Comprehensive financial sanctions against Russia, going well beyond the SWIFT exclusion often thought of as a “final stage,” were implemented swiftly and arguably more drastically than Moscow expected. They have significantly damaged the Russian public sector balance sheet and local financial markets. Russian President Vladimir Putin described Western sanctions on Russia as being “equivalent to declaring a war.”

Sanctions put Russia on par with Afghanistan, Iran, or Myanmar

Tough sanctioning of the Russian Central Bank has put this erstwhile reputable institution on the same level as central banks from countries such as Iran, Afghanistan, Syria, or Myanmar. All are markets with many fewer financial interconnections than Russia.

Private assets of many Russian public servants and oligarchs have also been frozen. Russia’s president and foreign minister (and their assets) have been personally sanctioned, putting them on par with war criminals like Syria’s ruler.

Short-term financial market stability only

Russia gained a few days of short-term financial market stability by closing local markets (e.g., the Russian stock exchange), suspending market price valuations, controlling capital outflows, and enforcing a strict administrative management of the foreign exchange market.

The latter can currently be somewhat stabilised in the short term as Russia still benefits from energy revenues from the oil and gas business. Russian exporters currently exchange 80% of their foreign exchange earnings directly. Further logical sanctions would be increasing the pressure or minimising the inflow of foreign currency through export earnings. Trade in oil and petroleum products generates around USD 500-700 million per day for Russia compared to some USD 150-200 million for gas.

However, the comprehensive consequences of financial sanctions already in place on the energy sector must also be considered. As of today, March 8th,  50-70% of Russian oil exports – without an official oil embargo – can no longer be processed by sea. Supporting services for foreign trade, such as trade finance, export insurance, and logistical capacities, have been cut. Consequently, the Russian crude oil price is trading well below the world market price (by around 20 USD per barrel), limiting Russia’s revenues and pricing leeway. The narrative that Russia profits from high oil prices is no longer true.

Sanctions wipe Russia off the global financial market

The determined will of the EU and the G7 in sanctioning the Russian banking sector and, above all, the Russian central bank has had an effect. Countries like Switzerland, South Korea or Singapore wanted or had to follow suit, which exponentially increases the sanctions’ effects. The massive public sanctions have also led to substantial private sanctions among financial market players. Payment service providers such as Visa, American Express, MasterCard and PayPal have stopped all transactions with a connection to Russia. Russian assets have also become de facto non-tradable and eliminated from relevant international trading and benchmarks.

The comprehensive sanctions ensured that Russia would plunge into an economic and financial crisis. Moreover, Russian risks are simply no longer financially insurable or morally acceptable. The Russian state, which had been prepared for “cosmetic” and selective sanctions, had to resort to measures for which they, most likely, had not planned.

The central bank has stopped stabilising the rouble. This is a clear admission of financial weakness. Before the escalation in Ukraine, the rouble was trading at a level of 73 to the USD. Currently, it trades at 130, with an annual average of 175 expected for the Dollar-RUB exchange rate in 2022.

The financial sanctions also directly affect Russian citizens at home and abroad, which is obvious when credit cards and payment flows no longer work. As of this week, even withdrawing foreign currency in Russia is said to be no longer possible – although there are substantial savings in dollars and euros still in Russia. Russia will also now find it difficult financially to support countries like Venezuela.

The all-or-nothing strategy destroyed 20 years of economic and financial reconstruction work

Ultimately, the Russian president has led his country into a financial and economic crisis at least as deep as in the late 1990s. In the course of one week, the G-20 Russian economy fell to the financial market status of a developing country and a candidate for a de facto or technical sovereign default from an international perspective (e.g., like, Venezuela). Under recent legislative changes in Russia, the Russian state will no longer be willing and/or able to properly service its foreign debts to “hostile” states, i.e., in hard currency.

Hence, it must carry out a forced conversion, clearly going beyond “currency change clauses” that it has in some financing contracts prepared in a finely legal manner following the Crimea annexation. As a result, on the financial market, the former stability-oriented economy is seen as risky as Venezuela, Sri Lanka, or Ethiopia and will (technically) be in a sovereign default soon. This reflects the Russian all-or-nothing strategy. In one week, the Putin leadership deliberately destroyed 20 years of economic and financial reconstruction work.

Unfortunately, the all-or-nothing strategy also prevents even the most massive economic and financial sanctions from bringing about a quick turnaround. This makes it all the more important to continue to reduce the Russian state’s sources of income, consistently increase the sanctions policy and choose sanctions channels that can be of a long-term nature. In the short and long term, the oil market is particularly suitable because it is more flexible than the gas market and brings Russia even more foreign currency income every day than the gas business.

US president Joe Biden on March 8th banned US imports of Russian oil and gas

Not surprisingly, the global energy superpower and net energy exporter USA has already imposed strict energy market sanctions. This from a position of strength or a lower dependence on Russian energy than Europe, for example. More importantly, however, the US president has clearly pointed to higher energy prices as the necessary price for supporting Ukraine.

The decision by the US and UK, home of the global financial centres of New York and London, will also make it even more difficult to trade, transport and insure Russian oil at all. In practice, this should substantially increase the sanctions’ impact, even though the US and UK “only” account for about 10% of Russia’s oil exports. The US decision shows its determination to stop Russia and is an expression of a unity in the US that was perhaps not expected in Russia.

Economic warfare – Further steps must respect the rule of law

The international community of states aiming at containing Russia with sanctions must uphold the rule of law and sufficiently differentiate between frozen assets and any expropriation of (state) assets. In the next few days and weeks, a joint task force of the EU, the US, and the UK will track down the assets of Russian oligarchs and actors of the security establishment more aggressively and block or freeze them. The latter is certainly not an easy factual and legal undertaking given the complex holding and offshore structures and assets such as yachts, real estate, cars, or football clubs. Legal challenges could also arise from these actions.

Pressure from within the Putin-Russia regime?

Interestingly, some oligarchs are trying to distance themselves from the Putin-Russia regime either out of conviction or as a hedge for legal disputes. Private assets of Russian citizens can certainly not be confiscated or used as compensation (wholly or simply) for misconduct or war crimes on the part of the Russian state. To do so, a very clear connection to the war machine would have to be proven, such as with the assets of representatives of the bureaucracy or the security apparatus. Especially since many western countries tolerated this influx of Russian money for a long time, at least silently, and part of the consulting and legal industry has profited from it.

However, one could still consider high and substantial taxation of oligarch money, as demanded by renowned economists (e.g., Thomas Piketty). Even lower taxation could yield substantial sums. After all, assets of Russian oligarchs abroad could amount to between 50-100% of Russia’s GDP. Neither should complete expropriation be the dominant strategy given that Russian propaganda is trying to accuse the west of banditry.

It has long been Putin-Russia’s strategy to tie the economic elites more strongly to its nationalistic policy. With fear of expropriation in the west, this could even succeed. Therefore, taxation would be preferable in terms of the rule of law and the west’s “enablers.” However, foreign assets of persons belonging to the Russian military and security apparatus must certainly be treated differently.

Russia’s foreign currency reserves war chest

Russia has undoubtedly prepared itself for the war in Ukraine and western financial sanctions in many dimensions – and economically,  as the foreign currency clauses conversion in market securities show (i.e., giving the right to pay in RUB if foreign currencies are blocked). The accumulation – of the now frozen – foreign currency reserves was also an important part of this cynical war preparation. Many thinkers and doers in state administration were certainly involved – perhaps without directly knowing about the planning for such a devastating war of aggression.

To illustrate the extent of the preparation: Normally, it stands to reason a country will hold foreign exchange reserves in the range of 6-12 months to cover imports. Russia, by contrast, has recently reached levels of 30 months. Of course, this exuberant accumulation of foreign exchange reserves has taken place at the expense of the domestic population and meant a departure from a sound prosperity-enhancing economic policy.

Russia must pay reparations to Ukraine

However, it is precisely these foreign exchange reserves that must be used to hold Russia and its state apparatus economically responsible for the humanitarian catastrophe and alleged war crimes in Ukraine. In all likelihood, Russia will, unfortunately, dominate some of the (peace) negotiations in the interest of conflict resolution, and official reparations from Russia to Ukraine can hardly be expected. Therefore, it will be all the more important to draw on the currently frozen Russian foreign currency reserves.

It is also essential to proceed moderately and cut Russia down to a realistic level. According to relevant import ratios, Russia will probably need foreign exchange reserves in the range of 200-300 billion euros at most. Given the gold reserves in the country and those deposited in China, about 250-350 billion euros of Russia’s frozen foreign exchange reserves should easily be available to reconstruct Ukraine. Such an approach would not be entirely unique. In the USA, some of the frozen funds of the central bank of Afghanistan shall be used to compensate 9/11 victims.

Confiscation of Russian public assets and/or those of individual actors in the military and security apparatus can certainly be justified differently than the private assets of oligarchs. In the first case, it will most likely be possible to establish a clear link between the Ukraine war and state actions. To this end, it is vital to pursue a further formal, legally clean, isolation and condemnation of Russia. This applies above all to the International Criminal Court in The Hague and the documentation of war crimes.

On the economic level, too, further sanctioning and isolation would certainly be necessary to prepare Russia’s reparation payments. Attempts to withdraw Russia’s voting rights in the IMF, to terminate Russia’s membership in international development banks, etc., could be considered. Only if Russia is successfully positioned as a “pariah state” at all levels can the outlined reparations strategy work.

Russia sails proudly into self-isolation, yet without a systemic financial risk to the world economy

Otherwise, Russia will have to be left to its own shrinking strategy in economic terms, just as the Soviet Union proudly went into economic decline in the 1980s. Russia, with its chauvinist-nationalist policy orientation, seems to be heading for a similar economic decline in the 2020s – although this creeping decline may also last for a very long time.

We must also be prepared for Russian economic countermeasures. Unfortunately, China is offering Russia a minimum hedge. Russia’s foreign exchange reserves in China are not frozen, and the payment service provider UnionPay still functions in Russia. Russia will also certainly supply oil to China in case of a western boycott – although this will probably be well below the world market price, which means that an oil embargo makes sense and is not just a political gesture.

At the same time, it is certainly important to closely observe the transmission effects of further measures (e.g., an oil embargo) and the far-reaching western financial sanctions that have already been imposed. Systemic risks must be limited to safeguard the economic capacity of those who aim to contain Russia’s war in this challenging situation.

In view of Russia’s active deleveraging in recent years and decoupling from international financial markets, Russia is unlikely to be in a position to cause a global financial crisis. In fact, the Russian risk on banking and debt capital markets should roughly correspond to the dimensions of Greece in 2008.

Moreover, most large Western corporates with exposure to Russia can cope with relevant write-downs. The “Greek debt crisis” caught many economic and financial market players unprepared; financial and economic risks in the euro area were factually and intellectually underestimated for a long time.

This has certainly not been the case with Russia on financial markets in recent years. We will now probably have to accept global stagnation in the real economy, with inflation rates more like those of the early 1980s. This scenario is undoubtedly challenging in terms of economic policy, but the global economy will not necessarily collapse.

BIO NOTE

Gunter Deuber is Managing Director and Chief Economist of Raiffeisen Bank International AG in Vienna. He collaborates closely with a team of local economists on-site in 14 countries in Central and Eastern Europe, for whom he has a steering and coordination function.

This view represents the personal and private opinion of the author Gunter Deuber and not necessarily the position of Raiffeisen Bank International AG.

Read more on the geopolitical and economic impact of Russia’s invasion of Ukraine:

Agricultural Production in Ukraine and Russia: Economic Implications for Europe

Europe’s divided security

What are the economic implications for the Russian and European economies? The Russian war against Ukraine

SWIFT exclusion is fine, sanctioning the Russian Central Bank is better

Follow all of the Bertelsmann Stiftung writings on this developing situation here

 

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