Dynamics of Isolation in Conditions of Fragmentation: The results of two years of the sanctions experiment

Sanctions experiment

The wide-ranging sanctions imposed on the Russian economy more than two years ago represent a kind of unique experiment with few historical parallels. This is due to three distinct features: the sanctions were imposed on 1) a large country with a substantial domestic market and strong export potential (mainly in resource markets), 2) a country integrated into the global economy, and 3) a country that was not experiencing economic collapse at the time of their imposition. The first criterion fundamentally distinguishes sanctions against Russia from, for example, the sanctions against North Korea. The second distinguishes the current sanctions from those against the Soviet Union, which was much less connected to the global economy outside the socialist bloc. Finally, the third criterion differentiates the situation in modern Russia from, for example, post-revolutionary Soviet Russia, which found itself economically isolated in the wake of a devastating civil war.

At the same time, Russia's integration into the global economy is maintained through several channels, each playing its own role under the sanctions regime. Russia is an important exporter of a very wide range of natural resources and has occupied this niche for a long time. Russia also was a significant importer of technologies from European countries and the USA and actively participated in establishing cross-border production chains. Over the past three decades, Russia's internal consumption standards have largely adapted to global ones: Russians bought the same brands of household appliances, wore the same clothes, watched the same movies, and read the same books as much of the world. In this respect, Russia differs significantly from Iran, which was much less involved in global trade when it came to consumption, at the point when sanctions were imposed. Finally, in recent years, Russia has attracted foreign investments. At least some of this investment has been linked to the authorities' actions to impose localisation requirements for production. Without these requirements (combined with the capacity of the domestic market), companies would prefer to import goods into Russia rather than create part of the value added domestically.

As a result, it is not easy to find analogues to the sanctions against Russia in order to assess possible scenarios of their long-term impact. Perhaps the closest case could be considered sanctions against South Africa (due to the greater integration of its economy into the global economy). Indeed, some of the processes observed in Russia today resemble the South African case. However, both the structure of sanctions and the structure of the global economy in the 1980s were very different from the current ones. In such a situation, errors in assessing the impact of sanctions are inevitable, and today it is quite clear that the dynamics of the Russian economy under sanctions are significantly different from what many expected.

Two years ago, there were widespread assumptions about the inevitable large-scale economic isolation of Russia, its transformation into a kind of giant North Korea. After the full-scale invasion of Ukraine, the country quickly became the champion in terms of the number of imposed sanctions measures. However, it should be realised that the very idea of ‘counting’ individual measures is linked to the nature of sanctions: rather than imposing a full trade embargo — as was the case of Yugoslavia or Iraq — Western countries continue to limit themselves to individual sanctions on industries, companies and individuals. However, many observers have speculated that the totality of these measures could be similar to a total trade ban. Two other factors were also expected to push Russia towards isolation: the voluntary departure of many Western companies from the Russian market (due to reputational considerations or logistical difficulties) and the general loss of trust from external players at all levels — from states to private businesses — due to the unpredictability of Russian policy, which was supposed to repel even those countries that formally did not join the sanctions.

But even if this scenario were to materialise, it would not mean the complete collapse of the Russian economy — market economies are highly resilient and adaptable — and would not necessarily lead to a change in Russian policy. For authoritarian countries, strong external pressures leading to economic decline can be a stabilising factor by ‘rallying’ elites and populations around the regime. However, instead of isolation, Russia's foreign economic relations have been restructured in two directions. First, their geographical structure has changed: the EU has been replaced by China and the countries of the Global South — India, Turkey, and the UAE. While these new connections do not fully replicate Russia's ties with the EU, they are developing quite dynamically. Second, there has been a significant shift in foreign trade (including the remaining connections with the EU and the Western coalition as a whole) into the informal sector. Goods from Europe are entering Russia through ‘gateway countries’ - Turkey and the member states of the Eurasian Economic Union (EAEU). As a result, the structure of Russia's foreign trade is much harder to assess today. 

These two trends characterise the general direction of the dynamics of Russian foreign trade. If we look at the short-term effects of the sanctions, we encounter even more unexpected phenomena. For instance, in 2022, the value of Russian raw material exports to the EU significantly increased compared to pre-sanction levels due to a sharp rise in prices (this effect ended by early 2023). Moreover, at the end of 2023 and the beginning of 2024, according to the Financial Times, actions by the Houthis in the Red Sea led to increased load on the Russian railway network. Thus, the dynamics of Russian foreign trade are highly responsive to market changes, despite all the sanctions.

Three main factors explain the resilience of Russian foreign trade to sanctions: 1) a fundamental contradiction inherent in the nature of sanctions, leading to what economists call the ‘logic of arbitrage’, 2) changes in the structure of the global economy, where non-Western countries — primarily China — now play a more significant role, and 3) the internal contradictions of the sanctions regime, which were partly inevitable due to political circumstances and partly due to the Western countries' miscalculation of the effectiveness of sanctions.

The logic of arbitrage and the effects of decentralisation

In the language of economic theory, sanctions represent a well-known phenomenon — they are a type of protectionist measures. In economic science, the main attention is given to protectionism associated with influential interest groups or the protection of domestic production. Sanctions are imposed for geopolitical or normative reasons, but this does not change the essence of the matter. Accordingly, sanctions create a situation where policymakers attempt to restrict trade between two markets, leading to an effect known since Napoleon's continental blockade of England and described as the ‘logic of arbitrage’. The more rigid the artificially created barriers between two large and attractive economic spaces, the greater the gains for players who can somehow overcome these barriers. In other words, sanctions create rents for those who can ignore them, operating in the shadow sector or in countries that have not joined the sanctions. The stricter the sanctions, the higher the rents.

Of course, this logic only works when sanctions are imposed on a sufficiently large country that is inherently interesting to trade with, due to the size of its market or its resources. For small and unattractive countries, the rents from overcoming sanctions may be insufficient compared to the costs and risks. For example, far fewer companies seek to overcome international sanctions against North Korea. However, in the case of Russia, we are talking about a country with vast resource potential and an internal market that still has a sufficiently large solvent demand. As a result, the arbitrage logic leads to the fact that sanctions pressure not only does not reduce interest in interacting with Russia (primarily from countries that have not imposed sanctions), but, on the contrary, this interest increases. For many players, economic interaction with Russia becomes interesting precisely under conditions of sanctions pressure because they, for example, obtain Russian resources at a discount that would not exist in the absence of sanctions, or because they see an opportunity to enter the Russian market under more favourable conditions, without strong competitors, as happened with the Chinese automotive industry.

This logic was described most succinctly back in 1914 by Austrian economist Eugen von Böhm-Bawerk in his famous article ‘Power or Economic Law’ (‘Macht oder ökonomisches Gesetz’). His argument is quite simple: in the short term, government intervention may lead markets away from natural equilibrium, but in the long run, market forces always dominate over political constraints. Similar logic applies to sanctions against Russia.

The second factor ensuring the sustainability of Russia's integration into the global economy is its changed structure. Today the global economy is more decentralised, and Western countries (including some geographically non-Western countries — Australia, Japan, etc.) do not occupy an unambiguously dominant position in it. The share of OECD countries in global GDP decreased from 82% in 2000 to 59% in 2022. Consequently, significant markets and players outside the Western coalition have emerged in the global economy, and the effectiveness of sanctions decreases if at least some of these do not join. In this sense, the sanctions imposed on Russia have become a vivid testimony to how far the decentralisation of the global economy has gone.

Today, the vast majority of countries in the Global South and China are not eager to join the sanctions — either because of their own geopolitical conflicts with Western countries (China), or simply because they perceive the war in Ukraine as distant and not affecting their interests, and therefore are unwilling to bear the economic costs of the conflict in Europe. Contrary to initial expectations, Russia's unprovoked aggression against Ukraine did not make it, in the eyes of Global South countries, a country fundamentally undeserving of trust. For them, unlike Europe, wars (including those started by Western countries, sometimes under very dubious pretexts) have remained part of the ‘normal’ reality of the past few decades. Therefore, they are quite willing to cooperate with Russia if it proves to be economically advantageous.

Another important factor is the existence of ‘bridge countries’ around Russia that provide access to the Russian market. These are the Eurasian Economic Union (EAEU) states, which are not under sanctions and, at the same time, participate in a customs union with Russia. As a result, re-export through Kyrgyzstan and Armenia (and partly through Kazakhstan) has become one of the key mechanisms for Western goods to access the Russian market. Of course, the EAEU countries emphasise their unwillingness to violate the sanctions regime. However, first, not all of them have sufficiently efficient bureaucracies to monitor the implementation of sanctions requirements (even Western countries cannot cope with this), and second, many are not ready to give up the economic advantages of cooperation with Russia and in any case seek to avoid open confrontation with the Kremlin. In this respect, Russia is in a similar position to South Africa was during the sanctions against the apartheid regime — at that time, the countries of the South African Customs Union also played the role of ‘gateway countries’ for companies that avoided direct interaction with South Africa. At the same time, the world economy was much less decentralised in the 1980s than it is today.

Of course, the question remains to what extent can alternative supply centres become a substitute for the EU and the US, especially when it comes to high-tech goods? Is China competitive enough in this respect? Currently, no one can provide a definitive answer to this question. Moreover, what Friedrich von Hayek called ‘the procedure of discovery’ is happening in the market right now: the interaction of countless economic players is revealing the real technological potential of China as a substitute for the West. All of this is overlaid with a fundamental change in the structure of the innovation process, linked to the revolution in artificial intelligence and ‘big data’, the potential of which remains a subject of debate today, and in which the comparative advantages of China and Western countries as sources of innovation are also changing. In any case, underestimating China's technological potential would be unwise.

Internal contradictions of the sanctions regime: settlement restrictions vs capital flight

In addition to the constraints already described, the emergence of which was practically inevitable regardless of the design of the sanctions imposed on Russia, the chosen sanction regime suffers from internal contradictions. Two contradictions can be identified — between export and import sanctions (which have been extensively discussed) and between restrictions on trade and capital export. The latter problem has received much less attention, although it may be even more important in the long term.

The first contradiction is related to the asynchrony of restrictions on the supply of goods to Russia (primarily from the EU) and on the export of Russian raw materials (especially energy resources). The initial sanction measures introduced in early 2022 restricted the import of dual-use goods into Russia; the withdrawal of Western companies also contributed to a decrease in goods supplies. At the same time, effective sanctions against Russian exports (primarily raw materials) were only introduced in 2023. As a result, throughout 2022, Russia continued to receive windfall profits from the export of energy resources and, to a lesser extent, spent the proceeds on imports from the EU. This allowed the government to stabilise the economic situation, avoid a sharp decline in the ruble exchange rate, and prepare for more serious restrictions imposed in 2023.

Many observers from the outset pointed out the asynchrony of sanctions as a problem and called for the imposition of harsh measures against Russian raw material exports. However, in the context of long-term confrontation, it was important for Western countries to maintain the stability of their own economies (including to ensure an adequate level of support for Ukraine and consensus among voters). Although the cessation of gas supplies from Russia did not lead to the catastrophic consequences claimed by Russian propaganda, for example, in Germany, a serious decline in certain industries (particularly the chemical industry) has contributed to the recession the country is currently experiencing. Moreover, the rejection of Russian raw materials often leads only to a redistribution of supplies — Russia ‘replaces’ the niche of other countries (whose raw materials are now supplied to Western countries) in non-Western markets. 

The second contradiction is linked to the primary instrument of sanction pressure: financial and banking sanctions. Western countries from the outset focused their attention on imposing sanctions concerning financial flows, such as disconnecting Russian banks from the SWIFT system, card payment systems ceasing operations in Russia, and terminating correspondent relationships with Russian banks, among others. The main effect of these sanctions was supposed to be a significant complication of transactions with Russia, including payment for dual-use goods supplies. Imposing sanctions on financial flows is much easier than restrictions on trade — monitoring goods supplies is much more challenging than tracking money transfers.

However, financial flow sanctions have another effect — they limit the ability to withdraw capital from Russia. In the absence of financial sanctions, Russian companies would have endeavoured by all means to withdraw their earnings from Russia (to avoid risks associated with unpredictable decisions of the Russian authorities). All of the ‘creative’ energy of business would have been channelled to this end.Instead, Russian capital, finding itself unwanted in the international banking system, remains in Russia, and is invested in the Russian economy, contributing to its stabilisation and economic growth. Russian oligarchs are even being forced to attempt to repatriate their funds to Russia. Financial sanctions stimulate unity among the Russian elites, who have lost the opportunity to keep their resources beyond the reach of the Russian regime, thereby increasing their dependence on it and readiness to cooperate with it.

Here again, it is useful to draw a comparison with South Africa: capital flight ultimately became the main factor that led to the weakening of the South African economy after sanctions were imposed. Capital flight could have been a much greater source of destabilisation for the Russian economy and the Putin regime than restrictions on dollar settlements.

Further dynamics of the sanctions regime

The most pressing question today is to what extent the threat of secondary sanctions by the United States will change the situation. Since the beginning of 2024, we have been able to speak of a qualitatively new period in the history of the sanction regime. While the application of this instrument remains limited, its impact on economic interactions with Russia in the banking sector can already be seen. Banks are particularly vulnerable to secondary sanctions: restrictions imposed on them by the US practically make it impossible to conduct transactions in dollars, something few banks would risk. Consequently, payments between Russian and Chinese (or Turkish) companies have increasingly been ‘stuck’ in banks or simply not going through in recent months.

There is no doubt that secondary sanctions will lead to increased costs for Russia in its interactions with the external world, but they are unlikely to result in the complete isolation of the Russian economy. First, the logic of arbitrage described earlier will play its role. In other words, if interacting with the Russian economy under secondary sanctions becomes too risky for one party, then for another, such a risky situation may become a competitive advantage. Russia's foreign economic partners will make every effort to, on the one hand, avoid secondary sanctions and, on the other hand, continue to maximise the benefits from economic interaction with it. Moreover, the position of Western countries is likely to remain inconsistent: the complete isolation of Russia could lead to the destabilisation of resource markets, which, for example, the US wants to avoid. That is why they use such an instrument as complex as a price cap for Russian oil exports. But the more complex the instruments, the more room there is for circumvention.

Second, China's political elites seem to assume that, in the medium term, an economic conflict with the US (and, accordingly, the imposition of US sanctions on China) is inevitable regardless of how relations with Russia develop. The perception of China as a threat and the recognition of the need for measures to contain it is a rare example of consensus between American Democrats and Republicans. In other words, from the Chinese point of view, the choice is not between engagement with the United States or Russia, but between cutting ties with the United States today (while maintaining ties with Russia) or in, say, five years (when it will no longer be possible to take advantage of the benefits of engagement with Russia that exist today). Third, even Western countries themselves are cautious about imposing secondary sanctions, fearing that they will contribute to the greater fragmentation of the global economy.

It can be assumed that in the foreseeable future, more active use of secondary sanctions will lead to a kind of cyclical dynamic in Russia's interaction with the outside world. New restrictive measures imposed by the US and the EU will lead to problems in foreign trade, followed, however, by the emergence of new channels of interaction that are ‘resistant’ to sanctions, and trade will recover. The US and EU will respond to this with new restrictions. A key condition in this respect is the ability of Russian business to adapt to constantly changing conditions and seek new non-standard ways of interaction with external partners. Russian private business is, in principle, characterised by a high degree of flexibility, ‘tested’ in a number of crises that Russia has experienced, and the ability to adjust to new conditions. 

Two other factors that will affect the degree of Russia's integration into the global economy are disruptions in logistics and the departure from the Russian market of those investors who have long sought to leave Russia but cannot do so due to the existing procedure for selling assets (some of them currently play an important role, for example, in facilitating settlements between Russia and the EU). Logistics disruptions, of course, limit the scale of economic interaction with Russia even for those companies that would like to trade with Russia in principle.

If investors ‘stuck’ in Russia do manage to leave the Russian market, this will contribute to the further fragmentation of economic ties (however, some companies seem to have deliberately stayed in Russia, hoping for a normalisation of the situation). Nonetheless, even in this case it will be more about the reorientation of Russian foreign economic relations rather than isolation. The Russian authorities themselves do not seem to be interested in assisting those private players from the EU or the US who continue to work with Russia: the Russian leadership seems to be proceeding from a scenario of long-term confrontation in relations with the West, including in the economic sphere.

Long-term factors: economic policy, structural changes and geo-economics

In the long term, however, Russia's position in the global economy may be affected by several additional risks that could have a decisive impact on the structure of Russian foreign economic relations. Above all, the risk to Russia's position in the global economy lies not so much in sanctions as in the actions of the Russian authorities.

The last two and a half years, from the perspective of Russian economic policy, represent a period of largely contradictory decisions. On the one hand, the economic bloc of the government and the Central Bank continue to attempt to manage the Russian economy as predominantly market-oriented, albeit using sometimes somewhat harsh measures (e.g., restrictions on cross-border capital flows). From an official standpoint, the rhetoric of the regime, including statements by Putin himself, twice — in 2022 and 2023 — calling for responding to sanctions by increasing economic freedom, is consistent with such an approach.

On the other hand, a number of decisions taken in recent years have potentially contributed to the erosion of the ‘market core’ of the Russian economy. This primarily concerns numerous cases of renationalisation initiated by the Prosecutor General's Office. Sometimes, these cases involve assets that passed into private hands back in the early 1990s. Typically, after this, the assets do not remain in the hands of the state but are transferred to ‘friendly’ businesses, but this does not fundamentally change the problem of the instability of property rights. In this respect, the Russian economy has entered a new phase, as previously, such cases were much rarer. The position of the country's political leadership on the issue of asset redistribution remains unclear. Along with the rhetoric of ‘economic freedom’, Putin has made it quite clear in his speeches that business freedom is fundamentally limited by his ‘patriotic’ stance. It is also worth noting the high probability of redistributive conflicts between influential groups for control over attractive assets. All of this undermines the market orientation of the Russian economy, and as a result, its ability to flexibly adapt to changing conditions and to function stably even under the influence of external shocks.

The less market-oriented the Russian economy becomes, the less attractive it will be for external players from a purely economic standpoint. The Russian market will shrink (reducing the willingness of entrepreneurs from China, Turkey, or Kazakhstan to take risks to access it). Even the extraction of natural resources will suffer: it depends not only on the availability of these resources, but also on the efficient organisation of extractive companies and, therefore, Russia's ability to turn its resource potential into revenue-generating exports will diminish.

Similar consequences may result from factors unrelated to economic policy but exerting a significant influence on it. For example, a new wave of mobilisation is likely to lead to serious disruptions in the Russian economy. Ukraine's attacks on Russian oil refineries have already dealt a significant blow to the industry. The ongoing war makes the situation unpredictable, and this could ultimately increase the likelihood of an isolation scenario.

However, the regime may be able to avoid obvious mistakes in economic policy. After all, it managed to avoid them after the start of full-scale invasion when many observers believed that a rapid ‘backslide’ into a new version of a planned economy was almost inevitable. However, the likelihood that state intervention in the economy will increase over time and take on an increasingly non-market character is quite high, both because of the inevitable degradation of the quality of state governance in contemporary Russia and because of the growing temptation for ‘quick’ decisions that support foreign policy ambitions. The focus of the head of state on geopolitics, combined with the extremely personalistic nature of the regime (in which, ultimately, there is no ‘fool-proofing’ against Putin's decisions, and the disastrous invasion of Ukraine is the clearest example of this), increases the likelihood that certain interest groups will, sooner or later, be able to ‘sell’ radically non-market measures to the regime, which will have large-scale negative consequences for the economy.

It is important to note, however, that in the absence of financial sanctions, the consequences of redistribution conflicts and state intervention could potentially be even more severe for the Russian economy because they would lead to rapid and extensive capital flight, which these sanctions block, forcing businesses to ‘put up’ with the regime instead of ‘voting with their feet’.

The second long-term factor that needs to be taken into account is technological changes in the global economy and the associated decline in demand for Russian commodity exports. We do not know what the demand for oil will be in the decades to come, given the green transition that many countries are currently undergoing. Another factor is the growing shortage of labour resources as a result of the demographic situation in Russia. This makes access to innovative technologies particularly important and, as mentioned, there is no certainty that the Global South will prove to be a substitute for the West in this regard. Finally, a slowdown in the Chinese economy (for domestic reasons) may also prove to be a factor limiting Russian economic dynamism.

Finally, it is also important to remember that sanctions trigger the adaptation process not only in Russia but also in the global economy. While for some players the ‘opportunity’ lies in the connection with the Russian market, for others this ‘opportunity’ will be the ability to take Russia's place in global markets — not only in natural resources, but also, for example, in military-industrial products. This adaptation will also lead to a reduction in the intensity of Russia's ties with the global economy. The scale of this adaptation will likely vary. While in some cases, finding a replacement for Russia may be relatively easy, in others, it may be impossible or take a long time.

The aforementioned long-term factors are more likely to contribute to the isolation of the Russian economy. However, there are factors that are more likely to counteract isolation. First, there is a broader process, which has accelerated since the full-scale invasion, of the world fragmenting into competing geo-economic blocs. Both Western countries and China now view economic interdependence as a source of risk and seek to reduce it by reorienting themselves towards cooperation with ‘friendly’ countries. In this situation, Russia is unambiguously a part of the ‘eastern’ bloc, and the interest that these countries have in reducing their economic interaction with Russia will diminish as their ties with the West diminish. 

Second, Russia's integration into the global economy will be supported by an alternative infrastructure for international settlements that exists independently of the West. The creation of such an infrastructure is a costly and complex process, but the more acute the conflicts in the global economy and the more often that the West uses the ‘sanctions weapon’, the higher the chances are that such an infrastructure will be created sooner or later. 

Russia should not be expected to become completely isolated in the foreseeable future, although the development of the sanctions regime may lead to the severing of some ties (which will be replaced by new ones). Ultimately, only the regime in power can isolate Russia, although this factor should never be underestimated.