How Russia Survives

This was not the plan. Last spring, while Putin counted on a quick military victory, Western leaders believed economic and financial weapons could overwhelm Russia. In early April 2022, Mario Draghi, then Italy’s prime minister, channeled this conviction when he defended sanctions on Russian energy exports by saying people had to choose between peace and air conditioning.

Fortunately, confidence in the efficacy of sanctions did not prevent the United States and its allies from sending weapons and other aid to Ukraine. But the initial expectation was that impounding Russia’s foreign exchange reserves held abroad, harsh restrictions on Russian banks and individuals, and cut-offs in trade in technology and raw materials would cause the Russian economy to collapse, potentially forcing Putin to abandon his “special military operation.” Less than two months after the invasion, the IMF was forecasting that Russia’s economy would contract by 8.5% in 2022 and by 2.3% this year.

Since then, however, the Fund has revised its Russian GDP estimate for 2022 and 2023 upward by a cumulative 9.4 percentage points. This was not a simple forecasting error, but rather a reflection of the West’s overestimation of its ability to control international trade and other key aspects of the world economy. The truth is that the collective West no longer reigns supreme over globalization. Moreover, most Western governments have been slow to grasp that revisionist authoritarian regimes don’t always put rational economic considerations first.

Putin has pressed on with his war on Ukraine heedless of the material and human costs, and Russia’s economic elites, while aghast, have made no effort to contain him. In fact, the oligarchs have cooperated with Putin and his war machine, even as they were privately telling foreigners they disliked his policies. This should have surprised no one, as the Kremlin/oligarch relationship is based on a sort of negative loyalty, a feature that has become typical of today’s Russia – and of corporate relations between Russia and the West in an era of sanctions.

LEAKS EVERYWHERE

We now know why optimistic predictions about the impact of economic sanctions were untenable. China, India, Malaysia, and Singapore have stepped up purchases of Russian oil, and companies in Western democracies have increased their imports of oil products that these emerging economies derive from Urals crude.

China, empowered by its new role as Russia’s main trading partner, is supplying the Russians with semiconductors, drones, and other dual-use technologies. Countries such as Turkey, the United Arab Emirates, Kazakhstan, Armenia, and other former Soviet republics have prospered as brokers between Western exporters and Russia for everything from smartphones to machine tools (after collapsing by 43% in the initial months of the war, Russian imports were largely back to their pre-war levels by November 2022).

Likewise, vested interests in a few countries have prevented the European Union from banning imports of key Russian products such as diamonds and steel. In fact, some EU countries doubled their imports of Russian semi-finished steel slabs last year, replacing supplies from Ukraine’s Mariupol mills, which Putin’s army destroyed.

Moreover, some of Russia’s key financial channels with the West have remained open throughout the war. The EU has not yet cut off Gazprombank, for example, despite having nearly ended gas imports from Gazprom, the bank’s holding company. In Cyprus, Gazprombank, Russia’s third-largest lender, continues to operate – under European Central Bank surveillance.

PROFITS WITHOUT HONOR

In addition, since Russia first came under sanctions in 2014, following the Kremlin’s illegal annexation of Crimea and support for separatists in eastern Ukraine’s Donbas region, some Western companies have displayed their own form of negative loyalty to their countries. By and large, they have abided by Western governments’ restrictions, but some have found ways to continue cooperating profitably with Russian counterparts – even supplying goods to companies that work for Russia’s military-industrial complex.

Last month, for example, the US Department of Commerce and the US Treasury’s Office of Foreign Assets Control imposed a combined $3.3 million fine on Microsoft. In 2016 and 2017, one of Microsoft’s subsidiaries entered into deals with two sanctioned Russian companies, one involved in the construction of the Kerch bridge linking Russia to Crimea and the other in the production of Russian warships.

A more recent example involves the Italian company Danieli, a large supplier of precision machine tools for steelmaking. Danieli announced a total withdrawal from operations in and with Russia only in late April, more than 14 months into the war, after press reports revealed that one of its subsidiaries had supplied steel-making technology to the Russian conglomerate Severstal last August. (Danieli denies any wrongdoing and no legal action has been taken against it.)

Severstal, a huge steelmaking conglomerate, is widely reputed to be a key supplier for producers of Russian submarines, warships, and armored vehicles. The company’s boss and controlling shareholder, Alexey Mordashov, one of Russia’s richest men, was placed on Western countries’ sanctions list soon after the invasion last February.

Two other listed companies, the US oil-services provider SLB and Italian cement maker Buzzi Unicem, are using a loophole that allows their Russian subsidiaries to keep operating. No company established in Russia under local law is required to abide by Western legislation, so what SLB and Buzzi Unicem are doing is legal – and very lucrative.

Both companies’ Russian subsidiaries have recorded increases in turnover last year, most likely benefiting from the voluntary withdrawal of their Western competitors. Both provided Russia with key products and – in the case of oil – strategic sources of revenue. (Like Danieli, SLB and Buzzi Unicem deny any wrongdoing, and face no legal action at home.)

Moreover, the most recent report by the International Working Group on Russian Sanctions, led by Andriy Yermak, the head of Ukrainian President Volodymyr Zelensky’s presidential office, and Michael McFaul of Stanford University, tackles the issue of the Western-made microchips found in Russian missiles and drones that have been fired on Ukraine.

According to the report, “Russian missiles and drones are equipped with foreign-made microchips that support GLONASS – Russia’s satellite navigation system – which guides them on selected targets,” while “foreign companies, including Linx Technologies, Qualcomm, and STMicroelectronics, reportedly continue to produce GLONASS-enabled microchips and sell them to Russia through numerous shell companies, whether intentionally or not.” All these companies are based in the US, with the exception of STMicroelectronics, which is jointly controlled by the governments of France and Italy.

To be clear, there is no evidence that microchips made in the West have been supplied to Russia after February last year, and there have been no allegations of sanctions evasion leveled against the companies involved. But these chipmakers could swiftly and easily change some of their chips’ features to prevent them from working with Russian weapons.

These are but a few of the cases, among many, that need addressing. The Yermak-McFaul report suggests that democratic governments should slap a 100% tax on profits that accrue to Western companies from their subsidiaries in Russia. They could also funnel such revenue to Ukraine.

But, in general, legal loopholes, opportunistic corporate behavior, government dithering, influential industrial lobbies in Western countries, and lack of cooperation by emerging economies have all contributed to blunting the impact of sanctions. But concluding that sanctions have failed would be wrong. In fact, there is a case for broadening and sharpening the sanctions regime, and making it more difficult to circumvent.

TIGHTENING THE SCREWS

Sanctions are clearly better than the alternative: enabling the Kremlin to fund murder and devastation in Ukraine with resources from payments for Russian imports – up to $1 billion per day for the EU alone. There are also obvious signs that the sanctions, however imperfect they may be, are working.

Already, Putin’s regime is being forced to sell commodities at a discount and to purchase technologies at a premium (owing to the costs of bypassing legal hurdles). Russia’s government budget this year is facing significant pressures as a result of military and national-security spending – which accounts for a record-high one-third of expenditure – and involuntary import substitutions. For now, the Kremlin can afford to fund these outlays, but any new external shock could seriously damage Russian public finances.

To mitigate these risks, Russian authorities are squeezing the economy for more revenue, including by collecting a windfall-profit tax from businesses and requiring Western companies leaving the country to pay a contribution to the federal budget of at least 10% of half of their assets’ market value (on top of giving buyers a 50% discount on their property’s valuation).

Putin needs these measures precisely because sanctions have taken a toll on Russia’s budget, particularly in the hydrocarbons sector, which accounted for nearly half of the government’s revenue in 2022. In the first four months of 2023, revenue from the sector fell by 45% year on year. Next year will be even harder for the Kremlin, as Putin is facing presidential elections in March. As usual, the process will be far from free and fair, but Putin will still need extra money to spend on buttressing his popularity. Businesses, both Western and Russian, may face new extortions.

Given the grim outlook for Russia’s fiscal position, relations between the Kremlin and some Russian oligarchs will be increasingly salient. In February 2022, there was a pervasive disbelief among business elites about the reality of the impending war. Having worked with Putin for decades, profiting from their closeness to a corrupt and bellicose power circle, they still failed to read their leader’s plans. But their initial state of shock gave way to a sort of negative acceptance as Western sanctions hit one tycoon after the other.

MEN IN GRAY

Russian elites, both senior officials and top businessmen, are highly pragmatic and non-ideological. Many billionaires made their fortunes in the 1990s and, of course, still consider their Kremlin ties a crucial asset. Sanctions have caused them unprecedented uncertainty, but they continue to demonstrate negative loyalty to Putin: unhappy with the situation but continuing to work in Russia, supplying resources to the war machine, and making money.

It took less than eight months for some of them to restore international operations and even find new customers.

Large cash flows from Asia and the Global South are their current reward. Together with the threat of official reprisal and the prospect of remaining on Western sanctions lists indefinitely, the lack of deterioration in their living standards means they have little reason to speak out against the regime.

Mordashov is a case in point. After the war started and he came under sanctions, Mordashov devoted considerable effort to whitewashing his reputation in the West. Major US media even ran sympathetic stories portraying him as a pro-reform oligarch who tries to keep his distance from Putin.

Yet Mordashov lent billions of dollars to Sergey Roldugin, a classical cellist widely reputed to hold assets for Putin, and attended meetings with Putin at the outset of the war. Similarly, in March, Alfa-Bank founder Mikhail Fridman, another sanctioned oligarch who clearly dislikes being branded as pro-Putin, collected at least a dozen letters from Kremlin critics attesting to his credentials as an independent and trustworthy businessman.

Such strategies suggest that Western sanctions are indeed hurting Russia’s tycoons. At the same time, Russian elites’ negative loyalty has left them atomized – complicit in the ongoing disaster but unable to unite behind meaningful action to avert even worse consequences.

Democratic governments might try to exploit such vulnerabilities. The most recent Yermak-McFaul report suggests setting a clear path for lifting sanctions against individuals if they actively distance themselves from the Kremlin and commit to the restoration of Ukraine within its 1991 international borders. This would be tantamount to trying to inspire in Russia’s oligarchs a “positive disloyalty.” To strengthen the incentive, it should be paired with the broadening of sanctions against a larger number of individuals in Russia.

TEST RESULTS

For the last 14 months, the world economy has undergone an unprecedented experiment: severing trade, financial, and personal links with a country that spans 11 time zones and sits at the heart of globalization. Before February 2022, far-reaching sanction regimes targeted countries at the margins of the global economy. Iran, the most important economy hit by blanket sanctions before Russia, isn’t even among the world’s top 40, with annual GDP barely reaching $365 billion. Russia, on the other hand, is a $2 trillion economy and the 11th largest globally. And while economic sanctions have become a relatively routine policy tool over the past 80 years, there are now more than 13,000 imposed on just one country – more than on Cuba, Iran, and North Korea combined. The only previous example of a large economy coming under such broad sanctions was Mussolini’s Italy in 1935, when international trade was a far smaller share of a country’s GDP.

The stakes of this experiment couldn’t be higher – and not just for Ukraine. We will soon learn whether measures such as trade embargoes, travel bans, and freezing private and state-owned assets are an exception or will become ordinary policy tools in a fragmented and fractious world. For example, according to well-informed sources, US policymakers are suggesting that European governments should sanction rogue ultra-nationalists sabotaging Serbia’s attempts to join the EU.

Will it work? It is hard to imagine democracies imposing secondary sanctions on countries helping Russia through parallel imports, as Turkey is doing for countless small and medium-size Italian businesses. In the case of China, it is downright unthinkable. Such an approach would be extremely difficult, if not impossible, to implement, and attempting to do so would negatively affect the standing of the US and the EU in developing and emerging countries. Instead, Western powers should be nurturing positive loyalty in developing and emerging countries by offering enticements, such as advanced and green technologies, to join forces in maintaining the sanctions framework.

More broadly, such measures call for more coordination and transparency. The creation of an international advisory body on sanctions – tasked with identifying loopholes and other shortcomings, sharing and managing information, and assessing impact – would be timely and helpful for governments and businesses alike. It is an idea that G7 leaders might usefully consider when they meet in Hiroshima, Japan, later this month.