Hello! Welcome to your weekly guide to the Russian economy — brought to you by The Bell. Our top story is a deep-dive into the EU’s nineteenth packet of sanctions against Russia, which looks set to include a ban on Russian diamonds and new rules on Russian oil sales. We also examine rising inflationary expectations, whether the country is in an inflationary spiral, and what this means for broader economic stability.
New EU sanctions on Russia suggest bloc settling in for ‘long war’
The European Union is drawing up another packet of sanctions against Russia — the twelfth since the full-scale invasion of Ukraine. Key measures are likely to include a ban on importing Russian diamonds and steps to stop Russia from evading the oil price cap. The EU will not accept final proposals until next month, but what we know so far suggests Europe has finally come to terms with the long-term nature of the war in Ukraine. They focus on closing loopholes in existing restrictions rather than imposing new ones.
Ban on diamonds
The headline grabber from the new sanctions looks likely to be a ban on the import, sale and purchase of Russian diamonds (or goods made from them). The EU plans to ban direct purchases of Russian diamonds at the start of next year and gradually extend that to cover Russian stones cut in India and other countries.
A similar ban introduced by the United States last year had little impact as the U.S. buys almost no diamonds from Russia.
There has been a lot of resistance in Europe to such a measure: in particular, Belgium has argued hard that it would damage Antwerp’s links with the global diamond trade. In 2021, Belgium was the destination for more than half of Russia’s total diamond exports.
However, the problem is not just concern over Antwerp’s economy — it’s also the convoluted structure of the international diamond trade. In particular, the fact that a rough diamond’s country of origin is considered to be the place where it was cut (not where it was mined). This is already a problem when trying to control the trade in so-called “blood diamonds” from conflict zones in Africa. However, technologies are being developed that can track a diamond’s entire journey from its place of extraction.
Sanctions against Russian banks and state diamond trader Alrosa reduced Russian diamond exports by almost a quarter last year. Alrosa’s export figures are not public, but trade publication Rapaport reported in May that exports were still falling.
Despite the controversy, diamonds are a relatively small issue: the total volume of diamond exports from Russia last year was estimated to be just $3.87 billion. That’s 60 times less than Russia’s oil exports, and a fifth of the value of fertilizer exports. Moreover, experience shows that markets are likely to quickly find ways to get around any restrictions.
Plugging oil loopholes
The second major component of the upcoming round of sanctions is set to be less eye-catching, but likely more significant for the Russian economy. The main purpose of the new oil sanctions, which are to be discussed by European diplomats, is to address systematic evasion of the oil price cap imposed by the G7 last year. Nobody is currently observing this cap: in the words of one European official, barely a single delivery of Russian oil by sea in October was at a price below the mandated maximum of $60 per barrel.
It’s important to remember that sanctions on both oil and diamonds share a common achilles heel — buyers for Russian commodities are not exclusively based in the West, and it is next to impossible to force every nation in the world to comply with Western restrictions.
In addition, Russia has several main ways to get around the oil price cap. First, changes to fiscal rules mean that Russian taxation rates are set according to global oil prices, not the real sales price for Russian oil. Second, Russian oil companies have learned to do business using small traders, and transport their cargo using old tankers with questionable insurance arrangements. Third, Russian exporters have created an entire “gray fleet” of oil tankers with hundreds of small operators that own a couple of old vessels registered in Liberia, Cameroon, Togo, and other nations offerring “flags of convinience”. Often these ships don’t have industry-standard insurance and, instead, are covered by Indian, Chinese or Russian providers. By the end of the summer, almost two thirds of this fleet had insurance of unknown origin.
The main proposal under discussion in the EU is to ban the sale of used tankers to Russia, and create a notification system that would enable such transactions to be blocked. It’s not entirely clear whether this would apply only to sales of old tankers to Russia and Russian companies, or whether it would apply to sales of all old vessels. If the latter, it would be a blow to European companies, making it harder for them to update their fleets. If it’s the former, it would likely mean Russian operators circumventing the ban with the help of intermediaries. In addition, such a measure could prove to be too little too late. The shadow fleet already exists and, as we can see, works effectively.
In addition, the EU is looking at introducing new requirements for the attestations that are part of oil sales contracts. This would mean contracts would have to include itemized ancillary costs, such as insurance and freight. Increasing prices for these ancillary costs would allow sellers to formally comply with the price cap. However, energy expert Sergei Vakulenko from Carnegie Endowment does not believe this will work. “Certificates with these new requirements will include dubious shipping costs and a completely misleading value for those services for which the certificate was needed,” he said.
In its search for a silver bullet, the EU is apparently even considering asking Denmark to check the insurance of tankers carrying Russian oil out of the Baltic Sea, The Financial Times reported Wednesday. The idea would be to force Russian exporters to buy insurance from Western companies, which are obliged to stick to the price cap. This idea was first floated by Craig Kennedy, a member of the Yermak-McFaul sanctions group in August. But there is a big question: is Denmark prepared to stop non-compliant tankers at sea, and run the risk of sparking a maritime conflict? For the moment, this measure is not included in the upcoming round of sanctions.
In fact, price cap enforcement is a next-to impossible task: the EU can’t strengthen controls without resorting to a wave of secondary sanctions against companies from countries that have not supported the price cap mechanism.
At present, only a handful of small traders from the Middle East have been sanctioned by the EU, US or the UK for the breach of the price cap rules. If they were rolled out more broadly, they would further fragment world trade and reduce the amount of Russian oil on the market (the whole point of the price cap was to restrict Russian oil revenue without reducing supply).
What’s not on the table
There does not look like there will be a decision on the fate of frozen Russian financial assets. The EU is not talking about confiscating the frozen funds, or even about whether — or how — to seize income generated from them. Despite the Belgian prime minister’s recent promise to transfer the profits earned in the first half of this year by Belgian depository Euroclear from Russian assets into a special fund, the EU and other Western nations are clearly far from a consensus.
This debate has also been playing out in U.S. media outlets. Michael McFaul, a former U.S. ambassador to Moscow, wrote in The Washington Post on Thursday in support of the U.S. confiscating all frozen assets and using them to support Ukraine. A group of lawyers at Yale University, however, opposed this, arguing against any violation of property rights and international law. Former World Bank economist Istvan Dobosi wrote in a letter to The Financial Times that, if the U.S. imposes too many financial sanctions, it would risk fueling the de-dollarization of the global economy (a stated goal of the Kremlin).
Why the world should care
Discussions about the next round of EU sanctions shows that Europe has come to terms with the fact the confrontation with Russia will be a long one. Western countries, and the EU in particular, appear now to be less concerned with introducing new sanctions, and more interested in reinforcing existing measures. There is a long battle of wills ahead between advocates of sanctions, and sophisticated schemes to circumvent them.
Inflationary expectations rise in Russia despite ruble recovery
According to the Central Bank’s latest survey, the expected rate of inflation rose to 12.2% in November, up from 11.2% the month before, and just 10.2% in June. This is the highest level since February. The asessment of observed inflation increased to 15.1% from 13,9%. The survey took place after the ruble began to recover against the U.S. dollar, making it impossible to claim that a weak ruble was driving the figures.
Increased expectations, coupled with an increase in actual inflation (the annual rate is currently 7%), mean the Central Bank is likely to raise interest rates once again at its final board meeting of the year on Dec. 15. In the four months since July, the base rate has doubled from 7.5% to 15%. The most recent hike of two percentage points triggered a barrage of criticism from the government, industry lobbyists and parliamentary deputies.
Central Bank head Elvira Nabiullina addressed her critics in the State Duma on Thursday. “It would be a mistake to think the base rate could have remained unchanged and loans would have remained as accessible as before,” she said. “Banks will not issue loans at a loss."
One of the main drivers of inflation is the rapid increase in state spending. With barely six weeks left of this year, the government has added another 3.4 trillion rubles ($37 billion) to the budget, the Financial Times reported earlier this month. Spending in 2024 is planned to hit 35 trillion rubles, more than a third of which will go toward financing the war in Ukraine.
Flush with cash, defense industry factories are operating 24/7 and raising salaries to recruit more workers. To compete, the civilian sector has also had to raise salaries. The combination of increased salaries and rising spending generates a demand for imports (both consumer and investment) because of the limits of domestic production.
Nabiullina emphasized that the ruble’s summer slump was linked to soaring inflation amid increasing demand for imports. “The higher inflation goes, the greater inflationary expectations will be in future,” she said. “The weakening of the exchange rate, which began in the middle of the year, was a direct consequence of the fact that increased domestic demand due to limited domestic production fuelled more demand for imports.”
Why the world should care
The Central Bank has been trying to deal with the consequences of rising government spending all year by raising the interest rate. So, we can already talk about an inflationary spiral. For the authorities, high interest rates are not just a trigger for endless complaints from industry lobbyists. They are also an image problem. The Kremlin is keen to push the narrative of economic stability, but this loses credibility when you remember the 15% interest rate. Healthy economies don't need double-digit key rate.
Figures of the week
- The State Statistics Services estimated economic growth in the third quarter of 2023 will be 5.5%, higher than the equivalent figures from the Ministry of Economic Development (5.2%) and the Central Bank (5.1%). Over the last three quarters, Russia’s economy grew 2.9%. Bloomberg Economics has calculated that almost half of GDP growth — excluding the financial sector — is driven by manufacturing, including the defense sector. And the news agency predicts that economic growth this year could reach 3%, but will slow to 0.9%-1% in 2024 due to a shortage of financial and labor resources.
- As expected, the Kremlin is increasing social spending in the run-up to the presidential election next year. From Jan. 1 2024, the minimum wage will rise by 18.5%, to 19,242 rubles. Over the whole of this year, the minimum wage increased just 6.3%. The minimum wage is used as the basis to calculate benefits for disabilities, parental leave, sick leave and other social handouts.
- For the first time since the summer, weekly inflation slowed: between Nov. 8 and Nov. 13, prices were up 0.23%, compared with 0.42% the previous week.
Alexandra Prokopenko, a visiting fellow at the Center for Order and Governance in Eastern Europe, Russia, and Central Asia at the German Council on Foreign Relations, contributed to this newsletter