Despite appearances, the Russia sanctions are working
In an era of instant gratification, it is perhaps not surprising that some foreign affairs commentators are expressing doubts about the effectiveness of the Western sanctions imposed on Russia since it began its invasion of Ukraine on Feb. 24. They cite a putative strengthening of the ruble and a recovery in the volume of Russian crude oil exports following an initial drop as evidence of the failure of sanctions to exact more than a mere flesh wound on the Russian economy.
A closer look reveals a somewhat different story. The ruble’s strength has less to do with confidence in the currency than with the imposition of, on the one hand, exchange controls and, on the other, a precipitous drop in imports of goods and services due to sanctions. Russian citizens are limited in their foreign currency purchases, Russian exporters are required to convert 50 percent of foreign exchange earnings into rubles, and foreign investors are prevented from repatriating capital and dividends. Consequently, Russia’s current account enjoys a surplus and Central Bank reserves (those not frozen abroad by sanctions) are holding steady, alleviating downward pressure on the ruble. This comes at the expense, however, of greatly reduced levels of private consumption and severe limits on the importation of industrial inputs essential for normal economic activity.
Russia’s oil exports to traditional markets in Western Europe have plunged as countries have banned Russian-flagged vessels from their ports, and port workers in some countries have refused to unload other vessels carrying Russian oil and refined products. Major international oil companies and trading firms have shunned Russian crude due to reputational concerns, and many tanker operators avoid carrying Russian crude or refined products for fear of not being able to unload them. While it is true that Russian oil exports have recovered since the initial days of the invasion, this is due to substantial discounts from the normal differential between Russian crude oil and the leading international benchmark oil prices.
The increase in global oil prices has somewhat offset those discounts, and clandestine ship-to-ship transfers of oil at sea have enabled Russia to partially evade sanctions. However, loopholes in remaining trade with the European Union will narrow in December when a total ban on seaborne Russian oil imports goes into effect and Germany discontinues Russian oil imports via pipeline. Then only Hungary and Slovakia will import smaller quantities of Russian oil via pipeline until that too ends once alternative sources are secured. Further, marine insurance companies in the EU, the United Kingdom and the U.S. will soon be prohibited from issuing coverage to carriers of Russian oil and gas — something which has largely occurred already. Russian oil exports will then shrink even further, leaving Russia as a supplier to China, India, and a handful of other buyers squeezing out even steeper discounts.
Natural gas exports are not yet subject to sanctions, but Russia seems to have imposed sanctions on itself by sharply reducing Gazprom’s shipments to its main customers in the EU as punishment for those countries’ “unfriendly actions.” Such weaponization of energy exports vindicates those who opposed Europe’s growing dependence on Russian energy and provides a powerful stimulus to the importation of liquified natural gas (LNG) from diverse sources. Having effectively destroyed European demand for its natural gas, Russia will be left with only China as a major buyer. Russia will be compelled to invest in additional pipelines and will have little bargaining leverage as it negotiates long-term contracts with the Chinese. As for Russian LNG exports, the problems with using Russian-flagged vessels and the difficulty of obtaining marine insurance are already taking a toll on exports. And planned expansions in Russian LNG export capacity have ground to a halt due to sanctions on the provision of Western equipment, for which there are currently no substitutes.
Altogether, this adds up to an impending catastrophe for the Russian energy sector. Oil production has already dropped by roughly 10 percent and is set for further cutbacks. As storage capacity is eventually filled up oil wells will have to be shut in, with the probability that many of those wells will not be able to resume production if Russia ever returns to global markets. With oil and gas exports historically accounting for approximately half of foreign exchange earnings and nearly half of overall government revenues, this portends a massive economic decline.
Turning to Russian manufacturing industries, sanctions prohibiting the export of a broad range of industrial inputs, particularly semiconductors, have crippled factory output. To cite one example, automobile production has decreased by nearly 85 percent over the past year. Those cars which are being built lack anti-lock brake systems, airbags and onboard navigational aids. Russian aeronautical manufacturers are facing even greater problems as Western aviation agencies stop issuing airworthiness certificates for Russian aircraft. The exodus of Western companies from Russia — now numbering more than 1,000 — leaves many factories idled due to a lack of imported components and proprietary know-how. In Moscow alone, 200,000 employees of foreign companies have been laid off.
As for the Russian consumer, the impact of sanctions is impossible to ignore. Many Western products to which Russians have become accustomed over the past three decades are no longer available. Iconic brands which once heralded Russia’s integration with the global economy have disappeared from the high streets of Russian cities. Of course, substitutes can be found, but rarely of the same quality. From cars to computers, from Big Macs to blockbuster movies, the options are severely limited. And any passenger on a Russian airplane will no doubt contemplate the fact that spare parts for aircraft are being cannibalized and factory-approved maintenance deferred.
We should not expect the Russian economy to collapse because of sanctions. Even as the effects of sanctions increase the Russian economy will still stumble along at some considerably lower rate of productivity and efficiency. However, sanctions will gradually degrade Russia’s ability to wage war on its neighbors as the production of military equipment declines and government revenues plummet. The big question is if the impact of sanctions on the Russian population will help contribute to the public’s growing disenchantment with their country’s leadership for embarking on an unnecessary war without a credible justification.
Edward S. Verona is a senior advisor at McLarty Associates who consults with clients on issues related to Russia and Europe. He is a former U.S. diplomat, former vice president of ExxonMobil Russia, and former president and CEO of the U.S.-Russia Business Council (USRBC). The opinions expressed in this piece are solely those of the author.