Russian invasion of Ukraine - Western sanctions and the mutual pain
Are the sanctions working? Hint: they certainly will, if left in place for years.
Since the Russian invasion of Ukraine, a large number of countries have imposed unprecedented international sanctions on Russia. The sanctions were introduced by the United States, United Kingdom, European Union, and other countries against businesses, industries, individuals, and officials from Russia. Since the start of the war, the following types of sanctions were introduced on Russia:
Major state-owned banks were sanctioned.
Some banks were cut off from the SWIFT system.
Russian Central Banks’ foreign reserves were frozen.
Task Forces were created to track down and freeze assets.
United States banned all Russian oil imports.
State officials, Kremlin-friendly businessmen, and oligarchs were sanctioned.
Financial Sector
On the day of the invasion, February 24th, the U.S. joined by the United Kingdom and European Union, started imposing sanctions on Russia. Russian state-owned financial institutions were cut off from US financial system:
Sberbank of Russia - the largest financial institution in Russia.
VTB Bank - second-largest financial institution, holding nearly 20% of banking assets.
Otktitie - 7th largest and systematic bank.
Sovcombank - ninth largest and systematic bank.
Debt and equity prohibitions on state-owned and private companies were introduced. The list includes Gazprombank - the third-largest financial institution and dominant in the energy sector, Rusagro - Russian Agricultural Bank (5th largest bank), Gazprom, Gazprom Neft, Transneft, Rostelecom, RusHydro, Alroa, Sovcomflot, and others.
Central Bank of Russia
Targeting the Central bank with sanctions is a rare occurrence and the freeze of foreign currency reserves was a significant move to pressure the Russian economy. While the implementation details are unclear, it was widely reported that the Russian Central Bank has lost access to roughly 300bln from its USD 640bln foreign currency reserves.
This will limit the Central Bank’s ability to finance and s stabilize the now-crippled Russian economy. Immediately as the Russian invasion started was ensued, the Russian Rubble sharply depreciated and lost around 75% of its value during the first few trading days. USD/RUB increased from pre-war levels of 80 to 139 in early March, before consolidating down to 110 levels where it is trading now (overall 36%+ depreciation). The currency moves created a massive panic in Russia, with street exchanges charging up to 200 USD/RUB prices for selling dollars to the public.
In order to limit the spillover, Central Bank has doubled interest rates on the Rubble to 20%, the Moscow stock exchange was closed for days and strict capital controls were enforced. Domestic businesses were ordered to sell 80% of their foreign currency assets. More measures were put in place for import and export businesses, urging the fast transition to Rubble-settled trade flows.
This week Russia has the first USD payments on their dollar bonds since the War with Ukraine and there is a high likelihood that this may trigger their default on foreign currency debt. Russian state and commercial companies owe about $150bln in foreign currency debt. Russia may try to make payment in Rubbles in order to override the contract, but it’s unclear what will be the exact implications of this move - rating agency Fitch claims it will still be a default.
Oligarchs and Officials
A wide number of officials and oligarchs were sanctioned. The list includes Russian President Putin and his cabinet members. Here is the incomplete list of sanctioned individuals: Vladimir Putin, Mikhail Mishustin (Prime Minister), Sergey Lavrov (Minister of Foreign Affairs), Sergey Shoygu (Minister of Defense), Alexander Lukashenko (President of Belarus), deputy ministers, military commanders, and many other officials.
Putin’s most trusted security officials, friends, and inner circle were also sanctioned by the US, EU, and allies. Task forces were created to track down and freeze assets of Russian oligarchs, who just a month ago were welcome in the United Kingdom and Europe. All the assets like businesses, real estate, and yachts are being hunted down and reportedly Oligarchs are running out of places to hide their assets.
Oil & Gas
Russia is the world’s third oil producer after the United States and Suadi Arabia. Despite the variety of sanctions unleashed soon after the Russian invasion, Oil and Gas were left untouched for the first two weeks. This has changed with the US announcement of stopping Russian imports and later UK and EU have followed with respective medium to long-term exit plans from Russian energy dependency.
As of now, fossil fuel imports to the EU continue uninterrupted from Russia. From February 24th to March 12th EU imported EUR 9bln (almost USD 11bln) worth of fossil fuels from Russia.
After deliberating this move for two weeks, on March 8th:
U.S. President Joe Biden announced a ban on Russian oil and other energy imports.
Britain also announced a plan to phase out the imports of Russian oil and oil products by the end of 2022.
European Union is not expected to join the ban this time.
EU will have to abstain from banning this time, as their economy and energy supply are too dependent on Russian oil and gas imports. This was also one of the major reasons why the EU insisted on enforcing only a partial ban on SWIFT, as they want to be sure energy payments will flow undisturbed to Russia.
Olaf Scholz, German Chancellor has mentioned several times that at the moment they see no fast way to substitute Russian energy imports that are vital for gasoline, heat, electricity, and other industries. U.S. has a different trade balance with just a small portion of imports being from Russia, they will be able to substitute it relatively easily from other countries.
To put the European dependence into perspective, it’s enough to look at 2021 data - the EU imported from Russia around 45% of gas imports and close to 40% of its total gas consumption. Germany is a heavy user of Russian gas, 35% of its gas is imported from there. Germans were working to source even more Russian gas via Nord Stream 2 pipeline, but that project has been stopped for now due to the Ukraine-Russia war.
War and uncertainty are always driving the commodity prices higher and this is exactly what happened since the crisis started. After the Russian invasion of Ukraine, Oil prices went sharply higher, Brent Oil broke above $130 during the 7-10 March time period, before erasing some of the gains and sliding down to around $100 as of 15th of March.
Under normal circumstances, as an exporter, Russia should benefit from higher oil prices. Here many aspects have to be considered - yes, if Russia finds enough buyers of its fossil fuel products, it will bear the fruits of elevated prices, significantly reducing the negative impact of the sanctions on its economy. The oil and gas sector is responsible for about 40% of Russia's federal budget revenues and is nearly 60% of its exports.
Several economists have estimated that each 10$ gain on oil price gives Russia around $20 bn of current account inflows per year. With all sanctions and trade embargoes, imports are expected to collapse this year and as a result, Russia's 2022 current account could exceed $200 bn.
So despite around $300bln of the Russian Central bank’s $640bln foreign reserves being blocked (by US, EU), the expectation is that Russia may be on the way to rebuilding the buffers from the current account surplus.
Russia naturally claims there are other markets they can supply oil and gas, should the EU decide to pull the plug on the imports - this statement however should be taken with a grain of salt. Europeans are unable to drop immediately the imports, however, the trend will be in one way only - everyone in the West will try to decrease dependence on Russian oil and gas going forward.
With Western buyers looking to cut purchases, Russia has no other option than to look East for buyers. China is already buying 20-30% and there were plans for India to buy more. Months before Putin authorized the invasion of Ukraine, Rosneft and Indian Oil Corp agreed on the supply of up to 2mln tonnes of oil to India by the end of 2022.
However, all these expectations of rebuilding the Russian economy due to high commodity prices seems too optimistic in the current environment.
Reportedly Russian oil producers are offering a 25%+ discount on dated Brent crude prices as of early March. If the sanctions are left in place, Russia’s export volumes may drop regardless of elevated oil prices on the markets and due to the likely discounts, it surely will be putting some pressure on revenues.
In the medium term, China (and possibly India, if they chose to collaborate) will be a winner from the perspective of commodity trading. They will hold the bargaining power on the pricing of goods (oil, gas, and numerous other commodities Russia exports), leaving Russia in a vulnerable economic position.
In the short term, even with half of the reserves frozen, Russia still has the stream of exports they supply to the world. These remaining reserves plus the increased current account this year should be enough to avoid a 1998-like economic collapse.
Overall as it stands now, Russia should be able to overcome current sanctions in the short term - yes the economy will surely go into recession, but it is unlikely to collapse. There are already multiple negative forecasts available, estimating the shrink of the Russian economy by 7% this year.
Mutual Pain
To substitute dependence on Russian oil, there are several options available to the Western allies:
1. United States will have to produce more - this is certainly viable as shale drilling is profitable when the WTI oil is above $60-70. US has produced 11.2mln barrels per day in 2021 and has a capacity to push it up to 15mln barrels per day. It will take time and capital investments to substantially increase it. Currently US oil consumption stands at almost 20mln bpd, dwarfing the domestic production.
2. Venezuela - US will have to revisit its approach towards this oil rich country. Venezuela has the world's largest proven oil reserves at an estimated 304 billion barrels (18% of global reserves). This will requires a lot of capital investment and political support in the United States - the latter may be more challenging than the former and either way will take at least 5+ years. Currently Venezuela produces up to 0.7mln barrels per day and has long way to move into Millions per day production.
3. Iran - US is already in discussions with Iran for lifting the sanctions. This will be very challenging as the trust is gone since Trump re-introduced the sanctions and with the 2024 US presidential elections coming, Iran will be careful on new deals (Republicans will be more hawkish as usual, Israeli lobby will push hardline strategy as expected, Saudi Arabia will lobby against it as well, etc). In 2021 Iran’s oil production fell to below 2mln barrels, from 4.3mln bpd in 2016 - this decline can be reversed but as mentioned there will be many political obstacles ahead.
All these options bring their share of challenges and none of them offer a short-term solution. The western allies should put a robust medium-term plan in place to substitute Russian energy supply from other producers. It will be far from smooth sailing and will take years to realize.
Meanwhile, the current post-covid world is under a threat from soaring inflation. In February, 40-year high inflation was recorded in the US, when annual CPI grew by 7.9%. Supply chain issues remain a challenge this year for the world economy and the recent spike in covid cases in mainland China isn’t helping either. As Chinese authorities enforce the so-called zero Covid policy, they are locking down 30mln people, factories, and ports - that will likely deepen the supply chain issues.
Looking at below 2019 Russian exports map, it’s easy to see why fossil fuels are vital for Russian exports (and European imports respectively). However, it has to be mentioned that Russia is a large player in other commodities as well.
In the metals, Russia is: World’s 3rd largest producer in Gold, 3rd biggest producer of Nickel with 7% of output, 1 or 2nd in palladium with almost 40% of global production, holds 3.5% of global copper production, and is 2nd producer of Aluminum with 6% of global supplies. The prices of metal commodities are already much higher on the markets since the start of the Russian invasion of Ukraine.
Importantly, Russia is also the largest wheat-exporting country with 17% of the global supply. Ukraine on the other hand is a large wheat exporter as well. Together Russia and Ukraine account for almost 25% of the world’s wheat exports. Since the conflict started, wheat prices are higher, as are corn (maize), barley, and other grains - causing significant food inflation across the globe.
The ascending inflation will be a heavy burden for the population of the US and many European countries - gasoline prices are already at uncomfortable levels for many low-income families in the United States and food prices are rising. This will be an important political factor for the White House in the near term, as they have to find a balance of a hawkish approach towards Russia with the tougher economic reality domestically.
A similar picture is in the EU with the added pain from the ceased trade exports to Russia. In this regard, Germany is an obvious economic loser, which used to export $30bln+ of goods. German exports include motor vehicles, industrial equipment, electrical machinery, pharma products, and others. The war and the sanctions are likely to reduce EU GDP growth this year by at least 0.7 to 1 percentage point. This economic pain will be unevenly spread across EU nations, with Germany likely taking the bigger toll, as they are an important trade partner of Russia.
Inevitably, there will be internal pressures and lobby from inside the United States, Germany, and other EU nations to soften sanctions on Russia.
If the aim is to punish Putin and squeeze his 22-year (and counting) totalitarian regime, the sanctions should be left in place for an extended time.
Putin’s aggression should have some repercussions and Ukraine’s suffering warrants it.
Peace.
Excellent analysis.. Didnt realize the current effect of the sanctions was this small.. :/