Iran, Russia, and the Limits of Financial War
In response to Vladimir Putin’s increasingly brutal invasion of Ukraine, the West has declared a financial war on Russia. The US Department of Treasury unveiled new sanctions on the Russian financial sector late last week, measures that “target nearly 80 percent of all banking assets” in the country. Forthcoming sanctions on the Central Bank of Russia (CBR), announced by the European Union jointly with the United States, United Kingdom, and Canada, will effectively freeze Russia’s gross international reserves. Further measures targeting Russia’s energy sector will make the Western sanctions programme among the most expansive ever devised, and certainly the most significant to target such a large economy. There has been impressive coordination between US and European authorities in designing and implementing these sanctions, which have been justified by Putin’s provocations. In their rapid imposition and their broad scope, these sanctions are clearly intended to have significant deleterious effects on the Russian economy. The strategy has shifted from deterrence to attrition and from targeted measures to full financial war.
The only other comparable financial war waged by the United States and Europe has targeted Iran. The Iran sanctions were applied more gradually than those being applied to Russia today. But in 2012, Iran’s central bank assets and energy exports were targeted in move that will be the model for the sanctions on CBR and Russia’s energy industry. These sanctions were initially multilateral in nature, with UN, US, and EU measures imposed in tandem. The multilateral sanctions were in place until 2016, when the implementation of the Joint Comprehensive Plan of Action (JCPOA) saw the lifting of most UN and EU sanctions as well as US secondary sanctions. Iran benefited from sanctions relief for just two years, enough time for a return to economic growth, but not enough time for a remediation of the harm that sanctions had caused most Iranian households. In 2018, President Trump withdrew from the JCPOA and reimposed US secondary sanctions on Iran, once again thrusting Iran into an economic crisis, later compounded by the COVID-19 pandemic.
Broadly speaking, the financial war on Iran has been in effect for a decade. The damage incurred by the Iranian economy has been extensive. Currency volatility and high inflation have sapped Iranian purchasing power, pushing millions of Iranians below the poverty line. Chronic weaknesses of the Iranian economy, such as high unemployment and systemic corruption have been exacerbated. Still, despite the many hardships, the Iranian economy did not collapse. Rather, the economy stagnated, growing an average of just 0.37 percent between 2012 and 2020. When excluding 2016 and 2017—the two years of sanctions relief under the JCPOA—the average falls to -1.96 percent. A decade of stagnation and the diminishing welfare of ordinary Iranians combined to create new political pressures on the Iranian government. Labour mobilisations have become commonplace and there have been multiple waves of nationwide protests focused on economic grievances. These protests have been violently suppressed by authorities. Even so, the Iranian government is today pursuing sanctions relief—in the context of renewed negotiations over the JCPOA—not because of fears an impending economic collapse, but because of a view that economic resilience allows Iran to engage in negotiations from a position of relative strength, seeking the conditions for a return to growth.
Unsurprisingly, Iran has become a touchpoint in the discussion around the growing Russia sanctions programme. But the focus has been the Iranian precedent for key moves, such as the removal of Russian banks from the SWIFT messaging network. So far, there has been little consideration of what the outcomes of the financial war on Iran might tell us about the prospects for the financial war on Russia. The cases are not only comparable because of the kinds of sanctions that are being applied, but because the two economies share important similarities. Of course, Russia and Iran are both major energy producers and revenues from oil and gas exports are centrally important for government budgets. But the two countries also boast large manufacturing sectors principally supplying internal markets. Despite general corruption and rentierism, key institutions exhibit technocratic sophistication.
In response to the 2012 and 2018 sanctions shocks, Iran demonstrated that its flawed economy could undergo structural adjustments to sanctions pressure. Such adjustments begin immediately, meaning economies targeted by sanctions can return to fragile growth in as little as a year. In Iran, this capacity for adjustment reflected the bottom-up resilience of households and companies seeking to survive the financial war. The Iranian state lucked out. Officials boasted of their “resistance economy” policies, despite failing to develop a cohesive response to sanctions pressure. Meanwhile, the composition of the Iranian economy meant that sanctions pressure could be absorbed. There is reason to believe that Russia will also absorb such pressure. Across key indicators, Russia appears in a stronger position than Iran was at the outset of its financial war.
Access to Foreign Exchange
Sanctions targeting a country’s central bank are the most significant measure in any financial war because of the direct impact on the national currency. During the Trump administration’s “maximum pressure” sanctions campaign, Iranian authorities maintained ready access to just 10 percent of the country’s gross international reserves, putting enormous pressure on the Iranian currency and making it very difficult for Iran to manage deficits with key trade partners. In January 2018, a few months before Trump announced his withdrawal from the nuclear deal, the free market dollar exchange rate in Iran was IRR 46,000. Today the exchange rate is IRR 263,000. The dramatic devaluation of the rial is often cited as evidence of the devastating impact of US sanctions. Indeed, devaluation made imported goods, including foodstuffs like wheat, on which Iranian households rely, more expensive. But the Iranian government demonstrated an ability to return order to currency markets, both by finding ways to supply foreign exchange into the market despite sanctions and also through better technical management of the market itself, including through the creation of a parallel market whereby exporters are required to sell foreign exchange earnings to importers. Russia is arguably in a better position than Iran to weather the attack on the value of its currency. It has gone through this storm before—the rouble lost half its value following the imposition of more limited sanctions in 2014, as part of the Western response to the annexation of Crimea. In response to the latest crisis, CBR has already hiked interest rates to 20 percent and imposed a new requirement for companies to repatriate foreign exchange earnings. If we assume that the 10 percent figure represents maximum efficacy for the freezing of central bank reserves, then that would leave CBR with access to approximately $63 billion. However, Russian reserves are equivalent to about 42 percent of GDP. In 2012, Iran’s reserves (then $104 billion) amounted to just 17 percent of GDP. So even if a similarly small percentage of the reserves remain available to CBR following the implementation of the financial sanctions, Russian authorities could fare better than their Iranian counterparts in stabilising the value of the rouble after the latest devaluation shock caused by the financial sanctions.
Energy Revenues and Fiscal Space
Despite initial attempts to create carve-outs for Russia’s energy exports, motivated by a desire to shield Europe from an economic shock and to leave room for escalation, it now appears likely that Russian energy exports will be targeted by Western sanctions. In the case of Iran, such sanctions provided highly effective in reducing exports of crude oil and mostly effective at reducing exports of petrochemical products. Broadly speaking the purpose of energy sanctions is to induce a fiscal crisis. Even in periods in which Iran was permitted to export limited volumes of crude oil under so-called Significant Reduction Exemption waivers, the revenues from these sales could only be used for humanitarian trade, meaning that the fiscal constraints remained significant. In the lead-up to 2012, oil sales accounted for around 80 percent of Iran’s total exports and around 60 percent of government revenues. Russia has a significantly lower dependence on energy sales, which today account for around 60 percent of exports and around 40 percent of government revenues. Tax administration in Russia is also significantly more developed than in Iran. In 2020, the Russian government collected $387 billion in tax revenue, equivalent to around one-fourth of GDP. By comparison, tax revenue in Iran was just $32 billion in 2012, equivalent to one-twentieth of GDP. Like the Iranian government, the Russian government is not heavily indebted. In 2012, Iran’s government debt was equivalent to 10 percent of GDP. Government debt in Russia was equivalent to 16 percent of GDP in 2021. The Russian government is likely to have more fiscal space than Iran in the aftermath of the sanctions shock given a similar debt level and more robust revenue sources. Notably, Iran did not really use what fiscal space it had as part of its response to sanctions, choosing to run austerity budgets aimed at slowing inflation. Russia could take a different approach, directing state investment to compensate for the lost growth in the energy sector.
Dependence on Manufacturing
Russia is the world’s second largest consumer of natural gas. Iran is the fourth. These high rates of consumption reflect that natural gas is used for heating homes, for power generation, and as feedstock in the manufacturing sector. The energy sector in Russia will contract dramatically just as it has in Iran over the last decade, but it will not collapse in large part because of the important role of the manufacturing sector in the adjustment to sanctions and wider economic resilience. In 2012, Iran’s manufacturing sector accounted for 14.4 percent of GDP. In Russia, based on data for 2020, the manufacturing sector accounted for 13.3 percent of GDP. The sectors are of similar importance to their respective economies. But these statistics also underestimate that importance. The relative size of the manufacturing sector in Russia and Iran fluctuates with the oil price—high prices mean that the oil sector contributes more than usual to GDP. Moreover, in both countries the manufacturing sector is a larger employer than the energy sector, given the relatively limited manpower necessary to operate modern energy infrastructure. Manufacturing is the sector that really matters.
The latest World Bank report on Iran, which details the country’s fragile economic recovery, notes that recent growth has been driven by manufacturing. The report points to two aspects of the adjustment to sanctions: “Less market competition—due to import restrictions on nonessential goods—and the price competitiveness of manufacturing and mining production—following the currency depreciation.” The resilience of Iran’s manufacturing sector under sanctions has been further detailed in a study by Hadi Esfahani, who used firm-level data to show that “manufacturing firms adapted to the sanctions environment, and many resumed growth based on domestic demand and resources.” While the sanctions shock does lead to a contraction in the manufacturing sector, it is declining output, not “exits” that are to blame. In other words, manufacturing firms do not tend to go out of business. In fact, manufacturers who produce goods for export markets, especially regional markets, can grow their profit margins as they earn foreign exchange. This adjustment is easiest for firms engaged in light manufacturing, as demand for consumer goods is relatively inelastic and as production of these goods is less capital intensive, shielding manufacturers from higher producer prices. But to take advantage of these conditions, manufacturing firms must maintain output.
Shifts in Trade Composition
The fundamental challenge for the Iranian manufacturing sector since 2012 has been disruptions in the supply of inputs and high producer prices. In this way, the impact of sanctions on imports of industrial goods may be more consequential for the targeted economy than the impact of sanctions on the sale of energy products. Iranian manufacturing firms remain in business and continue to produce for a large domestic market and newly growing regional demand. But to do so, they needed to maintain imports of industrial equipment. Purchasing managers’ index data for Iran makes clear that the primary constraint on the manufacturing sector’s economic performance under sanctions has been the reduction in raw materials and intermediate goods inventories and the high cost of replenishing those inventories. Historically, intermediate inputs and equipment were sourced from Europe. But beginning in the late 2000s, China became a larger supplier. The financial war on Iran accelerated the shift in the country’s trade composition as Chinese suppliers proved more willing to sell to Iran in the face of sanctions. One way to express the relative importance of Chinese and European supply is to look at the ratio of exports from the two suppliers. In 2012, Iran imported 1.2 times more goods from China than it did from the European Union. But machinery imports (HS Chapters 84 and 85) from China and Europe were about equal. By comparison, Russia is significantly more dependent on Europe as its financial war begins. The total value of all imports from the European Union is about twice that from China. The dependence is slightly lower when looking at machinery—the total value of Chinese machinery exports to Russia is 70 percent of European Union exports.
On one hand, this higher dependence may mean that the sanctions shock to the Russian manufacturing sector will be greater than that in Iran. But on the other hand, it demonstrates that Russia has yet to make the “Eastward turn” that many have observed in Iran and other Eurasian economies. To be clear, Chinese firms did not completely ignore Western sanctions on Iran and did engage in de-risking that left Iran behind its regional neighbours with regards to economic ties to China. Bilateral trade has stagnated since 2012 and the inability of Iran to maintain significant oil sales to China for large periods over the last decade also posed financial challenges for maintaining industrial imports. But whereas Iran is one of China’s many economic partners in West Asia, Russia has presented itself as a unique geopolitical partner within a wider Eurasian context. This may make the difference as Russian manufacturers seek alternative suppliers for crucial industrial goods.
Capital and Its Survival Instincts
If Russia does demonstrate a similar kind of economic resilience to Iran, that does not mean that there will not be economic hardship. In Iran, annual inflation exceeded 30 percent following the 2012 and 2018 sanctions shocks. Skyrocketing prices, especially for food products, pushed many working-class families into poverty. For a once upwardly mobile middle class, the diminished standard of living has been embittering. For most in Iran’s upper class, sanctions have been a nuisance. For some among the wealthy, they have been a boon.
One unique feature of the Russia sanctions programme is the focus on oligarchs and the perverse influence that individuals with extreme wealth have on the country’s politics, particularly in their perceived fealty to Putin. Western officials are directly targeting these oligarchs, both by targeting their personal assets and through measures targeted at the conglomerates they own. The Moscow Exchange suspended trading last week after a massive sell-off saw the main index fall 50 percent. European and American regulators are promising to review the lax rules that have allowed Russian oligarchs to purchase extensive real estate in Western cities. In both capital markets and real estate, the wealth of Russia’s ruling classes has been augmented by the commingling of domestic and foreign investor capital. As foreign investors retreat from Russia, and as high-net worth Russians are blocked from foreign real estate markets, oligarchs will take a hit. But capital has its own survival instincts.
Russia’s capital markets are far more developed than those of Iran. Unlike the Moscow Exchange, the Tehran Stock Exchange has never hosted significant foreign investment. Still, capital markets did play a role in Iran’s sanctions response in a way that diminished the political, if not absolute economic, impact of sanctions. In 2019, deep into Trump’s restarted financial war on Iran, the Tehran Stock Exchange was the world’s best performing equity market, with market value doubling in dollar terms. There were three reasons for this remarkable performance. First, many listed companies, particularly manufacturing firms, were posting strong financial results after adjusting to the new sanctions reality. Second, high inflation left Iranians scrambling to invest in a safe asset while sanctions made capital flight difficult and costly. For middle class families, the safe havens were hard currency or gold. For upper class families they were domestic real estate or stocks. Third, as wealthy Iranians increased their exposure to capital markets, a policy shift took place. Suddenly, developing the capital markets became a priority for the government and for the nascent financial services industry, particularly with the aim of increasing the number of retail investors. More money poured into the market, even from middle class households, driving prices higher. The returns outpaced inflation, drawing in more investment, and giving rise to what many considered to be a dangerous bubble. But in the meantime, a new feature of Iranian political economy emerged. The newfound importance of the country’s capital markets, an outcome of the financial war, was exemplified in the decision of the government to liberalise a “justice shares” programme that had granted shares in state-owned enterprises listed on the stock exchange to disadvantaged families. Overnight, Iran had 50 million new retail investors with an interest in the political and economy stability that favours stock price appreciation.
By comparison, Russia has around 13 million retail investors. There is significant potential for domestic wealth to pour into the stock exchange, whether spurred by the inflationary environment or encouraged as a matter of new government policy. The implication is that capital markets are useful tools for preserving capital—the desperation of middle and working classes in Russia may help shore the wealth of oligarchs, already in stocks and real estate. Many of the enterprises that oligarchs control may successfully adjust to the new reality and remain profitable. A new class of “light” oligarchs may emerge as certain light manufacturing enterprises benefit from reduced competition and better export prospects. The financial war could also provide a pretext for state capture, with private capital facilitating rentierism, corruption, or smuggling deemed expedient in the face of sanctions.
Take all of this together and it becomes clear that the most problematic aspects of Russian political economy—the obscene concentration of wealth among a politically-connected ruling class—will remain unchanged in the financial war. Meanwhile, the immiseration of the middle and working classes will further disempower civil society, creating a dynamic where dangerous protests are the only means through which to air grievances and in which deprivation focuses those protests on wages and bread. As Bourse & Bazaar Foundation board member Djavad Salehi-Isfahani has shown, just as poverty has increased since sanctions were imposed on Iran, so too has inequality risen. The rich are not getting poorer, but the poor certainly are.
Confounding Aspects
Iran’s economic resilience in the face of sanctions owes little to the state and a lot to its people, who have simply tried to prevent their own financial ruin. Economies are made up of individuals—some wealthy, most poor—who marshal the resources they have. How those resources are distributed determines the effects of sanctions on the wider economy. When comparing the fundamentals of the Russian and Iranian economies—the depth of the comparison here is limited by my lack of detailed knowledge about the Russian economy—it seems reasonable to assume that Russia will endure its financial war. The composition of its industry, the size of its domestic and regional markets, and the resources available to the state are all comparable to what Iran had at its disposal in 2012 on the eve of the financial war that has now lasted a decade. Given the fundamental comparability of the Russian and Iranian economies, it stands to reason that the Russian structural adjustment to the newly imposed sanctions may not even require astute political leadership. This may be a good thing. The Iranian leadership was more inclined to pursue diplomacy when it believed that it had achieved a stalemate in the economic war.
As Nicholas Mulder has observed, “Perhaps the most confounding aspect of sanctions is that regardless of technical sophistication, their outcome is never a matter of economic factors alone.” Western governments will no doubt be able to cause massive damage to the Russian economy, but the individuals who comprise that economy will attempt to adjust. The Russian public, like the Iranian public, is at best ambivalent about the policies of their leaders in response to which sanctions have been imposed. In Iran, a decade later, there is a widespread sense that the price endured by ordinary people is no longer proportional to the wrongs committed by their government. If the sanctions persist in the aftermath of a cessation of the conflict in Ukraine—which is likely—a similar reality may come to pass for the Russia. In this context, the resilience of ordinary people in the face of financial war will not be an act of political resistance, but of basic survival. They will toil for low wages in factories and fields, struggling to put food on the table and at times they will protest, facing down the violence of the state. Meanwhile, the economy will stagnate. So too will a dismal political reality.
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