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Turning the Screw

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The EU should maintain sanctions on Russia – and it would be well advised to strengthen them. Economic arguments for easing do not add up, and harsher sanctions would represent the right moral choice.

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© REUTERS/Sergei Karpukhin

For two years, the EU-Russia agenda has been dominated by the issue of sanctions – those imposed by the European Union on Russia after Moscow’s annexation of Crimea and its backing of the separatist forces in eastern Ukraine, and those imposed by Russia in retaliation. European sanctions (as well as those introduced by the United States and other countries) had a clear aim: to protest Russian aggression while avoiding any direct military confrontation with the Russian Federation.

The question up for debate since 2014 is whether the san­ctions changed Russia’s policies vis-à-vis Ukraine – if not leading it to return Crimea, at least pushing it to withdraw from the Donbass – and whether they are worth continuing, or even strengthening.

I would argue that they have and they are, and for at least three reasons. First, as became clear later, Western sanctions were extremely timely: it was in early September 2014 that oil prices fell below $100 per barrel and began their impressive downward slide. The situation in the Russian economy, not good since at least 2012, has deteriorated sharply, and sanctions definitely have contributed: for many years Russia’s economic growth was fueled by easy access to foreign capital and loans, so Russia was already under pressure.

Secondly, taking into account that Russia possessed huge reserves, enough to cover prospected budget deficits for more than four years, no one should have expected a change in the Kremlin’s course to come quickly – rendering evaluations of the sanctions’ efficacy premature.

But the most striking thing for me is a third aspect – what sanctions have achieved despite being inexcusably soft. If one looks at the sanctions levied by the US, EU, and UN against, for example, Iran or North Korea (which, it is worth pointing out, never annexed the territory of their neighbors nor incited civil war), one sees asset freezes, bans on oil and commodities exports, full-scale tra­de bans, disconnections from SWIFT and international bank clearing centers, and even prohibitions on servicing airplanes used by Iranian or North Korean airlines. Is there any doubt Russia would struggle under such a broad set of sanctions? President Putin would not be able to counter them for a single year – and I would argue such a set of rules was warranted after Russia attempted to undermine the founda­tions of the post-World War II political order in Europe.

Economic Interests at Play

Why did the Western nations decide not to impose all-embracing sanctions on Russia? I think that at the time the Europeans conside­red EU-Russian economic connections much more important than European ties with either Iran or North Korea. In 2013 the EU exported goods and services worth 119.5 billion to Russia, and its imports amounted to 206.9 billion, making up 9.6 percent of extra-EU trade turnover. Europe depended on Russian oil and natural gas. Some big European companies were highly exposed to Russia, and several EU policymakers have solid connections with President Putin or people in his inner circle. No one actually respected Putin much at that time, but economic interests played a decisive role. Russia’s counter sanctions were also economically driven, but in another fashion: in introducing a ban on agri­cultural products, Moscow attempted to sway European farmers and strengthen its pressure on EU governments. But even if the sanctions have not reshaped Russian foreign policy, it is important to understand how they have affected the Russian and EU economies before a decision is made regarding their extension at the June 23 EU summit.

First, the Russian economy is now in very poor sha­pe. Russia’s GDP for the first quarter of 2016 in current dollar terms will be only $242 billion, roughly 55 percent less than in the first quarter of 2014. Russia repaid more than $216 billion in net external debt between July 1, 2014 and January 1, 2016, while domestic investment fell by 8.4 percent in real terms in 2015 alone. Russia’s monthly imports were down from $27.4 billion in June 2014 to roughly $9.0 billion in January 2016. Real disposable incomes are falling for the third consecutive year, while the ruble has lost up to fifty percent of its value.

“Putinomics” Are Exhausted

No one should expect the economy to crum­ble anytime soon, but the trend looks clear: “Putinomics”, based on plundering oil wealth while putting the economy firmly under state control, has been exhausted. The era of 6-9 percent annual growth is over. The country will not undergo complete collapse, but it is just beginning what will be a prolonged recession.

Of course, the sanctions only played a small role in all this. If one tried to estimate the effects of Russian agricultural counter-sanctions, they would arrive at a figure of not more than 0.7 percent of GDP, and $1-1.2 billion in lost wages and depreciation of existing investments. Moreover, growth in the Russian agricultural and food proces­sing industries might well offset these losses. Some other branches of the Russian economy were da­maged as well, including military production.

The financial sector experienced the greatest losses: in 2015 the overall profits of the Russian banking industry contracted by 67.5 percent year-over-year, to 192 billion rubles ($3.15 billion), but the go­vernment did all it could to support financial institutions affected by the sanction regime. The different estimates of the combined damage caused by sanctions on Russia vary from a conservative 25 billion to an overstated $1 trillion. In any case, direct losses did not exceed 3 percent of Russia’s GDP.

Today, however, Europeans are less interested in the Russian economy than in their own – and here we see two consequences of the sanctions. While overall EU agricultural exports increased in 2015, they declined significantly in Central European nations, whose economies were often oriented toward Russian markets; and several nations (including Italy, France, Austria, and Greece) argue that the sanctions have hurt their manufacturing industries.

A Major Challenge

This is the major challenge Europeans will face when making their decision this coming June. In her statement on sanctions, Chancellor Angela Merkel said on February 1 that “sanctions against Russia must stay in place until Russia fully implements the Minsk agreement” and Ukrainian sovereig­nty over the Donbass (Crimea was not men­tioned) is restored; the Russians, meanwhile, have made little movement in that direction, and are apparently waiting for the damage caused by the sanctions to change Europeans’ minds.

But why do EU leaders assume that lifting sanctions would return business with Russia to conditions that existed two years ago?

Take trade flows as an example. In 2015 Russian imports from the EU were down by 40.8 percent, while imports from Korea fell by 49.4 percent, imports from then-friendly Turkey fell 39.4 percent, imports from Kaza­khstan fell 35.5 percent, and imports from China fell 31.3 percent. Why should one expect trade to explode if sanctions are lifted? I would argue that the Europeans underestimate at least three factors: oil prices have plummeted since 2014, so the ban on exporting oil and gas exploration equipment is hardly a relevant factor; the ruble lost close to a half of its value while inflation was limited, meaning imported food would now be twice as expensive in Russian shops (and the same applies to many other industries); and Russian entrepreneurs have much less ability these days to attract foreign loans, especially with many other markets that look now much more promising. Moreover, even if EU leaders decide to terminate financial sanctions against Russia, US authorities will not follow suit, making the European move senseless: taking into account EU banks’ exposure to the US market, none of them will try to violate the American sanctions if they are still in place.

In other words, the main argument of European politicians in favor of abolishing the sanction regime looks totally misleading, and the promise of a strong recovery in EU-Russia trade is pure illusion. Of course, some companies and countries may profit from economic normalization (including the Baltic states, Finland, or Poland) – but their governments are the strongest supporters of sanc­tions, their willingness to punish the neighborhood aggressor still greater than the desire to profit from trading with it. To put it more bluntly, Europeans now face a choice that is much more moral than economic.

No Economic Benefit

But that doesn’t make this choice easier. On the one hand, the very fact that the Russian economy has already been derailed (although not ruined) by the current situation in the energy markets, as well as by the irres­ponsible policies of the country’s political elite, may lead one to conclude that sanctions are no longer needed. In other words, sanctions were quite useful and they came at the right time; they delivered a blow to the Russian economy that provoked the slowdown, and now we may simply feel that Russia has been punished more than enough.

On the other hand, the same arguments may be interpreted the opposite way. If the Russian economy is doing badly, termination of sanctions would not give Europeans access to a market as strong as it was in the early 2010s. They will be unable to sell roughly half a million vehicles, as EU-based companies did in 2008, or provide financial services to a giant market – and that ignores agricultural sales. Russia has already become a much more autarkic and much less market-oriented country than it was even several years ago, and business with it will not be the same as it was before. It is now clear that the main Russian export for some time now has been not oil and natural gas, but corruption. So if there are no visible benefits from resuming economic cooperation with Moscow, why not leave the sanctions in place for another year – or even longer?

A Value-Based Choice

This makes the choice both easier and more difficult. I suggest that Europeans abandon the rhetoric of benefits and convenience when it comes to the sanctions regime and instead make a value- and interest-based choice, taking into consideration only political arguments. If the sanctions are lifted, after all, there might be an increase of EU exports to Russia of 5-10 percent, predominantly due to increased shipping of food. It would add 4-7 billion (or 0.3-0.5 percent) to overall ext­ra-EU exports – which would hardly change the economic situation in Europe. In some countries it might increase exports by up to 3 percent, but this too would not be a critical change – and all this would happen not when the Europeans ter­minate their sanctions against Russia, but only when Russia lifts its own counter-sanctions, which might take some time.

At the same time, ending sanctions would become a sign of reconciliation between Europe and Russia at a time when anti-EU propaganda inside Russia is at its peak and a policy of undermining the European unity is a top priority. The decision to lift the sanctions would be regarded in Moscow as a clear sign of European weakness and a signal for continuing Russia’s aggression against Ukraine. The EU would lose its moral standing while gaining nearly nothing, since the Russian market will not show any additional demand for European goods and services and Russian tourists will not flock to European destinations as they once did.

But this new economic reality creates an opportunity for the opposite option. With Russia dropping from the third to the fourth position in the EU’s ranking of most im­portant trade partners and presumably drifting further down in coming years, Eu­ropeans may increase their pressure on Moscow without fear of ex­cessive economic damage to themselves. The reason this option is attractive should be clear: Russia has not stopped supporting Donbass separatists and is doing its best to undermine the government in Kiev and destabilize Ukraine. If this happens, Europe will encounter an even greater problem than it faces in Syria and will suffer a major defeat in its foreign policy.

A More Confrontational Course

Thus I would suggest opting for a more confrontational course vis-à-vis Russia, dramatically increasing pressure on its current leadership. Where vital geopolitical interests are at stake, there is no need to take dubious economic considerations into account.

The main problem with EU sanctions was that they affected only a small group of Russians and were difficult to distinguish from the effects of the general economic slowdown. At the same time, they allowed President Putin to rally the Russian public, which is very sensitive to external pressure. If we want sanctions to be effective, we should change our tactics.

First of all, it should be made clear that the sanctions will not be lifted before Ukraine regains complete sovereignty over rebel-controlled regi­ons. There is no need for European leaders to convene every six month and debate an issue that is not progressing at all. Second, the sanctions regime could be reinforced with a demand that all European banks sell off all portfolio investments in Russia, whether these belong to the banks or are held by their clients. Even today, around 60 percent of all transactions in the RTS market involve a Western financial company. This divestment would lead to an un­precedented sell-off in Russian equities, and would send the RTS dollar-denominat­ed index well below 500 points. Since there is no significant internal demand for Russian equ­ities, this move will be felt by a majority of investors. Dec­lining valuations will produce margin calls for many Russian companies and cause a new wave of debt repayment, leading to a further decrease in investment.

Next steps might include a European memorandum stating that EU nations will buy 10-20 percent less Russian gas every consecutive year. If this mo­ve were to be made now, it would be especially effective – Russia will be unable to diversify its gas deliveries until at least 2020, and significant problems experienced by Gaz­prom would resonate across the Russian economy.

Moreover, there are a lot of me­asures that could be taken against the Russian ruling elite – today the Russian autho­rities themselves ban military, security, and police officers from traveling abroad, but the EU could announce a ban on issuing visas to all Russian government and municipal employees. Another option would be to change the policy to­w­ard Russian-controlled assets in Europe, announcing that holdings would have to be sold by, say, January 1, 2018. Russian citizens could be banned from establishing companies in the EU, participating in those that already exist, or holding banking accounts with €10,000 or more – and the list of measures may be extended.

Appeasement Isn’t Working

Why do I propose such complex measures? First, because a strategy of appeasement rarely brings good results. The West tried to reach a deal with Russia after its conflict with Georgia, and got Crimea and Donbass. If Europe and the US forgive Russia for its formal and informal occupation of vast areas of Ukrai­nian territory, Moscow will treat this as a carte blanche for further geopolitical adventures. Therefore, I believe, the pressure being exerted on Russia now is in many ways much more important than any current economic consi­de­rations.

Furthermore, sanctions should be desig­ned in a way that will affect millions of Russian citizens, not just Putin’s friends. Only then can there be hope that the Russians themselves will increase pressure on their government. If huge swaths of the Russian middle-class link their tro­ubles in Europe with President Putin’s policies aimed at redrawing European borders, a great deal may change in Russia, creating the space and impetus for a protest move­m­ent. This is how sanctions used to work and is how they worked in Iran, where the population began to back greater openness in the country, even at the price of its nuclear program.

Make no mistake: What we have seen from Russia since 2008 is an attempt to dismantle the postwar political or­der in Europe. What’s going on today is not only about Ukraine – it’s about the entire continent. The task of European policymakers consists not only in defending Ukraine – it includes protecting Europe, both from explicit Russian aggression and from its policy of undermining European institutions. We need to explore whether the price of san­ctions is as high for Europeans as depicted by Kremlin propaganda; to distinguish the losses caused by sanctions from those caused by a slowdown in the Russian economy; and reconsider a new sanctions package – one that would be able to bring Moscow’s leadership in line with reality. Any attempt to ignore what is said and done in the Kremlin would be an inexcusable mistake.

NB. A longer version of this article will be published by the Atlantic Council.

Read more in the Berlin Policy Journal App – May/June 2016 issue.

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