“We are going to wage a total economic and financial war on Russia,” French Finance Minister Bruno Le Maire told radio listeners on 2 March. “We are going to cause the collapse of the Russian economy.”
Former Russian President Dmitry Medvedev responded with a tweet: “Watch your tongue, gentlemen! And don’t forget that in human history, economic wars quite often turned into real ones.”
Le Maire later backtracked, but he wasn’t wrong. JPMorgan expects the Russian economy to contract by 35% in the second quarter of 2022, a contraction similar to that seen during the country’s devastating 1998 financial crisis.
“We shouldn’t be underplaying it to Western audiences,” says Maximilian Hess, a fellow of the US-based Foreign Policy Research Institute. “We have to refer to it as an economic war.”
Unlike previous rounds of sanctions, implemented after Russia’s annexation of Crimea and the poisoning of Sergei Skripal, the latest sanctions represent not simply a punishment or a deterrent against future aggression but a direct intervention in an active conflict.
What does it mean for such sanctions to succeed? The new sanctions regime seeks to end the war on Ukraine by exacerbating two ongoing crises: the Russian military’s crisis of logistics and the Russian government’s crisis of legitimacy.
Draining Russia’s coffers
With Russian troops facing strong, and seemingly unexpected, resistance from Ukrainians, the costs of the war are likely to vastly exceed whatever Vladimir Putin’s government had budgeted for. With that in mind, one element of the sanctions strategy has been to strike directly at Russian government finances.
The most significant move in this regard has been the bans announced by the US, EU and UK on trading Russian sovereign debt, bans that will significantly raise borrowing costs for the Putin regime.
In the short-term, however, the Institute of International Finance expects that Russia’s own banking sector could make up for any shortfall in government funds induced by the sovereign debt restrictions, ruling out the kind of immediate budget crisis that would bring the war effort to a screeching halt.
That is partly the result of deliberate preparations. Since 2014, the Russian government has consistently traded growth for fiscal consolidation, imposing harsh austerity measures in an effort to reduce government borrowing and reorient it to the domestic bond market.
These efforts paid off. The deepening of domestic financial markets allowed a dramatic increase in borrowing during the Covid-19 pandemic to be funded with little help from abroad, while years of fiscal consolidation were evident in Russia’s remarkably swift return to budget surplus in 2021.
Western powers are also mulling an embargo on Russia’s energy sector, an industry directly responsible for government revenues equivalent to more than 6% of GDP each year.
It is worth noting, however, that less than one-quarter of this would be immediately impacted by sanctions – the rest is accrued from taxes on extraction, which would only decline in the medium term.
That time horizon would give Russia an opportunity to seek out demand in other markets, although its ability to do so will depend on its capacity for liquefied natural gas (LNG) liquefaction (currently just 5% of global capacity, according to GlobalData, but set to rise to 9% by 2025) and progress with its planned pipeline to China.
Hitting Russia's supply lines
Western powers have also sought to degrade Russia’s military capability by targeting its supply lines. Since an energy embargo would be of little use against a fossil fuel superpower such as Russia, the US has opted to use its leverage in global technology markets, most notably in the form of an embargo on the export of semiconductor chips.
Semiconductors are a long-standing weak-point of the Russian military-industrial complex, so the ban poses a serious threat to Russia’s ability to access advanced weapons systems. While the US is only a minor player in the actual manufacturing of semiconductors, the vast majority of high-end chips rely on US-patented technology and will therefore be impacted by the embargo.
Chinese companies supply 70% of Russia’s chips and might well choose not to abide by the sanctions, but these chips are typically of lower quality and not suitable for more advanced applications. The main global producer of high-end semiconductor chips, Taiwan’s TSMC, has pledged to cooperate with the sanctions.
Chip manufacturers have also been preparing for the potential of Russian counter-sanctions since 2014, weaning themselves off vital Russian and Ukrainian inputs (neon gas and palladium).
Analysts expect the primary impact to be a degradation of Russia’s military systems over the longer term, reducing its ability to keep up with technological developments in the US and China. However, given the Russian military’s widely reported logistics failures, there could be acute effects.
The secrecy that surrounds military technologies and logistics means that accurate information on Russian stockpiles of equipment now affected by the sanctions is hard to come by. A shortage of trucks appears to be a major component of the crisis, but truck supplies are unlikely to be affected in any significant way by the chip ban. More promising are reports that Russia is running low on advanced weaponry, such as the Kalibr missile.
“The guidance system, the seeker head and other critical modules [in the missile’s front end] contain about 60% imported electronic components,” a Ukrainian defence enterprise director told industry magazine Breaking Defence. “None of these will be available after the long list of sanctions being imposed on Russia now, so it is hard to see where any new missiles would ever come from.”
Even if Russia does run down its stockpiles of such hardware, the US chip ban faces potential issues of enforcement. The complexity of global semiconductor supply chains means that US enforcement of the embargo will rely to a large extent on voluntary disclosures from manufacturers. Moreover, if a major manufacturer is found to be breaking sanctions, enforcement of secondary sanctions would risk exacerbating the already severe global supply shortage – a shortage that is already having dire effects on the US automotive industry.
A declaration of (economic) war
For Ukrainians on the brink of death and subjugation, it is the short run that matters. In that timeframe, the most consequential sanctions on Russia are likely to be those that aim to, in Richard Nixon’s memorable phrase, “make the economy scream”.
“If your economy is not functioning it is difficult to wage war,” says Peter van Bergeijk, professor of international economics and macroeconomics at Rotterdam’s Erasmus University and editor of the 2021 book Research Handbook on Economic Sanctions. “That is the basic mechanism of across-the-board sanctions.”
This is where the real impact of the sovereign debt market sanctions has lain so far; they have helped thrust Russia’s financial system into a sudden liquidity crisis, leaving banks struggling to fulfil their obligations to depositors, creditors and regulators and contributing to bank runs across the country. As of 5 March, when the central bank stopped publishing data, the shortfall stood at Rbs4.3trn ($31.5bn).
That crisis has been amplified by Western powers’ efforts to force a depreciation of Russia’s currency, the ruble. Several major Russian banks have been removed from Swift, the global financial messaging service that serves as the backbone of international and inter-bank payments.
Without access to Swift, Russian banks and businesses will struggle to make the international transactions necessary for trade, foreign investment and loan repayments. The decision of Visa and Mastercard to withdraw their support for cross-border payments involving Russian banks has dealt a further blow to such transactions.
The effects have been devastating and immediate, with the ruble losing 42% of its value against the euro in recent weeks. That means higher prices for imports and debt repayments, feeding into general price inflation.
In normal times, Russia’s central bank would be expected to deploy its sizeable foreign currency reserves in order to stabilise the ruble – buying up rubles in order to buoy the currency’s value in foreign exchange markets. That response has been deliberately hamstrung by Western powers, which have frozen whatever reserves are currently under their jurisdiction.
Russia, however, has been quietly preparing for such an eventuality. Ever since 2014, the government has been steadily stockpiling international reserves, de-dollarising them and physically relocating them from Europe and the US to China and Japan. Since 2016, Russia’s foreign currency reserves have grown from $377bn to $498bn, while the share located in Nato countries fell from 93% in 2013 to just 46% in 2021.
Yet, Russia seems to have been complacent about the risk of placing its cash in the hands of non-Nato Austria and Japan, both of which have signed up to freeze their share of the central bank’s assets (17%), alongside the rest of the EU, the US and the UK (46%).
Russia has also been busy bolstering its already-strong balance of payments, which in the months immediately prior to the invasion was the strongest it had ever been. That will provide a crucial safety buffer to prevent depreciation-induced import price inflation spiralling into a much deeper currency crisis.
Another element of Russia’s preparations has been the creation of home-grown alternatives to Western-controlled financial infrastructure. Russia’s alternative to Swift, called SPFS, currently handles about 20% of all domestic traffic and, according to the IFF, should be able to handle all of it if necessary. The central bank has even been developing its own alternative to Visa and Mastercard. Mir, launched in 2017, currently accounts for about 30% of all payment cards in Russia.
Neither SPFS nor Mir, however, are truly ready for use in facilitating international transactions. Efforts to link SPFS with China’s equivalent, CNAPS, have yet to see the light of day, while Mir’s only real international coverage is popular Russian tourist destinations.
“There is a difference of opinion about what [sanctions strategy] works best,” says van Bergeijk. “There is one school that says you have to start small and increase the pressure all the time, because it makes every next step more credible and you need to be able to escalate.
“The other school says that if you don’t do the big stuff straight away then the economy will have time to make preparations. I tend to be in the second school – the sanctions in 2014 didn’t work and they gave Russia time to prepare.
“I think the sanctions so far are relatively weak, compared with what could be done. There is a lot of restraint. The energy sector isn’t quite business as usual, but it is still continuing on a large scale.”
A question of energy
Despite making up half of Russia’s exports and a significant portion of government revenues, the country's energy sector is exempt from financial sanctions and has yet to be hit with any meaningful trade restrictions.
Were Russia’s energy exports to be cut off tomorrow, the country would be plunged into an immediate balance of payments crisis (energy exports are equivalent to about 85% of the country’s imports). Even a partial energy embargo, excluding Russia’s closest economic allies and making an exemption for gas, would be painful.
The reason behind Europe’s reticence to pull the plug on Russian gas is simple: with energy prices already soaring across the continent, further supply disruptions would entail potentially disastrous costs at home.
Reserves are already at an all-time low for the first few months of a year in many countries, largely due to a period of unusually low supplies from state-owned Russian company Gazprom – possibly another element of Russia’s war of position. Gazprom-controlled storage sites account for just 10% of European gas storage capacity but half the storage deficit.
According to analysis by Bruegel, a total disruption of Russian gas flows into Europe would not lead to any immediate crisis. In the absence of an unexpectedly cold spring, Europe would make it into summer without running down its reserves entirely.
Whether it could survive the following winter is another matter. Bruegel forecasts that a total shutdown of Russian gas imports would leave Europe without gas by January 2023. Overcoming this shortage would demand unprecedented imports of LNG, but with global supplies already under strain this would require both diplomatic wrangling and massive expenditure.
Even if the gas was secured, Europe may lack the necessary processing infrastructure to deliver it to much of the continent. There is still much uncertainty surrounding this issue – while Europe’s pipeline operators do conduct an annual modelling of different supply disruption scenarios, a sudden halt to Russian imports is, inexplicably, not among them.
According to Bruegel’s analysis, even if distribution issues were solved the additional supplies would be insufficient, making it necessary to reduce demand. Halting Germany’s phase-out of nuclear power and rapidly deploying solar farms and heat pumps would only go so far, making up for about half of the deficit. In the absence of significantly reduced domestic and industrial consumption, a turn to coal would be the only way out.
Could the West embargo oil, which is relatively easy to replace, while keeping the gas flowing? That is the plan being floated by the Biden administration, which has even been talking to regional nemesis Venezuela to discuss its re-entry into the US oil market.
Europe may hesitate at the thought that Russia could simply turn off the gas in retaliation. That prospect becomes more likely the more sanctions take hold – there is, after all, little purpose in Russia earning foreign currency that it cannot spend.
Russia's descent into pariah state status
Despite the carve-outs for energy, the impact of sanctions on Russia has been swift and devastating.
Unable to counter the sale of rubles with its own reserves-funded purchases, the central bank has been forced to try and halt them altogether through direct capital controls and a steep hike in interest rates. It has also sought to effectively commandeer corporate profits into its international reserves by requiring Russian companies to convert 80% of their dollar and euro earnings into rubles, all while taking emergency measures to stave off a liquidity crisis.
“This is all horribly unprecedented,” says Hess. “Russia is going to be a global economic pariah for the foreseeable future. The ruble is going to go down further. The fact that it hasn’t seen so much pain now is because the central bank’s actions have stopped a lot of those losses from being realised.
“It is guaranteed that Russia will be facing a collapse in living standards at least as bad as the 1990s. That is something really horrifying for my friends in Russia.”
Targeted attacks on civilians have long been forbidden by international law, but targeted immiseration is another matter – even if, in cases such as Yemen or Iraq, this distinction can be difficult to justify.
Not so in Ukraine, where direct military intervention would risk a nuclear confrontation. Until 2022, one could argue that the nuclear age had ended great power wars. In fact, it merely removed most of the tools available to fight them. Two remained, the blockade and the bomb, and it just so happened that neither made much of the distinction between combatants and civilians.
Ethics aside, immiserating Russians on its own does nothing to aid Ukraine. That will depend on whether the Russian government responds to the sanctions by changing its behaviour, or whether the Russian people respond by changing the Russian government.
That is a big ask in a country in which activists and journalists face harassment, imprisonment and assassination.
“I have tremendous faith in the Russian people, but I don’t want to sound too much like I think the Russian people are going to start a revolution tomorrow – I don’t think that," says Hess. "It is great how many Russians we are seeing speak out so far, but it is still nowhere near critical mass and the Putin regime is a very consolidated regime.”
Is Putin immovable?
With Putin having staked his premiership on the success of the invasion, expecting him to back down in response to sanctions might also be unrealistic.
“The reason Saddam Hussein didn’t give in to sanctions in the 1990s was that it would have meant the end of his reign and probably of his life,” says van Bergeijk. “I think that is how dictators evaluate what is happening to the economy: what is the cost of giving in?”
In a 2012 interview, Putin’s former long-time political strategist Gleb Pavlovsky warned that Russia’s elite would be unlikely to go down without a fight.
“In the Kremlin establishment, ever since Boris Yeltsin’s 1993 attack on the Parliament, there has been an absolute conviction that as soon as the power centre shifts, or if there is mass pressure, or the appearance of a popular leader, then everybody will be annihilated," Pavlovsky told the Guardian’s Tom Parfitt. "It is a feeling of great vulnerability.
“Our state is a unique hybrid of an insurance company and a casino. Everyone is guaranteed that they won’t fall below a certain level, while at the same time, a great gamble is being played with their money on the world market – but people won’t burn down an insurance company, because their insurance would go up in flames with it.”
Assuming that Putin is indeed domestically unassailable, could Russia’s military offensive survive its economic woes? The present situation is not quite unprecedented.
The build-up of Italian troops near Ethiopia in 1935 led the League of Nations to threaten punishing sanctions should Benito Mussolini invade, threats it was soon forced to make good. The plan was to drain fascist Italy of its foreign currency reserves through an import embargo, with the result that the country would have no means of paying for the imports that kept its army moving (in particular, oil). The hope was that, given Italy’s persistent current account deficit, the reserves would run out before the invasion was complete.
Yet, by cutting down on civilian imports, stockpiling essentials and building up its reserves, Italy was able to survive the financial onslaught for the seven months it took to reach Addis Ababa. (Unlike Mussolini’s Italy, Putin’s Russia enjoys both energy independence and a healthy current account surplus.)
Why did the League of Nations not go further? It had considered a direct ban on selling oil to Italy, but feared this would be undercut by oil companies in non-member states, namely the US. Meanwhile, penny-pinching European treasuries ensured that Ethiopia’s desperate pleas for material assistance went unheeded. The progress of US efforts to deliver warplanes to Ukraine will determine whether that chapter of history is repeated.
The sanctions against Italy did more than fail, however. As economic historian Nicholas Mulder notes in The Economic Weapon, which was released in March 2022, they also had the effect of forewarning the era’s other revisionist powers about what the League of Nations had in store for them. Germany and Japan immediately began stockpiling their own foreign reserves and more aggressively pursuing self-sufficiency.
In Japan’s case, that meant empire building. Sanctions-avoiding autarky was one motive behind the invasion of French Indochina, which in turn led to the other episode of sanctioning that most closely parallels the present-day Western sanctions on Russia.
In 1941, the US froze Japan’s New York-based foreign currency reserves in an effort to throw its economy into a tailspin, forcing a military withdrawal. The US ambassador at the time, however, was sceptical of the “theory put forward by many of our leading economists” that sanctions would bring about the collapse of the country’s military government.
The regime was backed into a corner, but withdrawal was unthinkable. Five days after the sanctions were imposed, Emperor Hirohito asked the head of his navy, Admiral Osami Nagano, whether he still thought war with the US should be avoided.
“I have not changed that principle,” Nagano replied, “but because our supplies are gradually diminishing, if we are going to fight, I think the sooner we do, the better.”
More coverage of the Ukraine invasion from Investment Monitor:
- ‘Who’s going to travel here or invest now?’: The impact of the Ukraine crisis
- Taiwan’s semiconductor ban could spell catastrophe for Russia
- Which countries are most exposed to interruption in Ukraine food exports?
- The impact of the Russia-Ukraine conflict on trade
- From Soviet steel to modern missiles: The Indian-Russian alliance explained
- What impact will the Ukraine invasion have on wheat prices?
- From hamburgers to helmets: How foreign companies in Ukraine are supporting the war effort
- Tax havens blur who Russia’s allies are when it comes to investment
- Germany’s stance on Ukraine-Russia dispute isn’t just about gas
- Why central bank sanctions should have Putin and Russia worried
- Ukraine: an FDI snapshot
- The impact of the Russia-Ukraine conflict on real assets
- Which multinational companies are most exposed to the Ukraine-Russia conflict?
- Institutional investors respond to the Russian invasion of Ukraine