Q&A with sanctions expert Dr Richard Connolly
Dr Richard Connolly is Director of the Consultancy, Eastern Advisory Group, an Associate Fellow at RUSI, and a Senior Honorary Fellow at the Centre for Russian, European and Eurasian Studies (CREES) at the University of Birmingham. His research focuses on economic policy, defence and energy industries, the impact of Western sanctions and Russia’s role in the global economy. Financial Crime Digest spoke to Richard about the latest sanctions, what they mean for the Russian economy and what could be next.
Could you give us an overview of the sanctions?
The first point to note is that there was already a sophisticated layer of pre-existing sanctions. It's worth thinking about this because if you've already had an industrial sector that has been sanctioned to death for eight or nine years, then more pressure is not necessarily going to yield the results you are looking for. We had a lot of individuals subject to travel bans and asset freezes in 2014 and subsequently. This was in response to the Russian annexation of Crimea, and alleged interference in the US election, the Skripal poisonings, and other malign activities. We already had a large number of individuals and entities cut off from the West. The energy industry had been placed under some significant financial sanctions and limits on their access to technology, and their banking system had been placed under some duress. It has meant that over the past eight or nine years, the Russian government has already been doing a job - not necessarily successfully - of adapting to being under sanctions, and expecting more. Since this expanded military campaign in Ukraine in February, at the top was the freezing of about half of Russia's foreign exchange reserves, that were held in currencies of the Western alliance - principally US dollar and euro, but followed by sterling, Swiss franc, yen. That was one I must admit I hadn't expected, because there are some obvious potential pitfalls for the countries imposing it.
Second was the partial block-out from financial messaging service SWIFT. That was not as impressive as some people presented it as being. There are some very large and important exemptions. Anything to do with the energy trade is exempt - they can still use SWIFT to make a transfer under the legislation. And if you look at what constitutes "energy", it's rather a broad list. When you consider that Russia is a commodity exporter, it really includes most of Russia's export profile. Some banks have been frozen - initially it was VTB which was not allowed to trade in dollars - through SDN blocking sanctions. That's not the same as being blocked from SWIFT, but they tend to accompany each other. VEB (now VEB.RF) was subject to blocking sanctions, and was blocked from SWIFT. Some banks were not initially, but that has tightened over time. Nevertheless, there are a large number of Russian banks that have access to SWIFT.
Third - which is important in the short run, and increasing over time, is the expansion of export controls on certain technologies and licenced technologies. The defence industry has been under some sanctions from 2014 onwards. That includes access to dual-use components - electronics or machinery that might be used in the manufacture of weapons. That already put quite a lot of technologies out of bounds for Russian importers. Even if you weren't in the defence industry, you would have to file an application to buy certain goods. Very often the US would say no. In the EU it was left to member states - so it was easier to get some of these things from, say, Italy or Bulgaria or Hungary. That was a loophole. The Italians, for instance, after 2014 continued to sell some military trucks to Russia. These export controls mean that Russia's access to goods embodying certain technological capabilities will be severely compromised.
Another sanction that will have a big practical implication over time will be the ban on aviation components and aircraft parts. That will have a big impact on a geographically large country relying on civilian passenger aircraft for transport. Again - how do you replace that? The big makers of passenger aircraft in the world are Canadian, European or American. Do you develop your own? Late Soviet-era designs would not be good for comfort, safety, or fuel efficiency. Those are the major ones - it has also been supplemented by what we might call "spontaneous" sanctions - individual firms have decided to reduce their presence or walk out completely from Russia. We've seen some really high-profile examples. BP's investment in Rosneft was a massive component of their corporate strategy. They felt compelled to walk away due to the reputational cost of doing business there. The headline statement is that the big sanctions were imposed at the beginning. The only ones left on the table are those to do with not buying energy, food, or raw materials. In a global inflationary environment, touching any of those is likely to cause prices to spike.
What is the specific purpose of the sanctions?
There are multiple reasons. One is intended to be deterrence. By imposing a cost, you are saying that there could be a future cost to the target's actions. You are establishing some credibility by imposing some quite draconian sanctions, and saying that you could go through the gears. I think it's difficult to say that this has been successful. There have been sanctions in place since 2014, there has always been the threat of them being dialled up, and listing what they might be to perform a deterrent effect, and it clearly hasn't worked because Russia launched a massive military attack on Ukraine. Ultimately when we are talking about sanctions, it is useful to consider how important the source of policy disagreement is to the target, and how important it is to you? I think the Russians have always felt that when it comes to Ukraine, it is a more important policy issue to them than it is to the Western countries that they are dealing with. As a result, they are prepared to bear greater pain. Sanctions also send signals to domestic audiences. People watch the BBC, see the news that is awful, and want something to be done. But of course, we know that we can't do too much because the Russians have the largest nuclear weapons arsenal in the world. But sanctions offer a way of signalling to your population "look, we are doing something, and it is severe". I think that there is gap between what politicians say the sanctions are doing, and what they are really doing, in practice... It is in the politicians' interest to say sanctions are causing immense pain.
And sanctions send signals to third parties, the obvious one being China. It says "if you were to get involved in some egregious violation of international law, this is what will happen to you". The Chinese must look at this, holding several trillion dollars of US treasury bonds and think that if the US or Europeans can basically take your money and freeze it, it calls into question why they have been building up all these savings over time. I think it has been shown that there is a cost to carrying out actions like those Russia has carried out in Ukraine. Punishment overlaps with regime change. No politician will admit to it, as it could be seen as constituting an act of war. But if we look at the track record of sanctions over the years - Iraq, South Africa in the 70s and 80s - when you are placed under these types of sanctions, then regime change is an implicit goal. You're hoping to dial up the pain so much that you change the political dynamic within that country - so that enough powerful people in the target country say to their leader, "we're experiencing a high cost here, we want you out". That's why Western sanctions target the elite who aren't necessarily part of the policy team.
A lot of the people who have been targeted by sanctions are not movers and shakers. But by freezing their assets you are incentivising them to boot out the guy in charge.
In mid-April, US President Joe Biden said we were "beginning to see that the sanctions are devastating Russia's economy and their ability to move forward." Meanwhile Russian President Putin has said the sanctions have backfired. What do you make of this?
I think there was a great deal of shock and awe at the beginning. Sergei Lavrov admitted that the Russians were taken by surprise. But as with a lot of things that are shocking, you adjust to a new reality. Take the impact on the ruble at the beginning. There was freezing of the reserves, the fact that there was a war, and a lot of companies were being targeted, the ruble sunk to a record low within 24-48 hours. But then the Russian government just imposed capital controls - that's an adaptive measure. It was easy for the ruble to tank for as long as it was a freely convertible currency. Capital convertibility was a big achievement of economic policy in Putin’s first two terms as president. That integrated Russia with the world's financial system, they wanted to be a part of the G8. Following the sanctions of February, what's the point? Russia is no longer a member of the Western part of the global economy, outside of the sale of raw materials. So why do they need capital convertibility? They don't. So they abandoned it, put capital controls in place, and artificially restored value to the ruble - now it's at pre-war levels. They adapted by altering the institutional basis of the Russian economy.
After the initial shock that they were basically shunned from the Western part of the global economy, they accepted it and acted accordingly. That has largely taken away the need for those foreign reserves. It is worth remembering that Russia spent about $300 billion at the end of 2014 defending the ruble. They were spending a lot of their foreign exchange reserves to give the ruble enough value so people had trust in it, so that they could carry out transactions and they could maintain capital convertibility. Well they lost $300 billion this time when it was frozen - but they no longer need capital convertibility - the whole reason [the reserves] were there was to support the ruble through times of crisis. The Russians are now supporting it through administrative means. I think that shows how they have adapted. They will have to develop their own technologies, with a much bigger import substitution programme than the one that was implemented from 2014 onwards. That will be expensive, but there will also be winners from it. People who set up factories that produce goods not previously produced in Russia will make a lot of money. It may boost employment. This is what happened in South Africa after the sanctions imposed in the late 70s. You encourage local production.
Russia is still a large manufacturing country - they have the potential to do this. Now, I don't for a minute think they will do it as well as a large American or Japanese firm. But there is a question of reasonable sufficiency - how well do they need to do it? If they produce a car with a sat-nav that isn't as good as a German one, but it helps them be less affected by sanctions and keeps some people in work, then actually that works reasonably well. The big thing that is helping Russia at the moment is the ruble income from export revenues has ballooned as a result of the last few months. They export geopolitically sensitive goods. The prices of these things go up when there is a war - oil, gas, food, rare earths. The price of all of these things is extremely high at the moment. In ruble terms, Russia is making between 3-4 times what it would have made per barrel of oil sold or thousand cubic metres of gas exported, compared to a couple of years ago. So once that is sold for dollars and exchanged for rubles at home the Russian government is sitting on a big cash pile. Looking at the most recent Russian central bank economic data, for Q1 they had a budget surplus. Imagine that - you have this enormously expensive war, punishing sanctions, and your revenues have gone up. If you look at the current account surplus, the first quarter was a record quarter. If these tendencies remain in place for the rest of the year, it will be a record current account surplus year. Now, the government has a lot of things to do with that cash - there are parts of the economy that need support, and inflation is eroding the living standards of ordinary people. There's also the war that is being fought. But I looked through the Russian budget for the first quarter, and defence spending has roughly doubled in March. It was about 250-300 billion rubles more than they would have expected before the war. That's eminently affordable, with their budget surplus measured in trillions of rubles not billions. So I think they can afford the war, at least in financial terms, and afford to funnel financial resources to parts of the population that are suffering or are important to the regime, that they want to keep happy - people working in big industrial plants in the Ural mountains, people working in Chelyabinsk.
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The losers are the well-heeled city dwellers, the speakers of multiple languages who reside in Moscow and St Petersburg, who travel, and work for multinationals, who have strong links with the West. People who might see the world like your average Western citizen. They would not vote for Putin in an election, they might vote for Navalny. You might say they have a liberal or cosmopolitan outlook. They are left with no other alternative - much like the so-called oligarchs. By freezing their assets over here, you are forcing them to go back to Russia, to keep their capital in Russia where they will be even more at the mercy of the state. They will do what they are told, otherwise it will be expropriated. It was ever thus for anyone who is rich in Russia. In terms of winners and losers, I think the Russian state has enough money to be able to satisfy those other parts of society that it needs to continue this system of political economy. Those people who are going to lose are rich Russians, Western-leaning Russians, multi-lingual Russians who travel and work for foreign firms, or owners of small businesses. They are the ones who will have faced the biggest shock over the past couple of months, and their incomes will have gone down the most.
How do you see the future of the Russian import substitution programme that emerged after 2014?
It takes a while for the policy process to catch up with these rapidly moving events. But we have already seen it in the last couple of months. A lot of commentators, particularly on the more nationalist end of the scale, say "we have a rupture with the West now, let's use this to do the things we should have done before. Instead of allowing rich Russians to park their money abroad, they should repatriate it now and invest it in domestic productive capabilities". What we have done inadvertently with the sanctions is facilitate the Russian nationalist agenda. While there were people calling for stronger import substitution programmes over the past eight years, the country still had access to a variety of Western goods which were better than what Russia could produce, that they went with inertia and carried on buying what they had always bought from the West in terms of electronic components and machinery. There was a big resistance in Russian industry to buy Russian - you would rather buy highquality Western or South Korean goods. That isn't an option now for a lot of oil and gas, or technology firms. They have to go Chinese or domestic. There are a lot of people saying now that Russia should not simply swap Western goods for Chinese - let's produce it ourselves, this is an opportunity. You could say that this is blind optimism in the face of a crisis, but there has been a large constituency calling for an import substitution programme with real teeth.
I don't think for a minute that they will be able to produce goods that are comparable in quality or cost to what they have been buying. The average Russian consumer is going to experience a lower quality product as a result. But, welcome to the Soviet Union. There were lots of consumer goods produced there, and they weren't particularly good, people didn't like them. But again it is a question of reasonable sufficiency. If it does the job, if the Russian produced iPhone is comparable to one that came in three years ago and you don't need to renege on your foreign policy ambitions, I think that the Russian leadership will see that as a price worth paying. If your car satnav is not as good as the Western equivalent because it is using GLONASS, well, so be it. State-owned enterprises will get bigger orders, or people who are close to the state, the Kovalchuks and Rotenbergs. It happened in 2014, one of the big people close to Putin, bought an apple concern that produced apples that were previously bought from Poland. You end up creating a massive industry for well-connected insiders because they have a captive market who have no other choice than to buy your goods. The people who work for you get higher wages. The people who pay the price are the consumers.
Do you anticipate that Western investors will move from Ukraine/Russia/Belarus to other countries in the CIS like Kazakhstan and Uzbekistan; or Eastern Europe Poland, Baltics, Balkans; or will they give up and take their capital elsewhere?
For as long as the war continues at its current level of intensity, it is difficult to see how many Western firms can justify their involvement in Russia. The fear of reputational damage will be too much for many. Hence the decisions of many multinationals to either freeze, relinquish or sell their assets in Russia. Where those multinationals choose to go instead will depend on what they were in Russia for in the first place. If you are an energy major and you were involved in oil and has extraction, there won’t be many places offering the same volume of oil and gas. And if you were an automobile manufacturer making cars for the large Russian market, there won’t be a comparable market in the former Soviet space or eastern Europe that will be as big. So where foreign investors choose to reinvest their capital will really depend on what they were getting from being involved in Russia in the first place.
What are the terms likely to be for de-escalation?
The more sensible people realise that you have to offer an incentive for Russia to behave well. If you say we want peace in Ukraine and for Russia to pull out its forces, and regardless of whether they do that or not the sanctions will remain in place... If sanctions are designed to alter their calculus, you aren't incentivising them. Antony Blinken said the other day that sanctions relief must be part of any peace process. If there is a ceasefire or peace talks, sanctions relief will have to be offered. I would be very surprised if there wasn't some sort of sanctions relief attached to peace negotiations when they begin. I don't know when that will be, but whenever the battle for the Donbass ends, if it ends on favourable terms for the Russians, and the Ukrainians feel the need to talk, the Russians will ask for sanctions relief and the West will be able to offer it. I think export controls will be in place for quite a long time. There may be some loosening around the edges. The reason for that is you are undermining their industrial capabilities and ability to wage war. It is very close to the military machine. Central bank reserves? I have to say I don't know. They are frozen, not expropriated - so they could unfreeze, or unfreeze some under certain conditions. I think the central bank part could be quite complex.
With SWIFT messaging, perhaps some banks could be allowed access again, or for certain transactions. I think an easy one could be allowing the sale of aircraft components. I think people could see the rationale for that on humanitarian grounds and say that there could be an increase in accidents if we don't allow this, and we are not trying to target the Russian people. I think politicians could easily row back on that one.
I don't think you will see a situation where big state-owned banks will be back in the financial system such that they will be able to tap global markets. I don't see that changing. I’m not even sure that the Russian banks would want to, even if they were so permitted.
The 2014 sanctions will be in place in perpetuity, with tightened export controls. So we will likely end up with something that is similar to the Soviet Union sanctions that were in place - CoCom. Export controls were in place for a long time, and the Russian banking system wasn't part of the international system. I think even with sanctions relief, you are looking at a landscape that will resemble the Soviet-era sanctions regime in many ways. Every policy that we have seen since the invasion has served to strengthen the role of the state in the Russian economy. It was strong to begin with, already about 65-70 percent of financial sector assets were in the hands of state-owned banks. That is going to be even more now. Alfa-Bank is not going to be able to function as a private bank in practical terms, even if it is owned by a private sector owner. Now that those people can't keep their capital elsewhere, they are at home and do as they are told. This is now a quasi-Soviet financial system where the state owns it, there are capital controls and you have to get permission to put your money abroad. This amounts to a very Soviet-era type of financial system.
Roger Hamilton-Martin, Financial Services Journalist
This article was first published in April's issue of the Financial Crime Digest. Read the edition in full here.