Putin’s Challenge and Western Sanctions

We take a step back to explore the bigger picture around the Russia-Ukraine crisis, and how the situation may develop in the coming weeks and months.

Following Russia’s recognition of the breakaway republics of Luhansk and Donetsk on February 22nd, and its invasion of Ukraine on February 24th, western governments and authorities, including the US, UK, Canada, Japan, Australia and the EU have moved quickly to impose sanctions in response. Despite boosting rhetoric, these measures – explained in our updates on the crisis – were relatively measured at first,  but have become increasingly severe. 

Nonetheless, although Ukraine continues to resist, Putin is showing no sign of pulling back, creating doubts over whether sanctions will have an impact quickly enough to make a difference in the battle for Ukraine. Russia is also likely to respond with economic counter-measures of its own soon, while in the longer term, its isolation is pushing it ever closer to China and experiments with an ‘alternative’ financial system that could undermine the impact of western measures. What is likely to result, therefore, is a medium- to long-term economic and financial ‘war of attrition’ between Russia and the West, which will make an understanding of sanctions regimes ever more vital to businesses with potential exposure.  

Previous Sanctions on Russia

As outlined in our report, The Evolving Use of Sanctions, western governments have imposed an increasing number of sanctions against Russia over the last decade, triggered by the Putin regime’s repeated abuses of international law, and its suppression of domestic dissidents. The US, EU, UK, Canada and others have targeted individuals in the state apparatus that have perpetrated abuses, as well as the political and business elite around Putin, the so-called ‘oligarchs’, with travel bans and asset freezes. They have also prohibited commercial and financial interactions with several major Russian state-backed financial institutions, and major businesses in key industries linked to the state, especially the defense, technology and energy sectors. 

The Current Crisis 

Western governments have announced a widening range of  measures since the start of the crisis. Because of the different starting points for each countries’ pre-existing Russia sanctions regime, as well as differing economic and financial links to Russia, there has been some variety of approach. However, these governments have largely followed a coordinated pattern that matches what has come before but on a grander scale, targeting:

• Perpetrators: senior military commanders involved in organizing and conducting the invasion, as well as members of the Russian Duma who supported the recognition of breakaway republics.
• Elites: Business leaders close to Putin, such as Sergei Ivanov, Igor Sechin, Kiril Shamalov, the Rotenberg brothers. Both President Putin and Russian Foreign Minister Sergei Lavrov have also recently been designated by the US, Canada, the EU and UK.
• Russian financial institutions and system: The designation of the largest commercial banks in Russia, such as the state-owned Sberbank and VTB, as well as trade in Russian sovereign debt and Russian operations in western capital markets. The US, UK and EU have also now prohibited dealings with the Russian Central Bank, Finance Ministry and Wealth Fund, and there has been agreement to remove major Russian financial institutions from the SWIFT international payments messaging system. 
• Strategic Industries: Russian companies  in military and logistical operations, technology and energy. Notably, Germany has postponed the certification of NordStream 2, the major gas pipeline between Russia and Germany.  

An Escalating Response

Some experts were initially disappointed by western governments’ actions so far. Tom Keatinge, Director of the Center for Financial Crime and Security Studies at the Royal United Services Institute (RUSI), a major security think tank, commented on 23 February that the UK’s initial measures were likely to be as effective as “taking a peashooter to a gunfight.” 

The UK and other western governments have enhanced the range and depth of measures announced since then, and there are expectations that the measures against Russia’s Central Bank and removal of key financial institutions from SWIFT will have a major impact. In the first instance, Russia will be unable to access around 40% of its $630bn of foreign reserves held in sanctioning jurisdictions, which could otherwise be used to mitigate the effects of western measures – for example by propping up the value of the Rouble. In the second, the partial removal from SWIFT will limit Russia’s capacity in the short-term to manage the international trade in oil and gas, much of which is managed through the major institutions subject to the SWIFT measures. 

However, there are some potential workarounds for Russia in response to these initiatives. A substantial proportion of its reserves sit outside the purview of western sanctions  – 13% are held in China, for example – giving it some limited options for open market operations to support its currency. The lack of a comprehensive removal from SWIFT will also allow Russia to start routing key trade business through smaller institutions that remain on the payments system. None of this ideal, of course, and will undoubtedly create massive financial and economic pain for Russian society. The key question will be whether the pain is enough to make Putin change course.  

Next Moves

Much of course depends on the intentions of President Putin; it is possible that Russian forces will withdraw after receiving a ‘bloody nose’ from the Ukrainian military, which has shown determined resistance. Talks between Russian and Ukrainian delegations now taking place might lead to this, with Ukraine making some minor concessions, for example on the status of the breakaway republics, to allow Putin to ‘save face’. In this event, some of the more severe western financial measures might be waived quickly, in order to encourage Russian compliance with any deal. 

However, this turn of events seems overwhelmingly unlikely, with President Putin committed in his recent public comments to bringing Ukraine within Russia’s sphere of influence permanently. A withdrawal now, without commitments from Ukraine that they will not seek to join NATO or the EU, will be hard for him to portray as anything other than failure. It seems probable therefore that Russian military action will continue, especially as Putin has been noticeably unmoved by the impact of sanctions in the past. 

Room to Escalate

What does this mean for western governments? In the face of continuing Russian action – and Ukrainian resistance – western governments will continue to tighten measures along the lines taken so far, with widening  numbers of designations of implicated state officials, members of the political and economic elite, banks and major industries – especially the oil and gas sectors, which have been relatively lightly touched so far – and further tightening of access to the international financial system. This will mean the designation of more Russian financial institutions, moving from the large to the medium size, along with new tranches of SWIFT removals. Western governments will also actively lobby other states to take similar measures to close loopholes. However, as noted above, current western measures, even if enhanced over time, will still give Russia some room for manoeuvre, especially in China, India and other large countries remain purposefully neutral and willing to interact with the Russian economy. As Iran and North Korea have demonstrated, authoritarian regimes can continue to defy western standards indefinitely if they are willing to allow their people to suffer.

Countermeasures and the China Option

If the conflict does continue, moreover, Russia itself will respond to western sanctions with its own economic and financial countermeasures. Initial Russian retaliation looked likely to be carefully calibrated; according to Russia Today on February 25th 2022, Valentina Matviyenko, the head of the Russian Senate, said that a Russian sanctions package would target western “weak spots,” but it would not mirror western actions, nor involve restrictions on gas exports. However, whether this position can hold in the event of a protracted conflict seems doubtful. If President Putin is willing to threaten western countries with nuclear retaliation, it is probable that he is also willing to consider applying the ‘gas weapon’ against western European countries that remain highly dependent on Russian supplies. 

A further effect of the western response to the conflict will be Russia’s increasing movement into China’s economic sphere. The relationship between the two countries is already close, and China has condemned western sanctions against Russia as inappropriate. As suggested above, Russia is likely to look to China as a partner in mitigating the impact of sanctions, firstly through accessing its foreign reserves in China, but possibly also through using China’s ‘rival’ to SWIFT, the Cross-Border Interbank Payment System (CIPS), which settles payments in Yuan. In light of the fundamental dislike of both countries for western economic statecraft, the current crisis seems likely to widen the scope for Russo-Sino cooperation, which might yet eventually evolve into a ‘parallel’ financial system. If this were to occur, it would, of course, severely undermine western governments’ capacity to affect the behaviour of any state that belonged to the alternative system. However, CIPS itself is still dependent on SWIFT to send messages at present, limiting its value for Russia, and China, which has a vital economic relationship with the US, is unlikely to push to create a genuinely ‘alternative’ financial system soon. Still, it remains a realistic long-term possibility, and something for businesses with relevant exposure to keep a watchful eye on.  

Challenging Years Ahead

Overall, the current picture suggests a challenging year – in fact years – ahead for businesses managing potential sanctions risk exposure to Russia. Western sanctions designations will expand, tranche by tranche, as long as Russian forces are active in the Ukraine, and probably after the end of the ‘official’ conflict. Recent events have fundamentally changed western governmental attitudes towards President Putin; it is hard to imagine a step back towards better relations under his leadership. If businesses are going to manage those risks, therefore, they will need to be prepared with comprehensive,  reliable, and most of all, up-to-date information. 

Originally published February 25, 2022, updated March 1, 2022