Battle of the Banks

Sanctions May Humble Putin but Bring Unknown Effects

Author: Sean O’Connell, Graphics: Nina Tagliabue

The BRB Bottomline

 The U.S. and its allies announced new sanctions on Russia targeting foreign assets and removing several banks from the SWIFT payment system. This unprecedented financial penalization could come with unintended consequences.

Frontline Finance

As the fight for Ukraine raged on the streets of the capital Kyiv, a different campaign was being waged in the boardrooms and back offices of the world’s central banks. On February 26, the U.S., EU, South Korea, UK, and other partners announced the removal of Russia’s major banks from the SWIFT electronic banking system and the curtailment of the Russian Central Bank’s (RCB) access to its $630bn foreign reserve stockpile. The CEO of an Oslo-based economic think tank called the move “symbolically speaking, a nuclear bomb in the world of global finance.”

Countdown to Crisis

The decision to curtail RCB assets and remove major state-backed financial institutions from SWIFT comes on the heels of years of evolving financial and trade sanctions. Since the Ukraine Crisis in 2014, the EU and U.S. have taken the lead in imposing sanctions on several Russian banks, energy companies, and oligarchs. Following the Russian invasion of Crimea in 2015, both powers banned security and chemical exports to Russia, with Putin retaliating in kind with import bans on EU and U.S. foodstuffs. 

The use of sanctions to limit Russian expansionism is part of a broader trend. A Treasury Department report from last year found that sanction use had grown by 933% since 2000, “from 912 sanction designations at the beginning of the millennium to more than 9,400 in 2020.” Many experts at the time claimed the sanctions on Russia had too many loopholes and lacked cohesive enforcement, allowing Putin’s government to find workarounds. Indeed, a 2020 Wilson Center analysis found that Russian trade with the EU was barely affected by sanctions in the 2010s. In fact, Russian GDP growth rose from 0.3% in 2016 to 2.8% in 2018 and Russia-EU trade remained robust. 

The initial round of sanctions following Russia’s invasion simply promised a harsher version of the status quo: asset freezes on major Russian banks and government officials, sanctioning 24 Belarussian companies with ties to Russia, and stopping the flow of high-tech exports. Chief among the restrictions was Europe’s decision to refuse Russian energy, representing almost 10% of EU natural gas and 40% of oil imports. This was a huge blow to Russia’s export-oriented energy sector. Further, Germany surprisingly agreed to halt the construction of the Russian Nord Stream 2 Pipeline, designed to transfer cheap natural gas to Europe. 

A former senior State Department sanctions official described the moves as “really pretty tough.” However, the sanctions stopped short of all-out financial onslaught—a tactic intended to mirror escalating tensions while offering the prospect of peace.

The Nuclear Option

On February 24, the situation changed. President Putin declared a “special military operation” against Ukraine and invaded the country on three fronts. Over the weekend, the U.S. and her allies did the unprecedented. As Kyiv faced encirclement and Kharkov endured shelling, the world’s leading economic powers, excluding China, decided to remove several major Russian banks, including Sberbank (the country’s largest), from the SWIFT payment system. 

SWIFT is the internationally accepted electronic payments system used by private banks to make transfers and payments in and between foreign currencies. By keeping Russian banks from participating in foreign currency flows, the international community is attempting to make the Russian ruble and Russian bond market seem like fools’ investments. This, in turn, might destroy domestic economic stability and force Putin to face civil unrest.

The plan seems to be working. Markets opened on February 28 to watch the ruble devalue an astonishing 30%, forcing the Russian Central Bank to more than double interest rates to 20%. Devalued currency might traditionally mean more exports, but with Russia sanctioned it could mean inflation at home, free falls in investment, and the drying up of foreign capital. Shortly after markets opened, Putin announced a ban on foreign currency exchange in order to stop capital flight and greater panic devaluation.

If that wasn’t enough, the Russian Central Bank faces a one-two punch in the form of asset freezes on about 40% of its $630 billion foreign reserves. The RCB holds large quantities of foreign currency deposited in foreign banks as well as very large foreign currency-denominated IOUs (debits) and receipts (credits) from Russian private and government transactions. By freezing assets, reserves cannot be exchanged for other currencies or be used to trade, making the reserves essentially useless. 

This makes Russia’s reserves vulnerable to freezing: the European Central Bank can, for example, simply refuse to fulfill an RCB request to validate a euro-denominated credit. As a writer for the Atlantic described the dilemma, “The dollars, euros, and pounds owned by the Russian central bank—Russia may own them, but Russia does not control them.” Foreign reserves help stabilize the ruble and buffer the economy against hard times, so restricting foreign reserve assets is essentially knee-capping the RCB’s macroeconomic policy options.

Combined, these moves seek to turn the sanctions game from a slap on the wrist punishment to a crippling condemnation hoping to bring the Russian economy to heel. An NBC News estimate claims the restrictions may halt approximately $1 trillion in Russian capital flows in the coming months.

Such extreme measures had only been used once in recent memory: against Iran in 2012, when the U.S. froze the country’s banks by refusing access to SWIFT. The economic effects cut deep and helped push Iran towards the 2015 Nuclear Deal with the United States. Central bank asset freezes are so taboo that you’d have to go back to the 1979 Iranian Hostage Situation to find precedent. But neither has ever been at scale against a great power like Russia. The move is truly nuclear in scale and novelty. And, like any nuclear weapon, it remains to be seen whether these measures will bring Russia towards peace or boomerang back on the West.

The Great Beyond

In the very short term, even the potent sanctions announced last week seem to be doing little to keep Putin from his military objectives. Russian armored columns continue their push to Kyiv, and peace negotiations remain tenuous. The new sanctions did, however, elicit a furious response from the Russian President, who declared the censures “illegitimate” and placed his nuclear arsenal on high alert in retaliation. Nuclear finance has, indeed, become truly nuclear.

But freezing Central Bank assets and cutting private banks out of SWIFT could set a dangerous precedent. Russia is not some small, rogue state; it is a major player in international finance. As one analyst from the Atlantic mused, “Central-bank sanctions are a weapon so devastating, in fact, that the only question is whether they might do more damage than Western governments might wish.” Sending the Russian economy down the drain could result in intense hardships for the average Russian. It also may make Putin’s government more convinced in its present aggressive course. “Win or die” is certainly not the mantra the U.S. and its allies are hoping to encourage by imposing tough sanctions, but Russia’s decision to respond with nuclear preparations might be a bad sign.

Another concern is the long-term viability of such a tough sanction policy. One report from the Times estimates that “A total economic blockade would likely hurt Europe as much as Russia.” This is in large part due to Europe’s heavy reliance on Russian fuels for its industrial and domestic energy needs. The Netherlands, in particular, has huge reliance on Russian energy imports—it is Russia’s second most valuable export market. Germany also stands to lose from stringent sanctions as Russia’s second largest import market, and it was as a result hesitant to chain the EU and U.S. in imposing the harsh SWIFT and asset restrictions. 

Further, upwards of 22% of RCB assets that are now frozen, as well as countless millions in Russian oligarch assets and private banking capital, are stashed away in countries like France and Germany. Russia is unlikely to forgive the way these countries held its foreign assets hostage, even if the crisis resolves itself. Thus, while the EU Commission President currently condemns Putin as “destroying the future of his own country,” prolonged sanctions may endanger the future of many European trade economies as well.
A final concern related to this last round of tough sanctions is more geostrategic in scope. China has long been wary of what it considers American financial heavy-handedness. As the world’s largest foreign currency reserve holder (nearly $3.2 trillion in November 2021), the mercurially unaligned country may need to rethink its asset portfolio to buffer against the types of financial censure facing Russia. A large-scale realignment of Chinese foreign assets by the People’s Bank of China could have global, and largely unknown, consequences.

A Brave New World

Without doubt, the most recent sanctions against Russia represent a seed change from a past defined by more limited, conventional scare tactics. The U.S. and its partners have made one thing clear: financial war is fair game when states disrespect national sovereignty. Putin is learning that his imperial ambitions no longer fit in a world ruled by another empire: global finance. Let us hope then that, in unleashing this new weaponry, the effect will encourage peace rather than desperation. 

Take Home Points

  • The new foreign asset and SWIFT sanctions represent a break with the past in terms of financial sanction strength and breadth.
  • The restrictions are already having an immediate impact in Russia: devaluing the ruble and threatening to completely isolate the domestic economy.
  • Few know what the result of these sanctions will be on the course of the Ukrainian invasion. Putin currently appears unphased and is continuing in his aggressive policy.
  • The long-term impact of the sanctions may hit Russia hard, but could also severely impact European trade and energy markets.
  • Making foreign asset freezes fair game in economic warfare could cause major geopolitical players like China to reconsider their asset portfolios.

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