Commentary on Political Economy

Tuesday 1 March 2022


How Vladimir Putin Miscalculated the Economic Cost of Invading Ukraine

The Russian leader apparently failed to anticipate the unprecedented targeting of the Central Bank of Russia, a step that has battered the ruble and shaken the country’s financial system.
A foreign currency exchange.
When the international markets opened on Monday morning, the value of Russia’s currency, the ruble, plunged by a third.Photograph by Andrey Rudakov / Bloomberg / Getty

When Vladimir Putin was a schoolboy, one of his biographers tells us, he spent a lot of time reading the works of Marx, Engels, and Lenin, all of whom regarded economics as the driving force of history, and political forces as secondary. Evidently, the future Russian leader took these lessons to heart. In ordering an invasion of Ukraine, he apparently assumed that the countries of Western Europe were so dependent on Russian energy imports and so economically beholden to the Kremlin that their governments wouldn’t introduce sanctions that would do serious harm to the Russian economy. In any case, over the past half a decade or so, Russia had built up more than six hundred billion dollars in foreign-exchange reserves to weather any foreign pressure.

If Putin was indeed calculating along these lines, he was gravely mistaken. On Saturday, Ursula von der Leyen, the president of the European Commission, announced that the E.U.—in coöperation with the United States, the United Kingdom, and Canada—was taking steps to “cripple Putin’s ability to finance his war machine.” The transatlantic allies moved to bar “selected Russian banks” from the global swift messaging system, which financial institutions use to facilitate cross-border transfers of money. And, in a more surprising step, they also announced that they would impose “restrictive measures” on the Central Bank of Russia, with the explicit aim of preventing it from using its large stock of foreign-exchange reserves to lessen the impact of the sanctions. “This will show that Russia’s supposed sanctions-proofing of its economy is a myth,” a senior official in the Biden Administration said, in a teleconference with reporters. “The six-hundred-billion-plus war chest of Russia’s foreign reserves is only powerful if Putin can use it.” The measures the allies announced were designed to block Moscow’s Central Bank from buying rubles from Western financial institutions, a step that could offset the impact of sanctions and stabilize the Russian currency. “The ruble will fall even further, inflation will spike, and the Central Bank will be left defenseless,” the U.S. official predicted.

In wartime, it is wise to treat statements from all sides skeptically. In this case, we don’t need to rely on the assessments of anonymous U.S. officials. When the international markets opened on Monday morning, the value of Russia’s currency plunged by a third. To stem the decline, the Russian Central Bank more than doubled its key interest rate, from 9.5 per cent to twenty per cent, and ordered Russian exporting companies to sell foreign currencies and buy rubles. These desperate moves helped trim losses, but at the close of trading in Moscow the ruble was still down by almost twenty per cent—a huge decline for any currency. In a briefing with reporters, Dmitry Peskov, the Kremlin spokesman, conceded that “economic reality had significantly changed.”

In Washington, meanwhile, the Biden Administration intensified its economic offensive by imposing a freeze on the Central Bank of Russia’s assets held in U.S. financial institutions. The Treasury Department also prohibited any U.S. person, including American banks and businesses, from engaging in transactions with Russia’s Central Bank, finance ministry, or sovereign wealth fund. “This action effectively immobilizes any assets of the Central Bank of the Russian Federation held in the United States or by U.S. persons, wherever located,” the Treasury said, in a statement announcing the new policy. In London, the U.K government has introduced a policy along the same lines.

It wasn’t immediately clear just how much money the Central Bank of Russia still holds in New York, London, and other Western financial centers—and which it will no longer be able to access. (According to some estimates, about two-thirds of Russian reserves are now blocked off in countries that have introduced sanctions.) Even so, experts on economic sanctions described the targeting as unprecedented and highly effective. “The G-7 sanctions against the Russian Central Bank, not the swift sanctions, are the real hammer, and they’re showing effect,” Jonathan Hackenbroich, a policy fellow at the European Council on Foreign Relations, said. “Russia’s Central Bank might struggle to fight massive inflation and panic even after it doubled interest rates and introduced capital controls.”

The fall in the value of the ruble will quickly force Russian consumers to pay more for everything, from French wine to iPhones. And the sanctions on the Central Bank could reverberate throughout Russia’s financial system, effectively cutting off large parts of it from the outside world and raising the possibility of bank runs. “Financial systems need one thing to function, they need trust,” Stefan Gerlach, a former deputy governor of Ireland’s central bank, told the Wall Street Journal. “If you suddenly realize that they can’t get help from their government if needed, it becomes incredibly riskier to deal with them. You just pulled the carpet from under the financial system.”

That such unprecedented steps have been taken in just five days is remarkable. This time last week, it seemed like Putin had sound reasons for being skeptical about the prospect of truly damaging sanctions. Russia supplies the European Union with about forty per cent of its natural-gas imports and about a quarter of its crude oil imports; Germany and Italy are among the most dependent on Russian natural resources for fuel and power. On February 18th, Mario Draghi, Italy’s Prime Minister and the former head of the European Central Bank, said that if the European Union were to impose sanctions on Moscow they should be “concentrated on narrow sectors.” As recently as last Thursday, Olaf Scholz, the German Chancellor, expressed opposition to barring Russian banks from the swift system. At that point, the idea of sanctioning the Russian Central Bank had been barely mentioned.

Less than a week later, Russia is an economic pariah. On Monday, the Japanese government announced it will join the sanctions on the Central Bank, saying that “Japan stands with Ukraine.” On Friday, uefa, the governing body of European soccer, voted to move the 2022 Champions League final from St. Petersburg, where it was scheduled to take place, to Paris. On Sunday, BP, the British energy company, announced that it would divest a twenty-per-cent stake it holds in Rosneft, the state-owned Russian energy giant, even though it will entail a big financial loss. Then, on Monday, another energy company, Shell, announced that it, too, was cutting ties with Russia: the London-based firm said it would exit oil-and-gas joint ventures with Gazprom, the Russian energy conglomerate, and also end its involvement with the Nord Stream 2 gas pipeline from Russia to Germany. When even Europe’s oil barons abandon Russia and its vast energy reserves, it is evident that the geopolitical—and geoeconomic—map has been redrawn.

Details of how the G-7 countries decided to target Russia’s Central Bank have yet to be revealed. Richard Nephew, a sanctions expert at Columbia University who worked in the Obama Administration on economic measures directed at Iran, told me that he and his colleagues had long been monitoring the Russian buildup of foreign-exchange reserves. “The question was, if it comes to sanctioning Russia in a future crisis, is there a way to do it effectively?” Nephew said. “Or does the country have enough liquid assets to ride things out?” In targeting the Central Bank and freezing Russia’s foreign assets, the Western allies found a way to make life difficult for Putin and his regime despite their large war chest. “It’s a pretty tough situation for them,” Nephew said. “There’s not really a way around these restrictions.”

Where do things go from here? In the coming days, Putin could conceivably move to cut off oil-and-gas exports to Western Europe. Even though the loss of revenues would exert further pressure on the Russian economy, such a move could cause greater pain in European countries, in the form of energy shortages and sharply higher prices. Hackenbroich told me that the government in Berlin, in agreeing to impose sanctions on Russia’s Central Bank, will most likely have planned for this possibility. During the past month or so, he noted, German economic officials had lined up alternative sources of natural gas, from countries such as Qatar and Azerbaijan. “It looks like the German government is ready to accept the possibility of a Russian energy cutoff and accept the consequences,” he said. “I don’t think that we are going there immediately, but so much that seemed impossible a week ago has already happened, and who knows where we will be at the end of this week.”

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