Russia's Crony Capitalism

by Anders Aslund

  The economic interests of the member states vary greatly. Russia and Kazakhstan are raw material exporters, while Belarus exports Soviet-style manufactured goods. To improve competitiveness, ordinary trade theory teaches that economies should open up to competition, but the EAEU has done the opposite. Russia is comparatively protectionist, and it has forced the other member countries to raise their tariffs to its level. Kazakhstan produces no cars, but it had to adopt Russia’s higher car tariffs. Russia and Belarus have gained captive markets, which will ultimately hurt their competitiveness. Belarus remains a highly regulated economy and does not qualify as a market economy.

  Even if the EAEU were an open market, its members would not necessarily benefit. The union is small—only 2 percent of global GDP at current exchange rates, less than one-tenth of the European Union. The EU countries have benefited from common, modern EU standards, whereas the EAEU has reinforced obsolete Soviet standards through an intergovernmental treaty, though many businesspeople praise the unification of standards. Nor has the Customs Union brought about any direct benefit—the members already pursued tariff-free trade. One advantage of the Customs Union is the abolition of border controls between member countries. Yet in the spring of 2017, Russia restored border controls with Belarus, not least because Belarus has been a major conduit in transit trade of sanctioned goods to Russia.30

  Kazakhstan is highly dependent on Russia because of its geography, and President Nazarbayev has consistently favored multilateral relations, preferring not to be left alone with Russia. He claims to have been the first to voice the idea of a Eurasian Union in 1994. Yet Kazakhstan has gained almost nothing economically from the EAEU. The World Bank assessed the cost to Kazakhstan of joining the Customs Union in its baseline scenario at 0.2 percent of GDP.31

  Belarus’s president Alexander Lukashenko has skillfully extracted large subsidies from Russia through cheap oil and gas supplies, and Russia offers a vast market for its not very competitive manufactures. From 2009 to 2013, Armenia worked on concluding an Association Agreement with the European Union, but suddenly on September 3, 2013, Putin met with President Serzh Sargsyan and persuaded him to switch to the EAEU, presumably threatening a Russian withdrawal or reduction of its vital military support for Armenia against Azerbaijan. Kyrgyzstan thrived on transit trade from China to Russia and Kazakhstan, which the Customs Union interrupted with a tall customs wall, so Kyrgyzstan was financially pressured to join the EAEU. In 2013, the Kremlin imposed great political pressure and economic sanctions on Ukraine to persuade it to join the EAEU, but Ukraine resisted.32

  The two greatest enthusiasts of Eurasian integration are Putin and his economic adviser for Eurasia, Sergei Glaziev. Putin often cites dubious numbers on EAEU benefits. In December 2012, he praised the Customs Union: “Trade with these countries grew by 10 percent [in 2012]—that is not bad at all. Most importantly, . . . we have a very good structure of trade with the Customs Union countries. Machinery and equipment make up 20 percent of [Russian exports]. That is very good, because machinery and equipment make up only 2 percent in our [exports to] the rest of the world.” In other words, Belarus and Kazakhstan were forced to raise their import tariffs for cars to buy cars from Russia rather than from South Korea and Japan.33

  When Ukraine discussed whether to conclude an Association Agreement with the European Union or join the EAEU, many econometric studies were produced using standard gravity and general equilibrium models. All but those of the Eurasian Development Bank obtained comparable results. Veronika Movchan and Ricardo Giucci made the most complete mainstream study of the effects on Ukraine of both the Deep and Comprehensive Free Trade Area with the European Union and the Customs Union. They concluded that in the long term, the Association Agreement would add 11.8 percent to Ukraine’s GDP, while the Customs Union would reduce it by 3.7 percent because of trade diversion. The Association Agreement would substantially increase trade (both exports and imports), whereas the Customs Union would reduce trade.34

  A group of economists affiliated with the Eurasian Development Bank presented a counter study that was based not on calculations but on “scenarios” with peculiar assumptions. Because of a reduction in exports to the EAEU countries, Ukraine would lose up to 1.5 percent of its GDP. Another Eurasian Development Bank study reached a similar conclusion: if Ukraine embraced the Customs Union, its GDP could be boosted by 6–7 percent by 2030. Glaziev stated that Ukraine would gain $9 billion a year if it joined the Customs Union, because Ukraine would be allowed to buy Russian oil and gas at the same low prices as Belarus. None of these studies reveals any solid quantitative methodology, leaving the impression that they are little but propaganda and assumptions about Russian subsidies or sanctions.35

  Some scholars in the West believe that the EAEU deserves to be taken seriously as a Russian attempt at economic integration for the benefit of economic efficiency. They emphasize the formal steps taken, such as the many treaties, but real integration has not developed correspondingly. Since their arguments are largely based on public statements rather than economic statistics, they fail to convince.36

  The EAEU isolates Russia from the rest of the world, limits competition at home, prevents its economy from modernizing, and aggravates its relations with its closest neighbors, while costing Russia billions of dollars every year in lost customs revenues and subsidies to other members. In December 2016, Belarus boycotted the annual summit of the EAEU in protest against the draft customs code to be adopted. The EAEU has been tried, but it has not worked. Russia and the other EAEU members would be better off without this geopolitical project but with the previously existing free trade area, which should have been reinforced with functioning arbitration.

  The big blow to Russia’s foreign economic policy has been the Western sanctions after Russia’s military aggression in Ukraine in 2014. In the night of February 27, 2014, Russian special forces without insignia seized the regional parliament in Simferopol in Ukrainian Crimea. Within days, they had occupied the whole peninsula. On March 18, Russia annexed Crimea, swiftly integrating it into Russia.

  Russia’s occupation of Crimea came as a complete surprise to the West. Military support for Ukraine was never considered an option, but the West felt that it had to do something. Immediately in March 2014, the European Union and the United States announced Crimea-related sanctions with visa bans and assets freezes on individuals and companies accused of undermining democracy, misappropriating Ukrainian property, and violating human rights. Gradually both the United States and the EU have expanded their sanctions to people responsible for Russian policy on Crimea and enterprises operating there. Ukraine has cut off almost everything—electricity, water, trade, and transportation—isolating Crimea from the outside world.37

  A novelty in the US sanctions was that four of Putin’s cronies were sanctioned, namely Yuri Kovalchuk, Arkady and Boris Rotenberg, and Gennady Timchenko, as well as their Bank Rossiya (as discussed in chapter 5). The European Union has also sanctioned Kovalchuk, Arkady Rotenberg, and another crony, Nikolai Shamalov, but it has not sanctioned Boris Rotenberg and Gennady Timchenko because they are Finnish citizens.

  The West had multiple aims with its sanctions: to punish the culprits, to isolate Crimea, to stop Russia’s aggression, and to deter Russia from further aggression. The Russian advance in Ukraine has been stopped, and Crimea is utterly isolated, but Russia has not withdrawn on either front, and no solution is in sight.

  In April 2014, anonymous Russian special forces tried to stir up unrest among ethnic Russians in eastern and southern Ukraine, but with limited results. Unrest took root only in parts of Ukraine’s two easternmost regions, Donetsk and Luhansk. In the summer of 2014, the military situation was fluid. With amazing speed, the Ukrainian military caught up and advanced against the Russian-backed volunteers, many of whom were Russian citizens. The war heated up in July. Russia reacted by sending in regular troops.

  In response to the regular Russian forces entering Ukraine, on
July 16, the United States imposed serious sectoral sanctions on Russia. The next day, a Russian Buk missile shot down a Malaysian airplane, flight MH17, from occupied Ukrainian territory, killing all 298 people on board, which convinced hesitant Europeans to impose similar sectoral sanctions. Most Western countries joined the US-EU sanctions, including Japan, Canada, Australia, New Zealand, and Switzerland, but no developing nation did. The sanctions differed slightly but were quite similar.

  The July 2014 sanctions went much further than the Crimea sanctions. They covered three sectors: finance, oil, and defense technology, focusing on large state companies. Individuals responsible for Russian policy in the occupied territories and enterprises involved were also sanctioned. These sanctions have been gradually expanded, but the same principles have applied.

  The financial sanctions have been quite effective. They prohibit lending to the sanctioned state banks and companies for terms of thirty days or more. The European Bank for Reconstruction and Development was blocked from offering new financing in Russia. Almost all international lending to Russia ceased, and the country nearly faced a liquidity freeze. Both the government and private firms had to pay off their foreign debt obligations as they came due, with minimal possibilities to refinance them. Western banks were afraid of being trapped if the sanctions were to change. Even the four big Chinese state banks obeyed the US financial sanctions, because they all have activities in the United States and all dollars pass through New York, thus being subject to US jurisdiction, and the US authorities can impose severe fines that are not subject to judicial appeals.

  The impact of the financial sanctions was the greatest in 2014, when Russia faced large foreign debt repayments. The IMF assessed the impact: “Model-based estimates suggest that sanctions and counter-sanctions could initially reduce real GDP by 1 to 1½ percent. Prolonged sanctions may compound already declining productivity growth. The cumulative output loss could lead to a cumulative output loss over the medium term of up to 9 percent of GDP, as lower capital accumulation and technological transfers weakens already declining productivity growth.” Over time, the effect has diminished as Russia has paid down much of its foreign debt.38

  Russian corporations had no choice but to pay off their debt service as it fell due, and they had scarcely any possibilities of refinancing. Russia’s total foreign debt declined from $732 billion in June 2014 to $519 billion in December 2015, and it has stayed at about that level. Meanwhile, Russia’s international currency reserves declined from $510 billion at the end of 2013 to a low of $356 billion in March 2015.39

  The energy sanctions were limited to three kinds of oil development: deep offshore drilling, arctic offshore, and tight oil. They did not harm production in the short term but damaged it in the long term. The European Union insisted that gas must not be subject to sanctions because of its great dependence on Russian gas.

  The sanctions on Russia were not severe in comparison with those imposed on Iran, though no such large country had been subject to such severe Western sanctions before. The Russian government itself was excepted, being allowed to sell bonds. Nor were the Central Bank of Russia and its reserves abroad subject to any restrictions, and Russia could continue using the international bank clearing system swift. Even assets abroad of most sanctioned companies were not frozen. The West was reticent to cause itself harm while also wanting to have opportunities to escalate.

  Because the Russian economy is so much smaller than the Western economy, Russia cannot respond effectively without hurting itself more. It sanctioned some Western officials, which was of little consequence. In August 2014, Russia introduced “countersanctions” against food imports from the countries that had imposed sanctions on Russia. These sanctions raised eyebrows because they hurt Russian consumers, with worse and fewer supplies of many foods and higher inflation, and the Russian customs office destroyed large volumes of food that had been smuggled into the country. Russia’s agricultural producers vocally supported this protectionism. In June 2017, Putin extended Russia’s embargo on food products from the West until the end of 2018. Many other kinds of sanctions were discussed, such as the prohibition of flights over Russian territory, but they were never adopted. The Kremlin realized that Russia was the underdog.40

  The cost to the West of the Western sanctions and the Russian countersanctions has been minimal. Russian imports fell sharply in 2014 and 2015, but that was because of the falling price of oil, and the European Union has maintained its large market share in Russia of about 45 percent. Plausibly, Daniel Gros and Mattia Di Salvo have concluded that “the position of European exporters in the Russian market has not been infringed” because of the EU sanctions. “The impact of the Russian counter-sanctions on agro-food imports from the EU has been minimal. Russian imports of these goods have fallen by about Ä400 million,” which is less than 0.3 percent of EU GDP, while overall EU exports of these goods have increased because of increased sales to other markets.41

  With regard to direct investments, Russia and the West have grown apart with the sanctions. In July 2017, Siemens announced that it would sell its 46 percent stake in a turbine factory in St. Petersburg because its partner, the state corporation Rostec, had delivered turbines to Crimea, contrary to its agreement with Siemens. Rostec had not been the original partner of Siemens, but it had purchased the dominant share of the company from a private investor, who had exited. A spokesperson for Germany’s foreign minister reminded Russia that it had been assured that sanctions would not be broken and lamented “that such a massive violation of sanctions would place new burdens on German-Russian relations.”42

  The Russian company Kaspersky Lab has become one of the largest global security software companies. During the 2016 presidential elections, the United States accused Russia of cybercrime, and the General Services Administration has instructed federal agencies not to purchase software from Kaspersky Lab.43

  The sanctions are like a squirrel’s wheel. Each measure provokes countermeasures, and both sides protect themselves, resulting in stricter security efforts, less foreign investment, and isolation. Businesspeople face sanction risks, because sanctions can change on short notice and are difficult to interpret, which then aggravates credit risks, and Russia’s hostile relationship with the West exposes foreign investors to reputational risks. Although Putin’s cronies and state corporations have been singled out for Western sanctions, the sanctions seem to have reinforced the role of both the state and the cronies in the economy, since they are being given even more privileges, as is usually the case and many bona fide private businesspeople flee abroad.

  Since the sanctions were imposed and the price of oil collapsed in 2014, Western investment in Russia has been tiny. The sanctions have aggravated Russia’s already low credit rating and rendered capital scarcer and more expensive. In defense, the Central Bank of Russia has maintained a very high real interest rate, which also depresses investment.

  The US sanctions were imposed through presidential executive orders, that is, by decree, which meant that they could be modified at any time, aggravating the sanctions risk. Because of the fear that President Donald Trump would abolish the Russia sanctions, Congress codified these sanctions into law in the Combating America’s Adversaries through Sanctions Act (CAATSA), which President Trump signed into law on August 2, 2017. As a consequence, the president can no longer alter the Russia sanctions without congressional consent.

  In April 2018, the US Treasury issued its first sanctions based on CAATSA, sanctioning twenty-four people and fourteen enterprises. The far-reaching nature of the sanctions caused shockwaves. For one thing, most of the people sanctioned are really close to Putin, including his former son-in-law, Kirill Shamalov. Several major oligarchs were sanctioned, notably Oleg Deripaska, as were no fewer than eight of his companies, including Rusal, which accounted for 6 percent of global aluminum production. The widened sanctions caused havoc in the global aluminum industry, forcing the US Treasury to backtrack several steps. Unli
ke the Obama administration, the Trump administration neither consulted nor forewarned its European allies, who were hit hard by the sanctions against Rusal.44

  Putin has used public means to compensate his sanctioned cronies, which reinforces state and crony capitalism. One of the nationalized banks that collapsed in the fall of 2017, Promsvyazbank, was singled out to finance sanctioned companies. The sanctions and countersanctions might have helped Putin’s endeavors to isolate Russia from the West with his “deoffshoreization” and import substitution. Major Russian businesspeople face the choice of staying in Russia and reducing their links to the West or selling their assets in Russia and moving to the West. By and large, the elite from the 1990s has made the latter choice.

  In parallel, direct Russian investment in the United States has plummeted as Russian businesspeople find it increasingly difficult to satisfy the contradictory demands of the US and Russian governments. The consequence is growing alienation between Russian and Western businesses. The general assumption is that the sanctions will likely last a long time. No solution of the Ukrainian conflict is in sight, and because the conflicts that caused them are not resolved, the sanctions tend to be inert, and, moreover, Congress codified them in July 2017. The outcome is deglobalization.45

  Through his many public statements, Putin has made clear what he thinks of the sanctions. He reacted strongly against the Magnitsky Act and the Western sanctions of March 2014 against his close friends, which blocked them from visas, cut them out of the Western financial system, and potentially froze their assets in the West. By contrast, he played down the impact of the sectoral sanctions and imposed the countersanctions on food for the Russian people himself.46