by Elisabeth Hellenbroich

Following the dramatic incident at Asov Sea that occurred Nov 25th between Ukraine and Russia in Kerch Strait (from the Russian point of view the incident occurred when three Ukrainian naval vessels were crossing off limits Russian territorial waters, which led to the detention of the naval vessels and the arrest of the naval crew), a major storm of protest has erupted in the US and Europe, calling for the imposition of more draconian economic sanctions against Russia. Spearheading the call for sanctions is the vociferous demand (especially from the Baltic states as well as from Poland and from the Greenies in Germany), to stop the Russian–German natural gas pipeline project “Nord Stream II” whose construction that began in 2017, is supposed to be finished by the end of 2019. Nord Stream II projects a 1,200 km offshore natural gas pipeline that will connect Europe to the world’s largest reserves in natural gas in Russia. Participating in this project is the Russian state owned company Gazprom as well as Western European energy and gas companies such as the Austrian OMV, Royal Dutch Shell, the German Uniper, Wintershall and the French Energy company Engie. The aim is to pump annually an additional 55 billion cubic meter gas from Russia to Europe.

The US administration under President Trump is at the moment intensifying all effort to stop that project and sell US-LNG to Europe. In order to bring Europe “in line”, it has deployed several high level envoys, including US State Secretary of the US Finance ministry Sigal Mandelker-who declared in an interview with the German Daily FAZ (Nov.20th), that the US will do everything to “force” Europe into breaking with the Iran nuclear deal (JCPOA) and force Germany to stop the “Nord Stream II” energy project. She was in line with US Foreign State Secretary Mike Pompeo who several days ago gave a speech at the German Marshall Fund, outlining the need for a US-led “New Order” that should be built against Russia and China.

Sanctions however, as painful as they may be for Russia, have proven to be ultimately quite inefficient, since they will “backfire.” As a recent Valdai report that was published in November by British scholar Richard Connolly (Senior Lecturer at the university of Birmingham, visiting professor at the Russian Presidential Academy of National Economy and Public Administration) under the title: “Russia’s response to sanctions: How Western Sanctions reshaped political economy in Russia,” documents, the sanctions imposed by western powers and their allies in the spring and summer of 2014, followed by a series of even more draconian sanctions, produced on Russia’s side the opposite effect: they caused policymakers in Russia to “reassess” the nature of the country’s relationship with the global economy. Instead of turning to “Soviet Era aspirations to autarky”, significant efforts were made by Russia to “build a more secure and durable system of political economy based on the development of domestic capabilities in ‘strategic’ industries as well as by cultivating closer ties with alternative source of technology and capital from outside the West and its allies.”

In his document Connolly refers to the August 2017 bill that was passed by US Lawmakers allowing the imposition of a range of new sanctions against Russia, including the placing of several high- profile Russian nationals that were placed on the US “Specially Designated Nationals (SDN) list” in April of this year (2018). Several senior officials and lawmakers in the US have also indicated a willingness to impose penalties on other countries that do not observe US- sanctions.

As Connolly concludes, sectoral sanctions that targeted Russian oil, defense and financial sectors “have largely failed”.While initially they caused “domestic disruption”, their impact on targeted sectors quickly subsided, given the fact that Russian authorities were able to utilize a range of tools and resources- many of which were readily available due to the specific characteristics of Russia’s system of political economy- to protect the targeted sectors from the worst effects of sanctions. In short, the strategic response of the Russia authorities reduced their impact. The Russian response resulted in a clear shift “towards a greater reliance on domestic resource- or ‘Russification’ – on the one hand, and towards more multidirectional foreign economic policy that emphasizes closer relations with non- Western countries, on the other.”

Why the US / EU sanctions backfired

In response to the sanctions regime by the West which evolved during 2014 in response to the annexation of Crimean, according to Connolly Russia formulated economic policies designed to reduce the impact of Western sanctions and insulate the domestic economy from similar measures in the future. These policies included: 1.The securitization of strategic areas of economic policy; 2. a concerted effort to support import substitution in strategic sectors of the economy; and 3. vigorous efforts to cultivate closer economic relations with non- Western countries, especially in Asia. Hence the Russian strategic response was to enhance Russia’s “economic sovereignty” through state directed efforts to boost Russia’s domestic economic capabilities and by diversifying Russia’s foreign economic relations. Very helpful in this respect was Russian state influence in key sectors of the economy, such as for example the “Russian energy industry”.

In summer 2014 restrictions on access to capital and technology were imposed on Russian gas and oil companies. As Connolly states: “Technological sanctions focused on plans for the development of ‘new frontier’ oil deposits, both offshore in the Arctic and onshore in the shale –oil formations (such as the Bazhenov and Domanik formations in Western Siberia and the Urals), although they also affected technology used in enhanced recovery of oil in brownfield deposit. Financial restriction also had impact on current operations of Russian energy firms. Russian policy makers produced support to the domestic oil and gas equipment industry in the governments wider import substitution strategy. This was accompanied by efforts to increase control over different aspects of the Russian energy industry, including exploration, oil services and production. Diversification involved the acceleration of efforts by both the Russian government and by state owned firms towards forging closer ties with Non- Western source of capital technology and demand for Russian energy.”

Especially hard hit were some Russian energy firms like Rosneft and Novatek as well as joint ventures with Western international companies. Aside attempts to give a new boost to the domestic oil and gas equipment industry, Russia tried to reduce its dependence from the West for technology, by increasing imports of equipment from non-Western (i.e. Asian) countries. The substitution of technology was accompanied by the steady increase in the use of non- Western sources of capital, with China leading the way in supplying capital to Russian energy projects on an increasingly large scale, Connolly emphasizes. Simultaneously diplomatic resources were used to open up a closer gas trade relationship with China. Alongside Russia’s emergence as China’s single largest supplier of crude oil, the intensification of energy trade between the two countries means that Russia is moving closer to achieving the objectives stated in energy strategy documents published before sanctions were put into place.

Russia’s Defense Industry

Russian Defense Industry or the military industrial complex has according to the Valdai document, occupied an extremely important position within Russia’s political economy. It is a source of industrial employment and represents one of the few areas of technology intensive manufacturing in which Russian firms are successful exporters. In the summer of 2014, “Russian defense enterprises were restricted from accessing capital and technology from sender countries. Western sanctions were buttressed by a moratorium on the supply of defense – industrial equipment by Ukraine. Unlike the energy industry, where access to only specific items of technology were prohibited, a blanket ban on the export of items that might be used in military production was imposed.”

Russia responded to these sanctions by a combination of “Russification” and “diversification.” In the military industrial complex this included an ambitious “import substitution program that aimed at replacing prohibited components and weapons systems” with “domestically produced analogues”, including helicopter and ship engines. This was accompanied by efforts to intensify defense – industrial cooperation with several non- Western states, such as China and India, indicating a visible shift of Russian policy makers to cooperation with the “Non West.” As Connolly notes, production facilities were upgraded “so that engines for large warships and helicopters were produced by indigenous companies. There was a concerted effort to boost domestic production capabilities and imported electronics from non- Western countries, especially China, reinforced the trend towards increasing reliance on Asian sources of equipment. Russia adjusted to the sanctions by continuing to pursue an ambitious program of military modernization (…) What enabled Russia to do this was Russia’s system of political economy, including state enterprises which resulted in strengthening the military and maintaining an independent and secure industrial base.”

The Financial Sector

In summer 2014 some of Russia’s most important financial organizations were restricted from accessing capital from Western countries. In response to financial sanctions the Russian policy response comprised a mixture of measures intended to promote the simultaneous Russification and diversification of financial flows. Certain measures were taken including Russification as a response to financial sanctions. For example most notably “domestic, state controlled sources of capital were used to fill the void created by the sudden stop of foreign capital inflows. Informal capital controls were also implemented to boost the repatriation of foreign currency from private and quasi- public entities and to reduce gross outflows of capital. The authorities also began to bolster the domestic banking system, i.e. by removing weak and financially risky banks while simultaneously providing capital to state owned banks. As result the state’s influence over the domestic banking system rose. At the same time they looked to alternative sources of foreign capital, both through the cultivation of closer links with a number of new multilateral financial organizations with non- Western powers that might be used to finance investment in the future.” These adaptive measures taken by policymakers after 2014 created the conditions for a more self- reliant financial and reduced the financial system’s vulnerability to any expansion of sanctions in the future.