Sanctioning Russia: An Effective Response or Just Prodding the Bear?
Much ink has been spilled in recent weeks as commentators weigh in on the range of policy options available to western governments in the wake of Russia’s de facto annexation of Crimea, and the considerable risk that it continues to pose to the stability of Ukraine’s post-Yanukovych government. A western military response has been ruled out for all intents and purposes and debate has focused on the political and economic measures available to try and coerce Russia to change its behavior. Initial responses were limited to suspending a number of bilateral and multilateral diplomatic contacts with Russia. However, earlier this week, the United States, Canada and the European Union all announced travel bans and asset freezes against a number of officials in both Russia and Ukraine.
Many have argued that sanctions will see Russian president Vladimir Putin reap an economic whirlwind that will cause him to regret his adventurism in Crimea. German Chancellor Angela Merkel, for instance, said that Russia would face “catastrophe” unless it changed its behavior, and President Obama said that Russia faced measures that would only “exact a greater toll” on its economy. At the basis of this thinking lies the recognition that many prominent Russians have chosen to invest their assets in western countries and financial institutions. Cut off from their assets in the west—so the thinking goes—and targeted individuals will quickly feel the pinch. Make that pinch painful enough and they will pressure Putin to change his policies and to allow Ukraine to undertake necessary political and economic reforms free from Russian interference. The reality is, however, that enforcement of these kinds of sanctions can be both difficult and time consuming. On the other hand, Russia could resort to its own form of economic retaliation with methods that have a rapid and material impact on western financial interests.
With the first round of sanctions against Russian officials now in place, it is important to recognize that their enforcement will be a complicated process. In an era when billions of dollars can move between bank accounts at the touch of a button, transferring assets beyond the reach of sanctions is entirely feasible. Moreover, the time required to undertake such preventative measures is far less than the time taken by governments to debate the sanctions provisions themselves.
Russia appeared to recognize the inevitability of sanctions last week. The Wall Street Journal speculated that the Russian government was responsible for the withdrawal of $105 billion in Treasury securities held in custody accounts managed by the U.S. Federal Reserve. If true, those bonds could have been moved very quickly into offshore accounts that are currently beyond the reach of any financial sanctions imposed by the United States or the European Union, even if the Russian state itself was targeted, which it was not. It is not beyond the realm of possibility that individuals who suspected that they would appear on any sanctions list would have undertaken similar precautions with assets they held themselves.
Even where funds or assets remain onshore when sanctions take effect, the process of linking them to sanctioned individuals can be highly complicated due to the legal structures surrounding their ownership. Property and bank accounts are often not held in the names of individuals, but owned by a perfectly legitimate chain of offshore holding companies, nominee shareholders, and other similar vehicles that can make the process of linking a particular asset to a named individual very difficult. If any of those companies are located in countries that are not party to the sanctions regime, the trail can quickly run cold. While a number of efforts have been undertaken in recent years to increase transparency in the financial services industry—specifically to facilitate the implementation of sanctions and the necessary due diligence that accompanies them—such measures are by no means foolproof. It could, therefore, take weeks or months for these types of sanctions to have any measurable effect, if at all.
Contrast this to retaliatory measures that Russia could choose to take. Earlier this month, Russian lawmakers announced that they were drafting legislation giving the government power to seize the assets of western companies doing business in Russia in the event that Russia was targeted for economic sanctions. It remains to be seen whether the sanctions announced this week will spur progress on that legislation; however, any retaliation against western companies could be enacted with much greater ease than is the case for those trying to enforce sanctions in the U.S. and the EU.
In 2013, Russia was the world’s third largest recipient of foreign direct investment (FDI) after the United States and China. Much of this inbound capital came from Russian companies and individuals routing funds out and back through offshore jurisdictions for tax and other reasons (so-called “round tripping”) but a significant portion of that FDI is attributable to foreign companies investing in Russia. Their investments will be easy to identify. They will often take the form of physical assets that bear the brand names or logos of western companies, or they will be registered in the names of Russian subsidiaries of those companies.
It is highly unlikely that Russia would choose to wage all out economic warfare against every western company doing business there. Regardless, a number of these companies will have concerns that they might be chosen as a target for symbolic retaliation in the wake of any economic sanctions imposed on Russia. At least one group of policy advisors recognizes that the situation may devolve into an economic tit-for-tat. The viewpoint expressed by them and others is that western governments will need to accept such responses by Russia and pursue sanctions regardless in the interests of the broader political stability in Europe that sustained pressure on Russia could yield.
Given the very differing nature of investment traffic out of Russia compared with that into the country, the question will need to be asked about where the effects of this sustained economic warfare will be felt first. Targeting the assets of selected Russian officials could, as already noted, take weeks or months to enforce given the need for careful due diligence to identify assets to be frozen. If anything, we can be certain that western governments will undertake such actions scrupulously and to the letter of the law. Even then, it remains questionable whether any assets will be found that are worth freezing given the time that individuals will have had to move them offshore as sanctions are debated. In contrast, a western company doing business in Russia could see its assets expropriated swiftly and with little care for legal niceties, resulting in a consequential drop in that company’s stock price and a material adverse impact on its financial performance. Faced with such circumstances, its executives and stockholders could start questioning the wisdom of the sanctions that provoked such action and begin pressuring western governments to alter their policies. The questions, then, is who might blink first in such a scenario?
Sanctions are only one economic consequence of Russia’s actions in Crimea and questions are rightly being asked about whether this crisis will weaken Russia’s economy in the longer term. For the time being, however, the focus remains on whether the sanctions announced this week will do anything to alter the overall political situation in the region.
The reality is that their effects will be mostly symbolic. Western financial institutions will already be scouring their books to identify assets owned or controlled by targeted individuals. However, the liquid nature of much Russian investment in the west, the complex and opaque means by which such investments are often held, and the relative ease with which they can be moved beyond the reach of western authorities means that we really need to see these measures as nothing more than window dressing. The next step will be to see how Russia chooses to respond. Western companies will be bracing themselves in hopes that these measures are not stringent enough to arouse the ire of Russian lawmakers and prompt seizures of assets in Russia that would be much easier to enforce.
It is remarkable how quickly western governments ruled out military responses to Russia’s invasion of Crimea. In the eyes of many policymakers, the globally integrated economy has made economic responses effective while avoiding bloodshed. However, the simple fact is that not all economic pressures are created equal. We need to recognize that there are inherent limitations to sanctions that may render them ineffective or unenforceable in practice. Even where assets can be found, the effect of freezing them will be indirect and not plainly evident for all to see. In contrast, we need to accept that Russia may retaliate swiftly and in a much more tangible fashion. Policy makers may well be prepared for that response. It remains to be seen whether western companies and their stockholders are equally happy to bear such a burden in the interests of the west’s broader geopolitical response to this crisis. That test will only come as we see how Russia chooses to respond over the next few days and weeks.
David J. Chmiel is the managing director of an international political and security risk consultancy. He previously practiced as a corporate lawyer in the London and Chicago offices of a major international law firm. The opinions expressed here are personal and do not reflect the opinions of any past or current client or employer. He can be followed on twitter @LONDJC.