EU-Russia Relations & the Sanctions Saga

EU-Russia Relations and the Sanctions Saga

 “I cannot forecast to you the action of Russia. It is a riddle, wrapped in a mystery, inside an enigma; but perhaps there is a key. That key is Russian national interest.”
—  Sir Winston Churchill

On April 28, the lower chamber of the French Parliament passed a resolution that called on the government to cancel the sanctions against Russia which were imposed by the EU in 2014 over Moscow’s takeover of Crimea and its support for pro-autonomy rebels in eastern Ukraine. The resolution, which was promoted by 85 deputies from the Republican Party, again brought to light the toothless EU sanctions against the mighty Russia that have, till now, been counterproductive. The advocates of the resolution believe that Russia’s counter-sanctions have discouraged French food companies and have created obstacles for them to return to the Russian market. They further argue that if sanctions are prolonged, the French companies will suffer even more than the Russian ones.

After the Russian annexation of Crimea in March 2014, the European Union (EU) slapped an array of sanctions on Russian individuals and businesses. These sanctions ranged from asset freezes and suspension of development loans to travel restrictions and a limited access to primary and secondary capital markets in the EU, and so on. Although these sanctions have been extended many a time in the past, yet each time they come up for renewal, speculations arise that some EU members might break ranks and vote against the trade and financing restrictions. In recent months, several European politicians and businesses have called for, at least, a partial lifting of sanctions imposed against Russia. The latest in this series is the vote in France’s lower house of parliament by which lawmakers have urged lifting of sanctions.

This viewpoint is in a stark contradiction to the position traditionally maintained by the European Council which has linked the lifting of economic sanctions to a “complete implementation of the Minsk Agreements,” which would involve reversal of Russia’s military presence in Ukraine’s Donbas region. However, it is hard to deny that without complete implementation of the Minsk Agreements, any lifting of economic sanctions would be an unwarranted act of appeasement.

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The proponents of a softer Western stance toward Russia often try to shift the debate away from considerations of international law, European security and Western unity, and toward calculations of commercial interests. They portray themselves as more pragmatic and realistic than their opponents. They often downgrade the national security concerns of Eastern European states, in favour of the ostensibly more tangible benefits of better business relations with Russian entities. Many of their arguments centre on the Russian market’s presumably high importance today and supposedly large potential in the future. This vision leads to permanent complaints, from EU businesses and their lobbyists, about allegedly high costs resulting from additional extensions of the sanctions regime.

In the last two years, EU-Russia economic ties have undergone a sharp downturn. According to Eurostat’s balance of payment statistics, the EU’s exports of goods to Russia peaked in 2012 at 122.1 billion euros, and stood at just 73.1 billion euros in 2015 (a fall of around 40 percent, EU exports of services to Russia peaked in 2013 at 30.3 billion euros, falling to 24.4 billion euros in 2015, a fall of 19 percent). Investment income (inflows) from Russia into the EU went from 26.7 to 19.1 billion euros between 2013 and 2015 (a fall of 28 percent).

At first glance, these figures could suggest grave effects of the Western sanctions and of Russia’s so-called counter-sanctions on the EU economy. But this is not the case. First, the EU economy has come out rather well. While some sectors and businesses have suffered more than others, the EU economy as a whole has shrugged off these developments as other markets have, to varying degrees, filled the gaps. Overall, in spite of the Russian economic downturn, the EU’s total goods exports rose from 1,692 to 1,785 billion euros between 2013 and 2015. Over the same period, services exports increased from 700 to 811 billion euros, and investment income from 541 to 580 billion euros.

Second, the sanctions were not the leading cause for the fall in trade with, and the fall in income flows from, the Russian Federation. Most of the decline was driven by Russia’s recession and by the depreciation of its currency, both of which occurred primarily due to the steep fall in oil prices that unfolded from late 2014. Structurally, Russia’s economic problems have far more to do with the country’s high dependence on revenues from raw materials exports (chiefly crude oil, oil products, and natural gas) as well as a lack of competitiveness in other areas of economic activity. The latter situation is exacerbated by institutional weaknesses, unpredictable state interventions in the economy, high levels of corruption, and a worrying decline in Russia’s working age population. Western sanctions, and Russia’s partly self-defeating ban on Western food imports, have played a lesser role.

The most cited estimate of the impact of sanctions on the Russian economy comes from the IMF, in its August 2015 Russia country report. It suggests a fall in GDP of 1 to 1.5 percentage points for the first year of the sanctions. These figures should be put in the larger context of Russia’s 2015 recession, in which real GDP shrank by 3.7 percent. Russia’s current equilibrium growth rate, assuming a stable oil price, appears to be around 1.5 percent. The total size of Russia’s 2015 downturn, as compared to that equilibrium, was therefore somewhere around 5 percent. Thus, the impact of sanctions may have amounted to between a quarter and a third of the total downturn.
As mentioned, losses to the EU have been well contained as the Union’s total exports and investment incomes have gone up, not down. The Russian market’s current importance for the EU is thus low. Official balance of payment statistics reveal a picture at odds with the rhetoric of Kremlin-friendly lobbyists. In 2015, Russia’s importance for the EU, as a percentage of the world total and excluding intra-EU flows, was 4.1 percent for goods exports, 3.0 percent for services exports, and 3.3 percent for investment income. For comparison, the United States’ share in the EU’s revenues from foreign economic relations stood, in 2015, at 21.3 percent for goods exports, 26.1 percent for services exports, and 28.5 percent for investment income.

Looking to the mid-term future, most economic forecasters assume that sanctions will be lifted at some point. These assumptions are not political predictions, let alone political opinions. Rather, they are part of the working assumptions that need to be plugged into the mathematical models that economists use for their forecasts. For example, in its latest World Economic Outlook from April 2016, the IMF assumes, implicitly, that conditions will return to “normal” from 2018. The IMF also assumes that the average price of oil will be US$34.75 a barrel in 2016 and US$40.99 a barrel in 2017, and will remain unchanged in real terms over the medium term.

Using the IMF’s projections for Russian GDP growth and for the ruble exchange rate, we construct a rough estimate of the EU’s future income flows from Russia in 2020, as compared to its income values from the rest of the world. For each type of flow separately (goods exports, services exports, and investment income), our assumption is that the ratio between the size of the flow in euros at current prices, and an EU partner’s GDP in euros at current prices, will be the same in 2020 as it was, on average, between 2010 and 2015. These ratios are then multiplied by the IMF’s forecasts for Russian GDP, and for world GDP, in 2020, converted into euros. Our approach assumes that the EU’s market penetration ratios, in Russia as well as in the world economy as a whole, will be at similar levels in 2020 as they were over the 2010-2015 period.

On the basis of these projections, we suspect that even if sanctions are fully lifted, trade and investment income flows with Russia are unlikely to recover to, let alone surpass, their peak levels of 2012-2013. For instance, we estimate that goods exports to Russia could be below 100 billion euros at current prices in 2020, as compared to the peak level of 122 billion euros in 2012. Immediately before the escalation of the so-called “Ukraine crisis,” Russia’s share in the EU’s foreign trade revenues was 7.1 percent for goods exports, 4.3 percent for services exports, and 4.9 percent for investment income. Our projections point to a steep fall — even if sanctions are lifted by 2018 — in Russia’s relative importance for the EU in 2020 to around 3.9 percent for goods exports, to around 2.4 percent for services exports, and to around 2.4 percent for investment income.

The main reason why our 2020 projections are so low is that, according to the IMF’s forecast, Russia’s GDP, when expressed at current prices and converted into euros, could still be lower in 2020 than it was in 2013. The IMF forecasts a positive but quite subdued recovery in Russian GDP when expressed in rubles, in combination with a slow and incomplete recovery in the value of the ruble. Of course, caveats, as always, apply. Above all, the oil price could recover much more strongly than the IMF currently assumes. As a result, the Russian economy, and its currency, would recover more strongly. Our predictions are also speculative insofar as they proceed from a ceteris paribus condition — that all other factors will remain equal. Many things could, however, change in the next five years.

We, nevertheless, make the following four conclusions. First, the Russian market was, in comparative terms, of limited importance to the EU even at its peak in 2013, when the price of oil was above US$100 per barrel and the ruble was strong. Second, this already small Russian share in EU trade has been further reduced by the combined effect of the oil price slump, Western sanctions, and other repercussions of the Kremlin’s aggression against Ukraine, its Syria campaign, and its clashes with Turkey, as well as various other economically damaging actions. Third, a partial recovery from the low levels of 2015 is possible in the medium-run, but cannot it be taken for granted.

Fourth, whether a recovery happens or not, Russia’s relative economic importance for the European Union — its share compared to other markets — will, for many years, be below or even far below what it was before the Ukraine crisis.

Extrapolating dated experiences into the future leads to illusory expectations. Policy recommendations should not be based on loudly circulated misperceptions. Russia’s large geographic size and prominent role in international diplomacy should not mislead Western decision-makers into seeing opportunities that are not there, at least in the near future. A possible lifting of sanctions, if discussed, should thus follow a political and security-based logic, rather than one based on narrow commercial interests. Specific EU businesses would almost certainly benefit from a relaxation of sanctions, but the effect on the EU economy as a whole would be very marginal.

To be sure, post-Soviet Russia’s considerable human and natural resources contain great promise. However, Moscow’s current rulers were not able to bring this potential to fruition in the recent period of favourable conditions. During the first decade of the new century, although energy prices were high and Western countries were eager to develop partnerships, Russia did little to modernize itself before the window of opportunity closed in 2014. For more than ten years, high oil and gas prices enabled the Kremlin to paper over the deep structural defects in the Russian economy. This period of (self-)deception is now over, both for the people of Russia and for their foreign partners. The Russian market they knew does not exist anymore, and will not reappear in the foreseeable future.

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