Ukraine Series: The Economic War Against Russia

The Russian offensive in Ukraine has been carried out along fairly traditional lines—airstrikes, heavy artillery, missiles, and tanks. But the West’s response has been primarily through economic means. What economic instruments is the West using right now against Russia?

Jana Grittersova: The important sanctions have been financial, and as a result of these sanctions, Russia is now effectively locked out of international finance. First, the Central Bank of Russia was prevented from accessing its reserves denominated in euros and dollars. The United States has sanctioned other central banks in the past. For example, in 2019, it sanctioned Venezuela and Iran. But a coordinated action by all Group of Seven (G-7) major industrial countries against a central bank as important and internationally active as the Central Bank of Russia, is unprecedented.

Currently, roughly half of Russia’s $630 billion of foreign exchange reserves have been frozen by international sanctions. At the end of 2021, 16 percent of Russia’s foreign reserves were held in dollars and 32 percent in euros. Countries hold reserves for two reasons: to intervene in currency markets to mitigate currency fluctuations, and, as a war chest or a national strategic buffer. When Russia’s financial system and its national currency come under pressure, then dollars and euros could be sold for rubles. The Russian central bank can support the value of the ruble and slow its devaluation. This would provide a relief to domestic importers and consumers. But without reserve funds to support the ruble, there is very little the Russian central bank can do to prevent the value of the ruble from collapsing.

The second sanction, which is consequential, is that seven Russian banks were disconnected from the SWIFT. SWIFT stands for Society for Worldwide Interbank Financial Telecommunication. It was created in 1973 and is a communication platform that connects 11,000 banks around the world and enables them to make fast and secure cross-border payments and currency conversions. It’s not the payment system itself. It can be replaced by other channels such as emails or telephones. But this would be obviously very lengthy.

Roughly 300 Russian banks communicate through SWIFT. The ban was selective. This selective ban on Russian banks was imposed because Europe continues to rely on Russia for its energy. And there were also concerns that removing all Russian banks would create further turmoil in global energy markets. Since 2014, following the U.S. and EU sanctions after the annexation of Crimea, Russia has developed an alternative platform called the System for Transfer of Financial Messages, which is used as the primary messaging system in 20 percent of Russia’s domestic transactions and includes about 23 foreign banks. But this Russian alternative platform is not as technically advanced as SWIFT and is mostly used domestically.

Vinnie Aggarwal: Jana covered the most important kinds of sanctions that the United States has imposed on the Russians. I agree that what’s distinctive from 2014 is that there’s much more unity now.

What Putin has done is unite the Europeans and the Americans.

It’s also interesting to look at civil society. I have some realist tendencies so I do not believe that civil society on its own can do a lot to the Russians, particularly Putin, who is quite aggressive in these matters. But I still think it’s worth noting that American multinational corporations have now been withdrawing from Russia.

For many years, Russia was very interested in attracting foreign investment and the fact that you have multinational corporations like Boeing and Airbus withdrawing from the market and refusing to supply Aeroflot and other aviation groups with spare parts, will have some impact on the Russians. I don’t think that the boycotts we’ve seen in the United States against vodka will make a difference. But it’s something interesting to think about. I also think that there’s been an effort to talk about the International Olympic Committee, and that also puts some pressure on the Russians.

Sanctions are a blunt instrument meant to induce behavior change by causing economic hardship. Vinnie, do sanctions normally work in general? How often do they achieve their goals? And Jana, do you think sanctions will work in this specific case, against Russia?

Vinnie Aggarwal: Sanctions have had a very mixed history. We’ve tried to sanction Iran, we’ve tried to sanction Venezuela. We’ve seen some behavioral changes. But most of the changes are just running their economy a bit into the ground, and I think that is effective. In the case of Russia, they do have reserves. So, I think going after those reserves was important. But if you’re a very highly motivated actor like Russia, then it’s not clear to me that sanctions will actually force them to pull back their troops. The fact that Ukraine is doing a very good job in resisting the invasion, attacking troops, attacking tanks, is more critical.

Once you start using sanctions, people start looking for alternatives. And as Jana pointed out, the Russians have developed an alternative system. People say we should be sanctioning the Chinese. But of course, this leads them to the next iteration of what we might call the economic sanctions game to develop alternatives. We have to be very careful when we’re using sanctions because global interdependence can be weaponized.

In this case, what I’m most impressed by, and here one has to give Biden credit: he’s been able to get the European allies and other countries to take this very seriously. And the Russians are very annoyed by this and call this economic warfare. It shows that this is having some effect. But whether this will immediately cause a pull out, we have not seen that, nor would I anticipate that.

Jana Grittersova: I agree with Vinnie.

Economic and financial sanctions have become a foreign policy weapon of choice for the United States.

They were used after the 9/11 terrorist attacks, for example, and after Russia’s invasion of Ukraine in 2014. But it looks like this time is different. The size, speed, and sweep of existing sanctions against Russia, supported not only by the United States but also by the entire European Union and several Asian countries, are exceptional. For example, Bruno Le Maire, France’s finance  minister, described sanctions against Russia as an “all-out economic and financial war.”

It’s clear that Putin underestimated Western capabilities and resolve. The only question now is whether the sanctions will be enforced and sustained. We have already seen some immediate effects of sanctions. For example, half of Russia’s foreign exchange reserves are frozen. The Russian stock markets are closed. The value of 31 Russian stocks that are traded in London has plummeted by 98 percent. Russia’s credit rating was downgraded to junk status by all major credit rating agencies, which led to plummeting bond prices and the risk of sovereign debt default. And as Vinnie mentioned, Western firms are departing. In 2014, Western sanctions caused the value of the ruble to drop by 50 percent against the dollar. After that, Russia tried to sanction-proof its economy by building substantial foreign reserves, diversifying those reserves to include more euros and renminbi, reducing the national debt and keeping foreign debt relatively low, around 20 percent of GDP.

But Russia is still heavily reliant on the dollar system and on Western markets. For example, the value of the ruble has now dropped nearly 40 percent against the dollar and it’s expected to continue to plummet. The central bank has also decided to stop exchanging rubles for foreign currencies, which means that the ruble is no longer convertible.

The effectiveness and cost of sanctions, including Russia’s isolation from global markets and loss of access to products and technologies from the West, will depend on two factors. One is the ability of Russia to keep exporting oil and gas to generate export revenues. Europe continues to buy large amounts of oil and natural gas from Russia. And the second is the extent to which China decides to support Russia.

That leads perfectly into my next question, which is: what are the unintended consequences of sanctions? You’ve referred to several of them—they can hasten the formation of alternatives to the dollar and to SWIFT; they can hurt ordinary people more than the government; they can promote nationalism and anger at the sanctioning countries.

Can you both reflect on the unintended consequences? I’m particularly interested in what you think China’s role has been so far and what are you anticipating in that role?

Vinnie Aggarwal: That’s a very important question. There’s still a great unknown in terms of to what extent President Xi wants to throw his lot in with the Russians. A lot of people were looking at the Russian invasion of Ukraine as somehow very strongly related to what China will do with Taiwan. I think, if anything, this has provided a signal that the Western countries are likely to sanction China very aggressively. But in the case of Taiwan, we have a defense alliance, and we’ll probably work directly with the military and go after the Chinese and Taiwan, which would be quite dangerous and lead to a lot of escalation.

The future geopolitical structure is a complicated question because, in my view, at the end of the day, the Russians’ greatest fear is not the United States or the Western Europeans, but the Chinese.

And if I was in demographic decline, as the Russians have been for several years, I would have to start thinking about Siberia and the fact that the closest place to Siberia is China. The Chinese have a very large population. And if I were to make predictions, I would say 20 years from now, we will likely be in an alliance with the Russians against the Chinese, and the Russians will want an alliance with the United States about how they’re going to deal with China.

In the short run, however, I think this has cemented the democracies against authoritarian countries. We have a Sino-Russian alliance in some ways, and the Europeans have been very reluctant to be aggressive towards the Russians. They’re much more reliant on Russian oil and natural gas. And there was, if I may say, some naivety on the part of the Europeans that engaging with the Russians would somehow control Putin’s behavior.

So, I think the unintended consequence is that this is bringing the EU together in a way it wasn’t before. There was no unified EU military position. If I were a betting man, I would say now there will be some effort to create a unified European force. Typically, it’s a crisis of some kind that leads countries to act in a more unified way. And I can’t think of a better crisis or worse crisis, to lead the Europeans into much more unity and cooperation with the United States.

Jana Grittersova: The war in Ukraine and sanctions fuel commodity prices increases. This heightens concerns about energy security and food security. And so many countries, including the members of the European Union, have to rethink their energy systems. We know that most of Russia’s exports are oil and petroleum products and gas and half go to the European Union. And so, one positive unintended consequence of sanctions is that they may accelerate the process of the green transition. European nations will probably seek to diversify their energy supplies and possibly delay plans to close or phase out nuclear and coal power plants. The problem here is that not all EU member countries have enough fiscal capacity to absorb the costs related to the green transition and simultaneously boost their defense spending in response to new security threats. Some countries, such as Italy, have high levels of public debt, while other countries like Germany are more exposed to the effect of sanctions.

Another unintended consequence of sanctions is that in the short term we may see an expansion of oil production to stop the rise of oil and gas prices. And similarly, as in the area of energy policy, many governments, including European governments and governments in the Middle East, may want to examine their food and agricultural policies more closely. I know that in Germany, for example, they’ve tried to scale back meat consumption and popularize alternative protein products.

Last Friday, G7 countries said they would end normal trade relations with Russia, which includes revoking the status that allows Russia to trade goods on preferential terms with many Western countries. How will the global trading system be impacted and remade with the exclusion of Russia? And what will China’s role be in this ecosystem?

Vinnie Aggarwal: I think we need to recognize that the Russians are actually a bit player in global trade. They’re very important in the global trade of energy and gas products. But when it comes to goods and services, they account for less than 2 percent of global trade compared to the 8 percent for the United States and 13 percent for China. To put it in stark terms, Taiwan exported more than Russia did in 2020.

Despite being a very large country in terms of population and size, they’re actually quite a bit player. And under Putin, they’ve let their economy run down in terms of manufactured goods. So really, it’s an all-liquid country: vodka, oil, and gas. I’m not terribly impressed by the Russian economy. The direct effect on the global trading system is very minimal.

Having said that, one should note that oil and gas prices are crazy. And when oil and gas prices go up, that obviously affects global trade because shipping costs become higher and that indirectly affects supply chains. And don’t forget that we are emerging from a time where the economy was very slow [because of COVID-19].

When oil prices are low, some parties that I won’t mention always get very excited, like, isn’t this a good sign of American leadership? No, it’s not. It just means the economy is in bad shape. It’s natural for oil prices to be somewhat high when the economy is booming. Even without this current invasion, oil prices would have continued to rise as the American economy and the European economy recover from the pandemic-induced depression of the global economy.

Jana Grittersova: In terms of global economic impact, there are several channels, through which war and sanctions have global effects. Vinnie mentioned higher energy and food prices, which lead to higher inflation. Higher inflation reduces the purchasing power of households. And obviously, it leads to lower demand. We know that in the United States, for example, inflation reached 40-year highs of 7.9 percent year-on-year in February 2022. Food and energy prices, in addition to rents, were the greatest contributors to this rapid increase in inflation. And we know that central banks facing high inflation may be forced to tighten monetary policy, particularly the Federal Reserve Bank and the European Central Bank. Yesterday the Federal Reserve raised interest rates by 25 basis points. It was its first hike since 2018. But when the Fed increases interest rates to fight inflation at home, this will likely raise the cost of issuing new debt in developing countries and it will also be harder for developing countries to access international capital markets. They can face destabilizing capital outflows, which will lead to weaker currencies and then inflation itself. And there are fears that inflation could become a source of political instability worldwide.

We’ve all heard about IKEA and other big brands pulling out of Russia. What’s happening in critical sectors like energy and I.T. and transportation?

Vinnie Aggarwal: I’ve always been bothered by the fact that there is often a divergence of interest between the interests of the state, that is, the U.S. government or the European governments, and multinational corporations. I teach in the business school, so I am somewhat favorable to global business. But I think naively, a lot of multinational corporations tend to believe that they can go into China and sell a lot of things and everything will be wonderful. What they found out was that the Chinese were able to either borrow, copy, or replicate that technology and sell goods back to Europe. So, that’s an awakening among multinational corporations.

Turning to Russia, Russia has been seen as the frontier market that’s going to be very great. American companies are quite happy to go into Russia thinking that the Russians have an interest in protecting them and everything will be fine. People are now very critical of multinational corporations going into these countries, and we may see more consumer boycotts of companies that are unwilling to cooperate, although, at the end of the day, if you’re an authoritarian country run by a guy like Putin, you can do with a lot of deprivation. And the Russians have a long history of dealing with deprivation under Stalin, and under other leaders as well. It’s naive to think going in is not going to be problematic, and it’s also naive to think they’re pulling out will somehow change Russian or Chinese policy.

In the Financial Times this morning, the chair of one of the major European banks was quoted as saying that the sanctions are the equivalent of a nuclear bomb. And these are international lenders who have lots of Russian staff, Russian customers. Jana, can you tell us a little bit about what this means for the international banks who are engaged in Russia?

Jana Grittersova: The global banks have not fully cut ties with Russia. Some of them departed—Goldman Sachs, JP Morgan Chase, for example. But Citibank, as well as many European banks with large exposures to Russia, such as Deutsche Bank or Commerzbank, have large exposures in terms of loans and deposits have stayed. It’s harder for them to leave the Russian market. Even major global banks like Goldman Sachs continue to sell Russian debt to hedge funds, for example, on the secondary market because trading in secondary markets is still allowed under U.S. sanctions.

For the banking sector, departures are more difficult than for manufacturing firms. As Vinnie mentioned, reputable Western companies, some 400 of them, are not only unwilling to continue buying from or selling to Russia, but they are also walking away from sizable investments there. Companies as diverse as British Petroleum or Shell or Ferrari or IKEA and Mercedes-Benz are leaving Russia. But saying you are leaving Russia is one thing. Getting your factories, equipment, goods and components out of Russia is another thing. And Russia is beginning the process of nationalizing the assets of these companies. It’s going to be financially very costly for Western companies to stay in Russia. But even if they leave, their remaining assets will be nationalized.

There are still some Western corporations that continue to operate in Russia. For example, Hyatt and Marriott continue running hotels there. Halliburton has continued to operate oil fields. Some corporations benefit from this conflict: arms makers, cable news, commodities firms, especially outside of Russia, mining firms and steelmakers, for example. The share prices of U.S. Steel have climbed by 38 percent since the beginning of the invasion. Carmakers are able to pass their costs on to the consumers. For example, Tesla has recently increased prices.

Vinnie Aggarwal: Bankers all get very excited that we’re never going to lend again. But I’ve written a book on debt rescheduling. And the leading explanation is what a banker once told me is the generational theory of lending, which is that after somebody defaults and you go into a big default, whether it’s Argentina, Brazil, Mexico or Peru, you tell your children: listen, never lend to that deadbeat country again. But the children don’t tell their children. Debt rescheduling is kind of a 50-year cycle. Those bankers who are saying “we’re never going to lend again” probably will not lend, but it doesn’t mean that a new generation of bankers will not start lending again. And we’ve seen this repeatedly in countries that have defaulted. I mean, for God’s sake, Argentina is still able to borrow money despite default after default. And a lot of people, as Jana was pointing out, are able to trade debt on the secondary market. And if you settle with the government, you can actually make a lot of profit if you buy debt cheap enough.

As two experts who have long studied, long watched global political economic shifts, as you have watched this unfold over the last month or so, what has surprised you most about what’s happening and what has not?

Vinnie Aggarwal: What has surprised me is that a number of University of Chicago’s students would like to cancel my friend John Mearsheimer. In 2014, John did this video in which he said the Americans are leading the Europeans and the Ukrainians down a path that will be very problematic. And from a realist point of view, John made a very simple prediction that this is going to be a big problem for Ukraine, and the best option, given the Russian sphere of influence, is to have a neutral Ukraine. Everybody gets very excited about this, but if you look at the current negotiations between Ukraine and Russia, they’re actually along these lines: probably some kind of neutrality, probably some kind of giving up some territory and some commitment not to join NATO.

What about you, Jana?

Jana Grittersova: The size, the speed, and the sweep of economic sanctions and financial sanctions, and also the fact that they were supported by all major industrial powers, is a very surprising element.

But I’m worried that sanctions may trigger a reversal in globalization and maybe the creation of two blocs: one oriented around China, and another around the United States.

Countries such as China and India have signaled initial willingness to continue doing business with Russia. Russia’s abundant resources and a desire to break away from the current U.S.-dominated financial system may motivate these countries and other countries to continue economic relations with Russia and move further away from the West. And so, the sanctions may contribute to the global reorientation of economic relationships.

Europe will reduce its reliance on Russian oil and gas, while Russia will have to rely primarily on non-Western allied nations for trade markets. And that could be beneficial to Russia’s relationship with China because Russia is a major provider of key resources that are critical to China’s long-term developmental plans, including energy and critical minerals used in semiconductor industries. On the other hand, Russia imports roughly 68 percent of its computers, semiconductors, and smartphones from China. Russia has expanded its Eurasian Economic Union, a free trade zone, which includes even countries like Vietnam, in addition to Armenia, Belarus, Kazakhstan, and Kyrgyzstan. So I am worried about a new Cold War, but definitely about some negative implications of sanctions or globalization.

Is Ukraine the signal that globalization is finally dead or at least on life support?

Vinnie Aggarwal: I’ve always been somewhat skeptical of the view that globalization is inevitable, and that it keeps moving in a unilinear fashion. I’m working with Tai Ming Cheung, who is the director of IGCC, on the Oxford Handbook on Economics and Economic Statecraft [forthcoming 2023, Oxford University Press]. And the point we’re trying to make in this book is that one must understand political economy and security in a combined fashion.

Most liberal economists, i.e., free market economists, view globalization as an unalloyed good. But the notion that globalization prevents war has simply not been the case. Economists tend to be so focused on the benefits of trade and finance that they forget about the downside and the very great importance of security and security intruding on the global economy, whether it’s business or trade or investment. We really need to have a much more integrated approach of politics and economics.

Jana Grittersova: In terms of the academy, I fully agree with Vinnie that we need to pay greater attention to and explore to a greater degree, the interconnectedness between trade, finance, economics, and security, as well as geopolitics. And we need to look more closely at the role of international factors in domestic policymaking. For the last 20- 30 years, scholars have been exploring the role of various domestic factors influencing foreign economic policies, such as institutions or domestic interest groups. But I think we should take into consideration or look more closely at the role of international politics: interdependence, dependency of countries on, for example, energy or food imports, and on the role of bargaining. So maybe we need better models, game-theoretical models of strategic interactions among governments and of their various bargaining strategies.