The US and European nations have imposed tough sanctions on the Russian economy in response to its invasion of Ukraine.
They started by freezing $630 billion of Russia’s foreign currency reserves. Some capital controls were imposed, blocking Russians from depositing money in foreign accounts and restricting planned investments in Russia and by it. Russia has also been shut out of the SWIFT payment system, which makes its isolation from the global financial system more severe.
The effect of these sanctions can be seen already. The ruble fell over 30%, Russia’s stock market has crashed and its rate of inflation is rising. In addition, its government external debt-to-GDP ratio has risen. Its central bank has increased interest rates from 9.5% to 20% in an attempt to tame inflation but that increased the cost of borrowing.
In the weeks and months ahead, the impact of increased sanctions on the Russian economy will alienate its financial system from the global monetary system even further. To get a sense of this, here are some numbers.
The crashing ruble is creating panic amongst Russian citizens, who have to stand in long ATM queues. If depositors start pulling all their money out, this could cause a run on some of the country’s banks and wreck its banking system .
Inflation is already rising, which will cause the purchasing power of the ruble to decrease every day, making the cost of essentials soar. A high inflation rate often creates distrust in the government and could change public opinion about Russian President Vladimir Putin, driving protests on the streets against the ruling autocrat.
Russia’s rate of inflation has already touched around 9% very quickly. Its central bank responded by increasing interest rates, which increases the cost of borrowing from banks. This makes it even more difficult for households and firms to obtain credit.
The freezing of credit – and the higher cost of accessing money – will make business in and with Russia even more difficult.
The effects of these trends are evident in the consumer and business confidence, which is precariously low. It signals that even for a military superpower like Russia, most of its people and businesses were not prepared to understand (or factor in) the potential consequences of war at this time.
It is worth recalling that economies around the world are still recovering from the Covid-19 lockdowns. This hurt businesses, firms, households, and governments (due to high fiscal expenditures).
As a result, Russia’s medium-to-long term scenario could include persistently high inflation, a poorly valued currency triggering low trust in its banks, further driving high costs of borrowing. This could dry up private investment, which according to Bloomberg estimates, could affect more than 1.5% of the GDP, causing a deep-long recession (which seems inevitable).
Despite the volatility seen in global stock market trends and in terms of oil prices (given that Russia is a significant crude producer), the global impact of the crippling Russian (and Ukraine) economy from a war is still likely to be limited.
Russia’s current account to GDP ratio is also very low (as evident from the figure below). It accounts for less than 2% of world exports and has a GDP of less than 1% of world stock market capitalisation. Ukraine’s share in these aggregates is even lower, at 0.01%-0.3% respectively.
Financing a war, no matter how strong a nation is militarily, stretches the fiscal limits of any nation. It also balloons a government’s debt obligations to the rest of the world (from loans to government bought debt in the form of bonds). As the value of the ruble falls, the external value of all debt will rise and so will the value of all interest payments.
In a post-Covid scenario, when the capacities of states to spend more have been precariously weak, Russian capabilities will be tested too. The spike seen in fiscal expenditure over the last few months paints a grim future. With a collapsing ruble, the real cost of financing increased military operations could take its toll on Russian coffers.
Impact on India-Russia economic relations
As per Indian figures, bilateral trade during April 2020-March 2021 amounted $8.1 billion (see figure below). Indian exports amounted $2.6 billion while imports from Russia amounted $5.48 billion. For the same period, as per Russian figures, bilateral trade amounted to $9.31 billion, with Indian exports amounting to $3.48 billion and imports amounting to $5.83 billion.
Russia is one of India’s largest arms suppliers and a key strategic ally. Indian Prime Minister Narendra Modi recently invited Putin to India, which was seen as a way of maintaining Russia’s close strategic alliance with India despite New Delhi’s increasing warmth towards Washington. One reason for doing so could be to also avoid a closer Russia-China relationship, which now, under the financial pressure of sanctions, may become more closely knit.
On defining the nature of Russia-India military relationship, as Sameer Lalwani et al recently argued:
“The breadth of Russian-origin platforms in the Indian military – which our analysis suggests composes 85 percent of major Indian weapons systems rather than the 60 percent figure often cited –have created a ‘lock-in’ effect, while the depth of relative support to India’s technology base and strategic systems have engendered a relatively high degree of indebtedness and trust in key strategic circles. Yet the quantity and sensitivity of Russian contributions to the Indian arsenal – features that could reinforce and sustain the relationship much to the chagrin of US policy makers – have largely been underappreciated.”
In other words, both India and Russia share a path-dependent relationship that continues from their historic Cold War ties. In the near future, however, it will not be easy for India to continue doing its business with an economically damaged and sanction-hit Russian economy. But finding trade-substitutes for relatively inelastic (or essential) Russian imports in areas of defence procurement and arms supplies would be extremely difficult.
Some wonder why Putin failed to see all this coming. Given what he was planning to do, he should have known about what sanctions could do to the Russian economy. Or, did he miscalculate by assuming the global response to his aggression in Ukraine to be like the response after Russia’s annexation of Crimea in 2014, which was far weaker and less well-coordinated?
It’s difficult to say.
But this time seems different. The global financial and monetary system too is quite different. Yes, the dollar is still the dominant foreign reserve currency, but it doesn’t have the same hegemonic role as it did a decade ago or more.
The Chinese government and Chinese money will surely play a more critical role in assisting Russia in its financial obligations, but we do not know to what extent.
The political economy implications of sanctions on Russia could be more catastrophic if there is a will in US and European allies to make Russia suffer over the medium to long term. There might not be any pipeline deals. For instance, the Nord Stream pipeline plan is already in jeopardy. There will not be much foreign direct investment in or out of Russia. After all, who would want to invest a long-term financial commitment in a country whose leadership is autocratic and has shown a reckless contempt for its own rule of law?
More importantly though, if America and its allies have the persistent will to go directly after the vast overseas wealth of Russian oligarchs who have surrounded Putin and helped him stay in power, the subsequent suffering unleashed on Russia could be far worse – and put him under pressure.
As economists Filip Novokmet, Thomas Piketty and Gabriel Zucman have pointed out, Russia has run huge trade surpluses every year since the early 1990s, which should have led to a large accumulation of overseas assets. Yet, official statistics show Russia with only moderately more assets than liabilities abroad.
Economist Paul Krugman, looking at this, has asked the question: “How is this possible?”
“The obvious explanation is that wealthy Russians have been skimming off large sums and parking them abroad. The sums involved are mind-boggling. Novokmet et al. estimate that in 2015 the hidden foreign wealth of rich Russians amounted to around 85 percent of Russia’s G.D.P. To give you some perspective, this is as if a U.S. president’s cronies had managed to hide $20 trillion in overseas accounts. Another paper co-written by Zucman found that in Russia, ‘the vast majority of wealth at the top is held offshore.’ As far as one can tell, the overseas exposure of Russia’s elite has no precedent in history – and it creates a huge vulnerability that the West can exploit.”
The question is, whether democratic governments across the world, in a deeply unequal wealth landscape, can collectively align against Russia to do this. Many of their own influential business-persons have their business and politics deeply entwined with Russian kleptocrats. This is true not only in the US but also in Britain and much of Europe.
If Western powers go after some Russian oligarchs and their wealth in offshore accounts, it is likely to yield adverse consequences for their own oligarchs, who have their wealth in these accounts as well, and their operations connected with Russians.
Deepanshu Mohan is an Associate Professor of Economics and Director at the Centre for New Economics Studies, Jindal School of Liberal Arts and Humanities, OP Jindal Global University.