How the West can increase its chokehold on Russia’s economy

The rouble’s depreciation has highlighted just how much pressure the war in Ukraine – and the sanctions imposed in response – has placed on Russia’s economy
While the sanctions are clearly working, Putin’s continued ability to fund his war shows more must be done

Sergei Guriev

Published: 3:30pm, 23 Aug 2023

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Within days of Russian President Vladimir Putin’s full-scale invasion of Ukraine 18 months ago, the West imposed unprecedented sanctions on Russia’s central bank, freezing hundreds of billions of dollars of its assets. The rouble plummeted, reaching a record low of 150 to the US dollar 10 days after the invasion. But, after the central bank imposed currency and capital controls, the rouble bounced back.

Russia’s leaders have less to celebrate today. The rouble exchange rate offers the most visible indication of Russia’s economic performance, at least for Russian households.

So, the currency’s recent dip below the politically important threshold of 100 to the dollar made the Kremlin nervous. And it put the central bank – which, over the past year, has loosened or removed many of its capital controls – under fire.

Putin’s economic aide, Maxim Oreshkin, wrote an op-ed blaming policymakers for being too “soft”. The central bank immediately called an extraordinary board meeting, where it decided to raise interest rates by 3.5 percentage points, and signalled that more hikes are likely to come.

Additional currency controls also appear to be on the table. Meanwhile, Finance Minister Anton Siluanov reportedly advocates forcing Russian exporters to repatriate their dollar revenues and sell them to the central bank.

To be sure, there is no reason to think that Russia’s economy is on the brink of collapse. There is nothing magical about the 100 rouble threshold. And the recent rate hike is a textbook reaction to rising inflation.

Nonetheless, the depreciation has highlighted just how much pressure the war – and the sanctions imposed in response to it – has placed on Russia’s economy.

04:15

Russia’s rouble falls to lowest value against US dollar since Ukraine war began

In April last year, I wrote that Putin should not celebrate the rouble’s rally, which reflected two developments that would ultimately prove bad for Russia’s economy.

First, imports had declined as a result of Western sanctions, resulting in lost access to imported consumer goods and intermediate inputs, thereby constraining Russia’s manufacturing capacity. Second, oil-export revenues had increased – a development that would motivate Western governments to impose an oil embargo and a price cap on Russian crude.

That is exactly what happened. In May 2022, Europe announced that an embargo on about 90 per cent of Russian oil imports would take effect within the subsequent six to eight months. Not long after, the G7 countries agreed to a price cap.

The delayed introduction of these policies allowed Putin to rake in huge revenues. Though the West had frozen about US$300 billion of the Russian central bank’s reserves, Russia’s record current-account surplus last year, at US$227 billion, almost made up for it.

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But this bonanza is well and truly over: in the first half of this year, Russia’s oil and gas revenues fell by almost half, causing the budget deficit to grow to 2 per cent of annual gross domestic product.

The oil embargo and price cap also caused Russia’s total exports to plummet by one-third, year on year, in January to July this year. As a result, Russia’s trade surplus shrank from US$204 billion to US$64 billion, and its current-account surplus declined from US$165 billion to just US$25 billion.

Predictably, the sharp decline in revenue from hydrocarbon exports has fuelled a rapid deterioration in Russia’s fiscal position. For a while, Russia’s leaders appeared unfazed: the country still holds substantial renminbi reserves, so it can afford its budget deficit.

And the war in Ukraine remains the Kremlin’s top priority: in the first half of this year alone, Russia’s military spending was reportedly 12 per cent higher than the amount budgeted for the entire year.

Beyond funding the war, Russia’s government hoped that continued spending would give the economy a Keynesian boost. But these hopes have not materialised, precisely because trade sanctions have undermined Russia’s productive capacity.

Isolated from the West and having lost hundreds of thousands of workers to the war and emigration, Russia’s economy simply cannot produce as much as Putin wants.

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With Russia’s economy overheating, higher government spending simply fuelled inflation. Add to that continued capital outflows – which accelerated after Wagner Group boss Yevgeny Prigozhin’s aborted mutiny in June – and the rouble’s recent depreciation was to be expected.

Nor should anyone be surprised by the central bank’s decision to pump the brakes, despite the likely impact of higher interest rates on output growth. Bloomberg now puts the probability of recession in Russia in the next six months at 21 per cent, compared to 6 per cent before the rate hike.

A Liberian-flagged oil tanker (left) transfers crude oil from a Russian-flagged oil tanker off the shore of Karystos, Greece, on May 29, 2022. Photo: TNS

The sanctions are clearly working. But Putin’s continued ability to fund his war in Ukraine shows that more must be done. In light of the elaborate methods companies have devised to circumvent the oil embargo and price cap, the West now must work to close sanctions loopholes, while lowering the oil-price cap from US$60 per barrel today to US$50-US$55 per barrel, or even less.

The other important takeaway from the rouble’s recent fall is that Putin is managing to circumvent trade sanctions. The rouble is cheaper because Russia needs US dollars to pay its import bill, which grew by one-third, year on year, in the second quarter.

This increase partly reflects the rising costs of bypassing sanctions, which are compounding the pressure on Russia’s budget and currency. By tightening the enforcement of export controls, the West can raise these costs further, putting Russia’s budget – and thus its criminal war effort – in a chokehold.

Sergei Guriev, provost of Sciences Po, is the co-author (with Daniel Treisman) of Spin Dictators: The Changing Face of Tyranny in the 21st Century. Copyright: Project Syndicate