Friday, December 19, 2014

What the EU's tough new sanctions on Russia do

Handout

The European Union agreed on July 29 to sweeping sanctions targeting the Russian financial and oil industries, plus its arms trade, in what amounts to the stiffest anti-Russian actions taken by Europe since the end of the Cold War. The decision belies the notion that Europe has been "soft" or "weak" on Russia since the downing of MH-17. The truth is simply that the EU's decision-making process is slow. It took time to build consensus for action, but now that the action has arrived Russia is about to be dealt three big blows.

1) Cut off Russian bank finance

The financial clauses of the new sanctions package go a bit beyond anything the United States has yet done. Specifically, they would ban all citizens of EU countries from purchasing new debt or stock issues by most of the Russian banking sector. The plan also proposes to bar Russian banks from listing new stocks on European stock exchanges, using those exchanges as an intermediary to raise funds from non-Europeans.

The banks targeted would be those firms that are at least 50 percent owned by the Russian state — which include the majority of the Russian banking system by assets. The proposal is similar to sanctions already adopted by the United States against Gazprombank and VEB, two major Russian banks, but would be even broader in their impact. European markets account for about half of the total bond issuance of Russian banks, so the impact on the Russian banking sector — and on the broader Russian economy — would be dramatic.

The idea here, in essence, is to force the Russian government to choose between either watching its economy collapse as bank finance dries up, or else massively redirecting Russian public funds toward shoring up the banking system. Money spent on bank bailouts can't be spent making mischief in Ukraine and foreigners are unlikely to want to invest in a Russian economy whose financial underpinning is so rickety.

2) Embargo Russia's arms trade

The desire of countries other than France for France to cancel the planned sale of two Mistral helicopter carriers to Russia is well-known. But France doesn't want to incur the over 1 billion that would cost them and nobody wants to compensate France. Instead, the EU is going to ban any new contracts to deliver advanced military hardware to Russia.

There is also an important imports angle. While the EU exports €300 million a year in weapons to Russia, EU countries import about €3.2 billion in Russian-made equipment. Those imports mostly go to former Warsaw Pact countries whose militaries have a legacy of using Russian arms. This is an appealing target because Eastern and Central European countries are also, in general, the countries most eager to see the EU take a more anti-Russian tilt.

3) End exports of oil equipment

Main As depicted in this chart from the Energy Information Administration, Russia's export economy consists overwhelmingly of fossil fuels. This sector is Russia's greatest point of vulnerability, but it is also the most costly sector for Europe to target since Europeans enjoy burning Russian oil and natural gas.

The EU is going to halt the export of certain categories of equipment and technology that are used in fossil fuel extraction. Europe will not target the natural gas sector, but is going to implement restrictions on the sale of equipment used in deep-sea drilling, arctic exploration, and shale oil extraction.

This won't put much short-term pressure on the Russian economy. What it will do, however, is possibly divide the Russian elite. The long-term financial prospects of the Russian oil sector depend on its ability to continue pressing into new sources of oil. The imposition of this kind of sanctions could turn Russian oil barons into a constituency for a more restrained foreign policy. There is nothing concrete at stake in Ukraine that is nearly as valuable as tapping Russia's own offshore and shale reserves.

Over the longer term, inability to access such equipment would retard Russia's ability to produce truly state-of-the-art military equipment or diversify its economy away from reliance on fossil fuel extraction.

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