All the Tsar’s Men
Why Mobilization Can’t Save Putin’s War
As tensions rise in eastern Ukraine and Russia talks ominously of a civil war in which it might have to intervene, observers from Washington to Brussels have started questioning whether sanctions -- the West’s current preferred method for dealing with Russia -- can hold the country at bay.
In fact, although sanctions have only a spotty record of achieving political objectives, they could be unusually powerful in this case. Russia’s relationship to global financial markets -- integrated, highly leveraged, and opaque -- creates vulnerability, which sanctions could exploit to produce a Russian “Lehman moment”: a sharp, rapid deleveraging with major consequences for Russia’s ability to trade and invest.
So, even as the West combines lesser sanctions with measures to support economic stability in Ukraine, lessen its long-term dependence on Russian energy, and otherwise signal that there will be costs to further aggression, it should hold the threat of robust financial sanctions in reserve. If Russia does move against Ukraine again, the West will need to hit back hard.
To date, the sanctions placed on Russia have been limited and largely symbolic. A small number of businesspeople and officials -- and one bank thought to be closely associated with the Kremlin -- have been hit with travel bans and asset freezes. The G-8 has been suspended and replaced with the G-7, which excludes Russia. And trade and financial negotiations between Russia and the West have been put on hold.
The rather muted response reflects worry, particularly in Europe, that deeper sanctions could dampen economic growth and provoke retaliation from Russia. Some in Europe also want to follow a tiered strategy, which preserves off-ramps should Russia decide to step back from the brink and holds out the possibility that tougher measures are in store. For example, there is apparent consensus that, should Russia move into eastern Ukraine, the G-7 would implement more far-reaching sanctions on specific companies and industries.
So far, sanctions have extracted a price from Russia for its belligerence. The country’s stock market is down ten percent so far this year. The ruble is, likewise, down nearly ten percent despite an emergency exchange market intervention and a sharp rise in interest rates. And, in the first quarter of the year, some $60 billion to $70 billion in capital fled the country. At the same time, there has been little, if any, effect on global markets, including German equities (which have been closely watched because of Germany's substantial exports to Russia). Developments on the ground in recent days, moreover, might have given political analysts shivers, but markets remained unshaken.
The lack of global fallout from the sanctions suggests that the West could safely ramp them up. But would that work? That depends greatly on what is meant by "work." If one means dislodging Russia from Crimea, probably not. A more realistic objective would be deterring Russia from any further excursion into, or destabilization of, Ukraine and sending a signal to other countries about respecting sovereign boundaries. And if that is the goal, there is room for hope.
In the past, sanctions have had a mixed track record of effectiveness. They have been more likely to work when they are multilateral, when they are aimed at a well-defined economic objective rather than a broad geopolitical agenda, and when the targeted economy is less developed and more vulnerable to a trade disruption. Russia thus seems like an unlikely candidate for sanctions. Even so, its economic complexity (unique for a sanctioned country) is an opportunity. Greater integration means that Russian oligarchs and business leaders have significant stakes in the West -- businesses, wealth, houses, and soccer teams -- that are vulnerable to sanctions.
Direct bans on business trade and investment would meaningfully reduce Russian wealth and growth. And, to the extent that business leaders influence policy, such bans could change Russian behavior. More powerful, though, would be financial sanctions. Broadly speaking, that has to do with the inherent importance of finance for cross-border trade and investment. More specifically, it reflects the complexity of Russian entities' financial dealings with the West and the potential for forced, rapid deleveraging -- an intense "Lehman moment" of the sort that global markets saw after Lehman Brothers collapsed and AIG was bailed out in September 2008. Without financing, denied access to the international payments systems, and with the loss of trust that such a huge financial break would engender, cross-border Russian investment could implode. A small-scale example came last month, when Visa and MasterCard temporarily halted payment services to Rossiya, the sanctioned (and very small) Russian bank. The bank was effectively severed from the global financial system. Although the impact for the overall economy was limited, the message was heard, and Moscow scrambled to develop an alternative national payments system.
The West can mete out some degree of financial punishment without even explicitly sanctioning Russian banks. Often underappreciated is the extent to which a simple tightening of know-your-customer and anti–money laundering rules can discourage Western financial institutions from taking on Russian clients. This would lead to the reduction of credit limits and the halting of joint projects. Even now, there is anecdotal evidence that companies doing business with Russia are becoming more cautious, waiting to see what happens. This may well be what the White House had in mind -- hoping that putting the gun on the table would send a tough signal, even if the weapon is never fired.
Financial sanctions, like all sanctions, are more powerful if they are multilateral, and the United States is right to seek the support of Europe and other partners for intensified sanctions. German support will be crucial in particular, and other Western partners must agree not to fill in the gap left by the United States with their own deals with Russia. But the U.S. position as the core financial center and as the minter of the global reserve currency allows its financial sanctions to have a broad reach even without universal buy-in. Consider that, because of the United States’ special role, financing and payments for assets are secured and cleared in U.S.-based systems. Those assets may then be refinanced, and so on, outside of U.S. institutions. But as long as a U.S.-based firm is involved in some leg of the transaction, financial sanctions can bite; like a string of Christmas tree lights, one nonfunctioning bulb can shut down the whole thing. Also helping matters is that, because Russian banks and commodity companies are major players in foreign exchange and commodity markets, they need access to dollar-based financing and collateral for transactions in those markets. The Bank for International Settlements reports that U.S. and British banks have $56 billion in direct hard currency claims on Russia, and another $135 billion in “other claims,” which are presumably mainly derivatives. That number highlights the scale of the deleveraging that could be required on Russia’s end if the United States cuts it off from U.S. financial tools.
For the time being, the potential for Russian retaliation and concern about the costs to the West from sanctions has put the brakes on further sanctions, and understandably so. With Europe receiving roughly 30 percent of its natural gas from Russia, the economic disruption caused by sanctions would be sizeable. Beyond oil, Russian financial sanctions would have meaningful and visible effects on certain Western markets: Asset prices would decline if sanctions reduced Russian investment. Trade would be lost. And some Western financial institutions would need to sell off their investments and hedges, and repay debt. The effects would be unevenly felt, and hard to quantify in advance. Central banks would need to ensure adequate liquidity to limit the deleveraging pressures in the West. But starting from a stronger fundamental position, and with better supportive policies, the damage to Western economies should be less than the damage to Russia.
The risks of retaliation should also be taken into account, but they should not be a barrier to action. Arguably, it is the costs of retaliatory sanctions on the West that adds power to its own commitment to sanction Russia. It makes Western sanctions more credible and sends a more powerful signal to other countries. Of course, sometimes you end up taking the pain when you would rather not (recall that the U.S. budget sequester was meant to be so draconian that Republicans and Democrats would agree on a long-term fiscal plan in order to avoid it). But it may be worth the risk given the stakes, a point that European leaders are now beginning to make too.
Sanctions, of course, cannot be expected to carry the full load. They need to be supplemented by an “all of the above” approach”: positive measures, such as strong financial support for Ukraine that reduces the amount of austerity required in the near term and the previously mentioned oil market measures. But together they can be effective. And any costs that they entail must be weighed against the costs of doing nothing and the risk of protracted instability. At a time when Russia is providing an unprecedented challenge to the existing rules of the international order, preserving the integrity of the Ukrainian state and supporting its economic and political reform may tip the balance toward action.