I’ve been asked a lot in recent weeks (and especially in the last week) about the potential economic implications of a major US-led sanctions package on Russia. Economic impacts depends not only on US and allied economic policies, but also on Russia’s response, including counter-economic measures and military choices, and of course on the decisions of third countries, most notably China. There are a wide range of scenarios, which build on each other and can amplify other vulnerabilities including global energy and fertilizer imbalances as well as a the rocky uneven exit from pandemic related policy accommodation which is challenging growth, especially in emerging economies.
The assessment of economic costs and recognition that any policy that brought significant economic stress to Russia would have meaningful impact on the global economy (especially Europe) via the energy and key commodity Channel has been clear for some years. this reflects not only Russia’s significant role as a supplier of key commodities – energy especially, but also grains, select metals, but also Russian policy choices In particular Russia has adopted very orthodox macro financial policies, has enforced savings and foregone growth to reduce exposure to sanctions and global capital. As many have noted, most segments of Russia’s economy now have net surpluses, which reduce reliance on foreign capital, even though it has lowered potential growth and foregone investment. Import substitution too, tho helped by a weakening RUB, has been challenging, especially in the technology sphere.
These potential risks to global consumers, especially via energy channels have been part of the ongoing negotiations between the US and allies, and those countries who might be caught in the middle (a range of commodity importers, including in the Middle East, India and East Asia). The likely package would try to alleviate some of the costs, either via upfront usage of general licenses to carve out short-term energy supplies and attempting to focus on new tools and asymmetries (such as export controls) as well as the power of the USD-based financial system. However, it is impossible to fully predict what sort of untended consequences, which interconnections and whether these measures would lead to desired policy change (see my thoughts on sanctions effectiveness here). Major financial stress might provide opening for an agreement, but only if there are assumptions of more meaningful upside.
The impact would depend exact measures applied, what sort of counter sanctions are adopted by Russia and ,assuming that any major sanctions package is taking place in the context of an invasion of Ukraine that may disrupt key infrastructure due to physical or cyber attacks, what sort of disruptions might come to supply chains for important commodities such as grain, critical materials and energy either produced by Ukraine or transiting through Ukraine or surrounding regions. The sanctions programs being considered by US (and their allies in UK, EU, Canada) aim to avoid disrupting key commodity flows. As a result, the focus remains on financial sector targets (delineating between smaller and more systemic institutions, which might receive only partial blocking measures), personal sanctions, individuals within energy companies, closing loopholes around financing of energy transactions as well as mineral and other sectoral measures. And importantly, a key part of the package would be the use of export controls that would aim to use what is seen as a persistent source of asymmetric power, admittedly one that will likely have more impact over the long-term due to stockpiling and the nature of the technology usage. there are no planned Russian agriculture targets, and no plans to disrupt current energy production, which might benefit from carveouts to any major set of financial sanctions.
Still, even with general licenses and carve-outs, major financial sector sanctions could have a meaningful impact as counterparts seek to avoid sanctions risk, de-risking and reinforcing some of the capital flight that has already been taking place. While Russia has significant external assets, it may face challenges in deploying this capital if transactions are blocked and banks are reluctant to facilitate these measures. The fiscal surplus and other sectoral surpluses leave the government in a stronger position and could allow pooling of capital. Russia has already made great strides to reduce reliance on the USD, reducing its holdings, moving assets out of US banking and government custodial relationships, however, the interlinkages between the US and EU banking systems suggest that planned measures would be painful. So far, Russia’s drive to boost domestic payment systems have yet to replace US-led ones, but there is a political push to use official currencies, shift payment terms and even step up planned cryptocurrency/digital asset transparency.
A major package couldn’t ignore energy given its importance to trade and government revenues, but the targeted focus would likely be on measures that undermine longer-term production. Also the politicization of Nord Stream 2 suggests it may bear the brunt of attention/attacks rather than other measures that might be more painful to Russia. This over-focus on the pipeline seems to be a red herring, with the impact potentially over-stated. Other more long-term measures such as restrictions on US/EU persons involvement in new Russian energy projects) might reinforce the impact of climate policies which have already increased the difficulty for major Russian LNG projects to garner financing (itself an area of contention with Russia). The Western countries have a strong incentive to keep energy measures targeted but the counter-sanctions might not.
Russia could well choose to cap exports of key commodities and more importantly, further restrict imports (which would fit with their very defensive macro policy response over the last 8 years) or other factors might limit their ability to export. Russia has an interest in seeming to be a reliable long-term supplier of commodities, and has tended to meet its long-term contracts for natural gas for example, while choosing not to provide one-off additional supplies or (more concerningly) to refill fuel storage. It is likely to seek opportunities to provide more stress on buyers unwilling to sign long-term contracts such as those in Europe. In that case, fuel prices might rise further to provide alternatives, something that has already happened due to the mid/late 2021 energy/power shortages in Europe. Higher LNG prices have diverted cargos, but at a cost to EU and global consumers of natural gas. More planned or unplanned outages would add to these strains.
Ultimately it remains to be seen if this stress will bring more supplies on to the market in the coming years. Note that while China is buying more Russian fuel, the infrastructure does not allow it to take up the bulk of what is offered to Europe – and it also continues to sign new agreements with the US. China thus remains a country focused on doing its best to balance different fuel suppliers, while it looks to reduce reliance on more sensitive Russian imports.
The major links to the US economy are via global energy markets and other key commodities, and via the impact on the global economy. US policies including fiscal and monetary policy and how pandemic is handled globally have more impact on US economy, but the combo of sanctions package and potential Russian countermeasures that likely would reduce exports of key commodities could add to these strains. Disruptions would add to the supply chain issues associated with the pandemic and reinforce the impact of what are still quite tight global energy markets. These potential disruptions would add to inflationary pressures in the near-term and likely weaken global growth. See here for more on some of the policy challenges, especially for EM-ex China, and particularly fuel and food importers.
The inflation risks and political risks are framing the sanctions package of course as policy makers don’t want to exacerbate these risks – eg energy production and agriculture/fertilizer are not on any US/EU list, but there could be disruptions that add to price/supply pressure. There are of course likely to be carve-outs for energy in any major package, but there still could be disruptions, counter-sanctions and uncertainty around investment decisions. Metals are more likely than energy to be subject to targets. Russia could choose to limit agriculture and fertilizer exports as well as energy either to add strains on importers or due to environmental issues – already Russia has capped exports of ammonium nitrate due to Russian domestic demands. Sanctions on Belarus are restricting some fertilizer exports, while Russia has stalled some exports on grounds of domestic shortages. Policies might reinforce this.
While some of the recent trends are good for US energy companies as revenues, and slowly increasing their production and export volumes, the volatility of prices and uncertainty of demand complicates planning. Long-term there are important questions about environmental rules (including on investment at home and abroad) that might complicate approvals. There are questions ahead for consumers and producers. Countries able to make a pitch for full cycle lower emissions for their fuel exports will likely be in a better stance.
Overall, the USD remains the primary transacting currency and store of value – with other alternatives stuck, in part due to policy preferences and choices (such as Chinese concern about losing control of the RMB). However, on the margin, there are increasing risks of new channels being created that create new bifurcated systems. The coordination among the US and EU may reduce the risk that EU puts in place new blocking measures, at least for now. This means the most meaningful risk would come from greater initiatives for other blocks transnational digital assets.
There are also important questions that stem from the potential use of export controls including those the use of the Foreign product rule on select software and micro-electronics. While Russia is not a major demander at a global level, use of these powers would be an important test case of implementation as so far such measures have only been used on individual companies or select military-linked entities, mostly in smaller countries. The economic impacts are likely to be more important over the longer-term. The European, developed Asia and Chinese responses will be important. EU new export control regulations limit the use of export controls to dual use technology and military equipment, meaning they may not be able to move with the US on this issue, but may choose not to oppose US unilateral measures – the same might be true for important US allies such as Japan, which recently signaled that it might join a G7 sanctions package in the case of an invasion. Where China is concerned, there may be important long-term implications if US export controls limit re-export.. The US use of these measures might increase Chinese efforts to de-Americanize their supply chains, which could increase global bifurcation of these markets.