EU gets tougher with sanctions on Russia - but there is a twist

Tuesday's decision by the European Union to impose Phase Three sanctions on Russia represents a significant escalation of international pressure on Moscow.

The EU’s strategy since Russia’s annexation of Crimea earlier this year has been to gradually ratchet up economic pressure on the country.

Early in the conflict Brussels adopted a three-phase approach to sanctions, ranging from low level targeted asset freezes and travel bans, to sanctions on specific areas of the economy.

Phase One involved bilateral restrictions, including banning Russia from international forums such as the G8, a move that was implemented immediately. Phase Two, which placed travel bans and asset freezes on specific individuals, became the EU’s main policy response, with the number of people on the sanction list gradually increasing to close to 100 along with a handful of entities.

Urgent response

While the EU had already initiated some of the measures included in the Phase Three list, such as the suspension of European Investment Bank projects in Russia, Tuesday's agreement to begin sectoral sanctions represents a new front in the West's approach to Moscow.

Ever since the annexation of Crimea, EU leaders have been asked to articulate what would constitute a trigger for Phase Three sanctions. The response was always ambiguous. The downing of flight MH17 earlier this month changed that: the shooting-down of a civilian plane, and the deaths of almost 200 Dutch nationals, was enough to change the tide of EU opinion on sanctions.

Despite internal divisions about the prospect of imposing sanctions because of some members' high dependency on Russian trade and energy, EU states agreed to put their differences aside this week and back sectoral sanctions. As the presidents of the European Council and commission said in a joint statement announcing the economic sanctions, the package is meant as "a strong warning" to Russia.

"When the violence spirals out of control and leads to the killing of almost 300 innocent civilians in their flight from the Netherlands to Malaysia the situation requires an urgent and determined response."

Nonetheless, the scale of sanctions agreed on Tuesday is limited. The package of measures targets the defence, banking and energy industries, but all three sectors are being hit selectively.

According to European Commission officials, one aim of the sanctions is that they should be reversible. "Our hope is that we can cancel them, scale them down, at the earliest possible opportunity. They're meant to be measures that can be rolled back without creating permanent scars," an EU official said.

Limited restrictions

All three sectors affected by the sanctions are protected in some way. The restrictions on energy, such as the banning of the sale of equipment that can be used in the energy industry, do not apply to gas, Russia's main export into Europe.

The arms embargo prohibiting the sale of weapons to Russia only applies to future sales, allowing France to proceed with the sale of two warships to Russia.

The fact that Russia produces most of its own military equipment and arms also means that its arms industry is unlikely to be severely affected by the sanctions. Similarly, the move to prohibit Russian banks from issuing debt and stock on EU capital markets contains potential loopholes.

One possibility is that Russian banks’ EU subsidiaries may be able to circumvent the rules and channel funds back to their parent company.

This was rejected by EU officials yesterday who said that, because the EU subsidiaries do not regularly engage in these kinds of bond issuances, any move to raise debt for the parent company would be easy to monitor.

However, with subsidiaries still permitted to transfer other funds to their parent companies, and Russian banks dependent on EU and US debt for less than 10 per cent of their funding, the impact of the restrictions on Russian state-owned banks is likely to be limited.

The country’s largest bank Sberbank, is not included in the US sanctions, though it is understood to be included in the EU’s list, which will be published later this week.

While Sberbank’s share price rose yesterday, other Russian banks saw their value slip as the market digested news of the new sanctions. Of concern for investors will be whether the EU moves to intensify the restrictions. It has already said it will review the sanctions after three months.

All economies affected

Of most concern will be how the measures have affected the EU as well as the Russian economy. With the European economy tentatively returning to growth, member states will be mindful of any move that might affect this.

This concern, as much as the sanctions' effectiveness in changing Russia's policy towards Ukraine, is likely to determine the EU's long-term strategy as regards sanctions against Russia.