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When Russia invaded Ukraine in February this year, the international community imposed a series of sanctions on the invading nation. They froze the assets of wealthy and powerful Russian citizens and restricted their ability to travel. They restricted the sale of Russian raw materials and energy and worked to prevent Russia from getting its hands on various types of defense and information technology. And they imposed financial sanctions on Russian banks and restricted Russia’s access to foreign capital and financial markets.
Many companies have followed these government-imposed sanctions with so-called self-sanction, whereby companies have restricted or terminated business relations with Russia and Russian companies. The effect, on paper, appeared to be a set of measures that struck at the heart of the Russian economy. This year’s spring forecast predicted a fall in GDP of at least 7-8% (and possibly as much as 11%) for 2022. Prices are expected to rise by 20-25%. Foreign direct investment by companies is expected to fall by 25-28% during the year.
But Russia was not brought to its knees. Far from it: forecasters say Russian GDP for 2022 will likely fall, but only by around 3.3-3.4%. Inflation, meanwhile, will probably end the year at around 12%: bad, but not as painful as expected. And foreign direct investment? According to estimates, it will fall by only 1%.
Meanwhile, the war in Ukraine continues.
So what was wrong? A report by Bruegel, a Brussels-based economic think tank, points to a number of flaws in the sanctions regime and several strengths in Russian defenses.
The most effective defense was put in place by the Central Bank of Russia, which designed and executed the “Fortress Russia” policy, aimed at protecting the Russian financial system. The system was hit hard early on, as sanctions on Russian central bank assets were much harsher than expected, cutting its bank reserves by 40%. However, thanks to competent management, the system has recovered and the Bank continues to hold large amounts of foreign exchange – up to $300 billion – for possible intervention in the foreign exchange and debt markets. And even though Russian banks have lost access to the SWIFT financial transfer system, they still seem able to get the cash they need to operate, as various other channels continue to allow Russian banks to interact with the outside world. In other words, despite some significant shocks, the central bank kept the Russian financial system intact and prevented a collapse of the broader Russian economy.
Many of the sanctions were aimed at hampering parts of the Russian economy’s ability to do business. Russia’s economy is less dependent on imports than most other major advanced economies and emerging markets, the report notes, but some sectors are highly exposed, particularly the manufacturing of transport equipment, chemicals, food and computer services. Sanctions did a good job initially of restricting Russia’s access to key imports, such as parts for manufacturing. Yet despite the initial shock, Russia quickly pivoted and began importing more goods from countries like China, Belarus and Turkey, which do not participate in the sanctions regime. In short, when it comes to imports of key materials, Russia was shut out of a number of markets, but it has since found new markets to meet many of its needs.
Sanctions on Russian exports have been even less effective. Many countries have stopped buying certain products from Russia, but the flow of key commodities continues largely unabated. And soaring inflation has only helped Russia in this area: Bruegel estimates that, rather than falling, Russia’s export earnings have increased by more than 40% to around $120 billion since then. the beginning of the year due to rising prices, and that they will probably remain as high. until the end of the year. The biggest contribution to this comes from natural gas, which is still in high demand across Europe and which, unlike coal, oil and other petroleum products, has not been sanctioned.
This contraction in imports and swelling exports means that Russia’s trade balance looks extremely healthy. The surplus for January-September was $198.4 billion, about $120 billion more than the same period in 2021, and more than double the previous record high in 2008. Bruegel estimates that poor health of Russia’s balance of payments will persist in 2023, as prices are expected to remain high, despite the EU embargo on crude oil and petroleum products and despite Russia’s decision to reduce natural gas flows to Europe. Bruegel estimates a surplus of around $100 billion in 2023 – a substantial drop from 2022, but not too shabby for a sanctioned state.
The Russian currency also appears to be in good condition. When the sanctions were first imposed, the ruble fell from around 70-75 to the dollar to almost 140 to the dollar. By April, however, the exchange rate was back below pre-invasion levels. Today the ruble fluctuates around 60 rubles per dollar. We’ve done a lot of reporting on why the ruble has rebounded so well, and you can read that report here. But the TLDR is that capital controls, combined with lower trading volumes and current account momentum, have all helped support the ruble.
Under the skin
Reading all of this, you could be forgiven for thinking that the coalition of nations sanctioning Russia is having a wild ride and that Russia is simply too big to fail. Bruegel maintains that this is not the case, that the sanctions are harms Russia, and that encouraging statistics hide serious damage to the Russian economy.
The strength of the ruble is a good example of this. For the casual observer, the ruble has recovered and is in good shape. In fact, the ruble is extremely weak: it has been supported by capital controls that make it difficult to sell rubles and force Russian companies to buy the currency against their will – or better. As Bruegel says, the current exchange rate does not reflect the value of the fundamentals of the Russian economy. Rather, it speaks to the fact that financial sanctions isolate the ruble internationally.
Russia’s pivot to new markets for key imports has been quick and effective, but it won’t be enough to save some important parts of Russia’s economy, Bruegel said. Self-sanctioning of companies wishing to distance themselves from Russia has been particularly damaging, in sectors such as car production and transport. The withdrawal of foreign automakers and the shortage of inputs have hit passenger car production extremely hard, with a 95% drop in May 2022 compared to the previous year. Air transport has also collapsed, following the cancellation of aircraft lease and maintenance contracts, and the closure of airspace in several countries to Russian planes.
Oil and gas exports seem to be a strong point, but they are under threat in the medium and long term, says Bruegel. Canada, the United States and Australia have banned all imports of Russian oil, while the United Kingdom has announced a phased reduction to zero by the end of the year. The European Union, which has been heavily dependent on Russian oil imports in the past, agreed in late May to halt maritime imports of Russian oil by the end of the year. By early 2023, more than 90% of Russia’s previous oil exports to the EU will be banned. It is true that Russia has found new markets for its oil, but it is selling that oil at a deep discount, and it will probably have to continue to do so if the most lucrative markets remain closed to it.
Bruegel notes that there is a way to expand the sanctions regime to significantly undermine Russian oil exports: through insurance. More than 90% of the world’s tankers are insured by the International Group of P&I Clubs, an association of insurers based in London. The EU and UK recently introduced an insurance ban for ships carrying Russian oil from early next year, which would have driven up insurance costs for Russia and had an impact significant on exports. The United States, however, watered down this measure and removed the tail stinger from it.
As far as natural gas is concerned, no sanctions have been imposed on Russia. Instead, says Bruegel, Russia has militarized its gas supply, blackmailing European countries into phasing out exports to Europe – now at around 20% of their 2021 levels. This will hurt Russia in the long run. term. Given that approximately 60% of Russia’s gas exports are destined for the EU and the UK, Russia will have to shut down a significant part of its gas export infrastructure, including production sites, at a significant cost. Gas export revenues will dry up and attempts to diversify export routes by creating new liquefied natural gas export capabilities will be hampered by a lack of access to Western technology. The redevelopment will take years.
In other words, sanctions have bite, but for Russia to feel the bite, coalition nations will have to sink those teeth deeper and hang on for the long haul, Bruegel says. They must find unity on effective measures such as the oil insurance ban mentioned above, and further restrict oil and gas shipments. The combination of a large and likely persistent fall in Russian imports and the permanent decoupling of European economies from Russian energy supplies will have significant negative consequences for the Russian economy in the medium to long term, the report says. Russia may find ways to mitigate some sanctions-related effects, but the overall loss of economic activity will likely be permanent.
In the short term, however, the Russian economy was not so inhibited that it was impossible for it to continue the war in Ukraine. Since the ultimate goal of sanctions is to stop this war, the EU and the other coalition nations, as Bruegel puts it, have more to do.
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