Effectiveness of Economic Sanctions on Russia’s Economy

In early 2015, Western leaders thought they had Russia cornered.  A year earlier they imposed on Russia economic sanctions, which ranged from restrictions on access to Western capital markets to bans on the export of oil-production technology, to punish it for its role in dismembering Ukraine.  Those sanctions and the Russian boycotts that followed threw Russia’s economy into turmoil.  With some justification, President Barack Obama declared that “Russia is isolated with its economy in tatters” in January 2015.  But two years later, Russia has stabilized its economy, annexed Crimea, and kept its “little green men” in eastern Ukraine.  What went awry?

Peak Pain

In financial terms, Russia felt the most damaging impact of the West’s economic sanctions within the first year of their imposition.  Suddenly, Russian companies, holding dollar and euro-denominated debt, had to repay their loans without the ability to refinance them.  Russian banks targeted by Western sanctions saw their overseas assets frozen.  That created a cash crunch.  Many companies were forced to suspend operations and slash jobs; some even required government capital injections to survive.  But they did survive.

Commodity Price Stabilization

Unfortunately for Russia, the West’s economic sanctions coincided with a steep drop in global oil prices.  That, more than anything else, exacerbated Russia’s economic woes, since much of the country’s economy depends on the production of commodities, primarily oil.  Oil prices plummeted from over $100 per barrel to under $35 per barrel in late 2015.  But then they began to recover the following year.  So too did the prices of other major commodities that Russia produces, including iron, aluminum, and copper.  No doubt global economic growth, which boosted commodity prices, helped Russia to better ride out Western sanctions.

Floating Currency

But the stabilization of commodities prices did not save Russia’s economy.  With economic sanctions darkening the country’s outlook, the value of the Russian ruble was cut in half.  At first, Russia’s central bank tried to defend it, consuming $200 billion in foreign exchange reserves in the effort.  But ultimately, Russia’s central bank took a leaf from the International Monetary Fund’s market-based playbook and allowed the Russian ruble to float.  That freed Russia’s central bank from having to defend the ruble and prevented an even greater outflow of hard currency that would have further undermined Russia’s economy.

Moreover, since commodities are generally priced in dollars, the sharply devalued ruble meant that though Russian companies faced falling prices for their goods, the dollars they did receive could be converted into more rubles.  That softened the economic blow—enough so that Russian energy companies could continue to reinvest in their businesses.  As a result, despite the sanctions on oil-production technology, Russia is able to produce more oil today than it did before the sanctions were imposed.

Inflation Control

With shortages of imported goods and more rubles in circulation, inflation became a real threat.  Rising prices ate away at the purchasing power of ordinary Russians.  But rather than reflexively enact price controls, Russia’s central bank used another market-inspired lever.  It raised interest rates, up to 17 percent by December 2014.  Credit naturally dried up, further depressing the Russian economy.  But fortunately for Russia, inflation was quickly brought under control.  That allowed Russia’s central bank to gradually lower interest rates to 10 percent, giving Russian companies much-needed breathing room to recover.

Fiscal Discipline

In the depths of its economic recession, Moscow could have increased government spending to boost economic activity.  But with falling revenues from Russian oil production, a surge in spending would have pushed Russia’s government budget deep into the red and fueled a potential economic crisis.  Instead, Moscow exercised fiscal discipline.  It held its spending in check and ran a budget deficit of only 3 percent of Russia’s GDP last year.  When more funds were needed, Moscow raised taxes and dug into its two sovereign wealth funds, draining a third of their assets before oil prices stabilized.

Wavering Western Resolve

Meanwhile, European companies, particularly German ones, gave Moscow hope.  They were never keen on the economic sanctions against Russia.  From the start, they lobbied German Chancellor Angela Merkel to water them down.  After they were imposed in 2014, German direct investment into Russia evaporated.  But only a year later, German companies returned, investing $1.8 billion into Russia.  Last year, they invested another $2.1 billion, more than they had in the year before economic sanctions were imposed.  Such continued investments have encouraged Moscow to question the strength of Western resolve.

Conclusion

The West’s economic sanctions have bent but did not break the Russian economy, despite its structural vulnerabilities.  What steadied it was a combination of several factors, the most important of which were the stabilization of global commodity prices and the market-oriented policies implemented by Russian authorities.  They made Russia’s economy more resilient and prevented an even deeper recession.

Ultimately, economic sanctions can make countries more vulnerable to global economic forces.  But rarely do they deliver a knockout blow themselves.  Western economic sanctions against Russia have proven the rule, rather than the exception.  Ironically, the West’s success in spreading open-market ideas at Russia’s central bank may have inadvertently weakened the effectiveness of its own economic sanctions.  If so, the further spread of such ideas could make economic sanctions even less effective in the future.

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Limits of Chinese Friendship: China’s Development Loans to Venezuela

In 2004, Chinese President Hu Jintao and Venezuelan President Hugo Chávez agreed to form a “strategic partnership for common development.” The benefits from that partnership looked as if they would ensure an enduring relationship between their two governments. China would gain greater access to Venezuela’s oil reserves, which are not only among the world’s biggest, but are also considered by China to be more strategically secure than others, because they reside in a country outside of American influence. In return, Venezuela would gain a benefactor who could enable Chávez to transform his country into a modern socialist state and export his “Bolivarian Alternative*,” an anti-American coalition, across Latin America.

China's Development Loans to Venezuela
Source: Inter-American Dialogue

Hence, it was no surprise when the China Development Bank (CDB) and Venezuela agreed to a multi-year loan agreement in 2007. It allowed Venezuela to borrow up to $5 billion each year from the CDB, providing Chávez with the immediate financing that he needed to pursue his ambitions. In exchange, Venezuela would service its debts by shipping oil to China.

But times change. Not only has the price of oil dropped, so too has China’s voracious appetite for it. Plus, Russia has been aggressively pitching its large and strategically secure oil and natural gas reserves to China. Meanwhile, Chávez’s socialist policies floundered. Rather than modernize Venezuela’s economy, they amplified its dependence on oil. From 1999 to 2014, oil’s share of Venezuela’s export revenues rose from 69 percent to 96 percent. Rather than improve Venezuela’s food security, they reduced its agricultural output. Today Venezuela imports more of its foodstuffs than it did before chavista land reform began. The failure of Chávism has put Venezuela in a precarious economic position.

Nonetheless, both the CDB and China Export-Import Bank have continued to make new loans to Venezuela. Nearly every year since 2007, China has ploughed money into the country (see the chart above). Although signs of trouble were already evident, Chinese President Xi Jinping decided to double down on Venezuela in 2014. He elevated China’s relationship with Venezuela to the status of a “comprehensive strategic partnership.” But as a condition for China’s continued investment, Venezuela would have to give Chinese companies more preferential treatment in its infrastructure contracts.

That bought Venezuela some time, but not much. In 2015, the revenues of Petróleos de Venezuela S.A., Venezuela’s state-owned oil company, plummeted over 40 percent from the year before. To help out, the CDB appears to have been willing to take less oil than what some of its loans required. In other cases, it was willing to accept payments in the form of devalued Venezuelan bolívars, instead of U.S. dollars. In July, the CDB opened an office in Caracas to nominally boost its relationship with Venezuela. But more likely, it did so to keep a closer watch on its investments there.

Certainly, China needs to do so. Increasingly desperate to raise money, Venezuela’s central bank sold over 30 percent of its gold reserves in the last year—12 percent in just the first quarter of 2016. In June, Reuters reported that Venezuela asked the CDB to further relax the terms of its loans. Caracas was said to have requested a one-year grace period in which it could escape principal payments if the price of Venezuelan oil dropped below $50 per barrel (which it already is). At this writing, it is unclear whether the CDB agreed to the request.[1]

China is learning that “yuan diplomacy” can be riskier than it once thought. Already, the CDB has had to forgive some $4 billion of its loans, mostly to African countries. One might expect China to do the same for at least some of Venezuela’s $65 billion worth of Chinese loans, given its friendship with Caracas’ chavista government. But China has not done so. Instead, China has distanced itself from Chávez’s successor, Nicolás Maduro. According to the Financial Times, China reached out to Venezuela’s political opposition, which controls the country’s legislature. Beijing likely sought assurances that should Maduro leave office Venezuela would still honor its debts to China.[2]

Perhaps China is concerned about triggering a wave of requests for loan forgiveness. After all, China has lavishly provided loans to many other energy-rich countries, all of which have felt the pinch from declining oil and natural gas prices and a slowing global economy. In the end, however, China may have to accept some sort of restructuring of its loans to Venezuela in order to avoid an outright default.

True friends are tested in adversity. Clearly, the Maduro government’s growing inability to repay its loans to China has put their relationship in a difficult spot. Equally clear is that Beijing’s desire to recoup as much as possible from its development loans to Venezuela has trumped its friendship with the country’s chavista government. By turning to his political foes, China must have upset Maduro. But it also made plain what China’s real priorities are.

* Now called the “Bolivarian Alliance for the Peoples of Our Americas”

[1] Corina Pons, Alexandra Ulmer and Marianna Parraga, “Exclusive: Venezuela in talks with China for grace period in oil-for-loans deal – sources,” Reuters, Jun. 15, 2016.

[2] Lucy Hornby and Andres Schipani, “China seeks to renegotiate Venezuela loans,” Financial Times, Jun. 19, 2016.

 

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The Bigger Picture: China’s Energy Exploration in the East China Sea and Japan’s Security Debate

Last week Japan released its annual defense review.  For the first time, it revealed photographs of Chinese offshore drilling rigs operating in the East China Sea.  The images reminded many of the international controversy that China stirred up in May 2014 when it sent the Hai Yang Shi You 981 offshore drilling rig (pictured below) into waters claimed by Vietnam.  The photographs reinforce the narrative that China is intent on pursuing its own interests, regardless of the consequences for its neighbors.  That, along with its island-building activities in the South China Sea, has made it increasingly difficult for Asian countries, like Indonesia and Malaysia, to set aside their concerns over Chinese actions in the region.

China offshore energy exploration

China’s foreign ministry quickly denounced the Japanese disclosure of the photographs.  It decried them as inflammatory and declared that Japan’s use of the photographs “provokes confrontation between the two countries, and is not constructive at all to the management of the East China Sea situation and the improvement of bilateral relations.”[1]

China maintains that the offshore drilling rigs that it has erected in the East China Sea are on its side of the median line through the two countries’ claims.  Thus, China has every right to develop the energy resources there.  Unfortunately, man-made demarcations cannot so neatly divide the East China Sea’s oil and natural gas deposits.  Rather, they tend to migrate towards areas of lower pressure.  Those occur whenever wells are drilled nearby.  Hence, Japan fears that Chinese wells will siphon off the oil and natural gas deposits under its claim from across the median line.

That prospect was thought to have been put to rest in 2008, when China and Japan agreed to jointly develop energy resources in the disputed waters of the East China Sea.  Neither side would unilaterally drill for oil or natural gas there.  But those were different times.  Since then, China has become not only more powerful, but also more willing to openly assert its power in the region.  Japan (whether consciously or not) antagonized China when Japan’s central government bought the disputed Senkaku Islands (or Diaoyu in China) from private Japanese owners in 2012.  That prompted a sharp rise in the number of clashes between Chinese fishing boats and the Japanese coast guard around the islands, and China to establish an air defense identification zone (ADIZ) over the disputed waters in November 2013.  At the same time, China did begin to unilaterally explore for oil and natural gas in those waters, as Japan’s photographs attest.

Even so, China may be correct to discern a political rationale for Japan’s photographic disclosure, though perhaps not the one that its foreign ministry seemed to intimate.  The main reason behind Japan’s disclosure may not have been to embarrass China, but rather to support Prime Minister Shinzō Abe’s effort to pass security legislation that will enable Japan’s Self-Defense Forces to participate in collective self-defense—or in other words, to fight alongside an ally when either it or Japan is threatened.  Indeed, the photographic disclosure was made only a week before the upper house of the Japanese Diet starts debate on Abe’s new security bills.

The photographs surely boost the argument of Abe’s party, the Liberal Democratic Party (LDP), that there is a clear and present danger to Japan’s national interests and more must be done to protect them.  But a chorus of Japanese politicians of different political stripes has joined in opposition to Abe’s effort to push through the security legislation without a thorough debate.  Many, including some within the LDP, are concerned about passing the security bills without a clear understanding of the circumstances in which Japanese military forces could be used.  The ultimate vote could be a close one, given that the LDP holds a slim majority in the upper house.  Pictures may be worth a thousand words, but Abe may hope that they are worth a few votes too.

[1] “Foreign Ministry Spokesperson Lu Kang’s Remarks on Japan’s Disclosure of China’s Oil and Gas Exploration in the East China Sea,” China Ministry of Foreign Affairs press release, July 23, 2015, .

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Decline in Oil Prices, Currency Pairs, and National Power

Last autumn, headlines began to declare national “winners and losers” from the precipitous drop in oil prices over the second half of the year.[1]  They contended that the United States and its friends would benefit from the fall in oil prices; and that its most strident adversaries would not.  While largely true, the headlines did not capture the whole story.

Since international prices for oil are quoted in U.S. dollars, the exchange rate between the U.S. dollar and another country’s currency (a currency pair) also matters when calculating the real impact of a change in oil prices on that country.  Take Russia for example.  Much has been made of the fact that half of Russia’s government budget is based on revenues from oil.  One might suppose, because oil prices have fallen about 50 percent over the last six months, that Russia’s government budget would be pinched by about 25 percent (reflecting the 50 percent fall in oil revenues on half its budget).  Such a contraction would be catastrophic for the Russian government and Russia’s economy, given its high dependence on government spending.  That might lead Western policymakers to believe they can easily wait out Russian President Vladimir Putin’s aggressive designs.

But one must remember that the Russian government does not pay for domestic goods and services in U.S. dollars, but rather in Russian rubles.  Any drop in the value of the Russian ruble against the U.S. dollar allows Russia to reap more rubles for its dollar-based oil revenues.  (Even so, a sudden devaluation in a country’s currency can still wreak havoc on that country’s wider economy, because it fails to let people adjust to the benefits of devaluation, before they feel its negative impacts.)  Given the devaluation in the Russian ruble (which has fallen in tandem with oil prices), the real impact of the fall in oil prices is closer to only 8 percent, rather than 25 percent. While that is still a big challenge for the Russian government’s budget, it is a lower hurdle for Putin to surmount.

Similarly, one might expect that Japan, a key American ally in Asia, to unreservedly benefit from the decline in oil prices.  As a country completely dependent on oil imports, any decline in oil prices should boost its economy.  Given that oil prices have fallen about 50 percent over the last six months and that Japan imported about 1.6 billion barrels of oil in 2014, one may naturally assume that Japan is now saving a vast sum that would act as a fiscal stimulus to its economy, making it a stronger country and one better prepared to cope with a rising China.

That has happened, but not to the degree that the halving of oil prices would suggest.  That is because the value of the Japanese yen against the U.S. dollar has fallen too.  During the second half of 2014, the yen devalued about 15 percent, as a result of the Japanese central bank’s quantitative easing policy.   That shaved one-fifth off the benefit from the decrease in oil prices to 40 percent in yen terms.  Ironically, the lower energy input prices had made it more difficult for the Japanese government to achieve its 2 percent inflation target, which Tokyo believes will help lift the country out of its decades-long deflationary economic stagnation. 

As the cases of Russia and Japan have shown, changes in currency exchange rates can make a real difference on the impact that changes in oil prices have on a national economy, whether they are net oil importers (those shaded in blue in the chart below) or net oil exporters (those shaded in red).

Effect of Exchange Rate Movements on the Decline in Oil Prices in Local Currencies

 

As a region, Asia has benefited from the drop in oil prices.  Almost every country in the region is a net oil importer.  Chief among them is China, whose slightly appreciating yuan against the U.S. dollar, has allowed it to fully benefit from the lower oil prices.  In fact, Beijing has taken advantage of them to less expensively fill its strategic petroleum reserve.[2]  But not far behind have been India and Indonesia.  The currencies of neither country have devalued by more than 6 percent, allowing them to realize almost all of the benefit from the decline in oil prices.  That, in turn, has allowed their central banks to cut their interest rates to spur their economies without having to worry as much about inflation.  Lower oil prices have also enabled Indian Prime Minister Narendra Modi and Indonesian President Joko “Jokowi” Widodo to slash fuel subsidies, which had been draining government coffers in the past, without a public outcry.  That has freed up resources that they can devote to infrastructure and defense, as both national leaders have promised.

However, the fall in oil prices has also pinched some American allies.  One such country is Australia.  Though it is a net importer of oil, Australia has ambitions to become among the world’s leading exporters of liquefied natural gas (LNG).  But LNG prices, which are often linked to those of oil, have followed oil’s prices downward.  That has put into jeopardy Australia’s new round of offshore LNG development.  According to the Australian government, it will likely miss out on about AUS$750 million in petroleum resource rent tax over the next four years—about the cost for one of the new diesel-electric submarines that its navy wants.  The situation would have been even worse had the Australian dollar not devalued by 13 percent against the U.S. dollar.[3]

Finally, some countries, like Venezuela, whose currencies are effectively pegged to the U.S. dollar, have felt the full impact of the decline in oil prices.  Unfortunately for Venezuela, it imports most of its consumer and industrial goods—including food, clothing, machinery, vehicles, etc.—and it holds debts mainly denominated in U.S. dollars.  Thus, any devaluation of the Venezuelan bolívar to temper the impact of lower oil prices would also cause the costs of goods to soar and make its U.S.-dollar debts crushing.  To avoid a financial crisis, Venezuelan President Nicolas Maduro has travelled to China this week.  In the past China has agreed to oil-for-loan agreements, in which China provides immediate financing to Venezuela in exchange for future deliveries of Venezuelan oil.  Already existing deals with China have begun to squeeze out Venezuela’s ability to use its oil to bring Latin American countries into its orbit.  Rather, new deals are more likely to move Venezuela close to China’s orbit.[4]

By the first week of January 2015, the benchmark prices for Brent and West Texas Intermediate crude oil had fallen to $51 and $48 per barrel, respectively.  As long as these conditions persist, oil-exporting countries will suffer and oil-importing ones will benefit.  But to really understand whether these countries are weakening or strengthening to the extent that the decline in oil prices suggest, one would be wise to also consider the trajectories of their national currencies.

[1] “Winners and Losers,” Economist, Oct. 25, 2014.

[2] Abheek Bhattacharya, “China’s Petroleum Reserve Builds Shaky Floor for Oil,” Wall Street Journal, Sep. 3, 2014.

[3] Australia is considering a Japanese submarine design for its next-generation submarine fleet.  The most recently launched Japanese Sōryū-class submarine cost $540 million and AUS$750 million converts to $615 million at today’s exchange rate.  John Hofilena, “Japan launches newest submarine Kokuryu amid party atmosphere,” Japan Daily Press, Nov. 04, 2013, Eric Yep, “Falling Oil Spells Boon for Most of Asia’s Economies,” Wall Street Journal, Jan. 4, 2015; Max Mason, “Oil price plunge sends petrol to four-year lows as Australia feels it at the pumps,” Sydney Morning Herald, Dec. 22, 2014; James Paton, “Plunging Oil Threatens to Spoil Australia’s Next Gas Boon,” Bloomberg News, Nov 27, 2014.

[4] Eyanir Chinea and Brian Ellsworth, “Venezuela’s Maduro to visit China, OPEC nations amid cash crunch,” Reuters, Jan. 5, 2015; Nicole Hong and Kejal Vyas, “Oil Shakes Venezuelan Debt to Its Foundations,” Wall Street Journal, Dec. 22, 2014; “Inside U.S. Oil,” Thomson Reuters, Aug. 22, 2014, pp. 7-8.

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