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The writer is former chief economist at the Institute of International Finance 

In failing to take a tougher stance on sanctions against Russia over its invasion of Ukraine, the EU might have stored up a series of problems that investors need to pay more attention to.

Two years after Russia’s full-scale invasion, it is now painfully clear that EU sanctions have failed to meaningfully curtail Moscow’s ability to wage war on its neighbour. What went wrong?

The first and most obvious issue is excessive reliance on financial sanctions — that is, blocking some Russian banks from intermediating payments with the west. Central bank official foreign exchange reserves were also frozen, but that measure targets a stock of assets, not ongoing flows, which are what matter for economic activity.

Financial sanctions can be highly effective when imposed on countries that run a current account deficit, because such countries must continually borrow from global markets to pay for imports. No more foreign credit causes the economy to collapse. However, before, during and after the invasion, the value of Russia’s exports has far exceeded what it pays for imports. As a current account surplus country, Russia effectively lends to the rest of the world: it accumulates foreign assets. (Russia’s current account surplus is forecast to be 4 per cent of GDP this year by the IMF.)

By sanctioning some Russian financial institutions, the west merely caused the accumulation of foreign assets to shift from sanctioned to non-sanctioned banks. Effectively, Gazprombank replaced Russia’s sanctioned central bank as the main financial intermediary with the outside world. This shift did not in any way curtail payments to Russia for its exports, so there was no impact on its ability to pay for imports. (Russia’s imports in 2023 were 20 per cent above pre-Covid pandemic levels.)

Why didn’t the G7 and EU sanction all Russian banks? That would be equivalent to a trade embargo (prohibition of exports), since countries would no longer be able to pay Russia for its fossil fuel exports (oil, gas and coal), bringing those exports to a halt. Russia exports about 8mn barrels of oil, on average, per day. How to squeeze Putin’s revenue without driving up the price of oil sharply?

In December 2022, the G7 and EU found an ingenious way forward, imposing a cap on the price that Russia can receive for its crude oil exports when these are transported in western-owned ships or use western services. In early 2023, a roughly equivalent cap was extended to cover refined products. Unfortunately, implementation of this oil price cap was at every turn undercut by a small number of western operators, especially Greek shipping magnates, that sold their oil tankers to “undisclosed” buyers — allowing Russia to export oil outside the cap.

To be fair, the Greeks are not alone. The massive rise in western exports to central Asia and the Caucasus is another example of western business at work. For example, German exports of cars and parts to Kyrgyzstan have risen 5,000 per cent since Russia’s invasion of Ukraine. There is no way these exports are staying in Kyrgyzstan. They are going to Russia, where they help keep the war economy going, and the same thing is happening via Belarus, Kazakhstan and other places.

In the December package of EU sanctions, there were other examples. There was a ban on imports of Russian diamonds but that did not cover industrial diamonds. Croatia also secured an exemption on importing Russian vacuum gas oil. So did other central Europeans on crude oil and steel products. And Hungary gained an exemption on nuclear energy services for its Paks II power plant project. 

At a time of heightened geopolitical tensions, the vital security objectives of western countries are being undermined by short-term interests and the profit motive of a few western businesses.

This weak sanctions enforcement has come at the expense of more aggressive action against Russia and thus — perhaps — a faster end to the war. That now risks coming back to bite it. If Donald Trump is elected in November, US support for Ukraine might end. Subsequently there would be a lot of squabbling in Europe over who pays for the defence of Ukraine.

Given that most countries are grappling with high debt, this would raise scrutiny of the financial state of EU nations, potentially adding pressure on the euro and widening the spreads on sovereign bonds between core bloc countries and other member states. Through its terrible trade-off, the EU has stored up all kinds of economic and markets pain for later — and that later is fast approaching.

Simon Johnson contributed to this article

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