All entries for Monday 30 May 2022

Can Western sanctions on Russia be effective without an energy embargo?

Writing about web page https://www.economist.com/finance-and-economics/2022/05/13/russia-is-on-track-for-a-record-trade-surplus

Yes, Western sanctions on Russia can be effective without an energy embargo. If "effective" means enough to raise the costs of Russia's war effort and undermine its sustainability, then Western sanctions are already effective. Adding an energy embargo is not only unnecessary but might also get in the way of Western support for Ukraine.

This argument seems to fly in the face of the conventional wisdom, so I will present it as carefully as I can. Objections and counter-arguments are welcome.

Russia is a major exporter of energy to the world, including the West. From the first days of Russia’s invasion of Ukraine, it has been said that by paying a billion Euros a day to Russia, Western economies are effectively paying for Putin’s war. There have been corresponding calls for an immediate Western embargo on Russian energy, despite the wrenching adjustments that this would require.

Who stands to lose more by stopping Russia’s energy exports? When Putin’s war is grinding on far longer than anyone anticipated, the argument that it is paid for out of Russia’s export revenues suggests that Russia must be desperate to keep its place in the world energy market. Meanwhile, most Western powers are working hard towards an embargo on Russia’s exports. They are also expending considerable political capital on efforts to bring backsliders into line, notably Hungary.

Yet Russia itself does not look desperate to maintain its export markets. Rather, the Russian government sets obscure financial conditions for Western buyers, such as payment in rubles, and has already halted gas supplies to Poland, Bulgaria, and Finland.

It seems that both sides are treating Russian exports as their own weapon. While NATO threatens Russia with a stop on purchases, Russia threatens NATO with a stop on sales.

If you find this confusing, then you’ve been paying attention. Too many Western commentators have fallen victim to an old mercantilist error—that the strength of an economy is measured by its ability to attract gold from others through its export trade.

What are the underlying facts?

First, Russia has a large and growing export surplus. The Economist puts last year’s trade surplus at 7.5 per cent of Russia’s GDP . This year, it is expected to rise to 15 per cent of last year’s GDP (this year’s GDP will be smaller by an unknown amount, perhaps 10 or 20 percent, pushing the share of the trade surplus still higher).

The reason for Russia’s growing export surplus is that, while exports are holding up, imports from a broad sample of Russia’s trading partners are collapsing—running at half the level of before the war’s outbreak. Why? There are two possibilities. One is that Western sanctions on Russia’s imports are working. The other is capital flight—holders of ruble balances are converting them into Western currencies, causing the ruble exchange rate to decline sharply and pushing up import prices for Russian consumers. In the short run it does not matter which.

An expert quoted by The Economist finds Russia’s growing trade surplus “disappointing.” Although sanctions on Russia’s imports may be working, it seems we are still buying Russian energy exports at levels similar to before. We are still “paying for Putin’s war”—or so it is said.

To understand what Russia’s growing trade surplus really means, it’s necessary to recall that the money flows are the counterpart of flows of real resources. As money flows into Russian hands, real resources flow the other way. If Russia’s trade surplus will be 15 percent (or more) of its GDP this year, then in terms of the real resources produced Russia is sending the same proportion of its domestic product abroad to be utilized by foreigners.

How does that matter for financing Putin’s war? It is sometimes said that GDP is a measure of a country’s capacity to fight a war, and this is correct—approximately. But when the shooting begins, wars are not fought with GDP. They are fought using the real resources available. For this purpose, exports are not available. What is available is domestic production not exported, plus imports.

The national accounting concept of the resources available to a country at war is not GDP but “domestic absorption”—the total of domestic expenditure, including expenditure on net imports.

With percentage points of last year’s GDP as the units, Russia’s trade surplus of 7.5 units left 92.5 for domestic absorption. This year, absorption will fall by the fall in GDP (say 20) plus the increase in the trade surplus (7.5), so 27.5. A GDP decline by one fifth becomes an absorption decline by nearly one third.

Two things follow. One, the fact that Russia is exporting one seventh of its national income to the rest of the work is weakening, not strengthening its war effort. Two, Russia’s exports are not “paying for Putin’s war.” They are certainly paying for something, but not that. What they are paying for is the accumulation of idle balances of foreign currency. This currency may be held by the state (within Russia) or by private citizens abroad (in the case of capital flight). But, if they cannot be used to import resources into Russia, they are not paying for Putin’s war.

A reality check is available. In two World Wars, the Allies blockaded Germany to prevent the import (not export) of resources. In both wars, Germany responded by confiscating resources from the countries it occupied, just as Russia today is accused of stealing grain and other valuables from Ukraine. In fact, in World War II Germany’s plan of overland occupation of the Eastern territories was designed in the expectation of an Allied blockade German overseas trade. It has been calculated that net imports from Germany’s wartime empire paid for more than one quarter of Germany’s war effort. Net imports, not net exports!

What are the implications?

• First, Western sanctions are working. They are working either directly (by cutting Russia’s imports) or indirectly (by causing capital flight). By the measure of real resources, Russia’s economy is suffering arterial blood loss at an increasing rate
• Second, Russia’s most likely retaliation will indeed be to reduce exports by cutting off energy supplies to the West. The rationale for this will be not only to damage Western economies but also to redirect capital and labour from the energy sector to Russia’s war sector.

It is sensible for Western countries to prepare for this. An efficient way to do so is to impose a tax on purchases of Russian energy, reflecting the risk attached to continued reliance. But it is also wise to ensure that, when the pinch comes, the blame for the disruption is seen to lie where it should belong, with Russia.

• Fourth, by pressing the unwilling, not only in Hungary but potentially in all Western countries, to do without Russian energy before the need arises, we are pointlessly spending NATO’s political capital (and sympathy for Ukraine) while exacerbating the national and social divisions on which Putin relies to make progress.
• Finally, are there risks in allowing Russia to continue to accumulate financial claims on Western economies accruing from energy sales? Yes, but as long as sanctions on Russia’s imports and financial institutions remain in place these risks are long term. The shape of the long term will be decided by the outcome of Putin’s war, which is being decided now.

It is far more important for everyone to do what it takes to win that war now, including focusing on Ukraine’s military needs, than to be distracted by worry about the distant financial implications of continuing to buy and pay cash for Russian energy while we can -- cash that Russia cannot currently spend.

Mark Harrison : 30 May 2022 14:34 |  Tags: Energy Russia Sanctions Ukraine War |  Comments (0) |  Close comments |  Report a problem