The big sanctions: A quick explainer

The goals and risks of SWIFT cutoff, central bank sanctions, etc.

The war in Ukraine rages on (For updates, check out my Twitter list). Although they’re still not thinking of getting involved militarily, the U.S. and European nations are openly delivering more weapons and other aid to the besieged Ukrainians. Germany, it’s worth noting, is one of the countries providing weapons — a very encouraging sign for a country that recently looked like it was sleepwalking through a global crisis. Whether this aid is enough for the Ukrainians to hold out against Russia’s ferocious onslaught remains to be seen.

But in addition, Western countries are now pulling out all the stops in terms of sanctions. The latest round includes:

• Cutting some Russian banks out of the SWIFT messaging system

• Freezing the Russian central bank’s access to its foreign currency reserves held in the West

• Increased sanctions on Russian banks in general

• Establishing an international task force to hunt down and freeze the assets of Russian companies and Russian oligarchs

Just a couple of days ago, these sanctions were almost unthinkable, with SWIFT cutoff sometimes called the “nuclear option” (not a phrase I like to use in this particular situation). But the moral clarity of the unprovoked and brutal Russian assault has changed minds I’ll discuss each of these in turn, but first an overview. These sanctions are designed to do two things:

1. To punish Russian oligarchs and Putin allies for supporting the war, and

2. To make it harder for Russia to finance its war effort.

Since the end of the Cold War, the Russian economy has become increasingly entangled and increasingly symbiotic with the economies of Europe. The Soviet economy was somewhat self-contained, doing much of both its resource extraction and its manufacturing domestically. Putin’s Russia, on the other hand, has focused on its comparative advantage — oil and gas — and let other countries do much of its manufacturing and services for it. You can see that when you look at Russia’s exports — almost all oil, gas, and other raw materials — and compare it to Russia’s imports:

Some of these imports are consumer goods (TVs, cars), some are inputs and tools for things like resource extraction and defense manufacturing. Russia needs not just a source for all these manufactured imports, but a way to pay for them. Sanctions make this harder. Starving Russia of manufacturing imports will hit Russian living standards and the Russian economy, increasing domestic anger against Putin and hopefully pressuring him to stop the war. If the war drags on and Russia’s munitions and equipment begin to run out, import shortages could also hurt Russia’s ability to manufacture weapons for use against Ukraine (something I’ll focus more on in another post).

In addition, many rich Russians, including key Putin allies in industry, government, and the security services, have become used to living lives of luxury as globetrotting rich guys. Sanctions make it harder to do this, hurting rich Russians’ freedom of mobility and their ability to splurge on travel expenses. This will hopefully cause them to put pressure on Putin to pull out of Ukraine.

So that’s the basic idea of sanctions at this point. Deterrence obviously failed, but enough pressure from Russian leaders and society might force Putin to call it a day. The question is how to do that without creating havoc in European economies at the same time.

The SWIFT cutoff and bank sanctions

SWIFT is a messaging system. For banks to do transactions with each other — borrow and lend money from each other, swap assets, whatever — they need a way to communicate securely and reliably, which SWIFT provides. For example, Russia has a whole lot of assets stashed overseas, in foreign currencies, and not being able to use SWIFT would make it very hard to spend those assets. The Russians have tried finding alternative methods to SWIFT for a while, but they just don’t work very well. The fear that a SWIFT cutoff would push Russia closer to China doesn’t make much sense, since Russia is already trying to get closer to China, and to set up payments through alternate routes.

If a Russian bank gets booted from SWIFT, it immediately becomes a less desirable place to keep one’s money. This could provoke runs on Russian banks. Runs on Russian banks would cause either widespread banking collapses (which would dry up lending and devastate Russians’ personal wealth), or force the government to engage in bailouts. Bailouts could cause inflation to accelerate via money creation or fiscal deficits, putting further pressure on the Russian economy and eroding rich Russians’ wealth.

It could also make it much harder for Russia to pay for its imports. If you buy, say, an oil drilling machine from Germany, you need to pay for that machine in Euros. A Russian company generally doesn’t have a bunch of euros sitting around, so it’ll have to swap some of its rubles for euros. It will generally do that via a Russian bank. But if Russian banks are cut off from SWIFT, they might not have any secure way to message the banks who have euros in order to make the swap; this makes it hard for the Russian company to buy the German machine.

This difficulty will manifest as a fall in the value of the ruble, the Russian currency (Update: This is now happening). If Russians are desperate to swap rubles for euros or other foreign currencies through any available channel because SWIFT won’t take their messages, they’ll offer rubles at a discount through whatever outlets they can access. On top of that, the looming specter of general weakness in the Russian economy will make all sorts of people need Russian currency less, hurting the ruble’s value even more. This is already manifesting; the ruble bounced back from its lows immediately after the invasion started, but is still drifting steadily downward; expect another fall after the announcement of these sanctions. A weak ruble will make it hard for Russian companies to buy imports, and it’ll also make it even harder for rich Russians to spend their money abroad.

There is a question of how well these SWIFT cutoffs will work. The cutoffs are very broad, covering half of Russia’s total banking assets. But there’s a huge, huge loophole in the SWIFT action — it still allows Russian banks to send messages related to energy payments:

Javier Blas @JavierBlas

UPDATED 3: The White House, in call with reporters tonight, made very clear that it's actively making sure that the SWIFT move against Russia does NOT impact energy payments, using two potential paths | #OOTT #ONGT #Ukraine The below is from Biden administration senior official

Since energy is the main thing Russia exports, this means the SWIFT cutoffs will create a bit of chaos in the Russian economy on Monday, but still don’t represent the crippling blow many people think of when they think of SWIFT. The reason, of course, is that Europe buys a ton of energy from Russia, and a complete SWIFT cutoff would mean a lot of economic pain for Europe — spiking power costs for European consumers and industry, and financial pain for European banks invested in Russian energy assets. Symbiosis works both ways, and though Russia would feel more pain, NATO and EU countries would also feel plenty.

Hence we’re not yet really unleashing the full power of SWIFT cutoffs. This is a symbolic move that will roil Russian markets a bit, but ultimately what it’s mostly about is scaring Russian businesses and Russian elites into breaking with Putin. Most importantly, it sets a precedent — it shows that Europe is willing to use SWIFT as a tool of policy. More devastating cutoffs might follow if Putin presses the attack.

It’s also worth it saying a bit about bank sanctions here. Some people ask “Instead of SWIFT cutoffs for banks, why not just sanction the banks?” And the answer, of course, is that we do both. Russian banks can use a series of intermediaries or roundabout financing paths through friendly countries like China and Iran to get around either type of curb, so we do both, in order to provide a layered defense-in-depth that makes it increasingly impossible for them to do business overseas.

The central bank freeze

In fact, the U.S. and Europe pulled out a potentially even more devastating financial weapon today — central bank sanctions. The Central Bank of Russia is responsible for stabilizing the country’s currency; when the ruble plunges, as it almost certainly will given increasing sanctions, the central bank buys rubles in order to prop up its value and limit the fall. The way you buy rubles is to spend other assets — dollars, euros, gold, yuan, whatever. Which means the central bank needs to keep some of that stuff on hand in order to spend. That’s called “foreign exchange reserves”, or just “reserves”.

For example, when the ruble plunged after Putin’s first attack on Ukraine in 2014, the central bank spent down almost 40% of its reserves in order to limit the drop:

This time, given the strength of sanctions and the promise of an open-ended war, the drop could be much deeper. So the central bank will need to spend a lot of its $640 billion in reserves.

Big problem, though: The central bank holds a substantial amount of those foreign exchange reserves — perhaps $300 billion out of the total — in foreign banks, mostly in the West. If the U.S. and Europe freeze those assets, Russia’s central bank won’t be able to use them to stop the ruble’s slide. Knowing that, currency traders will know that it’ll be that much easier to “break” the ruble — short-selling rubles in order to run the central bank out of reserves, so the currency plunges and the traders make a profit. This might become a self-fulfilling prophecy — speculators think the ruble is vulnerable to attack, so they attack it.

And the really ominous thing here is that there’s just not that much the Central Bank of Russia can do about this. We’ve become used to thinking of central banks as these all-powerful money printers, but the Central Bank of Russia can only print rubles. And printing rubles doesn’t help stabilize the currency — in fact, it devalues it further. So there will be no “money printer go brrr” memes for Russia. If the ruble crashes and the central bank runs out of accessible forex reserves, it’s game over. The Russian economy will be in ruins, Russians will start using black markets to buy stuff, and everyone in Russia will be really really mad. Furthermore, Russian defense manufacturers will be basically unable to buy needed components and materials overseas, which will severely hamper the war effort in Ukraine.

But here’s the thing — this isn’t really the kind of thing you can do in half measures. Either the Central Bank of Russia depletes its reserves or it doesn’t. And initial reports suggest that like SWIFT cutoff, the central bank asset freeze will be initially done in a surgical, limited way, as a threat and a proof of concept. But the problem with this is that if the Central Bank of Russia still has some channels with which to withdraw the $300 billion or so of reserves it keeps overseas, it will do so — and then this particular financial doomsday weapon will be neutralized.

So it’ll be interesting to see where this policy goes.

Update: It looks like the U.S. and EU realized that half measures just wouldn’t work here. They’ve decided to fully block any use or withdrawal of all of the Russian central bank’s foreign exchange reserves, and also to stop the central bank from participating in any of the foreign exchange markets under their control (i.e., most of them). Sanctions also cover other Russian government agencies, such as the sovereign wealth fund. Here’s a thread about the details:

Eddie Fishman @edwardfishman

(3) Now that the details are out, it looks like these are essentially blocking sanctions. (There are technical differences, but the effect is the same—"any transaction" with the CBR is prohibited.) The CBR will be unable to intervene in FX markets to prop up the ruble, full stop.

This is a pretty devastating blow, and dramatically raises the chances that the ruble will fall even further.

Bringing the pain to Putin’s cronies

Finally, there’s the idea of going after Putin’s friends, allies, and supporters. No dictator actually has absolute power — there is always a group of people, be they generals or spymasters or bodyguards or whoever — who are able to remove the dictator from power if they choose. And if they get mad enough, they will. So there’s the idea that by making life hard enough on the Russians who have the ability to remove Putin from power, we can get them to either pressure Putin to end the war, or maybe just remove him from power.

This is the thinking behind Biden’s idea of a multilateral task force to hunt down and deprive rich Russians of their toys and their money:

The White House @WhiteHouse

This coming week, we will launch a multilateral Transatlantic task force to identify, hunt down, and freeze the assets of sanctioned Russian companies and oligarchs – their yachts, their mansions, and any other ill-gotten gains that we can find and freeze under the law.

The attraction of this method is that it doesn’t really hurt the average Russian. Impoverishing the average Russian has many drawbacks. It might simply cause Russians to rally around Putin and despise the West instead of questioning the Ukraine war, as some of them now are. Even if not, the only thing average Russians can really do against Putin is to overthrow him in a mass uprising. And the last time impoverished Russians got mad and overthrew their regime, they eventually replaced that regime with…Vladimir Putin.

So of all the extreme sanctions methods, hunting down Putin’s allies and depriving them of everything they know and love about the post-Soviet era has the fewest drawbacks. Unlike SWIFT cancellation, it doesn’t risk causing major economic pain in Europe. And unlike central bank asset freezing, it’s pretty easy to do. I should also mention that it’s highly amusing:

Julia Davis @JuliaDavisNews

Sanctioned Russian TV Host Cries About Losing Italian Properties The impact of Putin’s war against Ukraine is starting to set in, startling even his most ardent state TV propagandists. It’s all fun and games 'till they seize your Italian villa. thedailybeast.com/sanctioned-rus…

The only drawback here is that it’s more annoying than terrifying. Russian elites can live without their Italian villas, but they can’t live without a functioning Russian economy. The question remains: Are we willing to risk major economic damage to Europe and/or utter chaos in a huge country with 1,456 strategic nuclear weapons just in order to apply more pressure on Putin to stop a war that’s already not going that great for him?

Given the hedging, tentative way that we’ve started rolling out the “big gun” sanctions, I don’t think we’ve answered that question yet.

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