Russia & Europe – An intertwined story of economic sanctions

Despite the sanctions in place since Crimean invasion by Russia in 2014, Europe relied heavily on Russia for raw materials, energy & Russia on Europe for medicines & advanced machinery like microchips. European banks even financed the development of technologically advanced industries in Russia & Russia's oil profits were also invested back into European financial markets, real estate & prestige projects especially in the UK. However, since Russia's invasion of Crimea, this trend had started to reverse & hundreds of thousands of highly educated young Russians emigrating to Europe & beyond, representing a significant loss of human capital for Russia.

Economic sanctions as financial weapon & Russian response

Financial sanctions aimed to severely limit Russia's ability to transfer, borrow, & hold money through the global financial system, to collapse ruble, cause high inflation & unrest among the population, ultimately forcing Russia to retreat. Russia amassed $600 billion in foreign exchange reserves, for the central bank to use to buy rubles & stabilize currency during sanctions. To avoid losing these reserves, it aimed to minimize the number of Western currencies in reserves. Still, due to the dominance of the $ & euro, a significant portion of Russia's war chest still consisted of European assets. Europe, Japan, & USA froze over 60% of Russia's war chest, effectively blocking Russia's central bank, private banks etc. from using various deposit accounts & bonds to stabilize ruble.

In response, both Russians & non-Russians attempted to get their money out of Russian banks & markets, causing ruble to lose more than 40% of its value, which in turn led to high inflation, but govt. also retorted quickly:

1. Central Bank of Russia raised interest rates, making ruble more attractive & imposed strict capital controls, limiting ability to sell rubles. Ruble was now not only recovering but also became stronger than ever.

2. Europe relied heavily on gas through pipelines from Russia so Russia imposed trade sanctions sharply reducing the flow of natural gas which led to 10x increase in energy prices in Europe, causing sky-high inflation. Anti-war protests erupted in Europe due to the dire economic situation while high energy prices made Russia more international money than ever before.

3. Thousands of Russians also began protesting the war but to curb it, Russia responded with a brutal crackdown, arresting thousands of protesters, signing a law criminalizing the spread of what the state deemed to be fake news, for up to 15 years in jail.

4. Many Russian oligarchs remained dependent on Putin for their power & wealth. The few who spoke out against Putin were either moved to less influential positions, died mysterious deaths, or fled the country.

The result of sanctions

Initially, sanctions caused real damage to both, but Europe eventually reduced its dependence on Russian energy:

1. Built liquefied natural gas (LNG) infrastructure off its coast, switched to alternative gas suppliers- USA & Qatar.

2. For some energy needs, switched to alternative sources of energy, such as coal, diesel, & renewables.

3. Reduced their energy demand by improving the efficiency of houses, machines, & business processes.

Allies imposed a price cap meaning any ship transporting Russian oil above 60$ couldn't be insured by allied insurance companies that dominated the market. Initially, this seemed to work well, but it became clear that Russia had assembled a shadow fleet of tankers that allowed Russian oil to bypass sanctions on an industrial scale.

Russia also reduced its dependency on Western goods by using:

1. Technologically regressive import substitution, replacing imported goods with inferior, old-fashioned domestic substitutes. E.g., Russian firms replaced newer Japanese engines with old Belarus counterparts for forklifts

2. Alternative suppliers, such as China, for crucial goods like microchips.

3. Smuggling operations via its neighbours, allied chips showing up in Russian missiles

These tactics weakened the impact of sanctions so much that apparently Russia is now importing more microchips than before the war. While the technologically regressive import substitution strategy may reduce the efficiency & competitiveness of Russia's industry in the long run, it has worked quite well in the short run.

Economic war had a significant impact on the lives of everyone, in the form of inflation, loss of property, & blocking the movement between these once so integrated economies. Many advocates of sanctions believe that even if they didn't stop the war, sanctions have still sent a powerful signal that invading your neighbors isn't without a cost.

Both economies were hit by high inflation, but the relative change was more extreme in Europe. Inflation in Russia 2x from 6.7% to 13.7% in 2022, but nearly 4x in Europe, 2.45% to 9.2% in 2022. Russian economy shrank by 2 to 4% last year IMF estimates it will grow by 0.3% in 2023FY v/s UK (-0.6%).

Some lessons from the first global war of the 21st CE

1. Safety of assets held in the Allied Financial system is no longer guaranteed. Invading a neighbor can put one's assets at risk.

2. Financial sanctions can be countered by raising interest rates & imposing capital controls but only if the country runs a sizable trade surplus.

3. Financial sanctions against individuals don’t necessarily pressure govt. if elites have more to lose from their govt. than from allied sanctions.

4. Heavy reliance on one trading partner, particularly for crucial supplies can be hazardous

5. The longer trade sanctions are in place, the more likely they will be avoided via reduced demand, import substitution, alternative suppliers, & smuggling operations. However, in the long term, sanctions can make an economy less competitive globally.

Sources:

Disclaimer: The opinions expressed in the Blog are for general informational purposes only and are not intended to provide specific advice or recommendations for any individual or on any specific security or investment product. It is only intended to provide education about the financial industry. The views reflected in the commentary are subject to change at any time without notice. Nothing on this Blog constitutes investment advice, performance data or any recommendation that any security, portfolio of securities, investment product, transaction or investment strategy is suitable for any specific person. From reading this Blog we cannot assess anything about your personal circumstances, your finances, or your goals and objectives, all of which are unique to you, so any opinions or information contained on this Blog are just that – an opinion or information. You should not use this Blog to make financial decisions and we highly recommended you seek professional advice from someone who is authorised to provide investment advice.