Why sanctions may as well work

Two days ago, Clifford Gaddy and Barry Ickes, two renowned experts on Russia’s economy published a short analysis on the possible effect of European and American sanctions on Russia. The outlook was grim, they concluded: not only were sanctions unlikely to produce the desired effect, but they would also lead to an increased state control over the Russian economy and they would make the Russian public rally around Vladimir Putin. While the two gentlemen make a number of valid and important points, I still think that sanctions, if properly implemented and accompanied by an adequate show of political will, do work. Here’s why.

Sanctions, in themselves, are no silver bullet. They will not solve Europe’s problems with Russia overnight. As they rarely immediately lead to spectacular changes, their effects are often overlooked and some of their adverse consequences are exaggerated.

An unquestioned leader?

We cannot assume that, as a consequence of economic sanctions, the Russian public (let alone the elite) will, per se, rally around Putin. The Russian president may call the ongoing fight for Ukraine as a battle between the West and Russia, but, as the example of Crimea and the disappointment of the nationalists showed, he can only count on a firm support as long as he is able to present the events, both to the Russian public and to the Russian elite as a constant winning streak.

By intervening in Ukraine, Putin tilted the previously established balance within both the Russian elite and the society, similar to how Mikhail Gorbachev did roughly twenty years ago. Putin was partly forced to do so, as the previous model, a ‘welfare consensus’ – not only an unspoken social contract but also a contract with the elite – seemed to have been exhausted. Putin opted to replace the previous model with imperial politics, namely the Eurasian Union, of which Ukraine was supposed to be an integral part.

A change like this works just as long as the new strategy designed by the leader is clearly beneficial enough for a large enough chunk of the elite and the society so as any deviation from it would be suicidal. The creation of the Eurasian Union and the intervention in Ukraine, were meant to be just shy of a triumphal march. As soon as cracks start to show, however, instability will come to the surface. Nationalists previously in opposition but fanaticised by government propaganda will get disappointed and turn against the government once again. Middle-class Russians, having taken a lukewarm pride in the bloodless annexation of Crimea, will get preoccupied by more tangible problems: their household budgets collapsing under the weight of more expensive imports, their holiday plans limited by a weaker rouble, their tax rates rising as the government is forced to plug widening holes in the budget. Conventional wisdom says that Russians are tenacious, resilient people. But had they ever had the privileges, the life standards that they have had in the past decade? Why are we so sure that they will be willing to give these things up, even though they do not actually hear gunfire under Moscow or St. Petersburg?

There is a similar fissure in the political and business elite. Vladimir Putin’s third presidential term has gotten the siloviki and the arms lobby back in position. Arguably, most of them are interested in maintaining a heavy-handed approach on Ukraine. However, potential opponents of the war do not only include market liberals like Alexei Kudrin, who warned that sanctions were suffocating the Russian economy, but also influential businessmen with business interests in Ukraine – like the Rotenbergs – or, alas, the energy industry that, as the chief of LUKOil, Vagit Alakperov warned, would find it increasingly difficult to raise funds for its expensive, but necessary development projects. Commodities industries are capital intensive: if this capital cannot be raised easily and, more importantly, in a cost-effective way, the industry in question will suffer.

Picking pockets

Whether the Russian elite actually believes in the murky ideology of economic autarky some of them invented to support their own business interests during the oil boom is debatable. However, the elite are interested in enjoying and further accumulating their wealth, and they are the ones, not Vladimir Putin himself, that control the rents from Russia’s lucrative commodities industries. Even if we accept that the well-being of the elite is not directly related to Russia’s economic performance, if rents, accumulated by extractive industries, are required by the central government to finance other sectors of the economy or social spending, the elite groups controlling the given rents will protest. We have seen such a struggle in 2012, when the government suggested to finance increased social spending, promised by the president, from the resources of Rosneftegaz, and a similar intra-elite dispute has started this week, with the announcement of plans to raise the VTA and introduce new taxes, shifting part of the burden of the Ukrainian campaign directly on to consumers, with market liberals in the government vehemently opposing such plans.

There is no doubt that the Russian government would try to substitute imports of technology and weaponry with domestic production (supposedly of lower quality), should the European Union introduce stricter sanctions. Furthermore, there is no doubt that allocating further resources to these industries, controlled, to a large extent, by siloviki groups, would, theoretically, cement the grip of these groups on power even more. However, substituting imports is expensive, and whether the Russian government can conveniently raise the extra money required for this step is highly questionable.

Regardless of the Russian government’s willingness (or rather, reluctance) to squeeze more money out of the energy industry, it is already a fact that the Russian budget does not have enough resources to cover the extra needs that have arisen in connection with the crisis in Ukraine. The development of Crimea will cost between 160 and 200 billion roubles per year starting from 2015, according to Economic Development Minister Alexei Ulyukayev, making the peninsula the single Russian region requiring the most budgetary aid, which already takes funding away from major infrastructure projects. Moreover, Russia will cover the lion’s share of its pipeline from Eastern Siberia to China, another project that became pressing due to Russia’s animosity towards the West. Other strategic projects, such as the development of the Far East or the restructuration of Russia’s single-industry towns receives so little attention and funding, against the backdrop of other endeavours that carry higher political value that they risk being completely sidelined as the looming recession – a consequence of Western sanctions and the erosion of trust in Russia – puts increasing pressure on Russia’s budget. It is always an option to tax heavier, but increasing the tax burden is less efficient, from a political point of view, in a more open society. Russia has become considerably more open both in social and in business terms, in the past decade.

The shadow of the dragon

Investment will, eventually, return to Russia. There is no doubt about this. However, just like in 1998, there is a crisis of confidence in Russian economy and Russian politics. Then, markets were shocked by the effects the economic crisis in Southeast Asia had on the Russian economy. Now they are shocked by the instability and insecurity still inherent in Russian economy and politics after its supposed integration into the global political and economic systems. The mere fact that it is perfectly believable that Russian authorities would lie about the amount of capital flight or the central bank’s currency reserves indicates how serious this lack of trust is. Any crisis of confidence will eventually simmer down, but timing matters, and the Russian economy is short of time.

If Russian business is denied (or restricted) access to Western finance, it can turn to Asia, and notably, China to finance energy investments, sounds the argument of the Russian government’s conservatives. Admittedly, fostering investment ties with China looks much more plausible in the short term than the success of Russia’s trade pivot to East Asia that will require enormous investments. Yet, increasing Russia’s dependence on China may cost Vladimir Putin (or his successor) a lot in political terms. When Russia’s political class is able to think in strategic terms, they are wary of, if not frightened by, China’s rise. From conflicting interests in Central Asia to the demographic pressure on Russia’s Far East, there is a range of issues on which the two countries differ, which essentially makes Europe Russia’s natural long-term ally. The Russian government is, accordingly, very cautious with China: the PRC is the only major power that has managed to coerce Russia into playing a cooperative game. Europe is a much more convenient and easier partner to handle both in the short and the long run, and replacing it with China would be enormously costly both in terms of money and politics.

Luckily for the Russian political elite, the European Union refuses to think in strategic terms, too. The shift away from the cacophony of voices representing 28 distinct national interests towards a foreign policy driven by strategic deliberation, anticipated by many following the crisis in Ukraine, has failed to materialise so far. The EU should not go all the way to the wall: moderate sanctions do work, if accompanied by a sufficiently firm rhetoric and political will. The EU, however, chose to take the harder way.

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