Measures taken by the US and Europe to punish Russia economically may cripple the Russian economy but they will not be enough to end Vladimir Putin’s war in Ukraine  

In the twilight of Donald Trump’s presidency, it appeared that China and the United States might fight a financial war as bilateral relations deteriorated. Yet save some selective decoupling of the two countries’ capital markets, the war never materialized.

As it turns out, the real financial war is being fought with Russia. America’s old arch-rival has returned to geopolitical center stage – at least temporarily – following Moscow’s abrupt and brutal invasion of Ukraine that began on February 24. The invasion, borne of Russian president Vladimir Putin’s deep-seated irredentist ambitions, is the largest conflict on European soil since World War 2. It has caused thousands of casualties and a major refugee crisis, with 2 million Ukrainians fleeing the country.

Having ruled out direct military intervention given the risk of war with nuclear-armed Russia, the U.S. and Europe are betting that harsh economic sanctions will force Putin to the negotiating table. Cognizant that Moscow shrugged off the mild sanctions imposed after Russia annexed Ukraine’s Crimean peninsula in 2014, Washington and Brussels are going big this time. They have partially banned Russian banks from SWIFT, the world’s paramount financial messaging system, and restricted Russia’s access to its foreign exchange reserves. In mid-March, Russian Finance Minister Anton Siluanov said that of Russia’s US$640 billion in FX reserves, it could not use US$300 billion.

Russian data from January show that US$100 billion of the reserves (16.4%) were held in U.S. dollars as of June 2021, 32.2% in euros and 13.1% in renminbi. Given Chinese leader Xi Jinping’s close personal relationship with Vladimir Putin – they declared a “no limits” partnership in early February – China is very unlikely to restrict Moscow’s access to the yuan reserves.

Moscow has striven in recent years to reduce its use of the US dollar while gradually relying more on the renminbi. From June 2017 to June 2021, Russia’s dollar holdings fell from 46.3% of its reserves to 16.4%, while the renminbi’s share of its FX reserves jumped from 0.1% to 13.1%.

That said, Russia has US$117 million in interest payments on dollar-denominated government bonds due, and it cannot use renminbi to pay for it. On March 13, Russia's finance ministry said that it was preparing to service some of its foreign currency debt and would pay in rubles if sanctions prevented banks from honoring debts in the currency of issue.

"Is that a default? ... From Russia's point of view, we are fulfilling our obligations," Siluanov said in an interview with Russian state television. Russia’s creditors are likely to feel differently about the matter.

With that in mind, a Russian default is probable at this point. Research firm Capital Economics said in a March research note that the default may have already started, pointing out that Russia’s dollar bonds had plummeted to trade at just 20 cents on the dollar.

Impact of the SWIFT ban

The decision by the US and EU to partially ban Russia from SWIFT is significant because of the Belgian payment network’s dominance in global banking. SWIFT accounts for about half of all high-value cross border payments globally and averages 42 million messages daily. Its network includes 11,000 financial institutions in more than 200 countries and territories. Since the messages are secure, the payment instructions are usually honored without question. As a result, banks can speedily process high volumes of transactions.

With the SWIFT ban in place, it will be more difficult for Russian firms and individuals to engage in any type of international financial transaction. They will struggle to receive cash for exports and pay for imports as well as borrow and invest overseas. Although Russian banks can use other payment rails to make payments through banks in countries that not have sanctioned Russia, these alternatives will be slower and less efficient than SWIFT.

One alternative is Russia’s own System for Transfer of Financial Messages (SPFS) that Russia’s central bank calls a “SWIFT” analogue. But it is a bit of non-starter given limited international connectivity. Currently, SPFS only provides international services to a handful of countries, such as Armenia, Turkey, Uzbekistan, and Kazakhstan.

Some observers have suggested that Russia use China’s CIPS payment platform. But this idea is even less feasible than the SPFS option. On the one hand, CIPS operates on the SWIFT network. If Russian banks banned from SWIFT try to transact on CIPS, that may be seen as a breach of the sanctions – a step China probably does not want to take. On the other, just 1.9% of global payments are settled in China’s currency, which limits CIPS’ utility funding cross-border trade.

More likely, Russian banks and their counterparts in countries that plan to continue doing business with Russia will develop workaround solutions using phones, faxes or messaging apps. One such system was developed by a foreign bank for Iran after it was banned from SWIFT in 2012 as part of sanctions for its nuclear program, according to Reuters. The solution required a small team that processed payments based on sending two faxes and two phone calls for each transaction.

This type of bespoke solution is no replacement for SWIFT though. It is much slower, more prone to error (given the manual transfer of data) and less secure. The high risk of errors will mean additional checks to prevent them, raising costs.

Given Russia’s inability to find an adequate replacement for SWIFT, the ban is likely to do substantial damage to the Russian economy. Iran’s experience may be instructive. Following its expulsion from the Belgian messaging network in 2012, Tehran lost about 30% of its foreign trade.

The limits of sanctions

Given the severity of the sanctions imposed on Russia, the Russian economy will fall into a deep recession. JPMorgan estimates that it will contract 35% in the second quarter and 7% in 2022. The US bank reckons exports will fall 13% this year, imports 30% and domestic demand 10%. The severity of the downturn may exceed the one in 1998, when a debt crisis caused a 5.3% contraction in GDP.

Nevertheless, Moscow continues to export oil and gas to Europe, which depends on Russia for a large portion of its energy needs. Russia accounts for half of Europe’s oil imports and is its largest supplier of natural gas. These energy exports are providing badly needed hard-currency support to Russia. Thus far, Europe has been unwilling to ban Russian energy imports given the potential fallout in European economies.

The US banned all Russian energy imports in March, but is a much smaller buyer of Russian oil and gas than the Europeans so the impact of the move will be limited. The United Kingdom and Australia also plan to phase out the import of Russian oil.

At the same time, Russian president Vladimir Putin remains ideologically committed to his war in Ukraine and his forces have a considerable military advantage over their Ukrainian opponents. Sanctions, while painful, cannot alone force Putin to give up the fight. The Russian president has never lost a war. Given that his political credibility is at stake, he is unlikely to agree to a ceasefire unless he sees that Russia cannot defeat Ukraine militarily.

The stakes are high for all sides. An outright defeat in Ukraine would humiliate Putin, weaken his political standing and perhaps even lead to his downfall. For Ukraine, the fight is existential. A decisive Russian military victory would lead to the collapse of the Ukrainian state. Putin might also be emboldened to widen the scope of his revanchist campaign and attack Baltic states that were part of the Soviet Union, such as Latvia, Estonia or Lithuania. Since those states are NATO members, an attack on any of them would result in war between Russia and the West.