“We are inflicting devastating economic pain”. That’s how the Foreign Secretary introduced the UK’s sanction package last week.
On Monday this week, the Chairwoman of the Bank of Russia, Elvia Nabiullina – a woman famous for sending coded messages about the economy by her choice of dress and brooch – appeared in full black to announce a more than doubling of the interest rate, from 9.5 percent to 20 percent.
It was often speculated that sanctions were going to have a limited effect on the Russian economy, and indeed there is limited evidence that sanctions work: a comprehensive Peterson Institute study estimates that they work about a third of the time.
But the sanctions placed on Russia are of a different order entirely from those we usually see.
In the Telegraph in January, Nataliya Vasilyeva describes how Russia has, at least since the Crimean crisis in 2014, attempted to wean itself off the international economy. Russia has, for example, created a national replacement for the SWIFT system, and tried to ‘de-dollarise’ the Russian economy by encouraging transactions with other currencies and reducing the share of the dollar in reserves. At the start of this crisis, Russia had the fourth largest foreign currency reserves in the world, about $633 billion. As Matthew Klein points out in The Overshoot, this would have been enough to cover 2021 spending on imports, and three quarters of the country’s foreign-denominated debt.
Thus, at the beginning of the invasion there was understandable scepticism about the potential impact of any sanctions regime. The Russian economy had clearly tried to future-proof itself, and even SWIFT sanctions have work arounds (it also does not help in this respect that the EU has chosen not to deny SWIFT to two key Russian banks handling energy payments); it is right that the Foreign Secretary has called for this disparity to be rectified.
However, what makes this sanction regime different is that for the first time, a G20 economy has had its central bank assets frozen and sanctioned by G20 partners, meaning that the massive foreign currency reserve accrued over years has been rendered to a large extent useless. As Adam Tooze, a leading political economist put it, the freezing of central bank reserves means “crossing a Rubicon…we are at financial war”.
By freezing Russian central bank assets, Russia has effectively been deprived of 60 percent of its foreign exchange reserves. And the other 40 percent will be severely restricted because so much of Russia’s financial architecture is also sanctioned, meaning that it cannot sell gold for dollars and euros at foreign institutions, who are prohibited from conducting business with the central bank. Combined with the sanctions placed on Russia’s sovereign wealth funds, it is now exceptionally difficult for Russian financial institutions to maintain the value of its currency and prevent a liquidity crisis.
Already, the ruble has hit a record low against the dollar (meaning one ruble is worth less than a penny), blocked coupon payments to foreign bondholders, and investors with ruble-denominated bonds have been prevented from selling them, to arrest even further downward pressure on the ruble’s value. They have also forced exporters to exchange 80pc of their foreign currency reserves for rubles, and foreign exchange loans and bank transfers have been banned since March 1st. Sberbank, Russia’s largest lender, has seen shares fall more to near zero on the LSX. We do not yet know the damage on the Russian stock market, since it will be closed until at least the 9th of March.
What is abundantly clear is that the scale of these sanctions have effectively deprived the Russian state of many of the macroeconomic levers usually available to manage an economic crisis. It is now extremely difficult for Russian firms to trade abroad in foreign currencies (which many of Russia’s exporting industries require), and its central economic institutions cannot provide the necessary stabilisation as the funds to do so are now frozen in accounts abroad. As such, the Russian central bank has been forced to drive interest rates extremely high, which will inevitably provide more drag on the Russian economy.
The other key element of the sanctions regime is the extent of the psychological impact. In a widely cited paper, Philip Levy notes that sanctions in South Africa during apartheid likely signalled the extent of international isolation. As one South African bankerput it at the time “South Africa needs the world”. In a similar vein, while likely having a smaller impact, the sanctions on oligarchs coupled with the freezing of the state’s assets will be a very powerful signal to elites that they are now pariahs. It has got so bad that even the Asian Infrastructure Investment Bank – headquartered in Beijing – has announced an investment freeze. This profound pariah status will be felt at the highest levels of the Kremlin.
Sanctioning countries really have inflicted devastating economic pain. The economic fallout could be more severe than the Russian economic collapse in the 1990s. What we need to think about now is a strategy to use loosening sanctions as a carrot (or series of carrots), something explored in an interesting piece by Hoover Institution fellow Michael Bernstam in the Financial Times.
One problem for the UK is that our sanctions regime, at least from Government reports, requires a higher burden of proof to implement than our allies. If this is indeed true, the Government should proceed with emergency legislation without delay. Policy Exchange Senior Fellow Richard Ekins has written today on this subject. One other point the United Kingdom may want to consider are humanitarian exemptions, so that NGOs can conduct legitimate humanitarian business in Ukraine, even if that means transacting with otherwise sanctioned Russian entities. This sort of exemption is already well-established in US law, but not in the UK’s current regime; some MPs have called for this exemption already.
In the short term, the United Kingdom should also prepare its people for an incoming economic shock. Energy prices are rising, as Russian oil and gas is cut off from the market. It’s not just that Russia is itself constraining supply; the sanctions regime put in place has resulted in Russian gas attracting few buyers, even with a more than $20/barrel discount compared to the world benchmark. Estimates suggest that export losses could amount to 3-4 million barrels a day. This week has seen the biggest price increase for commodities on record, and wholesale gas has reached over 500p per therm, another record. Energy price rises coupled with a tight labour market and supply chain shocks will be a significant drag on growth. This is even before considering the very real impacts of a trade slowdown provoked by war on the European continent.
In terms of the international economy, there is an open question as to what these unprecedented actions mean in the long term. Given that, for the first time, a G20 nation’s assets are not safe from its partners, this will no doubt lead to serious discussions in Tehran, Beijing and other capitals about ways to end reliance on the dollar (China’s digital RMB is an example of this). Adam Tooze also posits that the sanctions regime may lead to an unorthodox and expansive fiscal and monetary response from Russian authorities, definitively breaking with the hawkish conservatism and broadly globalised economic outlook for which Russian state institutions were known. At this rate, they have very few levers left to reflate the economy, although departing from standard economic practice also carries inherent risks.
At this juncture, we are also reminded of the continued economic dominance of the United States. With so much of the international economy (oil, for example) still denominated in dollars, it remains the key economic power, and can operate in concert with its allies.
Perhaps the continued US dominance is best exemplified this way: despite the impending war in Europe, US Treasury yields actually fell, as investors sought a ‘flight to safety’ last week. The almighty dollar indeed.