Who is winning the economic war after one year (Europe or Russia)?

Who wins the economic war after one year (Europe or Russia)?

 

One year ago, an alliance of Democratic states led by the G7 responded to Russia's invasion of Ukraine by declaring economic war

on Russia, an economic war that wasn't fought with weapons. No, no. It was fought with sanctions that would, in the words of European

Commission President von der Leyen, be imposing. Massive costs on Russia, costs that will further isolate Russia from the international financial system and our economies. And the goal of these sanctions was then. To cripple Putin's ability to finance his war machine.

 

But now Putin's war machine is the one preparing for a new offensive. While the G7-backed Ukrainian army is reportedly running out of resources. So after one year, why did sanctions against Russia fail to live up to expectations?

 

To answer that question, we first need to recap some of the major sanctions and countermeasures of the economic war. Then we can judge how much sanctions have actually hurt the economies, currencies, and war effort of both Russia and the allies. We can then use this to extract some key lessons learned which will, in turn, help us to assess what the next phase of the economic war might look like. So let's get back in time right before Russia's invasion.

 

Before the invasion of Russia in Ukraine

 

Just before the war, despite quite a few sanctions already being in place since Russia's invasion of Crimea in 2014, there was still a heavy trade dependence between the European allies and Russia. While the alliance of countries that sanctioned Russia for a large part consists of giants like Japan, South Korea, and the United States,

I will mostly focus on European countries because they have the tightest integration with the Russian economy. When it comes to trade, you could roughly say that Europe relied on Russia for raw materials and energy in the form of oil and gas. At the same time, Russia depended heavily on Europe for medicines as well as advanced machinery and microchips. On the financial side, European banks financed the development of technologically advanced industries and notably the exploration of difficult-to-reach energy fields. At the same time, many of Russia's oil profits were invested back in European financial markets, as well as in real estate and prestige projects such as football clubs like Chelsea, especially in the UK. When it comes to the exchange of people between these two economies,

 

Russia's oligarchs famously love to spend their energy profits on London real estate and yachts in the Mediterranean. Although since Russia's invasion of Crimea in 2014, this trend had already started to reverse somewhat.

 

What's more, from this point onward, migration from Russia to Europe accelerated. People even called it a brain drain as hundreds of thousands of highly educated young Russians emigrated to work and start businesses in Europe and beyond.

At the same time, thanks to its gigantic trade surplus, Russia had assembled a $600 billion war chest of foreign exchange reserves. The idea was that in the unlikely case that Russia was to be sanctioned, its central bank could use these reserves to buy rubles and thereby prevent it from collapsing.

Now, to avoid losing these reserves, Russia was keen to minimize the number of Western currencies in its war chest. However, because of how dominant the dollar and euro were, a large part of Russia's war chest still consisted of European assets.

Given their dependence on Russian energy, Putin had gambled that the Europeans were far less likely to mess with these reserves than the Americans. So with a full war chest to defend the ruble, Russia began its invasion of its sovereign neighbor, Ukraine. In response, the Allies announced two types of sanctions against Russia financial sanctions and trade sanctions.

 

Russia's financial sanctions and trade sanctions

 

Let's focus on financial sanctions first. These types of sanctions severely limited the ability of Russia's state central bank, private banks, and elite individuals to transfer, borrow and hold money through the dollar-dominated global financial system.

 

And based on the success of financial sanctions against Iran in 2010. The hope was that Russia's currency would quickly collapse, leading to sky-high inflation and an unhappy population, and then hopefully a Russian retreat. Of course, Russia's war chest stood in the way of that. Therefore, in an unprecedented move, Europe, Japan, and the United States moved together to freeze over 60% of Russia's war chest. And in practice, this meant that while Russian banks and their central bank still technically owned various deposit accounts and bonds in allied banks, they can no longer use them to stabilize the ruble. In shock, both the Russians and non-Russians tried to get their money out of Russian banks and financial markets as quickly as possible.

 

This caused the ruble to lose more than 40% of its value, which in turn led to sky-high inflation in Russia. Around the same time, thousands of Russians started protesting the war. So at that point, financial sanctions seemed to work precisely according to plan, just as they did in Iran in 2010. And if that wasn't enough, Russia's elites were hit hard by financial sanctions that were specifically targeting their European bank accounts, townhouses, and gigantic yachts.

 

But did sanctioning Russia's elites actually make a difference? You see the hope of Allied countries had been that even if the people wouldn't be able to convince Putin, then Russia's rich oligarchs would surely pressure him to change course. However, what I've read and heard from experts on Russia is that since these elites get their riches and power from the regime, they are too dependent on Putin to actually challenge his authority.

 

They were hurt tremendously by allied sanctions. However, only very few elites ended up speaking out against Putin, and those who did subsequently were moved to less influential positions, died mysterious deaths, or understandably fled the country. The response of the Russian government to the people protesting in the street was equally brutal, arresting thousands of protesters. And in March, Russia's government even signed a law that stated that those that spread what the state deemed to be fake information could face up to 15 years in jail.

 

So then, rather than change Putin's mind, hundreds of thousands of Russians decided to vote with their feet and flee the country. This is already where we see that while sanctions do have a big impact, they don't always work as intended.

 

What's worse

 

Now it was time for Russia to start making its own moves in the economic war. First, they employed financial countermeasures when in response to people trying to get their money out of Russia, Russia's central bankers raised interest rates, and that raised the attractiveness of the ruble. But more importantly, they imposed strict capital controls, limiting the ability of people to actually sell their rubles.

 

Next, Russia basically imposed trade sanctions on Europe when it sharply reduced the flow of natural gas to the continent. Now, because you mostly relied on gas through these pipelines, it wasn't easily able to replace it with gas from other providers. Therefore, the Russian energy squeeze caused the price of energy in Europe to increase tenfold, which in turn led to sky-high inflation and a dire cost of living crisis.

 

This then led to big anti-war protests in Europe rather than in Russia. At the same time, soaring energy prices meant that even though Russia sold less gas, it made more international money than ever to convert into rubles. And this, along with restrictions on selling rubles, meant that the ruble was not only recovering, it became stronger than ever.

 

The second type of sanctions (trade sanctions)

 

But not surprisingly, around this time, the allies increasingly emphasized that the second type of sanctions, The trade sanctions, were actually the important ones and that they were in fact, working. Remember that Russia relied on the allied nations for high-tech chips and machines to make and maintain advanced weapons systems? Well, many of the allied trade sanctions were precisely aimed at preventing these goods from reaching the Russian economy.

 

And in the second half of the year, they indeed seemed to be working while Russia stopped publishing its import statistics, which is already suspicious. Sign export statistics from other countries revealed that Russian imports were way down.

Then over the summer, Russia's war efforts stalled. And while it's hard to separate the impact of trade sanctions from Russian military blunders or Ukrainian successes, increasingly there were reports that Russia's army was indeed suffering from microchip and manpower shortages. So at this point, it seemed that trade sanctions were doing real damage both to the Russian and European economies.

 

However, this was before both economies started adapting to the sanctions first and in the name of the free power, the EU plan. Europe surprised basically everyone by rapidly reducing its dependence on Russian energy in three main ways. First, it managed to build a liquefied natural gas or LNG infrastructure off its coast at unprecedented speed.

 

This allowed it to completely switch to alternative gas suppliers such as the US and Qatar. Second, for some of its energy needs, Europe was able to switch to alternative sources of energy, such as coal, diesel, and renewables. Finally, and really importantly, Europeans were able to reduce their energy demand in relatively painless ways by improving the efficiency of houses, machines, and business processes. Both energy prices and the ruble started to fall again, and Europe felt confident enough to start imposing sanctions on Russia's crucial energy sector.

 

This was important because, as research analyst Edwards Fishman said. “The way I look at it is, you know, trying to, you know, impose significant sanctions on Russia without touching its oil sector is sort of like trying to master Russian literature without reading Tolstoy”.

 

So after diversifying away from Russian oil, the allies imposed a price cap of $60 on Russian oil, meaning that if any ship that transported Russian oil above that price couldn't be insured by the allied insurance companies that dominated the market.

 

But while initially, the price cap seemed to work surprisingly well, it recently became clear that Russia has assembled a so-called shadow fleet of tankers that allowed Russian oil to bypass sanctions on an industrial scale. To make matters worse for the allies, the Russians also reduced their dependency on Western goods. The first way that they did so was through a process that famous economist Branko Milanovic has dubbed technologically regressive import substitution. And with this, it means replacing imported goods with inferior old-fashioned domestic substitutes for Russia.

 

This meant that U.S. companies didn't have access to advanced allied machinery. But when, for example, Russian firms could no longer replace their Japanese engines in their forklifts, they just installed old engines from Belarus. These are inferior products, so this will reduce the efficiency and therefore competitiveness of Russia's industry in the long run. But it works quite well in the short run, making allied trade sanctions much less effective.

 

Now, the second way that Russia does its sanctions is through alternative suppliers. Recent reports indicate that China is now providing

many crucial goods, such as microchips, to Russia. Third, thanks to a gigantic smuggling industry operation via Russian neighbors, allied chips are once again showing up in Russian missiles recovered in Ukraine. This has a weakened sanction so much that Russia is now apparently importing more microchips than before the war started. And that brings us to today.

 

So who is winning the economic war after one year?

 

After an initial shock, trade and financial sanctions from both sides are now far less effective. That being said, Europe is still dealing with energy prices that are uncomfortably high. And at the same time, Russia's economy is far less competitive when it comes to anything other than exporting raw resources than it used to be.

 

Let's finally answer the question who is winning the economic war after one year? Well, to assess this, we need to keep in mind that the original goal of sanctions was to stop or reduce the war effort by creating economic pain and inflation. So let's start by looking at inflation. When looking back at the year.

It became clear that both economies were hit by sky-high inflation that then later subsided. But whereas inflation in Russia doubled from 6.7% in 2021 to 13.7% in 2022, it nearly quadrupled in Europe, soaring from a low value of 2.45% to a quite remarkable 9.2% in 2022. Now, of course, not all of this was due to the economic war, but given that a large part of Russian inflation happened right after the ruble crashed in March and Europe's inflation peaked right after energy prices peaked in summer,

we can safely assume that the economic war played a major role. So if we look at the raw percentage increases of inflation, both economies lost the economic war on fairly equal terms.

However, compared to its history of low inflation, the relative change was more extreme in Europe. And therefore I think that on the inflation front, Russia lost a bit less than Europe. But what about GDP? First, let's be clear that the Russian economic performance really surprised both Western and Russian analysts. The latest estimate I read, is that correct for inflation, the Russian economy shrank by 2 to 4% last year. That is much better than the international estimates of -50%, as well as leaked Russian estimates of -8% during the year.

 

What's more, current IMF estimates for Russia are that it will grow by 0.3% next year, which is more growth than, for example, it expects for Britain in 2023. But it also has to be said that against Russian expectations, Europe's gas-starved economy is also predicted to grow by 0.3% next year, and that is after it narrowly escaped a recession in 2022. So on average, while it definitely hurt Europe's economy, still quite a bit better than that of Russia and is likely to have a rosier future, given that hundreds of thousands of working-age Russians left the country or died on the battlefields of Ukraine. So on average, I'd give this one to Europe. Even though Russia's economy has proven surprisingly resilient. Finally, when it comes to the war effort, it is clear that sanctions failed to cripple the Russian war machine. And similarly, Russia's energy weapon did not discourage the Europeans from imposing sanctions on Russia and supporting Ukraine as the Russians had hoped.

 

So in this key category, the result is inconclusive. And therefore, I do understand that people would say that sanctions have been a failure. After all, even though Russia's economy was hit the hardest, allied sanctions did not achieve their ultimate goal of stopping Putin's war machine. But let's not forget that the economic war had a gigantic impact on the lives of everyone, in the form of inflation, loss of property, and by blocking the movement between these once-so-integrated economies. What's more, many advocates of sanctions believe that even if they didn't stop the war and this failed, sanctions have still sent a powerful signal that invading your neighbors isn't without a cost.

 

So now that we have discussed the complete sanctions timeline and the end result, here are my five takeaway lessons about the economic war.

 

Lesson one.

 

Assets held in the Allied Financial system are no longer completely safe, but at the same time, you could say that for most countries

they are still completely safe. As long as you don't invade your neighbor, which shouldn't be that hard anyway.

 

The second lesson

 

Russia has shown us that financial sanctions can be countered by raising interest rates and imposing capital controls. As long as you run a sizable trade surplus.

 

The third lesson

 

By the oligarchs, “ financial sanctions against individuals don't pressure the government. If elites have more to lose from their government

than from allied sanctions.

 

Fourth lesson

 

Europeans and mostly the Germans have now learned the hard way, and that is that it is no longer the best strategy to heavily rely on one trading partner for crucial supplies that are difficult to replace, such as pipeline gas.

 

Conclusion

 

Now, finally, both Russia with its energy weapon and the allies with trade sanctions, are now finding out that the longer trade sanctions are in place, the more they will be avoided, either via reduced demand, technologically regressive import substitution, alternative suppliers, and or smuggling operations.

Although it should be noted that in the long term, sanctions can still make an economy like that of Russia much less competitive on the global stage. So then what are the implications of all of this for the next phase of the economic war? Well, for a large part that depends on the actual war in Ukraine. If Russia stops fighting, some of the worst sanctions could be eased, although the allies haven't really given Russia a clear indication that if that happens, they will actually be eased. So if sanctions remain in place from both sides, we would likely see a stabilization scenario where things slowly return to normal, but where energy prices remain elevated. In Europe. Well, trading with Russians in general remains very difficult.

 

Still, that scenario is much better for the world than a complete escalation of the economic war, something that could potentially happen if China would come to believe that given that Russia's economy was surprisingly resilient, it can also handle allied sanctions and decides to invade Taiwan. Sanctions against China would be far worse for the world because the Chinese economy is just so much bigger than that of Russia. So with that context, I think it makes sense that more and more economists that I follow are saying that we could already be in a second Cold War. And if that is correct, then we could look at the first Cold War to get an idea of what happens next economically.

Probably the emergence of separate trade and financial systems that are dominated by three blocks. The first block consists of the United States and its allies, and the second block consists of China and its allies. And there might also be a third bloc that consists of countries

that are trying to get it both ways and do business with both sides. One of the most important signs that this is actually already happening is that China has been working hard behind the scenes to promote its currency, the renminbi, as payment.