Megara, a little-known town in western Greece, holds the honor of being the world’s first recorded victim of financial warfare. In 432 BC, the Athenian empire sanctioned Megara, excluding it from trading with Athens-allied ports and markets, to punish the town for allying with the Spartans.  The Athenians’ refusal to accede to the Spartan demand for the sanctions to be withdrawn is believed, by many, to have led to war. Since then, financial warfare -- in the form of sanctions, embargoes, and asset freezes -- has become a frequent tool of statecraft. But arguably, the concept has never before been put to the test as it is now in Russia.

Sanctions are normally twinned with the threat of force. For example, in addition to severe international sanctions, Iran has always had the possibility of an Israeli strike looming over its head. But the sanctions regime imposed on Russia by the United States, Canada, and the European Union is bereft of its sibling. No one seriously expects the outside world to respond to Russia’s actions in Ukraine with violence and so, perhaps for the first time, sanctions have been left on their own. Since they have not forced Russia to immediately withdraw from Ukraine, some commenters, including former Cold War West German Chancellor Helmut Schmidt, have derided them as toothless and failing.

Yet unlike the case of Iran, where the goal was to force it to de-escalate its nuclear program as quickly as possible, with Russia, the world can take time to tighten the screws. The goal is not to freeze the assets of individuals or immediately change their behavior but to fully undermine Russian President Vladimir Putin, whose power and legitimacy flows from Russian economic success. Creeping sanctions can target Russia’s trading connections with the West, its use of the global capital markets, and its reliance on the international banking system one by one. That will sow uncertainty about Russia’s financial future and will be more palatable to those in the international community who have their own parochial interests in Russia, such as warship deals, energy supplies, or financial services. 

Even prior to its actions in Ukraine, Russia was dealing with strong economic headwinds, including a sharp reduction in foreign investment. According to the World Bank, Russian GDP growth will likely fall from 3.4 percent in 2012 to an estimated 1.3 percent for 2013. This is far below the average rate of seven percent during the previous decade. Putin’s actions in Ukraine are at best going to lead to economic stagnation and at worst to a contraction on an economy that can ill afford to be the victim of such an own goal. Already, the country’s Ministry of Economic Development forecasts that capital outflows in the first quarter of 2014 will to be close to $70 billion, which is more than the entire year’s total in 2013.

Since sanctions were announced, the pace of negative financial news has increased. Stock prices have fallen. The Russian ruble has weakened. That has dealt a blow to Russian companies with foreign-currency-denominated borrowings and has increased the cost of imports. In turn, inflation is set to rise even higher than the seven percent level that Russia’s Ministry of Economic Development expected for March. Meanwhile, Russian government and corporate borrowing costs have escalated after the central bank announced a temporary increase in its key interest rate, due, it said, to “the risks for inflation and financial stability arising from the recent increase in financial market volatility.” Domestic government bond sales have been cancelled due to unfavorable conditions, and international investor demand for Russian stocks is drying up, which makes the country’s planned $7 billion of international bond borrowing for 2014 look doubtful. Visa and MasterCard have suspended certain services in Russia, and the rating agencies Fitch and S&P have lowered their outlooks for Russian debt.

Perhaps feeling the heat, Putin called U.S. President Barack Obama last Friday to arrange another round of talks between U.S. Secretary of State John Kerry and Russian Foreign Minister Sergey Lavrov. Over the weekend, the two discussed political solutions to the standoff over Ukraine. And all this has come after sanctions on only a handful of individuals and one bank, Bank Rossiya.

So how have such “toothless” sanctions had such a big payoff? The reason is that Russia’s economic growth, although often attributed to its energy exports and the rise in oil prices in the last decade, was not dependent on expensive energy alone. It also came from investor confidence, stable bank lending, bond market borrowing, and stock market placements. Russia, unlike other recent targets of economic sanctions, such as Iran and North Korea, is fully plumbed into the global financial marketplace. And if that global financial marketplace loses confidence in Russia, all that will be wiped out. The creeping sanctions regime has already given the financial community doubts. And those will likely only get worse. As Russian deputy Prime Minister Igor Shuvalov observed, the greatest damage may come not from the announced sanctions but from covert financial actions coupled with fear of what might come next.

In other words, drastic steps such as sanctioning the Central Bank of Russia or cutting Russia off from SWIFT, the international financial messaging service, are not needed. Banks looking to protect themselves and their investments will self-sanction to avoid any risk of association, however tangential, with blacklisted individuals or companies. As Lee Wolosky, a partner at Boies, Schiller & Flexner, observed in his recent article for Foreign Affairs, in the case of Iran, financial institutions withdrew voluntarily before being legally required to do so. The past few weeks have seen this process begin again.

So what should the West do to keep the uncertainty about Russian banks alive? It will be essential to keep investors and lenders guessing, which will limit the return of confidence in Russian investments. Sanctions on individuals well connected with Putin and the Russian economy have proved effective. They should be repeated, as should the strategically selected sanctioning of the business interests of these individuals. The goal is not to freeze assets or entire industries but to demonstrate to Russia that if it wishes to continue to benefit from the global economy -- which has helped it recover from its broken state in the 1990s -- it needs to abide by accepted global norms of behavior.

Sanctions on the energy industry are unnecessary. The development of U.S. shale gas, the possible tapping of strategic oil reserves, Europe’s adoption of policies to reduce reliance on Russia and create greater energy independence (Germany is reconsidering its populist Energiewende policy to shut down nuclear power stations in the aftermath of the Japanese Fukushima disaster), and Iran’s expected return to the international energy market will reduce demand for, and thus income from, Russian energy exports. With global oil markets already close to Russia’s break-even price, the Russian economy is set to suffer with or without sanctions.

Of course, Russia’s financial position is still far from precarious. It has $490 billion in foreign exchange and gold reserves sitting in its central bank. That is certainly enough to prop up banks shunned by the international capital markets and global banking system, support a currency avoided by investors and depressed by rising inflation, and keep afloat an economy weakened by subdued demand for its main export. But Putin’s power is closely linked to Russian economic success, and any financial pain will not go unnoticed.

Whether by design or (more likely) necessity, the West’s creeping sanctions are effective. They sow uncertainty in the minds of investors and put increasing pressure on Putin’s Potemkin economy. For the foreseeable future, there is no doubt that Crimea is lost to Russia and that the fallout from sanctions will mildly damage the global economy. What is far less clear is the price that Russia is prepared to pay for its revanchist actions, a price that will be determined by Western governments’ willingness to nurture and feed the growing market uncertainty and fear. Ultimately, perhaps as demonstrated by this weekend’s flurry of diplomatic activity from Moscow, what we may be witnessing is the coming of a new era of financial warfare.

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  • TOM KEATINGE, a former investment banker at J.P. Morgan, is an analyst of finance and security. Follow him on Twitter @keatingetom.
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