How Russia may respond to the Western economic sanctions

The Russian assault on Kyiv and other Ukrainian cities has intensified uncertainty in world economies. It is the second invasion after Crimea in 2014. Global economies are still recovering from the pandemic recession with slow growth. The markets are highly volatile, the financial markets are squeezed and oil prices are rising unprecedentedly. As evidence shows, […]

The Russian assault on Kyiv and other Ukrainian cities has intensified uncertainty in world economies. It is the second invasion after Crimea in 2014. Global economies are still recovering from the pandemic recession with slow growth. The markets are highly volatile, the financial markets are squeezed and oil prices are rising unprecedentedly. As evidence shows, these are all global recession recipes and the war in Ukraine is intensifying the process.

Conventional wisdom says that unattended problems have a habit of becoming a crisis. To condemn the war, leaders of the Western economies announced some restrictive economic measures to target the Russian financial institutions and individuals.

Like any global economy, Russia’s financial institution is an important component of the Russian empire. For example, the Central Bank of the Russian Federation acts as the government’s agent for regulating money supply and economic growth. Others engage in commercial banking, investment, brokerage, pension fund and insurance services. In essence, the sanctions will be affecting the financial sector that manages risks and allocates resources within the Russian system.

The economic sanctions include: removing some selected Russian banks from the SWIFT messaging system; restricting the Russian Central Bank from using its $630 billion international dollar reserves in ways that undermine the sanctions; identifying and freezing the assets of sanctioned oligarchs and companies in the West; prohibiting the wealthy Russians connected to the Russian government from becoming citizens of the Western countries to avoid gaining access to their financial systems; and engaging other governments to detect and disrupt the movement of ill-gotten gains, and denying these oligarchs the ability to hide their assets.

Due to the EU’s dependence on oil and gas from Russia, the bloc is still contemplating imposing a full SWIFT suspension. The EU is trying to avoid making payments through outdated methods like fax machines. European banks are the world’s most exposed financial institutions to Russia’s new sanctions, specifically Austria, France and Italy. Bank for International Settlements (BIS) figures show that, unlike their EU counterparts, the US banks have been decreasing their exposure to the Russian economy since the sanctions in 2014.

The Internation Energy Agency is suggesting a plan to European Union for reducing reliance on Russian supplies by over a third within a year. They cited a combination of measures that included non-renewal of gas supply contracts with Russia. Germany had already suspended the new Nord Stream 2 gas pipeline from Russia. Shell is forfeiting billions of dollars worth of trade in Russia.

Switzerland, a country that had remained neutral during wars, has since endorsed the EU’s entire package of Western economic sanctions against Russia. That means the country will not be a cash haven for Russians. The Swiss financial service hosts almost 80 per cent of Russian virtual commodity trading. Gazprom and several Russian state banks have major branches in Switzerland. The BIS also emphasised that it would not allow Russia to bypass Western sanctions in Switzerland. Switzerland and the UK, are the biggest destinations for Russian oligarchs seeking to keep their cash given their strict banking secrecy laws. The 2020 Swiss National Bank data shows Russians held nearly $11.24 billion in Switzerland.

However, many Asian countries are considering trading with Russia despite the sanctions. The reason for this is to protect their local markets. Creative currency arrangements like China’s alternative to SWIFT – the Cross-border Interbank Payment System may be used in bilateral trades. India-Russia bilateral trade is estimated to be $9 billion, about 10 per cent of Russia’s trade with China – Russia’s biggest trading partner and behind three other bilateral partners, Germany, Italy and Belarus.

The West had previously imposed sanctions on Russia following the annexation of Crimea in 2014. Then, due diligence was conducted to cherry-pick the sanctions to ensure minimal economic shock on the European economies. Before the announcement, S&P Global Ratings had cut Russia’s credit rating to BB+ from BBB- which is below investment grade – a junk status. The Russian economic sanctions are creating economy-wide stress for the country’s financial institutions. Putin’s government responded quickly as the ruble plunged by almost 30 per cent. Russians are withdrawing their ruble at banks to exchange them for currencies with stable value like the dollar or euro. A bank run – a rush to withdraw cash from banks – is reported already. Putin and his central bankers will have three limited options to calm the situation.

First, they will have to print more money to cover all withdrawal demands. Doing so will generate more inflation in the economy. The federation has also appealed to residents to be calm amid fears of sparking a bank run.

Secondly, they have raised the key interest rate to 20 per cent from 9.5 per cent  in an emergency fashion, saying the Russian economy’s external conditions are changing. The Russian government is now forced to choose between facing a full-blown recession or a financial crisis. Raising the rates may attract bank customers to save their rubles in Russian banks because of attractive returns. But rational citizens will not be drawn due to the ruble’s volatility. On the one hand, if successful, it may eliminate inflation. On the other hand, spending and investment within Russia will significantly decline. Thus, leading to a recession.

Lastly, Putin may have to introduce a domestic withdrawal embargo and capital control in Russia. The capital control will limit how much money can be withdrawn and be taken out of the country, which will starve the economy. But since the economic sanctions are targeting the oligarchs and companies, shifting money away from Russia will be difficult. Understandably, any economy facing credit starvation will have a full-blown financial crisis.

Many would think Putin has experience navigating Russia out of the 1998 financial crisis, the Great Recession of 2008 and the 2014 financial crisis, amplified by sanctions. He has improved the financial institutions and legal system. However, this time around, the unprecedented sanctions look different.

 

Dr Nasir Aminu is a Senior Lecturer in Economics and Finance at Cardiff Metropolitan University (Twitter: @AminuEcon)