Opinion

The Great Debate

Sanctions finally find Russia’s Achilles heel

By William E. Pomeranz
July 23, 2014

Russia's President Vladimir Putin gestures as he chairs a government meeting at the Novo-Ogaryovo state residence outside Moscow

Russian President Vladimir Putin and President Barack Obama were reportedly engaged in a heated telephone conversation last Thursday when Putin noted in passing that an aircraft had gone down in Ukraine. The tragic crash of the Malaysian airliner in rebel-held eastern Ukraine continues to dominate the headlines, but it is important to remember what agitated Putin and prompted the phone call in the first place — sanctions.

Sanctions against Russia have been the centerpiece of the U.S. response to Putin’s interference in Ukraine. While they primarily have been directed against prominent friends of Putin and their businesses, the underlying target has been a weak Russian economy.  The sanctions have definitely found Russia’s Achilles’ heel, and with harsher sanctions looming in the aftermath of flight MA17, Putin is finding it increasingly difficult to craft an effective reply.

Obama had raised the ante for Russia the day before the Malaysian airliner disaster by unexpectedly announcing a new round of sanctions. The designated enterprises included several major Russian banks (Gazprombank, VEB), energy companies (Rosneft, Novatek) and arms manufacturers. They were not, however, the full sectoral sanctions that Putin dreads the most. These would essentially exclude Russia from the international financial system and restrict major technological transfers. Though key Russian banks and energy companies are now prohibited from receiving medium or long-term dollar financing, U.S. companies are not otherwise prohibited from conducting business with them.

But even by hinting as to what sectoral sanctions might look like, Obama has upset Russia’s economic calculations. Obama is often criticized for not backing up the “red lines” that he draws. But in Ukraine, Obama essentially has drawn a “gray line” — demanding Russia take certain actions to end the crisis. No one knows when this gray line is crossed, however. So these new sanctions only heighten the uncertainty — and risk — of doing business in Russia.

Russian President Putin and German Chancellor Merkel walk during a meeting in Rio de JaneiroThe market responded immediately, with dramatic declines in the Russian ruble and the Moscow stock market. In addition, the sanctions only exacerbated an already difficult situation for Russian companies. Syndicated loans for Russian commodities producers are down more than 80 percent over the past six months. The appetite for Russian bonds has also decreased considerably in the aftermath of the Ukraine crisis. So the current round of sanctions made a bad situation worse.

Not surprisingly, Russia responded to these new sanctions with tough rhetoric of its own. Igor Sechin, the chairman of Rosneft, called them illegal, while the deputy foreign minister, Sergei A. Ryabkov, vowed there would be harsh countermeasures.

But how can Putin retaliate? These sanctions hit at a time when the Russian economy is especially vulnerable to outside pressure. Budget projections point to significant declines in revenue — so much so that the Finance Ministry is considering the reintroduction of a sales tax.

Russia is also is trying to reform how it taxes domestic oil revenues, the prime source of income for the state treasury. This “tax maneuver,” however, has produced loud protests, particularly from Sechin and other Russian crude producers, who would have to pay more in taxes to make up for the proposed lost revenue from export duties. There is no consensus on how the Russian government should generate income going forward.

Moscow possesses significant hard-currency reserves and has promised to help VEB and other Russian companies if Western financing dries up. Yet the Russian state has already committed to several mega-projects, including the reconstruction of Crimea. Meanwhile, the U.S. administration will likely attribute any sudden drop in Russia’s hard-currency reserves as an indirect benefit of the sanctions program.

Putin has often pursued a divide-and-conquer strategy with his European partners. He may try this now since several European Union members are still reluctant to match U.S. sanctions. That being said, on the same day that Washington imposed the new round of sanctions, the EU announced its intention to stop all new loans to Russia from the European Investment Bank and the European Bank for Reconstruction and Development.

The EU is expected to announce additional sanctions on specific individuals and companies soon, but words will have to be followed by concrete actions before the European sanctions are felt — and taken seriously — by Russia.

Russian President Putin, Indian Prime Minister Modi, Brazilian President Dilma, Chinese President Xi and South African President Zuma join their hands at a group photo session during the 6th BRICS summit in FortalezaPutin also wants his BRICS allies — Brazil, India, China and South Africa — to rally to Russia’s defense, but this group is largely focused on common economic issues.  It has no reason to speak out jointly about the dispute in Ukraine. Indeed, China abstained in the U.N Security Council vote on the legality of the March independence referendum in Crimea — in large part because such acts of self-determination violate China’s longstanding notions of territorial integrity.

Putin cannot even rely on the support of his Eurasian neighbors in this crisis. Russia specifically wants to punish Ukraine for pursuing a free-trade agreement with the European Union by placing increased tariffs on Ukrainian goods coming into Russia. Russia first approached its Eurasian Union partners — Kazakhstan and Belarus — to impose union-wide sanctions, yet both refused. This forced Moscow to impose sanctions unilaterally.

Even if Russia raises tariffs on Ukrainian products, they can still ship duty free into Belarus and Kazakhstan and from there have direct access to the Russian market. So a potential bypass already exists to this attempt by Moscow to punish Ukraine.

Russia’s Economic Development Minister Aleksei Ulyukayev has already admitted that increased Western sanctions will have negative ramifications for Russian economic growth. Russia’s deepest fear is that Washington introduces sanctions that are targeted to sectors of the economy — particularly the banking sector.

Indeed, Russia went through all sorts of legal hoops — including amending its privacy law — just so individual Russian banks could remain in compliance with the U.S. Foreign Account Tax Compliance Act.  This extraterritorial law essentially requires foreign banks to provide information to the Internal Revenue Service about accounts held by U.S. citizens, or be forced to pay major penalties. Moscow ultimately complied with the law because it did not want to face the financial consequences of being labelled non-FATCA compliant.

Sanctions may not be enough to persuade Putin to change course in Ukraine, nor, unfortunately, will the tragic downing of the Malaysian airliner. Yet the sanctions are slowly inflicting serious damage on the Russian economy and no one knows when the next gray line will be crossed.

The risk premium for Russia is rising.

 

PHOTO (TOP): Russia’s President Vladimir Putin gestures as he chairs a government meeting at the Novo-Ogaryovo state residence outside Moscow, June 25, 2014. REUTERS/Alexei Druzhinin/RIA Novosti/Kremlin

PHOTO (INSERT 1): Russian President Vladimir Putin (R) and German Chancellor Angela Merkel walk during a meeting in Rio de Janeiro, July 13, 2014. REUTERS/Alexey Nikolsky/RIA Novosti/Kremlin

PHOTO (INSERT 2): (L-R) Russian President Vladimir Putin, Indian Prime Minister Narendra Modi, Brazilian President Dilma Rousseff, Chinese President Xi Jinping and South African President Jacob Zuma join their hands at a group photo session during the 6th BRICS summit in Fortaleza, July 15, 2014. REUTERS/Nacho Doce

Comments
25 comments so far | RSS Comments RSS

Mr. Pomeranz: As the “deputy director of the Kennan Institute at the Woodrow Wilson Center for Scholars in Washington”, could you please put your intellectual heft to work and give us a few scenarios and probabilities for Russia’s response to this clear declaration of war by the US? Since our national brain trust seems to fail in their predictions most of the time, please provide scenarios which you even deem unlikely…in fact, let’s start there shall we? Thank you

Posted by sarkozyrocks | Report as abusive
 

Putin will continue to cave. He can thump his milky chest…. but Russia doesn’t have a pot to piss in. Their chief exports are babies and AIDS.

Posted by AlkalineState | Report as abusive
 

So if my bank won’t give me a loan because they deem me a bad risk, or people don’t want to do business with me because I’m belligerent, that is tantamount to a declaration of war?

Posted by oneof7billion | Report as abusive
 

{Obama is often criticized for not backing up the “red lines” that he draws.}

Cheap shot.

Yes, he did not “pile in” to Syria as he did for Libya.

So … ?

Posted by deLafayette | Report as abusive
 

I’m really surprised that Russia hasn’t revoked their permission for us to transit supplies for Afghanistan through their airbase.

Posted by majkmushrm | Report as abusive
 

russia’s economy has been humming along nicely, over the last decade they have averaged 5% growth year to year. forecasts for this year will be closer to 3%. the characterization that russia’s economy is in the dumps isn’t accurate.

Posted by spartyb | Report as abusive
 

There are no signs that Putin has called off his subversives and mercenaries from east Ukraine following the MH 17 disaster. This contravenes the UN Security Council resolution.

The sly, duplicitous Putin talks peace but makes war.

Posted by havryliv | Report as abusive
 

rasPutin couldn’t care less about sanctions, his criminal enterprises have netted him 70 billion net worth according to Forbes.
War with rasPutin will be the only way to stop this ex-KGB agent with supreme power in Russia.
USA arming Ukraine and providing logistics will be the only thing that will stop rasPutin.

Posted by UScitizentoo | Report as abusive
 

China would undoubtedly help Putin but at what cost? The Chinese are very smart business men. Putin already took a terrible beating at the recent Beijing conference about long-term oil and gas supplies from a still totally unexplored Siberian region.

China basically disapproves of Putin’s land grab in the Crimea. Putin’s argument that you can take a territory if the majority of the people is Russian sets an ominous precedent for China. China could now grab a large part of Siberia where the population is Chinese. As the headline of the Shanghai “Global Times” stated: “Putin’s Way is not our Way.”

Posted by pbgd | Report as abusive
 

Congress should write and pass legislation that allows the U.S. to aggressively export natural gas to the EU. The U.S. is the “Saudi Arabia” of natural gas. And such a move would reduce Russia’s stranglehold of this commodity.

Posted by xyz2055 | Report as abusive
 

China will not grab Siberia for the same reason Putin will not grab W. Ukraine – They want clients, not subjects. Clients give you money, you give subjects food. Sanctions haven’t worked pretty much anywhere else they have been tried, weak and ineffective ones will not bring down Putin. This is all for show, and Putin knows that.

Posted by ARJTurgot2 | Report as abusive
 

Hey, Will,
Good job. The fact that KAZ and Belarus refused to follow Moscow in imposing sanctions on Ukraine is important to point out. Just to nitpick:
It’s “SECHIN” not “SACHEM” and FATCA, not FACTA. Other than that, a solid overview.

AC

Posted by Policywonk1 | Report as abusive
 

Didn’t the pot of WWII started to simmer when in 1933 the Jewish World Congress put the heat on and declared war on Germany by instigating the west to boycott Germany?

Posted by boreal | Report as abusive
 

Not a word as to WHY President Obama announced the sanctions.
Pouring weapons into Ukraine, such as Buk SAM systems, is good cause.
Illegally invading Ukraine is good cause.

Trying to prevent another Syria, with most of the dead felled by Russian munitions is good cause.

Posted by cirrus7 | Report as abusive
 

we need to bring back ISOLATIONISM type foreign policy…screw all the involvement in “conflicts” that shouldn’t concern us…and screw all(or most) foreign aid.

Posted by ppmueller | Report as abusive
 

Sanctions will work with the other trading partners participating.
if the US is alone in sanctions, meh.
if the US, and EU and China, and Japan, and Korea participate, that’s going to have a real and positive impact.

Posted by Hubbert | Report as abusive
 

One sign that sanctions started working is diminishing number of comments posted by the paid Putin’s trolls online. :)

Posted by UauS | Report as abusive
 

Most folks responding here forget that the West instigated the removal of a pro-Russian president, which lead to subsequent events. As Russia had to go into Crimea to protect its naval base and therefore security of its borders from Western aggression, I think overall Putin has shown great restraint given the circumstances.

Posted by AmericanKestrel | Report as abusive
 

Sanctions are fake to make tax payers to believe that their government takes care.
And so called trolls disappear as any different view is banned by Reuter censors (moderators) ))) People can feel nice: no trolls – good sanctions )))

Posted by Andrey22 | Report as abusive
 

Hi, moderator! Don’t be afraid. I am not a paid agent. I am just ordinary Russian. Who wastes his time trying to get another point of view to this respectable discussion.

Posted by Andrey22 | Report as abusive
 

U.S. “Foreign Account Tax Compliance Act” = FACTA… Doesn’t look quite right. They’ve missed an opportunity for an even more delicious acronym:
FATCA…T = “Foreign Account Tax Compliance Act Treaty” = FATCAT. There. Fixed that!

Posted by matthewslyman | Report as abusive
 

U.S. citizens think. Unhealthy aggressive policy of Washington leads you to a new war and a devastating consequences. Not to believe provocations of Ukrainian nationalists. Ukraine has turned into a fascist country read the information on 2 may 2014 Odessa “the House of Union”. They are a fearful people decided morality.

Posted by fhvfutljy | Report as abusive
 

“the underlying target has been a weak Russian economy. ”

As opposed to the United States’, for example? As the U.S. economy continues its fall out of the leading role in the world, the Russians will care even less what the United States thinks.

Posted by BrianHughesMA | Report as abusive
 

Author, Obama’s sanctions are insignificant to Putin.

Posted by Leatherrope | Report as abusive
 

Oh, yes, he does not care

Posted by Xerx | Report as abusive
 

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