How Britain became Russia's banker of choice, and what that means for sanctions

There’s an assumption out there – one reflected in the briefing document inadvertently flashed to photographers by an official outside Downing Street – that economic sanctions on Russia would not be worthwhile.

The rationale has two strands: first, that any bar on trade and finance with Russia would end up being worse for Britain than for Russia; second, that Russia, with its experience of illicit financial flows, would be able to circumvent the sanctions anyway.

Both of these arguments are bogus. There’s reason to believe that sanctions on Russia would be more effective now than at any time in recent years. In order to understand why, one must first of all examine the economic linkages between the UK and Russia. This is no mean feat as much of the cash flow between the two countries is thought to be illicit, and therefore flies beneath the radar. But with the use of one or two big numbers, one can, at the very least get an idea.

The first thing to remember here that when one talks about economic sanctions, there are two main elements: first, bars on trade; second, bars on financial flows.

The impact of the trade barriers are relatively predictable, because we have a far better idea of how many goods pass between our two countries. According to the Pink Book, the definitive annual ONS survey of trade flows, Russia is a relatively important trade partner for Britain – the 12^th biggest destination for UK goods exports and the 25^th biggest destination for services exports. It’s the 14^th biggest source of UK goods imports and the 29^th biggest source of UK services imports, which puts it behind Cyprus and a touch ahead of Austria.

In other words, in trade terms, Russia is no minnow, but neither is it as essential a trade partner as the US, Germany or France.

The interesting bit comes when one considers the flow of cash between the two countries. Let’s focus first of all on Russian cash heading into the UK. Pinning down just how much there is is tricky. We know that a lot of money has escaped from Russia in the past few years. The central bank quoted a figure of $56bn of outflows in 2012 alone, two-thirds of which it believes may be illicit. Parsing International Monetary Figures to try to get a sense of outflows, the total between 2005 and 2013 is a touch more conservative at about $103bn. Either way, these are big numbers, and reflect cash that has simply left the country for other shores.

There’s no definitive measure of how much of this flow has come into the UK, but based on the country’s international investment position – a measure of how many assets Russians hold in the UK (and vice versa) – the answer is likely to be: an awful lot. According to the latest numbers, a quarter of the Russian banking sector’s entire foreign assets are in the UK. The total ($27.6bn) is greater than is in any other country worldwide.

The flow in the other direction is equally important. According to figures I’ve analysed from the Russian central bank, Britain has, in recent years, become the biggest provider of loans to Russian businesses. Now, to some extent both this and the previous numbers are a reflection of the fact that London is the world’s premier centre of finance; much of this cash will originate in other countries and simply flow through the UK.

Nonetheless, this underlines that Russia has been highly reliant on flows of money through the UK in recent years and remains so today. In other words, were there to be financial sanctions on the country, they would have more impact if levied by the UK than by any other country in the world. The flipside, of course, is that would also represent a significant financial blow for the City which, on the basis of these numbers, has become quite reliant on Russian business as well.

But the evidence above underlines that far from having little impact, a ban on financial links with Moscow would make an enormous difference. This impression is reinforced when one recalls that Cyprus, which used to provide the bulk of finance to Russia, is much less likely to be able to given it is still yet to remove the capital controls it imposed during its euro crisis last year.

In other words, while there may well be alternative sources of finance for Russian businesses, they may not be big and liquid enough to replace the City of London.

Finally, it so happens that this is a moment of particular vulnerability for the Russian economy. The past couple of years have been tepid in terms of economic growth. The central bank’s decision to raise interest rates by a full 1.5% this week comes at about the worst possible time. The collapse in the stock market on Monday is a further signal of financial stress. Though there are perpetual fears that the country might turn off the gas pipelines into Europe, it’s worth remembering that this is something the country has never fully gone ahead with – not during the previous Ukraine crises, not even during the dying days of the Cold War.

What’s remarkable, actually, is how little Russia’s gas production levels have changed over the past quarter of a century. And there’s a good reason for this: it is deeply reliant on that gas revenue.

All of which makes Putin’s actions in Ukraine even more of a gamble. The country is extremely sensitive to sanctions – both financial (primarily London) and trade (primarily those countries which consume lots of Russian gas, such as Germany, Ukraine and Turkey). Beneath the bluster, Putin will be hoping desperately that the G7 governments remain too wary to impose them at all.