5 August 2015

Time for tougher economic sanctions on Russia

By Adam Memon and Sevinc Bermek

The actions of Putin’s government in Ukraine and elsewhere pose a threat to the freedom and security of Europe which must be taken seriously and challenged. Endless violations of the Minsk agreement demonstrate the territorial ambitions of the Russian-backed separatists. Failing to deter further Russian aggression will endanger the viability of the Ukrainian state as well as increase the threat to Britain’s Baltic NATO allies. The time is right for broader and deeper economic sanctions on Russia.

Russia is currently undergoing a sharp and rapid deterioration in its economy and it is quite clear that the sanctions put in place since last year, alongside lower oil prices, have contributed to that. Russian GDP fell by 4.2% in the year to June and retail sales fell by 9.4% in the second quarter of this year. Gazprom, which generates 10% of Russian GDP and 20% of government revenues, has seen its output contract by almost a fifth over the last year and is expected to fall by another third over this year. Inflation is running at 15.8% and is more than double the rate it was a year ago which means that real incomes have been subjected to a sharp contraction. Consumer confidence is at a record low and the slump in fixed capital investment over the last 18 months continues unabated.

Trade restrictions – both Western and Russian – have prevented the country from generating stronger export volumes and have increased price pressures. Despite cutting interest rates last month from 11.5% to 11%, it is perfectly possible that the Central Bank of Russia will have to raise interest rates again to provide support to the Rouble even with the perilous state of domestic demand. It is therefore not surprising that the IMF estimates that if the Western sanctions and Russian counter-measures which have been implemented so far stay in place in the medium term, then Russia could see a significant cumulative loss in real GDP of 9%.

However, whilst the sanctions have clearly had a severely recessionary effect on the Russian economy, they have not yet been powerful enough to persuade the Russians to pull back from Ukraine. The disturbing revelation in The Times that the separatists in eastern Ukraine are working to develop a radioactive ‘dirty bomb’ with the assistance of Russian nuclear scientists merely serves to highlight Russia’s deeply malign influence in Ukraine. Pro-Russian forces are flouting the ceasefire every day and once again, the crucial port city of Mariupol is under threat.

Tougher economic sanctions at a time when the Russian economy is already in a downturn would focus minds in Moscow. As the costs of his actions grow and the economy worsens, the pressure on Putin will increase from within his regime to change course or at least to hold back pro-Russian forces. As well as reducing, accelerating net capital outflows and undermining the Rouble, more powerful sanctions would also exacerbate Russia’s fiscal situation. The country’s pension fund and oil reserve fund are running dry, many regional governments are on the verge of bankruptcy and the central government is running an uncomfortably high budget deficit given its dependency on oil revenues.

This strategy should include targeting more financial institutions which have so far been exempt from sanctions as well as other petrochemical producers and defence firms. These sanctions should encompass export bans, prohibitions on dual-use technology and asset freezes. In combination with the existing sanctions, such measures would damage Russian oil-field development plans in Siberia as well as plans for deep-water and Arctic exploration. Without the necessary technology and without the option of joint ventures with Western firms, Russian oil investment will stay stagnant and output will contract. If this is combined with gas import diversification in Europe, through more Liquefied Natural Gas Terminals, more interconnectors and reverse-flow capacities, then one of Putin’s most effective tools can be weakened.

The ban on receiving debt financing with a maturity of over 30 days should be cut further to 7 days. Russian firms have significant foreign currency debts to refinance in the coming months but despite falling reserves, the Central Bank of Russia is still able to provide support. Moreover, net private sector debt repayments last year were only about half of the debts which were due. This suggests that much of the foreign debt is actually debt to other Russians operating abroad which has been refinanced or rescheduled. Cutting the maturity restriction to 7 days would place further pressure on Russian firms with inevitable political ripple effects.

As the sanctions are tightened, more Russian firms will try to find ways to bypass them. The EU, US, Canadians and others should be vigilant in the application of current and new sanctions. The EU nations are Russia’s most important trading partner by a long way and is a significant net importer, accounting for 57% of Russian exports and 46.5% of Russian imports. Whilst Russian trade is important for the EU, it accounts for a much smaller 9.5% of EU trade volumes. So whilst Russian counter-measures will hurt, they are likely to hurt the Russian economy more.

One of the most powerful sanctions would be to suspend Russian membership of the SWIFT banking system. SWIFT is crucial in global finance because it sends the messages between banks that enable financial transactions to take place. Russia’s financial system would be crippled if it was suspended from SWIFT and a full-blown crisis would likely ensue. Over 600 Russian financial institutions use it and over 90% of the total payments made by Russian banks to destinations abroad use it. Not for nothing did the Polish Foreign Minister say “When it comes to sanctions, SWIFT is the nuclear weapon.” The West should be clear that if Russia threatens a NATO member or moves to annex significant new territory in Ukraine, it will face a credible threat of suspension from SWIFT.

The current sanctions have exerted significant economic damage on Russia but the ceasefire in Ukraine continues to be violated and the Minsk agreement is close to breaking down completely. Failing to deter further aggression from Putin would not only mean abandoning the independence and democracy of Ukraine but would endanger the security and freedom of the rest of Europe. Tougher economic sanctions are necessary.

Adam Memon is Head of Economic Research at the Centre for Policy Studies. Dr. Sevinc Bermek is Managing Editor at the Centre for Research and Policy on Turkey.