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The West is too locked in to Russia to cause it pain. But it inflicts a lot of pain on itself

No one wants to be dependent on Russia. This is not sanctions.  It is common sense

Hamish McRae
Wednesday 23 July 2014 18:33 BST

The trick with economic sanctions is to put pressure on a country by damaging its economy, but without doing more damage to your own. That is not easy in our interconnected global economy. But fortunately, in the case of Russia, the target country is busy imposing sanctions on itself. In the short run we should not expect too much from sanctions, but in the long run any uncertainty in Russia’s economic relations with the developed world undermines an already difficult position.

The central point to grasp is that the Russian economy is a one-trick pony. More than 80 per cent of its foreign exchange earnings come from pumping or digging stuff out of the ground. Oil and gas account for two-thirds of its exports, with minerals a further 15 per cent. It is even more dependent on these primary products that it was in the Soviet era, when it had substantial machinery, armaments and other manufactured exports too.

It is a sizable economy, with about the same GDP as Italy – around No 9 in the world. But no other large economy is so dependent on a single source of revenue. It has 142 million people whose future prosperity depends on the price of oil and gas.

The entire supply/demand equation is now being changed by the boom in US production of both oil and gas, thanks to fracking. The US this year passes Russia as the largest producer of oil and gas combined, and price of gas in particular looks vulnerable as the US starts to crank up exports of gas in its liquefied form – Liquefied Natural Gas (LNG).

If that seems scary, it gets worse. The principal market for Russia’s oil and gas is Europe, and Europe can buy its oil from anywhere. It just has to pay the world price. Gas is more complicated to transport, for it needs either pipelines or expensive LNG terminals to import it. At the moment Germany in particular does need Russian gas, and until now thought it had a stable supplier. When the Nord Stream pipeline down the Baltic from Russia to Germany was inaugurated in 2011 it was greeted by Angela Merkel as “the biggest energy infrastructure project of our time”. Until then, most of Russian gas exports to Germany came through Ukraine.

In the short run nothing changes. Germany will not stop importing Russian gas. But in the medium term western Europe will gradually seek to diversify away from relying on Russia. We are already doing it: the South Hook terminal in Wales can take the largest LNG tankers. It has not yet shown through in our gas bills, but wholesale prices have fallen by a quarter since April, and the UK is buying cheap gas from Qatar. No one wants to be dependent on Russia. This is not sanctions. It is common sense.

There is a further twist. Russia needs the West as a market, for though it will always be able to sell its oil and gas to someone, it will have to cut the price – it has just done a gas deal with China on what for Russia looks like poor terms. It also needs Western technology to get the stuff out. One of the reasons why BP is a partner in Rosneft, Russia’s largest oil producer (BP has a 20 per cent share stake), is that BP knows more about getting oil out of difficult places.

So there you have it. European sanctions, like the US ones announced last week, will not undermine core trading relations with Russia. Germany will go on buying the gas; BP will continue its participation in Rosneft; and rich Russians will go on buying their BMWs and blowing money in Monte Carlo. A handful of individuals known to be close to the Russian leadership have had their foreign bank accounts frozen, and some will find it impossible to get visas to travel to the West.

But the combination of rising perception of the risks of investing in Russia and the threat of further restrictions is already pushing up the price at which Russia can borrow on the financial markets. At the beginning of the year the government could borrow for 10 years at 7.7 per cent; on Tuesday night the rate was over 9 per cent. Unsurprisingly, capital is flowing out, some $70bn in the first half of this year. Share prices have fallen; the rouble has weakened. The economy is almost certainly back in recession.

But all this is short-term. What really matters to Russia is the long-term progress of its economy. It can choose to be poor, or at least poorer than it need be. Or it can choose to become a normal, successful, diversified market economy, rather than the odd skewed entity that it has become. The path to prosperity lies in cooperation with the West, using the resource of the human capital of its people, plus Western know-how, to create goods and services the rest of the developed world wants to buy.

There is nothing wrong with being a primary producer, but the trick is to use the natural resources to build a wider economic base, as Canada has done. Russia could be to the EU what Canada is to the US.

But how do you deal with a leadership of a country that is determined to act against that country’s long-term self-interest? Maybe sanctions will give a nudge.

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