Russia Sanctions: Hardening Europe’s Economy

Background

 

The recent cycle of sanctions and counter-sanctions relating to Russia has focused government attention on the economic impact of such policies. An analysis of which countries could be hurt most by aggressive European Union (EU) sanctions, and the ways to mitigate that impact, is therefore valuable. 

 

The Russian Federation has (re)developed a full range of instruments of aggression. Ukraine has been the victim of a broad-spectrum campaign that has included the infiltration and subversion of state bodies; economic warfare, notably in the field of energy; hostile propaganda in both traditional and online media; the deployment of state-sponsored combatants, ranging from unarmed violent mobs to a mix of mercenaries, special forces and regular troops; and a credible threat of a large-scale military invasion. EU and NATO countries need to enhance their capabilities to deter threats in all of these areas. One important area for further development is economic coercion.

 

At an abstract level, economic coercion is essentially not different from other forms of conflict. There are offensive, counteroffensive and defensive moves. Governments can invest in target hardening, i.e., raising the resilience of their economic systems to outside attack. They can also invest in the development of offensive means. The magnitude, sequence, timing and signaling of actions are essential to determining effectiveness and outcomes. While some scholars insist on measuring success only in terms of outright victory, namely whether one side has successfully imposed its will on the other, the reality is gradated. At the basic level, the goal of an economic attack is to harm the other side economically, so by that metric most sanctions almost always work, particularly in the short run. Political signaling effects also matter: regardless of outcomes, imposing trade sanctions signifies disapproval to the target country and helps to mobilize opinion and resources in the sending country.

 

Attacking moves

 

The Russian Federation is a highly experienced economic warrior. Typical attacks involve the following operational procedure. First, the economy of the target country is analyzed to identify vulnerabilities, e.g., dependence on Russian oil or gas supplies; dependence on Russia as an export market for certain goods. This identifies the general area of attack. Second, more detailed parameters are refined for the planned attack to be more damaging, e.g., cutting off gas supplies in winter rather than in summer. Third, in some cases, an additional triggering attack is prepared with the purpose of creating an economic pincer movement, i.e., the target is to be maneuvered into having only two choices: either endure the triggering attack, or run into the main attack. This particular approach was used by Putin in his January 2006 and January 2009 attacks against Ukraine in the area of gas supplies. The triggering attack was to impose unacceptably abrupt price increases, while the main attack was to cut off supplies. A fourth aspect is the communication accompanying the attacks, which is beyond the scope of this article.

 

Of course, the attacking country typically incurs economic losses as well, e.g., lost revenue from energy sales or costs relating to import or export substitution. But when Russia attacks Ukraine using its energy supplies, it benefits from – to borrow one more term from the military lexicon – economic escalation dominance. In response, Ukraine can unilaterally withhold payments, but it will suffer proportionately more than Russia under any escalation scenario.

 

Russia’s recent import restrictions against the European Union are another interesting case. For the EU, the four sectors that are most exposed in terms of their share of exports to the Russian market are not high-technology manufacturing sectors but fruits and nuts (32.4 percent of EU exports in 2013), edible vegetables (25.3 percent), trees and plants (22.8 percent) and meat (19.8 percent).[1] This explains why the Kremlin chose to impose sanctions on food and food products: it was looking to cause maximum relative damage, as it is high relative damage that has the best chances of causing business bankruptcies and political pressure in the target countries, in this case the EU. Furthermore, these sectors are not strategically important for Russia – for example, in terms of its military buildup or its domestic energy sector – so within this limited example Russia also benefits from economic escalation dominance.

 

This dominance ceases to hold if one looks at other commodity groups, however. The EU’s exports of machinery or vehicles are not especially exposed to the Russian market, while Russia has significant import dependence levels for many such goods. Therefore an effective action from the EU perspective could be to impose export restrictions on manufactured goods. The effects, while slightly painful, should be quite manageable and rather disruptive for Russia – especially if a common approach could be reached between the EU, the United States, Japan and South Korea, among others.

 

Target hardening

 

Exports to Russia are close to negligible for large Western European countries such as the UK, France or Spain. Contrary to popular perception, even Germany is not especially exposed, with just 3.4 percent of its total goods exports going to Russia. For the EU as a whole, the share of exports to Russia is 6.8 percent (excluding intra-EU trade), representing a value of just 1.2 percent of EU gross domestic product (GDP). This figure is much higher than any plausible worst-case scenario: to experience that level as an actual GDP loss one would have to have a full shutdown of all exports to Russia while also assuming zero redirection of trade. In sum, the impact of comprehensive trade sanctions – let alone of those sanctions already in place – should not be exaggerated.

 

What is true for most EU countries is, however, not true for all. In the case of Russian retaliatory measures to sanctions, the most exposed EU countries are Lithuania (19.8 percent of total goods exports in 2013), Latvia (16.2 percent), Estonia (11.4 percent) and Finland (9.6 percent). However, the next-most-exposed EU country is Poland, with just 5.3 percent. In sum, the EU’s vulnerability is concentrated in just a few countries. The distribution of vulnerabilities as compared to the overall EU vulnerability suggests that an EU solidarity mechanism would be both very effective and of limited total cost for the Union. To this end, an EU Solidarity Fund could help to share the cost of EU sanctions (or of third-party sanctions against the EU), thus increasing the ability of EU governments to support strong collective measures when necessary.

 

Building on a proposal by Center for European Policy Studies (CEPS) Director Daniel Gros, the idea would be to have a special fund at the EU level to disburse solidarity payments among strongly affected businesses.[2] The payment eligibility criteria should be not only based on the minimum proportion of business volume that is affected, but also how fast and to what extent a reorientation toward new markets can occur. Compensation payments should be time-limited to provide clear incentives for EU companies to reorient their sales or purchasing patterns. Also, precautions should be built in to avoid abusive claims for compensation.

 

One further idea to generate financial resources for this new Solidarity Fund would be to impose unilateral import tariffs (and possibly export taxes) on EU-Russia trade. This would not shut down EU-Russia trade but would give a signal that one is ready to “grow apart” from a country that has chosen the path of aggression.

 

This type of instrument could also be applied to energy products. This would de facto act as a “diversification tax.”[3] Faced with the price wedge created by such a tax, e.g. 20 percent on all energy imports from Russia, EU companies and consumers would be incentivized to find substitutes for Russian energy. The proceeds of the tax could be used to cofinance a more rapid diversification of energy sources and source countries – and to finance any other solidarity measures or resilience measures that may be necessary.

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