Farewell to the economy: Vladimir Milov on how the new round of sanctions will affect Russia

The best indicator of the seriousness of the new steps taken by the Biden administration is the reaction of the Russian authorities. If they really «couldn't care less», they wouldn't go to such extremes as actually expelling the US ambassador simultaneously with recalling the Russian ambassador from the United States (apparently in connection with the impending sanctions), publicly rejecting the much-coveted summit with Biden just proposed by the Americans, and making a slew of radical threats such as «complete renouncement of the dollar» and other unrealistic frighteners. When you really don't care, you don't act like that.

Why do the Russian authorities care? After all, what does it matter even if the US were to place some middle-level Russian officials on the sanctions lists? The government will still protect these public servants, and they have no need to travel to the West. Moreover, the Russian authorities are no longer embarrassed to accord preferential treatment to persons who might become subject to sanctions.

Biden's new package of sanctions contains an important clue - the sanctions targeting Russian sovereign debt, the notorious federal loan bonds (OFZs). The move has been discussed for a long time, and it has infuriated the Russian leadership not because of its immediate consequences, but for two different reasons. Firstly, OFZs are important not so much as a borrowing tool to cover the budget deficit, but as a general indicator of Russia's position in the global financial market. As long as OFZs remained outside the scope of the sanctions, Russia was not considered an outcast by international creditors. Now this is no longer true.

And, secondly, the West has recently been discussing a number of stronger measures to be taken in respect of Putin - these included sanctions against sovereign debt, state-owned banks, Putin's «moneybags» and some of the more radical steps such as disconnecting Russia from the SWIFT interbank system or imposing an oil embargo. If only a small part of these measures - let alone SWIFT or the embargo - are implemented, it will hit the economy hard, cutting off Russia's financial authorities and major corporations from international financial markets and the possibility of purchasing equipment and technologies, effectively blocking the country's economic development.

These are not Iranian-type sanctions yet, by a small margin. Incidentally, “thanks” to Putin for building a rigid system in which the major state-owned banks and state monopolies dominate the largest sectors of Russia's economy, it is now much easier to put entire industries in jeopardy by targeting a few major players.

So, after the large-scale package of sanctions imposed by the United States, the EU, and their allies in 2014 following the shooting down of the Malaysian Boeing over Donbass, no other serious steps followed apart from certain restrictions on some government officials and minor companies in the defense and IT sectors.

Contrary to popular misconceptions, the 2014 sanctions had an extremely serious effect on the Russian economy - corporate borrowers were effectively cut off from international capital markets, which directly resulted in capital outflow and the inability of taking out new corporate loans in the West (a practice Russian companies had been actively engaged in until 2014) and stripped Russia of any prospects of economic growth.

But corporations aside, government loans were almost untouched by the sanctions, and the Ministry of Finance portrayed itself boastfully as “the most reliable borrower” before international investors (Russia had low public debt, a large supply of money in the National Wealth Fund and stable oil revenues - indeed, OFZ investors had nothing to worry about). Investors adored OFZs, their market share peaked at 35% (in March 2020, when the Covid-19 crisis struck and oil prices fell).

Now what?

By themselves, OFZs are not super-critical for replenishing the budget. Although the volume of government debt on those bonds has tripled since early 2015 and increased nearly 20 times in 10 years, it still accounts for just 3% of Russian GDP, and it cannot be said to seriously affect budget stability. Although new bonds are periodically issued, the volume of OFZ borrowing has recently oscillated around the $40bn mark, and Finance Minister Anton Siluanov complained in an interview to Vedomosti that new loans are too expensive for Russia, preventing it from building up its public debt: “Our public debt costs too much. We are now borrowing at 5.5-6.3%, while the developed countries borrow at less than 1%. We already pay over 800 billion rubles annually in interest, if we double our borrowing, we will be paying nearly 1.5% of GDP, that is over 6% of the entire budget – and we will have to cut other expenditure.»

In reality such high interest rates are a payment for the sanctions risk – a “shout out” to everyone who claims that «Western sanctions do not work.» But OFZs themselves are not critical to borrowing. It's just that government bonds are at the top of the Russian debt pyramid. Since our economy does not by itself generate long-term cheap money, we can only borrow it from Western financial markets (China, for which Putin had high hopes, is not a keen international creditor, and mostly lends money to support Chinese exports of goods and services). Our economy actually stopped growing when, in 2014, the corporate sector was prevented, through Western financial sanctions, from continuing its borrowing frenzy.

However, OFZs as the chief instrument of Russia's borrowing have so far remained outside the scope of the sanctions. It was therefore possible for Russia to pretend that the sanctions concerned only individual companies while Russia in general remained a respectable player in the global financial market and in many ways a favorite among international creditors (because of its oil reserve, resplendent NWF, low public debt, and all of that). Biden's new sanctions have changed the situation drastically. Now, the investment memorandum of any Russian borrower will start with a passage to the effect that the entire Russian borrowing system, starting from the very top, is, in fact, toxic and subject to international sanctions. In short, we will not secure further loans. And it is not only US creditors who will stay away from Russian debt for the fear of US sanctions.

The Russian authorities will find a way to balance the budget - they will pump money from state banks into OFZs. In fact, this will turn into emission financing, since the state banks will receive aid from the Central Bank in return, one way or another. But I think we are already beginning to get used to the idea that the period of low inflation is over. And you can kiss economic growth goodbye. That is the price of the new US sanctions - Russia has no internal sources of growth, the notorious government investments and «national projects» (remember those?) just don't work.

But it's not this that makes the situation much worse for the Kremlin, it's the fact that after several years of standoff, the West nevertheless got off the ground and began taking steps that feel more substantial than yet another package of sanctions against government officials, generals and internet trolls. Many in the West expected a new cooling of relations with Putin, and because of this, all OFZ sanctions proposals (there have been many of them) were rejected. But now the ice has broken. This means sanctions against state-owned banks, state corporations, and oligarchs can be expected soon. It is unlikely Russia will be disconnected from SWIFT or subjected to an oil embargo (the embargo will shock the global energy market; as regards disconnection from SWIFT, this has only ever been done hitherto for violation of the nuclear nonproliferation treaty), but these other measures will have very serious consequences.

Putin and Co. are super-annoyed over the recent developments - they have managed to provoke an escalation of the sanctions policy, which has reached a qualitatively new level after the calm of 2014–2021. The fear of taking new, serious steps has been abandoned; the process has started. Contrary to some of the outside observers who are waiting for some «major and final» sanctions, which will make Putin immediately surrender, the Biden administration understands it won't happen and it's better to gradually tighten the screws, leaving room for maneuver. However, the plan for further action is already clear – the House Democratic majority leaders (particularly, the new chairman of the Senate Foreign Relations Committee, Bob Menendez of the Democratic Party) have already called for a continuation and for new sanctions against state banks, oligarchs, and Nord Stream 2.

Putin strongly fears the outcome might not be in his favor, especially amid the rapid recovery of transatlantic relations between the US and the EU and the risk that Europe will impose sanctions similar to the US ones. Russia will become more and more isolated, increasingly dependent on China (which is in no hurry to come to the rescue; in fact, it uses Russia's dependent position to buy its resources at ultra-low prices). Economic problems will only get worse - Putin is already in trouble with his ratings in the run-up to the State Duma elections as 2024 looms ahead of him; according to opinion polls Putin does not have a clear majority in support of the extension of his rule, and most people aged under 40 are against it.

That is why the Kremlin's reaction to the sanctions is so painful. The Anti-Corruption Foundation has also taken a blow in the process. The Prosecutor's Office has demanded that the Foundation be recognized as «extremist», literally on the same day the US ambassador was expelled. I have no doubt that these actions were linked, with the paranoiacs in the Kremlin and the Security Council acting in accordance with their twisted logic: «all the oppositionists are agents of influence of the US.»

So, the Iskanders are no longer laughing, a new round of sanctions has been launched, welcomed by many politicians in developed countries. Soon it will be picked up by Europe, and there will be new measures from the United States. Do not expect a super-bomb such as disconnection from SWIFT - rather, there will be a gradual tightening of the screws. Putin understands this better than any of the pundits who argue about the «insignificance» of the new sanctions. Hence the hysterical reaction and the desire to «show strength in return.» But the forces are unequal – as everybody in the world understands. A new round of international isolation will undoubtedly weaken Putin's position both in Russia and the world. And that is good.

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