LONDON — Western nations have responded to Russia’s invasion of Ukraine with a raft of sanctions intended to cripple the country’s economy, and economists suggest it could work.
The G-7 (Group of Seven) major economies have imposed unprecedented punitive sanctions against the Central Bank of Russia along with widespread measures by the West against the country’s oligarchs and officials, including Russian President Vladimir Putin.
Key Russian banks have been barred from the SWIFT international payments system, preventing them from secure international communication and ostracizing them from much of the global financial system.
Sanctions announced by the U.S. over the weekend also targeted the National Wealth Fund of the Russian Federation and the Ministry of Finance of the Russian Federation.
They also effectively prohibit western investors from doing business with the central bank and freeze its overseas assets, not least the vast foreign currency reserves the CBR has used as a buffer against the depreciation of local assets.
In the latest crackdown on Moscow, U.S. President Joe Biden announced Tuesday that Russian flights would be banned from U.S. airspace, following similar decisions by the EU and Canada.
French Finance Minister Bruno Le Maire on Tuesday told a French radio station that the aim of the latest round of sanctions was to “cause the collapse of the Russian economy.”
The Russian ruble has plunged since Russia invaded its neighbor last week and hit an all-time low of 109.55 against the dollar on Wednesday morning. Russian stocks have also seen massive sell-offs. Moscow stock markets were closed for a third consecutive day on Wednesday as authorities looked to stem the bleeding in local asset prices.
Meanwhile, the country’s largest lender, Sberbank, exited its European operations and saw its London-listed shares fall more than 95% to trade at a penny. Shares of the country’s other major players on the London Stock Exchange, including Rosneft and Lukoil, also collapsed.
The CBR on Monday more than doubled the country’s key interest rate from 9.5% to 20% in a bid to curtail the fallout, but analysts believe the move to freeze its foreign exchange reserves is the key to blocking its ability to stabilize the Russian economy.
Swedish economist and former Atlantic Council senior fellow Anders Aslund tweeted on Wednesday that the western sanctions effectively “took down Russian finances in one day.”
“The situation is likely to become worse than in 1998 because now there is no positive end. All Russia’s capital markets appear to be wiped out & they are unlikely to return with anything less than profound reforms,” he added.
Facing a ‘serious financial crisis’
“While previously the CBR could rely on its reserves to smooth out any temporary volatility in the Ruble, it is no longer able to do so. Instead, it will need to adjust rates and other non-market measures to stabilize the Ruble,” said Clemens Grafe, chief Russia economist at Goldman Sachs.
“Limiting Ruble volatility without adequate reserves is more difficult and the Ruble has already sold off, with implications for inflation and rates.”
Goldman Sachs has raised its end-of-year forecast for Russian inflation to 17% year-on-year from a previous projection of 5%, with risks skewed to the upside given that the ruble could sell off further, or the CBR may be forced to hike rates further to maintain stability.
Economic growth is also expected to take a severe hit, and the Wall Street giant cut its 2022 GDP (gross domestic product) forecast from a 2% expansion to a 7% contraction year-on-year, though Grafe acknowledged uncertainty surrounding these figures.
“Financial conditions have tightened to a similar level to 2014 (Russia’s annexation of Crimea), and hence we think domestic demand will contract by 10% [year-on-year] or slightly more,” Grafe said.
“While exports are, in principle, not significantly restricted by the sanctions so far, we expect them to contract by 5%yoy because of the physical disruption of exports through the Black Sea ports, which are instrumental for dry bulk exports, and the risk of sanctions reducing other exports.”
This scale of decline is similar to the 7.5% fall during the 2008/9 financial crisis and the 6.8% contraction during Russia’s financial crisis in 1998.
“The ratcheting up of Western sanctions, alongside a tightening of financial conditions and the prospect of a banking crisis, mean that Russia’s economy is likely to experience a sharp contraction this year,” Liam Peach, emerging markets economist at Capital Economics, said in a note Tuesday.
Although the outlook remains highly uncertain, Capital Economics’ baseline forecast is for a 5% contraction in Russian GDP in 2022 compared to its previous forecast for 2.5% growth, and for annual inflation to reach 15% this summer.
Peach suggested that a worst-case scenario for Russia in terms of international sanctions would involve restrictions on the flow of oil and gas, which represents about half of all goods exports and a third of government revenues.
“Restricting these would also choke off a key source of dollar incomes for energy companies that have FX debts and perhaps cause a much more significant financial crisis in Russia,” he added.
Depth of recession depends on exports, China
Steven Bell, chief economist at BMO Global Asset Management, said Russia is now facing a “serious financial crisis,” with the role of China becoming ever more important to Moscow due to its demand for raw materials and energy.
“Russia has also moved a large portion of their foreign exchange reserves into the Chinese currency and switched their payment systems to Chinese banks. China may hold the key to Russia’s ability to sustain the conflict,” Bell added.
As yet, there are no sanctions on Russian exports, and SWIFT exclusions are targeted at specific banks to allow export payments to continue being processed. Goldman Sachs’ Grafe suggested that this might not be the case much longer.
“The willingness of the G7 to incur costs is rising and it might ultimately imply that restricting Russian exports and accepting higher commodity prices could become politically feasible,” Grafe said.
A major constraint for Russia is its inability to use its foreign exchange reserves to underwrite the ruble, but Grafe suggested this could be overcome by changing the ruble’s reference currency to the Chinese yuan from the U.S. dollar.
“This would also allow the CBR and the Ministry of Finance to adhere to their fiscal rule that channels the excess fiscal savings due to higher oil prices into foreign assets,” he said.
However, creating a cross-currency market would need full cooperation from Beijing, which Goldman Sachs sees as unlikely given the risk to China of secondary sanctions for helping Russia sidestep western sanctions.
China’s banking regulator on Wednesday said the country opposes and will not join financial sanctions against Russia. China’s Ministry of Foreign Affairs has thus far refused to call the attack on Ukraine an invasion, instead promoting diplomacy and negotiations.
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