability of the next round of sanctions against Russia, given inevitable losses for the Western economies. The opinion of Anton F. Börner, President of the German Federal Association of Wholesale and Foreign Trade, is noteworthy in this respect. He observed that with 80% of oil and gas going to the West, earnings from their sale account for more than a half of the Russian budget revenue and about a quarter of the country’s GDP. According to Börner, Russian-European trade generates 1% of GDP in the European Union but 15% in Russia. He believes that a ban on the import of gas would be painful for Germany but would endanger the very existence of the Russian economy and cause it to lose $100 million worth of daily income. But this would not be so critical for Germany which has enough gas in storage to last for about six months during which time it can easily find alternative suppliers. 

Naturally, this is the opinion of only one German entrepreneur. But it is not marginal in EU countries by any means. And given the above examples of Western countries’ sanctions imposed even to their own detriment, Börner’s words may prove correct.  

However, there are other opinions in the West as well. American political scientist George Friedman, who runs the private intelligence company Stratfor, thinks that sanctions against Russia will not be effective. As the world’s eighth largest economy and a strong military power, Russia has possibilities for response. And the stronger the sanctions, the freer Moscow will feel in choosing how to respond. He insists that finding effective sanctions against Russia is a much more complex task than against Iran, for Russia has a variety of means to react, including military ones.     

I don’t want to wind up this artcle with some final formula that can help calculate the effect of sanctions and countermeasures to them. The very situation where sanctions are considered something real and already happening cannot be normal and acceptable because they make us restrict our economic contacts with the rest of the world. But in a world where economies are unprecedentedly interdependent it is impossible to limit contacts with a group of countries (most industrialized ones) without losing ties with all the other ones. China, on which we pin our hopes, is not fencing itself off from the West. By drifting away from the most advanced countries Russia can find itself cut off from development opportunities. Creating substituting production capacities, operating a semi-isolated financial system, spending resources to overcome trade barriers and looking for new markets will require enormous and unjustified expenditures, which will inevitably affect the competitiveness and efficiency of the national economy and lead to the impoverishment of the population. This scenario seems implausible in the 21st century but unfortunately cannot be ruled out completely under the current circumstances.  

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