When Russia invaded Ukraine in February of this year, the international community slapped a raft of sanctions on the invading nation. They froze the assets of wealthy and powerful Russian citizens and restricted their ability to travel. They restricted the sale of Russian raw materials and energy and worked to prevent Russia from getting its hands on various kinds of defense and information technologies. And they imposed financial sanctions on Russian banks and curtailed Russia's access to foreign capital and financial markets.
Many corporations followed up on these government-imposed sanctions with so-called self-sanctioning, whereby companies restricted or halted commercial relations with Russia and Russian firms. The effect, on paper, appeared to be a set of measures that struck at the heart of Russia's economy. Forecasts in the spring of this year predicted a drop in GDP of at least 7-8% (and possibly as much as 11%) for 2022. Prices were expected to rise by 20-25%. Foreign direct investment by corporations was forecast to fall as much as 25-28%t over the year.
But Russia has not been brought to its knees. Far from it: Forecasters say Russian GDP for 2022 will likely fall, but only about 3.3−3.4%. Inflation, meanwhile, will likely end the year at roughly 12%: bad, but not close to as painful as predicted. And foreign direct investment? Estimates say it will fall by a mere 1%.
Meanwhile, the war in Ukraine grinds on.
Strong points
So what went wrong? A report from Bruegel, a Brussels-based economic think tank, points to a number of flaws in the sanctions regime, and several strong points in the Russian defenses.
The most effective defense has been mounted by the Central Bank of Russia, which designed and executed the "Fortress Russia" policy, aimed at protecting the Russian financial system. The system did take a big hit early on, as sanctions on Russia's central bank assets were much stronger than expected, reducing its bank reserves by 40%. However, thanks to competent management, the system recovered, and the bank continues to hold large amounts of foreign currency — as much as $300 billion — for potential intervention in the currency and debt markets. And even though Russian banks lost access to the SWIFT financial transfer system, they still seem able to get the cash they need to operate, as various other channels continue to enable Russian banks to interact with the outside world. In other words, despite some big shocks, the central bank has kept Russia's financial system intact and prevented a collapse of the wider Russian economy.
Many of the sanctions were aimed at inhibiting parts of the Russian economy's ability to do business. Russia's economy is less reliant on imports than most other large, advanced economies and emerging markets, the report notes, but some sectors are highly exposed, especially the manufacturing of transportation equipment, chemicals, food products and IT services. Sanctions did a good job initially of restricting Russian access to key imports, such as parts for manufacturing. Still, despite the initial shock, Russia pivoted quickly, and began importing more goods from nations like China, Belarus and Turkey, which are not participating in the sanctions regime. In short, when it comes to imports of key materials, Russia has been shut out of a number of markets, but it has since found new markets to meet many of its needs.
Sanctions on Russian exports have been even less successful. Many countries have stopped buying certain goods from Russia, but the flow of key commodities continues largely unabated. And roaring inflation has only helped Russia in this area: Bruegel estimates that, rather than falling, Russia's export income has risen by more than 40% to roughly $120 billion year-to-date because of higher prices, and is likely to stay that high through the end of the year. The largest contribution to this comes from natural gas, which is still in high demand throughout Europe, and which, unlike coal, oil and other petroleum products, has not been sanctioned.
This shrinkage in imports and swelling of exports means that Russia's trade balance looks extremely healthy. The surplus for January-September stood at $198.4 billion == roughly $120 billion higher than for the same period in 2021, and more than double the previous record in 2008. Bruegel reckons the rude health of Russia's balance of payments will persist into 2023, as commodity prices are likely to remain high, despite the EU embargo on crude oil and petroleum products and despite Russia's decision to cut natural gas flows to Europe. Bruegel estimates a surplus of around $100 billion in 2023 – a substantial drop compared to 2022, but not too shabby for a sanctioned state.
Russia's currency appears to be in equally good shape. When sanctions were first imposed, the ruble dropped from about 70-75 to the dollar to close to 140 to the dollar. By April, however, the exchange rate had returned to below pre-invasion levels. Today the ruble fluctuates at about 60 rubles to the dollar. We have reported extensively on the reasons why the ruble has bounced back so impressively well, and you can read that reporting here. But the TLDR is that capital controls, combined with falling trading volumes and the dynamics of the current account, have all helped prop the ruble up.
Under the skin
Reading all of this, you could be forgiven for thinking that the coalition of nations sanctioning Russia are on a fool's errand, and that Russia is simply too big to fail. Bruegel contends that this is not so, that the sanctions are hurting Russia, and that rosy statistics are concealing some serious damage to the Russian economy.
The ruble's strength is a fine example of this. To the casual observer, the ruble has recovered and is in good health. In fact, the ruble is critically weak: it has been propped up by capital controls that make it difficult to sell rubles and which force Russian companies to buy the currency against their will — or better judgment. As Bruegel puts it, the current exchange rate is not a reflection of the value of the Russian economy's fundamentals. Rather, it is a testament to the fact that financial sanctions are isolating the ruble internationally.
Russia's pivot to new markets for key imports was speedy and effective, but it will not be enough to rescue some important parts of Russia's economy, Bruegel says. The self-sanctioning by corporations wishing to distance themselves from Russia has been particularly damaging, in sectors including auto production and transportation. The withdrawal of foreign car manufacturers and the shortage of inputs has hit passenger car production extremely hard, with a 95% decline in May 2022, compared to the previous year. Air transportation has also collapsed, following the cancellation of aircraft leases and maintenance contracts, and the closure of several countries' airspaces to Russian planes.
Exports of oil and gas look like a strong point, but they are threatened in the medium to long term, Bruegel says. Canada, the United States and Australia have banned all imports of Russian oil, while the United Kingdom has announced a phase-down to zero by the end of the year. The European Union, which has been highly dependent on Russian oil imports in the past, agreed at the end of May to stop seaborne imports of Russian oil by year-end. By the start of 2023, more than 90% of Russia's previous oil exports to the EU will be banned. It's true that Russia has found new markets for its oil, but it is selling that oil at a significant discount, and it will likely have to continue to do so if the most lucrative markets remain closed to it.
Bruegel notes that there is one way the sanctions regime could be expanded to significantly undermine Russian oil exports: via insurance. More than 90% of the world's oil tankers are insured by the International Group of P&I Clubs, a London-based association of insurers. The EU and the UK recently introduced a ban on insurance for ships carrying Russian oil from the start of next year, which would have jacked up insurance costs for Russia, and had a meaningful impact on exports. The U.S., however, diluted this measure, and took the sting out of its tail.
When it comes to natural gas, no sanctions have been imposed on Russia. Instead, Bruegel says, Russia has weaponized its gas supply, blackmailing European countries by progressively cutting exports to Europe – now down to around 20% of their 2021 levels. This will hurt Russia in the long run. Because roughly 60% of Russia's gas exports go to the EU and UK, Russia will need to close a sizable portion of its gas-export infrastructure, including production sites, at significant cost. Export revenues from gas will dry up, and attempts to diversify export routes by building new liquified natural gas export capacity will be hindered by a lack of access to western technology. Redevelopment will take years.
In other words, the sanctions have teeth, but for Russia to feel the bite, coalition nations will need to sink those teeth in deeper and hang on for the long term, Bruegel says. They need to find unity on effective measures such as the oil insurance ban mentioned above, and to restrict oil and gas shipments further. The combination of a large and likely persistent fall in Russian imports, and the permanent decoupling of European economies from Russian energy supplies, will have significant negative consequences for the Russian economy in the medium to long run, the report says. Russia may find ways to mitigate some sanctions-related effects, but the overall loss in economic activity will likely be permanent.
In the short term, however, Russia's economy has not been inhibited to the point where it is finding it impossible to prosecute the war in Ukraine. Given the ultimate aim of sanctions is to stop that war, the EU and other coalition nations, as Bruegel puts it, have more to do.
