US mulls further sanctions on Russia; all of which however look counter-productive

Jon Huntsman, the new ambassador to Russia who President Donald Trump has appointed, has downplayed the prospect of further sweeping sanctions against Russian companies and businesspeople being announced by the US on 29th January 2018.

Ambassador Huntsman instead says that only a report will be published on that day

The date when additional U.S. sanctions may be imposed on Russian individuals and companies has not been set, while January 29 is the date of publishing the ‘Kremlin report’, U.S. Ambassador to Russia Jon Huntsman told reporters on Tuesday.

The media has reported the possibility of new sanctions but all that has been happening so far is the implementation of the law, there is nothing new, Huntsman said.

The law Ambassador Huntsman is referring to is the new sanctions law voted by Congress in August and signed under protest by President Trump that month.

There has been much secrecy about this report, which the law specifies must be published by 29th January 2018.  Latest reports say that a list is being drawn up of 300 businesspeople and companies who are to be placed on a new sanctions list.

As I have discussed previously, additional sanctions against individual Russian businesspeople and companies might cause serious problems for the businesspeople and companies concerned but they will have little or no impact on the Russian economy overall.  On the contrary if they lead to more Russian businesspeople and companies keeping their money in Russia they will serve the Kremlin’s interests.

However there have been rumours that the US is considering more sweeping sanctions targeting not just individual businesspeople and companies but the entire Russian economy.  Three sorts of such sanctions have been mentioned

(1) Cutting off Russian banks from the SWIFT interbank payment system;

(2) Freezing Russian gold and foreign currency reserves held in the US; and

(3) Prohibiting US investors from buying Russian sovereign debt.

What are the prospects of any of these sanctions being imposed?

The first thing to say is that all three of these sanctions would be exceptionally aggressive steps, which would send shockwaves across the international financial system.  Countries like China which also have issues with the US – and which the US is now also threatening with sanctions in connection with the North Korean crisis – would almost certainly interpret such moves as a long term threat to themselves.

Implementing actions of this sort would over time only hasten moves by countries like China and Russia to set up alternative international financial institutions of their own.  That would undermine the US led ‘globalisation’ of the international financial system.  Since the US is the principal beneficiary of this system implementing these sort of sanctions would hardly be in the US’s own long term interests, which is of course precisely why such sanctions were not imposed on Russia at the peak of the Ukrainian crisis in 2014.

Assuming however that in the current hysterical atmosphere there really are proposals to impose these sanctions on Russia, what would their consequences be?

(1) Disconnecting Russian banks from SWIFT

The first point to make about this proposal is that the US does not have the power to impose it unilaterally.  SWIFT is based in Brussels, not the US, and is regulated by EU law, not US law.  The US government is not in a position simply to order that Russian banks be disconnected from SWIFT.

As it happens it is known that the Obama administration and the British government did actively lobby for Russian banks to be disconnected from SWIFT back in 2014.  However they ran into a wall of opposition both from SWIFT itself and from European governments, with the German and Austrian governments especially strongly opposed.

There is no indication that such a proposal is being seriously debated at this time in European capitals, which makes it unlikely that it is being considered.

However assuming that it is being considered, what would its effect be?

US and British politicians who have lobbied for Russian banks to be disconnected from SWIFT seem to think this is some of ‘magic bullet’ or ‘nuclear option’ which would tip the whole Russian economy into crisis, but is this really so?

There is a huge amount of mystification about SWIFT.  However ultimately it is nothing more than an electronic transfer system which banks use in order to transfer money between each other.

Banks could transfer money between each other before SWIFT appeared.  I can remember a time not so long ago when most money transfers between banks did not use SWIFT.

The fact that SWIFT is an electronic transfer system means that it can be duplicated, and that is exactly what the Russians have reportedly done.

Back in 2014 the disconnection of Russian banks from SWIFT would indeed have been a heavy blow because Russian banks used SWIFT to transfer money between each other within Russia itself.

However the reports that the US and Britain were lobbying for Russian banks to be disconnected from SWIFT caused the Russian Central Bank to create its own alternative to SWIFT as a back up system.

Not only does this system apparently already exist, but it has apparently been field tested, though for the moment it is not in actual operation because of the continued availability of SWIFT.

Most probably most Russian banks and bank branches are not yet connected to this alternative system.  However if Russian banks really were disconnected from SWIFT the alternative system would not only be rapidly brought into operation but priority would be given to extending it across the whole Russian banking system.

Doubtless there would be a period of disruption, but a country like Russia has the technological and administrative resources to solve that sort of problem, and I suspect doing so would take more than a few months.

Russian banks would of course still be prevented from making electronic transfers via SWIFT to Western banks.  However the impact of this can be exaggerated.

Since 2014 the big state owned Russian banks which account for 70% of the Russian banking system and an even higher proportion of the foreign operations carried out by Russian banks have been effectively cut off from borrowing in Western financial markets.  Their foreign based customers would no doubt suffer if they were disconnected from SWIFT , but it is unlikely the big state owned banks would themselves be seriously affected.

Which brings me back to the main objection to cutting off Russian banks from SWIFT.  Many of the bank customers who would be most seriously affected are Western companies and businesspeople with investments in Russia.

With trade between Russia and Western European actually increasing over the last few months, many European businesspeople and companies would be very seriously affected.

Not only would that hurt them badly but some of these are influential people and companies who would be likely to complain.  That of course is why the decision was taken back in 2014 not to disconnect Russian banks from SWIFT in the first place.

Overall disconnecting Russian banks from SWIFT looks neither like a magic bullet nor like something that European business would willingly accept.  Frankly the political and financial costs of doing it look greater than any conceivable benefit.

(2) Freezing Russian gold and foreign currency reserves

Since this would be tantamount to seizing the sovereign property of the Russian state it would unquestionably be illegal and would as Russian officials have said be equivalent to an act of war.  However US has officials shown an increasing willingness to take illegal actions and it is unlikely that the fact that this step is illegal would be enough in itself to deter them.

If the US did take this step what would its economic impact be?

Russia does keep some of its foreign currency reserves in the US with the IMF, but it is not clear how great the amount is and claims that it is much as a third of the reserves is probably an overstatement.

There is no doubt that such a step would have a serious impact, causing the value of the rouble to fall, at least for a short time.

However Russia runs a trade surplus and has paid off most of its foreign debt and the Central Bank since 2014 has been letting the rouble float.

The economy would swiftly adjust as it did to the crisis of 2014, with the Russian trade surplus growing still further as Russia’s trade position benefitted from the rouble’s fall and from the surge in oil prices which would be likely follow such a measure.

Doubtless inflation in Russia would be higher, though it would be unlikely to go as high as it did during the inflation spike of 2015.  However the political impact of the increase in inflation within Russia would be mitigated with the Russian government in a position to blame the US for causing it.  Besides as happened following the inflation spike of 2015, once the economy adjusted inflation would fall back again.

If freezing the Russian state’s foreign currency reserves in the US would only have a short term impact on the Russian economy, it would nonetheless constitute a colossal shock across the world financial system.

It would show that the US is prepared to abuse its position at the core of the world finance system and as the host of institutions such as the IMF to target not just the financial reserves of the smaller economies such as Libya, Venezuela or Iran but also the reserves of big G20 economies such as Russia.

The Chinese especially – who have been on the receiving end of similar threats against their reserves for some time – would be horrified.

It would be difficult to imagine any step the US might take that would galvanise more countries like China and Russia to set up their own alternatives to the world financial system and its institutions which have historically been under the control of the US.  Such moves are already underway and following the freezing (ie. seizure) of whatever proportion of Russia’s reserves are on US territory that process would be bound to accelerate.

It is impossible to see how that would benefit the US.

(3) Prohibiting US investors from buying Russian sovereign debt

In my opinion this is by far the most likely of any further sectoral sanctions the US might introduce.  It is the one further sectoral sanction the Democratic Senators who published the recent report about Russia which I discussed in a recent article have actually recommended it.

The U.S. Treasury Department is required to report in early 2018 on the possible effects on Russia’s economy of sanctions on sovereign debt, which could have the potential to foreclose external sources of funds. While the head of Russia’s central bank believes that ‘‘there won’t be any seriously negative consequences’’ from such sanctions, economists have warned that such sanctions ‘‘may totally stop other foreign investors, not the U.S. investors only, from buying the new government debt, fiercely pushing up borrowing costs for Russia.”

This sanction would also almost certainly be illegal but as I have said in my previous discussion of the proposals to freeze whatever foreign currency reserves the Russian state has located on US territory (see (2) above) that no longer seems to be a significant constraint on US actions.

It would however only be a limited sanction.  The US cannot prevent Russia from floating bonds in the international money markets – in Asia if not in Europe – and the Democratic Senators’ assumption that prohibiting US investors from buying such bonds will dissuade other international investors from doing so is also almost certainly wrong (the cited authority for the claim are not ‘economists’ but two articles in Bloomberg Markets).

The problem anyway is that with Russia now expected to run a budget surplus next year, and with Russia’s trading position also in healthy surplus, and with Russia’s gold and foreign currency reserves now standing at more than $430 billion and growing, it is not obvious that Russia needs to borrow at all.

Unless this measure is combined with a freezing of Russian gold and foreign currency reserves, it is difficult to see how this could be more than a pinprick, just as the Democratic Senators report Russian Central Bank Chair Nabiullina having said.

However if the US were to freeze Russian gold and foreign currency reserves this step would not be necessary anyway, since US investors would not want to buy Russian foreign debt in those circumstances if the Russian reserves were frozen.

At that point of course the US would be facing all the consequences outlined in (2).

Needless to say, if US investors were prohibited from buying Russian debt but no action was taken against Russia’s reserves, then the US would simply be forcing its own investors to forego an opportunity to make money by buying into a strong financial asset which was being bought by other international investors elsewhere.  Again it is not obvious how this would benefit the US.\

Summary

What all these proposals have in common is that they highlight is the simple fact that the sectoral sanctions which were imposed by the West on Russia in 2014 have failed.

The sanctions did not break the Russian economy, or cause a popular revolution in Russia, or lead to an oligarchs’ coup against Putin – all things their advocates variously predicted would happen because of them.

Nor have they achieved their stated purpose, which is to force Russia to change its policies towards Ukraine.  Even the Democratic Senators in their recent report very grudgingly admit as much

Sanctions Pressure Has Been Insufficient: U.S. and EU sanctions have not resulted in the implementation of the Minsk Agreements nor the return of Crimea to Ukrainian control.  The Russian government appears to have been able to resist this pressure because the cost imposed by sanctions has been manageable.

The trouble is that faced with this simple fact the advocates in the US and elsewhere of more confrontation with Russia refuse to learn the lesson that sanctions against Russia do not work.

Instead they demand more and more sanctions of a sort which were rejected in 2014 when the original sanctions were imposed precisely because they the sort of sanctions that over the long term are more likely to cause harm to the US and the West than they are to Russia.

The key point is that the Russian economy is many orders of magnitude bigger and more sophisticated than the sort of economies – such as those of Cuba, Iran, Iraq, Libya, North Korea and Venezuela – upon which the US has imposed sanctions previously.  Applying the supposed lessons of the impact of sanctions on those economies in the case of Russia makes no sense, even if those lessons had been learnt correctly, which they have not. Unlike all those economies Russia’s economy is far bigger, already possessing the technology, capital and resources it needs to develop autonomously.

As a self-sufficient continental economy sanctions on Russia almost by definition can have only a limited impact, and one which over time must diminish anyway.

As it happens the most effective sanctions the West could have imposed on Russia, both in terms of their impact on the Russian economy and their limited impact on the economies of the West, were the sectoral sanctions which were imposed in 2014.

Those sanctions did stop for a time the flow of capital from the West into Russia at a time when Russia was facing heavy debt repayments and when the price of its main export products – oil and gas – was collapsing.  The result was to deepen the recession caused by the collapse of oil and gas prices whilst further lowering the value of the rouble in a way which intensified the inflation spike.

With oil prices now rising, most short term Russian foreign debt repaid, and with the rouble floating, none of the sanctions discussed in this article look like they can have anything like the impact on Russia that the sanctions imposed in 2014 did.

The fact that the Russian economy successfully – in fact almost effortlessly – adjusted to those sanctions despite the difficult conditions ought to serve as a warning that further sanctions against Russia will not work, and if they are of the sort discussed in this article are counter-productive.

Jon Huntsman’s comments may suggest that there are people in the US who understand this, and that the demands of those who want ever more confrontation on this occasion are unlikely to be followed.

However the lesson of the last few decades is that to expect rational decision making in Washington especially on the subject of Russia is to expect altogether too much.

One way or the other the next few weeks will show the direction decisions in Washington are taking.