The Cost of Sanctioning Russia

As you know, the Russian invasion of Ukraine has, for now, bogged down. The Western world is rising up in anger and is sanctioning Russian companies and individuals. We are very good at sanctions. We can use them to punish people, which we all consider to be a good thing.

And yet, in an interdependent world, sanctions do not just hurt those they are supposed to punish. Disrupting supply chains damages economies outside of Russia, and it hurts people around the world.

Besides sanctions on trade and commerce, the war has caused economic activity in Ukraine to slow down, even to stop. And it has caused European nations and America to cease doing any business with Russia.

The Wall Street Journal has compiled a fairly comprehensive list of the industries and the nations that are being hurt by Russia’s Ukraine incursion.

It is useful, in order to stay informed, to examine the fallout of the war and the sanctions. It makes us feel good, but it is certainly going to cost us.

The Journal begins with factory shutdowns:

Russia’s invasion of Ukraine is piling new troubles onto the world’s already battered supply chains. The fighting has shut down car factories in Germany that rely on made-in-Ukraine components and hit supplies for the steel industry as far as Japan. It has severed airways and land routes that had become crucial since the pandemic began gumming up sea trade.

Russia and Ukraine export many commodities, and these have been largely curtailed:

The conflict is also bottling up Ukraine and Russia’s vast commodity exports, sending the price of oil, natural gas, wheat and sunflower oil rocketing. Shipping from Ukrainian ports, an important corridor for grain, metal and Russian oil shipments to the rest of the world, has all but ceased.

Closing airspace to Russian airlines makes it more expensive to fly cargo:

Freighters and airlines have warned that the decision by many European nations to close their airspace to Russia, as well as Russia’s tit-for-tat retaliation, will increase the cost of flying cargo from Europe to Asia, potentially making some routes commercially unviable.

As you know, Russian banks have been banned from the global financial payment system called SWIFT. This has not just hurt Russia:

Western sanctions—especially banning some Russian banks from the Swift global financial payment system—will make it cumbersome for many companies to conduct any type of trade with the country, even in sectors that aren’t being sanctioned. There is also the risk of sanctions on individual Russian commodity players, or of Russia retaliating by choking off supply of its products.

Russia has been supplying important commodities for industry, like neon gas and palladium:

Economists and business leaders fear this will hit supply chains that rely on components and little-known commodities from Russia such as neon gas and palladium, important ingredients to make semiconductors. Industries such as car manufacturing have already been disrupted by a surge in demand after the easing of pandemic lockdowns and persistent production bottlenecks.

Automobile manufacturing will be impeded, at the least, by the sanctions regime and the war:

The car industry, which has long relied on extended cross-border supply chains, was among the first to feel the blow of the fresh economic dislocations. Leoni AG , which makes wire systems in Ukraine that it ships to European auto makers, last week shut its two factories in Ukraine and sent the roughly 7,000 employees home.

The next day, Volkswagen AG said that it could no longer get wiring systems produced in Ukraine and would have to stop production at plants in Zwickau in eastern Germany, the most important factory in VW’s push into electric vehicles, and Dresden for several days this week. VW said it would have to furlough more than 8,000 workers until it could resume production.

Within hours of the invasion, car companies dependent on parts from China and Eastern Europe were forming task forces to plot out alternative routes. “Ukraine is not central to our supply chain, but suddenly we discovered that when this part is missing, it is,” a VW spokesman said.

Ukraine is home to 22 foreign companies like Leoni running 38 factories that make goods for the automotive industry, producing wire harnesses, electronics, seats and other products, according to UkraineInvest, a government body that promotes investment in the country.

“We don’t have a problem today, but it’s too early to tell if we have a problem,” a spokesman for Mercedes-Benz Group AG said.

Nicely explained.

And then there is the problem producing semiconductors. As of now, the world is suffering a shortage of these chips. The situation in Ukraine and the sanctions imposed on Russia is likely to make things worse. These chips need specialized materials and many of those materials come from the belligerents:

The disruption of commodity and raw materials supplies from Russia and Ukraine could worsen a global semiconductor shortage that has already been roiling businesses world-wide. U.S. semiconductor makers import neon gas, the chemical compound hexafluorocyclobutene, and palladium, which are used to make chips, almost entirely from Russia and Ukraine, according Techcet, a research group that analyzes dependency on critical materials used in manufacturing.

Russia’s MMC Norilsk Nickel PJSC mines 40% of the world’s palladium, also used in catalytic converters to reduce vehicle emissions, as well as around 11% of global nickel production, used to make stainless steel and electric vehicle batteries, according to JP Morgan. Russia mines around 4% of the world’s cobalt, another battery ingredient; a quarter of its vanadium, used in steel making; and 3.5% of its copper, according to the U.S. Geological Survey.

And, let’s not forget more banal commodities, like wheat from Russia and Ukraine. Their wheat feeds a large number of the world’s people. To say that the peoples of Northern Africa, a large consumer of said wheat, are anxious is an understatement:

Russia and Ukraine combined account for almost a third of the world’s wheat exports, 19% of its corn exports and 80% of the world’s sunflower oil, according to Commerzbank AG, and much of that flows through Black Sea ports that are currently closed. Soaring grain prices adds to concerns for the mainly developing world countries, like Egypt and Indonesia, that rely on the shipments and where food prices were already rising.

And then there is the SWIFT situation. David Goldman has been following it in the Asia Times. He is especially concerned that Russia might circumvent the SWIFT sanctions by routing fund transfers through the Chinese equivalent system.

Clearly, Chinese authorities have been measuring the risk and reward of allowing Russia to get around SWIFT. If they do, Goldman explains, it will be a major blow to American financial dominance, and to the reserve status of the American dollar. As part of the sanctions against Russia some, but not all, of its banks have been excluded from the SWIFT system:

China’s Cross-Border International Payments System (CIPS) can replace SWIFT for Russian trade financing, a Chinese academic told the Shanghai-based Observer news site (guancha.cn) in a February 27 interview.

Over the weekend, the United States and its allies excluded a list of Russian banks from the SWIFT, or Society for Worldwide International Financial Telecommunications, network that clears interbank payments in US dollars and other Western currencies, although Russia has not yet been subject to a blanket exclusion.

China might be reluctant to help Russia circumvent SWIFT sanctions, said Professor Chen Xi of the Shanghai Advanced Institute of Finance at Jiaotong University in an “Observer” interview because the United States might retaliate by imposing sanctions on Chinese banks. That would have disastrous consequences, Chen added.

He continues:

Risks to the financial system cut both ways, the German daily Die Welt wrote on February 27. “CIPS already handles US$50 billion of daily transactions. That is considerably less than the $400 billion of transactions that pass every day through SWIFT, but CIPS volume has increased rapidly,” the German newspaper reported.

“If Russia and China linked their systems and offered an alternative to other authoritarian states, this could threaten American domination of financial markets,” Die Welt concluded.

Obviously, circumventing SWIFT is easier said than done. I include Goldman’s analysis:

For example, the payment system built by China may be independent of the SWIFT system controlled by the United States, but the intermediate nodes are all banks. The United States can sanction these banks. If no one is allowed to do business with Chinese banks, and other countries cooperate with these measures, then this system will not work.”

“Russia also built its own independent payment system,” Chen said. “It also could adopt the cross-border payment system established by China as a potential replacement for SWIFT. But the key point is that these international cross-border systems all require the participation of actual banks.

“The United States is likely to threaten all financial institutions. If anyone deals with Russia, it might sanction them. If this is the case, the big Chinese banks may not dare to deal with Russia. In this case, Russia would only be able to do business with some small banks.”

But “if the United States sanctioned Chinese banks in this way, the damage to the global economy would be too great for anyone to bear,” Chen said.

For now China has been on the sidelines in the conflict between Russia and the West. To give us some perspective, Goldman explains:

China has a net foreign asset position of $4 trillion and holds $2 trillion of US Treasury securities. It is also by far the largest exporter in the world, with 15% of global export trade compared to 8% for the United States.

“In the final analysis,” Chen explained in the Observer article, “ the game between major powers depends on strength. If the United States doesn’t need Russian resources at all, and it doesn’t need Chinese products, it certain could impose severe sanctions.

Of course, the United States and the world do need Russian resources and Chinese products. Complete independence is more a pipe dream than a reality:

“However, given the current level of international exchange, if trade between China and Russia were cut off completely, it would  take a long time for the United States to adjust to it, and the damage to supply chains would cause damage to the entire global economy.”

“A drastic measure probably would trigger a long-term financial and economic crisis, so the United States is also very hesitant to do this,” Chen concluded.