The west’s coordinated response to Russia’s invasion of Ukraine has been swift, severe and largely financial in nature. The additional sanctions announced over the past week will impose significant new pain on the Russian economy. But they say there’s no such thing as a free lunch, and this applies to the measures imposed on Russia as well. We have never seen the weaponisation of finance on this scale for a large country before, and there will inevitably be some blowback for the west.
A number of financial sanctions were imposed rapidly. The US, along with EU member states and G7 allies, limited Russia’s ability to transact in US dollars, British pounds, euros and yen, froze the assets of four major Russian banks and imposed export controls on technology. The US, EU, UK and Canada agreed to block some Russian banks from using SWIFT, the messaging system that facilitates most of the world’s interbank transactions. Energy purchases have been carved out of the SWIFT sanctions for now.
The US and its allies also froze the assets of—and prohibited transactions with—the Central Bank of Russia (CBR). Russia has been reducing its exposure to the US dollar since 2014, with dollar reserves falling from 43 per cent of the total to 16 per cent by mid-2021. Gold accounts for over 20 per cent of Russia’s foreign reserves and the renminbi accounts for 13 per cent, so these actions won’t bite quite as hard as they would have in the past. The west has previously sanctioned Iran and Venezuela’s central banks, but this is the first time such restrictions have been imposed on the central bank of a major economy.
The implications of these measures for the Russian economy are drastic, triggering bank runs and a rush to purchase luxury goods that might hold their value better than cash. The ruble torpedoed on the first trading day after the sanctions were announced, the Russian equity market did not open, the CBR more than doubled interest rates to 20 per cent and capital controls were imposed to stop money fleeing the country. The sanctions on the CBR rendered most of Russia’s roughly $630bn in foreign reserves unusable, and so the central bank now has limited power to prop up the currency.
What are the implications for the rest of the world? Higher prices, goods shortages and some financial issues are guaranteed. Brent oil prices rose nearly 10 per cent in the few days after the sanctions were announced. Natural gas prices have spiked, hitting the EU disproportionately given roughly 40 per cent of its gas is imported from Russia. Higher energy costs will continue to drive inflation up and may push the eurozone into a downturn. The risk of stagflation—stagnant growth and high inflation—has risen across the developed world, which would put major central banks in the unenviable position of having to choose between supporting growth or damping inflation.
Shortages for some goods will be exacerbated. Russia and Ukraine supply roughly one-third of the world’s wheat and a significant amount of fertiliser, both key for global food production. Food shortages could hit the Middle East in particular in the spring. Russia produces roughly 10 per cent of the world’s aluminium and nickel and 40 per cent of the world’s mined palladium, key inputs for catalytic converters, batteries and semiconductor chips. The auto industry will suffer, and the global shortage of semiconductors may get worse.
The measures already taken will devastate the Russian economy, but so far they don’t seem to have significantly changed the path of the conflict
It is less clear what the financial implications of the sanctions will be globally. There are two key uncertainties. If Russian banks removed from SWIFT cannot receive payments, they cannot make them either. The risk to counterparties will rise and we could see a series of defaults. Banks in the allied countries have reduced their direct exposure to Russia significantly since 2014. Among European banks, Raiffeisen Bank International, Societe Generale and Unicredit are particularly exposed, but even a wipeout of Russian and Ukrainian assets would probably not generate a systemic crisis.
We also don’t yet know the implications for funding markets. Russia’s earnings from gas and oil exports aren’t just sitting in a vault, they are being invested. Since 2018, Russia has shifted dollar holdings away from US Treasuries into short-term foreign exchange swaps. This means Russia has lent dollars in exchange for non-dollar collateral. Those holdings of reserve deposits in non-US central banks have now been frozen, which could create a market event. Add to this a flight to safety as a result of the current crisis and stress in the dollar funding markets is unsurprising. The Federal Reserve and European Central Bank have both taken a hawkish bent in recent months, but may have to reverse course and loosen monetary policy, potentially having to step in to make markets the way they did when the pandemic first hit.
The measures already taken will devastate the Russian economy and could impact the west as well. But so far they don’t seem to have significantly changed the path of the conflict. The west has a few more sanctions it could apply. Cutting off imports of Russian hydrocarbons would wipe out a significant portion of Russian revenues, but would also inflict a hefty cost on those imposing it, particularly Europe. The allies could kick all Russian banks out of SWIFT, but then we would lose all visibility on international transactions involving Russian banks. Further sanctions could be imposed on the market for Russian sovereign bonds, making it difficult for Russia to borrow as its deficit is skyrocketing. Central banks could increase the risk weighting for Russian assets, as some Swiss banks already have, making Russian assets less attractive. Russia could be dropped from major emerging market indices, pushing institutional money out of the country. And finally, payment systems such as Visa and Mastercard could ban operations in Russia.
These measures could wreak more havoc on the Russian economy, but they could also cause unintended financial consequences elsewhere. Expect economic volatility until there is a resolution to this crisis.