How Sanction-Proof Is Russia’s Economy?

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Russia–Ukraine War

Russia–Ukraine War


By Christopher Miller·March 17, 2022

Fletcher School, Tufts University

The problem:

The United States and the European Union responded to Russia’s invasion of Ukraine by imposing a series of economic sanctions. Despite claims by the Russian government that its economy is “sanctions-proof” by accumulating a large stockpile of foreign currency reserves and developing alternative payment mechanisms, financial sanctions are already proving to be a potent economic weapon. The Russian currency collapsed, financial markets struggled and factories were closed. It remains to be seen whether the sanctions encourage the Kremlin to modify its foreign policy.

As long as Russia is willing to spend substantial sums on its foreign policy, we should expect Russia to pursue broader foreign policy goals than the moderate size of its economy would suggest.

Facts:

  • Even before Russian troops entered Ukraine this year, Russia had pursued policies aimed at shielding its economy from the impact of sanctions. There was a precedent: sanctions were imposed on Russia after it annexed Crimea and invaded the Donbass region of Ukraine in 2014. These sanctions banned all foreign companies in Crimea, prohibited the transfer of advanced technologies oil drilling to Russia and limited the access of major Russian players. companies to Western capital markets. These sanctions had a minor negative impact on Russian oil production and a slight negative impact on investment in Russia and economic growth. The Russian government knew that the West might impose additional sanctions and therefore tried to protect its economy from such measures. This has been called the “Fortress Russia” strategy. This includes efforts to limit foreign debt, amass reserves of central bank foreign assets to support the value of the ruble, and the creation of domestic payment systems in case Russia faces sanctions that cut off its support. access to foreign bank transfer mechanisms such as SWIFT (see here) . The cost of these measures was substantial, as the government placed funds in reserves, saving them rather than spending or investing them for immediate needs.
  • Efforts to “protect” the Russian economy from financial pressures prior to the invasion of Ukraine had only limited success. The West’s long-term investments have not diminished over the past decade. SWIFT and other non-Russian financial messaging systems, vital for banks’ international transactions and even credit card use in Russia, transmitted about five times as many messages as MIR in 2020. Russia’s central bank held about half of its foreign exchange reserves outside the country at the time of the invasion of Ukraine. The Russian government has also talked about reducing its dependence on foreign technology, but has made little progress. “Import substitution” – reducing imports by boosting domestic production – has been a popular political slogan in Russia. However, it had limited impact on reducing Russia’s integration into international supply chains or reducing imports of capital goods and machine tools.
  • The extent to which current sanctions are likely to impact Russian exports depends, in part, on how they are marketed. Oil is by far Russia’s most important export, accounting for almost half of export earnings, depending on the price of oil. Russia exports oil to many different countries, and since oil is largely traded via ships – which can sail directly to any port – if a country stops buying Russian oil, Russia can usually sell to other buyers. Therefore, the recent decision by the US government to ban imports of Russian oil into the United States will have a limited effect. The United States will increase its purchases of oil from other oil exporters; other oil importers will buy more Russian oil. Russia also exports a substantial amount of coal which, like oil, is traded globally. So if a country stops buying Russian coal (the United States has banned imports), Russia can sell directly to other countries. It’s a different story for natural gas, which is Russia’s second largest export product. Most Russian natural gas is exported to Europe, via gas pipelines that pass through Ukraine, Belarus and the Baltic Sea (Nord Stream I). Russia also has a gas pipeline that goes to China as well as some facilities to liquefy natural gas, allowing it to be shipped around the world. The existing pipeline and liquefaction infrastructure is limited, so the gas fields that currently supply gas by pipeline to Europe have no other outlet if Europe stops buying Russian gas. This is a major vulnerability for the Russian gas industry. However, it is also a weakness for Europe, which depends on Russia for its imports of natural gas: the share of Russian gas in the supplies of the European Union and the United Kingdom has fallen from 25% of the the region’s total gas demand in 2009 to 32% in 2021, according to the International Energy Agency (see graph). Countries like Germany and Italy have long purchased gas from Russia and lack the liquefaction infrastructure to acquire sufficient quantities of liquefied natural gas from other sources. If they were to stop buying Russian gas – or if Russia were to stop selling – energy prices would skyrocket and some energy-intensive industries might have to shut down.
  • Russia’s dependence on imports also makes it vulnerable to sanctions. Russia imports many consumer goods and industrial products, including technology and machine tools. Russia has a manufacturing base inherited from the Soviet Union, but much of the remaining manufacturing sector is now deeply integrated into international supply chains. For this reason, Russia is heavily dependent on access to components and tools from the United States, Europe, Japan, South Korea and Taiwan. The automotive industry, aircraft industry and other manufacturing sectors will struggle to function without components from Western countries and their allies in Asia. Many Russian car factories across the country have already been closed due to component shortages. All types of complex manufacturing will face significant delays. Sectors like aircraft manufacturing, which are under severe restrictions, may struggle to produce goods.
  • Western companies have withdrawn from the Russian market, which further harms Russian consumers. The closure of McDonalds across Russia is a high-profile example of Western companies exiting Russian markets. The reduced availability of consumer goods – and the reduced diversity of products on offer – will leave Russian consumers worse off. No less important is the perception it will create among the wealthier layers of the urban population in big cities like Moscow and St. Petersburg, where the upper middle classes have grown accustomed to consumerist lifestyles. Now they will have a much more limited selection of products available.
  • The withdrawal of business services from the Russian market will be even more disruptive. Russia is deeply integrated into Western markets for business services, from insurance to finance to logistics. An example is in aviation, where many aircraft in Russian airline fleets have been leased to European-based aircraft leasing companies. Sanctions have banned such transactions and now a substantial share of planes that used to fly in Russia are grounded or removed from the country. Spare parts will soon also be a difficult problem.
  • Sanctions against rich and powerful people (“oligarchs”) are likely to have less effect on the economy. The Russian economy is marked by strong inequalities. Some US and EU sanctions target wealthy individuals, often referred to as oligarchs, who own big businesses in Russia. Most of these people in Russia often have substantial assets abroad, including real estate in London or New York. The effect of seizing these assets, while detrimental to these individuals, is not likely to have a major impact on the Russian economy as a whole.

It is already clear that Western sanctions against Russia will have a major economic impact. Will they achieve their political goals? Sanctions seem unlikely to reverse the Russian invasion, though by increasing the cost they may make Russia slightly more willing to compromise. The sanctions seem likely to complicate the Kremlin’s internal calculus, though typical Russians have few channels through which to express their displeasure. The sanctions will certainly make it harder for Russia to fund its foreign policy as well as supply its military, given its reliance on Western technology for components, especially microelectronics and computer equipment. If the West escalates sanctions trying to cut off Russian oil exports, it would deprive Russia of its main source of export revenue. However, as long as Russia is prepared to spend substantial sums on its foreign policy – much higher as a percentage of GDP than Western countries – we should expect Russia to pursue broader foreign policy goals than suggests the moderate size of its economy. This can help achieve Russia’s foreign policy goals, even if the cost will intensify domestic economic hardship.

  • Editor’s note: Christopher Miller is the author of “We Shall Be Masters: Russian Pivots to East Asia from Peter the Great to Putin”, Harvard University Press, 2021 and “Putinomics: Power and Money in Resurgent Russia”, The University of North Carolina Press, 2018.
  • Topics:

    Economic sanctions / Russia-Ukraine War


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