Not Oligarchs, Not SWIFT

First, talk of financial sanctions has previously tended to focus on the flows of Putin government–connected and, often, criminal financing that make their way through Western banking systems — notably including London. Restrictions on the ability of this or that oligarch to transact as they wish, whilst important, are closer to a severe nuisance rather than applying critical pressure. Likewise, the ban on “golden passports” for oligarchs is long overdue, but hardly a knockout blow.

Second, the critical part of the package is not the removal of three major Russian banks from the SWIFT interbank messaging system. There has been significant confusion over this, and to the extent that SWIFT is mistaken for a payments system or something fundamental to the operations of a bank, noisily announcing a sanctioned removal of Russia from the system could undermine public confidence in its banks.

But SWIFT is not a payments system, and is not required for conventional domestic transactions; it facilitates the more rapid request of money transfers between international banks, and therefore facilitates foreign trade. It is not essential to foreign trade: banks in different countries can request money from each other in different ways if they are denied access to it, even if that has to be via fax.

Since 2014, after the United States first threatened to pull the plug on Russian access to SWIFT, the country has been busily setting up its own interbank communications system, SPFS, operational since 2017. “Sleeving” of trades, in which a third party is commissioned to provide trade credit and undertake trade between Russia and some country seeking to buy oil or gas, is also an option.

Russia isn’t unusual in establishing its own, alternative monetary systems. China has a separate bank payments system, the Cross-Border Interbank Payments System, operational since 2015 and providing renminbi-denominated payments services for eighty participating banks, HSBC and Standard Chartered amongst them. India is currently moving toward establishing a rupee-denominated payments system to “soften the blow of sanctions.” India, whose ties with Russia stretch back to its earliest years free of the British Empire, continues to be Russia’s biggest market for defense and security equipment. A similar system was established by New Delhi to swerve round sanctions imposed on Iran.

Over the longer term, the political restrictions now being made to the US-centered (if Belgium-headquartered) main global interbank messaging service are likely to only reinforce the tendencies against globalization, and toward the organization of the world economy into regional blocks.

But the immediate impact is what matters this morning. Deprived of full access to SWIFT, trade between Russia and the rest of the world will become harder, including the crucial oil and gas trade. (S&P Global here have details on how Russia trades its oil.) That, in turn will make accessing foreign currency harder and, therefore, a step down the line, might begin to threaten the stability of its banking system. As Zoltan Pozsar of Credit Suisse argues, a SWIFT ban will act to further weaken the Russian economy — with some risk of financial blowback in the West. But it’s not the main financial weapon being deployed here.

Nor has oil and gas trade been directly targeted. With prices for both already shooting up, and with Russia supplying about 40 percent of Europe’s natural gas, the costs to those trying to apply the sanctions start to look greater than the benefits of applying them. Liquefied Natural Gas (LNG) from producers including Qatar and the United States now supplies about 20 percent of demand across the continent. But there are limits to supply, both at the production end and at LNG terminals in Europe, and European demand is only part of a global market. Any increase in demand here is competing with demands for gas across Asia and beyond. Gas stocks in Europe, meanwhile, are at a record low: were Russian gas flows to halt entirely, the continent has about six weeks’ of supply at hand. It is, no doubt, an awareness of this dependency that emboldens the Putin government.

Weaponizing Central Banks

There is, however, an economic weapon that can be utilized at no economic cost to those wielding it. A bank run in Moscow costs Berlin, London, or Washington nothing. And so the primary weapon of the sanctions package are the restrictions on Russia’s central bank. The joint communiqué says:

[W]e commit to imposing restrictive measures that will prevent the Russian Central Bank from deploying its international reserves in ways that undermine the impact of our sanctions.

Specifically, this is aimed at blocking the Bank of Russia from selling much of its reserves on international markets, these reserves being valued at around $640 billion. In recent days, it has been selling these at pace, buying up rubles in an effort to preserve the currency’s international value. If Bank of Russia cannot sell its reserves, with institutions holding its assets unwilling to offload them, and others unwilling to buy them, the operation to prop up the ruble becomes impossible. The ruble will collapse, as we have seen this morning. That, in turn, threatens a bank run, as depositors look to remove their increasingly worthless rubles from bank accounts, and turn them into more valuable and stable currencies — like the dollar or the euro. A run on Russian banks may, at the time of writing, already be underway, with queues at banks reported over the weekend.

Not all of Russia’s central bank reserves have been rendered useless. Around $145 billion of them are held as gold (which is physically held in Russia) and, if it cannot be sold directly — literally transferring physical bars of the yellow metal — it can in theory be converted into promises to pay them later. A further $90 billion (or around 14 percent) of these reserves are held as renminbi, and China has consistently indicated it will not join measures against Russia.

Bank of Russia has spent the years since 2014 busily both building up its reserves and divesting itself of dollars and dollar-denominated assets. Its $6 billion holdings of US Treasuries today are far below the record high of $176 billion in October 2010.

This was completely political — a deliberate attempt to minimize the potential impact of future sanctions, of the kind being applied now. Its huge current account surplus, the $19 billion difference between what Russia exports and what it imports that has been built up over a decade of oil and gas sales, also provides some protection against aggressive economic sanctions. The share of dollars in Russia’s export trade has fallen from 69 percent in 2016 to 56 percent in early 2021 — still significant, but a reduction in potential exposure nonetheless.

Likewise, the “swaplines” that came into their own between the Federal Reserve and major economy central banks in the depths of the 2008–9 financial crisis, providing cheap dollar funding from the Federal Reserve to other central banks when interbank markets were not able to, have been increasingly emulated by non-dollar economies. The Council on Foreign Relations has an animation, showing the growth of global swaplines since the 1997–98 East Asian crisis here, alongside an explainer of their operations.

These swaplines now form the backbone of an emerging and increasingly regionalized financial system. Swapline arrangements are globally worth $1.9 trillion, and other “regional financing arrangements” $1.4 trillion. Both are hugely bigger than the International Monetary Fund (IMF)’s $1 trillion of available resources for use in financial emergency.

China and Russia have had a renminbi swapline open since 2014, whilst China has signed more than thirty-two swapline deals with different countries since 2009. The declaration, just a few weeks ago, by China and Russia of a “friendship without limits” showed the direction of travel back then.

But China-Russia direct trade remains only a part of Russia’s exports. And evidence is mounting that Chinese financial institutions, fearful of “secondary sanctions” against those dealing with Russia from the United States and its allies, are quietly tiptoeing away from support. China may want a post-dollar world, but Russia’s invasion of Ukraine preempts that goal by perhaps decades.

How the ECB Deployed the Central Bank Weapon

The economic blow from central bank sanctions on Russia will remain exceptionally severe. Bank of Russia will likely find that capital controls and dramatic interest rate hikes are what it relies on to try and defend the ruble and thus its banking system.

Central banks are the nerve center of any currencies’ finance and banking system. Their primary function is to act as a “lender of last resort” for a currency’s banks, stepping in to guarantee that banks in financial difficulties do not fail. As an extension of this primary function, they may well have powers to (for instance) defend the value of a country’s currency — which can be seen as a subset of defending the credibility of its banks.

But this huge domestic power can be flipped, judo-style, into an overwhelming weakness where a country no longer has full control over its central bank and cannot, as a result, guarantee the stability of its banking system.

There is a precedent for the weaponization of central banking that we are now seeing play out. Documents leaked in November 2014 showed that the European Central Bank (ECB) threatened the Irish government with the collapse of its banking system if it did not accept the ECB/EU/IMF bailout four years earlier. Even more dramatically, the ECB repeatedly threatened to end emergency support for Greece’s insolvent banks if the newly elected Syriza government did not accept the bailout conditions it was offered from February 2015 onward. These conditions included extended austerity, to which Syriza was vehemently opposed. Syriza attempted to get out of the bind with a referendum on accepting the bailout in July that year, but its gambit failed. Europe’s first radical left government in decades was brought to heel.

Both Ireland and Greece were eurozone members and politically aligned with the European institutions — ultimately, it was Greece’s unwillingness to break more fundamentally with those institutions, by leaving the euro, that allowed the ECB to threaten its banks’ collapse, and scuppered Syriza’s anti-austerity program. Outright central bank sanctions, too, were used during the financial crisis. Britain’s freezing of Icelandic financial assets in October 2008, using the powers available under the Anti-Terrorism, Crime and Security Act 2001, saw its central bank briefly (if incidentally) targeted.

The same ECB technique — attack the central bank to undermine the banking system — has now moved from threat to application against a hostile country, presently at war with a close ally of those applying sanctions. The warhead of the weapon is the same, but the context is radically different, and radically more dangerous as a result: Putin’s lurch from dark hints to the mobilization of Russia’s nuclear forces shows both how effective the weapon is, but also the grave consequences of actually using it.

Russia cannot respond in kind to the central bank attack — Russia’s financial system is small, relative to the dollar-finance system, and weakly integrated into it — and so its government has instead responded where it has the capacity to do so. It is troublingly unclear how far this prospect of an immediate Russian military escalation was built into the Western powers’ planning.

The people that suffer most immediately from the joint powers’ central bank sanctions will, of course, be the Russian public, now contemplating the loss of an elementary utility in modern life, the banking system, alongside the serious prospect of hyperinflation. The rest of us, meanwhile, are being dragged terrifyingly closer to the precipice of nuclear war.