September 11, 2018

Tightening Sanctions on Russia

By Peter Harrell and Elizabeth Rosenberg

With Congress actively debating new sanctions on Russia, the United States may be poised to enact the first significant increase in economic pressure on Russia since Congress passed the Countering America’s Adversaries Through Sanctions Act (CAATSA) in August 2018.

Russia’s ongoing attacks on U.S. elections and on U.S. allies, including Russia’s March 2018 chemical weapons attack in the UK, merit a more forceful response than the steps taken to date, which have failed to deter Russian aggression. But as Congress considers new sanctions measures, it also needs to consider unintended adverse costs on the United States and U.S. allies. Unlike North Korea, which has a miniscule global economic footprint, or even Iran or Venezuela, which are relatively minor global economic players, Russia has an annual GDP of more than $1.5 trillion. New U.S. sanctions will need to grapple with the fact that most U.S. and European multinational companies do business in Russia and that Russia is one of the world’s most important energy players. Russia is also a major destination for investors from both the United States and Europe. Poorly tailored sanctions could inadvertently impose billions of dollars of collateral costs on Americans and Europeans.

This commentary offers recommendations for the U.S. Congress as it evaluates new sanctions on Russia. It describes four principles that Congress should apply when developing new sanctions on Russia. It then evaluates a number of the specific proposals that Congress appears to be considering and makes recommendations regarding those proposals.

Four Principles for New Sanctions on Russia

Congress should adhere to four principles in developing new sanctions on Russia: sanctions should have serious economic impacts; sanctions should minimize collateral costs to the United States and its allies; sanctions should be built for the long term; and sanctions should be coordinated with allies, particularly the European Union, to the greatest extent possible.

First, if the goal of sanctions is to change Russia’s behavior, Congress should ensure that sanctions have more meaningful macroeconomic and fiscal bite than the sanctions that the United States has imposed so far in 2018: Part of the reason that Russian President Vladimir Putin has embraced such an aggressive foreign policy over the past two years is that the fundamentals of the Russian economy have improved significantly. After a recession in 2015 and 2016, the Russian economy rebounded last year, with GDP up by approximately 1.5 percent in 2017 and projected to grow 1.5-1.8 percent annually over the next few years. Russia estimates that it will produce just over 11 million barrels of oil per day in 2018, the second consecutive year that Russia will set a post-Soviet production record, and Russia’s Gazprom is exporting record quantities of natural gas. Higher oil and gas production means that Russia is on track this year to record its first budget surplus since 2011. Russian unemployment recently hit a post-Soviet low.

Sanctions policymakers often use currency depreciation as a measure of evaluating success of sanctions, and it is true that sanctions, particularly the Trump administration’s April 6 measures on several Russian oligarchs and their companies, have contributed to a depreciation of the ruble. However, Russia’s economic dependence on natural resources and basic materials exports means that devaluing the ruble can actually provide the Russian government with important domestic financial benefits: a falling ruble lowers production costs inside Russia, which are generally priced in rubles, while having no impact on Russia’s export revenues, which are typically priced in dollars and euros. Indeed, RUSAL, the Russian aluminum company, reported earlier this month that the lower value of the ruble had contributed to a 75 percent increase in quarterly profits despite the fact that the United States sanctioned RUSAL on April 6, 2018. The same effect occurred for energy exporters in 2014 when the effect of sanctions and a price collapse was blunted by the ability to continue to earn hard currency for the foreign sales while paying for local service costs in the devalued ruble.

Given Russia’s improving macroeconomic and fiscal picture, Russia has little to fear from sanctions that are largely symbolic or that cost Russia merely a few billion dollars annually. The sanctions the United States and the EU imposed on Russia in 2014, which a number of experts have argued at least partly deterred Putin from occupying an even greater portion of Ukraine, were estimated to cost Russia 1-1.5 percent of GDP in the near term, with larger impacts over a multiyear period. Only sanctions with similarly severe economic costs would have any meaningful chance of altering Putin’s strategic calculus.

Second, Congress should design new sanctions in ways that minimize collateral impacts on the United States and its allies: Collateral costs from new sanctions will be inevitable, given the scale of Russia’s economy and close links to many foreign markets. Earlier rounds of U.S. sanctions, notably the sanctions on borrowing by large Russian banks and energy companies, have already hit the areas where the United States can have a strong impact on Russia with scant collateral consequences on the United States and its allies. For example, any new sanctions on Russia’s energy sector are likely to impact the Western energy companies that have invested billions of dollars in Russia over the past two decades and, if poorly designed, could simply shift control of joint ventures in Russia from Western companies to their Russian partners if Western firms simply have to pull back from investments that the Russian can readily step into, rather than targeting activities that Russian firms need western capital and expertise to pursue.

Companies will undoubtedly have to bear collateral costs from new sanctions, and Russia’s attacks on the U.S. and our allies make a forceful U.S. response necessary. But U.S. policymakers should work to minimize likely collateral costs. For example, Congress should consider exempting existing or ongoing projects that involve U.S. or foreign companies from new sanctions and instead target only future projects, which will minimize losses for the United States and U.S. allies. Indeed, in developing new sanctions, Congress should consider asking the Congressional Research Service to formally publish an assessment of potential costs and impacts of proposed sanctions on Russia before passing sanctions into law in order to understand and mitigate potential consequences.

Third, Congress should build sanctions for the long term: Even punishing new sanctions on Russia are unlikely to change Putin’s strategic calculus in the near term, and the United States needs to be prepared for a potential long-term strategic confrontation with Russia. New U.S. sanctions should be designed to have not only short-term, but long-term economic impacts, and should be designed to curb both Russia’s economic and political power over time. CAATSA’s existing sanctions on Russia’s defense sector are an example of this approach: they cut into Russia’s ability to sell weapons globally, which deprives the Russian government of arms export revenues in the short term, and, over the longer term, prevents the Russian government from using arms sales to build strategic defense relationships.

A long-term sanctions strategy will also mean laying out a clear escalatory ladder, establishing a series of long-term goals, and being very clear about what policy changes from Russia might cause the United States to escalate, or deescalate—even including removal of sanctions. Executive branch sanctions policymakers are often wary of tipping their hand about future sanctions out of concern that the intended targets will hide their assets or undermine U.S. policy strategy. This is a sensible concern with sanctions that target individuals, like targeted sanctions on drug traffickers, because tipping one’s hand can let a target take his assets outside U.S. jurisdiction, including converting them out of the U.S. dollar. But in a case like Russia, where the goal of sanctions is fundamentally to deter future malign and destabilizing activities, a clear vision of specific policy goals and a defined escalatory ladder is valuable: it lets Russia know the costs it will face if it continues to attack the United States, and what may be gained if it decides to alter its policies. In 2014 the Obama administration and the European Union signaled clearly to Russia what steps would be taken if Russia increased its involvement in Ukraine, a fact that helped the sanctions deter even greater Russian intervention in Ukraine.

Finally, Congress should bolster multilateral efforts to impose sanctions on Russia and should emphasize coordination with the European Union: The EU has far larger trading and financial ties to Russia than does the United States, and European cooperation with U.S. sanctions will dramatically expand both the economic and the political impact of the sanctions on Russia. It will also strengthen the connectivity and capacity of transatlantic countries as security partners, a valuable development in a period of great mistrust and disdain among traditional allies. In addition to directing the Trump administration to seek to coordinate new U.S. sanctions with the EU and other allies, Congress should consider creating incentives for U.S. allies to cooperate. For example, Congress could authorize the Trump administration to exempt European entities from new U.S. sanctions on Russia if the Trump administration certifies that the countries in which these entities operate have enacted substantially comparable sanctions of their own. Moreover, the United States could consider other exemptions where European governments, through their diplomatic, development, and legal apparatuses, are actively and meaningfully engaged in efforts to counter Russia’s illiberal attacks on democracy, rule of law, and good governance in Europe and beyond.

Evaluation of Specific Proposals

Congress is currently evaluating several significant pieces of Russia sanctions legislation. Two of the most significant are the Defending Elections from Threats by Establishing Redlines Act (“DETER Act”), which was introduced by Sen. Marco Rubio (R-FL) and Sen. Chris Van Hollen (D-MD), and the “Defending American Security from Kremlin Aggression Act (“DASKAA”), which was recently introduced by Sen. Lindsey Graham (R-SC) and Sen. Bob Mendendez (D-NJ). In addition to these bills, several other congressional offices in both the House and the Senate have introduced legislation targeting Russia, such as Senator John Barrasso’s (R-WY) “ESCAPE Act,” and appear to be actively exploring proposals for additional Russia sanctions.

Congress appears committed to developing Russia sanctions through a “regular order” process, including a series of hearings in both the Senate Foreign Relations Committee and in the Senate Banking Committee, and through stakeholder engagement with the Trump administration, outside experts, and the private sector. This is a welcome development given the need for careful coordination among branches of the government in order to ensure legal clarity and an appropriately calibrated message, and consequences, to Russia. Furthermore, it may help to mitigate some of the political overtones surrounding efforts to toughen Russia sanctions, helping to ensure that an increase in U.S. pressure on Russia has broad bipartisan support.

Congress should consider sanctions on new Russian sovereign debt, but give Treasury flexibility in implementation to avoid unintended adverse impacts: Both the DETER Act and DASKAA would impose sanctions on “new” Russian sovereign debt, defined as Russian sovereign debt issued beginning several months after the bill is signed into law. Existing U.S. sanctions prohibit U.S. persons from purchasing corporate debt issued since 2014 by many large Russian energy companies and banks, including Rosneft and Sberbank, but do not prohibit transactions related to Russian sovereign debt. As a result, Russia has been able to continue borrowing at a sovereign level while providing assistance to state-owned and independent companies affected by sanctions.

Although the total value of Russia’s outstanding external sovereign debt declined by approximately $5 billion between the beginning of 2014 (before any U.S. sanctions were imposed on Russia) and mid-2018, Russia has issued Eurobonds in each of 2016, 2017, and 2018, including a $4 billion issuance in March 2018, just weeks after Russia poisoned former Russian operative Sergei Skripal in the UK. In addition, Russia has borrowed heavily on domestic markets with total outstanding ruble-denominated Russian debt rising by more than 3 trillion rubles ($45 billion) since the beginning of 2014. A recent analysis by Citi estimated that foreign owners of Russian ruble-denominated debt make up more than 20 percent of total holders and that sanctions on new Russian sovereign debt would raise Russian sovereign debt yields by 2 percent and would potentially cause a 5 percent depreciation in the value of the ruble.

Well-crafted sanctions against new Russian sovereign debt would represent a way to increase pressure on Russia’s federal budget while limiting collateral costs. Such sanctions would need to be carefully tailored to avoid adverse impacts on holders of existing Russian sovereign debt issued before the sanctions come into force: holders of existing Russian sovereign debt include numerous U.S. pension funds invested in emerging markets, which would face potentially billions of dollars in losses if the sanctions blocked Russia’s existing sovereign debt. Congress should provide the Treasury Department with appropriate latitude to develop implementing regulations to minimize the collateral impacts of sanctions on new Russian sovereign debt.

Congress can consider requiring the Trump administration to sanction at least one Russian bank, but must work to mitigate unintended consequences: Both DETER and DASKAA would require the Trump administration to place one or more Russian banks on the U.S. Specially Designated Nationals and Blocked Persons (SDN) list, which would freeze any bank assets in the U.S. and block all transactions with the bank that come into U.S. jurisdiction. This would be a significant tightening of sanctions on the Russian banking sector, which to date have primarily focused on restricting Russian banks from borrowing money in the west, but which have not prohibited large Russian banks from engaging in other transactions with the U.S.

The most likely target for such sanctions appears to be Vnesheconombank (VEB), a state-run development bank that Putin has used to finance priority national projects, notably the Sochi Olympics, and which also provides export financing for a range of Russian exports. As a state-run national development bank with a close relationship with Putin, VEB is in many respects an attractive sanctions target. However, any sanctions on VEB would have to recognize that VEB plays other important roles in connecting Russia to the Western financial system: Notably, VEB serves as the payment agent for Russian payments on existing sovereign bonds. The United States would not want sanctions to inadvertently prevent Russia from repaying U.S. investors who hold existing Russian sovereign debt, a potential consequence of prohibiting U.S. persons from engaging in any transactions with VEB. Any new sanctions on VEB or an alternative Russian bank should be targeted in a manner that would minimize adverse collateral impacts, for example by allowing the Treasury Department to issue licenses that would allow VEB to continue processing payments on existing Russian sovereign debt.

Congress should tighten CAATSA 231 sanctions on Russia’s defense sector: Several congressional offices have expressed interest in tightening sanctions on Russia’s defense sector. The United States already prohibits most exports to Russia’s defense sector, and Section 231 of CAATSA requires the State Department to impose sanctions on foreign entities that engage in “significant transactions” with the Russian defense sector. To date, the State Department has primarily used CAATSA Section 231 to reduce Russian exports of defense equipment, and in recent Senate testimony State Department official Chris Ford stated that the Department had used Section 231 had denied Russia “billions of dollars” of exports.

While the State Department’s campaign to reduce Russia’s defense exports has helped to curb Russian export revenues and disrupt Russia’s defense relationships with other countries, CAATSA 231 could also be more directly applied to prohibit Russia from purchasing internationally-made component parts for use in weapons and defense systems. Over the past several years Russia has embarked on a program to reduce its reliance on foreign-made defense component parts, but it continues to source some technology internationally. Congress should consider cutting off Russia’s international defense supply chain by amending CAATSA Section 231 to direct the State Department, working with the Commerce Department and Department of Energy, to publish a list of specific goods and equipment that Russia purchases internationally and uses in defense production, and to impose sanctions against foreign companies that sell equipment on the list to Russia’s defense sector.

Congress should limit Russia’s revenue earning potential, including in the energy sector, but must be extremely careful to avoid adverse impacts on U.S. interests and market stability: Sanctions targeting Russia’s energy sector, which represents Russia’s single largest source of revenue, and other sources of Russian export revenue, will be a key component of any tough new sanctions on Russia. Sanctions on the energy sector could limit Russia’s future production potential, which has been quite strong over the past several years, and Russia continues to rely on foreign investment, foreign technology, foreign capital, and foreign expertise to replace and expand energy resources. Congress, however, needs to consult carefully with relevant experts to craft energy sanctions that succeed in clipping Russia’s long-term energy export earnings while mitigating adverse impacts on global supply and consumers, including a number of important U.S. allies.

Both the DETER Act and DASKAA include provisions that would tighten sanctions on Russia’s energy sector, which remains a dominant source of Russian government revenue. The DETER Act would require the Trump administration to place large Russian energy companies on the U.S. SDN sanctions blacklist, effectively cutting them of from international commerce. DASKAA would prohibit new international investments in Russia’s crude oil sector and seeks to restrict new major energy investments by Russian companies outside of Russia.

Placing large Russian energy companies like Rosneft and Gazprom the SDN list, though sending a very strong message to Russia, would risk severe unintended consequences and undermine U.S. economic and strategic interests. For example, placing Gazprom on the SDN list would effectively immediately prohibit most European purchases of Russian natural gas, and would severely impact a number of major U.S. and Western energy companies that have longstanding joint ventures in Russia with Gazprom. That would undermine European energy availability and security, with serious economic consequences, and hurt some of the countries already under attack by Russian political influence campaigns and economic pressure. It would also likely precipitate a hasty and chaotic exit by Western companies from most of their joint venture operations linked to the Russian gas sector, potentially handing Russian companies an unexpected windfall as they simply take over projects that Western companies had already sunk capital into.

DASKAA’s approach of prohibiting new investments in Russia’s energy sector while

allowing existing projects to continue represents an approach that tries to mitigate unintended consequences by avoiding impacts on Russia’s current production. DASKAA also includes a provision designed to restrict Russia’s ability to acquire strategic energy assets outside of Russia, as Rosneft recently did with Indian refiner Essar Oil. These provisions attempt to advance important goals of reducing Russian oil production over time, without disrupting current markets, and also reducing Russia’s global reach and ability to more directly access consumer markets. However, the potentially significant adverse impacts on several major Western oil companies that have large projects in Russia and on near-term global oil prices need to be carefully weighed and modifications made to reduce unintended adverse consequences. Congress should also ensure that any new sanctions on Russia’s energy sector focus on projects, technologies, and financing for which Russia requires assistance from abroad, rather than on projects that Russia could pursue on its own without the involvement of Western companies.

Congress should consider new limitations on Russian investments and dirty money entering in the United States: DASKAA seeks to limit the ability of “grey market” Russian money to come into the United States by requiring reporting to the U.S. Treasury Department about all-cash purchases of high-value U.S. real estate, building on a Treasury Department initiative that started in 2016 to more aggressively pursue realestate–related money laundering. Given widespread press reporting about Russian purchases of high-value U.S. real estate, Congress is right to consider ways to begin restricting Russian investments and dirty money in the United States. In addition to real estate, Rusnano, a Russian state-backed venture capital firm, continues to operate an office in Silicon Valley to try to place investments in the United States, and prior to being sanctioned in April Russian Oligarch Viktor Vekselberg had made significant investments in the United States.

While Congress’s recent passage of CFIUS reform legislation will make it harder for Russians to acquire strategic assets in the United States, Congress should continue to promote greater transparency regarding Russian investments in the United States and take other steps to reduce the ability of Russian government-linked companies and oligarchs to secretly acquire strategic assets inside the United States or to launder dirty money in the United States. The time is right for the U.S. Congress to pass proposed legislation that would require greater beneficial ownership information disclosure in the corporate formation process. Such transparency requirements, already in place in other countries, would have a major impact in exposing and deterring Russian placement of funds in the U.S. market and criminal financial activity more generally. In addition, Congress should begin studying ways to expand anti-money laundering requirements, which currently apply primarily to banks and money services providers, and to other kinds of professional service providers that Russian rely on to move money into the U.S., such as investment advisors and certain professional services providers.

Congress should refrain from requiring the Trump administration to place the largest Russian companies on U.S. blacklists: Many of Russia’s largest companies, such as Rosneft, Sberbank, and Gazprom, are highly integrated into the global economy. Blacklisting these companies by putting them on the SDN sanctions list would likely have very severe unintended consequences, harming global energy and financial markets. Treasury’s April 6 designation of Russian aluminum company RUSAL, for example, caused global aluminum prices to rise more than 20 percent before the Treasury Department issued licenses allowing RUSAL to remain in business while seeking to force its principal shareholder, Putin-linked oligarch Oleg Deripaska, to sell down his stake. While sanctions on large Russian companies can be appropriate, for example when a large Russian company directly and significantly supports Russia’s threatening and destabilizing global adventurism and illiberal attacks, such sanctions need to be very carefully weighed and designed with strategies to mitigate unintended consequences. Congress should refrain from simply requiring the Trump administration to impose such sanctions on the largest Russian companies.

Congress should maintain pressure on the Trump administration to sanction Putin’s cronies: Putin’s sharply negative reaction to the sanctions that the United States has imposed on several of his longtime friends and associates, such as Arkady and Boris Rotenberg, and on Putin’s former son-in-law Kirill Shamalov, show that sanctioning close Putin cronies can have an important impact in putting pressure directly on Putin’s inner circle. The U.S. Treasury Department already has a number of authorities to sanction close Putin cronies involved in corruption, human rights abuses, and in Russia’s ongoing attacks on the U.S. and its allies. Congress should press the Trump administration to continue imposing sanctions on Putin’s inner circle as a way of signaling that Putin and his cronies will face direct consequences for Russia’s malign activities.

Congress must carefully approach the issue of designating Russia a “State Sponsor of Terrorism:” Several proposals in Congress would require the Trump administration to determine whether or not to designate Russia as a “State Sponsor of Terrorism” under U.S. law. Given that Russia conducted a chemical weapons attack in the UK, has assassinated political opponents globally, and supports Syrian President Bashar Assad’s use of chemical weapons, it is certainly reasonable to conclude that Russia meets a common sense definition of supporting international terrorism. However, formally designating Russia as a State Sponsor of Terrorism, a listing that currently applies to North Korea, Iran, and Sudan, would not only be a highly symbolic act, it would have significant economic consequences. For example, it would prohibit large classes of U.S. exports to Russia. It would also likely make most U.S. banks quite wary of engaging in ordinary financial transactions with even private companies in Russia, given regulatory requirements for banks that engage in commerce with designated State Sponsors of Terrorism.

While it is certainly appropriate to call Russia to account for its global malign and criminal attacks, including actions such as assassinating political opponents, that fit within a common-sense definition of “terrorism,” Congress and the Trump administration should approach the issue of formally designating Russia as a State Sponsor of Terrorism carefully. Congress and the Trump administration should ensure that they fully understand what the ramifications would be before taking such a step and refrain from doing so if the collateral costs appear to outweigh the benefits. Other steps, such as referring to Russia as “supporting terrorism,” or as having “engaged in terrorist attacks” may ultimately prove more appropriate than formally designating Russia a State Sponsor of Terrorism as part of a broad new package of U.S. sanctions on Russia.