PAUL DAVIES, SYDNEY
The world has launched an economic war against Russia to stop the war in Ukraine. This will be as decisive as the battles on the ground.
Russia’s invasion of Ukraine challenges the world order. It requires a commensurate response. Russia can escalate war up a ladder that culminates in a nuclear first strike. NATO does not, for now, appear to be climbing the ladder of military escalation. Supplying Ukraine with the weapons to fight for its independence is risky, but not as risky as becoming a co-belligerent.
If Russia dominates the military escalation ladder, however, the major economic powers dominate the ladder of economic coercion, and we are climbing it rapidly. We have the advantage of surprise. We may well be able to impose costs that reverse Russia’s course.
The West’s economic strategy now goes well beyond targeted sanctions. Targeted sanctions were a response to the common criticism that sanctions indiscriminately target the poor. That’s why, until now, we reserved our penalties for Russia’s elite. But Russian elites have proven adept at evading sanctions and insulating their business affairs. We needed a more powerful weapon. That’s what we’re rolling out now.
This economic strategy rests on four pillars: finance, trade, people, and international coordination. The goal of is to give Russia a choice: gain Ukraine and lose the world–or not. These measures target the whole Russian economy.
And there’s more to be done.
RUSSIA IS VULNERABLE
Yesterday, the Kremlin claimed that Russia “has the necessary potential to compensate for the damage” from wide-ranging sanctions. “The economic reality,” said Kremlin spokesman, Dmitry Peskov, “has significantly changed.”
But Russia has a relatively weak economy, one of less consequence to the world than one might think—and the world is of far more consequence to Russia than the Kremlin claims.
Russia’s population has not grown since 1995. A shrinking population means fewer local consumers, fewer growth opportunities for domestic firms, a lower private spending multiplier effect on incomes, and no potential for increasing living standards apart from a boom in trade or productivity. Agriculture and mining apart, productivity growth is not a feature of Russia’s economy. Its trade is dominated by volatile oil and gas markets.
Finance is Russia’s strength and its weakness. Global financial sanctions have been imposed quickly, forcing Russian authorities to react. On Monday, when the sanctions first hit, the ruble fell 30 percent against the US dollar. The Russian central bank immediately raised interest rates from 9.5 percent to 20 percent, but the damage was done.
Hydrocarbons are bought and sold in dollars. Russia’s trade in hydrocarbons is huge. This has helped the Russian central bank build a massive foreign reserve buffer of more than US$600 billion. The IMF says that in a healthy economy, a central bank should hold foreign reserves equivalent to at least six months’ worth of imports. Russia has four times this amount.
But the sudden degradation of the ruble will shorten that period. The disequilibrium in Russia’s currency market will change the price of everything in the Russian economy—from commercial debt to housing and companies. Russians are losing the value of the assets they’ve created. It is not just the Kremlin that will feel the uncertainty and fear, but companies and households. We expect to see runs on Russian banks.
A comprehensive attack on Russia’s sources of finance involves much more than kicking its banks off of SWIFT. It means blocking off trade finance for Russian firms.
Trade requires the Russian central bank to post foreign currency as collateral. Suspending transactions with Russia’s central bank prevents it from doing this. Russia has effectively lost access to global foreign currency markets. Nearly all of the world’s big economies except China and India have frozen Russia’s dollar- and euro-denominated assets.
Russia’s foreign currency reserve is big enough that it will be difficult to block ruble convertibility or exclude Russia, completely and immediately, from trade finance markets. As Adam Tooze shows, Russia’s petrodollars are still circulating through western central banks, where they underwrite a good deal of bank and credit finance. Excluding Russia from the global trade finance ecosystem will be a slow grind. But these measures will eventually cost Russia its capacity to shield itself from currency attacks.
This is a shock to the global financial system, too. The US and the EU won’t find it easy to manage the collateral effects. But the global economy is more liquid and deep, and—more importantly—it is more open. It should be able to maneuver around the damage.
Russia, however, can’t easily circumvent these moves. That would take time, and it would require the use of currencies that don’t trade as freely as the dollar or the euro, such as the renminbi or the Indian rupee.
The coordinated attack on Russia’s foreign reserves sets the clock ticking toward default. Russia’s ability to forestall the time bomb is limited.
CUTTING OFF TRADE
Trade is Russia’s soft underbelly. The economic war doesn’t yet extend to trade. The financial measures are doing that job: Without access to interbank clearance and the foreign currency markets, Russian trade will be profoundly hindered, even in ways direct trade sanctions wouldn’t achieve.
As the economic war grinds on, however, and as Russia contrives means to circumvent the closure of currency markets, trade will become more salient.
Russia is a member of the World Trade Organization. It trades on the same basis as any other sovereign state. It receives the same benefits for its exports as states that don’t invade their neighbors. Should Russia retain its “Most Favoured Nation” status? Not anymore.
The formal WTO legal process for expelling a country is laborious, by design, and perhaps unnecessary. It might be better if governments just placed punitive tariffs on Russian exports until further notice. If Russia’s MFN status can be suspended through coordinated global effort, it will hurt Russia’s trade far more than the financial sanctions it now faces.
But let’s be clear, Russia too can take hostages in global trade. Russia and Ukraine dominate the global supply of certain strategic metals. Palladium, titanium, and neon–the key ingredients in electronics and semiconductors–are mainly sourced from Russia and Ukraine. In 2022, this war will disrupt the global supply chain for everything from semiconductors to computer chips. But the virtue of globally integrated markets is this: They don’t have single points of failure. They provide fast, immediate incentives for producers to respond to shocks.
If Russia’s palladium exports go offline, supply will ramp up elsewhere, even if palladium will cost more. Investment will be mobilized in Canada, South Africa, Zimbabwe, and the United States. These countries have proven palladium reserves and a better investment climate. It will take time, to be sure, but the electronics supply chain will become more resilient, permanently weakening Russia’s ability to take economic hostages.
Dependence on Russia’s oil and gas, many feared, would be the critical weakness undermining a cohesive Western sanctions response. These fears have not been borne out. Germany’s cancellation of Nordstream 2 and Chancellor Olaf Scholz’s Sunday statement that Germany would “change course” in energy policy—putting nuclear, LNG and coal extension back on the table—neutralizes the long-term threat of Russian countermeasures.
RUSSIA WILL LOSE
Russia may well respond by imposing barriers to Western exports. Who would lose in this scenario?
In 2020, Russia imported US$43 billion worth of nuclear reactor devices, US$29 billion in electrical machinery, US$18.5 billion in transport rolling stock, US$11 billion in pharmaceuticals, US$18 billion in plastics, US$8 billion in optical or visual equipment, US$5 billion in steel products and $5 billion each of fruits and organic chemicals. These numbers are not as big as they seem. Russia is not the leading market for any of these products, nor is it the main market for any trading partner. Restrictions on trade with Russia will barely affect its trading partners while imposing profound damage on Russia’s economy.
In some sectors, like food grains, Russia has pockets of competitiveness. Its farms have benefited from better mechanization, mostly with Western technology. Russia still imports more food than it exports, but it’s one of the world’s largest producers of wheat.
The way to target this is obvious: Prohibit sales to Russia of agricultural technology such as tractors, farm equipment, and pesticide. Ban food exports to Russia. The next growing season will be affected by the lack of trade finance for seeds, new machinery, and the higher cost of debt for tasks like planting and harvesting before crop sales in the autumn. A supply crunch of equipment to Russian agriculture will add to the pressure. Sanctions may shift Russia’s resources to domestic self-sufficiency, which would reduce the productivity benefits it gains from global competition. Under this scenario, Russia won’t starve, but its farms won’t thrive, either.
Would this pose a risk to the global food supply? At the margins, perhaps. But Russia’s food exports are mostly interchangeable bulk commodities. If they’re withdrawn from global markets, competing suppliers can replace them. A slightly higher price for wheat could motivate exporters in Argentina and India or provide incentives to millet producers in Ethiopia. None of this would undermine global food security.
Ukraine’s heroic fight has inspired the severity of these coordinated Western measures. An economic war aims to achieve economic damage. The costs of maintaining such an effective and coordinated approach will grow with time.
But the damage is more easily reversible than the damage from kinetic war. A bridge destroyed, an airfield bombed, an apartment building blown up—that is the kind of damage that takes years to repair, and lost lives can never be recovered. An asset’s value can be regained faster; an interrupted flow of funds can be turned back on.
The world is giving Russia a choice. If you persist with your violence in Ukraine, you will watch your economy dissolve, alone. If you come to the table, we’ll restore your connection to the world.
If Ukraine falls, the short-term costs to Western banks, manufacturers, and energy consumers will rise. There will be calls to dilute these measures. That’s when the world’s resolve will be tested.
When Russia comes to the table, we must have a credible offer to make. We can’t leave the Russian state with no good options. Russia’s history shows that it is a lung: When pressed from the outside it shrinks, holds its breath, and absorbs invasion—think of the Golden Horde, Napoleon, Hitler. Russia also breathes out and expands when it senses an opportunity–think of Peter the Great and Stalin.
Putin’s war is Russia breathing out. The world’s economic war on Russia should be a jolt to the solar plexus that makes them breathe in again.
Paul Davies is a former Australian diplomat, trade negotiator, ministerial adviser, and DC-based trade and investment consultant.