The new sanctions against Russia agreed by the EU on Tuesday are described by European officials as “level three”. This implies higher levels still to come if Russia’s approach to Ukraine fails to satisfy the US and EU – the logical end point being, as in some computer game, a final confrontation with the supreme adversary: President Vladimir Putin. All such talk of levels obscures the reality that there are only two types of sanctions.
The impact of the lesser type of sanction works through sentiment. The actual measures in this category have targeted individuals and economically insignificant businesses owned by those individuals. Such measures have created an atmosphere in which Russian companies have found it increasingly difficult and expensive to refinance their foreign debt (totalling $650bn at the end of 2013) and the collapse of Russian issuance in the capital market. This has intensified capital outflow, rouble weakness (resuming now, after a bounce in May-June) and declining domestic investment. Real gross domestic product growth fell below 1 per cent in the first half of 2014 compared to the same period last year and 1.3 per cent last year as a whole.
The US already moved up to the second broad category of sanctions on July 16 (the day before the downing of Malaysia Airlines Flight MH17). This type of sanctions is designed to squeeze the financial lifeblood out of the Russian economy by banning credit and capital flows to major Russian banks and corporations, starting with Rosneft, Novatek, Vnesheconombank and Gazprombank. The EU is set to follow the US across this Rubicon – with the focus, judging by the European Commission’s consultation paper, on cutting off Sberbank, VTB and other state-controlled banks from external funding markets.
Whatever sanctions the EU governments finally agree to impose now and in the future, the US’s control of the dollar funding markets gives it the financial power to tip the Russian economy into recession single-handedly. Since the European economy would suffer much more from a slump in Russia than the US, the main significance of the MH17 tragedy in this context is that European governments no longer object to the US using that power, so there will be no transatlantic splits for Russia to exploit. As it turns out, the EU is proving ready not only to endure the effects of serious sanctions passively but to follow the US across the sanctions Rubicon. This will tighten more quickly the financial garrotte around the neck of the Russian economy.
Placing Russia under a financial interdict will have a more powerful longer-term impact than other so-called sectoral sanctions, such as the European Commission’s recommended ban on defence equipment and advanced drilling technologies for tight oil and offshore hydrocarbons in the Arctic. The natural Russian response will be to step up import substitution efforts. While this always takes time even in normal conditions, in the absence of easily accessible financing, the challenge will be that much tougher – and perhaps insurmountable in some cases.
It follows that Russia will have to fall back on its domestic savings. The country’s strong national balance sheet includes about $160bn in the government’s reserve funds that could be used to recapitalise and fund the state banks, which could then refinance the existing foreign debt of non-financial corporations. But with almost $100bn of principal external debt repayments falling due between now and the end of 2015, the sanctions regime will result in these reserves being rapidly depleted – leading in turn to further devaluation, credit rating downgrades and negative growth rates.
If the Ukraine crisis is not resolved by this stage, the whole European economy will feel the pain. A Deutsche Bank study at the outset of the crisis in March concluded that a repeat of the 8 per cent contraction in output suffered by the Russian economy in the wake of the global financial crisis in 2009 would now reduce Germany’s already lacklustre growth rate by half a percentage point.
Until these general blowback effects are felt, the main burden of the EU sanctions mooted by the commission would appear to fall on the UK. The core measure targets debt and equity capital raising by the Russian state banks and bans European intermediaries from offering associated underwriting and advisory services, and the bulk of such business is done in the City of London. Capital market funding is also a small portion of overall foreign funding of Russian banks (about 3.5 per cent as of March 2014), so an important detail about the EU sanctions package as regards both overall impact and burden sharing between the member states will be whether the prohibition on financing Russian banks will extend to ordinary lending. The international syndicated loan market for Russian borrowers is dominated by continental European banks. French banks have the largest exposure of $52.5bn.
This analysis presupposes that the EU will never go for the “nuclear” sanctions option of banning gas imports from Russia, and that the EU and US together will not try to replicate against Russia the ban on oil exports imposed on Iran. The EU cannot for now substitute its present annual gas import volumes of 150bn cubic metres from Russia, and the loss of Russia’s present level of crude oil exports – 7m barrels a day, compared to Iran’s 2.5m b/d – would trigger a sharp rise in the oil price and a global economic slump. This would be the economic equivalent of the Cold War-era concept of nuclear deterrence based on mutually assured destruction.
Short of the “Mad” options, the Russian economy will decline and Europe will suffer, but there will be no knockout blow and, as so often in Russia’s history, the Russian nation may be expected to rally around in the face of hardship caused by foreign foes.
Christopher Granville Managing director and director, Russia/FSU research for Trusted Sources