Russian sanctions – are they worth it?

The BBC recently asked me about the impact Russian sanctions would have on the City of London last week, followed up by European CEO, who interviewed me on the subject.

My view is that sanctions are no good for anyone.

The reason I say sanctions are not good is that it ends up in a tit-for-tat spat where each side stops trading with the other.  The political manoeuvres remain the same – Russia still wants to support the annexation of Ukraine and other near abroad nations (the old Soviet Union territories) whilst the President of the Ukraine wants to keep the country in Europe – and the sanctions just damage businesses that were trading with each other.

After Europe, Canada and America placed their latest sanctions on Russia’s oil and gas supplies and technology, banking and finance, and arms sales, the Russian government imposed a one-year ban on imports of meat, fish, cheeses, fruit, vegetables and dairy products from Australia, Canada, the European Union, the United States and Norway.

This all sounds reasonable to stop Putin trying to support pro-Russian Ukrainian rebels – the ones who brought down the MH17 flight from Amsterdam to Kuala Lumpur – but, in practice, it just means one business fails here and another fails there, hurting individual traders and achieving little politically.

By way of example, Aeroflot recently launched a discount flight operator Dobrolet, which has failed and stopped all flights from August 4^th as the sanctions meant that Western counterparties could not provide aircraft insurance or fulfil maintenance and leasing agreements. But the sanctions are cutting both ways, and the collapse of Dobrolet equally hurts U.S. aviation giant Boeing, which had supplied the airline's small fleet of new twin-engine 737-800 jets which are now cancelled.

In banking, the sanctions will make it exceedingly difficult for the state-owned banks to raise debt and equity in the European and North American markets.  The EU measures go further than United States sanctions to cover all Russia banks with more than 50 per cent public ownership, rather than just two Russian banks, Gazprombank and VEB.

The four largest Russian banks with state ownership of over 50 per cent are Sberbank, VTB, the Russian Agriculture Bank and VEB, and the first two are listed on the London Stock Exchange.  

Will this cause issues in the City?  Yes, to an extent although only 1% of the City’s earnings come from Russian markets and institutions.  Austria's Raiffeisen Bank, which has a large retail banking operation in Russia, is far more exposed, as is France's Société Générale in second place.

Nevertheless, London will see some loss of earnings.  For example, a ban on trading in equity of Russian state-owned banks entered into force last week, with the aim of cutting off Russia's access to European financial markets, transactions that are almost entirely carried out in the City.

In particular, the banning of bond issues in the London markets sees half of the market value disappear, about £6 billion, a major hit to that sector.

This was already a challenge, as the Economist magazine reported that the financial sanctions were hitting the Russian economy even before they were toughened up in July. The flow of dollar-denominated loans to Russia dropped to $7.9-billion (U.S.) in the first half of 2014 from $25-billion a year earlier. Bloomberg reported that no Russian companies received loans in dollars, Swiss francs or euros this past month, the first such instance in five years.

There is also a major exposure in Europe to the Russian banks, far more than the USA.  US banks have been less generous funders of Russia in the past, whist European banks had lent Russian institutions around $155 billion (£92 billion) at the end of March 2014, according to the most recent figures available from the Switzerland-based Bank for International Settlements.

And the fact is that Europe needs Russia probably more than Russia needs Europe.  The EU does more than 10 times as much trade with Russia as the United States does.  European Commission estimates put the cost of the sanctions to the EU at £32billion (€40 billion) this year, a loss of 0.3 per cent of GDP at a time when many Eurozone countries are hovering on the brink of recession.

In particular, Europe relies on Russian natural gas to fuel its industry and power its cities, and the Ukraine carries half of all Russian gas through pipelines to Europe (this is down from 80% a few years ago thanks to the creation of the Nordstream pipeline).

There is also a mutual reliance between the Ukraine and Russia, as part of this. The Ukraine needs Russia for money and fuel, and Russia needs the Ukraine to help it to supply Europe’s fuel.

So this is a very fine balance between inflicting pain on Russia and preventing fragile EU nations from sliding back into recession.

Meanwhile, Russian businesses are not putting pressure on Mr. Putin to reverse course in Ukraine.  Why?  Because many of them are making money out of this crisis.   A weak Rouble helps Russian exports, commodity prices have gone up significantly since the start of the crisis, and many of their overseas investments are doing fantastically well.

For example, targeted sanctions against Russians and pro-Russian Ukrainians are proving a boon to London's real estate market. Some of the $51 billion that fled Russia in the first quarter of 2014 is headed there, with attempts by the U.K. government to curb the use of London property as a haven from the new Cold War's economic fallout unlikely to create an effective barricade against this cash inflow.

Remember that as the Rouble weakens, the pound strengthens.  Add to this that, in 2013, the average British home appreciated by 8.4 percent, while London prices grew by 14.9 percent.  That is why, as the British Property Federation recently found, 61 percent of newly-built property was bought as an investment last year. Foreigners drove the boom, with 49 percent of new housing in prime areas of Central London bought by non-UK residents.

Russian oligarchs have long seen residential property in London to be an investment safe haven. They currently account for around 2% of the super-prime ‘core’ of the capital, according to Savills data. 

Do sanctions work?

Sanctions have been invoked more than 100 times in the past 50 years against dozens of countries, and often succeed in lowering living standards in the target country, but only sometimes achieve their political objective.

Here are a few examples:

Cuba: The U.S. banned travel and most trade with Cuba in 1960, in protest against the turn to communism by Fidel Castro, whose revolution against the regime of Fulgencio Batista succeeded in 1959. The sanctions have been maintained ever since, though loosened a bit of late. They have probably helped to keep Cuba poor. However, they have not induced any major change in Cuba’s communist system.

North Korea: The United Nations imposed sanctions on North Korea in 2006, trying to discourage it from pursuing its nuclear weapons program and to punish it for human-rights violations. There is little evidence that the sanctions have affected the actions of Kim Jong-Il, North Korea’s former dictator, or his son Kim Jong-Un, the current dictator. North Korea has lived with international sanctions on and off since 1950.

South Africa: In protest against Apartheid, a policy of racial segregation and discrimination by whites against blacks, there were various efforts by countries and by private parties to organize sanctions. The United States got serious about sanctions in 1986, during President Reagan’s term, imposing a variety of trade and capital-flow restrictions.

With Nelson Mandela leading a peaceful uprising by the black majority in South Africa, the country repealed most of its Apartheid laws in 1991. While the economic sanctions were not the only factor leading to repeal, they helped to make the South African government take the opposition’s demands seriously.

The United States. In 1973-1974, the Organization of Petroleum Exporting Countries (OPEC) imposed the so-called Arab Oil Embargo, designed to discourage U.S. support for Israel. The U.S. suffered a recession, but it never abandoned its friendship for Israel, or its practice of supplying Israel with advanced weapons.

This blog entry is an amalgam of different contributions from a variety of sources.  The main ones of note include:

• Will sanctions work against Russia? Iran’s experience offers a few clues, the Washington Post
• Why Sanctions Against Russia May Actually Work This Time, Time Magazine
• The true cost of Russian sanctions to London and UK investors, City Index
• City of London to bear the brunt of EU sanctions on Russia, The Telegraph
• Grounding of Russian airline first corporate casualty of EU sanctions, the Globe and Mail
• Ukraine crisis: U.S., EU, Canada announce new sanctions against Russia, CBC
• EU and US sanctions against Russia: which will they hurt more? the Guardian
• Buy London Mansions on Russia Sanctions, Bloomberg