Economic Sanctions 101 - An Early 2022 Perspective
The news are buzzing with “Economic Sanctions” being imposed on Russia. But apart from ever-increasing superlatives of the severity of these sanctions, there is little explanation as to what they really are.
Let’s have a look at a brief overview of what economic sanctions are, how they are intended to work and how they are likely going to affect Russia in 2022.
What are Economic Sanctions?
They are penalties that one economic entity puts on another. An economic entity in this case is usually a sovereign country or group of countries that are enacting financial and/or commercial on another country or group of countries.
These sanctions are intended to limit the target’s ability to perform their usual economic activities through imposing higher costs and limiting their ability to trade.
Imagine you are going to a market, wallet filled with cash and credit cards.
But when you get there, you are only allowed to purchase from one stall. And that stall only accepts one of your credit cards and no cash. Further, the stall limits the amount of fruit and veg that you can buy and if that was not enough, your bank has imposed a limit to your daily transactions on your card.
Let’s look at the sanctions on a larger scale.
Trade Barriers & Tariffs
The most common restrictions are applying limits to trade. This can be done through imposing limits on quantity of goods, banning the import/export of goods or even just making it harder to trade through increases in bureaucracy (think Brexit!).
Tariffs are the most common form of barriers to trade. Like an extra tax that the purchaser needs to pay for a good.
Making it more costly to purchase goods results in changes to the purchasing power of your own currency as well. And this is something we commonly observe where the currency of the country under restrictions is not desirable to hold, leading to an increase in inflation. That in turn makes everything more expensive at home, and on we go.
As such the rationale for trade barriers is fairly easy to understand. But what is often seen is that trade barriers lead to trade wars, where both sides impose restrictions (China and the USA).
This flies in the face of free trade, which hampers global trade overall.
So trade barriers can be effective in the short term, but really only if the side that has the restrictions imposed on it relies on the free flow of trade with the other country/countries.
Restrictions to Financial Transactions
The other major branch of economics sanctions is limiting financial transactions.
This could be in the form of cutting off certain financial institutions from accessing global financial markets, or individual asset freezing as well as hampering a currency to be used for purchases.
The potentially most severe form of modern financial restrictions is cutting a country off from SWIFT (Society for Worldwide Interbank Financial Telecommunication). You can think of it as the gmail of modern banking.
Although no money is held through SWIFT itself, it is the communication tool used for around 40 million financial messages in a day.
If you want to inflict real economic pain, this is the one.
Just look at what happened to Iran in 2012 when as part of the EU’s sanctions to punish Iran’s nuclear programs the country was cut off from SWIFT. This option is only possible if the EU was to decide on cutting a country off from SWIFT since it is overseen by the National Bank of Belgium (+ representatives from other major central banks).
Economic Sanctions and Russia in 2022
First up is that Russia has learned from what happened after the Crimean annexation in 2014. It now looks like a practice run to see what would the West do and how could Russia prepare for similar and even more severe sanctions after further military action.
Ok, so let’s now look at what economic sanctions are likely going to do to Russia in 2022.
Russia is mainly self-sufficient when it comes to agriculture, raw materials ranging from metals to wood and most prominently: energy (including gas and oil).
This also puts Russia in stark contrast to the other recent example of a country which had sanctions imposed on it: Iran.
Additionally, Russia’s defence sector is massive and kept up-to-date through massive annual investments. And important for modern nations is of course also the IT sector and again Russia has spent substantial amount of resources on it.
Russian Gas
When it comes to trade the most important commodity that Russia has to offer is arguable its gas.
Europe heavily relies on it, which might explain why they have (so far) not cut Russia off from SWIFT. Although it is believed to inflict a 5% reduction in annual GDP alone.
The announcement to stop Nord Stream 2 by the German government is more tokenistic at this stage sine no gas has been delievered through this pipepline so far.
But Europe is not the only customer of Russian gas of course.
Enter: China.
New Financial Paradigm
Following the annexation of Crimea in 2014, Russia’s currency, the Rubel, experienced massive devaluation and inflation spiked to over 16%.
And that despite Russia’s massive foreign exchange reserves, which allow it to continue trading with foreign entities even if they were cut off further from the global financial system. Plus they can use that money to help stabilise a run on their own currency.
Russia learned from 2014. They have continued to invest their oil and gas profits into bolstering their foreign exchange reserves, so any economic sanctions will take a reeeaaallly long time to hit now. Their reserves are now around 70% larger than in late 2015!
But even more important is that Russia diversified their ‘war chest’, which was made up of 60% USD previously and now this sits around 15%, limiting the effects of US sanctions. Furthermore, in that time frame China’s payments to Russia using USD has fallen from 97% to 33%! Note, this does not mean total payments have fallen, just the share of USD, thus limiting Russia’s reliance on dollars.
Now what?
Trade barriers and financial sanctions can work. They are not one-sided as both sides will suffer from them.
The West has one more major restriction in reserve: cutting Russia off from SWIFT.
But Russia has learned its lessons! It has seen how the West responded in 2014 and cut domestic corporate borrowing by half, bolstered its foreign exchange reserves, diversified that reserve and has secured new partnerships with China to lessen its reliance on the West.
For all the saber-rattling that our politicians have done so far, I am not sure the Kremlin has even noticed it.
References:
https://www.cfr.org/backgrounder/what-are-economic-sanctions
