Why Putin may not be checkmated by sanctions

It was déjà vu for global financial markets when Russia began a full-scale invasion of Ukraine on February 24, 2022. Eight years ago, in the last week of February 2014, Russian troops had captured strategic locations across Crimea, leading to the installation of a pro-Russian government there.

Immediate repercussions were seen in financial markets with Russian stocks losing more than half of their value, Russian currency depreciating over 40 per cent and yields of Russian sovereign bonds increasing sharply. The reaction of financial markets was led by fears of disruption in trade and supply chains impacting inflation and growth, especially at a time when global economy is trying to get back to its feet.

The above factors appear to have weighed heavily on the US, EU, Canada and their allies while imposing economic sanctions on Russia. For these actions are double-edged swords that impact all countries, and not just the aggressor. This is borne by the dire consequences of the sanctions imposed in 2014 on global commodity prices and growth.

But then, the allies can not be seen to be doing nothing, therefore they have taken some measures. But the impact of these will be far from debilitating or ‘crippling’ as some media reports would have us believe. They could be mere posturing with limited ability to make Russia halt its aggression.

Ban from SWIFT in 2022

The discussed sanction announced so far is the decision by the US, European Union, UK and Canada to cut off some of the larger Russian banks from the international SWIFT (Society for Worldwide Interbank Financial Telecommunication) system. The SWIFT is a messaging system used in cross-border payments between banks with linkages to 200 countries and more than 11,000 institutions.

This ban will however not stop Russian cross-border payments completely. As Jamie Dimon of JP Morgan Chase & Co said in a recent Bloomberg interview, “The SWIFT thing (sanction) says I can’t use a communication (tool) to do business with you. I can still do business with you.” In other words Russian banks have not been banned from transacting with banks from other countries, only they cannot use the cross-border messaging channel. Also, the SWIFT ban is on some Russian banks only.

Besides, there are many alternative channels to the SWIFT system that can be used instead. Payments may get chaotic and delayed until the alternates are worked out, but there will not be a complete halt.

Also, Russian President Vladimir Putin has been preparing for expulsion from SWIFT since 2014. Russia has been working on an alternative system for inter-bank messaging — SPFS (Sistema Peredachi Finansovych Soobscheniy) — since the US and its allies threatened to cut Russia off from SWIFT in 2014. But it is still a work in progress and only 23 foreign banks were connected to it by 2020-end.

Russian banks could however use China’s CIPS (Cross-border Inter-Bank Payments System) and there is also work underway to connect SPFS to CIPS. According to Reuters, 1,280 financial institutions including 23 Russian banks are connected to CIPS towards the end of January 2022.

The US and EU could actually be doing more harm to themselves by this move. If the G-10 countries begin using SWIFT as a weapon to threaten other countries, it will only increase the usage of other financial messaging systems, leading to the weakening of the dollar and euro hegemony.

Partial freeze of Russia’s reserves

The more serious threat held out by the allies is the intention to impose “restrictive measures” on the Russian Central Bank from using its foreign exchange reserves in ways that will “undermine the impact of sanctions”. The EU Commission President has stated that this will prevent the central bank from financing Putin’s war.

Russia has been building a war-chest over the last few years, increasing its foreign exchange reserves to $630 billion towards the end of January 2022. According to Washington Post, as of June 30 last year, 32 per cent of Russia’s foreign reserves were held in euros, 16 per cent in US dollars, 7 per cent in British pounds and 13 per cent in Chinese renminbi.

The sanctions imposed by the allies suggest that Russia’s forex reserves are invested in securities of other central banks and the allies can access them. But this may not be so. The IMF guidelines on reserve management do not specify that forex reserves have to be invested in sovereign bonds only. The guidelines only require the securities to be liquid relatively risk free.

It is highly likely that Putin has learnt a lesson from the US’ freeze of $7 billion of foreign exchange reserves of Afghanistan recently and would have taken steps to secure his forex kitty, moving it away from the reach of other central banks.

According to Bloomberg, Russia held just $4.4 billion worth of US treasury securities towards the end of December 2021 (see chart). It’s likely that Putin has likewise reduced the holding of EU sovereign bonds as well. Another precaution that has been taken by Russia is to increase its gold holdings in forex reserves; from $45 billion in 2015 to $132 billion currently.

Even otherwise, the joint order of the allies speaking about freezing the assets is rather ambiguous and talks about denying access to Russian central bank for certain actions only. There appears to be confusion among the allies on the way to implement the freeze.

Sanctions in 2014

Other economic sanctions against Russia such as limiting sale of citizenship through the golden passport mechanism, freezing assets belonging to members of the Russian elite who are close to Kremlin also seem to have limited impact.

The relatively tentative approach being adopted by US and its allies could be due to the drastic fallout of the economic sanctions imposed in 2014. These countries had then imposed three types of sanctions on Russia.

One, access to Western financial markets and services was denied for Russian state-owned companies in the banking, energy and defence sectors. Two, embargo was put on exports to Russia of hi-tech oil exploration and production equipment. Three, export of military and dual-use goods to Russia was also embargoed. Russia retaliated then by banning import of food items from Western nations in August 2014.

The impact of these tit-for-tat sanctions in 2014 was quite severe on commodity prices with Thompson Reuters CRB index halving in value between 2014 and 2016. This was led by over 70 per cent drop in crude oil prices from $120 per barrel in February 2014 to $39 by January 2016. With Russia slipping into a recession and other commodity producers too badly hit by this collapse, global growth too stalled in the 2014-2016 period.

In a world that is interconnected in every sense, there is no way punitive action can be imposed on one country while insulating others. The allies seem to have realised that and that could explain these ambiguous sanction. Also, each country that is part of the alliance could want to protect its interests while deciding on the kind of sanction that will be imposed, thus reducing the effectiveness of the sanctions.

This episode has just begun and there could be further sanctions in the offing. It is to be seen if the restrained approach to economic sanctions continues.