Overreach, page 33
CHAPTER 11
The Price of Illusion
There’s lots of talk of off ramps. We want to close the off ramps and help Putin accelerate into the brick wall into which he is headed.
US Army Lieutenant General H. R. McMaster, 5 April 20221
Economic Blitzkrieg
One of the main planks of the Kremlin’s messaging, both to the Russian people and to the rest of the world, was that the Russian economy was shrugging off sanctions. ‘The economic blitzkrieg against Russia never had any chances of success,’ Putin told an audience at the St Petersburg Economic Forum in June that included no regional leaders apart from Belarus’s Aleksandr Lukashenko – but did include a delegation from the Taliban. ‘Like our ancestors, we will solve any problem; the entire thousand-year history of our country speaks of this … Gloomy predictions about the Russian economy’s future have not come true.’2
Russia’s Ministry of Economics put out the superficially logical line that though exports of both oil and gas were down, rising prices more than compensated for the reduction. Many Western commentators bought it. As late as June 2022 Bloomberg reported that ‘even with some countries halting or phasing out energy purchases, Russia’s oil and gas revenue will be about $285 billion this year … That would exceed the 2021 figure by more than one fifth.’3 Quoting those numbers, respected columnist Fareed Zakaria concluded in The Washington Post that ‘it is now clear that the economic war against Russia is not working nearly as well as people thought it would … the Russian government will make considerably more revenue from oil and gas than it did before the war.’4
In fact the Russian government’s statistics were a carefully concocted lie, falsely projecting relatively stable March figures on the future and, as key economic indices slid, cherry-picking numbers to conceal the true scale of the economic damage. The major study published in July by the Yale School of Management into the real impact of sanctions on the Russian economy looked past a wall of obfuscation by Russia’s Ministry of Economics and used real-world data from retailers, energy traders and investors to reveal a picture very different from the rosy image presented by Putin.5 The reality was that by May total monthly Russian oil and gas revenues had dropped to $14.9 billion, less than half earned in the first month after the invasion.6
Some Western commentators latched onto the apparent stability of the ruble (which after an early plunge soon returned to pre-war levels) and the relative health of the Russian stock market (the benchmark MOEX Russia Stock Index was down a mere 50 per cent) as evidence that Russia’s economy was riding out sanctions relatively unscathed. In truth, both of those indicators have been deliberately manipulated. According to new rules introduced by the Central Bank in March, any company in Russia receiving income in foreign currency was forced to convert 80 per cent of it to rubles, skewing the market in the ruble’s favour. Gazprom also forced its Western customers to pay for their gas in rubles – which in practice merely meant that they had to open ruble accounts at the few Russian banks that had escaped sanctions and formally convert their hard-currency payments into rubles before the contract was considered settled. In Moscow, only a fraction of pre-war volumes of rubles were actually traded, and then most were notional dollars, unbacked by actual hard-currency reserves.
As for the stock market, the reality is that foreign shareholders from ‘unfriendly countries’ (i.e. the West) were barred from closing out their positions – effectively keeping the market in a state of suspended animation. As Russian economist and Renaissance Capital founder Andrei Movchan pointed out, the suspension of normal stock trading effectively reduced the equity value of Russian stocks if not to zero, then ‘to an unknowable value no longer determined by the market’. Functionally, shares were traded at a 30–40 per cent discount from their notional market value – which had already fallen by half. And since many companies relied on their own stock as collateral against loans, that meant that a large proportion of Russia’s privately owned companies were, for all practical purposes, functionally bankrupt – along with all Russian banks that had lent against the value of Russian-listed stocks. That left ‘the state as the lender of last resort’, said Movchan – the only source of capital in a country cut off from international financial systems. And while the Kremlin could in theory print as much money as it wished, in practice the Russian economy remained far too reliant on imported equipment, technology, consumer goods and foreign expertise to prevent catastrophic inflation. ‘When you create too much money you risk the Zimbabwe option [of hyper-inflation]’, said Movchan. The value of the ruble, whether the Kremlin likes it or not, ‘is still relative to [Russia’s] imports’.7
In the first two months of the war well over 1,200 Western companies closed down their operations in Russia. The value of the Russian revenue represented by these companies and the value of their investments in Russia together exceeded $600 billion – and their departure ‘almost single-handedly reversed three decades’ worth of Russian economic integration’ with the rest of the world, while ‘undoing years of foreign investment into Russia’, according to the Yale report. These foreign companies employed some 5 million Russians directly and up to 8 million indirectly.8 Some of these workers found new jobs in clone businesses set up by new Russian owners. One was the Vkusno i Tochka (‘Tasty and that’s it’) chain set up on the old premises of McDonald’s, using the same equipment and offering a similar menu. Another was the Stars Coffee chain founded by the rapper Timati – best known for his hit song ‘Putin Is My Best Friend’ – which took over Starbucks’ cafes and used a near-identical logo.9 But millions found themselves out of a job – leaving the state little choice but to create new jobs in the public sector.
Ever since the Crimean annexation of 2014 and the Western sanctions that followed, the Kremlin had striven to make Russia’s economy, and in particular its manufacturing sector, independent of imports and therefore immune to future sanctions. The first post-Crimea economic mantra was ‘import substitution’ – the concept that somehow Russia could survive and thrive without importing goods, services or talent from the West. The second was ‘technological sovereignty’ – the theory that Russia could create its own technologies, from mobile-phone transmitters to gas turbines, which would match Western ones.
Both initiatives failed. When the EU and US hit Russia with a full shutdown of the import of foreign parts, software and especially computer chips in 2022, the effect on Russia’s economy was crippling. By the end of May, Russian car production had fallen by over 75 per cent. Russian gross domestic value added indicators fell by 62 per cent in the construction sector, 55 per cent in agriculture and 25 per cent in manufacturing. Russian manufacturers – including the arms industry – were forced to cannibalise and recycle parts.10 By the end of March, Uralvagonzavod – Russia’s largest tank factory, based in Nizhny Tagil – was forced to suspend production of T-72B3 tanks due to a lack of processors, according to Ukrainian intelligence.11 ‘We have reports from Ukrainians that when they find Russian military equipment on the ground, it’s filled with semiconductors that they took out of dishwashers and refrigerators,’ US Commerce Secretary Gina Raimondo said in May.12 Aeroflot, Russia’s flag carrier, was forced to ground some 40 per cent of its aircraft in order to use existing aircraft parts to continue servicing its remaining fleet – even though Boeing and Airbus had cut off all support and service and issued warnings that cannibalised aircraft were not safe for operation. ‘All planes immediately stopped getting software updates,’ one Kremlin-connected businessman complained to journalist Yevgenia Albats. ‘[So we] ask a young man with a black briefcase to come in and hack the software.’13
Officially, the Russia Consumer Price Index indicated a post-war inflation rate of around 20 per cent. But the real inflation figures in import-dependent sectors such as technology, hospitality and automobiles were, according to market research by major retailers, running between 48 and 61 per cent. Each day of the war cost Russian taxpayers about $500 million. In July Russian Finance Ministry statistics showed a federal budget deficit of 892 billion rubles, a year-on-year drop of 22.5 per cent in oil and gas revenues despite high energy prices, and a nearly 30 per cent drop in revenue from tax collection. The expected loss of GDP by the end of 2022 year was estimated at 8 per cent, with a further contraction of the economy over the course of a year and a half or two years.14
To cover the deficit, Russia’s money supply doubled from February to June and Russian foreign-exchange reserves declined by $75 billion in the first six months of the war. Finance Minister Anton Siluanov admitted in July that by the end of the war the Russian government budget would likely be in deficit by an amount equivalent to 2 per cent of Russian GDP – a gap that he suggested closing by withdrawing fully a third of Russia’s National Wealth Fund.15
So sanctions were undoubtedly hurting the Russian economy. But were they working? It depended on how you defined their purpose. In March Biden announced that sanctions were intended to ‘inflict damage that rivals military might’ to ‘sap Russian strength’ and to ensure that Russia ‘would never be able to threaten its neighbours again’. By that measure, sanctions certainly seemed to have been effective in depleting the Kremlin’s war machine. By the end of August Moscow was buying artillery shells from North Korea and drones from Iran, and had withdrawn aircraft, rockets and personnel from its military mission in Syria.
But were sanctions likely to erode Putin’s power, or change his behaviour? Biden claimed that was never the point. ‘I did not say that in fact the sanctions would deter him,’ Biden told a NATO summit in March. ‘Sanctions never deter.’16 That was frankly disingenuous. According to a former White House official who was instrumental in drafting the first round of sanctions in 2014, a major part of the Biden team’s strategy was ‘to drive a wedge between the siloviki in the Kremlin and Russia’s business class’. Admittedly, that strategy had not worked between 2014 and 2022 – but the principle that ‘there is a contract between Putin and the [business] elite that they stay out of politics and he allows them to get rich’ remains, the official stated.17
Some wealthy Russians did indeed flock to safe havens as sanctions bit. According to the Yale survey, some 15,000 – or 20 per cent – of Russia’s high net worth individuals, defined as people worth more than $30 million, left the country. Despite restrictions, capital transfers out of Russia jumped from $22 billion in the first quarter of 2022 to over $70 billion in the second, by the Central Bank’s own figures. Dubai real estate firms reported 100 per cent and even 200 per cent year-on-year increases in sales to buyers from Russia.18 But these statistics can also be read the other way: 80 per cent of wealthy Russians remained. Most had no choice – their business interests were too closely tied to Russia, and to the Russian state, to make exile a rational choice.
The mood among the dozen or so wealthy Russian businesspeople I spoke to in Moscow in the months after the invasion was one of more or less stoical resignation – ‘What can we do about it?’ and ‘It will all blow over’ – combined with a deep and often furious anger directed not at the Kremlin but at the West. ‘Those lickspittles [in Europe] were very happy to take my money and kiss my ass,’ said the head of a major Russian technology importation firm who owned properties in Italy and London. He was not personally on any sanctions list but had nonetheless found his European bank accounts frozen simply because he was Russian. ‘What happened to their rule of law and respect for private property?’ Europe and the US ‘has decided that we are all criminals, and must suffer for the crimes of one freak [Putin]’, railed a St Petersburg-based telecoms magnate. ‘They want us to sit here in Russia. Fine. We’ll sit here, with our own.’
The Kremlin was accused of applying its own standards in its dealings with foreign countries – for instance its assumption that Zelensky and the Kyiv elite were venal and easily corrupted. But the West, too, seemed to assume that Russians would react like Europeans or Americans to the prospect of economic hardship – by blaming their leaders and demanding change. However, Russia’s reality was very different. For one, economic crises – some worse than the 2022 sanctions-driven slump – had occurred within recent memory, from the hyperinflation of 1992–93 to the collapse of the ruble in 1997, 2008 and 2014. For most urban Russians, living something like a prosperous, European, middle-class life where Ikea, Starbucks and Zara were things to be taken for granted was something relatively recent. For the Russians who lived on or below the average wage of £802 a month – or the 14 per cent of the country who lived below the poverty line of £120 – the loss of luxury stores in Moscow or the price of imported electronics made little difference.19
More important, for the majority of Russians and for their government, was a clear sense that their sufferings were for a good cause. ‘What do we live for, as Russians?’ asked TV anchor Vladimir Solovyov in late August. ‘Not for McDonald’s or for Kentucky Fried Chicken. The purpose of our life is to stand up for truth, for what is right. To defend our brothers with our living bodies when they attacked by fascist scum.’20 The constant message on Kremlin-controlled TV channels was that the West was facing economic devastation as a result of sanctions. ‘People accustomed to false patriotic rhetoric can remain silent for decades. [The] limits of patience of ordinary citizens … have not been really tested yet,’ wrote economist Valery Kizilov of Moscow’s Financial Research Institute in an influential essay part-titled ‘Why Russians don’t notice the economic crisis’. ‘At the level of the highest Russian authorities, [this] cannot be called an outright crisis. The official view is that the economies of the opposing countries are suffering much more. In this sense, the regime has returned to the stagnant rhetorical models of the late 1970s and early 1980s.’ Russia faced ‘not collapse, but decay’.21
Perhaps the most telling sign that the Kremlin feared neither a backlash from the elite nor from the people over economic decline was Putin’s decision to gamble Russia’s main economic ace – Europe’s dependence on Gazprom – in an attempt to gain political advantage.
Gas versus Guns
By early autumn 2022, it had become clear that the endgame of the Ukrainian war would be a battle between gas and guns. As Western-supplied weapons battered Russian positions on the ground, a gas cut-off by Russia battered European consumers with soaring energy prices and the worst cost-of-living crisis in a generation.
In 2021 Russian gas accounted for some 45 per cent of the EU’s gas imports. Germany, Europe’s biggest economy, was most dependent of all on Gazprom – and generations of its leaders had been instrumental in increasing that dependence. The logic had not been entirely irrational. Former German Chancellor Gerhard Schröder (who would join the board of the Nord Stream pipeline and of the Russian state oil giant Rosneft after stepping down in 2005) argued that German dependence on Russian gas equalled Russian dependence on German money. More economic integration would make for a more stable relationship between Europe and Moscow.
The moral hazard inherent in that equation became apparent after the Russian annexation of Crimea in 2014. As we have seen, instead of cancelling the planned Nord Stream 2 pipeline – and in defiance of strong US pressure – Schröder’s successor Angela Merkel green-lit the €10 billion, Gazprom-financed project.
At a NATO summit in Brussels in July 2018, US President Donald Trump complained that ‘we’re supposed to be guarding against Russia and Germany goes out and pays billions and billions of dollars a year to Russia … Germany is totally controlled by Russia, [because] they are getting 60 to 70 percent of their energy from Russia and a new pipeline … I think that’s very inappropriate.’22 Trump’s warnings were roundly ignored – and when he made a similar point at the UN General Assembly, German delegates openly laughed and scoffed.
Europe’s gas Achilles heel was clearly apparent as Brussels prepared sanctions against Putin in the wake of his 2022 invasion of Ukraine. The sanctions included banking and export restrictions, and even an oil embargo to be enforced from December 2022. But they did not include gas – rendering the sanctions essentially toothless. In fact, Europe had become more dependent on Russian gas than it had been in 2014. Key EU energy-consuming nations had become politically fixated with green-energy agendas that meant the closure of coal-fired power stations, scrapping plans for hydraulic fracturing (‘fracking’) and, in Germany, closing nuclear power stations. Natural gas – which emits fewer pollutants and less carbon dioxide per unit of energy – was embraced as a semi-green stopgap until renewables such as wind and solar power could make up the gap left by coal and nuclear.
Gas was Russia’s most powerful weapon in its diplomatic war to undermine Europe’s political and military support for Ukraine. But instead of using escalating threats, over the summer of 2022 Putin simply cut supplies – not only effectively sanctioning himself but also giving Europe months of warning to prepare for winter gas shortages. From June onwards Gazprom cut off Poland, Latvia, Lithuania and Finland, and reduced the gas flow to Germany via the Nord Stream 1 pipeline by 40 per cent, ostensibly because a crucial set of gas turbines sent for repair by Siemens Energy in Canada had been sanctioned.
The immediate effect was, as Putin had hoped, panic. As Robert Habeck, Germany’s Economy Minister, put it in July, a complete cut-off of Russian gas would be his country’s ‘nightmare scenario’. Under pressure from Berlin and the International Energy Agency, and ignoring Ukrainian objections, the Ottawa government lifted sanctions measures on the turbines. Canada’s Minister of Natural Resources Jonathan Wilkinson justified the decision by claiming that ‘our European friends and allies’ needed to retain their ‘access [to] reliable and affordable energy as they continue to transition away from Russian oil and gas’.23
In mid-July – the lowest gas-consumption month – German gas storage capacity stood at 63 per cent, far short of the goal of 90 per cent by 1 November. Contingency plans were put in place prioritising access to electricity and gas in case of serious cuts, with hospitals and emergency services top of the list, then households, then industrial concerns. Local authorities across Germany drew up plans to shut swimming pools, turn off street lamps and traffic lights, and repurpose industrial-scale dormitories designed for coronavirus patients as ‘warm rooms’ or ‘warmth islands’. Meanwhile demand for electric and oil heaters, infrared panels and camping stoves soared, and installers of wood-burning stoves and heat pumps reported long waiting lists and a chronic lack of parts and qualified personnel.24 Klaus Müller, Germany’s energy regulator, said gas prices for consumers might triple by 2023. And former German ambassador to London Thomas Matussek warned that ‘if push comes to shove, we are probably entering the biggest economic crisis that Germany has experienced since the end of the Second World War.’25
