Money has become a weapon in the expanding crisis over Russia’s demands for a halt to Nato’s eastern expansion. In the Cold War Russia and the West were ideologically opposed and had two systems: capitalism vs communism. Following the failure of the socialist experiment the emerging markets have all changed side, and that means the economies of the world all now share one idea: money and the need to make profits.

At a controversial press conference on January 19, US President Joe Biden officially promised that in the event of a Russian invasion of Ukraine, the United States would cut Russian banks off from the ability to work with the dollar – the first time the US currency has been named as a possible weapon to counter Russia’s aggression against its smaller neighbour.

Biden’s speech was more assertive than previous White House comments and the US president said: “I assume that he will move there, he must do something,” in contrast to the previous official position that Putin had not made up his mind on what to do next.

Biden went on to say that Putin does not want a full-scale war. “I suspect that it matters which side of the bed he gets up in the morning to know exactly what he is going to do,” the American president added.

Putin will "pay a high price" for invading Ukraine and will regret it if he does so. “He has never seen sanctions like those that will be imposed on him in this case,” Biden went on mentioning for example, Russian companies “may lose the opportunity to use the US dollar.”

Biden gave no details of how this sanction would work, but previously the US government has threatened to fine any bank that does business with a sanctioned entity and the compliance departments of banks will immediate block dealing with that entity, effectively cutting them off from that entity. As every major bank in the world has US representation a threat like this effectively becomes a global ban. Even Chinese banks became reluctant to do business with Russian Oleg Deripaska after he was included in an oligarch sanctions list in 2018, as they had some operations in the US that could have been targeted by the US Treasury Department (USTD) that oversees policing the sanctions regime.

Earlier, Bloomberg, citing sources, wrote that the US authorities are considering imposing restrictions on the conversion of the ruble into the dollar, euro and pound sterling as a potential punishment if Russia invades Ukraine.

Sanctions against foreign exchange transactions have not previously been applied, but there is a legal regulation of such restrictions. One of the simplest ways to implement this sanctions is for the USTD to add the relevant agents performing dollar-ruble exchange operations to the SDN (Specially Designated Nationals) sanctions list. Anyone on this list suffers a complete ban on access to the US financial system. For example, in 2019, the United States added the Venezuelan government to the SDN list, as a result of which Caracas had to pay interest on a Russian government loan in rubles rather than dollars, reports The Bell.

The latest “the sanctions from hell” bill names 13 Russian banks that would be targeted in the event of a Russian invasion of Ukraine and added to the SDN list.

Russian response

Talk of sanctioning Russian banks and its financial sector began almost immediately after the annexation of Crimea in 2014 and the Kremlin has been preparing ever since. Putin has also used money as a weapon, but in his case as a defensive one.

The most obvious place where Russia uses money to defend itself is the accumulation of reserves. Last year CBR Governor Elvira Nabiullina said her reserves “comfort level” was $500bn, a target that was hit and then surpassed to the point where Russia’s reserves at the start of this year were $630bn – an all-time high.

However, this amount of money is equivalent to 38% of GDP, or a couple of years of import cover, and far in excess of what is needed to ensure the stability of the ruble – some three months of import cover, according to economists. It is enough money to pay off Russia’s entire external debt and public debt tomorrow in cash and still have $100bn left over, which is itself still more than the three months' import cover needed to keep the ruble stable.

The only reason that the governor of Russia’s central bank would contemplate holding so much cash is because she is expecting trouble.

At the same time, Russia has paid down its external debt until it was a mere 14% of GDP. This is in a world where many countries are currently running debt to GDP ratios of over 100%, well in excess of the 60% of GDP that the Maastricht criteria to join the EU recommend as a maximum safe level.

In the last year, thanks to the double whammy of an oil price shock and the coronacrisis, Russia’s external debt has ticked up to around 20% of GDP, but that remains amongst the lowest government debts in the world.

In addition to the investments of reserves made by the government, Russia has reduced its exposure to the US T-bills by $100bn, the de rigueur investment of reserves for governments around the world. Russia’s companies have also long ago deleveraged following the 2008 global financial crisis and another crisis and deep devaluation in 2014, and have not leveraged up again since.

All these measures have made Russia largely sanction-proof, as without debt there is no point of leverage the US has over the Russian government, and with such huge hard currency reserves the Kremlin has the financial resources to bail any part of the economy that is targeted by the US.

The one place where the Russian government is vulnerable is its Russian Ministry of Finance ruble-denominated OFZ treasury bills that are the workhorse of the Ministry of Finance, used to fund the budget spending.

Since the capital markets revolution in 2011, Russia was hooked into the international settlements and payment system Clearstream and traders in London and New York can buy the OFZ bonds from the comfort of their own trading desks. Some $40bn of investments have flowed into the Russian domestic bond market. Today foreign investors hold some 19% of the outstanding OFZ bonds, down from a peak of 32% in March 2020.

One of the harshest mooted sanctions is to ban foreign investors from holding or trading in these bonds, but even in the latest sanctions from hell, proposals that target both the primary and secondary markets in OFZ bonds already in circulation have been excluded. Thanks to the so-called “Russia risk” these bonds are very lucrative and widely held by international and US institutional investors. Any punitive sanctions on the widely held existing bonds are unworkable as they become impossible to sell and would have to be marked to zero, causing the backbone of the US insurance and pension fund business to incur billions of dollars in loses, as the USTD found out when it tried to ban ownership in Deripaska’s bonds.

Fiscal fortress

Putin has long understood that having a lot of money is a strategic weapon and one of the unintended consequences of the sanctions regime has been to goad the Kremlin into making long overdue deep structural reforms to squeeze more cash out of the economy.

There are three main areas where these reforms have made the most progress: the budget execution, the tax system and the banking sector.

The Russian economy has returned to the happy position of running triple surpluses – trade, current account and federal budget – and as in the words of Charlie Robertson, head of research of Renaissance Capital, is “swimming in money” at the moment.

“Exports are up 41% year on year ($350m) every day vs a year ago and topping $1.2bn a day ($50mn per hour). A reminder that when an oil exporter adds to geopolitical risk, it makes more money. Even better for Saudi, which gains without the same risks,” Robertson said in a tweet. Oil prices hit $88 on January 20 – their highest level in years.

However, the 2021-2023 budget is yet again an austerity budget, where the government is cutting public spending and keeping borrowing low. Even in the depths of the coronacrisis it spent only 3% of GDP on economic stimulus programmes – one of the lowest levels in the world – to support the economy and incomes.

That has led to the economic growth potential being limited to a lacklustre 2% pa, whereas if the government spent some of its reserves or leveraged up the economy it could boom. Putin has long shown that he is prepared to sacrifice the country’s prosperity to achieve his geopolitical goals.

The tax and banking sector reforms the sanctions are partially responsible for promoting have both been highly successful and are almost complete.

Prime Minister Mikhail Mishustin cut his teeth in investment banking, where he was a specialist in building financial IT systems before being appointed head of Russia’s tax service. The IT revolution he carried out there and a campaign to shutter the myriad tax scams led to a 20% increase in tax revenues in a period where the tax burden was only increased by 2%.

Likewise, when CBR Governor Elvira Nabiullina was appointed in 2013 she began a campaign to close down the “bank-like institutions” that were at best glorified treasury operations for companies and at worst money-laundering chutes to whisk cash offshore out of the hands of the taxman. The number of banks fell from over 2,000 to 372 as of the start of this year.

The banking sector clean-up is now over and Russia has a banking system largely similar to that of Germany, as Russian President Vladimir Putin ordered at the start of the reform.  

No unity amongst Nato members

The issue of money has become divisive amongst Nato members. The US has suggested that one of the more extreme measures that could be used against Russia is to cut it off from the SWIFT messaging service that enables international money transfers.

However, German business newspaper Handelsblatt ran a story this week citing an anonymous government source saying that Berlin had taken a SWIFT ban off the table and it would not be included in any sanctions package. The story was later denied by the German government, but the idea of a SWIFT ban has been very controversial. It would make it very difficult for EU members to pay for imports of Russian gas and oil and other commodities and some analysts have suggested shutting Russia out of SWIFT could spark a financial crisis in Europe and worsen the energy markets already roiled by the ongoing gas crisis.

Russia’s trade with the EU has fallen by about a third since sanctions were first imposed in 2014 following the annexation of Crimea but the annual trade turnover was still around €200bn in the first ten months of last year, making the trade club Russia’s biggest trade partner. Most of those payments would become problematic if Russia was banned from SWIFT.

The EU’s reluctance to impose sanctions that actually cost it money was highlighted by the five rounds of some of the harshest sanctions ever imposed on Belarus over the last two years. Despite bans on trade with some of Minsk’s biggest earners such as potash fertiliser, trade between the EU and Belarus doubled in 2021, triggering some to question whether Western sanctions are strong enough, including the exiled Belarusian opposition leader opposition leader Svetlana Tikhanovskaya, who says Lukashenko has exploited "loopholes" to circumvent them, reports RFE/RL.

US Secretary of State Antony Blinken was in Kyiv on January 19 to show solidarity with Ukraine but went on to Berlin the next day where he met with his German, French and British counterparts to try meld a united front against Russia before his scheduled meeting with Russian Foreign Minister Sergei Lavrov in Geneva on January 21.

De-dollarisation

It remains to be seen if Biden will actually follow through on his threat to cut Russian banks off from the dollar, as if it happens it will likely have serious long-term consequences for the US.

Moscow and Beijing were already uncomfortable with their dependence on the dollar to settle international trade contracts and have started to use their national currencies to pay each other. From nothing in 2008, today a quarter of Sino-Chinese trade is settled in local currencies. At the same time, Russia has reduced the amount of dollars it holds in its reserves and introduced the yuan to the basket.  

In bilateral trade with China, about 14% of payments are already done in yuan, and about 7% to 8% in the ruble, according to Russia’s Finance Ministry.

“The structure of Russia's foreign exchange reserves is clearly different from most other central banks in the world. At the end of June 2021, 32.3% of the reserve was in euros and 16.4% in dollars. In 2018, the central bank transferred a significant portion of its dollar investments to the Chinese yuan, and in June 2021, the share of yuan-denominated investments was 13.1%. Gold accounted for 21.7% of total reserves. According to IMF statistics, the yuan accounted for only 2.6% of central banks' foreign exchange reserves in June. The Central Bank of Russia accounted for a quarter of all central bank yuan investments ($314bn),” Bank of Finland Institute for Economies in Transition (BOFIT) said in a recent note.

Weaponising the dollar will only catalyse this process of de-dollarisation. The basis of any financial system or fiat currency is trust. The British pound bears the legend “I promise to pay the bearer one pound” as the note is not money qua money, but a note of promise to pay money to the holder of the note, originally in the form of gold. Using money as a weapon undermines this trust.  

The use of dollars as the currency of preference gives the US enormous geopolitical power and at the same time being the reserve currency of choice it also creates an enormous pool of money for the US government to draw on in its own borrowing.  

Undermining that trust and penalising Russian banks will only drive Russia closer into the arms of China, with which Russia has already been actively developing an alternative payment system. Moreover, China will be equally concerned by Russia’s exclusion from the dollar settlement system, as clearly Biden’s agenda is to deal with the China problem next and Beijing will be next in line for the same treatment. Other countries that are also on the US problem list will be equally concerned and also want to have alternatives to the dollar system. None of this is in the US long-term strategic interest.