If de-dollarization occurs, the impact will be felt wide and far. Severe sanctions are a double-edged sword which will impact every nation.
Russia’s invasion of Ukraine has been condemned by the majority of countries in the United Nations. NATO has not intervened militarily since that runs the danger of a wider conflagration with the possible use of nuclear weapons. So, instead, the NATO powers have supplied Ukrainian forces with weapons and imposed severe sanctions on Russia. Evermore sanctions are announced every week.
It was said that this would degrade Russia’s capacity to wage war by freezing its assets held in Western banks. Also, its earnings through trade would decline and impoverish it. It was also argued that the Russians would be hurt through multiple channels – higher inflation, the inability of its citizens to get dollars, a collapse in prices of financial assets, like, shares and so on.
Thus, while Russia is attacking militarily, the West is hitting back through economic means. Further, there is also a cyber and media component to the war. It is perhaps the first war on multiple fronts. Will the Russians be hurt enough to stop the war? Can one draw lessons from the sanctions against Iran?
Iran’s economy is 0.3% of the world’s Gross Domestic Product (GDP) and severe sanctions against it did not bring it to its knees. The Russian economy is 1.7% of the world’s GDP and is much more advanced technologically and is a supplier of critical items. Therefore, its economy may be less impacted by the severe sanctions.
Not just the size of the Russian economy but its exports are critical for the rest of the World. As such, all of Russia’s exports cannot be sanctioned immediately without hurting the rest of the world economy. Crucially, it is a major exporter of energy – oil and gas, especially to Europe. So, a complete ban on Russia’s exports of oil and gas has not been possible. Russia has also turned the tables by asking for payment in rubles and not in euros or dollars.
This has put the Europeans in a quandary. Since they have stopped exporting goods and services to Russia, how do they get rubles? There are two options. First, they continue to trade with Russia and earn rubles. Second, they buy the rubles from Russian banks. But most Russian banks are disconnected from SWIFT so the Europeans will have to use the Russian SPFS, the alternative to SWIFT. In both cases, sanctions will be violated.
Russian assets in Western banks are being frozen, so why would the Russian banks sell rubles to the Europeans? They would have to accept euros and convert them to rubles but because of sanctions, the euros would get frozen. In effect, they would have to provide rubles for free.
So, the option for Europe would be to either find alternative energy sources or continue trade with Russia to meet its energy needs. A shift to alternative sources is not that easy and will be much more expensive. Thus, in the medium run, trade is likely to continue between Russia and Europe. The consequence of Russia stopping supplies of energy to Europe would be severe if payments are not made in rubles. Power cuts and cuts in production will follow and a recession is likely.
Alternatives for Russia
If Russia curtails supplies of energy to Europe its own production would decline. But, Russia can supply energy to China and other countries like India. To make it attractive, it is offering a huge discount on the world price. India is getting a $35 discount on the pre-conflict price and is buying substantially more than earlier. If Russia is able to sell to others, and this is likely given China’s huge demand for energy, the impact of sanctions on Russia would be softened.
Further, Russia also exports critical raw materials like metals, fertilizers and agricultural products. There are a few alternative sources for some of the metals like palladium, nickel and neon gas. If the supply of these items is curtailed then the production of integrated circuit chips and batteries which are already in short supply would be globally impacted. Food and fertilizer prices have already risen because of the war and they can go up further if supplies are blocked. Thus, while Russia may go into a recession, the rest of the world will also be impacted adversely.
Are exports financing the war?
The argument that the curbs on Russian exports will lead to a shortage of foreign exchange to finance the war is erroneous. The war requires people, energy, armament and ancillaries which Russia produces indigenously. Dollars are not needed to buy them.
Russia’s main imports from Europe in 2019 were “machinery and equipment (€19.5 billion, 19.7%), motor vehicles (€8.95 billion, 9%), pharmaceuticals (€8.1 billion, 8.1%), electrical equipment and machinery (€7.57 billion, 7.6%), as well as plastics (€4.38 billion, 4.3%)”. Stoppage of most of them will not impact the war effort and certainly not in the short run. The West does not supply any advanced technology to Russia so an embargo on technology is also hardly going to impact Russia’s war effort.
Further, most of the items that Russia is getting from the Western powers can be substituted by China and other nations which need Russian oil. Russia is capable of producing these items itself in the medium run since it is technologically quite advanced. Yes, these may cost more and their quality may not be as good. Stoppage of luxury items imported by Russia will hardly dent the war effort.
In brief, on the trade front, given the critical items supplied by Russia and its huge trade surplus, there will be a marginal impact of sanctions on Russia, especially if China (and India) continue to trade with Russia.
Impact of financial sanctions
The financial sanctions are severe. So, will they bite? These consist of a) delinking most of the Russian banks from SWIFT, b) freezing of assets of the Central Bank, c) freezing of assets of Russian leaders and the oligarchs living abroad and d) MNCs closing operations and liquidating their investment in Russia.
As argued above, Europeans will have to continue to trade at least for some time and will need some payment mechanism. For this reason, some Russian banks have not yet been removed from SWIFT. Alternatively, some European banks will have to use the Russian payment system, SPFS. Even then the payment for Russian exports in ruble will pose a problem and Europe will have to find a solution for that.
The freezing of the Central Bank’s assets will not pose a problem since transactions involving foreigners have been frozen. Neither MNCs wanting to pull their investments out of Russia nor Russians wanting to buy foreign currency are allowed. So, no payments are required to be made to anyone in dollars or Euros. Even if Russia’s trade declines, it would still be in surplus so other nations would owe it money and that would strengthen the ruble vis-à-vis other currencies. Already the ruble, after having sharply fallen at the start of the sanctions, has recovered back to its pre-sanctions value.
Freezing the foreign assets of leaders and oligarchs poses no problem for the economy and will be a personal hit to those individuals. Will they put pressure on the leadership to stop the war and come to some agreement? Possibly, but a determined leadership could ignore these pressures for the medium term. We don’t know if this could lead to a coup or a regime change. It could destabilize the situation further and be dangerous.
The financial sanctions may not impact Russia much due to its trade surplus but the implications for the MNCs could be serious. Those of them that have closed their businesses in Russia have mostly lost their capital and the income flow from that. So, their balance sheets will have a big hole. For instance, Shell may write off upwards of $4 billion and BP may lose $3 billion. The future profits would also be lost. The increase in oil prices may compensate them for their loss of profits but the loss of capital would stay. For non-oil MNCs, the loss would be substantial. All this would impact the stock markets in the rest of the world.
Russians may not be affected by the withdrawal of the MNCs. They could simply nationalize the assets of these companies (for free) and continue to operate the businesses using the existing labor and management.
Russian entities have also borrowed in the international markets and repayments are falling due. If the Russians renege on payments of these dues then it will impact the health of their lenders. The Russians can do this since they can claim that their assets in the Western world are frozen. The option would be for the governments of the Western world to allow these repayments out of the frozen funds. But these would be unauthorized payments and would amount to the nationalization of international assets and that would dent the financial systems. Other countries would also worry that this could also happen with their assets.
De-dollarization a Possibility
China has been viewed as a strategic competitor by the US and the Western powers. Tensions have been rising between the two both militarily and economically. Since this is a long term factor, China will support Russia so that they can form a powerful bloc. China would also get many critical supplies cheap from Russia. So, a collaboration is in China’s long term interest and this would dent Western sanctions.
If this invites Western sanctions against China, the world economy would face problems. China has become the biggest manufacturing hub and if supplies from there are disrupted then the world economy would slip into a deep recession. Of course, China would also be severely impacted. For these reasons, sanctions against China would be limited. Also, would China adjust to Western demands to some extent? It will be a dynamic situation of brinkmanship and it is hard to predict how the situation develops.
Everything is pointing to a de-dollarization of the world economy. Trade between Russia and the rest of the world would not be denominated in dollars. China’s trade is also likely to get denominated in its currency, Yuan. Blocking of SWIFT for Russian Banks would lead to the evolution of the Russian system SPFS and the Chinese system CIPS. Some countries may want to switch their reserves to other currencies as a matter of abundant caution.
Russia’s insistence that it be paid in rubles is also a start of de-dollarization. The US economy is likely to slip into a stagflation due to supply bottlenecks leading to further inflation and recession hitting it. This would lead to a decline in the holding of dollars and its weakening vis-à-vis other currencies. This would raise the level of inflation in the US in a vicious cycle. In this situation, Russia linking the ruble to gold will be like adding fat to the fire.
With trillions of dollars floating around the world, de-dollarization would add to the pressures on the US economy. The US would not be able to sustain the huge current account deficit and budget deficit. This could impact living standards in the US and have social and political consequences.
While the war in Ukraine is not global, the economic war is global in sweep. Russia will certainly be adversely impacted but much will depend on how quickly the economic sanctions are implemented and the role China plays. Most likely, China will aid Russia in its long term interest. Given the critical exports from Russia, supply bottlenecks will increase globally. If sanctions are also imposed on China for its trade with Russia the world economy would be further hit. De-globalization is very likely. All this could push the world into a recession. If de-dollarization occurs the impact on the US will be aggravated. So, severe sanctions are a double-edged sword that will impact every nation.
First published in The Wire ‘Sanctions on Russia Are a Tool That Must Be Calibrated Like Any Other’ on 9th April,2022.
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About the author
Arun Kumar, Malcolm S. Adiseshiah Chair Professor, Institute of Social Sciences, New Delhi, and a Retd. Professor from Jawaharlal Nehru University