Economy under sanctions. Ukraine-Russia crisis: Economic consequences

1. Economy under sanctions. Ukraine-Russia crisis: Economic consequences Svetlana Ledyaeva Aalto University School of Business Spring 2016

2. Reasons for sanctions Part 1

3. How it started: Chronicle of events 21 November 2013 - then-president Viktor Yanukovych suspended preparations for the implementation of an association agreement with the European Union. => Months of protests called “Euromaidan”. 22 February 2014- Yanukovych was ousted by the protesters. 18 March - Annexation of Crimea by Russia. Subsequently, unrest in Donetsk and Lugansk oblasts of Ukraine evolved into a war between the post-revolutionary Ukrainian government and pro-Russian insurgents.

4. Why annexation of Crimea by Russia? From Mikhail Khodorkovskij speech in Kyev, 10 March 2014: “This is no mere territorial dispute about a few extra square kilometres.  Crimea has no reserves of oil, and for the Russian economy it is more likely a burden than an acquisition.” EUOBSEVER (March 2014): Why is a world leader prepared to risk international opprobrium and, possibly, crippling economic sanctions for an obscure piece of land? -Ordinary Russians are not Putin priority.   -What is his potential interest in agricultural south Ukraine? Or East Ukraine, home to former Soviet mining, coal, and steel industries, which need massive investment?

5. Why annexation of Crimea by Russia? EUOBSERVER (March 2014): -What is Putin potential interest in agricultural south Ukraine? Or East Ukraine, home to former Soviet mining, coal, and steel industries, which need massive investment? Perhaps the answer is more simple: oil and gas. -By annexing Ukrainian land on the Black Sea coast, Putin also annexes the rights to any hydrocarbons found in its maritime zones. -There are signs the Black Sea contains a lot of wealth. -Energy firms such as ExxonMobil, Chevron, Shell, Repsol, and Petrochina have begun to show real interest in working with Kiev to explore the area. Source: https://euobserver.com/opinion/123496

6. Crimea's Strategic Value to Russia: Military benefitsBy Paul N. Schwartz, March 2014 -Access to the naval base at Sevastopol, home to Russia’s Black Sea Fleet.   -Russia’s current lease of Sevastopol runs through 2042, but due to recent events Russia had become increasingly concerned that its future access might be compromised. -Ability to project power in and around the Black Sea. -Important strategic defense capabilities. Source: http://csis.org/blog/crimeas-strategic-value-russia

7. Crimea's Strategic Value to Russia: Thorn in Ukraine`s side By Paul N. Schwartz, March 2014 The need to regain influence over Ukraine’s future direction, which was diminishing rapidly following the removal of Yanukovich. Crimea will serve as a symbol to encourage pro-Russian factions in Ukraine to support Russia and resist efforts by Kiev to achieve closer integration with the West. The West will hesitate to incorporate Ukraine while it is deeply embroiled in a territorial dispute with Russia over Crimea. These are all elements of the playbook that Putin used in Georgia and elsewhere in the CIS to counter past efforts at NATO and EU expansion. Source: http://csis.org/blog/crimeas-strategic-value-russia

8. Western sanctions against Russia Part 2

9. Reasons and target Official reasons: -The Crimean referendum was illegitimate. -Russia’s illegal annexation of Crimea. -Russia’s continued violation of Ukrainian sovereignty and support for the pro-Russian separatists. Sanctions` target: -The EU and US sanctions have been carefully designed and are “targeted” to have as much impact as possible on the regime and minimisethe impact on the population. Source: Oxenstierna and Olsson (2015): http://foi.se/rapport?rNo=FOI-R--4097--SE

10. Adeep disagreement over the post-Cold War security order in Europe • Russia wants to preserve the former Soviet “sphere of influence”, including remaining former Soviet republics in Europe (Ukraine, Belarus, Georgia, Moldova, Armenia and Azerbaijan) and Central Asia. • Meanwhile the West regards these countries as sovereign states that are free to engage in any international cooperation they choose and form the alliances they want. Source: Oxenstierna and Olsson (2015): http://foi.se/rapport?rNo=FOI-R--4097--SE

11. European sanctions against Russia March 2014: The first sanctions targeting individuals and legal entities. Assets in the EU countries were frozen and individuals were banned from travel into the EU. June 2014: Sanctionsagainst the import of goods from Crimea and Sevastopol and against technical and financial assistance and insurance in connection with such imports (Council Regulation 692/2014). These sanctions were extended on 30 July to incorporate sectorial investment and export bans (Council Regulation 825/2014). • 18 December 2014 a general investment ban and restrictions on tourism services were added. July 2014: Economic sanctions which restricted the opportunity of Russian state-owned banks to seek financing on European capital markets and trade with certain sectors. The EU also imposed an embargo on the export and import of arms from Russia and connected services. The export embargo includes dual-use products and advanced technologies used by the oil industry. September 2014: The economic sanctions were reinforced and broadened. Source: Oxenstierna and Olsson (2015): http://foi.se/rapport?rNo=FOI-R--4097--SE

12. US sanctions against Russia The aims of the US sanctions are to increase Russia’s political isolation as well as the economic costs to Russia, especially in areas of importance to President Putin and those close to him. March 2014: • Asset freezes for specific individuals and specific entities, particularly state-owned banks, energy companies and arms producers. • Restrictions on financial transactions with Russian firms in finance, energy and defence; on exports of oil-related technology; on exports of dual-use technology. April 2014: Expanded export restrictions on technologies and services regulated under the US Munitions List. July 2014: The US Treasury imposed several economic sanctions. Gazprombank, VEB, Bank of Moscow, Rosselkhozbank and VTB Bank were included. Two Russian energy firms, Novatek and Rosneft, and nine Russian arms firms were sanctioned. December 2014: The US Treasury extended the economic sanctions. Russia’s largest bank – Sberbank – was included in the list of sanctioned financial institutions. In addition, the Treasury blocked the assets of five more Russian state owned defence technology firms. Sanctions were imposed that prohibit the export of goods, services (not including financial services) and technology in support of exploration or production for Russian deep water, Arctic offshore and shale projects that have the potential to produce oil. Source: Oxenstierna and Olsson (2015): http://foi.se/rapport?rNo=FOI-R--4097--SE

13. Sanctions impact on Russian economy Part 3

14. Main macroeconomic indicators of Russia in 2012-2015 (World bank data + me)

15. GDP dynamics

16. Indices of production by broad sector

17. Indices of industrial production for processing industries

18. Inflation (CPI, annual, Dec. vs. Dec.)

19. Exchange rate of ruble (Bank of Russia data)

20. Oil price dynamics

21. Russian GDP drop – western sanctions effect or something else? EUOBSERVER.com: The sanctions, imposed by the EU and US in mid-2014, prompted the Russian economy to contract by 1 to 1.5 percent more than it would have done in 2015, a State Department official told press in Brussels. The Russian economy shrank 4 percent in total in 2015. In normal circumstances, it might have grown by up to 5 percent, the US official said. The slump in world oil prices, which coincided with Russia’s invasion of Ukraine, was the main factor, costing at least 4 percent of GDP. Lack of structural reforms, such as loosening state control on major firms, also had a bigger impact than the Western measures. Source: https://euobserver.com/foreign/131812

22. Sanctions impact on Russian economy: Expert opinion The most damaging sanction was the ban on accessing new Western debt and credits because even though that action is directed against a handful of state banks and energy companies, the effect has been an almost total ban by all Western banks and trade organizations on any Russia risk. That has certainly hurt the economy and contributed to the current recession. But how much? Difficult to say because that particular sanction was applied almost exactly as the oil price rolled over and started a steep decline. Without the sanctions the economy would today be in recession because of the oil price collapse. If oil had not collapsed then the sanctions alone would not have caused the recession. However, the sanctions accelerated the decline and made worse the problems resulting from the falling oil price. The lower oil price strained the availability of local liquidity which would normally be compensated by accessing foreign debt markets. The selective ban on supplying some services and equipment to the oil industry has not yet had any noticeable impact. Longer term it will, or may, but not over the short to medium term. Source: Expert opinion of Chris Weafer, a senior partner with Macro Advisory, a consultancy advising macro hedge funds and foreign companies looking at investment opportunities in Russia. http://www.themoscowtimes.com/opinion/article/how-much-have-sanctions-really-hurt-russia/525228.html

23. A major medium-term risk for the economy lies in the continued dearth of investment (World Bank) Low investment demand hints at the deeper structural problems and has already initiated a new era of potentially small growth. Higher interest rates are exerting pressure on Russian banks as their costs of funding rise, credit levels decline, and more loans default. • a vicious cycle of a shortage of project credit, rising lending rates, and a tightening of access to credit. More fundamental factors that could limit investment demand: The uncertainty related to geopolitical tensions and sanctions is still holding investors back and it is likely to take some time until their confidence is restored. Source: http://www.worldbank.org/en/country/russia/publication/russia-economic-report-33

24. Foreign Direct Investment into Russia, billion USD 2005-2015

25. Investment into fixed capital, percent to corresponding period in previous year

26. Long term prospects for Russia (World Bank) • Despite the path to more selective integration into the world economy, Russia will continue to depend on natural resource exports. Here a serious challenge will be to assure progress in adopting technology that can support exploration of less accessible oil and gas fields. • Future growth in productivity may well be threatened if natural resource revenues are not invested to improve long-run growth prospects, particularly given restricted access to external financing. Specifically, less foreign direct investment could limit the transfer of innovation and technology that is critical to heighten Russia’s growth potential. • As long as access to external finance continues to be a constraint, a policy of careful management of financial sector risks and buffers will be vital. A greater focus on the efficiency of spending and prudent management of fiscal buffers is necessary to ensure continued fiscal sustainability at all administrative levels. Source: http://www.worldbank.org/en/country/russia/publication/russia-economic-report-33

27. Any positive effects for Russia? (World Bank) The only bright spot is that the weak ruble could create incentives for expansion in some tradable industries. However, high level of capacity utilization, structural rigidities, and the surging cost of imported investment goods and credit may dampen these benefits. Source: http://www.worldbank.org/en/country/russia/publication/russia-economic-report-33

28. Russia`s counter sanctions and their Impact on Russian economy Part 4

29. Russia`s countersanctions Russia`s ban on the import of certain foods from the EU, the US, Australia, Canada and Norway imposed on 7 August 2014. New Zealand, Japan and Switzerland were not included in the “ban” list (Though some media sources claim the opposite). The list of products that should not be imported includes meat in all forms, fish, dairy products, fruit and vegetables.

31. Countersanctions impact on Russia: Inflation

32. Sanctions` effects for the World economy Part 5

33. Impact of sanctions on EU-Russia trade European Parliamentary Research Service /EPRS/ (Marcin Szczepański 2015): Russia is the European Union's third-biggest trading partner. In 2014, trade volume between the European Union (EU) and Russia decreased. In 2014, EU goods exports to Russia fell, with estimates of the decrease varying from 12.1% to as much as 14.5%. => -14.3% - my calculations based on UN COMTRADE data.

34. EU-27 export to Russia, billion USD

35. EU-27 export to Russia, growth rate in % to corresponding month of previous year

36. EU export to Russia: further details Szczepański2015: Exports to Russia have been affected in two ways: Firstly, -by the EU ban on the sales of certain goods, such as 'dual-use' technology intended for the exploration of oil and gas deposits, -by the Russian import embargoes. Secondly, The rouble’s depreciation, exacerbated by capital flight from Russia, has weakened Russian purchasing power. Since sanctions and the economic crisis in Russia are intertwined, areas of exports not subject to sanctions also face deteriorating prospects, due to spill-over effects and the worsening economic situation.

37. Overall damage to Europe`s economy: Some estimates European commission: -0.3% of the EU's GDP in 2014 and -0.4% in 2015 (€40 and €50 billion respectively). Moody's: believes that the overall impact on EU GDP growth would be limited to less than one percentage point in 2015. Institute of Economic Forecasting of the Russian Academy of Sciences: -0.5% of EU GDP (-8-10% of Russian GDP).

38. Geographical distribution of the damage Szczepański 2015 : Baltic countries, Finland and Eastern European Countries will be affected more than the EU average of 0.3% of GDP in the short term and 0.8% in the long run. In absolute values Germany, as the biggest exporter to Russia, is unsurprisingly likely to be the most affected. Assis. Prof. Francesco Giumelli, University of Groningen: EU countries most affected by ban on the sale of “dual use” technology for the exploration of oil and gas deposits: Germany, Italy, France. EU countries most affected by ban on the import of European food products: Lithuania, Poland, Finland, Greece and Spain.

39. Sectoral distribution of the damage WIFO: In the short-term: the exporting industries and their suppliers, as well as industries specialized in the production of investment goods will be the most affected: agriculture and manufacturers of food products, the metal product industry, the manufacturing of machinery, equipment and motor vehicles, as well as manufacturing related services (wholesale, business services). These effects are then likely to spread to industries that are more dependent on final household demand: construction, wholesale trade, business services and retail trade.

40. Damage to EU financial sector Szczepański2015: Russia has received loans from European financial institutions, and some could face significant risks if Russian companies or banks were to default. Russian debt by estimates is approximately between 147 and 165 billion USD. Most exposed EU countries: France (US$44 billion), Italy (US$27 billion), Germany (US$17 billion), UK (US$15 billion). Large-scale defaults by Russian debtors, if they were to happen, could worsen the financial position of some EU banks but, according to the majority of experts, not to the point of risking the stability of the whole European banking system.

41. Damage to EU agri-food sector Szczepański2015: EU agri-food exports account for 7% of total EU exports of goods. About 9% of these agri-food exports go to Russia, which is the second most important destination for EU agricultural products, after the USA. In 2013, overall EU agricultural exports to Russia were worth €11.3 billion. The Russian countersanctions covered about 43% of these exports, worth approximately €5.1 billion (representing about 4.2% of total EU agri-food exports). However, the embargo does not include many important sub-sectors, such as wine and spirits, cereals, pasta, olive oil, beverages, and a range of other products.

42. Damage to EU agri-food sector: continue Szczepański 2015 : The World Bank has also evaluated the impact as small overall, but substantial for some sectors. An early 2014 forecast indicated that the losses of US$6.7 billion due to the embargo could endanger as many as 130 000 jobs in the agricultural sector. Alternative markets. Oversupply of affected goods at EU market – downward pressure on prices. Boom in domestic Russian production of imitations of embargoed foods and the possible long-term damage to the image of European products. Alan Matthews (Prof. Emer. At Trinity College Dublin): the alternative markets may not be as remunerative as the Russian market, leading to some losses for food producers nonetheless.

43. Food import to Russia, billion USD and monthly growth rates in 2014 (to corresponding month in 2013)

44. Food import to Russia by country, monthly growth rates in 2014 (to corresponding month in 2013): Developed European countries

45. Food import to Russia by country, monthly growth rates in 2014 (to corresponding month in 2013): Developed non-European countries

46. Food import to Russia by country, monthly growth rates in 2014 (to corresponding month in 2013): Transition European countries

47. Food import to Russia by country, monthly growth rates in 2014 (to corresponding month in 2013): Russia`s allies

48. Simulation results by country: employment and real value added impacts due to adecline in tourism demand and exports (WIFO)

49. Russia-Ukraine economic relations Part 6

50. Russia-Ukraine trade war Reason: pressure on the Ukrainian government to disrupt the signing of association agreement with the EU. In July and Aug. 2013, Russia launched all kinds of trade sanctions against Ukraine, notably against imports of agricultural goods and steel. These sanctions have gradually intensified in 2014. The obvious consequence should be a substantial turn of Ukraine’s trade from Russia to Europe.