Yes, sanctions on Russia are working

They are limiting war production and weakening Russia's industrial base.

I encounter a lot of people — and some op-ed writers — who claim that the sanctions on Russia aren’t working. The three main reasons they give are that:

1. The ruble is strong,

2. Russia is managing to sell lots of oil, and

3. The Russian economy has contracted by less than expected.

In fact, all three of these things are true. After an initial plunge when the sanctions were levied, Russia’s currency soared in value over the summer, and is now historically strong:

Russia’s oil production is still down, but not by that much compared to before the war:

As for Russia’s economy, initial forecasts were for it to shrink 15% in 2022, but now the World Bank forecasts it to only shrink 6%.

But despite these facts, the sanctions on Russia are working, so I thought I’d write a post explaining why.

What is the point of the sanctions on Russia?

First, we need to understand the purpose of the financial sanctions that we levied on Russia when it invaded Ukraine. To be honest, it seems possible we may not have had a very coherent idea of what we were doing — we may have been simply trying to levy as stern and rapid a punishment on Russia as we could, in order to maintain our credibility after making a bunch of prewar threats. We can’t really say the sanctions are “working as designed”, since they weren’t really designed at all.

But regardless of what the thought process was behind their inception, what can sanctions hope to accomplish? To many observers, the intuitive answer is probably a simple one — to make Russia poorer. But why would we want to make Russia poorer? Making it hard for some poor babushka to buy bread isn’t going to stop Putin from prosecuting his war in Ukraine. It’s highly unlikely to lead to a popular uprising that topples the regime, as sanctions on Iran and the embargo on Cuba have shown over the past half century. In fact, hurting the Russian people seems to have a good chance of making them simply rally around their leader.

So causing human suffering in Russia is not the point. Likewise, people who think that Russia is a country ruled by oligarchs who can pressure Putin to stop the war if we take away their Italian villas need to get their heads out of the 90s — Putin rules his oligarchs, he is not ruled by them.

The only purpose of sanctions that makes any logical sense is this: Sanctions should make it harder for Russia to prosecute its invasion of Ukraine, as well as any other future invasions that Putin may decide to carry out. And the way to weaken Russia’s military machine is to weaken Russia’s defense production. And the way to weaken Russian imports, so that Russia can’t buy the parts and machinery it needs to make weapons.

In that sense, as we’ll see, sanctions are already working quite well. So first, let’s talk about the big jump in the ruble.

What is the point of a strong ruble?

Lots of people think that an expensive currency is the sign of a strong country and a strong economy. And in normal times that’s true. When your economy is doing well, lots of people want to invest in you. In order to invest in you they need to buy a bunch of your currency, which makes that currency appreciate in price.

That’s not what’s happening to Russia. We don’t see a rush of investment into the country; indeed, companies are getting out of Russia as fast as they can. Even China is investing less — its Belt and Road spending in Russia has dropped to zero and some Chinese companies have exited.

So why is the ruble doing so well? The answer is that Russian exports have risen, while Russian imports have collapsed. Importing goods requires Russia to sell rubles in exchange for other currencies, which pushes the value of the ruble down. When Russia exports goods, other countries have to buy rubles to pay for those goods. So higher Russian exports and much lower Russian imports — i.e., a Russian trade surplus — drive up the price of the ruble.

But remember, reducing Russian imports was the whole point of sanctions! Russia needs to import a ton of parts and machinery in order to make tanks, missiles, air defense radars, jets, and all its other implements of destruction. Now, thanks to sanctions, it can’t do that nearly as much. In fact, exports to Russia have rebounded a bit since the initial plunge, but almost all of the rebound has been in consumer goods, rather than in machinery, materials, and other “dual-use” goods. And that’s exactly what we should want — we’re not starving the babushkas, but we are starving Russia’s military machine.

In other words, the strong ruble is pointless, because the cause of the strong ruble is that sanctions are preventing Russia from getting the imports its military needs.

How about those oil exports?

The other big reason people think the Russian economy is doing well is that they’ve exported a lot of oil. Production is down, and in terms of barrels of oil, exports are down too:

So why did Russia’s exports surge so much in the second quarter? Because the price of oil increased a lot, which more than made up for the reduction in barrels sold:

Russia didn’t get to see all of this increase; because sanctions made it much more difficult for Russia to sell oil to Europe, it had to offer India and China discounts because they now held more leverage. But even so, the price rise was a windfall for Russia.

But notice that oil prices have fallen back down, to about where they were before the war! And most of this drop took place in July and August. Remember that the Russian economic data everyone is looking at is for the second quarter of the 2022, which ended in June, when oil prices were still very elevated. Going forward, the oil price drop, combined with fewer barrels exported, could reverse Russia’s good fortune in Q2.

At the same time, it’s important to remember that exports of oil aren’t what matters most. Russia’s war machine needs parts and machinery, and if it can’t actually use the earnings from its oil exports to buy those parts and machinery, then sanctions are working.

Weakening Russia’s war machine

During the Soviet years, the USSR was pretty much self-reliant in terms of manufacturing; it could make stuff on its own, even if it didn’t make stuff efficiently. Putin’s Russia is far less industrially self-sufficient, depending heavily on German machinery and American computer chips. Sanctions’ best hope for weakening Russia is to cut off these technological imports, thus making Russia unable to produce weaponry. Theoretically, China could make up the difference, but this would require significant retooling on Russia’s part — and so far, China is selling less stuff to Russia as well.

Given this dependence on imported inputs, it’s little surprise that as soon as sanctions hit, Russian production of industrial goods dropped sharply:

Joey Politano 🏳️‍🌈 @JosephPolitano

Sanctions are hitting Russian industry incredibly hard. Compared to last year, Russia had an -85% drop in passenger car production -80% drop in Fiber optic cable production -70% drop in AC electric motor production -50% drop in fridges, washing machines, and elevator production

As for military production, the details are obviously kept secret, but rumors indicate that production of tanks has slowed dramatically. Missile production is struggling too. This reduced production, along with continued major losses in Ukraine, have forced Russia to switch from precision weapons to unguided weapons in many cases, and to pull large amounts of obsolete Soviet-era equipment out of storage.

A July paper by a large team of economists gives an even more comprehensive picture of the difficulties Russia is facing. Sonnenfeld et al. (2022) first go over various reasons why the Russian economy isn’t as strong as the headlines are reporting — to no one’s surprise, data manipulation is part of the story here. They then explain why Russia’s short-term fossil fuel exporting prowess is unlikely to be sustainable. And then they move on to the really important part — struggling Russian production. Here are some excerpts:

Despite Putin’s bravado and personal conviction, the fact remains that import substitution has not been successful thus far – and Russian innovation lags far behind that of peer countries. Taking the automobile sector as an example, despite the fact that foreign-made automobile sales have come to a complete halt as referenced above, there has not been any compensatory increase in domestic auto production within Russia – and quite to the contrary. Russian domestic production of automobiles has actually plummeted, as the production of automobiles within Russia has long been reliant on international supply chains for not only raw materials such as steel and machinery, but also complex parts such as brakes and airbags in addition to western technology in semiconductors. While Russia is continuing to salvage and cannibalize parts while snatching parallel imports of microchips to continue some production, these obstacles impede scaling up production to the levels envisioned by Putin lest Russia be able to design and produce their own technology – a highly unlikely proposition…

Indeed, an analysis of Russian domestic industrial production volumes of motor vehicles and motor parts and accessories suggests a significant slowdown in domestic manufacturing…[the situation worsened] even more dramatically in May, with motor vehicle manufacturing falling 75% YoY and parts manufacturing falling 54%. Even at these minimal production levels, significant shortcuts are being taken….Likewise, within aerospace, even though the state aviation authority Rosaviatsia issued production certificates to five Russian companies authorizing them to make bootleg parts for aircraft, the manufacturers are apparently struggling to produce anything beyond minor cabin items such as seats and galley equipment, with sensitive flight-critical components still far off…

When domestic industrial production is measured by volume rather than value added…the picture becomes even bleaker suggesting large-scale shutdowns of the Russian industrial base, which is evidently operating at a fraction of its usual capacity. Industrial production volume in crucial industries such as appliances, railways, steel, textiles, batteries, apparel, and rubber fell by well over 20%, while other sub-industries such as electronics, sports, furniture, jewelry, fertilizers, and fishing fell in excess of 10%. And despite Putin’s rallying cries of self-sufficiency, all of these industries share a crucial similarity: they simply cannot replace imported parts and components that Russia lacks the technological prowess to make, and illicit, shadowy parallel imports can only go so far. For example, the Russian tank producer Uralvagonzavod has furloughed workers based on input shortages; Russian production of tanks, missiles and other equipment relies on imported microchips and precision components that simply cannot be sourced right now. Likewise, Russia’s Caspian pipeline has had challenges finding spare parts related to the US and EU’s ban on exports related to gas liquefaction. Each of these supply disruptions – which cannot be replaced by import substitution or parallel imports – leads to production shutdowns which then ripple across the entire supply chain, bringing various ancillary products and services into a simultaneous standstill.

It’s very hard to fight a modern war if you can’t produce things.

So in the short term, the sanctions are working much as we would want them to work if we had designed them carefully beforehand. They are stopping the kinds of production that we most want to stop. But if they’re sustained, the sanctions’ impact on Russia’s overall economy will likely be graver and more widespread than it is now. Sonnenfeld et al. point out that Russia’s fossil fuel industry is also dependent on imports, and is also likely to suffer further production cuts if the sanctions continue. No oil price spike is going to save Russia in that case; the country will simply get a lot poorer, and eventually it’ll stop being able to afford imported consumer goods as well. At that point the babushkas will indeed begin to suffer.

Update: Here is a long and excellent article about how sanctions are crippling Russian military production. In other news, Russia’s fossil fuel exports are now falling, as predicted.

---