West pinches Russian central bank and banks. How far does this economic warfare go?

In recent days, it has symbolized the Western inability to hit Russia to the maximum with sanctions: while Ukrainian cities were bombarded by the Russian invasion force, Europe and the United States did not decide to cut Russia off from the international payment system Swift, a severe financial penalty.

That changed Saturday night: then announced the European Union, the United Kingdom, the United States and Canada to deny ‘selected Russian banks’ access to the SWIFT system.

The debate over Swift diverted attention from an – potentially – even tougher measure the transatlantic club announced on Saturday: sanctions against Russia’s central bank. The Russian central bank has kept a lot of foreign exchange reserves across the border. Those reserves would now be frozen, which means that the ‘piggy bank’ of the Russian state will partly disappear. The West’s confrontation with Putin is now turning into economic warfare.

1Why are the sanctions against the Russian central bank important?

In the words of the group of Western countries, these are “restrictive measures that prevent the Russian central bank from using its international reserves in a way that could undermine the impact of the sanctions”.

The step is far-reaching and unusual. There are only three known cases in the past: North Korea, Venezuela and Afghanistan, three states that have international pariah status. When the Taliban seized power in Afghanistan last fall, after the departure of American and other Western military personnel, they believed they had $9 billion in foreign exchange reserves. Because most of these were abroad – the lion’s share in the New York branch of the US Federal Reserve – the new Afghan rulers could not reach them.

With the pariah status that the Russian central bank now enjoys, access to and use of foreign exchange reserves abroad is also becoming more difficult. Russia’s foreign exchange reserves are used to defend the ruble’s exchange rate, selling dollars or euros and buying rubles, as the central bank did on Friday. That is probably going to be very difficult now. Since the beginning of this year, the ruble has fallen by more than 10 percent against the dollar. On Monday, when financial markets reopen, the Russian ruble could fall into a free fall. The fact that the Russian central bank still has limited access to its own reserves may also limit the Russian government’s ability to, for example, rescue banks that are suffering from Western sanctions.

Foreign exchange reserves are Putin’s main ‘war chest’ against other Western sanctions. The central bank has converted $631 billion in reserve. Although the share of dollars in this has shrunk, from 43 percent in 2014 to 16 percent now, dollars are still needed to pay for imports. 32 percent of Russia’s foreign exchange reserves are made up of euros.

Russian reserves include government bonds from Western countries (in dollars, euros or pounds) and more than a fifth of gold. It is unknown exactly how many of the reserves are held in Western countries, and are therefore no longer accessible to the Russian central bank. The International Institute of Finance, in which international banks work together, says it has no reliable data. But judging by the statements of the Western countries, it is a significant part.

Also read: Previous Sanctions Built Putin’s Financial Fort

2What exactly is Swift?

Swift is, in essence, a communication system between banks to facilitate cross-border payments. The organization Swift (in full: Society for Worldwide Interbank Financial Telecommunications) was founded in 1973 by American and European banks. Previously, banks communicated by telex before transferring money to each other. The financial system runs on trust and all kinds of safety valves have been built into Swift to guarantee that the transaction that is announced actually takes place properly. About 40 million messages are sent via Swift every day. More than eleven thousand financial institutions worldwide are connected to it, including more than three hundred Russian ones. Transferring money internationally without Swift is possible – only the processing becomes a lot more complicated, slower and more uncertain.

Swift is, legally speaking, a private membership organization. Its members are financial institutions. But the organization must comply with regulations, including sanctions. Since Swift’s head office is located in La Hulpe, Belgium, these are primarily EU rules. US regulations are also important, because an important Swift data center is located in the US state of Virginia. If Western authorities decide that banks from a certain country should be thrown out of the system, Swift has to cooperate. In 2012, this happened to Iranian banks, because of the western sanctions against this country. Now Russian banks are in the crosshairs.

3 What will be the effect of the Swift sanction?

In principle, this sanction could affect Russia considerably. Especially because it comes on top of the measures taken against individual Russian banks that were previously taken by the US, the United Kingdom and the EU. Their ability to make payments in Western currency has already been severely curtailed.

However, the effect strongly depends on the scope of the Swift disconnection, which is still unclear. For the time being, this does not concern all Russian banks, but ‘selected’ banks. Which one, will become clear shortly. An important question is whether large banks such as Sberbank (by balance sheet total accounting for 38.8 percent of the Russian banking sector) and VTB (19.8 percent of the banking sector) will be included on the list.

The question is also whether transactions in all economic sectors will be affected. The sanctions that the west imposed on individual Russian banks last week, including Sberbank and VTB, showed that an exception had been made for payments in the energy and raw materials sectors. This is because Western countries want to continue to make payments for energy supplies from Russia (good for about 700 million dollars a day, Bloomberg commentator Javier Blas recently calculated). Some EU countries, including Germany, are heavily dependent on Russian gas and fear an explosion in prices. The US is not, but will have to deal with higher energy prices on the world market if Russia can no longer sell energy because payments are no longer possible.

Another question is whether Russia can work around Swift. In order to circumvent Western jurisdiction over Swift, Russia (like China) has been working on alternatives in recent years. Russia now has the SPFS system, which handles 16 percent of interbank payments. Whether this system will work in practice, especially across borders, is highly questionable. Certainly because more and more individual Russian banks are also subject to Western sanctions.

4Will ordinary Russians also suffer from all sanctions?

This seems inevitable, although no one can predict exactly how the sanctions will affect the Russian economy. Their precise scope has yet to be determined.

In any case, the combination of measures against the Russian central bank, private banks and the decoupling of Swift is intended to paralyze the financial system, and thus the economy in Russia. The bill falls to the Kremlin, which must be given less financial elbow room for the war, but also to Russian citizens.

In the case of a free fall of the ruble, imports will become much more expensive, if the import can be paid for at all because of the banking sanctions. The Russian experiences of the Soviet times (empty supermarkets) and of the 1990s (hyperinflation) can thus be repeated in the 21st century. Whether the Russian banks will survive is also questionable. The Russian central bank was forced to declare on Sunday that the Russians can access their bank balances at all times.

If the Russians themselves lose confidence in their own currency and want to continue to buy foreign products, that in turn could contribute to ‘dollarization’, the circulation of more and more dollars among the population and business: exactly what Putin did not want.

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