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Explainer: How economic sanctions work

·Finance Reporter, Yahoo Finance UK
·12-min read
Sanctions People take part in a demonstration in front of the Russian embassy, after Russian President Vladimir Putin authorized a military operation in eastern Ukraine, Sofia, Bulgaria, February 24, 2022. REUTERS/Spasiyana Sergieva
The sanctions are meant to force Vladimir Putin to back down. Photo: Spasiyana Sergieva/Reuters

As western countries moved swiftly to impose an arsenal of economic sanctions to combat Russia’s invasion of Ukraine, the question remains of how much pain these sanctions will cause Russian president Vladimir Putin.

World leaders widely condemned Russia’s attack on Ukraine and within a day the US, the European Union and the UK all announced a first set of economic sanctions on Russia. Australia, Canada and Japan have since joined in.

What are sanctions and how do they work?

Sanctions have become one of the most favoured tools for governments to respond to geopolitical challenges.

Sanctions can take various forms and refer to many actions used by one country to hurt another, usually to deter aggressive actions or breaches of international law.

The three most commonly used sanctions fit into three categories: economic, diplomatic and military.

For many policymakers, economic sanctions have become the tool of choice to respond to major challenges when diplomacy alone is not enough, but military force is too risky or heavy-handed.

The sanctions now imposed on Moscow are intended to impose extreme economic costs on Russia and its people.

They are also the west’s main weapon to inflict punishment as the US and its allies ruled out direct military intervention with another nuclear power.

Read more: What Ukraine invasion means for consumer prices in the UK

However, the harder the sanctions hurt Russia, the harder the west may feel it as prices of commodities rise.

US president Joe Biden acknowledged as much in his remarks at the White House. “Defending freedom will have costs, for us as well and here at home,” he said.

“We need to be honest about that.”

He added that he would take steps intended to minimise an increase in gas prices.

US-imposed sanctions

Biden signed an executive order aimed at crippling the Russian economy, its financial institutions and its access to technology.

The move include cutting off Russia’s largest bank, Sberbank (SBRCY), from the US financial system and imposing sanctions on Russia’s second-largest bank, VTB Bank (VTBR.ME), and freezing any of its assets that touch the US financial system.

Biden also ordered sanctions on two large state-owned Russian financial institutions that are key to the Kremlin and the Russian military.

Vnesheconombank, which has over $50bn (£37.3bn) in assets, was described by a US official as a "glorified piggy bank for the Kremlin".

U.S. President Joe Biden delivers remarks on Russia's attack on Ukraine, in the East Room of the White House in Washington, U.S., February 24, 2022.  REUTERS/Leah Millis
US president Joe Biden is said to be keeping 'the mother of all sanctions' in reserve. Photo: Leah Millis/Reuters

The other institution, Promsvyazbank, which has over $35bn in assets, finances the activities of the Russian military, the US said. Both will be shut out of the global financial system.

Sanctions also target Bank Otkritie, Sovcombank OJSC, and Novikombank.

The White House said it would cut off 13 major state-owned companies from raising money in the US, including energy giant Gazprom (GAZP.ME) and Sberbank.

The sanctions on Russia’s top financial entities include the imposition of “full blocking and correspondent and payable-through account sanctions, and debt and equity restrictions, on institutions holding nearly 80% of Russian banking sector assets”, the White House said.

Penalties were also announced against 24 individuals and entities, including two state-owned banks, in Belarus, which is hosting Russian troops participating in the invasion.

New sanctions announced include export blocks on technology, a centrepiece of Biden's approach that he said would severely limit Russia's ability to advance its military and aerospace sector.

In a statement, the White House said: "This includes Russia-wide restrictions on semiconductors, telecommunication, encryption security, lasers, sensors, navigation, avionics and maritime technologies."

Despite the harsh new measures against Russia, Biden is said to be keeping the “mother of all sanctions” in reserve.

UK-imposed sanctions

Prime minister Boris Johnson has imposed “the largest and most severe package of economic sanctions that Russia has ever seen”.

All major Russian banks will have their assets frozen and be excluded from the UK financial system, stopping them from being able to access sterling and clearing payments through the UK.

This includes a full and immediate freeze of VTB bank which is majority-owned by the state, Rossiya, IS Bank, General Bank, Promsvyazbank and the Black Sea Bank.

The Foreign Office said the banks being targeted had bankrolled the Russian occupation of Crimea since 2014.

Bank Rossiya has been under US sanctions since 2014 due to its close ties to Kremlin officials.

Read more: Evraz biggest FTSE 100 riser as earnings soar

Promsvyazbank is a top 10 Russian bank, which services 70% of state contracts signed by the Russian ministry of defence.

Rossiya is stakeholder in National Media Group which supported the destabilisation of Ukraine after Russia's 2014 annexation of Crimea, the UK government said.

The Black Sea Bank is a Crimean bank and was created in 2014 after Russia annexed the region. The General Bank is a financial institution which also operates in Crimea.

Johnson said the goal was "to exclude Russian banks from the UK financial system".

Russian state and private companies will also be prevented from fundraising in the UK.

Billionaires Gennady Timchenko, Boris Rotenberg and his nephew Igor Rotenberg, who were named as close associates of the Putin regime, will have their assets in the UK frozen.

Sanctions SOCHI, RUSSIA - MAY 16: Russian President Vladimir Putin (R) and businessman Gennady Timchenko (L) in action during a Nignt Hockey League match on May 16, 2015 in Sochi, Russia. Putin was joined by fellow politicians, businessmen and retired NHL players. Putin's team won 18-6, with eight goals scored by Putin. (Photo by Sasha Mordovets/Getty Images)
Gennady Timchenko (L), described as Putin's (R) crony, has had his assets in the UK frozen. Photo: Sasha Mordovets/Getty

Additionally, 100 individuals and entities will also have their assets frozen, Johnson said, adding that this includes "all the major manufacturers that support Putin's war machine".

Other oligarchs that will have their assets frozen include Kirill Shamalov, Russia’s youngest billionaire, who was married to Putin's second daughter, Petr Fradkov, CEO of Promsvyazbank, and son of the former head of the FSB (the main successor of the KGB), Denis Bortnikov, deputy president of the state-owned VTB Ban, Yury Slyusar, director of United Aircraft Corporation, and Elena Aleksandrovna Georgieva, the chairwoman of the board of Novikombank

The Aeroflot (AFLT.ME) airline will be banned from landing in the UK and there will be a limit on deposits Russians can make to UK bank accounts. The plan is to set a £50,000 limit but details are still to be confirmed.

There will be a suspension of dual-use export licences to cover items which can be used for military purposes and “within days” the UK will stop exports of hi-tech items and oil refinery equipment.

Financial sanctions will be extended to Belarus for its role in the assault on Ukraine.

Johnson also outlined plans to establish a new dedicated team in the National Crime Agency "to target sanctions, evasion and corrupt Russian assets hidden in the UK".

EU-imposed sanctions

European leaders agreed to what they called a “massive and painful” package of economic penalties, following Russia’s full-scale invasion of Ukraine.

The sanctions will hit five areas: the financial sector, the energy sector, the transport sector, export controls and visa policy.

Read more: The Russian banks and billionaires targeted by UK sanctions

The EU will freeze Russian assets in the bloc and halt its banks' access to European financial markets as part of what EU foreign policy chief Josep Borrell described as "the harshest package of sanctions we have ever implemented".

The sanctions also seek to limit Russia's access to sensitive technology, as well as aircraft components and equipment.

"Our sanctions will hurt the Russian economy in its heart," said Belgian prime minister Alexander De Croo.

“This package includes financial sanctions that cut Russia’s access to the most important capital markets. We’re now targeting 70% of the Russian banking market, but also key state-owned companies including the field of defence,” European Commission president Ursula von der Leyen said.

A view shows a section of an oil platform operated by Lukoil company at the Kravtsovskoye oilfield in the Baltic Sea, Russia September 16, 2021. REUTERS/Vitaly Nevar
Sanctions from the EU are targeting Russia's oil refineries. Photo: Vitaly Nevar/Reuters

When it comes to energy, “our export ban will hit the oil by making it impossible for Russia to upgrade its oil refineries,” she added.

The EU had already approved a first round of sanctions on Wednesday, including blacklisting Russian politicians and curbing trade between the EU and two breakaway regions of eastern Ukraine whose independence Moscow has recognised.

But it was Germany who emerged as Putin’s toughest opponent by shutting down the controversial Nord Stream 2 pipeline.

The pipeline project was designed to double the flow of Russian gas direct to Germany. Seen as Europe's most divisive energy project, it cost $11bn.

Canada-imposed sanctions

Canada has joined its allies in imposing new sanctions against Russia.

Prime minister Justin Trudeau unveiled additional sanctions against Russia that he said would target dozens of individuals and entities, including financial elites and major Russian banks.

Sanctions will target the Russian Security Council, including the defence minister, the finance minister, and the justice minister, Trudeau said.

Read more: How Russia's war on Ukraine is impacting stock prices

Canada will also cancel all export permits to Russia, required for shipments of certain items, such as aerospace, technology and mineral goods.

Canada's new sanctions target more than 30 individuals and 27 entities, officials said.

Although the government did not immediately release a list of the entities and individuals targeted, officials said they included financial elites in Russia, major Russian banks, oil and gas companies and companies in the defence, telecommunications and transportation sectors.

Japan-imposed sanctions

Japan will impose a range of sanctions targeting Russian financial institutions, military organisations and individuals in response to the invasion of Ukraine, prime minister Fumio Kishida announced.

The package of sanctions includes export controls on high-tech products such as semiconductors, a freeze on assets held by Russian financial institutions and a suspension of visa issuance for certain Russian individuals and entities.

“It is an extremely serious situation with ramifications for the international order, not just in Europe but Asia and beyond,” Kishida said.

Japan will also ban the issuance of Russian bonds in the country.

The three Russian banks targeted by Japan’s sanctions are VEB, Promsvyazbank, and Bank Rossiya, Japanese officials said.

Japan said it was not sanctioning Russia’s two top banks, Sberbank and VTB Bank, both of which were targeted by the US.

What about SWIFT?

There has been speculation that Russia could be cut off from SWIFT, the international payments system, a move that would deliver a heavy blow to the country’s banks and its ability to trade beyond its borders.

SWIFT is the global financial highway that allows the seamless and rapid transfer of money across borders. It stands for Society for Worldwide Interbank Financial Telecommunication.

Read more: What is the Swift payment system the UK wants Russia thrown out from?

The move would have a major impact, damaging Russia's economy immediately and in the long term.

It would cut Russia off from most international financial transactions, including international profits from oil and gas production, which in all accounts for more than 40% of the country's revenue.

Western leaders are split on whether Russia should be removed from SWIFT.

A protestor holds a sign that reads
A protestor holds a sign that reads 'No Swift for Russia' outside the German chancellery, after Russia launched a massive military operation against Ukraine. Photo: Michele Tantussi/Reuters

The UK repeated calls on Friday for Russia to be banned from the SWIFT payment network. Canadian prime minister Justin Trudeau is also reported to have backed removing Russia from SWIFT.

But earlier on Thursday, German chancellor Olaf Scholz warned that his country had reservations about such a move and so did the EU.

Asked about SWIFT, Scholz said: "We need to keep sanctions ready for later times."

Italy and Austria are also reported to have opposed the measure in order to maintain some leverage over Russia. All three European countries are highly dependent on Russian natural gas, which would be difficult to pay for if Russian companies like Gazprom were cut from SWIFT.

The US is also not pushing for it at the moment. "It is always an option but right now that's not the position that the rest of Europe wishes to take," Biden said of the SWIFT option not being exercised at this time.

Will the sanctions have an effect?

The sanctions announced were not the most severe option available. Countries are adopting a step-by-step approach and appear ready to escalate with even further punitive measures if Moscow does not back down, but do not want to deplete their sanction arsenal just yet.

In 2014, Russia annexed Crimea from Ukraine prompting the US and allies to impose economic sanctions on Moscow. Fast-forward eight years and the sanctions barely seemed to have had an impact.

Russia’s economy started growing after a sanction-induced recession and the measures so far have not deterred Putin from trying to take Kyiv.

Over the past several years, Russia has restructured its economy for the specific purpose of withstanding Western financial pressure.

Since 2014, Russia has been moving away from relying on the dollar and trying to sanction-proof its economy.

It has built up international reserves to record levels so that it can support the rouble for some considerable time.

To protect from US-led sanctions only 16% of its foreign exchange is now held in dollars, down from 40% five years ago.

Russia has also been eager to explore alternative markets. It used to mainly export products to Europe, but now it is increasingly exporting oil and natural gas to China.

Read more: Oil prices pull back from $100 on hopes of talks between Russia and Ukraine

While Putin is in the sanctions crosshairs, he can still inflict economic damage on the West.

A rapid escalation in sanctions against Russia could further deepen a cost of living crisis.

"German chancellor Olaf Scholz has issued an order to halt the process of certifying the Nord Stream 2 gas pipeline," Dmitry Medvedev, a former Russian president and the deputy chair of Russia's security council, said in a tweet.

"Well. Welcome to the brave new world where Europeans are very soon going to pay €2.000 for 1.000 cubic meters of natural gas!"

Europe depends on Russia for 30% of its gas supplies.

Global oil prices rose on fears that the Ukraine situation would disrupt global supplies.

British airlines have also been banned from landing at Russia's airports and from crossing its airspace.

Watch: Russia 'has insulated itself from sanctions'