A Tough Nut to Crack: The Global Economic Implications of Sanctioning Russia

As the tragedy of the shot down Malaysia Flight 17 continues to unfold and human remains continue to be found, the US and Europe have started to grill the apparent culprits: the Russian President Vladimir Putin and the Russian government.

A Malaysian aircraft carrying 298 passengers was mistakenly shot down on July 17th by Russian separatists, backed by the Russian government and President Putin, who concurrent with the tragedy, were fighting Ukrainian forces, and assumed the plane was Ukrainian. As the backlash from the catastrophe progressed, Putin denied Russia’s involvement and attempted to shift the blame onto Ukraine. The US in conjunction with the European Union’s investigation concluded that Russia supported the separatists who shot down the plane. In addition, since the Russian government not only rejected the disbanding of the Russian separatists but also increased their support for them by supplying them with more weapons, the US and EU decided that the the Russian government’s actions necessitated disciplinary economic sanctions.

The US and the EU have come up with a severe economic sanctions plan which is meant to impede Russia’s banking, defense, and energy industries. Although these same sanctions will negatively reverberate through their own economies, the US and Europe are unmoved in their stance that the Russian government’s behavior must be addressed in order to progress towards stability. Although not crippling, these sanctions will considerably undercut the Russian economy.

The primary target of the sanctions will be Russia’s banking system. Many of Russia’s state controlled banks such as VTB, Sberbank, Gazprombank and Vnesheconombank will suffer. State controlled Russian banks will encounter difficulties trying to increase equity and debt on Western capital markets. In addition, Western capital markets will not be able to buy any debt, equity or other financial instruments for longer than 90 days in any Russian state owned banks or their affiliates. Finally, Russian banks are barred from brokering to European markets, as well banned from any other services linked to such transactions.

The newly formed barriers will make paying debts an onerous responsibility for the Russian state owned banks as future external funding is impossible unless the Russian banks find financial backing elsewhere, e.g. domestic financing or China. The latter situation is not without its costs. If Russian banks must solely rely on external funding from one source, the Chinese could capitalize on this dependency by pressuring their financial ward: Russian banks, into granting them access to valuable Russian natural resources. Comparatively, this sanction does not affect the US market as much since America would still have a majority of trading partners in Europe and around the rest of the world.

Ultimately, since the flow of international capital will come to a screeching halt for Russian banks, the Russian economy will be severely disadvantaged.  Banks have an invaluable role in the economy as they allow businesses to receive more cash to innovate or invest, allow households to acquire mortgages, and assist government monetary strategies. Ultimately, with less international capital, Russian state owned banks will see a decrease in money, future troubles financing investments, and improving the economy.

The Russian government’s defense industry is also under fire by the newly issued sanctions. The arms trade between Russia and the EU, both imports and exports, is now banned. However, this sanction only includes future deals and excludes current defense deals. One of which is France’s $1.6 billion sale of Mistral class warships. This sanction particularly disadvantages the EU, and its markets, since many of its weapons, contrary to the Mistral class warships deal, are actually bought from Russia.

The final piece of the US and EU sanctions, energy, affects the two parties the most as both groups are reliant on Russian energy.  In the consideration of their own interests, the EU and US have made sure that the sanctions do not target Russia’s oil exports. The sanctions also do not touch the natural gas pipelines leading into the EU since 30% of European countries’ gas is imported from Russia, making Europe extremely reliant on Russian energy. The sanction instead sets up an embargo on Western technology which will obstruct Russia’s attempts to drill new and not easily accessible oil fields in the Artic areas surrounding Russia. The embargo set by the US and EU will in this way thwart Russia’s hydrocarbon revenue in years to come. In addition, this sanction will set back Russia’s economy as they struggle to keep up with other countries in the region, such as Sweden and Norway, who can still drill in other Artic locations due to Western technology.

One Russian company particularly struck hard by this sanction will be Rosneft, Putin’s favorite oil company. Ten years ago Putin destroyed another oil company named Yukos and awarded its assets to Rosneft. This deal set up Rosneft to become the largest stock-market recorded oil company by output, currently 4 percent of the world’s crude and over 8 percent of Russia’s GDP is produced by Rosneft. Putin’s chief motive for doing this was so that a Russian oil company would be under close state control. President Putin wanted the Russian government to once again have control over Russian oil. Furthermore, since oil is Russia’s biggest export, the Russian government would be wield a significant degree of control over the Russian economy. However, because of the new sanctions set in place by the EU and the US, Rosneft’s chances of becoming the world’s largest oil company by output and joining other oil giants such as Exxon Mobil and BP has been destroyed. Moreover, because Rosneft is the Russian government’s brainchild, Russia’s chances are now dim as the leading energy power in the future, because of the technological embargo.

One could look to the sanctions placed on Iran to validate Russia’s waning economic future. Iran, similar to Russia scoffed at the oil sanctions placed onto them by the US and other countries. Iran parallel to Russia’s actions, presently could not imagine sanctions not having a backlash against the US and the countries that imposed them. The sanctions on Iran took half of the revenue from the country’s oil exports, since Iran no longer had access to some of the products needed for the oil industry, which led in turn to many oil companies withdrawing from Iran. In addition, another limiting aspect of Iranian oil exports was a decline in oil production efficiency since an embargo on Western technology was also initiated. Moreover, in addition to the oil sanctions, Iran’s banks were cut off from the SWIFT Banking Network (Society for Worldwide Interbank Financial Telecommunication), which forced Iran to only accept cash or gold for their imported products and oil exports. This was problematic since billions of dollars are impossible to deal with using cash or gold. The final consequences of the US sanctions on Iran resulted in Iran’s economy contracting in 2012, the inflation rate topping 40 percent, and clashes in the streets when Iran’s currency, the Iranian rial, collapsed.

Contrary to Iran, Russia is more integrated in the global economy, supplying more than three times the oil than the former. Unlike Iran, Russia could decide to confiscate companies’ foreign investments in Russia in retaliation to the sanctions as well as turn off or raise costs of the oil pipelines running into the EU. In fact, this plan of action is beginning to look more feasible as Russia has just recently signed a 30 year energy deal with China running natural gas pipelines from two gas fields in Siberia to mainland China. This would mean that in case heavier sanctions fell upon Russia. China’s could still be relied on as an economic safety net. On a negative note for Russia, the Chinese know that because of hefty sanctions, Russia has less opportunity to choose their investors, meaning that China was able to leverage the situation and pay for the natural gas pipelines at a much lower price than countries in the EU were able to. This energy deal was openly opposed by Putin before the Ukrainian crisis and sanctions; however, now China’s investment in Russian energy is needed to boost a soon to be dwindling Russian economy.  The proof for this soon to be receding economy is only supported by the lone fact that Russia’s economy was already struggling before the Ukraine incident. Likewise, Russia’s future growth reports were also considerably low. While Russia does have the upper hand in some aspects, such as being more involved in the global economy and having extensive resources similar to Iran, it is lacking in others.

Nevertheless, when predicting the effectiveness of the US and EU sanctions on Russia, the sole factor one must consider is Putin’s breaking point.

Putin’s efforts in the Ukraine, and recovering Crimea are more important to him than his diplomatic ties with the western world and any sanctions they impose, even if it does cripple the Russian economy. This is clearly evident in President Putin’s disregard for the US and EU requests to stop supporting and arming Russian separatists in the Ukraine. President Putin’s primary concern is his public image in Russia. The Russian leader is at a crossroads between gaining support from the Russian people by resisting the Western world or submitting to US and EU sanctions. By submitting, Putin would ultimately lose Ukraine as well as respect from other countries opposed to the US and the Western world such as China, North Korea, and Iran.

Many members of the Russian government also see the incoming sanctions, as well as the Ukrainian crisis, from the same perspective as Putin. Their view is one of coinciding unity on the Ukrainian predicament; that Russia is in the right and that the Crimea should belong to Russia.  This being said the Russian parliament is attempting to unify Russia as the Ukrainian conflict and sanctions wear on. To accomplish this, Putin and the Russian leadership are bracing themselves for the heavy sanctions to come by having the Russian government as a whole take an isolationist stance. Members of Russian government are trying to convince the Russian people about the positive effects of Russian industry on the economy as consumers have to switch to buying domestic goods instead of foreign goods.

In a way, Putin’s firm stance of disregarding the US and EU requests to have the Russian separatists leave the Ukraine is supported by the Russian people. One poll done by the Levada Centre estimates that 82% of Russians believe the Ukrainian military is responsible  for the shooting of Flight MH17, and that President Putin is therefore in the right for defying US and EU sanctions. On the other hand, those who are being directly impacted by the sanctions, the business and political elite of Russia, have differing views on Putin abstaining from diplomacy. But, as Western financial support and technology is no longer an option for Russian state run banks and oil companies, respectively, Russian industry knows it must stay true to Putin and his views in order to survive the financially tough road ahead.

President Putin knows that Russia’s future is full of political difficulties as he continues to spite the US and the EU’s diplomatic nudges. In fact, although the US and the EU will most certainly take a dent in their own economies because of the sanctions, the EU significantly more than the US, Russia will take the worst of the blows since their economy is already deteriorating.  In many ways, Putin’s sole regard for his own political future as he sacrifices Russia’s economy and its people to the economic sanctions, is a selfish move. Putin’s tough stand for Russia’s global influence to hold is one with many shortcomings as the US and EU will only increase the severity of the economic sanctions, similar to what happened to Iran in 2009. Moreover, as Russia’s economic recession continues to spiral downwards, at least the Russian people will have someone to blame.  As President Barack Obama stated at the beginning of the sanctions, “It didn’t have to be this way, this is a choice that Russia and President Putin in particular made.”

 

 

Works Cited:

Ackerman, Spencer and Borger, Julian and Mason, Rowena. “US follows EU in setting new

sanctions targeting Russian economy.” Theguardian. Guardian News and Media. July 29, 2014. Web. 3 Aug, 2014

Berliner, Uri. “Crippled By Sanctions, Iran’s Economy Key In Nuclear Deal.” NPR. NPR. 25

Nov, 2013. Web. 3 Aug, 2014

Noack, Rick. “Will sanctions work against Russia? Iran’s experience offers a few clues.” The Washington Post. The Washington Post. 31 Jul, 2014. Web. 4 Aug, 2014

Perlez, Jane.“China and Russia Reach 30-Year Gas Deal.” The New York Times. The New York Times. 21 May, 2014. Web. 4 Aug, 2014

“This is going to hurt.” The Economist. The Economist Newspaper. 2 Aug, 2014. Web. 3 Aug, 2014