Russia Sanctions: the Exception, or the Rule?
24 Apr 2019

Recently, media outlets reported that Russian arms sales increased to USD $15 billion in the past year. Meanwhile, Moscow’s international adventurism and willingness to project military power beyond its borders seems unabated, as evidenced in recent weeks by the arrival of 100 military advisers in Venezuela to support the Maduro regime. This is all occurring despite an extensive array of economic sanctions imposed on Russian officials, oligarchs and significant elements of their export trade by both the US and EU.

So, is this the exception to the rule that says that multilateral action tends to get results when economic leverage is applied, or are looks deceiving?

Sanctions: targeted and sectoral

From a compliance officer’s perspective, there are two broad classes of sanctions applicable to the Russian Federation. Firstly, there are asset freezes imposed on individuals and organizations for a variety of reasons. These include involvement in Russia’s annexation of Crimea, its incursion into eastern Ukraine, cyber intrusions and election interference. A limited number of Russian government officials and oligarchs are also sanctioned, in some instances for their alleged role in a tax fraud scheme linked to the death of Muscovite attorney Sergei Magnitsky. While there is significant overlap in the designations made by the EU and the US, the targeted parties are not harmonized between the two sets of regulations.

Secondly, there are sectoral sanctions imposed on selected organizations in the Russian defense, financial services and energy industries. In all three, there are prohibitions in dealing with various classes of longer-term debt financing. The stock issues of Russian financial services firms may also not be bought, sold or otherwise dealt in. Additionally, firms may not participate in transactions that enable the designated energy firms to conduct certain types of energy exploration. As is the norm for OFAC, that definition of prohibited participation is very broad, ranging from financial services such as insurance or project financing, to provision of supplies. In 2017, prohibited participation in such Arctic offshore, shale, or deepwater exploration projects was redefined to include projects where the party listed on OFAC’s Sectoral Sanctions Identification (SSI) list had a 33-percent or greater ownership stake in the project. Again, the EU sanctions regime is similar, but not the same. Those points of difference limit the effectiveness of the stricter regime to impose penalties, and the effectiveness of the more lenient regime to provide incentives for changes of behavior.

So far, there has been one enforcement action under the US sanctions program. ExxonMobil agreed to a settlement with OFAC because, although no economic benefit was derived, the company signed a number of contracts with the head of Rosneft, who was a sanctioned person on OFAC’s Specially Designated Nationals (SDN) List at the time. In retrospect, however, it seems more an exercise in highlighting that regulatory liability starts when deals are signed and obligations are entered into, rather than a traditional penalty imposed because money exchanged hands.

US officials have also authorized sanctions on third-party entities that undermine American policy goals. Under Sec. 231 of the Countering America’s Adversaries Through Sanctions Act (CAATSA), the President is empowered to impose a number of sanctions (aka “menu sanctions,” because the sanctions to be imposed are derived from a set of multiple options) on parties that conduct “significant” transactions with listed elements of the intelligence and defense sectors of the Russian government and economy. To date, only one set of designations has been made.

Relaxing restrictions

Over the past year, EN+ Group and its subsidiaries United Company Rusal and EuroSibEnergo have negotiated their way off of OFAC’s sanctions lists.These firms were majority-owned by Oleg Deripaska, who owned, at one point, seventy percent of EN+. His ownership stake was reduced to a still-hefty 45-percent stake, and his voting rights were effectively reduced even further. The deal also restricted Deripaska from currently receiving the economic benefits from his remaining ownership in a number of ways, including dictating that dividends be placed in a restricted account.

As this article is being written, GAZ Group, another of Deripaska’s holdings, is seeking to make a similar deal to be removed from the SDN List.

These actions call into question the purpose of the sanctions themselves: are they intended to put pressure on the Russian government by denting its economic fortunes, or by putting pressure on the oligarchs who represent the real power in Russia? Would it not have put more pressure on Deripaska and, by extension, Moscow for the US government to not agree to deals that would allow significant contributors to the Russian economy to essentially continue business as usual? In fact, United Company Rusal, which accounts for approximately seven percent of global aluminum production, is investing $200 million dollars in a plant located in the United States. One would think that such a move, while it provides economic benefit to the Kentucky-based plant, also boosts support for the Kremlin among Russian citizens, who see economic health undeterred by Western pressures.

Balancing act: sanctions aims and policy goals 

For all the seeming power of sanctions, there are countervailing economic forces at work that prevent more being accomplished by them. These forces derive their power from the pure might of Russian industry. Until this year, Russia was the world’s largest producer of crude oil and its second-largest natural gas producer. Even so, when one delves into Russia’s energy exports, one discovers that much of that production ends up heating the homes of America’s allies in Europe. Indeed, the Nord Stream 2 gas pipeline, while essential to Western Europe’s future energy needs, undermines the ability of the EU to increase pressure on Moscow.

This has not gone unnoticed. An April 2018 study for the European Parliament states:

Most energy-rich authoritarian states use their energy wealth to ensure regime survival. But, more than others, Russia uses its energy wealth as well to protect and promote its interests in its ‘near abroad’ and to make its geopolitical influence felt further afield, including in Europe. It uses gas supplies to punish and to reward, affecting both transit states and end-consumers.

As one of the world’s largest economies, Russia has a nominal GDP more than four times that of Iran, the next largest country targeted by US sanctions. It also has the kind of geopolitical and diplomatic sway few other countries have. Not only does Russia’s permanent seat on the UN Security Council give it instant credibility and influence, but it also wields its influence, in addition to the leverage it has due to its energy production, through a robust arms trade. Recent sales of Russian missile systems to Turkey, a member of the North Atlantic Treaty Organization (NATO), and India further underscore the difficulty in building a greater coalition against Moscow’s adventurism elsewhere, when that political alignment may cut against those countries’ economic interests.

To further illuminate the balancing act with regard to allies of the US and EU, and Russia’s economic clout, one of the first general licenses issued by OFAC under its (then) Ukraine-related sanctions program authorized all transactions conducted involving DenizBank. DenizBank, while a wholly-owned subsidiary of Sberbank, which is subject to OFAC’s sectoral sanctions, operates in Turkey. At the time of the issuance of the general license, the US had a keen interest in Turkey’s assistance in combating the Islamic State in the Levant (ISIL). Conversely, the US also wanted to ensure that Ankara did not aggressively confront the Kurdish population in Syria that was part of the coalition battling the Assad regime. Thus, DenizBank was exempted from the sectoral sanctions imposed on its parent, and was able to provide economic benefit to Sberbank unimpeded by regulatory pressures.

Exception, or the rule?

The US and EU Ukraine/Russia-related sanctions programs seem to be extensive, but the economic leverage that Moscow has over potential allies in the sanctions effort does not permit the imposition of real economic pain that could incentivize a change in behavior. The EU, for example, is not united in its support of these sanctions. Serbia recently stated that it would not impose EU restrictive measures on Moscow, and German government ministers have advocated for relaxing the current regime.

The US could, in theory, impose asset freezes on the firms on the sectoral sanctions list, as was done recently to the Venezuelan state oil company PdVSA. However, the economic consequences for EU allies that rely on Russian energy production could be dire, and might threaten cooperation on other issues. Similarly, any attempts to rein in Moscow’s arms trade by imposing the CAATSA 231 sanctions might push strategically important allies away and further into Russia’s sphere of influence.

In that regard, the US cannot, in the current environment, build a sufficiently large coalition to create economic incentives for a change in Russian behavior. Therefore, the existing EU and US sanctions programs prove the general rule, only it’s Moscow that wields economic leverage fundamentally.

Where can we go from here?

If the world wants to truly affect Russia’s behavior, it needs economic leverage. However, when one adds up the petroleum production from the countries that Washington has imposed sanctions on, it adds up to over twenty-two percent of global oil output. Asking allied countries to keep the pressure on all three countries (Russia, Iran and Venezuela) simultaneously is not a realistic option, especially when that would undoubtedly raise the cost of energy for those nations. If the US truly wants to pressure Moscow, it has to back off and seek diplomatic rapprochement with Caracas and Tehran, at least temporarily. Having those countries’ production of over six million barrels a day would go a long way to offsetting the loss of Russia’s 11 million barrels. US President Donald Trump has recently said that increased oil production from the United Arab Emirates and Saudi Arabia could help offset the loss of Iranian oil, which amounted to almost four million barrels per day in 2018. That additional production could almost make up for the remaining difference in unsanctioned oil production.

Similarly, while arming the world is not in the interests of long-term global stability, providing Western alternatives to purchases of Russian armaments would make it more palatable for more countries to help isolate, to a certain degree, Russia economically and diplomatically. Alternatively, the West could encourage or incentivize the development of such industries in strategically important countries.

Absent such changes in US and European behavior, however, the current sanctions on Russia appear to be more for show than anything else. The real economic brunt is being paid by Western firms whose compliance burden has climbed dramatically since the start of the sanctions programs in 2014.

Eric Sohn

Eric A. Sohn, CAMS, global market strategist and product director, Dow Jones Risk & Compliance, New York, NY, USA, eric.sohn@dowjones.com

Photo: Ilya Varlamov [CC BY-SA 4.0], via Wikimedia Commons

Read more:

Safe haven? Russian assets and the English courts

Brittle roads and gilded domes: the price of corruption in Russia

Sanctions: The new ‘Deripaska Rule’ – a twist to regulation?

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