Western countries have ramped up sanctions against Russia in response to its invasion of Ukraine. The measures are the toughest since those imposed on Iran in 2010 and North Korea in 2013.
Russia is the largest economy and the largest country globally, by population, against which such strong sanctions have ever been implemented. Western leaders know that they will not immediately stop the war, but hope that they would inflict enough damage on the Russian economy to help de-escalate the conflict.
So how tough are the sanctions? They are much tougher than those previously imposed on Russia in the aftermath of the annexation of Crimea and the start of the war in Eastern Ukraine in 2014, but I would not call them “nuclear”. That is, they could damage the Russian economy but not obliterate it, given some major loopholes purposefully left by the sanction architects. What follows is my insight into how the current package of sanctions will and will not hurt the Russian economy and why.
Undoubtedly, the most powerful blow to the Russian financial system is the imposition of sanctions on the Central Bank of Russia (CBR), which plays a crucial role in the domestic foreign exchange market. The CBR has enormous foreign exchange reserves amounting to $640bn and it traditionally regulates the level of the rouble exchange rate.
The freezing of the CBR’s assets and accounts in the G7 countries means that it is left with gold reserves worth $127bn held in Russia and renminbi reserves worth $70bn. Both are useless from the point of view of maintaining stability in the domestic foreign exchange market. From February 24 to March 2 the CBR loaned 4.4 trillion roubles (3.4 percent of GDP) to banks as part of its efforts to maintain stability in the financial system. The sanctions against the CBR affected the domestic foreign exchange market immediately after they were announced. By the end of that day, the selling rate of dollars in exchange offices of banks had risen by at least 45 percent compared with the earlier day. In the next days, the gap between selling and buying rates in the banks’ offices was between 20 and 50 percent.
Starting from the next night, the CBR and the government issued several new regulations imposing currency control. Exporters now have to sell 80 percent of foreign exchange earnings for roubles. Foreigners cannot sell Russian stocks and bonds and transfer coupons and dividends to their accounts, while residents and non-residents from 43 countries (that imposed sanctions on Russia) cannot transfer funds to their accounts with banks outside Russia. A side-effect of the sanctions on the CBR is the freezing of assets belonging to the Ministry of Finance, current accounts and funds of the National Welfare Fund. But it does not seem that this will have any effect on the current economic situation.
On the one hand, at the current level of oil prices, Russia’s budget is in surplus, and the Ministry of Finance does not need to use reserves. On the other hand, when the Ministry of Finance sells its foreign currency reserves, the buyer is the CBR; the Ministry of Finance does not need to go to the market for this. Consequently, even if the accounts of the CBR are frozen, the Ministry of Finance will be able to receive roubles from it, if at some point it wants to sell some of its currency reserves.
However, the devaluation of the rouble will certainly affect consumer inflation, which may grow by an additional 4-5 percent for a 40-50 percent increase in the value of the dollar. By the end of February, consumer price inflation in Russia exceeded 9 percent, with food inflation exceeding 12.5 percent. Devaluation of the rouble, potential problems with imports, and general political uncertainty may undermine a business’s desire to take risks and result in lower growth in agriculture, lower supply, and even higher food inflation. In addition, disruptions in the payment system may lead to disruptions in the supply of imported goods to Russia, further accelerating inflation by reducing supply.
The EU and the US have put on their sanctions list a number of Russian banks and major companies. This will result in Russia’s largest bank, Sberbank, which holds 33 percent of the banking system’s assets, being unable to make its payments and those of its customers denominated in dollars. Its correspondent accounts with US banks will be blocked and the bank had to pull out of the European market. Four other banks, VTB, Otkritie, Novikombank, and Sovcombank will face the same fate. In addition, the US blocked 13 major Russian companies and banks from accessing its capital markets and banned US investors from buying new issues of Russian government bonds in their initial public offerings and on the secondary market. The G7 countries also decided to disconnect several Russian banks from the SWIFT system. Disconnecting banks from the SWIFT system does not limit their ability to make foreign exchange payments. It only slows down payments and makes them more expensive.
So what does this mean for the Russian economy? The Russian financial system is highly integrated into the global system. Russia is one of the largest raw materials suppliers to the world market. At the same time, the Russian economy is a significant importer of consumer goods, technology and investment equipment. That is why international payments are critical. Disconnecting the largest banks from making customer payments will disrupt the flow of goods, accumulate a consumer market deficit and accelerate inflation. Some companies whose business is in importing goods to Russia or selling imported goods in Russia may go bankrupt. The average Russian citizen will pay the price for this, as real household incomes shrink. As usual, inflation will hit the poor harder.
However, it is important to point out that Western countries have not limited payments related to Russian energy resources, which constitute 50 percent of Russian exports. In this way, Europe guarantees that energy prices will not skyrocket and damage its own economy. For Russia, this means that it will be able to offset the negative impact of financial sanctions with a solid current account balance due to proceeds from raw materials exports, which are not threatened. Furthermore, the scale of application of sanctions by the EU is significantly less than that of the US, which leaves the possibility of virtually unlimited payments in euros. This means, for example, that while the dollar accounts of a sanctioned Russian bank will be blocked, its euro accounts will be operational.
Another significant aspect of the Western sanctions is the ban on the access of Russian banks and companies to Western capital markets. As a result, there will be a substantial outflow of foreign investors from Russia; predictions by various experts range from $30bn to $50bn of investments lost in a year. The ban will also affect banks’ ability to repay foreign debt. If the official statistics are to be believed, Russia’s foreign debt is not too large. As of October 1, it was $478bn or 27 percent of GDP. However, from the point of view of its impact on the economy, it is not so much the amount of debt that matters, but the schedule for its repayment and the share of short-term debt.
In the next 12 months, Russian banks and companies will have to repay more than $100bn. This is a hefty schedule, and many Russian borrowers counted on refinancing old debts. Now, this opportunity will be closed for many of them. This means that the Russian economy will have to channel substantial financial resources to repay foreign debt. The only way to do this is to use domestic savings, undermining already weak economic growth. It is too early to assess how much the Russian economy will slow down, but it is clear that the recent IMF projection of 2.8 percent growth is unrealistic.
Can Russia rely on China to provide financial resources to help prop its economy? The Russian leadership had such hopes in 2014-2016 when it was hit by Western sanctions over the annexation of Crimea. But despite numerous requests for loans from the Russian side, Beijing gave only a minimal amount of assistance and tied it to Chinese companies being allowed to access Russian production and exports. There is no reason why China’s position would change today.
Sanctions are also restricting Western exports of technology, equipment, and components to Russia, which could affect Russian imports of machinery, equipment, and technological goods. These sanctions will seriously impact the technological level of the Russian economy. Russia has traditionally been an importer of advanced technology, used in all kinds of technologically complex products, from vacuum cleaners to nuclear-powered icebreaker ships. Many military products will be impossible to produce in Russia if sanctions remain in place. The severity of these sanctions is amplified by the boycott of Russia by global companies that do not want to take political risks. BP and Shell are withdrawing from oil and gas projects in Russia. Car companies, such as Ford, Volvo, Jaguar, Hyundai, BMW and Toyota, have announced they will stop production or stop supplying cars to Russia.
Shipping companies have stopped shipping containers to and from Russia. Banks have stopped lending to traders to buy Russian oil and insurance companies are sharply increasing their rates for transporting it by sea. For one sector of the Russian economy, aviation, the export sanctions will have a catastrophic impact. The EU sanctions have affected the supply of aircraft and components and the provision of aircraft maintenance services. European-made aircraft (Airbus) make up about 40 percent of the fleets of Russian airlines and they carry 41 percent of their passengers. The two largest companies, Aeroflot and S7 operate respectively 117 and 66 Airbus aircraft, which means they will be significantly hit by the sanctions.
Russia produces its narrow-body Superjet, which will not be able to replace Airbus because it is produced in small numbers and its capacity does not exceed 98 passengers, and its maximum flight range is 4,500km. This means it cannot be used for longer flights with a larger passenger load. A critical restriction that will substantially impact the current situation, but which is likely to be short-lived, is the closure by EU countries of their airspace to Russian aircraft, including business aviation. Flights to Europe are essential for Russian airlines because they are more profitable; they actively use transit flights from Asian countries to European countries. This restriction will affect the most affluent Russians who fly to Europe for business or leisure. Russian authorities have imposed similar bans on European airlines, which means a real Iron Curtain 2.0 for Russian citizens.
There are also more symbolic sanctions, including those targeting specific individuals with visa bans and asset freezes, severing business ties, cancelling sports competitions and cultural events, restricting the reach of Russian state media, etc. They may not affect the economy of the country, but will increase the feeling of international isolation that the country will suffer as a result of the war.
The Russian economy is going down the ice chute, and no one knows today when this downward spiral will end. It is safe to say that the economy will slow down sharply and the standard of living will fall, but it is premature to give any quantitative estimates today.