The war in Ukraine: an economics reader (1)
What we know so far
I was on The Bottom Line on Radio 4 last night, discussing the economic impact of Russia’s invasion of Ukraine with Anna Leach from the CBI, Chris Rogers from Flexport, Greg Jackson from Octopus Energy and the BBC’s Evan Davis. You can listen back here. I feel we covered a lot of ground in 28 minutes but there is plenty more to say. This post is a compilation of readings which I have found useful in trying to assess the economic fallout.
For anyone wanting to follow the progress of the actual fighting, I’ve found the twitter feeds of Shashank Joshi, Mark Urban, Michael Kofman, Rob Lee, Mick Ryan and Franz-Stefan Gady especially helpful.
This is a big topic, so I’ll be dealing with it in two parts. Today I’m covering the impact on Russia and the sanctions themselves. On Monday I’ll turn to the spillback and spillover impacts on the rest of the global economy.
Sanctions and the Russian economy
The situation has moved quickly. A week ago the initial package of US, EU and UK sanctions looked, if anything, underwhelming. Over at the Overshoot, Matt Klein wrote (days before the Russian invasion) that whilst Russian had prepared its economy to withstand sanctions the European reliance on Russian gas had left them ill prepared to impose them.
Russia’s fortress balance-sheet seemed to offer it a great deal of insulation against the likely Western response.
Meanwhile, Russian businesses and other borrowers responded to external financial pressures—and domestic political ones—by slashing their foreign-currency denominated debt by $200 billion since the beginning of 2014. The Russian government also spent $200 billion adding to its stockpile of reserves (gold, bank deposits, and bonds) since mid-2015.
The net effect is that Russia’s central bank now has enough foreign exchange reserves ($630 billion as of last month) to cover 2021 spending on imports ($368 billion) plus 75% of the country’s entire stock of foreign-currency denominated debt ($353 billion as of 2021Q3).
Much of that debt isn’t even due for at least two years.
Matt though, unlike many analysts, was far sighted enough to see that this fortress could be breached.
None of this, however, is sufficient to protect Russia from the impact of sustained Western sanctions. As the Taliban has discovered, foreign reserves are useless if your counterparties freeze your accounts. Even Russia’s $132 billion in gold reserves couldn’t be used to settle payments if Western banks were banned from touching anything involving Russia.
The breach has happened much faster than just about anyone foresaw. The sanctioning of the Central Bank of Russia has effectively frozen many of its reserves.
FT Alphaville published a helpful explainer.
Financial intermediaries in the rest of the world may also not want to deal with the CBR, even if they are not directly covered by the sanctions. When the US puts you on its blacklist, it can have a chilling effect. Famously, Carrie Lam, Hong Kong’s leader, resorted to “piles of cash” after local institutions were reluctant to bank her and other city officials who came under US sanctions.
This was a much bigger - and more meaningful step - than the cutting off of Russian banks from the SWIFT messaging service. Indeed we should be in no doubt, that sanctioning a G20 central bank is a huge escalation. Adam Tooze, writing at the New Statesman, dubbed it an act of financial war.
In the economic realm the US and Europe have applied sanctions that were never previously considered. The freezing of Russia’s central bank reserves means crossing the Rubicon. It brings conflict to the heart of the international monetary system. If the central bank reserves of a G20 member entrusted to the accounts of another G20 central bank are not sacrosanct, nothing in the financial world is. We are at financial war.
This is made all the more emphatic by the decision to apply the most draconian financial sanctions to a violator of international law not in retrospect but in the middle of an ongoing conflict in an attempt to cripple the aggressor-state. It is the difference between punishing an assailant for their attack and intervening in a fight to wrestle the assailant to the ground.
The latter is clearly the more committed position. It changes your relationship to the person on whose behalf you intervene and the person whom you seek to immobilise. Unlike in a court judgement you surrender the idea of a higher authority. It may be the right thing to do but it is a far more dangerous and indeterminate situation. Any claim to neutrality disappears. As the person intervening you must expect not only to dish out coercion, you must expect to get hurt yourself and the assailant has little reason not to up the ante.
But how effective will this financial war prove to be?
In the FT today Paul McNamara of GAM writes that:
Russia might believe it is self-sufficient in capital. After the experience of the 1998 financial crisis, the country opted for rigid fiscal discipline and has been running a sustained current account surplus. So the combination of capital controls and sanctions should in theory not require a significant adjustment at the macroeconomic level. However, that theory is reliant on sanctions not inducing big changes in behaviour. This seems optimistic.
The Russian authorities have boasted of how little the country relies on imports. It is comfortably self-sufficient in food and energy. However, Russian industry is reliant on western machinery and parts. And Russia’s efforts to prepare for sanctions have also been heavily reliant on China.
While Paul has little doubt that the sanctions will seriously hurt the Russian economy, he does not go as far as Maximillian Hess writing for Al Jazeera who thinks a collapse more akin to 1918 than 1991 or 1998 is possible.
There is surely little doubt that the Russian financial system faces a painful adjustment and that Russian asset prices face collapse. But there remains room for debate on how painful the hit to the real Russian economy will be. The base case though has to be ‘pretty damn painful’.
Even leaving aside tighter financial conditions and a direct hit to real incomes from higher inflation, the impact of cutting Russia off from the global financial system will be felt across the economy.
Take civil aviation for example
The ever growing list of firms moving further than the sanctions legally require them to by cutting ties with Russia will hurt.
Writing today (and yes I do wonder how he finds the time) Adam Tooze speculated on the Russia macroeconomic policy response, provocatively asking “what if Putin’s war regime turns to MMT?”
What if, within the beleaguered fortress of Russia, Putin’s regime dissolves the bind between globalization and domestic economic orthodoxy? Since it is now in an open confrontation with the West, why should Russia not use its monetary and fiscal sovereignty, reinforced by the new regime of exchange controls, to launch a stimulus program and, in so doing, negate a large part of the impact of sanctions?
If Russia has been cast into the outer darkness, what incentive does it have to uphold its orthodox reputation in fiscal matters? In a situation of direct financial confrontation with the West, markets are no longer interested in Russia’s fiscal fundamentals. If sanctions cause the ratings agencies to write Russia down to junk from one day to the next, is it surely inconsistent to expect his regime to go on playing by the fiscal and monetary rules?
The likes of Oreshkin certainly need no tutoring on the scope of action conferred by monetary sovereignty. What if Putin answers our sanctions with a “Russian Rescue Plan”? Might that negate the impact of sanctions on ordinary Russians that we are counting on to force a shift in Putin’s position?
These are important questions. And the dropping of the fiscal, rather orthodox, conservativism of recent years is perhaps likely.
But I remain sceptical that expansionary macro-policy offers Russia a way out of what is in effect a severe supply shock. If, for example, the civil aviation sector is collapsing because it lacks access to fuel and parts then tax breaks and subsidies will not help.
But even if the sanctions can inflict a great deal of economic - as well as financial - damage, it remains to be seen whether they can actually force a change in Russian policy. The Economist’s Free Exchange column a couple of weeks back mused on Nick Mulder’s very timely new book on sanctions and came up with some depressing conclusions.
Governments that believed themselves vulnerable to sanctions withdrew even further from the global economy, in order to secure strategic independence. In the 1930s Japan sought to develop a “yen bloc”, an economic zone including Korea and Taiwan, so as to reduce dependence on the Allied powers. In the mid-1930s Germany gunned for “raw-materials freedom”, in part via the construction of massive capacity for the synthetic production of oil. (Anyone witnessing Russia’s efforts in recent years to wean itself off Western finance may conclude that nothing much has changed.) It also necessitated conquest. “I need Ukraine”, said Adolf Hitler in 1939, “so that they cannot again starve us out like in the last war.”
In that sense the international search for effective sanctions and the ultra-nationalist search for autarky “became locked in an escalatory spiral”. Sanctions did not work in a deglobalising world, and contributed to its continued fracturing, in turn setting the stage for the second world war. Mr Mulder is too careful a historian to labour the parallels between what happened in the inter-war period and today, when geopolitics is once again fractious and globalisation is in retreat. But the lessons are sobering.
Norma Cohen, an ex FT correspondent turned historian of war financing, is a touch more optimistic. The Great War can be viewed as battle for capital, one that the allies ultimately won.
It was the fact that Britain had access to capital, allowing it to buy what its military and civilians needed, that allowed it to outlast its enemies and declare itself the victor. The question is whether Russia will be able to do the same in its war against Ukraine.
Perhaps this a question of time frames and commitments? In the short term sanctions have rarely proved that effective in terms of changing state behaviour but in the longer term access to capital is crucial to war fighting ability?
Whilst the new sanctions regime on the Russian financial system - especially when coupled with the further steps taken by Western businesses - are surprisingly tight there is a obvious gap: the Russian energy complex.
Although even here one needs to be careful to distinguish between oil and gas.
Whilst Europe continues to import Russian gas, the oil market is behaving strangely.
This is clearly visible in pricing.
I find myself in two minds about the lack of sanctions on gas. Europe is (finally) taking the steps to reduce it’s dependence on Russian natural gas supplies but that process will be measured in months and years not days and weeks. Whilst the case for an immediate boycott is obvious, the impact on an already damaged Russian economy may not be worth the pain that would be inflicted on European households and firms. But more on that next week.
If you’re enjoying Value Added, please do consider subscribing. You’ll get more posts and I’ll get the resources to carry on producing it.