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Beware Russia: Expect more sanctions from the West

The tragic downing of Malaysian Airlines flight MH17 accelerates pressure on the West to put full “sectoral” sanctions in place targeting entire industries across Russia. The economic disruption could be profound, but the West—backed by a larger, stronger economies and central banks flush with liquidity liquidity—is far more resilient than Russia for what is to come.

It is easy to criticize the West’s most recent sanctions as incremental and timid. The European Union last week added 33 individuals and entities to their sanctions list, including senior Russian security service officials and oligarchs. France continues to insist it will provide warships to Russia, and economic interests seem to be blocking tough action. Even the most recent sanctions by the United States only moved to block new debt and equity issuance by a number of energy, financial and military companies. What’s more, U.S. sanctions exclude Sberbank, which holds the majority of Russian deposits.

While such criticism is fair, it does not suggest that leaders are being too soft on Russia. European leaders—led by the United Kindom, the Netherlands, Germany and the European Commission—now may be ready to surprise us with sanctions against banks, energy and military companies that surpass the U.S. measures (notably by sanctioning more banks). This is short of the broad “sectoral” sanctions many had hoped for, as the move only blocks a narrow band of new debt and equity. But in terms of institutions, the U.S. and proposed European measures are sufficiently broad in the sense that its effects on the Russian financial system could be systemic. Further, there are compelling reasons to expect that sanctions will continue to be extended in coming months, resulting in comprehensive sectoral sanctions on finance and energy by the end of the year.

For one, we have little evidence that Russian President Vladimir Putin is backing down in his support for separatists, as there have been recent reports of missiles fired from Russia; the country has also intensified troop movements near the border. The second reason, related to the first, is that the Ukrainian military is showing improved capabilities and is gaining ground. This provides renewed hope for political stability in Ukraine, but the risk of provocation on the ground that will draw additional sanctions will only intensify in coming weeks.

The third reason —which hasn’t received much comment—relates to market efforts to evade the sanctions in place. The profit incentive is a powerful motive to innovate and evade the controls whether on trade or finance. Some evasion is anticipated, and can even be a useful “escape value” for pressure in markets. But substantial evasion undermines both the effectiveness of the measures and the U.S. government’s credibility.

It is therefore not surprising that the Obama Administration has made it clear they are willing to extend the sanctions either by expanding the list of sanctioned institutions or the types of transactions that are prohibited. The sanctions applied recently may apply have only targeted new debt and equity issuance, but if, for example, the U.S. Treasury saw an increase in use of derivative contracts to mimic the effects of new debt, the agency would extend sanctions to cover the new financial instruments. Treasury will not catch all the financial innovations that take place, but it is quite likely that the effort to sustain the effectiveness of the controls will still lead to their expansion over time.

Market reaction suggests investors expect more sanctions under way: True, Russian bond and stock markets have been resilient on hopes that sanctions would have a limited impact on the economy. While comprehensive financial sanctions would cause severe market effects, the impact of the current incremental approach is better measured by the longer-term effects on growth. In this regard, the trajectory is grim, as large-scale capital flight has continued and is on track to exceed $100 billion this year. Foreign investments into Russia are dropping on concerns about existing sanctions, a cutoff in lending by western financial institutions, and both economic and legal concerns about future sanctions. What’s more, Russia’s central bank last week raised interest rates, reflecting concern about the inflationary consequences of sanctions, including a weaker rouble that boosts import prices.

To be sure, growth in Russia was already slowing prior to the crisis, and a projected recession—some analysts project declines in excess of 5% of GDP—now is likely. This concern about the longer term was well captured by former finance minister Alexei Kudrin who last week warned on severe consequences for Russia from the current policy path.

Herein lies the conundrum. The West’s incremental approach to economic sanctions is working and will have a profound effect on the Russian economy, but it will take time. In the same instance, the political pressures to act credibly and decisively have grown. The disconnect between economic and political timelines calls for a reassessment, with an eye to policies that produce more visible, immediate costs for Russia.

Robert Kahn is the Steven A. Tananbaum senior fellow for international economics at the Council on Foreign Relations in Washington, D.C. Previously, he was a senior strategist with Moore Capital Management. He also has held positions at the World Bank, IMF, U.S. Treasury, and Federal Reserve.