Matthew Boesler wrote . . . . . . . . .
The European Union, the U.S., and a handful of America’s allies in Asia have responded to Russia’s invasion of Ukraine with financial sanctions unprecedented for a target Russia’s size. The steps taken to isolate it within the global financial system are aimed at punishing President Vladimir Putin by sowing chaos in his country’s economy.
In the first week of the conflict, Russia’s central bank was struggling to contain the fallout on its own side of the border, while Ukraine’s was able to maintain a semblance of stability even as it rallied global financial resources around its defense effort.
Central banks have been key players in war finance since their inception. “You can go back to the establishment of the Bank of England in the 1690s, and you can see directly where that establishment was in large part in order to be able to finance wars against Louis XIV, and also to help stabilize the economy during those wars,” says Paul Poast, a political science professor at the University of Chicago.
The Central Bank of Russia was indeed central to Putin’s strategy in the years leading up to the invasion—since 2014, when he annexed Ukraine’s Crimea region and Western nations responded with sanctions aimed at making it more difficult for Russia to transact in the U.S.-dominated global financial system.
The repercussions from that episode were severe. Combined with a collapse in oil prices that year, it sent the ruble tumbling more than 40% against the U.S. dollar, forcing the Russian central bank to enact dramatic interest-rate increases that pushed the economy into recession.
From that point the bank embarked on a massive accumulation of foreign exchange reserves. That stockpile, now the fourth-largest in the world, at around $643 billion, could be deployed to defend the ruble in the event of another crisis. “They have been trying to ‘bulletproof’ their economy from sanctions since 2014,” says Elina Ribakova, deputy chief economist at the Institute of International Finance in Washington.
That bulletproofing came at a significant cost. Hundreds of billions of dollars brought in via oil and gas exports were salted away instead of being reinvested in the economy, which has averaged growth of 1% a year since 2014. In that sense, Russian citizens have already been bearing the cost of the current conflict for many years.
That’s why the new raft of sanctions, and in particular the extraordinary targeting of Russia’s central bank, is such a big deal. Putin was counting on the world’s, and especially Europe’s, reliance on Russian energy exports and investments by a host of marquee foreign corporations to prevent governments from taking extreme measures in the opening days of the invasion. It didn’t work: Just days after Russian troops marched into Ukraine, the U.S., European nations, and other allies topped off a barrage of harsh sanctions by cutting off access to hundreds of billions of Russia’s reserves parked in their jurisdictions. (China did not follow suit.)
With that, Putin’s war chest was effectively cut in half overnight. “At this stage, ‘Fortress Russia’ is going out the window,” Ribakova says. The move to freeze reserves “significantly limits their options in terms of helping the financial sector, looking after common Russians—you know, financing the war effort.”
The financialization of warfare is bringing the social character of money to the fore on a global scale. Or, as Bloomberg Opinion columnist Matt Levine put it: “Russia’s foreign reserves consist, in the first instance, of a set of accounting entries. But in a crisis the accounting entries don’t matter at all. All that matters are relationships, and if your relationships get bad enough then the money is as good as gone.”
And the fallout has been severe. To halt the ruble’s free fall without depleting its greatly diminished stock of foreign reserves, Russia’s central bank instead hiked its benchmark interest rate to 20%. Stagflation is sure to follow as the economy sinks into recession while a weaker currency propels already-elevated inflation higher.
Russian officials also were forced to put stringent controls in place to deter capital flight and stem a bank run that drained some $14 billion in deposits in a single day. Measures included freezing the assets of all nonresident investors, making it impossible for them to liquidate their holdings, and a ban on converting rubles into other currencies. And companies bringing in export revenue from overseas were instructed to sell 80% of their foreign exchange, effectively drafting businesses to help put a floor under the ruble.
The U.S. and Europe also moved to disconnect several major Russian banks from SWIFT, the global messaging system used to facilitate payments between financial institutions. That will force them to figure out complicated workarounds.
If the objective of all these moves is to precipitate a financial crisis in Russia, the strategy seems to be working. One telling indicator: The cost of insuring Russia’s government debt has shot up, with one gauge showing the likelihood of a default had climbed to as high as 65%. Fitch and Moody’s each downgraded Russia’s sovereign credit rating to junk status on Wednesday, saying sanctions would weaken the economy. “In terms of economic war, this is jumping into the void,” says Yakov Feygin, associate director of the Future of Capitalism program at the Berggruen Institute in Los Angeles.
Even if President Volodymyr Zelenskiy succeeds, with a big assist from his friends abroad, in repelling Russia’s attack, Ukraine’s economy will suffer heavily from the physical destruction of the military incursion. Yet unlike in Russia, the central bank at least has been able to maintain liquidity in its domestic financial system to support the nation’s defense. On Day 1 it put a new twist on the central bank’s traditional war-finance role by setting up a crowdfunding account to process donations from foreigners. It has raised almost $200 million so far.
Ukraine’s finance ministry sold 8.1 billion hryvnia, or $277 million, of war bonds paying 11% interest to international investors on Tuesday. It also made a regularly scheduled interest payment of about $300 million on outstanding debt.
International assistance is flooding in through other channels. The U.S. and European countries have already authorized billions of dollars’ worth of funds and equipment to aid Ukraine’s defense, and more is on the way. For the first time in its history, the EU is supplying arms to a country at war, using a financial vehicle it calls the Peace Facility.
Smooth operations at the National Bank of Ukraine offered a modicum of stability on the ground in Kyiv in the first several days of the invasion, even as air-raid sirens were ringing and residents fled to bomb shelters. On Day 7 the central bank eased previously instated restrictions on foreign-currency withdrawals for individuals, lifting the cap to 30,000 hryvnia, or almost $1,000, a day.
Supplies of basic goods are running low in cities sustaining heavy damage from the Russian assault, such as Kyiv and Kharkiv, according to Nataliia Shapoval, chairman of the KSE Institute at the Kyiv School of Economics. But in areas of the country where civilian infrastructure hasn’t been targeted, business is more normal and prices have not been affected. “Macrofinancial stability is important, and the ability of the central bank and ministry of finance to be in control is important,” Shapoval says.
Russia, despite the heavy sanctions, still retains its oil and gas exports as a critical financial lifeline. “We have a situation where energy prices are high, and they may get even higher, and this is a help to the Russian economy,” says Vasily Astrov, an economist at the Vienna Institute for International Economic Studies. “This is a difference to the situation in 2014, when it was a double shock of Western sanctions and falling energy prices.”
The U.S. and the EU have been loath to take any actions that would result in a serious disruption to oil and gas supplies, as they would be on the receiving end of some of the economic repercussions. Russia provides approximately 40% of Europe’s natural gas, and the European Central Bank has estimated that a total shutoff would result in an economic hit equal to 3% of gross domestic product. The resulting spike in oil and gas prices would also stoke inflation, which has become a political problem.
But Ukraine’s allies can keep climbing an “escalation ladder” if they so choose, according to Ribakova, of the Institute of International Finance. The EU is looking at ways to limit access to its ports and waters for Russian vessels, expanding on an earlier ban of Russian flights into the bloc’s airspace. And on Wednesday, the White House announced restrictions on exports of oil technology to the country aimed at “degrading Russia’s status as a leading energy supplier.”
The extent to which the newfangled techniques of financial warfare will prove an effective substitute for old-fashioned troops and tanks remains to be seen. Julia Friedlander, a senior fellow at the Atlantic Council and former U.S. Treasury Department official, worries that the outcome could be a lose-lose situation. “I think this is going to be a conflict that is going to go on for a very long time, and we could very much see it completely destroy Ukraine. That’s my biggest fear: You impoverish Russia through sanctions, but they destroy Ukraine in the process, and no one gets anything.”
Source : Businessweek
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