The Russia Sanctions Cul-de-Sac

The Russia sanctions are likely to have an adverse impact on Russian, U.S. and Chinese economy and could push Europe to a triple-dip recession. A diplomatic solution could deter diminished global prospects.

Last March, President Obama initiated and expanded sanctions against Russia in financial services, energy, defense and related materials sectors. Meanwhile, China’s Ambassador to Germany Shi Mingde cautioned the West against sanctions, saying such measures could “trigger a spiral with unforeseeable consequences.”

In May, Russia signed a 30-year gas deal with China. The agreement between Russia’s Gazprom and China National Petroleum Corp (CNBC) was estimated to be worth over $400 billion. Moscow diversified its energy markets from the West to the East.

On July 16, Washington initiated unilateral restrictions targeting powerful interests in Russia’s financial, energy, and military technology sectors, including Gazprombank, Vnesheconombank, Novatek, and Rosneft; as well as senior government officials. After Malaysia Airlines Flight 17 was shot down in Ukraine and 300 people perished, EU leaders joined in the sanctions against Russia.

In turn, Moscow banned the import of agricultural goods from countries that had imposed sanctions on Russia. The tit-for-tat move reflected the deepening standoff between the Kremlin, Washington and Brussels.

Sanctions united Russia 

In Russia, growth forecasts are being downgraded, prices are rising and food shortages are felt. Washington and Brussels hope that the Ukraine crisis and the sanctions will quash the popularity of President Putin in Russia. For the time being, the net effect has been precisely the reverse.

Before the Ukraine crisis last October, Putin’s approval rating had plunged to 61 percent; the lowest since 2000. In March, the annexation of Crimea galvanized public opinion behind Moscow. Two months later, Putin’s rating soared to 83 percent; and recently, to a record high of 87 percent.

Instead of focusing on economic reforms in Russia, the West opted for a political approach to crush Moscow. That is likely to prove expensive to Russia, Europe and the United States.

In the 2000s, Russia’s growth exceeded 7 percent on average until the global crisis 2008/9, which caused a dramatic contraction. In the subsequent years, growth halved to 3-4 percent, while inflation remained at 5-8 percent. Meanwhile, Putin’s domestic support dwindled to 61 percent. By 2013 growth halved again to 1.3 percent. In 2014, Russia is likely to suffer a mild contraction, even as inflation amounts to 7 percent.

In the absence of the West’s sanctions, Putin’s approval ratings might have declined to low 50s. That, at last, was the trend line. Instead, sanctions unified Russia behind Putin.

Despite efforts at diversification, oil, gas and petroleum products accounted for some 70 percent of total exports in 2013. Growth is likely to stay around 1-1.8 percent until 2020, with inflation around 5 percent.

In brief, Russia needs economic reforms, not political sanctions.

Undermining sanctions objectives

Instead of pushing Russia into a corner, the US-EU sanctions are incentivizing new cooperation between Russia, China and other large emerging economies. Moscow’s reliance on Chinese loans could blunt the impact of the current sanctions. The Treasury Department believes that it has “increased the cost of economic isolation for key Russian firms.” Yet, the proposed isolation does not extend to the Russian energy giants’ reliance on Chinese lending.

Russia and its BRICS partners are already creating a development bank to serve as an alternative to the West’s International Monetary Fund and the World Bank.

The sanctions also banned sales of energy-related equipment to Russia. However, that could boost its domestic oil equipment industry, which is becoming competitive globally, and Chinese companies.

Bilateral strategic collaboration has been precipitated by years of cooperation at international forums, including the Shanghai Cooperation Organization.  Moscow may turn to Beijing for military and aerospace components. Further, Russian efforts to launch large-scale cooperation with Chinese manufacturers could pave the way toward technology alliances among BRICS member states.

The EU ban prohibits dual-use technology exports to Russia that can be used for military purposes. While Moscow will seek to supplant Western dual-use imports through other trade partners, including Beijing, it will need a few years and large investment to develop domestic substitutes for advanced European sensors, lasers and other items.

Meanwhile, America is pricing itself out of the arms export markets, while the quality of Russian exports has improved. Since 2003, the U.S. has dominated arms exports globally, but last year Russian weapons exports surpassed the U.S. by over $2 billion.

As five Russian state-owned banks have been cut off from access to European capital markets, investment and lending in Russia has decreased. As a result, Russian companies, such as MegaFon and Norilks Nickel rushed to snap up Hong Kong dollars, which are not subject to Western regulations and are pegged to the U.S. dollar. By early August, Hong Kong’s monetary authority had spent $9.5 billion to protect its peg for the currency, boosted by the Russian buying binge.

In the long-term, the most serious implication from the sanctions could be an accelerated risk to the dollar dominance.

Economic spillover threats

America accounts for a relatively small share of Russia’s trade and investment. Last year, Russia imported less than 6 percent of its goods from the U.S. and exported less than 3 percent of its goods to the U.S. Less than 1 percent of foreign investment in Russia is from the U.S.

But the sanctions are likely to be more harmful at the firm- and sectoral level. Many large U.S. corporations export to Russia, have joint ventures, or rely on Russian suppliers. These include ExxonMobil’s cooperation with Rosneft in the Russian Arctic; Pepsi’s operations; Ford’s partnership with Sollers; GE’s joint ventures; Boeing’s exports and so on.

Sanctions also have significant indirect economic effects on Russia, including undermining investor confidence (e.g., capital flight).

But it is America’s most important trade and investment partner, the ailing Europe that has the most to lose in the sanctions debacle. In the financial sector, European banks had 75 percent of Russia’s foreign bank loans in late 2013. Russia supplies Europe with a third of its oil imports and over two-fifths of its natural gas imports.

It is for this reason that Germany’s Chancellor Angela Merkel rushed to Kiev to pave the way for peace talks between president Putin and Ukrainian president Petro Poroshenko. Her balancing act was designed to sustain Europe’s economic development, despite the sanctions. While Moscow does not want to see Ukraine in the NATO, Merkel indicated that she did not see “membership” in the agenda but that Kiev could continue its “cooperation” with the NATO.

Then came the reports from Kiev suggesting a “Russian invasion” was under way. Now even the Euro zone core economies – Germany, France, and Italy – began to ponder extra sanctions on Russia, while NATO encouraged Ukraine to pursue membership.

As Merkel’s cautious recalibration was undermined by these real and alleged events, Washington kept pressuring the EU leaders. But the latter opted to wait how Russia will react to Poroshenko’s new “peace plan,” while Beijing advocated negotiations.

If the West will tighten current sanctions incrementally, global economic prospects still remain manageable. If, however, the West takes the sanctions to still another level, the consequences could prove particularly severe in the key economies. In Russia, that would test Putin’s popularity and turn a mild contraction into a more serious recession. In Europe, it could push the region into a triple-dip recession. In the U.S., it would threaten the fragile recovery directly through sectoral pain and indirectly through European stagnation.

In the nascent multipolar world, Cold War era sanctions no longer achieve their objectives, but are likely to have an adverse impact on all affected economies and could drastically diminish global economic prospects.

Sanctions must be replaced by a diplomatic solution – the sooner, the better.

Originally released by China-US Focus on September 1, 2014

One Response to "The Russia Sanctions Cul-de-Sac"

  1. windriven   September 5, 2014 at 9:58 am

    "In the absence of the West’s sanctions, Putin’s approval ratings might have declined to low 50s. "

    I wonder on what you base that assertion? Putin's surging approval numbers result from his revanchist moves to grab first Crimea and now Eastern Ukraine.

    "[I]t is America’s most important trade and investment partner, the ailing Europe that has the most to lose in the sanctions debacle."

    It is also Europe (and NATO) that has the most to fear from an expansionist Russia.

    "Then came the reports from Kiev suggesting a “Russian invasion” was under way."

    No need for scare quotes. A Russian invasion was under way as satellite images have clearly demonstrated.

    "Sanctions must be replaced by a diplomatic solution – the sooner, the better."

    A diplomatic solution is clearly reachable. My question to you is: what would be an acceptable cost? I really dislike drawing parallels with 1930s Europe but the resonance is obvious. Perhaps Putin simply wants to avoid Ukraine as a NATO member. That would, given Russian history, not be an entirely paranoid desire and one could argue that Putin has been transparent about his discomfort with the western drift of Ukraine. But do we in the west simply ignore Putin's bald-faced lies about arming the rebels, firing from Russian territory into Ukraine, complicity in downing a civilian airliner, and ultimately invading Eastern Ukraine? Is this likely to boost peace and tranquility over the long term?