Tag: Sanctions

Cognitive Dissonance on Belarus: Recovery and Adaptation or Stalemate?

Posted on January 8, 2024 | Policy Brief

20240107 Cognitive Dissonance on Belarus Image 02

A closer look at the Belarusian economy over the recent year, produces two initially competing narratives. The first one emphasizes that tough sanctions have led to a deadlock for the Belarusian economy. The second one stresses that output losses have turned out to be much lower than expected, and that the economy has displayed a rather high degree of adaptability – securing an early and rapid recovery. This policy brief shows that these narratives are not mutually exclusive but rather elements of the same bigger picture. A short-term focus gives the impression that the current stance is ‘more good than bad’. This reflects the fact that output has recovered and almost reached historically high levels, made possible due to a combination of exports protection mechanisms and compensatory effects on output. However, this does not eliminate the disappointing medium- and long-term prospects for the country. On the flip side of the immediate survival of the Belarusian economy is the country’s economic and political stalemate. This includes the lack of opportunities for future sustainable growth and Belarus’ enormous and continuously growing dependence on Russia. Within this stalemate, stagnation is the best plausible scenario. At the same time, much worse scenarios, both economically and politically, are also highly likely. Ultimately, breaking the deadlock is the only way to a better future for Belarus.

The Belarusian Economy and the Changing Narratives

About 1.5 years ago, Western countries introduced tough sanctions against Belarus, punishing the Lukashenka regime for its role in Russia’s invasion of Ukraine. This gave rise to a huge uncertainty regarding Belarus’ economic prospects. A FREE policy brief published about a year ago (Kruk & Lvovskiy, 2022) presented a model-based estimate of a potential rock-bottom for the Belarusian economy in the new environment, which amounted to 20 percent of output losses. The authors however argued that actual output losses might be significantly lower given Russia’s support and policy responses, which were unaccounted for in the model. At the same time, downside risks and a lack of output consistency seem to have become permanent traits of the Belarusian economy.

Expectations of a large and prolonged recession in Belarus prevailed into mid-2023. International institutions (IMF, World Bank) and rating agencies (S&P, Fitch Ratings) mainly expected a recession in Belarus up to 10 percent 2022-2023.  The reality has however turned out to be quite different with the recession being relatively contained and short-lived. The output losses between the peak (Q2-2021) trough Q3-2022 amounted to 6.8 percent. In Q4-2022 a recovery began, and in Q3-2023 the economy had almost fully recovered, reaching nearly the same levels as in Q2-2021 (see Figure 1). Further, in terms of average real wages and household consumption, the situation appears to be even more positive. The real average wage reached its pre-war level in Q1-2023 and has since displayed record high levels, and household consumption follow a similar trend (see Figure 1).

These dynamics have given rise to a new narrative. As of lately, the Belarusian economic situation is at times treated as ‘more good than bad’. Further, most international financial institutions currently forecast a continued weak recovery growth in the coming years (EBRD, 2023; IMF, 2023; Izvorski et al., 2023).

Figure 1. Real GDP, Average Real Wages, and Real Household Consumption (index, seasonally adjusted, 2018=100).

Source: Author’s estimations based on Belstat data.

Factors Behind the Recent Recovery Growth

The underlying reasons for the recovery growth can be divided into two groups: (i) export protection mechanisms under sanctions and (ii) positive shocks and compensatory effects on output.

Export protection mechanisms under sanctions are twofold. Firstly, the Belarusian regime turned out to be somewhat successful in adjusting to the new sanctions-environment. This partly due to a somewhat geographical U-turn of Belarusian exports, underpinned by new logistics and payment schemes. The best example of this turn is the re-orientation of oil product exports from the EU and Ukraine to Russia (Kharitonchik, 2023). Moreover, some exports to traditional markets, which were challenged by logistics and payment barriers rather than sanctions, were secured by crossing these barriers. The best such example is the recovery of potash fertilizer exports to China, Brazil and India. Since early 2023 these displayed a rapid recovery due to Belarus finding logistic solutions through Russian sea ports instead of EU ports, and by using railway transportation.

Secondly, the practices of sanctions evasion may also have played a significant role. The scope of sanctions evasion is however difficult to assess due to its secretive nature. Moreover, the difference between avoiding and evading sanctions is not always clear.

Export protection mechanisms allowed Belarus to cushion actual export losses, making them transitory (see Figure 2). Actual losses in exports were close to the rock-bottom scenario estimates for only a couple of months. Instead of an expected level shift in exports by roughly 40 percent (from the pre-war level), exports displayed a recovery trajectory. Hence, what was modelled as a permanent shock in Kruk & Lvovskiy (2022), turned out to be transitory.

Figure 2. Physical Volume of Exports (index, seasonally adjusted, 2018=100).

Source: Author’s estimations based on Belstat data.

One important aspect to mention is that part of this recovery is due to oil-product exports taking place already in 2022 (Kharitonchik, 2023). In Kruk & Panasevich (2023) the authors show that the oil-refinery industry is of extreme importance for the entire Belarusian economy. Due to inter-industrial linkages, the oil-refinery industry indirectly accounts for about 11 percent of Belarus’ output, despite its modest direct contribution to the GDP (slightly more than 1 percent). Hence, due to protecting these exports (and the corresponding production of oil products), a large amount of output losses was avoided. A similar situation unfolded also for potash fertilizer exports and the chemical industry producing them (although inter-industrial linkages and effects on output are much weaker for that industry).

Besides export protection mechanisms, the recovery of exports and output stem largely from various positive and compensatory effects on output Some of them arose from Belarus’ and Russia’s respective regimes responses to sanctions, and from Russia’s readiness to support Belarus. Others are classical external positive shocks (to no degree related to sanctions) while some are a combination of both. They include: (i) increasing energy (gas) subsidies from Russia, (ii) a prolonged period of extra-high price competitiveness, especially in the Russian market, (iii) expanded access to the Russian market, (iv) other forms of Russian support (debt restructuring, budget transfers, new loans), (v) favorable trade conditions and export prices (apart from on the Russian market), (vi) a (macro)economic environment that allow for more  room for domestic economic policy interventions.

Taken together, these positive output drivers largely contributed to curbing the recession in 2022 and to the output recovery in 2023. A straightforward decomposition of the actual output growth path is unfeasible (due to the close interconnection of export protection mechanisms and output drivers, and the lack of available statistics). However, approximating the actual path in a model environment results in the following: between Q2-2021 and Q3-2022, about 12 percent of losses due to sanctions (taking into account the export protection mechanisms) and a deprivation of the Ukrainian market, and 5.2 percent of gains due to output shocks, resulted in actual output losses of 6.8 percent. Later in 2023, due to increasing effects from the export protection mechanisms, the sanctions-related output losses shrank to about 6.6 percent, while output shocks expanded output by roughly the same level. This allowed output losses to be zeroed out, i.e. the level of output in Q3-2023 was almost identical to Q3-2021.

An Economic Stalemate

Is the ‘more good than bad’ economic situation sustainable? Does the recent recovery mean that Belarus has overcome the major challenges to the economy? The short answer is no. Even with short-term thinking, there are still numerous downside risks. Sanctions still form a permanently challenging environment for the Belarusian economy, putting exports and output in jeopardy. The export protection mechanisms are not persistent, and they largely depend on Russia’s political will to support them. Moreover, the updated logistics and payment chains may also be vulnerable and sensitive to changes in the sanctions’ environment, and short-term trends in external prices. The aforementioned positive output effects are short-term by their nature and there are indications of them starting to fade already in 2023 (BEROC, 2023). Hence, even short-term projections for 2024 are challenging: the output growth is expected to weaken significantly or even fade away, while inflation spikes and financial destabilization risks are high (BEROC, 2023). Therefore, a return to a stagnant economic environment appears to be the most plausible short-term outlook.

The medium-term outlook seems even worse. According to Kruk (2023), the Belarusian macroeconomic balance (a) is very fragile, (b) is subject to numerous and huge downside risks, and (c) cannot be secured by macroeconomic policies because of the structural weaknesses in their design and the lack of room for maneuver. This means that even the existing weak long-term growth potential cannot be realized in the medium term, while the likelihood of recessions, inflation spikes and financial destabilization is high.

Re-shifting focus to a long-term and international perspective makes the viewpoint ‘more good than bad’ appear inconsistent. First, the long-term growth potential for Belarus, which was very weak even before the sanctions, keeps on worsening. This as adverse supply shocks and a deterioration of the productivity determinants continue eroding it (Kruk & Lvovskiy, 2022). Estimations of the growth potential (that rely on historical time series) are mainly within the range of 0-1 percent per annum. However, even such disappointing estimates might be optimistic bearing in mind the current political and sanctions-related risks and uncertainty (absent in the historical data). This makes stagnation the best possible long-term outlook, although it cannot be guaranteed.

Second, despite the milder recession and rapid recovery, the well-being gap between Belarus and its EU neighbors keeps on expanding (see Figure 3).

Figure 3. Well-being in Belarus vs the average among its EU neighbors (Latvia, Lithuania, Poland), 1990-2022, in percent.

Note: The GDP per capita PPP in 2017 constant international dollars is considered as well-being. The average well-being for EU Neighbors is the simple average in GDP in Latvia, Lithuania, and Poland.
Source: Author’s estimations based on World Bank data.

The average well-being in Belarus (measured in GDP per capita in constant international dollars) vs. that among its EU neighbors reached an (almost) historically low level in 2022. After attaining a level of well-being of roughly 75 percent of the average in Latvia, Lithuania, and Poland in the early 2010s, the well-being in Belarus has fall to about 52.5 percent, almost as low as in the mid-1990s. Given the economic stagnation as the most likely outlook, this means that the country will, in relative terms, keep on getting poorer in comparison to its EU neighbors.

A Political Stalemate

The hypothetical way out of the economic stalemate is more or less obvious. For instance, there is somewhat of a consensus among Belarusian economists about strengthening the long-term growth and securing macroeconomic stability (see Daneyko & Kruk, 2021; Kruk, 2023, for an overview of a collective view from a group of Belarusian economists). This vision, however, clashes with the views of the Lukashenka regime, which has inhibited its implementation throughout decades. Hence, democratic transition, or at least deprival of power of the Lukashenka regime has long appeared to be a highly likely precondition for moving away from the stalemate.

This, however, has changed in the last couple of years. The Belarusian economy’s dependence on Russia has moved from large to absolute. Prior to 2022, Russia was an important market for Belarusian exports (about 40 percent), the single energy supplier, and de facto the lender of last resort. To date, Russia’s role has expanded dramatically. The share of exports to Russia has increased up to about 65 percent. Moreover, the majority of the remaining 35 percent is exported with the assistance of or through Russia, using Russian infrastructure. Therefore, it would be fair to argue that Russia in some form “controls” roughly 90 percent of Belarusian exports. Further, being Belarus’ sole energy supplier, Russia has increased its significance for Belarus through expanded energy subsidies. The size of the energy subsidies reached a historical high in 2022, and the mechanism of the energy subsidies has become a cornerstone for macroeconomic stability in Belarus. Furthermore, Russia has turned out to be the only effective creditor for Belarus. Overall, Russia has accumulated a significant number of tools to undermine Belarus at any given moment.

A democratic transition or at least deprival of power of the Lukashenka regime might therefore not be sufficient preconditions for breaking the economic deadlock. Even if domestic political will to do so should emerge, the risk that Russia will successfully suppress it using the above outlined economic tools is very high. Hence, apart from a democratic transition, the way out of the economic stalemate requires a way out of the political stalemate. This seems to only be possible through either a politically weakened Russia, and/or an external political force, allied to the Belarusian democratic forces, and strong enough to suppress Russia.

Conclusions

Recently, the narrative on the Belarusian economy has changed. The prevailing expectations of a large and prolonged recession has been substituted by expectations of a gradual recovery. The narrative ‘the jig is up’ has somehow been crowded out by the ‘more good than bad’ viewpoint on the Belarusian economy. However, these narratives are not mutually exclusive. Behind the current ‘more good than bad’ viewpoint on the Belarusian economy, a severe economic and political deadlock prevails. Moreover, future economic and political deadlocks are the actual price being paid for the recent survival and recovery of the Belarusian economy.

From a positive perspective, the economic and political deadlock means that the country is likely to, at least, be bogged down in stagnation. Belarus’ total dependency on Russia makes the country hostage to Russia’s political preferences and country-specific risks. Should Russia decide to exert further economic and/or political influence over Belarus, it is likely to succeed. Consequently, any economic downturn faced by Russia would automatically impact Belarus.

From a normative perspective, breaking the economic and political deadlock might be the only solution, and for this, the order might matter. Prior to 2020 there was a widespread opinion that breaking the economic deadlock must be prioritized, and that it could – in turn – break the political deadlock. As of now, the tables have turned. The current order postulates the political deadlock comes first, as it seems to be the only way of breaking the economic stalemate. However, breaking the political deadlock appears to require external political will.

With these conclusions in mind, the recent Belarusian democratic forces’ manifest regarding Belarus’ EU membership aspiration, deserves attention (BDF, 2023). At first, such aspiration might appear schizophrenic given the actual political situation inside of the country. However, taking a Belarusian EU membership serious (within the EU and among Belarusians) might be the answer to Belarus’ political and economic deadlock. From this perspective, the task for the Belarusian society is thus to convince EU counterparts that this is not madness, but rather a feasible solution. It is rather evident why this solution is both desirable and feasible for the Belarusian society. The main question to be answered is therefore whether, and why it would be desirable and feasible for the EU.

References

Disclaimer: Opinions expressed in policy briefs and other publications are those of the authors; they do not necessarily reflect those of the FREE Network and its research institutes.

Risks of Russian Business Ownership in Georgia

Posted on November 27, 2023 | Policy Brief

Image of Tbilisi at night representing risks of Russian business ownership in Georgia

This policy brief addresses risks tied to Russian business ownership in Georgia. The concentration of this ownership in critical sectors such as electricity and communications makes Georgia vulnerable to risks of political influence, corruption, economic manipulation, espionage, sabotage, and sanctions evasion. To minimize these risks, it is recommended to establish a Foreign Direct Investment (FDI) screening mechanism for Russia-originating investments, acknowledge the risks in national security documents, and implement a critical infrastructure reform.

Russia exerts substantial influence over Georgia. First and foremost, Russia has annexed 20 percent of Georgia’s internationally recognized territories of Abkhazia and South Ossetia. Further, it employs a variety of hybrid methods to disrupt the Georgian society including disinformation, support for pro-Russian parties and media, trade restrictions, transportation blockades, sabotage incidents, and countless more. These tactics aim to hinder Georgia’s development, weaken the country’s statehood, and negatively affect pro-Western public sentiments (Seskuria, 2021 and Kavtaradze, 2023).

Factors that may also increase Georgia’s economic dependency on Russia concern trade relationships, remittances, increased economic activity driven by the most recent influx of Russian migrants, and private business ownership by Russian entities or citizens (Babych, 2023 and Transparency International Georgia, 2023). This policy brief assesses and systematizes the risks associated with Russian private business ownership in Georgia.

Sectoral Overview of Russian Business Ovnership

Russian business ownership is significant in Georgia. Recent research from the Institute for Development of Freedom of Information (IDFI) has addressed Russian capital accumulation across eight sectors of the Georgian economy: electricity, oil and gas, communications, banking, mining and mineral waters, construction, tourism, and transportation. Of the eight sectors considered by IDFI, Russian business ownership is most visible in Georgia’s electricity sector, followed by oil and natural gas, communications, and mining and mineral waters industries. In the remaining four sectors considered by IDFI, a low to non-existent level of influence was observed (IDFI, 2023).

Figure 1. Overview of Russian Ownership in the Georgian Economy as of June 2023.

Source: IDFI, 2023.

There are several reasons for concern regarding the concentration and distribution of Russian business ownership in the Georgian economy.

First, it is crucial to keep Russia’s history as a hostile state actor in mind. Foreign business ownership is not a threat in itself; However, it may pose a threat if businesses are under control or influence of a state that is hostile to the country in question (see Larson and Marchik, 2006). Business ownership has been a powerful tool for the Kremlin, allowing Russia to influence various countries and raising concerns that such type of foreign ownership might negatively affect national security of the host country (Conley et al., 2016). Similar concerns have become imperative amidst Russia’s full-scale war in Ukraine (as, for instance, reflected in Guidance of the European Commission to member states concerning Russian foreign acquisitions).

Further, Russian business ownership in Georgia is particularly threatening due to the ownership concentration within sectors of critical significance for the overall security and economic resilience of the country. While there is no definition of critical infrastructure or related sectors in Georgia, at least two sectors (energy and communications) correspond to critical sectors, according to international standards (see for instance the list of critical infrastructure sectors for the European Union, Germany, Canada and Australia). Such sectors are inherently susceptible to a range of internal and external threats (a description of threats related to critical infrastructure can be found here). Intentional disruptions to critical infrastructure operations might initiate a chain reaction and paralyze the supply of essential services. This can, in turn, trigger major threats to the social, economic, and ecological security and the defense capacity of a state.

Georgia’s Exposure to Risks

Identifying and assessing the specific dimensions of Georgia’s exposure to risks related to Russian business ownership provides a useful foundation for designing policy responses. This brief identifies six distinct threats in this regard.

Political Influence

Russia’s business and political interests are closely intertwined, making it challenging to differentiate their respective motives. This interconnectedness can act as a channel for exerting political influence in Georgia. Russians that have ownership stakes in Georgian industries (e.g. within electricity, communications, oil and gas, mining and mineral waters) have political ties with the Russian ruling elite facing Western sanctions, or are facing sanctions themselves. For instance, Mikhail Fridman, who owns up to 50 percent of the mineral water company IDS Borjomi, is sanctioned for supporting Russia’s war in Ukraine. Such interlacing raises concerns about indirect Russian influence in Georgia, potentially undermining Georgia’s Western aspirations.

Export of Corrupt Practices

The presence of notable Russian businesses in Georgia poses a significant threat in terms of it nurturing corrupt practices. Concerns include “revolving door” incidents (movement of upper-level public officials into high-level private-sector jobs, or vice versa), tax evasion, and exploitation of the public procurement system.  For instance, Transparency International Georgia (2023) identified a “revolving door” incident concerning the Russian company Inter RAO Georgia LLC, involved in electricity trading, and its regulator, the Georgian state-owned Electricity Market Operator JSC (ESCO). One day after Inter RAO Georgia LLC was registered, the director of ESCO took a managerial position within Inter RAO Georgia LLC. Furthermore, tax evasion inquiries involving Russian-owned companies have been documented in the region, particularly in Armenia, further highlighting corruption risks. We argue that such corrupt practices might harm the business environment and deter future international investments.

Economic Manipulation

A heavy concentration of foreign ownership in critical sectors like energy and telecommunications, also poses a risk of manipulation of economic instruments such as prices. The significant Russian ownership in Armenia’s gas distribution network exemplifies this threat. In fact, Russia utilized a price manipulation strategy for gas prices when Armenia declared its EU aspirations. Prices were then reduced after Armenia joined the Eurasian Economic Union (Terzyan, 2018).

Espionage

Russian-owned businesses within Georgia’s critical sectors also pose espionage risks, including economic and cyber espionage. Owners of such businesses may transfer sensitive information to Russian intelligence agencies, potentially undermining critical infrastructure operations. As an example, in 2022, a Swedish business owner in electronic trading and former Russian resident, was indicted with transferring secret economic information to Russia. Russian cyber-espionage is also known to be used for worldwide disinformation campaigns impacting public opinion and election results, compromising democratic processes.

Sabotage

The presence of Russian-owned businesses in Georgia raises the risk of sabotage and incapacitation of critical assets. Russia has a history of using sabotage to harm other countries, such as when they disrupted Georgia’s energy supply in 2006 and the recent Kakhovka Dam destruction in Ukraine (which had far-reaching consequences, incurring environmental damages, and posing a threat to nuclear plants). These incidents demonstrate the risk of cascading effects, potentially affecting power supply, businesses, and locations strategically important to Georgia’s security.

Sanctions and Sanction Evasion

Russian-owned businesses in Georgia face risks due to Western sanctions as they could be targeted by sanctions or used to evade them. Recent cases, like with IDS Borjomi (as previously outlined) and VTB Bank Georgia – companies affected by Western sanctions given their Russian connections – highlight Georgia’s economic vulnerability in this regard. Industries where these businesses operate play a significant role in Georgia’s economy and job market, and instabilities within such sectors could entail social and political concerns. There’s also a risk that these businesses could help Russia bypass sanctions and gain access to sensitive goods and technologies, going against Georgia’s support for international sanctions against Russia. It is crucial to prevent such sanctions-associated risks for the Georgian economy.

Assessing the Risks

To operationalize the above detailed risks, we conducted interviews with Georgian field experts within security, economics, and energy. The risk assessment highlights political influence through Russian ownership in Georgian businesses as the foremost concern, followed by risks of corruption, risks related to sanctions, espionage, economic manipulation, and sabotage. We asked the experts to assess the severity level for each identified risk and notably, all identified risks carry a high severity level.

Recommendations

Considering the concerns detailed in the previous sections, we argue that Russia poses a threat in the Georgian context. Given the scale and concentration of Russian ownership within critical sectors and infrastructure, a dedicated policy regime might be required to improve regulation and minimize the associated risks. Three recommendations could be efficient in this regard, as outlined below.

Study the Impact of Adopting a Foreign Direct Investment Screening Mechanism

To effectively address ownership-related threats, it’s essential to modify existing investment policies. One approach is to introduce a FDI screening mechanism with specific functionalities. Several jurisdictions implement mechanisms with similar features (see a recent report by UNCTAD for further details). Usually, such mechanisms target FDI’s that have security implications. A dedicated screening authority overviews investment that might be of concern for national security and after assessment, an investment might be approved or suspended. In Georgia, a key consideration for designing such tool includes whether it should selectively target investments from countries like Russia or apply to all incoming FDI. Additionally, there’s a choice between screening all investments or focusing on those concerning critical sectors and infrastructure. Evaluating the investment volume, possibly screening only FDI’s exceeding a predefined monetary value, is also a vital aspect to consider. However, it’s important to acknowledge that FDI screening mechanisms are costly. Therefore, this brief suggests a thorough cost and benefit analysis prior to implementing a FDI screening regime in Georgia.

Consider Russian Ownership-related Threats in the National Security Documents

Several national-level documents address security policy in Georgia, with the National Security Concept – outlining security directions – being a foundational one. Currently, these concepts do not specifically address Russian business ownership-related threats. When designing an FDI screening mechanism, however, acknowledging various risks related to Russian business ownership must be aligned with fundamental national security documents.

Foster the Adoption of a Critical Infrastructural Reform

To successfully implement a FDI screening mechanism unified, nationwide agreement on the legal foundations for identifying and safeguarding critical infrastructure is needed. The current concept for critical infrastructure reform in Georgia envisages a definition of critical infrastructure and an implementation of an FDI screening mechanism. We therefore recommend implementing this reform in the country.

Conclusion

This policy brief has identified six distinct risks related to Russian business ownership in several sectors of the Georgian economy, such as energy, communications, oil and natural gas, and mining and mineral waters. Even though Georgia does not have a unified definition of critical infrastructure, assets concentrated in these sectors are regarded as critical according to international standards. Considering Russia’s track record of hostility and bearing in mind threats related to foreign business ownership by malign states, this brief suggests regulating Russian business ownership in Georgia by introducing a FDI screening instrument. To operationalize this recommendation, it is further recommended to consider Russian business ownership-related threats in Georgia’s fundamental security documents and to foster critical infrastructural reform in the country.

References

Disclaimer: Opinions expressed in policy briefs and other publications are those of the authors; they do not necessarily reflect those of the FREE Network and its research institutes.

Russia’s Data Warfare

Posted on April 18, 2023 | Policy Brief

20230417 Russian Data Warfare Image 01

After Russia’s invasion of Ukraine in February 2022, a broad spectrum of previously publicly available statistics on economic indicators has been removed from the public eye. This reduced transparency affects any analysis of the state of the Russian economy and assessments of the effects of sanctions. The strategy is also part of a larger disinformation campaign that has become an integral part of Russia’s war on Ukraine. In this brief we provide a short overview of the main indicators on economic activity that have been masked in various forms by Russia’s data producing institutions. We also touch upon some alternative strategies, employed to gain a better understanding of the actual state of the Russian economy while official data is unavailable or unreliable.

Following Russia’s war on Ukraine, Russia has ceased to publish large amounts of previously publicly available statistics on economic indicators. This reduced transparency affects any attempts to analyze the Russian economy with regular data and models, and is an integral part of the information war that has followed Russia’s aggression. In particular, it aims to reduce or obscure the analysis of the effects of sanctions that have been imposed on Russia by Ukraine’s partners. The reduced precision of this analysis is then used in various propaganda channels to claim that sanctions are useless and that they are, instead of hurting Russia, harming the EU, the US and other sanctions implementing countries.

In this brief we present a short overview of some of the most important statistics on Russia’s economic performance no longer publicly available (with a detailed list to be found in the Online Appendix). We also discuss some alternative measures to track the Russian economy which can be used to provide more accurate assessments of the effect of sanctions and thus reduce the impact of Russia’s data warfare.

What Data is Being Masked?

Russia’s cessation of statistical publications has occurred across several dimensions including foreign trade, budget, and finance.  Most notably, data has been masked by the Central Bank of the Russian Federation (CBR), the Ministry of Finance of the Russian Federation (Ministry of Finance), the Federal State Statistics Service (Rosstat) and the Federal Customs Service of Russia.

Budget Data

Data on federal and consolidated budgets in Russia was previously easily accessible on the Ministry of Finance’s and Rosstat’s webpages.

The Ministry of Finance has however, as of January 2022, ceased publishing data on budget expenditures. This includes monthly data for a wide range of budget expenditure categories such as spending for public administration, national defense and law enforcement, environmental protection, education, healthcare, social politics, mass media and culture. This data is no longer available despite the webpage for budget expenditures being updated as late as March 17th 2023.

Data on certain budget indicators is also missing on Rosstat’s webpage. While statistics on taxes, fees and other mandatory payments are available for 2022, budget expenditures are available only for 2021. This is however not surprising given that Rosstat receives its figures on the financial sector, including figures on public finances partly from the Ministry of Finance.

Foreign Trade Data

Foreign trade statistics is normally published by the Federal Customs Service of Russia, CBR and Rosstat.

Since the invasion, the Federal Customs Service of Russia has however stopped publishing statistics on foreign trade and commodity structure. The latest available monthly data on Russian foreign trade with its main partners (the EU, Commonwealth of Independent States countries and others), and the commodity structure of exports and imports – including processed goods and oil and gas – is from January 2022 (as of April 3rd 2023).

Foreign trade data from CBR has been withheld throughout 2022. CBR has however recently resumed parts of their publications and, as of April 3rd 2023, monthly data on total export and import is available for all of 2022 as well as for January 2023. Still, these figures display total exports and imports only and are not broken down by trade partner or commodity.

Similar to CBR’s publishing pattern, figures on export and import as part of GDP by use were unavailable on Rosstat’s webpage from February 2022 and throughout the year.  As of April 7th 2023, quarterly aggregated data is however available for all of 2022.  Monthly data on export and import by country is nonetheless still available only for 2021, despite the webpage being updated in November 2022.

Financial Data

To provide information on the national finance system and its dynamics is a main tasks of any country’s central bank, with Russia being no exception. Despite this there are about 40 financial indicators that, since the beginning of 2022, are no longer available on CBR’s webpage (as of April 3rd 2023). This contravenes CBR’s calendar, which states that statistics are supposed to be published in the next reporting period, i.e. the next quarter/month for quarterly and monthly data respectively.

The most deferred data (more than 20 indicators) can be found, or rather can’t be found, in the so-called External Sector Statistics category. For example, monthly data on balance of payments, remittances and financial transactions in the private sector, and international investment position of the banking sector is missing as of January 2022. Similarly, quarterly data on foreign investments, foreign assets and liabilities in the banking sector has been unavailable since January 2022. The same goes for data on external debt of the corporate sector of the Russian Federation in the form of loans, credits and deposits raised as a result of non-resident placement of Eurobonds and other debt securities.

In the so-called Banking Sector Statistics category, data on indicators such as assets, risks, operational data, international reserves and volume of FX operations is no longer available. Furthermore, figures on turnover of the interbank spot and forward markets have also been unavailable since February 2022.

Two comments are due considering the ease of access to above mentioned data/data sources. Firstly, in order to access the CBR’s and the Federal Customs Service of Russia’s webpages, one at times needs make use of a Virtual Private Network (VPN). Secondly, there are, for all sources mentioned, large discrepancies between the Russian language and the English language webpages, with the latter being severely patchier in its information.

Hiding Data: Reasons and Implications

What drives the authorities to mask seemingly relevant figures? Alexandra Prokopenko, an expert on Russian economic policy, argues that Russian authorities mask certain numbers related to the sanctions to impede evaluations of the effect of sanctions (Prokopenko 2023). Making the data less transparent and accessible in order to hide sanctions’ effect across various sectors to try and paint a better picture of the economic activity has also been a Russian policy goals. The head of the Federal Customs Services, Vladimir Bulavin, in April 2022 announced trade statistics were masked partly to “avoid […] speculation and discrepancies in import deliveries” (Uvarchev, 2022).

In this context, it is worth mentioning that Russia is obliged to report to the International Monetary Fund (IMF) on several of the previously discussed indicators since the country is subscribing to the Special Data Dissemination Standard (SDDS) as of 2005. SDDS aims at providing transparent economic and financial data to the public and according to the IMF “Serious and persistent nonobservance of the SDDS, therefore, will be cause for action” (IMF, 2023). If Russia does not publish data according to the SDSS commitments, it could be excluded from the list of countries that subscribe to the SDSS.  This affects how the country is viewed by investors and others and will further increase the risk premia that is applied to dealing with Russia.

Further, in its efforts to restrict insight into how the Russian economy is faring following the sanctions, the authorities have however created a large uncertainty also for Russian domestic markets, adding to the sanction’s effects. For instance, Elvira Nabiullina, Russia’s Central Bank Governor, has been arguing to revoke the decision to classify large amounts of data saying that investors, analysts and researchers simply need the data to do their work properly (CBR News, 2023).

Alternative Ways of Understanding the Real State of the Russian Economy

How can we learn about the state of affairs in Russia without the previously discussed data? While deducing Russia’s budget expenditures and many financial indicators may be cumbersome, more can be done when it comes to trade data. Specifically, a BOFIT Policy Brief by Simola (2022) proxied Russia’s imports and exports by tracking the imports of Russia’s main trading partners (17 economies) between March and June 2022. Similar proxying efforts have been made by Darvas, Martins and McCaffrey (2023), who tracked Russia’s foreign trade by considering detailed trade data from China, the United States, South Korea, Japan, India, the United Kingdom, Turkey and the EU, putting together publicly available datasets which span from January 2019 to January 2023.

Proxying trade data by considering trade partner’s statistics is emphasized by Sonnenfeld et al. (2022), who not only considers such data but rather a wide variety of available and reliable data sources – emphasizing the need to also crosscheck data from official Russian statical sources with more reliable ones (for a full overview of the methodologies used, the estimated indicators on the Russian economy and the implications from this, see Sonnenfeld et al. 2022).

Other efforts to map out Russia’s economic activity consider more creative methods such as using satellite data and/or ship location (AIS) data. Examples of such efforts include a recent Bruegel dataset which tracks Russian crude oil trade (Heusaff et al., 2023) and CREA’s “Russia Fossil Tracker”. For both examples, the authors utilize the location data for individual crude oil tankers, and (for Heusaff et al. 2023) combine it with data from OPEC, BP and Eurostat, to assess monthly crude oil exports from Russia to a set of major destinations (mainly the EU, China and CIS countries).

Similarly, satellite data has been previously used to estimate carbon emissions from flaring (Böttcher et al., 2021). While there is an ongoing debate on whether flaring can be trusted to give insight into gas and oil production (World Bank, 2023), one could potentially make use of such data to get a better view of the productivity within the Russian oil and gas sector following the imposed price cap mechanism and sanctions.

The struggle of creating reliable estimates for an economy polishing or masking information did not arise with the withdrawal of certain Russian statistics. The actual status of the North Korean economy remains much of a mystery to analysts (see The Economist) as the country, in 2017, was yet to publish a Statistical Yearbook. While Russia is far from North Korea in several aspects, the reality is that the alternative measures used to estimate North Korea’s economic activity (such as making use of Chinese trade data etc.) are partly the ones now being undertaken by analysts looking beyond the figures from Kremlin.

Conclusion

Russia’s decision to stop publishing regular economic data is part of the disinformation and propaganda efforts that are integral parts of its war on Ukraine, with the purpose being to complicate any analysis of what is going on in the Russian economy. While being partially successful in this regard, the data withholding likely creates further negative implications for Russia’s external economic relations and undermines the functioning of its domestic markets.

Given the lack of data following Russia’s disinformation efforts it is essential that any analyst concerned with mapping the Russian economy not only considers alternative but also multiple sources and consult experts with a plethora of competencies. Already today, new creative ways of getting hold of relevant data is providing increasing insight into the state of the Russian economy. With continued efforts, these measures will progress over time, improving our understanding of how sanctions affect the Russian economy.

Online Appendix

An overview of all indicators discussed in this brief can be found in the Online Appendix. The information in the Appendix is valid as of April 7th 2023.

References

Disclaimer: Opinions expressed in policy briefs and other publications are those of the authors; they do not necessarily reflect those of the FREE Network and its research institutes.

Georgian Economy and One Year of Russia’s War in Ukraine: Trends and Risks

Posted on March 13, 2023 | News

20230228 Georgian economy and one year of Russia Image 01

Russia’s invasion of Ukraine profoundly impacted the global economy, immediately sending shockwaves across the globe. The attack of a country that was once a major energy supplier to Europe on the country which was one of the top food exporters in the world, sent food and fuel prices spiralling, causing major energy shortages and the prospect of protracted recession in the United States and the European Union.

The unprovoked and brutal aggression resulted in nearly universal condemnation and widespread sanctions placed on Russia by the United States, the EU, and other Western allies. Financial sanctions were perhaps the most unexpected and significant with the potential for immediate impact on Russia’s neighbours, including those that did not formally join the sanctions regime. In addition to sanctions, the major consequence of the war was mass migration waves, particularly from Ukraine, but also from Russia and Belarus to neighbouring countries.

At the start of the war, it was expected that the Georgian economy would be severely and negatively impacted for the following reasons:

  • First, as a former Soviet republic, Georgia historically maintained close economic trade ties with both Russia and Ukraine. The ties with Russia have weakened considerably in the wake of the 2008 Russo-Georgian war but remained significant. Russia was the primary market for imports of staple foods into Georgia, such as wheat flour, maize, buckwheat, edible oils, etc. Russia and Ukraine were both important export markets for Georgia. Russia was absorbing about 60 percent of Georgian wine exports and 47 percent of mineral water exports, while Ukraine was one of the leading importers of alcohol and spirits from Georgia (46 percent of Georgia’s exports). Tourism and remittances are other areas where Georgia is significantly tied to Russia and somewhat weaker to Ukraine. Before the pandemic, in 2019 Russia accounted for 24 percent of all tourism revenues, while Ukraine for 6 percent. Remittances from Russia accounted for 16.5 percent of total incoming transfers in 2021.
  • Second, while the Georgian government chose to largely keep a neutral stance on the war (announcing at one point that they would not join or impose sanctions against Russia), the main financial and trade international sanctions were still in effect in Georgia due to international obligations and close business ties with the West. These factors were reinforced by strong support for Ukraine among the Georgian population, where the memory of the Russian invasion of Georgia in 2008 remains uppermost.
  • In addition, Georgia is a net energy importer, and while the dependence on energy imports from Russia is not significant, the rising prices would have affected Georgia profoundly.

Original publication: This policy paper was originally published in the ISET Policy Institute Policy Briefs section by Yaroslava Babych, Lead Economist of ISET Policy Institute. To read the full policy paper, please visit the website of ISET-PI. 

Disclaimer: Opinions expressed in policy briefs and other publications are those of the authors; they do not necessarily reflect those of the FREE Network and its research institutes.

The Belarusian Currency Market During War in Ukraine: Hidden Problems and New Trends

Posted on December 5, 2022 | Policy Brief

20221205 Belarusian Currency Market Image 01

Belarus has faced unprecedented sanctions during the last year and the new economic conditions have led to a GDP decline and inflation growth. At the same time, the situation on the currency market has been stable since April 2022. The Belarusian Ruble demonstrated a gradual appreciation to the US Dollar and the Euro and a decline to the Russian Ruble. The appreciation of the Belarusian Ruble against the US Dollar has given households the illusion that the economic situation is not that bad. This brief analyses the main factors of the current situation on the currency market as well as describes the challenges which might destabilise the market. The importance of changing selected currencies in the currency basket and the start of a reorientation of the Belarusian economy from Western to Eastern partnerships, are also described.

The National Bank of the Republic of Belarus’ Policy on the Currency Market

In Belarus, currency has always played an important role as an indicator of economic stability. Household’s reactions to sharp fluctuations of the Belarusian Ruble have been expressed in an immediate demand growth for foreign currency (US Dollar and Euro mostly). After the war in Ukraine started and the exchange rate of the Belarusian Ruble began declining, people tried to make currency deposits from banks and buy foreign currency. In contrast to the Central Bank of Russia, the National Bank of the Republic of Belarus (NBRB) introduced no restrictions on the currency market. However, Belarusian financial institutions imposed their own limits on carrying out non-cash exchange operations, cash withdrawals from ATMs and from bank accounts. Financial institutions also limited the availability of currencies in exchange offices and imposed limits on payment transactions by credit card outside of Belarus. All these processes took place under the condition of a sharp devaluation of the Russian Ruble.

The dynamics in the Russian Ruble have affected the Belarusian Ruble fluctuation (see Figure 1). The correlation between the currencies was strong even before the war, given that the Russian Federation is a dominant economic partner for Belarus, and has since become stronger.

The share of Russian Ruble in the Belarusian currency basket is at 50 percent. Moreover, in Q1-Q3 2022 the Belarusian dependency on the Russian economy increased in the aftermath of losing the Ukrainian market and facing European export shortages. Between January and August 2022, the share of export of goods to CIS countries (where the main share of exports goes to Russia) was 65,7 percent, as compared to 58,4 percent for the corresponding months in 2021. The same tendencies are apparent when considering the import of goods. The share of import from CIS countries reached 64,7 percent between January and August in 2022, as compared to 61,3 percent for January-August in 2021 (BSCBR, 2022).

Figure 1. The weighted average exchange rate of the Belarusian Ruble, in Belarusian Rubles.

Source: Statistical Bulletin #9 (279) 2022.

Sanctions and the Russian Central Bank’s policy have led to a stabilisation on the Russian currency market. The Central Bank of Russia has introduced restrictions on capital outflow from the country, limited cash withdrawals from bank accounts and foreign currency purchases in exchange offices (Tinkoff, 2022). The cancelation of budget rule has further supported the Russian Ruble exchange rate. But the main reason for the Russian currency exchange rate reversal post March 2022, relates to the situation regarding foreign trade. Due to sanctions, imports had significantly decreased. At the same time, high energy prices allowed for export growth. Between January and June 2022 Russia displayed a high positive trade balance (169,62 billion USD), the largest in the last 7 years (CBR, 2022). As a result of sanctions, the Central Bank of Russia started to prepare the market to work with currencies of friendly countries.

Similar tendencies can be seen in Belarus. NBRB has changed the composition of the foreign currency trade to turn the Belarusian economy from a Western to an Eastern direction regarding economic cooperation. In July 2022 the Chinese Yen was included in the currency basket. At the same time the share of Russian Ruble was at 50 percent, the US Dollar at 30 percent, the Euro at 10 percent and the Chinese Yen at 10 percent. In August 2022, the NBRB began to define daily exchange rates for the Vietnamese Dong, Brazilian Real, Indian Rupee and UAE Dirham. Finally, since October 2022, the exchange rate for the Qatari Riyal has been defined on a monthly basis (The National Bank of Belarus, 2022). These changes are indicators of ongoing and planned structural changes to the economy to accommodate increased cooperation with the Eastern economies.

Currency Market Stabilisation and Current Risks

The Belarusian Ruble has not repeated the fluctuation of the Russian currency. It did however copy its tendency to appreciate to the US Dollar and the Euro, as of April 2022. Besides the appreciation of the Russian Ruble and personal bank’s restrictions on national currency markets, the stabilisation of the Belarusian Ruble can be explained by the positive trade balance. In contrast to Russia, the growth of net export in Belarus was due to a faster decline of imports than exports. There are several reasons why this can be a problem for currency market stabilisation in the future.

First, Belarus’ foreign trade has become more and more oriented toward the Russian market. If the main trade partner experiences difficulties (for example, oil price caps) this could lead to a devaluation of the Russian Ruble and, as a result, declining competitiveness of Belarusian goods on the Russian market.

Second, reorientation of Belarusian exports from Western to Eastern countries require time and additional financial resources and exports are not always profitable due to high logistical costs. Any additional sanctions may further limit such opportunities.

Third, main export-oriented services, such as the Transport and ICT sectors, are affected by sanctions and their consequences. In Q3 2022, the transport turnover was equal to 68,3 percent, as compared to the same period 2021. The ICT sector is still having a positive impact on GDP growth. However, in January-September 2021 the positive contribution from this sector to the Belarusian GDP was 0,9 percent, while it between January and September 2022 was only 0,2 percent.

Recent success in foreign trade is mostly due to the continuation of selling potash, nitrogen fertilisers and other products on the global market, a strong Russian Ruble and Russian market openness towards Belarusian companies, low levels of Belarusian imports, and cheap Russian gas (the special price for Belarus is 128 US Dollars for 1000 cubic meters). If the terms of trade with Russia worsen and key export-oriented industries suffer from sanctions and reputational risks, the currency market could however be destabilised.

Another problem for the Belarusian Ruble stability in the middle and long term is related to household behaviour. In January-August 2022 Belarusians sold more foreign currency than they bought. Despite the Ruble fluctuation, the high levels of net sales in March was due to bank restrictions. In June, the net purchase was related to seasonal factors (see Figure 2). For the other months of the period the net selling can be explained by a stable situation on the currency market and real incomes declining. People sold currency in an attempt to maintain their previous standards of living.

Figure 2. Balance of purchase and sale of foreign currency by households (+ “net purchase”, – “net sale”), mln. USD.

Source: Based on data from the National Bank of Belarus.

In September-October 2022 Belarusian households bought more than (an equivalent of) 300 mln. USD on net basis, primarily in USD or Euro, which is very unusual for the Belarusian market situation. There are several possible explanations for such behaviour:

  1. Despite difficulties with obtaining visas Belarusians are going to Poland and other European countries to shop. Because of sanctions, retaliatory sanctions as well as a high price control on the domestic market, the range of goods has shrunk, and prices have risen. In European countries Belarusians can purchase much cheaper goods both for personal use and for resale.
  2. Partial mobilisation in Russia has increased the uncertainty of further political steps in Belarus. Households thus purchase foreign currency to establish an extra safety cushion.
  3. In Q3 2022 there was a net cash outflow on international remittances, for the first time since 2017. Traditionally, Belarus has seen a net inflow of foreign remittances. In 2022 Belarusian banks were switched off from the SWIFT system which incurred problems with operations in foreign currencies for banks under sanctions. As a result, cash inflow has declined (see Figure 3). Cash outflows however remained on the same level as in previous years. This can be explained by high-level specialists and people employed within ICT leaving the country. During relocation people have sold apartments and cars and exchanged accumulated incomes from Belarusian Rubles to US Dollars or Euros and sent to foreign bank accounts (even under the conditions of facing difficulties with conducting money transfers).

Figure 3. Net cash inflow (+)/ outflow (-) for international remittances, USD mln.

Source: Based on data from the National Bank of Belarus.

Maintaining the trend of net currency purchase together with possible trade balance deterioration may exacerbate the situation on the domestic currency market. Another risk to the currency market stability is posed by the insufficient size of FX reserves (in the amount of less than 3 months of import). Moreover, the 900 mln. US Dollars in reserves, given by the IMF in 2021 as support to fight Covid-19, can’t be used as this financial support is given in the form of SDR (Special Drawing Rights), and the exchange of SDR to US Dollars or other currencies is challenging due to sanctions (Congress, 2022).

At the same time, the Government’s decision to make external debt payments in Belarusian Rubles supports the FX reserves level. It has also been decided that payments on Eurobonds to the Nordic Investment Bank, the European Bank of Reconstruction and Development and the International Bank of Reconstruction and Development are to be paid in Rubles. These decisions have decreased the country’s long-term rating on foreign liabilities to the Restricted Default level. In that sense, short-term gains can lead to significant financial losses in the long term. In the future it will be necessary not only to pay outstanding debts but also to improve Belarus’ reputation on the international financial market. Today, the Russian Federation is the main investor in the Belarusian economy. But since its support is limited, it is likely to be insufficient for the safe functioning of the Belarusian economy.

Conclusion

The stability of the Belarusian currency market is not the result of economic success, but rather a reflection of the tightening of the economy. The appreciation of the Belarusian Ruble to the US Dollar and Euro has taken place during an accelerated reduction in Belarusian imports. At the same time the weakness of the Belarusian currency to the Russian Ruble entails competitiveness of Belarusian products on the Russian market. Foreign exchange reserves, although insufficient, have maintained in size due to the low demand for foreign currency and foreign debt payments in Belarusian Rubles. Disruptions to economic and political relations with Western countries stimulates the Belarusian authorities to reorient the economy towards Eastern partners, which has led to a modification of the currency basket composition. In the long run, the current stability of the Belarusian currency can quickly disappear in case one or several risks are realised. If the Russian Ruble devaluates or trade balance deteriorates and demand for foreign currency increases, the stability of the Belarusian Ruble exchange rate can be ruined.

References

Disclaimer: Opinions expressed in policy briefs and other publications are those of the authors; they do not necessarily reflect those of the FREE Network and its research institutes.

The Bleak Economic Future of Russia

Posted on October 31, 2022 | Policy Brief

20221031 Economic Future of Russia Image 01

Is the Russian economy “surprisingly resilient” to sanctions and actions of the West? The short answer is no. On the contrary, the impact on Russian growth is already very clear while the economic downturn in the EU is small. The main effects from the sanctions are yet to be realized, and the coming sanctions will be even more consequential for the Russian economy. The biggest impacts are however those in the longer run, beyond the sanctions. Mr. Putin’s actions have led to a fundamental shift in the perception of Russia as a market for doing business. The West and especially EU countries are on a track of divesting their economic ties to Russia (in particular in, but not only, energy markets) and the country is simultaneously losing significant shares of its human capital. All these effects mean that the long-term economic outlook for Russia is not just a business cycle type recession but a lasting downward shift.

Introduction

The global economic outlook at the moment seems rather bleak. According to the International Monetary Fund’s (IMF) most recent World Economic Outlook, global growth is expected to slow from above 6 percent in 2021, to 3.2 percent this year, and 2.7 percent in 2023. For the US and the Euro area the corresponding numbers are slightly above a 5 percent growth in 2021, between 2 and 3 percent in 2022, while barely reaching 1 percent in 2023. At the same time inflation is up and central banks are trying to curb this by raising interest rates.

From an EU perspective it is an open question what proportion of the lower growth is caused by the economic consequences of the Russian invasion of Ukraine. Certainly, energy prices are affected as well as issues relating to natural resources and agricultural products (though the consequences of shortages in these goods are far larger for Middle Eastern, North African and Sub-Saharan countries). But it is not the case that all of the economic problems in the EU are due to the changed economic relations with Russia.

In assessing the economic impact of Russia’s war, and in particular the impact of sanctions, it is important to focus on both expectations as well as proportions. A widespread narrative portrays Russia’s relative economic resilience (compared to the expectations of some in March/ April 2022) as the Russian economy being surprisingly unaffected, while the EU is depicted as being badly hit, especially by high energy prices. In a European context, the Swedish daily newspaper Dagens Nyheter claims that “experts are surprised over Russia’s resilience” and the Economist, a British weekly newspaper, recently portrayed recession prospects for Europe as “Russia climbs out”. We argue that such point of view is misleading. To get a more balanced image of what is unfolding it is important to think both about the expected consequences of sanctions, including how long some of them take to have an effect, but also (and maybe most important when thinking about the long run), what economic consequences are now unfolding beyond the impact of sanctions.

Sanctions Against Russia

Let us start with what sanctions are in place, what types of impact these have had so far and what can be expected in the future. There are three types of sanctions currently in place. First, and most impactful in the short run, are limitations on financial transactions, especially those imposed on the Central Bank. In this category there are also the restrictions on other Russian banks disconnecting them from a key part of the global payment system, SWIFT, as well as measures targeting other assets: divestments from funds, investment withdrawals, asset freezes, and other impediments to financial flows. The main short-term aim of these actions was to reduce the Russian government’s alternatives to finance the army and their military operations. Second there are sanctions on trade in goods and services. At the moment these target particularly technology imports and energy and metals exports. These take a longer time to be felt and are potentially more costly to the sanctioning countries as well. They also contribute, in principle, to reduced resources for war. Besides affecting the government’s budget, both financial and trade sanctions disturb ordinary people’s lives as well and might create discontent and protests. A third group of sanctions are so-called sanctions of inconvenience such as limitations to air traffic, closure of air space, exclusion form sport and cultural events, restrictions of movement for both officials and tourists, and others, which aim at disconnecting the target country from the rest of the world. These are partly symbolic in nature, but can also impact popular opinion, including among the elites. However, a potential problem is that such sanctions can push opinion in either of two opposite directions: against the target regime in sympathy with the sanctioning parties; or against what is now perceived as an external enemy in a so-called rally-around-the-flag effect.

Along these dimensions the sanctions have so far had mixed effects in relation to the objectives listed above. We will return to this issue below, but in short, the sanctions on the Central Bank and the financial system, albeit powerful, fell short of causing anything like a collapse of the Russian financial system. Some of the trade restrictions, together with other global economic events, created an environment where lost trade volumes for Russia were compensated by price increases in resources and energy exports. When it comes to restrictions on imports of many high-tech components, these are certainly being felt in the Russian economy although still not fully. Public perceptions in Russia are hard to judge from the outside, especially given the problems of voiced opposition in the country, while public perceptions in sanctioning countries have mainly been favorable as people want to see that their governments are “doing something”.

What Do We Know About Sanctions in General?

A key question when judging whether sanctions “work” is to study what a reasonable benchmark can be. As discussed in a previous FREE Policy Brief (2012), sanctions don’t enjoy a reputation of being very effective. This is true both in the research literature as well as in the public opinion. There are reasons for this that have to do with both how “effectiveness” is intended and the limits that empirical enquiries necessarily face in trying to answer the question of effectiveness. This does not mean, however, that sanctions have no effect. Another FREE Policy Brief (2022) summarizes a selection of the most credible research in this area. In short, a majority of studies find that sanctions affect the population in target countries through shortages of various kind (food, clean water, medicine and healthcare), resulting in lower life expectancy and increased infant mortality. The types of effects are comparable to the consequences of a military conflict. In the cases where it has been possible to credibly quantify the damage to GDP, estimates are in the range of 2 to 4 percent of reduced annual growth over a fairly long period (10 years on average and up to 3 years after the lifting of sanctions). One has to keep in mind that lower growth rates compound over time, so that the total loss at the end of an average period is quite substantial. As a comparison, the latest estimate of the total loss in global GDP from the Covid-19 crisis stands at “just” -3.4 percent. Other studies find similarly significant negative effects on other economic outcomes such as employment rate, international trade, public expenditure, the value of the country’s currency, and inequality. There is of course variation in the effects depending on the type of sanctions and also on the structure of the target economy. Trade sanctions tend to have a negative effect both in the short and long run, while smart sanctions (i.e. sanctions targeting specific individuals or groups) may even have positive effects on the target country’s economy in the long run.

Sanctions and the Current State of the Russian Economy

When it comes to the Russian economy’s performance in these dire straits, the very bleak forecasts from spring 2022 have since been partly revised upwards. Some are surprised that the collective West has not been able to deliver a “knock-out blow” to the Russian economy. In light of what we know about sanctions in general this is perhaps not very surprising. Also, one can recall that even a totally isolated Soviet economy held up for quite some time. This however does not mean that sanctions are not working. There are several explanations for this. As already mentioned, some of the restrictions imply by their very nature some time delay; large countries normally have stocks and reserves of many goods – and on top of this Mr. Putin had been preparing for a while. Also, the undecisive and delayed management of energy trade from the EU reduced the effectiveness of other measures, in particular the impact of financial restrictions. Continued trade in the most valuable resources for the Russian government together with spikes in prices (partly due to the fact that the embargo was announced several months ahead of the intended implementation) flooded the Russian state coffers. This effect was also enlarged by the domestic tax cuts on gasoline prices in many European countries in response to a higher oil price (Gars, Spiro and Wachtmeister, 2022). This is soon coming to an end, but at the moment Russia enjoys the world’s second largest current account surplus.

The phenomenal adaptability of the global economy is also playing in Russia’s favor: banned from Western markets, Russia is finding new suppliers for at least some imports. However, although they are dampening and slowing the blow at the moment, it is difficult to envision how these countries can be substitutes for Western trade partners for many years to come.

The Russian Economy Beyond Sanctions

Given all of this, the impact on the Russian economy is not nearly as small as some commentators claim. Starting with GDP, an earlier FREE Policy Brief (2016) shows how surprisingly well Russia’s GDP growth can be explained by changes in international oil prices. This is true for the most recent period as well, up until the turn of the year 2021-2022 and the start of hostilities, as shown in Figure 1. Besides the clear seasonal pattern, Russian GDP (in Rubles) closely follows the BRENT oil price. This simple model, which performs very well in explaining the GDP series historically, generates a predicted development as shown by the red dotted line. Comparing this with the figures provided by the Russian Federal State Statistics Service, Rosstat, for the first two quarters of 2022 (which might in themselves be exaggeratedly positive) indicates a loss by at least 8 percent in the first and further 9 percent in the second quarter. In other words, GDP predicted by this admittedly simple model would have been 19 percent higher than what reported by Rosstat in the first half of 2022. As a comparison, Saudi Arabia – another highly oil dependent country – saw its fastest growth in a decade during the second quarter, up by almost 12 percent.

Figure 1. Russian GDP against predictions

Source: Authors’ calculations on GDP in rubles based on figures from Rosstat and the BRENT oil price series. Note that GDP is denominated in Rubles to avoid confusion due to the USD/Rubles exchange rates being volatile (given the lack of trade post invasion) and thus hard to interpret.

Other indicators point in the same direction. According to a report published by researchers at Yale University in July this year, Russian imports, on which all sectors and industries in the economy are dependent, fell by no less than ~50 percent; consumer spending and retail sales both plunged by at least ~20 percent; sales of foreign cars – an important indicator of business cycle – plummeted by 95 percent. Further,  domestic production levels show no trace of the effort towards import substitution, a key ingredient in Mr. Putin’s proposed “solution” to the sanctions problem.

Longer Term Trends

There are many reasons to be concerned with the short run impact from sanctions on the Russian economy. Internally in Russia it matters for the public opinion, especially in parts that do not have access to reports about what goes on in the war. Economic growth has always been important for Putin’s popularity during peace time (Becker, 2019a). In Europe it matters mainly because a key objective is to make financing the war as difficult as possible, but also to ensure public support for Ukraine. A perception among Europeans that the Russian economy is doing fine despite sanctions is likely to decrease the support for these measures. However, the more important economic consequences for Russia are the long-run effects. Many large multinational firms have left and started to divest from the country. There has always been a risk premium attached to doing business in Russia, which showed up particularly in terms of reduced investment after the annexation of Crimea in 2014 (Becker, 2019b). But for a long time hopes of a gradual shift and a large market potential kept companies involved in Russia (in some time periods more, in others less). This has however ended for the foreseeable future. Many of the large companies that have left the Russian market are unlikely to return even in the medium term, regardless of what happens to sanctions. Similarly, investments into Russia have been seen as a crucial determinant of its growth and wellbeing (Becker and Olofsgård, 2017), and now this momentum is completely lost.

Energy relations have been Russia’s main leverage against the EU although warnings about this dependency have been raised for a long time. In this relationship, there has also been a hope that Russia would feel a mutual dependence and that over time it would shift its less desirable political course. With the events over the past year, this balancing act has decidedly come to an end, if not permanent, at least for many years to come. The EU will do its utmost not to rely on Russian energy in the future, and regardless of what path it chooses – LNG, more nuclear power, more electricity storage, etc. – the path forward will be to move away from Russia. Of course, there are other markets – approximately 40 percent of global GDP lies outside of the sanctioning countries – so clearly there are alternatives both for selling resources and establishing new trade relationships. However, this will in many cases take a lot of time and require very large infrastructure investments. And perhaps more important, for the most (to Russia) valuable imports in the high-tech sector it will take a very long time before other countries can replace the firms that have now pulled out.

Yet another factor that will have long-term consequences is that many of these aspects are understood by large parts of the Russian population, and those with good prospects in the West have already left or are trying to do so. It has been a long-term goal for those wanting to reform the Russian economy, at least in the past 20 years, to attract and put to fruition the high potential that have been available in terms of human capital and scientific knowledge. However, these attempts have not succeeded and the recent developments have put a permanent end to those dreams.

Conclusion

In the latest IMF forecast, countries in the Euro area will grow by 3.1 percent this year and only 0.5 percent in 2023. In January the corresponding numbers stood at 3.9 percent and 2.5 percent. This drop, caused in large part by the altered relations with Russia, is certainly non negligible, and especially painful coming on the heels of the Covid-19 crisis. However, it is an order of magnitude smaller than the “missed growth” Russia is experiencing. When judging the impact from sanctions on the Russian economy overall, the correct (and historically consistent) counterfactual displays a sizable GDP growth driven by very high energy and commodity prices. Relative to such counterfactual, the sanctions effect is already very noticeable. In the coming months, economic activity will slow down and many European household will feel the consequences. In this climate it will be important that, when assessing the situation with Russia perhaps performing better than expected, the following is kept in mind. Firstly, Russia is still doing much worse compared to the EU as well as to other oil-producing countries. Secondly, and even more important, what matters are the longer run prospects. And these are certainly even worse for the Russian economy.

References

Disclaimer: Opinions expressed in policy briefs and other publications are those of the authors; they do not necessarily reflect those of the FREE Network and its research institutes.

Belarus Under War Sanctions

Posted on October 17, 2022 | Policy Brief

Image of farm tractor loaded on a freight train representing Belarus Under War Sanctions

Numerous developed countries have imposed tough sanctions on Belarus, as the Belarusian regime has become part of the Russian aggression against Ukraine. At the same time, economic relations with Ukraine have been disrupted. These shocks have simultaneously disturbed the Belarusian economy and triggered a severe recession. Thanks to several positive effects from the external environment, some success from measures undertaken by the authorities to stabilize output, and some degree of resilience – all seasoned with a large portion of good luck – the situation of the Belarusian economy is however “not that bad”. Nonetheless, the Belarusian economy is experiencing its worst economic crisis since the mid-1990s, and the current path of the economy is highly unstable and associated with numerous risks and threats. In economic terms, it is likely the case that the full costs from the sanctions are yet to be paid.   

Sanctions, Multiple Shocks and Their Potential Implications

As the Belarusian regime has become part of the Russian war on Ukraine many developed countries have adopted tough sanctions against Belarus. These sanctions include an embargo on a large share of Belarusian exports and imports, prohibitions and restrictions on transportation of goods of Belarusian origin, restrictions on and/or blocking actions regarding financial operations and settlements, a freeze of parts of the Belarusian international reserves, and numerous restricting and blocking actions against banks, companies and individuals. Such sanctions, combined with a new external environment, cause powerful indirect effects with foreign companies exiting the Belarusian market and refusing business with Belarusian counterparts. Additionally, some Belarusian businesses and employees have left the country. On top of this, economic relations with Ukraine, formerly Belarus’s second largest trading partner, have been virtually reduced to zero.

In economic terms, the above mentioned may be treated as a bundle of simultaneous powerful shocks to the national economy, differing in direction, mechanics, size, and persistence. These shocks may be grouped into three clusters.

The first cluster covers demand shocks, and in particular export shocks. According to our assessments, the exogenous demand shock following the sanctions may reduce Belarusian exports (in physical terms) by 40 percent, compared to previous steady-state levels. This figure should however be seen as a potential lower bound which may be realized if no measures to mitigate the impact from the sanctions are undertaken. Belarusian authorities and businesses are however doing their best trying to find new buyers for the “vanishing” exports, bypass restrictions in order to connect to “old” buyers, and establish new logistic and financial chains. The extent to which these attempts may be successful depends on the global environment, the degree of the price competitiveness of Belarusian producers, and numerous non-economic factors. Additionally, all factors affecting exports are unstable and volatile. Exports under these new conditions are therefore less sustainable and may fluctuate in an extremely wide range. Shocks to consumption and investments stemming from weakened sentiment and expectations further amplify the demand shocks.

The second cluster of shocks relates to the supply side of the economy. It includes business closures, emigration that weakens labor supply, and production bottlenecks due to the inaccessibility of imports. Supply shocks are hard to quantify, but we perceive them as persistent and cumulative. Business closures and emigration have irrevocable effects on the national economy (at least in the medium-term), and a continuation of such drop-outs will likely amplify the size of the shock.

The third cluster combines different primarily nominal shocks: price, exchange rate, financial stability and fiscal ones. Such shocks have become permanent companions to the Belarusian economy under the sanctions, and they are volatile in terms of size. As a result, the corresponding economic indicators are likely to also become highly unstable.

This bundle of adverse shocks shifts the economy down from the previous, close to steady-state, trajectory. A new trajectory is however far from predetermined. Firstly, it depends on the effectiveness of the government in curbing the shocks stemming from the sanctions, as the actual path of the economy may be considerably affected by monetary or fiscal policy and other interventions. Secondly, some positive exogenous shocks may partially offset the effects from adverse ones. Lastly, the economy, at least for a while, may resist through exploitation of accumulated buffers (such as, international reserve assets, financial reserves of State-owned enterprises that were accumulated under favorable conditions in 2021 etc.).

Considering the worst possible assumptions regarding the above mentioned issues, our model-based simulations predict a severe recession of about 20 percent (as compared to the output peak in 2021-Q2). This recession is accompanied by a sharp increase in inflation (which in turn is highly likely to be supplemented by a full-fledged financial crisis). This simulation should however be regarded as the potential rock bottom. Whether it will become reality or not critically depends on the Belarusian government’s policies.

Policy Response by the Authorities

The root cause of the problem, namely the provision of Belarusian territory for the Russian army, has never been publicly discussed by Belarusian officials. Instead, the government has focused on strategies which treat the symptoms, rather than focusing on curing the disease itself. The main coping strategies that were publicly discussed include: 1) expected increase in Russian support and exports to Russia 2) re-orientation of exports towards Asian and developing markets 3) greater mobilization of domestic resources and 4) monetary, fiscal and other stimuli.

The Russia-related initiatives are often beyond convention and include some radical proposals. These are, for instance, accelerating the establishment of sea terminals in Russian ports, promoting exports to Russia, and requesting greater financial support from Russia linked to the so-called “deep integration” package (mainly in the form of energy subsidies, import substitution investments and direct subsidies). Adherence to these proposals would mean that Belarusian authorities de facto accept serving as a Russian protectorate and correspondingly take on the role of a puppet government.

Belarusian authorities have reached some success from choosing the “Russian track” as the debt payments to Russia were postponed, new cheap gas and oil prices were granted and export to Russia increased by 15 percent in the first 8 months of 2022. The Belarusian regime’s $7 billion compensation claim for incurred economic losses due to the war has however been rejected by Russia so far.

The coping strategy of export re-orientation serves primarily as a rhetoric intervention as China and other Asian countries considered by the government cannot fully replace the European market. For many Belarusian exports, the EU was a premium, high-margin market while re-orientation means at best lower margins. The success of re-orientation depends on the degree of price competitiveness, which can change greatly over time.  The only success from this strategy to date is the re-orientation of 10 percent of potash exports to China via railroad (incurring greater transportation costs).

The third strategy “greater mobilization of domestic resources” firstly assumes more interference with the business activity of State-owned enterprises (SOE). Despite severe demand shocks these are pressured by the government to maintain production and/or salaries, the latter in order to support output via sustained consumer demand. Further, a “discipline” component of the strategy is implemented through renewed catch-pay-and-release practices. In effect, businessmen are arrested based on anti-corruption or tax fraud criminal charges. They are then offered to pay certain amounts to the state and released if they choose to pay.

Since late spring, when direct financial shocks have been suppressed, the authorities have intensified stimulus measures to the economy. In the fiscal sphere, these are aimed at promoting exports and mainly provided on an individual or sectoral basis. To a large extent, these stimuli may be seen as partial compensation to SOEs for their output-supporting role. In the monetary sphere a specific environment in which the Russian ruble is appreciated vs. the US dollar, despite the worldwide strength of the latter, has allowed the authorities to implement a “magic” (but highly likely temporary) solution: The Belarusian national currency is manipulated to depreciate vs. the Russian ruble (both in nominal and real terms) but appreciate vs. the US dollar. The former leads to a great increase in price competitiveness (as Russia is today the dominant trading partner), while the latter serves as a buffer for fragile prices and provides financial stability. Moreover, the authorities have excessively softened monetary policy, trying to spur domestic credit. These measures lead to heightened inflation pressure, which is however somehow suppressed by reinvigorated direct price controls.

Current Situation and Future Implications

Until now, the Belarusian economy places far from the potential rock bottom. By the end of the second quarter in 2022, output losses (vs. the output peak in 2021-Q2) amounted to about 5.5 percent. By the end of 2022, they are however expected to increase to about 8.5 percent (vs. the 2021-Q2 output peak). The Belarusian economy is stuck in a heightened inflation environment – with the inflation being as high as 20 percent in annual terms. Although the inflation is considerably higher than in “normal times”, it is still not a disaster (considering the much higher projected level under the worst-case scenario and the background of 40-year peak in global inflation). Moreover, the current situation is still far from a full-fledged financial crisis, despite some financial turbulence.

The position of the economy as “not that bad”, is a result of existing buffers, positive effects from the external environment and some immediate efficiency from actions undertaken by the authorities to stabilize output – all seasoned with a large portion of good luck.  For instance, the jump in price competitiveness accounts for a large share of curbing efforts that counter the sanctions. This is, in turn, due to a combination of high global prices, low and frozen energy prices for Belarus, and a very specific and unstable stance on monetary policy underpinned by direct price controls. Some buffer savings that Belarusian SOEs succeeded to accumulate during the period of the so-called “foreign trade miracle” in late 2020 and 2021 also play an important role. Last but not least, the Belarusian authorities seem to have succeeded in the partial curbing of the export shock. Since the beginning of summer, there are some signs of recovery in exports which most likely reflects a partial recovery of exports within the most sensitive domains: oil products and potash fertilizers (corresponding statistics have been blocked out).

However, the “not that bad” position of the economy does not mean good. According to all standard metrics, Belarus is currently experiencing a severe economic crisis. The notion that it could be even more severe is bad news, not good ones. Moreover, the current situation is extremely unstable and fragile. The economy is facing numerous distortions, contradictions and risks, all of which can still shift the scenario of the crisis from the “not that bad” situation to the worst possible.

Conclusion

The Belarusian regime’s involvement in the Russian aggression against Ukraine have propelled Belarus into the most severe economic crisis since the mid-1990s. Until recently, fortunate external economic circumstances, a specific policy mix and a good portion of luck have allowed for a partial mitigation of the crisis. The situation is however extremely unstable and the full effects from the sanctions are likely yet to be realized.

Disclaimer: Opinions expressed in policy briefs and other publications are those of the authors; they do not necessarily reflect those of the FREE Network and its research institutes.

Sanctions Enforcement and Money Laundering

Posted on October 3, 2022 | Policy Brief

US dollar hang out to dry representing Sanctions Enforcement and Money Laundering

With sanctions becoming an increasingly important tool in ostracising autocratic regimes from western markets, the need for effective enforcement of Anti-Money Laundering (AML) policies is increasing. The global AML regime will be the backbone in detecting evasion of sanctions. This regime has, however, been widely criticised as ineffective. In this brief, we discuss issues with the current AML regime and propose a reward scheme for whistleblowers to enable asset seizures. A powerful feature of our proposal is that it does not rely on the effectiveness of the AML regime.

Introduction

Before Russia’s invasion of Ukraine, we wrote a FREE Policy brief expressing concerns over the ability of the current Anti Money Laundering (AML) regime to keep money launderers out of the international financial system. In the brief, we concluded that “The ease with which criminals have evaded present detection methods should cause concern about the effectiveness of sanctions”. The issue has now received renewed attention as the current sanctions against Russia will only be effective if it is difficult or costly to circumvent them. Sanctions evasions have a lot of similarities with money laundering, and the methods for detecting both is very similar, such that the proposal we discuss in this brief is applicable to both.

While an initial shock due to unexpected sanctions may generate disruptions, prohibited goods can later be imported/exported through third-party intermediaries in non-sanctioned countries to circumvent the sanctions. False labelling of origin, misinvocing, etc., are likely to occur and may be very difficult to detect. Analogously, sanctioned individuals’ assets may shift hands, and be laundered through shell companies without known beneficial owners.

In this brief, we consider a way to enhance enforcement, as outlined in a recent paper (Nyreröd, Andreadakis, and Spagnolo, 2022). The approach builds upon the US Kleptocracy Asset Recovery Rewards Program which offers up to $5 million “for information leading to seizure, restraint, or forfeiture of assets linked to foreign government corruption” (US Treasury, 2022).

The AML Regime

To justify the enforcement mechanism we later propose, some background on the AML regime is necessary. The global standard-setter for AML is the Financial Action Taskforce (FATF), which has since 1989 issued recommendations to countries on how to combat money laundering and terrorist financing. While initially focusing on drug money, the regime expanded in the last decades and has now received increased attention as it will be an important tool in ensuring sanctions against Russian oligarchs are effective.

The regime imposes numerous obligations on financial and other entities as they must assess risks and conduct due diligence along various dimensions, collect documents, and send reports to the national Financial Intelligence Unit. This regime has been widely criticized. Widespread AML non-compliance within banks, lack of rigorous supervision and enforcement by national supervisors and high costs relative to verifiable benefits are some of the issues that have been identified (Spagnolo and Nyreröd 2021; Nyreröd, Andreadakis and Spagnolo, 2022). The World Bank estimates that between 2 and 5 percent of global GDP is laundered annually, and that only around 0.2 percent of the proceeds from crime, laundered via the financial system, are seized and frozen (UNODC, 2011). Researchers have also been critical – for example Pol (2020), cites 22 papers that have “identified gaps between the intentions and results of the modern anti-money laundering effort, including its core capacity to detect and prevent serious profit-motivated crime and terrorism” (p.103).

Recent responses by the European Commission and others have focused on ensuring compliance within covered entities. Yet, increasing compliance with current AML rules may be costly and non-sufficient to stem the flows of illicit money in the international system. Even if widespread compliance within covered entities is obtained, and the AML procedures are effective, this may not be enough – even minimal non-compliance rates may result in major damages. We have seen how Danske Bank Estonia, a relatively small branch, managed to transfer around $230 billions of suspicious funds within the span of a couple of years (Bruun and Hjejle, 2018).

Some have suggested providing whistleblower rewards to those who report significant violations of AML rules by covered institutions (Spagnolo and Nyreröd, 2021; Scarcella, 2021). Yet, such rewards are only desirable if the AML regime is effective in achieving its policy objectives, which is not a given (we elaborate on this in Nyreröd, Andreadakis and Spagnolo, 2022). Enhanced compliance with the AML regime does not necessarily entail increased detection and deterrence of e.g., money laundering.  Numerous laundering methods exist that circumvent the reporting rules required under AML. A better option may be to incentivize facilitators of money laundering to provide information leading directly to asset seizures, as they have the best information that can lead to such forfeitures.

Incentivizing Facilitators

Money laundering is a derivative crime and requires what is called a “predicate offense” (such as human trafficking, drug sales, or corruption) that generates illegal money whose source needs to be obscured. The EU Directive (2018/1673) stipulates 22 categories of criminal activities that constitute predicate offenses.

There is a large infrastructure facilitating money laundering including financial advisers, real estate agents, tax advisors, and lawyers – crucial to criminals seeking to launder money. Bill Browder, famous for his work on advocating the Magnitsky Act, describes how he was aided by Alexander Perepilichnyy, a financial adviser for individuals involved in a large tax theft in Russia. Perepilichnyy helped launder the money for those involved in the tax theft, but eventually turned whistleblower when he provided bank statements to Browder that led to the freezing of $11 million related to this fraud (Browder 2022, p. 39). His information provided a “road-map” to even be able to start investigating where the illegally stolen assets had ended up. Perepilichnyy later died while jogging near London in 2012, which some believe was a murder in retaliation for blowing the whistle. A reward scheme would aim at people like Perepilichnyy, persons who are unrelated to the predicate offense, yet have information on the source and location of illicit funds.

Reward Programs in AML

The US has used whistleblower reward schemes in several regulatory areas including tax, procurement fraud, and securities fraud. These programs offer 10-30 percent of the recoveries or fines to whistleblowers that bring information crucial to issue the fines or recover public funds. Rewards to whistleblowers are therefore paid by the wrongdoing party, not the taxpayer.

These programs have received increased attention as several studies have found that they are effective at uncovering and deterring wrongdoing (Dyck, 2010; Wiedman and Zhu, 2018; Raleigh, 2020; Leder-Luis, 2020; Dey et al., 2021; Berger and Lee, 2022, see Nyreröd and Spagnolo, 2021 for a review). Agencies managing these programs have widely praised them, and studies show they are highly cost effective. More countries are also starting to experiment with offering rewards for information.

A salient feature of the US programs is that some degree of culpability in the wrongdoing does not disqualify an individual from an award. In 2012, Bradley Birkenfeld received $104 million under the Internal Revenue Service’s reward program despite serving a jail sentence for his involvement in facilitating tax evasion. In fact, when one of the most effective and famous whistleblower laws was enacted, the US Senator who tabled the bill argued that the bill aimed at “setting a rogue to catch a rogue” which “is the safest and most expeditious way I have ever discovered of bringing rogues to justice” (Howard, 1863).

Motivated by these experiences, we propose that AML should incorporate a whistleblower reward scheme, targeting those facilitating money laundry, with three central pillars:

Witness protection: aim at shielding whistleblowers and their families from negative consequences, if there are concerns that they might become victims of retaliation, harassment, or mistreatment of any kind. If the whistleblower is based in a hostile country, guaranteed asylum should be granted.

Leniency: offer immunity for any reported offense related to money laundering, but not for any other crime. Without immunity, a whistleblower will have no incentive to turn to authorities as they would immediately incriminate themselves and risk jailtime for money laundering.

Large, scaling, and mandatory rewards:  offer large, mandatory rewards that scale with the level of recoveries. As noted above, successful US programs pay 10-30 percent of the recoveries to whistleblowers. In the money laundering case, this percentage range may be lowered. Also, similarly to whistleblowers’ rewards in other cases, AML rewards would come from confiscated funds.

Numerous other design dimensions are important, but due to space limitations we refer the reader to other lengthier pieces that go into further detail (Nyreröd, Andreadakis and Spagnolo, 2022; Spagnolo and Nyreröd, 2021; Nyreröd and Spagnolo, 2021; Engstrom 2018).

Conclusion

The Russian aggression against Ukraine and the subsequent sanctions have put increased emphasis on the ability and effectiveness of the current AML regime to detect money laundering. Justified concerns about this regime have been raised, and its performance record is still under question. Programs offering whistleblowers witness protection, leniency, and large rewards could be an effective complement to this regime.

References

  • Berger, P. and Lee, H. (2022), “Did the Dodd-Frank Whistleblower Provision Deter Accounting Fraud?”, Journal of Accounting Research, early view, available at: https://doi.org/10.1111/1475-679X.12421
  • Browder, B. (2022b). Freezing Order, Simon & Schuster, New York, NY.
  • Bruun and Hjejle. (2018). “Report on the Non-Resident Portfolio at Danske Bank’s Estonian Branch”. Danske Bank.
  • Dey, A., Heese, J. and G. Pérez-Cavazos. (2021). “Cash-for-Information Whistleblower Programs: Effects on Whistleblowing and Consequences for Whistleblowers”, Journal of Accounting Research, Vol. 59, No.5, pp.1689-1740.
  • Dyck, A., Morse, A. and Zingales, L. (2010). “Who Blows the Whistle on Corporate Fraud?”, The Journal of Finance, Vol. 65, No.6, pp.2213-2253.
  • Engstrom, D. (2018). “Bounty Regimes.” In Arlen, J. (ed.) Research Handbook on Corporate Crime and Financial Misdealing, Edward Elgar.
  • Howard, J.M. (1863). Congressional Globe, Senate, 37th Congress, 3rd Session, pp. 955-956.
  • Leder-Luis, J. (2020). “Whistleblowers, Private Enforcement, and Medicare Fraud”, Working Paper, Massachusetts Institute of Technology, available at: https://sites.bu.edu/jetson/files/2020/07/False-Claims-Act-Paper.pdf.
  • Nyreröd, T. and Spagnolo, G. (2021). “Myths and numbers on whistleblower rewards”, Regulation and Governance, Vol. 15, No.1, pp.82-97.
  • Nyreröd, T., Andreadakis, S. and Spagnolo, G. (2022). “Money laundering and sanctions enforcement: large rewards, leniency, and witness protection for whistleblowers”, The Journal of Money Laundering Control, early view available at: https://www.emerald.com/insight/content/doi/10.1108/JMLC-05-2022-0068/full/html
  • Pol, R. (2020). “Responses to money laundering scandal: evidence-informed or perception-driven?”, Journal of Money Laundering Control, Vol.23, No.1, pp.103-121.
  • Raleigh, J. (2020). “The Deterrent Effect of Whistleblowing on Insider Trading”, University of Minnesota Working Paper, available at: https://papers.ssrn.com/sol3/papers.cfm?abstract_id=3672026.
  • Scarcella, G. (2021). “Qui Tam and the Bank Secrecy Act: A Public-Private Enforcement Model to Improve Anti-Money Laundering Efforts”, Fordham Law Review, Vol. 90, No.3, pp.1359- 1395.
  • Spagnolo, G. and Nyreröd, T. (2021). “Financial Incentives to whistleblowers: a short survey”, Sokol, D. and van Rooij, B. (Ed.), Cambridge Handbook of Compliance, Cambridge University Press, Cambridge UK, pp.341-351.
  • Spagnolo, G. and Nyreröd, T. (2021a). “Money Laundering and Whistleblowers”, report written for Centre for Business and Policy Studies (SNS), available at: https://snsse.cdn.triggerfish.cloud/uploads/2021/11/money-laundering-and-whistleblowers.pdf.
  • UNODC. (2011). “Estimating Illicit Financial Flows Resulting from Drug Trafficking and Other Transnational Organized Crimes”, Research Report, United Nations Office on Drugs and Crime, available at: https://www.unodc.org/documents/data-and-analysis/Studies/Illicit-financial-flows_31Aug11.pdf.
  • US Treasury. (2022). “U.S. Departments of Treasury and Justice Launch Multilateral Russian Oligarch Task Force”, March 16, available at: https://home.treasury.gov/news/press-releases/jy0659.
  • Wiedman, C. and Zhu, C. (2018). “Do the SEC Whistleblower Provisions of Dodd-Frank Deter Aggressive Financial Reporting?”, 2018 Canadian Academic Accounting Association Annual Conference, available at: https://papers.ssrn.com/sol3/papers.cfm?abstract_id=3105521.

Disclaimer: Opinions expressed in policy briefs and other publications are those of the authors; they do not necessarily reflect those of the FREE Network and its research institutes.

The Effects of Sanctions

Posted on May 10, 2022 | Policy Brief

20220510 The Effects of Sanctions Image 01

Sanctions imposed on Russia after its invasion of Ukraine are argued to be the strongest and farthest-reaching imposed on a major power after WWII, more numerous and more comprehensive than all other measures currently in force against all other sanctioned countries. A question often asked, which is hard to answer, is whether sanctions are effective. In the present case, the effect most associate with success would be a swift end of the hostilities, perhaps accompanied by a regime change in Russia. But even when it seems these prizes are out of reach, sanctions certainly have effects, all too often glossed over by the debate but nonetheless of significance.

Why Are Sanctions Seen as Ineffective?

Sanctions are restrictions imposed on a country by one or more other countries with the intent to pressure in effect some desirable outcome, or conversely to condemn and punish some undesired action already taken. When evaluating sanctions, therefore, the focus is naturally on whether they succeed to discourage this particular course of action, or to remove the decision-makers responsible for it. And on this account, sanctions are overwhelmingly seen as unsuccessful. However, a few complications cloud this conclusion.

First of all, sanctions that are implemented already failed at the threat stage. If the threat of a well-specified and credible retribution did not deter the receiving part from pursuing the sanctioned course of action, it is because they reckoned that they can afford to ignore it. So, unless this punishment goes beyond what was expected, in scope or in time, its implementation will also fall flat. This implies that any effort to evaluate sanctions retrospectively suffers from the negative selection problem, when almost exclusively cases of failure, intended in this particular sense, are observed.

Second, sanctions are a rather blunt instrument, that often cannot be targeted with the precision one would desire. Even though sanctions have over time become “smarter”, in the sense that stronger efforts are made to target the regime, or elites that may have the clout to actually affect the regime (think the oligarchs in Russia), they often fail to reach or affect in a meaningful way those individuals that are the real objective, for various reasons. Instead, they can cause significant “collateral damage”, to groups of a population that often are quite far removed from any real decisional power, including those in the sending countries, and even third parties who are extraneous to the situation. The damage inflicted to those parties can only in very special circumstances be part of a causal link eventually impacting the intended outcome. For instance, citizens struggling in an impoverished economy could be led to a riot, or in some other way put pressure on their government – but this implies that the country is sufficiently free for riots to take place or for voters’ opinions to be taken into consideration.

To this, it should be added that, once a course of action has been taken, it might be not obvious how to change or undo it, notwithstanding the signaled displeasure from the sanctioning parties. Sanctions are therefore rarely working in isolation. When positive outcomes are achieved, it is often the case that diplomatic channels were kept open and clear incentives offered for a way out. But then it might be unclear whether it was the sanctions or something else that led to the success.

Other Effects of Sanctions

The pitfalls highlighted above, which make it tricky to answer whether sanctions are effective at reaching their aim, also apply when studying other effects that sanctions might have. There is of course a range of outcomes that might be affected: in this literature we find studies looking at inequality (Afesorgbor et al., 2016), exchange rates (Dreger et al., 2016), trade (Afesorgbor, 2019; Crozet et al. 2020), the informal sector (Early et al, 2019), military spending (Farzanegan, 2019), women’s rights (Drury, 2014), and many more. But as it often happens the most studied outcome is GDP, as this is a measure that efficiently summarizes the whole economy and correlates very nicely with many other outcomes we care about.

Suppose then that we would like to investigate what is the effect of sanctions on a target country’s GDP.  One problem is identifying an appropriate counterfactual; to observe what would have happened in the target country in the absence of sanctions. It is also an issue that the incidence of international sanctions is often a product of a series of events in the target or sender country (e.g. the Iraqi invasion of Kuwait or the apartheid system in South Africa), which also have impacts on the economy that would need to be isolated from the impact of sanctions themselves.

A variety of econometric techniques can be of help in this situation. One first idea is to use, as a reference, cases where sanctions were almost implemented. Gutmann et al. (2021) compare countries under sanctions to countries under threat of sanctions, while Neuenkirch and Neumeier (2015) contrast implemented sanctions to vetoed sanctions, in the context of UN decisions. Both studies find a relatively sizeable negative impact on GDP, in a large group of countries over a long period of time. In the first study, the target country’s GDP per capita decreases on average by 4 percent over the two first years after sanctions imposition and shows no signs of recovery in the three years after sanctions are removed. The second study estimates a reduction in GDP growth that starts at between 2,3 and 3,5 percent after the imposition of UN sanctions and, although it decreases over time, only becomes insignificant after ten years. It should be considered that a lower growth rate compounds over time: experiencing a slower growth even by only 1 percent over ten years implies a total loss of almost 15 percent. As a comparison, the average GDP loss due to the Covid-19 pandemic is estimated to be 3,4 percent in 2020.

These studies have limitations. Countries under threat of sanctions are probably making efforts to avoid punishment, which might imply that these countries are precisely the ones who would be most negatively affected by the sanctions. If so, the impact found by Gutmann et al. (2021) is probably underestimated. Neuenkirch and Neumeier (2015) only look at UN sanctions, which on one hand might give a larger impact because of the multilateral coordination. But on the other hand, the issue of an appropriate counterfactual emerges again: countries whose sanctions are vetoed might be larger, more influential, and better connected within the international community or to some of the major powers, which may also affect their economic success in other ways.

Kwon et al. (2020) adopt a different technique and come to a different conclusion. They use an instrumental variable (IV) approach and find that standard OLS overestimates the negative effect of sanctions, in other words, that sanctions’ effects are less negative than we think. They find an instantaneous effect on per capita GDP that becomes insignificant in the long run, just as if sanctions never happened.

Our confidence in these estimates hinges upon the validity of the IV used. In this case, the actual imposition of sanctions is replaced by its estimated likelihood based on sender countries’ variation in institutions and diplomatic policies (which are exogenous to the target country’s economic developments) and pre-determined country-pair characteristics (trade and financial flows, travels, colonial ties). Therefore, episodes where sanctions are imposed because the sender country happens to be in a period of hawkish foreign policy and because the target does not have strong historical relations with them are contrasted to episodes in which the opposite is true, and sanctions are therefore not implemented, everything else being equal.

The results also show that there is heterogeneity across types of sanctions, with trade sanctions having both a short and long run negative impact, while smart sanctions (i.e. sanctions targeted on particular individuals or groups) have positive effects on the target country’s economy in the long run.  This is quite an important point in itself. Often, sweeping statements about effectiveness of “sanctions” lump all the different measures together, and fail to appreciate that there may be substantial differences. However, the effect of one or another type of sanctions will vary depending on the structure of the economy that is hit.

A third approach is the synthetic control method. Here the researcher tries to replicate as closely as possible the path of economic development in the target country up to the point of sanctions’ implementation, using one or a weighted average of several other countries. In this way, evolution after sanctions’ inception can be compared between the actual country and its synthetic control. Gharehgozli (2017) builds a replica of Iran based on a weighted combination of eight OPEC member countries, two non-OPEC oil-producing countries and three neighboring countries, that match a set of standard economic indicators for Iran over the period 1980-1994. The study finds that over the course of three years the imposition of US sanctions led to a 17.3 percent decline in Iran’s GDP, with the strongest reduction occurring in 2012, one year after the intensification of sanctions (2011-2014) was initiated.

This is a stronger effect than those presented earlier. However, it only speaks to the special case of Iran, rather than estimating a broader global average effect. Another study focusing on Iran (Torbat, 2005) makes the important point that the effect of sanctions varies by type: financial sanctions are found to be more effective (in lowering Iran’s GDP) than trade sanctions – which contrasts with what is found to be true on average by Kwon et al. (2020).

Finally, the relation between economic damage and the effectiveness of sanctions in terms of reaching their goals is debatable. In a theoretical model, Kaempfer et al. (1988) suggest that this relation might even be negative and that the most effective sanctions are not necessarily the most damaging in economic terms. The sanctions most likely to facilitate political change in the target country are those designed to cause income losses on groups benefiting from the target country’s policies, according to the authors.

The Effect of Sanctions on Russia

Are these results from previous studies useful to form expectations about the effects of the current sanctions on Russia? The invasion of Ukraine which started at the end of February was a relatively unexpected event, at least in character and scale, in contrast to what can be said in the majority of situations involving sanctions. However, the context leading up to it was not one of normality either. Besides the global pandemic, Russia was already under sanctions following the Crimean Crisis in 2014. The impact of those economic sanctions, and of the counter-sanctions imposed by Russia as retaliation, is still unclear – and will be in all probability completely dwarfed by the current sanction wave as well as other exogenous shocks, such as significant changes in oil prices in this period. Kholodilin et al. (2016) estimated the immediate loss of GDP in Russia to be 1,97 percent quarter-on-quarter, while no impact on the aggregate Euro Area countries’ GDP could be observed. A Russian study (Gurvich and Prilepsky, 2016) forecasted for the medium term a loss of 2,4 percentage points by 2017 as compared to the hypothetical scenario without sanctions. This pales in comparison to the magnitude of consequences that are being contemplated now. Even the potentially optimistic, or at least conservative, assessment of the current situation by the Russian Federation’s own Accounts Chamber, in the words of its head Alexei Kudrin, suggests that: “For almost one and a half to two years we will live in a very difficult situation.” At the end of April, they published revised forecasts on the economic situation, among which the one for GDP is shown below. Russian Central Bank chief Elvira Nabiullina also sounded bleak, speaking in the State Duma: “The period when the economy can live on reserves is finite. And already in the second – the beginning of the third quarter, we will enter a period of structural transformation and the search for new business models.” The World Bank has forecasted that Russia’s 2022 GDP output will fall by 11.2% due to Western sanctions. These numbers do not yet factor in the announcement of the sixth EU sanction package, which famously includes an oil embargo (see an earlier FREE Policy Brief on the dependency of Russia on oil export).

Figure 1. Revised forecasts of growth rates for the Russian economy

Source: Macroeconomic survey of the Bank of Russia, April 2022.

Are these estimates realistic, and what would have been the counterfactual development without sanctions? If we believe the studies reviewed in the previous section, and also taking into account the unprecedented scale and reach of the current sanctions, at least the time horizon, if not the size, of the consequences forecast by Russian authorities is, though substantial, certainly underestimated. But there is too much uncertainty at the moment, hostilities are still ongoing and sanctions are not being lifted for quite some time in any foreseeable scenario. One reason why these sanctions are not likely to be relaxed, and why their impact is expected to be more severe than in most cases, is that a very broad coalition of countries is backing them. Not only this but the sanctioning countries see Russia’s conduct as a potential threat to the existing world order, so their motivation to contrast it is particularly strong relative to, say, the cases of Iran, North Korea, or Burma.

Moreover, these loss estimates do not yet factor in the announcement of the sixth EU sanction package, which famously includes an oil embargo. Oil is a fundamental driver of growth in Russia. An earlier FREE Policy Brief shows how two-thirds of Russia’s growth can be explained by changes in international oil prices. This is not because oil constitutes such a large share of GDP but because of the secondary effect oil money generates in terms of domestic consumption and investment. Reducing export revenues from the sale of oil and gas will therefore have significant effects on Russia’s GDP, well beyond what the first-round effect of restricting the oil sector would imply.

In short, it is too early to venture an assessment in detail, however, the scale of loss that can be expected is clear from these and many other indicators. In the longer run, it will only be augmented by the relative isolation in which Russia has ended up, implying lower investments and subpar capital inputs at inflated prices, and by the ongoing brain drain (3,8 million people have already left the country since the war began).

Conclusion

In conclusion, the debate about economic sanctions as a tool of foreign policy is often restricted to a binary question: do they work or not? There is ample support in the literature studying sanctions to say that this question is too simplistic. Even if we do not see immediate success in reaching the main aim of the sanction policy, they do cause damage, in many dimensions, and such damage is non-negligible. The political will and the regime behind it may be unaffected, but the resources they need to continue with their course of action will unavoidably shrink in the longer run.

References

  • Afesorgbor, S. K. (2019). The impact of economic sanctions on international trade: How do threatened sanctions compare with imposed sanctions?. European Journal of Political Economy, 56, 11-26.
  • Afesorgbor, S. K., & Mahadevan, R. (2016). The impact of economic sanctions on income inequality of target states. World Development, 83, 1-11.
  • Crozet, M., & Hinz, J. (2020). Friendly fire: The trade impact of the Russia sanctions and counter-sanctions. Economic Policy, 35(101), 97-146.
  • Dreger, C., Kholodilin, K. A., Ulbricht, D., & Fidrmuc, J. (2016). Between the hammer and the anvil: The impact of economic sanctions and oil prices on Russia’s ruble. Journal of Comparative Economics, 44(2), 295-308.
  • Drury, A. Cooper and Dursun Peksen. “Women and economic statecraft: The negative impact international economic sanctions visit on women.” European Journal of International Relations 20 (2014): 463 – 490.
  • Early, B., & Peksen, D. (2019). Searching in the shadows: The impact of economic sanctions on informal economies. Political Research Quarterly, 72(4), 821-834.
  • Farzanegan, Mohammad Reza. (2019). “The Effects of International Sanctions on Military Spending of Iran: A Synthetic Control Analysis.” Organizations & Markets: Policies & Processes eJournal .
  • Gharehgozli, O. (2017). An estimation of the economic cost of recent sanctions on Iran using the synthetic control method. Economics Letters, 157, 141-144.
  • Gurvich E., Prilepskiy I. (2016). The impact of financial sanctions on the Russian economy.  Voprosy Ekonomiki. ;(1):5-35. (In Russ.) https://doi.org/10.32609/0042-8736-2016-1-5-35
  • Gutmann, J., Neuenkirch, M., and Neumeier, F., 2021. ”The Economic Effects of International Sanctions: An Event Study” CESifo Working Paper No. 9007
  • Kaempfer, W. H., & Lowenberg, A. D. (1988). The theory of international economic sanctions: A public choice approach. The American Economic Review, 78(4), 786-793.
  • Kholodilin, Konstantin A. and Netsunajev, Aleksei. (2016) Crimea and Punishment: The Impact of Sanctions on Russian and European Economies. DIW Berlin Discussion Paper No. 1569, SSRN: https://ssrn.com/abstract=2768622
  • Kwon, O., Syropoulos, C., & Yotov, Y. V. (2020). Pain and Gain: The Short-and Long-run Effects of Economic Sanctions on Growth. Manuscript.
  • Neuenkirch, M., & Neumeier, F. (2015). The impact of UN and US economic sanctions on GDP growth. European Journal of Political Economy, 40, 110-125.
  • Torbat, A. E. (2005). Impacts of the US trade and financial sanctions on Iran. World Economy, 28(3), 407-434.
  • World Bank. (2022). “War in the Region” Europe and Central Asia Economic Update (Spring), Washington, DC: World Bank.

Disclaimer: Opinions expressed in policy briefs and other publications are those of the authors; they do not necessarily reflect those of the FREE Network and its research institutes.

Russia’s Real Cost of Crimean Uncertainty

Posted on June 10, 2019 | Policy Brief

Blue sky with fighter jets flying across the sky representing Russias Real Cost of Crimean Uncertainty

The annexation of Crimea has real costs to the Russian economy beyond what is measured by some items in the armed forces’ budget; social spending in the occupied territories; or the cost of building a rather extreme bridge to solve logistics issues. Russia’s real cost of the annexation of Crimea is also associated with the permanent loss of income that the entire Russian population is experiencing due to increased uncertainty, reduced capital flows and investment, and thus a growth rate that is significantly lower than it would have been otherwise. Since the years of lost growth are extremely hard to make up for in later years, there will be a permanent loss of income in Russia that is a significant part of the real cost of annexing Crimea and continuing the fighting in Eastern Ukraine. It is time to stop not only the human bleeding associated with Ukraine, but also the economic.

Estimating the real cost of Russia’s annexation of Crimea and the continued involvement in Eastern Ukraine is complicated since there are many other things going on in the Russian economy at the same time. In particular, oil prices fell from over $100/barrel in late 2013 to $30/barrel in 2016 (Figure 1). Becker (2016) has shown that 60-80 percent of the variation in GDP growth can be explained by changes in oil prices, so this makes it hard to just look at actual data on growth to assess the impact of Crimea and subsequent sanctions and counter sanctions.

Figure 1. Russian GDP and oil price

Source: Becker (2019)

The approach here is instead to focus on one channel that is likely to be important for growth in these circumstances, which is uncertainty and its impact on capital flows and investment.

From uncertainty to growth

The analysis presented here is based on several steps that link uncertainty to GDP growth. All the details of the steps in this analysis are explained at some length in Becker (2019). Although this brief will focus on the main assumptions and estimates that are needed to arrive at the real cost of Crimea, a short description of the steps is as follows.

First of all, in line with basic models of capital flows, investors that can move their money across different markets (here countries) will look at relative returns and volatility between different markets. When relative uncertainty goes up in one market, capital will leave that market.

The next step is that international capital flows affect investment in the domestic market. If capital leaves a country, less money will be available for fixed capital investments.

The final step is that domestic investments is important for growth. Mechanically, in a static, national accounts setting, if investments go down, so does GDP. More long term and dynamically, investments have a supply side effect on growth, and if investments are low, this will affect potential as well as actual growth negatively.

These steps are rather straightforward and saying that uncertainty created by the annexation of Crimea leads to lower growth is trivial. What is not trivial is to provide an actual number on how much growth may have been affected. This requires estimates of a number of coefficients that is the empirical counterparts to the theoretical steps outlined here.

Estimates to link uncertainty to growth

In short, we need three coefficients that link: domestic investments to growth; capital flows to domestic investments; and uncertainty to capital flows.

There are many studies that look at the determinants of growth, so there are plenty of estimates on the first of these coefficients. Here we will use the estimate of Levine and Renelt (1992), that focus on finding robust determinants of growth from a large set of potential explanatory variables. In their preferred specification, growth is explained well by four variables, initial income, population growth, secondary education and the investments to GDP ratio. The coefficient on the latter is 17.5, which means that when the investment to GDP ratio increases by 10 percentage points, GDP grows an extra 1.75 percentage points per year. Becker and Olofsgård (2018) have shown that this model explains the growth experience of 25 transition countries including Russia since 2000 very well, which makes this estimate relevant for the current calculation.

The next coefficient links capital flows to domestic investments. This is also a subject that has been studied in many empirical papers. Recent estimates for transition countries and Russia in Mileva (2008) and Becker (2019) find an effect of FDI on domestic investments that is larger than one, i.e., there are positive spillovers from FDI inflows to domestic investments. Here we will use the estimate from Becker (2019) that finds that 10 extra dollars of FDI inflows are associated with an increase of domestic investments of 15 dollars.

Finally, we need an estimate linking uncertainty with capital flows. There are many studies looking at risk, return and investment in general, and also several studies focusing on international capital flows and uncertainty.  Julio and Yook (2016) look at how political uncertainty around elections affect FDI of US firms and find that FDI to countries with high institutional quality is less affected by electoral uncertainty than others. Becker (2019) estimates how volatility in the Russian stock market index RTS relative to the volatility in the US market’s S&P 500 is associated with net private capital outflows. The estimate suggests that when volatility in the RTS goes up by one standard deviation, this is associated with net private capital outflows of $30 billion.

These estimates now only need one more thing to allow us to estimate how much Crimean uncertainty has impacted growth and this is a measure of the volatility that was created by the annexation of Crimea.

Measuring Crimean uncertainty

In Becker (2019), the measure of volatility that is used in the regression with net capital outflows is the 60-day volatility of the RTS index. Since we now want to isolate the uncertainty created by Crimea related events, we need to take out the volatility that can be explained by other factors in order to arrive at a volatility measure that captures Crimean induced uncertainty. In Becker (2019) this is done by running a regression of RTS volatility on the volatility of international oil prices and the US stock market as represented by the S&P 500. The residual that remains after this regression is the excess volatility of the RTS that cannot be explained by these two external factors. The excess volatility of the RTS index is shown in figure 2.

It is clear that the major peaks in excess volatility are linked to Crimea related events, and in particular to the sanctions introduced at various points in time. From March 2014 to March 2015, there is an average excess volatility of 0.73 standard deviations with a peak of almost 4 when the EU and the USA ban trade with Crimea. This excess volatility is our measure of the uncertainty created by the annexation of Crimea.

Figure 2. RTS excess volatility

Source: Becker (2019)

From Crimean uncertainty to growth

The final step is simply to use our measure of Crimean induced uncertainty together with the estimates that link uncertainty in general to growth.

The estimated excess volatility associated with Crimea is conservatively estimated at 0.7 standard deviations. Using this with the estimate that increasing volatility by one standard deviation is associated with $30 billion in capital outflows, we get that the Crimean uncertainty would lead to $21 billions of capital outflows in one quarter or $84 billions in one year. If this is in the form of reduced FDI flows, we have estimated that this means that domestic investments would fall by a factor of 1.5 or $126 billions.

In this period, Russia had a GDP of $1849bn and fixed capital investments of $392bn. This means that $126 billions in reduced investments correspond to a reduction in the investments to GDP ratio of 7 percentage points (or that the investments to GDP ratio goes from around 21 percent to 14 percent).

Finally, using the estimate of 17.5 from Levine and Renelt, this implies that GDP growth would have been 1.2 percentage points higher without the estimated decline in investments to GDP.

In other words, the Crimean induced uncertainty is estimated to have led to a significant loss of growth that has to be added to all the other costs of the annexation of Crimea and continued fighting in Eastern Ukraine. Note that recent growth in Russia has been just barely above 1 percent per year, so this means that growth has been cut in half by this self-generated uncertainty.

Of course, the 1.2 percentage point estimate of lost growth is based on many model assumptions, but it provides a more sensible estimate of the cost of Crimea than we can get by looking at actual data that is a mix of many other factors that have impacted capital flows, investments and growth over this period.

Policy conclusions

The annexation of Crimea and continued fighting in Eastern Ukraine carry great costs in terms of human suffering. In addition, they also carry real costs to the Russian economy. Not least to people in Russia that see that their incomes are not growing in line with other countries in the world while the value of their rubles has been cut in half. Some of this is due to falling oil prices and other global factors that require reforms that will reorient the economy from natural resource extraction to a more diversified base of income generation. This process will take time even in the best of worlds.

However, one “reform” that can be implemented over night is to stop the fighting in Eastern Ukraine and work with Ukraine and other parties to get out of the current situation of sanctions and counter-sanctions. This would provide a much-needed boost to foreign and domestic investments required to generate high, sustainable growth to the benefit of many Russians as well as neighboring countries looking for a strong economy to do trade and business with.

References

Disclaimer: Opinions expressed in policy briefs and other publications are those of the authors; they do not necessarily reflect those of the FREE Network and its research institutes.