EconoMonitor

Thoughts From Across the Atlantic

Limits on the Efficacy of Russia’s Economic Weapon

The United States and European allies responded to the Russian annexation of Crimea by announcing targeted economic sanctions against a list of Russia individuals (plus one bank) and threatening to impose stronger sanctions in the future. The sanctions included travel restrictions and asset freezes for the listed individuals. On March 24, the Group of 8 suspended Russia from member activities.

WHY IMPOSE ECONOMIC SANCTIONS?

The traditional case for using economic sanctions is that they could be a humane alternative to military action. President Woodrow Wilson offered a famous justification for sanctions:

“A nation that is boycotted is a nation that is in sight of surrender. Apply this economic, peaceful, silent, deadly remedy, and there will be no need for force. It is a terrible remedy.  It does not cost a life outside the nation boycotted, but it brings a pressure upon the nation, which, in my judgment, no modern nation could resist” (Hufbauer et al). Since Wilson’s statement in 1919, there has been extensive use of economic sanctions, and in most cases, they have not been effective in achieving their goals (Hufbauer et al).  An extreme example is the use of sanctions by the U.S. against Cuba beginning in 1959. The goal was to topple the Communist government of the Castro brothers, but after more than 50 years of U.S. sanctions, the Castros  remain in power. The main problem is that the U.S. has no monopoly power, as nearly every other country in the world trades with Cuba.

STRONG VERSUS WEAK SANCTIONS

The initial sanctions imposed by the US and the EU were weak and did not include trade, because the countries contemplating sanctions had very different economic connections with Russia. Some countries, such as Estonia, Latvia, Lithuania, and Poland are heavily dependent on Russia for natural gas. Others, such as the United Kingdom do not import natural gas, but do an active business with Russian companies and individuals. The United Kingdom, and others, are reluctant to impose sanctions on foreign individuals or foreign businesses because their own laws protect the property rights of law-abiding foreigners. British courts recently ruled in favor of the property rights of Saudi Arabian and Iranian businesses operating in the UK. Stronger sanctions that would include trade would impose greater cost on Russia, but they would also impose greater losses on the countries imposing sanctions and the weak European economies.

Why would countries impose weak sanctions If they know the sanctions will not cause Russia to withdraw from Crimea? The leaders have ruled out military intervention, but they seem obligated to show their voters that they have done something to register their protest over Russian aggression.

RUSSIA IS NOT IRAN

Some observers in the U.S. State Department have cited the efficacy of sanctions toward Iran aimed at limiting its nuclear project. So far it is unclear whether Iranians have done anything more than talk about limiting their nuclear program, but new Iranian leaders have cited the adverse economic effects of sanctions on the Iranian economy. Russia and Iran are both specialized exporters of energy, but they are in very different situations. Russia is a much bigger country than Iran and its oil exports are also substantially larger. According to estimates by the U.S. Energy Information Administration, Russia exports about 7.2 million barrels of oil per day (see the chart below), which is almost three times more than Iran did before the recent sanctions that reduced Iran’s exports by about 1 million barrels per day were introduced. To put a similar pressure on Russia, its oil exports would have to be cut by about 3 million barrels per day, which would result in a significant increase in oil price, at least in the short run.

 

 

 

 

 

 

 

 

 

Iran was a relatively smaller player on the global market and it was thus less painful for the sender countries to sanction it. In addition, an importer of Iranian oil can rather easily switch to oil from another source while Iran’s natural gas exports are negligible. Russia, however, is a large exporter of natural gas, which is mostly delivered by pipeline, and trade is much more regional than global. At the same time the weight of natural gas in the total mineral exports of Russia is relatively small (see chart below). Russian natural gas is thus a powerful short-term lever relative to its current regional customers.

 

 

 

 

 

 

 

 

LONG-TERM LIMITS ON THE NATURAL GAS WEAPON

In the short-run, stronger sanctions that include trade, would impose large costs on countries imposing sanctions without necessarily achieving their goal.  In the long-run, current importers of Russian natural gas could make themselves less dependent on their current unreliable supplier. The new government of Ukraine could eliminate the large subsidies to the use of natural gas that they have retained since gaining independence in 1991. Indeed, loans from the IMF are likely to be conditional on eliminating subsidies that currently contribute to Ukraine being one of the largest users of energy per dollar of GDP. EU members could diversify their sources of gas by building facilities to import liquefied natural gas, as Poland is currently doing at the Baltic port of Swinoujscie and Lithuania is doing at the Baltic port of Klaipeda.  The United States, which has recently become a much bigger producer of natural gas, could remove its obsolete restrictions on exports of natural gas. The U.S. Department of Energy approved an export application on March 24, and 24 more applications are currently waiting for approval.

New discoveries of natural gas off Israel and Cyprus could contribute to reducing the regional monopoly power of Russian gas. Conversely, restrictions by some EU countries on exploration for shale gas contribute to protecting Russia’s monopoly power. So does Germany’s resolve to abandon nuclear energy.

There is another factor that reduces the economic leverage of Russia in the long-run. When the Russian government seizes territory and assets in Crimea, or when it seizes the assets of political opponents in Russia, it blatantly ignores the property rights of owners and the rule of law. If investors have access to world markets that provide better protection for their property, many of them will move their funds abroad. In the first quarter of 2014, the Russian government announced an estimated capital outflow of $70 billion (compared to an outflow of $63 billion for all of 2013). If these funds were withdrawn from what would have been productive investments, the large capital flight would be harmful to the Russian economy. The latest World Bank forecast calls for a drop in Russian real GDP of 1.8% for 2014.

CONCLUSION

Weak economic sanctions against individual Russians and Ukrainians (and Bank Rossiya) have not deterred Russia from annexing Crimea. Stronger sanctions that would include restricting exports and imports have been avoided so far, because they would do large damage to some countries imposing sanctions, as well as to Russia. Based on the history of the use of economic sanctions, they would be unlikely to achieve the goal of persuading Russia to withdraw from Crimea. Limits on transporting natural gas strengthen Russia’s short-run monopoly power in the region. Current importers from Russia can reduce their long-run vulnerability to supply interruption by investing in alternative sources of natural gas and other forms of energy. As an inefficient user of natural gas, Ukraine can reduce its vulnerability to an interruption by immediately ending its subsidies to the use of energy. The United States could contribute to increasing sources of natural gas by immediately ending limits on natural gas exports.

REFERENCES

Hufbauer, Gary et al. Economic Sanctions Reconsidered, 3rd ed, 2007

Reuters:  ”EU Options on Russian Energy Stranglehold Few and Pricy,” March 24, 2014

Wall Street Journal: “Court Rulings Against Penalties Make EU Wary,” March 21, 2014

5 Responses to “Limits on the Efficacy of Russia’s Economic Weapon”

Mikhail ChebanApril 1st, 2014 at 4:51 am

Sanctions in long run will work if
1.Us to sell its oil reserve which is obsolete
To reduce oil prices $10-$15
2.Restrictions on high end military equipment
Exports to Russia.
3.restrictions on technology exports to Russia

4.financial restrictions of credits and investments to Russia
In long run above named sanctions will degrade Russia development into high end economy.

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