On September 6. I testified in front of the Senate Banking Committee on the resilience of Russia’s economy to sanctions, the recent development of new economic and financial cushions and the risk of unintended consequences from new sanctions:
The full testimony can be found here.
Russia’s economy has largely adjusted to sanctions imposed by the U.S. and Europe, despite recurrent pressures on its financial markets when new measures are imposed. This adjustment has sparked debate about whether existing tools are insufficient and need to be extended or merely implemented more stringently. Given the significant measures being considered by Congress, I will lay out some of the factors that have shaped the impact of sanctions on Russia’s economy and the drivers of Russian economic resilience to sanctions, in the hope of better targeting measures to achieve political, rather than just economic, objectives.
Given the sources of resilience and adjustment in Russia’s economy, there are grave potential consequences to the global economy and key U.S. allies from significantly tighter broad-based sectoral sanctions on Russia. These could include risks to global energy supply and spillover effects on other financial markets, especially in emerging economies. Russia has become more resilient to U.S. and European sanctions in the last three years, thanks to higher global oil prices and output, sound management of Russian macroeconomic policy (fiscal, currency, banking, and monetary), and the deepening of Russia’s supply and financing channels at home and abroad, particularly from China and the Middle East.
Paradoxically, many of the factors that cap Russian long-term economic growth potential at around the current 1.5-2% pace have contributed to its resilience to economic sanctions. These include concentration of assets in its state banks, inefficiencies of selected state-owned enterprises, and difficulty attracting long-term capital. At the same time, Russia has used the last four years to build up its domestic resilience, maintaining a tighter fiscal stance to reduce its reliance on foreign capital markets, liberalizing its currency regime to allow the currency to be part of its adjustment toolkit, and deepening relationships with other state-led economies, including China and Saudi Arabia. These countries have fewer governance or other demands on Russia and empower those in Russia who are more focused on self-reliance and extending state capitalism. The combination of sanctions and the oil price shock helped Russia indigenize and bring home selected financial assets and supply chains. Russia’s economy may not be thriving, but it is surviving. This increases the challenge of imposing broad-based sanctions, as it diminishes U.S. leverage. Russian resilience suggests that the sort of blunt measures that might impose meaningful economic stress on Russia might also create damaging global spillovers, primarily by increasing energy prices. This, in turn, could dampen global consumption, spread contagion to emerging markets, and extend U.S. dollar strength that challenges U.S. exports. Such measures are also more likely to be seen by the Russian government as acts of war, and by others, including U.S. allies, as disproportionate, thus limiting their impact.
That said, Russia does have vulnerabilities that proposed financial sanctions would target. It has drawn down much of its sovereign wealth savings, has many structural rigidities, and has low potential for growth. The main source of vulnerability for Russia’s economy lies in its dependence on natural resource exports, especially oil and gas, but also agriculture and metal production, which collectively account for the bulk of government revenues, trade revenues, and performance of its financial markets. This implies that the sort of severe economic shock that would prompt a recession in Russia might require significant reductions in demand for Russian resources, including oil and gas. A shock severe enough to force significant quantities of Russian oil and gas off the market (a much more aggressive outcome than being considered by current legislation), would come with significant global costs, including potential sharp increases in energy prices for U.S. and global consumers. These energy-price spikes, in turn, could provide a potential windfall to Iran, undercutting U.S. policy toward that country. Such measures should not be considered now given their significant costs to the global economy and potentially international stability.
The Russia sanctions program, at its most effective, has been targeted and coordinated with allies, traits that contributed to its initial economic and financial impact. This Committee, and Congress more broadly, have an opportunity to refocus on targeting those responsible for malign behavior by the Russian state, rather than broad punitive actions, which would be less effective in achieving U.S. policy with respect to Russia and could undermine the effectiveness of future sanctions tools.