The implications of sanctions against Russia

On 29 July the European Union (EU) imposed so-called tier three sanctions against Russia. The real effect of these measures is only starting to be felt now, yet the implications are far deeper than many had imagined. At stake is not only Europe’s geopolitical and regional stability; businesses and individuals on both sides of the table are starting to feel the impact of sanctions as well.

Uncertain ground

The new round of sanctions imposed on Russia is in many respects unprecedented. The EU has restricted Russian banks' access to long-term loans, it has imposed an embargo on the export of dual-use equipment for military use, and it has banned the export of a wide range of items and technology related to the oil industry. The gas sector, however, has been left untouched so far. These measures go far beyond the visa-bans and assets freezes that were already in place against certain individuals involved in the destabilization of Ukraine.

But sanctions are also unprecedented for another reason: the EU had never before imposed economic sanctions against a country with which it shares so many commercial, energetic, and security ties. While the EU has had some experience - and some would even argue success - in the use of economic sanctions against Iran, this time it has entered into unchartered waters.  And few seem to have thought thoroughly through the consequences of these measures.

Far from forcing Putin to back down and put a break to his ambitions in Eastern Ukraine, sanctions have contributed to harden his position. Moreover, and even though unintended, they have sparked a nationalistic flare in Russia, with polls registering a spike in Putin's popularity. Yet while Putin rallies support at home, the EU and the US are unwilling to go back to business as usual with him after the traumatic redrawing of Europe's borders by an ever assertive Russia. Escalation has thus led to a political deadlock were neither Putin nor the West are willing to make unilateral concessions to solve the crisis. And given the unlikely prospect of a direct military confrontation between the two parts, a war of economic attrition seems the only scenario left. With a solution to the regional crisis slipping away, the coercive effect of sanctions is starting to be felt on both sides.

The economic costs of sanctions

Although no one knows for sure what the real cost of sanctions is, one thing is certain: they are imposing a huge economic burden on Russia. The flow of international investment into Russia has stalled, and the European Bank for Reconstruction and Development has frozen all new projects in the country. Moreover, Russian banks have seen their access to Western capital cut. This has increased the refinancing costs of banks, making it increasingly difficult for Russia to pay its debt and limiting the Kremlin’s capacity to invest and modernize infrastructure, especially in the extraction sector.

Furthermore, the rouble has kept falling against the dollar increasing the cost of imports. These difficulties add to the shortages of products in supermarkets caused by Putin’s ban on imports of food and agricultural products from the EU, which has backfired forcing businesses to struggle for substitutes in an underdeveloped domestic market. To make things worse, inflation is expected to soar in the coming year.

Yet the most daunting task Putin has yet to face is an uncertain future with increasingly low oil prices. With more than half of Russia’s revenues originating in the export of oil and gas, financing the budget deficit is likely to become challenging. Also, if prices remain low in the longer run, Russia is likely to have a bigger problem, as its economy is stagnating and its budgetary estimations are based on high oil and gas prices.

However, sanctions are having their toll in Europe as well. Most importantly, sanctions have generated an immense uncertainty amongst business circles. European firms are trying to make sense of the limitations and scope that sanctions impose on their commercial activities, including trade, investment and insurance operations with third parties operating in Ukraine and Russia. Due to the legal consequences that businesses could face in case of violation of sanctions, concerns have arisen regarding the extent to which it is possible to carry on with their regular activities.

Unfortunately, complying with sanctions is not a straightforward task. Besides the difficulties to understand what it is allowed and what is not due to a lack of clear regulatory provisions and national or European guidelines, other issues such as linguistic differences between EU and US provisions - i.e. concepts like "derivatives" mean different things in the US and the EU - posit further challenges for private companies. As a consequence, businesses are devoting increasing economic and human resources to make sure they comply with current EU and US legislation.

However, the biggest concern for EU policy-makers is the fear of Russian retaliation. Putin's ban on food and agricultural imports from the EU has already had a very negative impact on Southern European farmers. And whilst the European Commission has reacted swiftly by setting up a compensation fund to pay for export losses, new retaliatory sanctions are looming in the horizon that might generate bigger disruptions for European economies.

The most obvious concern for some EU member states relates to a potential cut of Russian gas supplies during the winter. Putin has warned EU countries and Ukraine that they could see the flow of gas stopped if the latter does not manage to pay its debts. Since the most important pipelines connecting Russia with EU countries cross Ukrainian territory, anxiety amongst member states that are heavily dependent on EU gas have grown.

But the Kremlin has also threatened to impose other countermeasures. First, it has insinuated that it could close its airspace to EU commercial flights. This would substantially increase the cost and duration of European flights to Asia, as airlines would have to divert to longer routes, consequently requiring larger amounts of fuel. And second, Putin has remained passive to a legislative action in the Russian Duma that would allow to nationalize foreign assets to pay for the losses of Russian companies.

The geopolitical implications of sanctions

Whilst the current deadlock between the West and Russia over Ukraine remains, other actors have taken advantage of the situation. Latin American countries have been keen to replace the EU's exports of food and agricultural produce following Putin's ban on EU imports and have ignored EU pledges not to do so.

Most strikingly, and even though the EU has managed to convince most of the countries on the path to EU membership to align themselves with its sanctions regime, Serbia has refused to do so, rolling out the red carpet for Putin's visit to Belgrade last week instead.

The EU's incapacity to convince its allies to support its sanctions regime has also been evident in Asia, where Japan has only imposed mild sanctions on Russia and where South Korea has refrained from imposing any measure whatsoever.

Yet the indisputable benefiter of Western sanctions has been China. Since the beginning of the crisis, China has played an ever important role, with Russia moving closer to its eastern neighbour. The relation between both countries has improved substantially in the last months, leading to a historic agreement on the construction of gas pipelines from Russia to China.

Regional tensions are also mounting in other parts of Europe, as the Swedish government has been involved in the chase of an (allegedly) Russian submarine in its territorial waters and as Russian spy planes have repeatedly violated Estonia's and Sweden's air space.

A way out?

The mutual trust that has been built between the West and Russia since the end of the Cold War has vanished. Undoubtedly, sanctions stand in the way to improving the relationship with the Kremlin, yet the EU is not willing to lift them without prior changes in Russia's behaviour. Sanctions are thus likely to remain in place for the foreseeable future, with all the uncertainty that this implies.

However, the political deadlock should not be read as a new version of the Cold War. Russia is now much more integrated into the world economy, it has become a member of the World Trade Organization and it largely depends on its exports of oil and gas to keep its economy afloat.

Moreover, it is questionable that Russia's new economic and political opening to Asia, and especially to China, constitutes a feasible long term alternative, as it will lead to an uncomfortable asymmetric relationship for the Kremlin. Whether this shift actually takes place remains to be seen, but it is more likely that Russia veers again towards Europe in the next few years.

The current uncertainty makes it hard to predict what will happen next or how long the conflict is likely to persist. The only thing that seems clear is that Crimea's annexation by Russia is now an irreversible process. Russia will struggle to find international recognition for its action, and the West is likely to keep sanctions against the peninsula in place until a solution is eventually found in the future. But for the time being, this is likely to become yet another frozen conflict in the heart of Europe.

While many questions remain unanswered, Western analysts are starting to accept that the standoff is going to last longer than initially expected. A solution to the crisis is however not impossible, but it will require huge doses of imagination, patience and, above all, time. As time passes and sanctions impose higher costs on both sides, incentives should emerge to normalize relations with the parts. The signing of a gas deal between Russia, Ukraine and the EU is a step in the right direction, yet it needs to be backed by a strong legal and political commitment by all parts. This could then lead to more compromises regarding the situation in Eastern Ukraine.