Sanctions Against Russia Failing – What Now?

By David Ruff, Portfolio Manager

The magnitude of the current economic sanctions leveled against Russia by the US and Western countries exceed anything imposed to date on a major global power. The intent is to debilitate Russia’s economy to starve their War machine, resulting in a swift end of the Ukrainian War with its bloodshed and destruction. As long as we’re in this world of hope, maybe the economic damage will lead to President Putin’s removal from power, replaced with a leader friendlier to the West, and one who pursues democratic reforms. Unfortunately, these sanctions will probably largely fail in achieving these objectives, but they will continue to impact the global economy. One key change is they will alter the structure of global trade flows, especially fossil fuels. Despite the current equity market riot, perceiving these changes to be universally negative, this significant restructuring will not be a long-term negative for the global economy and there will be several beneficiaries of this new world order.

The sanctions include freezing hundreds of billions of Russian currency reserves, blocking most Russian bank access to the international financial transaction system, implementing high tariffs on goods, and banning Russian-company sourced fossil fuels. First, why will the economic sanctions fail? Learning from history, except for instances of an already weakened political leader, economic sanctions in and of themselves do little to bring about regime change or stop militant behavior. Successful sanctions need to be done in conjunction with overwhelming force. This is not something likely to be achieved by Ukraine alone, despite receiving weapon support from the US and Europe. Note, military power accompanied the successful sanctions against Serbia and Iraq in the 1990s. Sanctions lasting more than a decade against North Korea, multiple decades against Cuba, and more recently against Venezuela and Iran provide examples of their ineffectiveness. If anything, sanctions tend to be counterproductive, emboldening support from the aggressor’s populace for their leader. This is happening in Russia now. Combined with effective propaganda, nationalism is almost always stronger than the truth or liberalism. Sadly, far from achieving the desired political goals for the targeted country, economic sanctions frequently create collateral economic damage to parties unrelated to the conflict. Witness the current rapid inflation from higher fossil fuel prices globally.

To be successful, there needs to be universal worldwide sanction application. Unfortunately, this rarely happens against a major power and its probability of success in the case of Russia is very low. Far from it being Russia against the rest of the world, we’re increasingly seeing the world fragment into regional blocks with large segments of the earth’s population not on the West’s side. Beijing, predictably, is not on board the sanction bandwagon, refusing even to condemn the invasion. China’s April imports from Russia hit a record at $8.89 billion, up 56.6 percent from a year earlier, with much of this increase due to oil and gas. Distressingly to US policy makers, however, India, although a democracy, will not acquiesce to US pressure to halt purchases of Russian crude. In fact, India is stepping up purchases. In US discussions with New Delhi, the initial US approach of saying India “you need to do the right thing” or making a moral argument about energy sanctions was a non-starter. Being ninety percent dependent on imports for crude oil and getting it 30% cheaper from Russia is too big of an economic temptation. Further, India depends on Russia for weapons and weapon maintenance, thought to be necessary against Pakistan. Approximately 50% of their military equipment comes from Russia, US weapons viewed as being too expensive. Additionally, India believes Russia can be a counterweight in their trade and border frictions with China. Thus, China and India, each with approximately 1.4 billion people or 2.8 billion total, accounting for 35% of the world’s population, are not on the West’s side of the sanction ledger.

Even sanction support from Europe may not be what it seems. What’s the strongest major currency year-to-date? Drumroll please…it’s the Russian ruble. Plummeting initially after the invasion, the currency has rebounded impressively, making a two-year high against the greenback as of this writing. Although Western Europe threatens to end purchases of Russian natural gas, we note twenty European countries have opened Gazprombank accounts to pay for Russian gas in rubles. Notably, Germany blocked the EU from imposing a complete Russian energy embargo, saying it can only happen gradually. As reflected in Germany’s half-hearted support for Ukraine in stymying weapon exports and sending semi-worthless WW II surplus tanks without ammunition, German leadership, influenced mainly by German corporate titans, wants to maintain Russian gas imports. Thus, the country pursues hypocritical and superficial policies for purposes of maintaining support from the EU and their own populace but backs away from meaningfully punishing Russia. Although we believe Europe will eventually move to source more fossil fuels from other sources, including the Middle East, this will be an evolutionary, not immediate, process.

Although disruptions will continue in the short-term as energy supply chains realign, Asia and ASEAN sourcing Russian energy supplies grow. This will more than compensate for the loss of EU markets in the long-term. Since the Middle East cannot provide for all the energy needs of Europe and Asia, this is a positive development from an economic standpoint. More Middle East energy going to Europe, and Russian gas and crude oil rerouted to Asia should take the edge off energy prices longer-term, allowing for less inflationary pressures and better economic performance generally. We note Asia, benefiting from cheaper energy and greater trade with Russia, will be an immediate beneficiary. The following table shows how Western sanctions are leading to a realignment of Russian trade with Asia and ASEAN.

These developments have significant investment implications. First, as explained above, the energy situation in Europe will not be as dire as the markets are discounting. With the War creating a huge valuation discount in European equities, the market’s gradual understanding of the evolutionary energy supply chain adjustment will benefit European equities more than other regions. We also look for foreign currencies, which have been a persistent headwind, to turn into a tailwind as countries seek less dollar exposure. The US weaponization of the greenback against Russia by freezing reserves has induced much of the world to seek ways to lower dollar exposure both in terms of reserves as well as international transactions. This will eventually put pressure on the dollar as its universality weakens. Finally, we note the greater regionalization of trade. Notably, Asia will trade more with Russia and within Asia itself. The sanctions will probably fail in their primary objective, but the global economy including Europe and Asia, will not fail. We believe many of our investments in the International ADR and global strategies will benefit from these themes.

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