The effect of sanctions on the Russian economy

The effect of sanctions on the Russian economy

The United States and the European Union have now both announced that they are extending the economic sanctions they first imposed against Russia in March 2014 for its actions in Ukraine. One year on, the West thus remains committed to a policy which has failed so far and which has no chance of succeeding in the future. The sanctions policy was destined to fail because it was based on false assumptions about how most Russians think in particular, how they think about security. 

The current official Western view is that sanctions are a way to punish Russia for violating the rules of the international order and to correct its behavior in the future. The Russian peoplebelieve, that sanctions are designed to weaken Russia and reduce its ability to defend itself. These different views are only the tip of the iceberg of mutual misunderstanding between Russia and the West, misunderstanding that is rooted in our fundamentally different views of how nations can best ensure their security in today’s world. The sanctions against Russia bring to an end a 25-year-long quest to make Moscow a partner of the West. 

The main economic sanctions are the following:

• EU nationals and companies may no longer buy or sell new bonds, equity or similar financial instruments with a maturity exceeding 30 days, issued by:

• five major state-owned Russian banks, their subsidiaries outside the EU and those acting on their behalf or under their control.
• three major Russia energy companies and
• three major Russian defence companies.

• Services related to the issuing of such financial instruments (brokering), are also prohibited.
• EU nationals and companies may not provide loans to five major Russian state-owned banks.
• Embargo on the import and export of arms and related material from/to Russia, covering all items on the EU common military list.
• Prohibition on exports of dual use goods and technology for military use in Russia or to Russian military end-users, including all items in the EU list of dual use goods. Export of dual use goods to nine mixed defence companiesis also banned.
• Exports of certain energy-related equipment and technology to Russia are subject to prior authorisation by competent authorities of Member States. Export licenses will be denied if products are destined for deep water oil exploration and production, arctic oil exploration or production and shale oil projects in Russia.
• Services necessary for deep water oil exploration and production, arctic oil exploration or production and shale oil projects in Russia may not be supplied, for instance drilling, well testing or logging services. 

After months of disjointed action, America and Europe finally put together a package of sanctions targeting state-owned banks and forbidding the export of technologies needed by Russia’s oil and defence industries. The restrictions on technology exports to the oil sector left the gas industry conspicuously untouched, an obvious concession of Europe’s dependence on it.  On their own, the sanctions will not bring Russia to its knees, but they could do real damage to its economy.

The sanctions against state-controlled banks present the biggest and most immediate threat to Russia’s economy. VTB, Sberbank, Gazprombank and Vnesheconombank have around $15 billion in bonds denominated in dollars, euros and Swiss francs maturing in the next three years. The new sanctions make it harder for lenders such as these to raise equity and debt on Western capital markets. Without access to long-term external financing, their debts will be harder to pay.

The fall-off in business activity is without doubt US and EU sanctions, meaning the cut-off of foreign credits, the inability of the Russian majors to roll over hard currency debt. The sell-off of assets to meet credit calls hit the stock market. This, in turn, produced shock waves in the banking and insurance sectors, including weaknesses at such major institutions as Uralsib Bank and at big Russian insurers, whose portfolios were devalued, forcing them to abandon various sectors and let go a great many employees.

The flow of international capital into Russia has already fallen. Dollar loans from foreign banks dropped to $7.9 billion in the first half of 2014, from $25 billion a year earlier, local firms have become more reliant on state-controlled Russian banks as a result. Although state banks can draw on domestic savings, and perhaps other sources of financing in places, like China, less money will be available to finance investment. And if China does offer money, it would only be in exchange for preferential access to Russia’s natural resources.

The main medium-term risk for Russia’s growth lies in the continued dearth of investment and lack of affordable credit. In particular, less foreign direct investment could limit the transfer of innovation and technology that is critical to increasing Russia’s growth potential. The World Bank notices that systematically lower investment rates will ultimately reduce Russia’s prospects for growth in the coming years and limit already modest growth potential.

The sanctions do not target Russia’s energy exports. But an embargo on Western technology will limit Russia’s ability to tap new and hard-to-reach in the Arctic and elsewhere, and we can get a possible decline in hydrocarbon revenue in years to come.

Deep structural problems in the Russian economy was an important cause of the slowing Russian growth in 2014, and this was compounded by the terms of trade shock, geopolitical uncertainties, and the economic sanctions later in the year.

Butdespite the influence of factors that hit the economy in 2014, Russia has so far avoided recession. The influence of the main shock, the slump in oil prices, only began to affect the economy in the final quarter of last year, and the impact will be more profound in 2015 and 2016. Moreover, the Russian government and Central Bank were able to respond quickly with policy responses that successfully stabilized the economy.

The economic effect of sanctions will continue for some time. As lessons from international experience demonstrate, economic sanctions could well change the structure of the Russian economy and the ways in which Russia integrates with the rest of the world. And going forward, risks arising from a lower oil price and continued economic sanctions environment will need to be managed and regulated.