Hey, what about sanctions?

Sanctions have been used for a long time against individuals, companies or countries to punish or prevent a “bad behaviour”. Sanctions are never an easy tool to use, but they might seem indispensable when other, diplomatic or military, venues are not available or exhausted. One has to have extensive powers to be able to apply sanctions, therefore it is little surprising that we find the US, the dominant superpower of nowadays, at the forefront of sanction policies.

?US sanctions against Russia regained importance in the last decade, through the Magnitsky Act in 2012 and series of executive orders following the annexation of Crimea in 2014 and the election interference in 2016. In 2017 a legislative framework was put in place to formalize the decision-making process, and in some ways to guide the executive’s hand, through the “Countering America’s Adversaries Through Sanctions Act” (or CAATSA, for those obsessed with acronyms). The US legislature is likely to soon approve another sanction bill, called “Defending Ukraine Sovereignty Act” (or DUSA), further specifying the options. It is important to note that in this bill new sanctions must be triggered by Russia’s actions, and therefore the bill should be seen as an attempt to deter rather than to punish. That said, the wording on triggers is vague enough to maintain high degree of uncertainty on the timing and extent of eventual sanctions.

Before looking into the possible range of sanctions let’s take a short pause and think about some principles. First, sanctions should be proportional to the degree of aggression. However, there is no established scale to measure aggression, and as I have previously discussed (https://www.dhirubhai.net/pulse/three-reasons-invade-viktor-e-szabo-cfa/) there are many shades even when it comes to invasion. Should a single cyber-attack not targeting critical infrastructure be a trigger for sanctions? And if so, what is a proportional measure? And will this information asymmetry encourage the target to constantly test the framework to figure out the exact triggers?

Second, sanctions should be targeted. They must hurt the aggressor, but limit the collateral damage. In our case sanctions on Russia, depending on their severity, could have a material impact on foreign investors, financial or commodity markets, Russian population or Europe’s energy supply. Many saw targeting oligarchs close to the Kremlin as the least damaging option to put pressure on Russia, but then the Rusal case in 2018 highlighted that even targeted individual sanction can cause significant collateral damage (in that case sanctions on the owner of Russia’s largest aluminium producer company led to a spike in global aluminium prices forcing the US to backtrack).

Third, sanctions are only effective if they can be properly enforced. In a globalized world there are many ways to circumvent sanctions, so the involvement of and coordination with multiple countries could be required. This multi-lateral approach is complicated by the countries’ particular interests and potential exposure to the side-effects of sanctions. Unsurprisingly, the US, which has less to lose, can be much more hawkish than Europe, which has higher exposure to and dependence on the supply of Russian commodities.

?Now let’s take at the look at the sanctions. This listing is not exhaustive, but should cover the most likely steps.

-?????????Sanctions against individuals. This is an oft used tool, at any time there are many individuals under sanctions (for example 735 Russians are under US sanctions over the annexation of Crimea). The scope can range from government or military officials to politicians and business people, both in state-owned and private companies. There seems to be one particular exemption, and that is president Putin himself. Although he is the ultimate leader of Russia and hence is singlehandedly responsible for the country’s actions, somehow no country dared to target him personally, probably for fearing of completely breaking down diplomatic ties. Sanctions on individuals usually mean visa/travel restrictions and ban on holding overseas assets. Although in recent years the Kremlin has encouraged the repatriation of offshore assets, the Russian elite still has significant financial and real estate interests across the world, and hence could be vulnerable to such sanctions.

-?????????Sanctions against sovereign debt. The US has already banned American financial institutions from buying Russian government bonds on the primary markets (i.e. at issuance), the next level of sanctions would prohibit the buying or selling Russian sovereign debt that has been issued after the DUSA comes into force. This would make it impossible for US firms and investors to hold new debt. Similar sanctions would likely apply to the debt of several state-owned companies. For compliance reasons one might expect investors to offload even the pre-DUSA debt. While the repricing of the yield curve would raise the cost of financing for Russia, as foreigners financed roughly a quarter of local government debt issued in recent years, it would not wreck the country’s finances given its strong fiscal and reserve positions, but could hurt western investors exposed to Russian debt instruments. Some of that hit could be mitigated by allowing a winding-down period, so not to force the fire-sale of assets.

-?????????Sanctions against financial institutions. The US has already imposed sanctions on smaller state-owned banks following the annexation of Crimea. These sanctions could be expanded to larger, more important state-owner and private banks (the latest list includes a dozen of large financial institutions), but I expect a more cautious approach to large retail banks, to limit the collateral damage to Russian households.

-?????????Expelling Russia from the SWIFT system. This is the toughest and therefore the least likely sanction. Cutting Russia off would mean that Russia could no longer participate in international financial transactions, service its debt, receive payments for its exports or pay for imports. While in the recent years Russia has developed its own financial transfer system, it could not replace SWIFT. This sanction could be highly damaging not only to Russia, but to the international financial system. Russia would have to stop exports, depriving Europe of its oil, gas and metals. It is possible to envisage a “SWIFT-light” version, where only selected banks are disconnected, not the entire financial system, but it would be still be highly disruptive given the global interconnectedness of banks.

-?????????Sanctions against the extractive industry. The Russian economy and its public finances are heavily reliant on hydrocarbon exports, therefore it would seem natural to target those with sanctions. The largest Russian energy companies (including Gazprom, Rosneft, Lukoil) already face various lighter sanctions, but measures which could materially affect current production or exports are unlikely, as the resulting hit to the global commodity market/prices and through it to the Western economies would be too high of a price to pay. Let’s keep in mind that Russia supplies around 45% of EU natural gas and 25% of oil imports. And while the probability of much harsher sanctions on the extractive industry is low, I must note that the Republican-backed “Guaranteeing Ukraine’s Autonomy by Reinforcing its Defense Act” (GUARD), which ran parallel to DUSA, puts much more emphasis on energy sector sanctions. Another way to sanction Russia is to undermine the development of its extractive industry. Current sanctions in place prohibit US trade related to the development of Russian deep-water, Arctic offshore, or shale oil projects and such projects worldwide in which sanctioned companies own more than a third. As the introduction of these sanctions coincided with a weak global oil market, which put most new and investment-intensive exploration projects on backburner, these sanctions had little bite so far, but could gain more importance in the long run.

-?????????Sanctions against Nord Stream 2 (NS2). By using this new pipeline Russia could directly supply gas from its Arctic region under the Baltic Sea to Germany, bypassing Ukraine and foregoing paying the latter transition fees. The US tried to block the construction of the pipeline through the “Protecting Europe’s Energy Security Act” (PEESA) of 2019, imposing sanctions on companies and vessels involved in the project. Despite these sanctions the pipeline had been completed late last year, and is now awaiting the approval of the German regulator. Further sanctions on NS2 would be controversial, as Europe is deeply divided over it. Some countries see the pipeline as increasing, others as undermining Europe’s energy security. As German and Dutch utility companies have already signed long-term contracts to buy gas supplied through the pipeline (while my native Hungary’s current government ?always stands ready to veto any EU sanction in exchange for cheaper Russian gas) it would be hard to see Europe agreeing to block the NS2, so the US might need to move unilaterally here. (Just a hypothetical blackmail scenario: if due to escalation Russia cut its gas supply through Ukraine, would Europe expedite the approval of NS2 and accept gas through it?)

-?????????Sanctions against exports to Russia. Export controls did not make it into the DUSA bill, despite being actively used against several other countries. It may be down to the realization that in a globalized world it almost impossible to cut off any country with sufficient financial resources from anything, unless most third countries agree to comply, which is not going to be the case in the current polarized world. Yet sanctions could make it more difficult for Russia to source higher-end semiconductors used for example in aviation, telecommunication and weapon systems. Such export controls can be imposed by the White House without prior approval from the Congress.

The list above is not a ranking order, the toughness goes from individual and corporate sanctions, export controls, sector-wide sanctions, NS2 to financial system sanctions. Furthermore, more names and companies can be added to the sanction lists at any time, giving an even greater degree of fine-tuning flexibility. It would still be a difficult balancing exercise with a need for an accurate cost-benefit analysis at every step, while taking into account Russia’s acts and reactions, which remains unpredictable. One would hope that this extensive arsenal of sanctions carries a significantly high cost for Russia to avoid an escalation, and there will be no need to implement any of them.?