Will Russia or the West Win the Economic and Financial Battle?

Originally published at Project-Syndicate | September 1st, 2022

After six months of unprecedented Western sanctions, Russia’s economic situation, though bad, is arguably better than most observers expected. This does not bode well for the outcome of the West’s financial war against the Kremlin.

PARIS – Six months ago, the West faced a dilemma: It could neither let Russia’s aggression against Ukraine succeed, nor send troops to fight President Vladimir Putin’s invading army. So, it chose to provide weapons to support Ukraine’s resistance, and to wage its own economic and financial war against Russia in the hope of weakening it significantly. Within days, Western powers deployed an unprecedented array of sanctions; the “shock and awe” effect was expected to compel the Kremlin to pay dearly and possibly force it into submission.

As The Economist has documented, the sanctions comprise three elements. First, there have been high-profile but trivial measures such as travel bans and the seizure of Russian oligarchs’ yachts and villas. Second, extraordinary financial punishments have been imposed, especially the freezing of the Russian central bank’s reserves and the exclusion of selected Russian commercial banks from the SWIFT interbank messaging system. Third, a comprehensive ban on technology exports to Russia was put in place, coupled with pressure on Western multinational firms to withdraw from the Russian market.

The really novel sanctions were the financial penalties. Since World War II, such measures had been applied only rarely and to relatively insignificant financial players such as Iran and Venezuela. None of the West’s confrontations with the Soviet Union had elicited such a response. And it was more than a year after Nazi Germany invaded much of Europe in 1940 that German assets in the United States were frozen. But when Russia attacked Ukraine in February, the West responded within days.

The US, the European Union, and the United Kingdom weaponized their control of critical financial infrastructure – a possibility foreseen by Johns Hopkins University’s Henry Farrell and Georgetown University’s Abraham L. Newman in a 2019 paper. Previously, foreign-exchange reserves were presumed to be nearly untouchable and akin to inviolable property. For that reason, many countries, especially in Asia, started accumulating reserves after suffering under harsh International Monetary Fund conditionality in the late 1990s.

Global currencies, especially the US dollar, were regarded as a sort of public good. The same was largely true of SWIFT. Although the system is legally private (it is a cooperative under Belgian law), it serves as a common market infrastructure and, until February this year, had no meaningful rival. What the Western response to Russia’s war indicated, however, is that these were in fact conditional public goods.

Such conditionality could carry legitimacy if there were widespread support for excluding a country from access to global public goods because of its deviant behavior. Had the vast majority of G20 countries adopted a common position regarding financial sanctions against Russia, this would have been the case.

But that did not happen. Soon after the G7 and Australia announced financial sanctions, China, India, Indonesia, Turkey, Argentina, Brazil, Mexico, and South Africa issued similar statements to explain why they were not joining the Western sanctions. The G20 was split.

Could the West have built a larger coalition? It was in too much of a hurry to try, and China would have abstained anyway. At a deeper level, the Global North’s selfishness and erratic behavior have wrecked trust.

The other necessary condition for the financial sanctions to succeed was effectiveness. For a while, the shock seemed strong enough to destabilize the Russian economy. The ruble initially collapsed, inflation skyrocketed, interest rates soared, and output dwindled. Six months on, however, Russia’s economic situation, though bad, is arguably better than most observers expected.

Clearly, the shock from freezing Russia’s central-bank assets has been offset by continued revenues from oil and natural gas exports. Russian oil is trading at a smaller discount than it was three months ago. Although the EU has been reluctant to exclude gas-focused Russian banks, such as Gazprombank, from SWIFT, ban oil imports from Russia completely, or apply a tariff to imports of Russian gas, in the hope that Moscow would implicitly agree to continue exporting energy, Putin has turned natural gas into an economic weapon. The EU has also lacked unity: Greek shipowners are busy transporting Russian oil, the French company TotalEnergies is still drilling in Siberia, and Hungarian Prime Minister Viktor Orbán openly opposes sanctions.

Experts are divided regarding the sanctions’ effectiveness. Yale’s Jeffrey Sonnenfeld maintains that they are crippling the Russian economy, while Elina Ribakova from the Institute of International Finance thinks they are proving porous. The evidence points to lower-than-expected effectiveness but to a longer-term impact for measures restricting Russia’s access to foreign state-of-the-art technology. In other words, the Russian economy is not collapsing, but its growth outlook has deteriorated and will weaken further.

This does not bode well for the outcome of the West’s financial war. With natural gas currently trading in Europe at the equivalent of more than $400 per barrel of oil, Russia will enter the autumn in a position of financial strength. It is increasingly obvious that the Kremlin will impose a selective ban on gas shipments to a divided EU. Putin may lose in the longer term, but the EU may suffer defeat in the financial war before Russia loses the economic war.

If that were to happen, the West would have squandered its control of globalization’s monetary and financial infrastructure. While Europe and the US are no longer globally dominant in terms of output, trade flows, or even technology, they remain for the time being unrivaled monetary and financial powers. By signaling that the public goods they are offering are in fact conditional, the Western powers have already weakened this privilege and accelerated the search for substitutes. By losing their financial war against Russia, they would signal that financial sanctions are no more than a paper tiger.

The West has gone too far to back down. It no longer has a choice, and must endure the ordeal. As Margaret Thatcher famously told then-US President George H.W. Bush on the eve of the 1990-91 Gulf War, this is no time to go wobbly.

Jean Pisani-Ferry: A senior fellow at the Brussels-based think tank Bruegel and a senior non-resident fellow at the Peterson Institute for International Economics, holds the Tommaso Padoa-Schioppa chair at the European University Institute.

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