Hitting Putin Where It Hurts
The Fed and the European
Central Bank move hard, fast, and together.
By David
Frum
FEBRUARY 27, 2022, 12:04 AM ET
About the author: David
Frum is a staff writer at The Atlantic and the author
of Trumpocalypse:
Restoring American Democracy (2020). In 2001 and 2002, he was a
speechwriter for President George W. Bush.
The EU Commission
announced this afternoon that the European Central Bank will deploy its most powerful financial weapon against Russian
aggression. Several hours later, Secretary of State Antony Blinken announced that
the Federal Reserve will impose sanctions of its own upon the Russian central
bank.
Central-bank
sanctions are a weapon so devastating, in fact, that the only question is
whether they might do more damage than Western governments might wish. They
could potentially bankrupt the entire Russian banking system and push the ruble
into worthlessness.
Russia is also being
hit by a partial cut-off from the SWIFT system. SWIFT is a messaging
technology based in Belgium that allows banks to talk to one another in secure
ways, enabling the safe and sure electronic transmission of funds. SWIFT is not
a bank, nor is it exactly a payments system. It is instead a way to guarantee
that money moves where it is supposed to go. Countries cut off from SWIFT, as
Iran was in 2012, are effectively cast back into the precomputer era—forced to
rely on primitive barter transactions, or Breaking Bad–style
pallets of physical cash, to fund their governments and their economies.
Details are still
pending about the Western central-bank sanctions. To better understand the
possibilities, I spoke with Michael Bernstam, an economist and Soviet-born
analyst at Stanford’s Hoover Institution. Bernstam has studied the potentially
decisive impact of such sanctions since the prior Russian invasion of Ukraine,
in 2014.
Bear with me as I
walk you through some banking and currency technicalities. I promise the
destination will be worth the trouble.
Suppose you are a
Russian company that buys things from the outside world and sells them to
Russians. You earn your income in rubles. You spend in euros, U.S. dollars,
British pounds, Japanese yen, South Korean won, or possibly Chinese renminbi.
How does that work, exactly?
Well, a Russian
business or individual might convert the rubles earned inside Russia into
foreign currency at a Russian bank. Or—because the ruble has a strong tendency
to lose value against foreign currency—that Russian business or individual
might set up an account at a Russian bank denominated in euros or dollars. Both
of those are legal to do in postcommunist Russia.
Most of these
conversions from rubles into foreign currency take the form of computer clicks
that credit or debit the electronic ledgers of financial institutions. The
deposit of rubles into a bank is a click. The sale of rubles for euros or
dollars is another click. The arrival of the foreign currency into the Russian
customer’s account is only one click more. Very seldom does any actual paper
money change hands. There’s only about $12 billion of cash dollars and euros
inside Russia, according to Bernstam’s research. Against that,
the Russian private sector has foreign-currency claims on Russian banks equal
to $65 billion, Bernstam told me. Russia’s state-owned companies have
accumulated even larger claims on Russia’s foreign reserves.
Despite the relative
scarcity of physical foreign currency inside Russia, all of these clicks can
happen because Russians generally have confidence that their banks could pay
foreign cash if they had to. If every Russian depositor—individual, corporate,
state-owned—showed up at the same time to claim their dollars and euros, you’d
have a classic bank run. But Russians don’t run on their banks, because they
believe that in a real crunch, the Russian central bank would provide the
needed cash. After all, the Russian central bank holds enormous quantities of
reserves: $630 billion at the last tally before the
start of the current war on Ukraine. In an emergency, the central bank would
draw upon its reserves, provide cash to the commercial banks, and every
depositor could be paid in full in the currency promised. With $630 billion in
reserves, there is no way Russia would ever run out of foreign currency. You’ve
probably read that assertion many times in the past few days. I actually wrote
such an assertion myself in an article published last week.
Not so fast, argues
Berstam. What does it mean that Russia “has” X or Y in foreign reserves? Where
do these reserves exist? The dollars, euros, and pounds owned by the Russian
central bank—Russia may own them, but Russia does not control them.
Almost all those hundreds of billions of Russian-owned assets are controlled by
foreign central banks. Russia’s reserves exist as notations in the records of
central banks in the West, especially the European Central Bank and the Federal
Reserve. Most of Russia’s reserves are literally IOUs to the Russian central
bank from Western governments.
Remember the saying
“If you owe the bank $10,000, you have a problem—but if you owe the bank $10
billion, the bank has a problem?” We, the people of the Western world
collectively owe the Russian state hundreds of billions of
dollars. That’s not our problem. That’s Russia’s problem, an enormous one.
Because one thing any debtor can do is … not pay when asked.
To finance its war on
Ukraine, Russia might have hoped to draw down its foreign-currency reserves
with Western central banks. The Russian central bank would tell the Fed or the
ECB to credit X billion dollars or euros from the Russian central bank to this
or that private Russian bank. That bank would then credit the accounts of
Russian businesses or individuals. Those businesses or individuals would then
pay Western companies to whom they owe money.
All of this requires
the cooperation of the Fed or ECB in the first place. The Fed or ECB could say:
“Nope. Sorry. The Russian central bank’s money is frozen. No transfers of
dollars or euros from the Russian central bank to commercial banks. No
transfers from commercial banks to businesses or individuals. For all practical
purposes, you’re broke.” It would be a startling action, but not unprecedented.
The United States did it to Iran after the revolutionary regime seized U.S. diplomats as hostages in 1979.
Iran did not feel
that freeze, however, because it was earning massive amounts of new foreign
currency from oil sales. But if Russia’s foreign income slows at the same time
as it is waging a hugely costly war against Ukraine, it will need its reserves
badly. And suddenly, it will be as if the money disappeared. Every Russian
person, individual, or state entity with any kind of obligation denominated in
foreign currency would be shoved toward default.
Of course, long
before any of that happened, everybody involved in the transactions would have
panicked. Depositors would race to cash out their dollar and euro holdings from
Russian banks, the Russian banks would bang on the doors of the Russian central
bank, the Russian central bank would freeze its depositors’ foreign-currency
accounts. The ruble would cease to be a convertible currency. It would revert
to being the pseudo-currency of Soviet times: something used for record-keeping
purposes inside Russia, but without the ability to buy goods or services on
international markets. The Russian economy would close upon itself, collapsing
into as much self-sufficiency as possible for a country that produces only
basic commodities.
Russia imports almost
everything its citizens eat, wear, and use. And in the modern digitized world,
that money cannot be used without the agreement of somebody’s central bank. You
could call it Berstam’s law: “Do not fight with countries whose currencies you
use as a reserve currency to maintain your own.”
There is one
exception to the rule about reserves as notations: About
$132 billion of Russia’s reserves takes the form of physical gold in
vaults inside Russia. Russia could pledge that gold or sell it. But to whom?
Most potential customers for Russian gold can be threatened with sanctions.
Those who might defy the threat couldn’t afford to take very much: The entire
GDP of Venezuela, for example, is only about $480 billion.
Only one customer is
rich enough to take significant gold from a sanctioned nation like Russia:
China.
Would China agree to
take it? And if China did agree, would it not demand a big and painful discount
for helping out a distressed seller like a sanctioned Russia? How exactly would
the transaction occur? Would China be content merely to take legal ownership of
the gold and leave the metal inside in a Russian vault? Doubtful. One ton of gold is worth about $61 million, so
$139 billion would weigh about 2,290 metric tons. It’s certainly conceivable
for a locomotive to pull a train of that weight from
Moscow to Beijing. But it would constitute a considerable logistical and
security undertaking to load, move, unload, and secure the gold for a train
trip across Siberia.
What would be
accomplished by such a move? Russia already has $84 billion of assets denominated in
Chinese renminbi. If Chinese-denominated assets were of any real use
to Russia, Russia would not need to sell the gold to China in the first place.
Russia’s renminbi reserves can certainly be used to buy things from
China. But that does not solve the real problem, which is not to buy
specific items from specific places, but to sustain the ruble as a currency
that commands confidence from Russia’s own people. China cannot do that for
Russians. Only the Western central banks can.
And here we bump into
the limits of central-bank sanctions as a financial weapon: A weapon that
altogether crushes an adversary’s banking system may be just a little too
powerful. The West wants to administer penalties that cause Russia to alter its
aggressive behavior, not to crush the Russian economy. The central-bank weapon
is so strong that it might indeed provoke Putin into fiercer aggression as a
desperate last gamble. So the next question is: Is there any way to use the
central-bank-sanctions weapon more incrementally?
Perhaps there is.
Western banks do not need to freeze the Russian central bank’s accounts
altogether. They could put the Russian central bank on an allowance, so many
billions a month. That would keep Russia limping along, but under severe
restraint—asphyxiation rather than sudden strangulation. The West could not
prevent Putin from spending foreign currency on his war or favoring cronies in
the distribution of foreign currency. But the restraint would rapidly make the
terrible cost of Putin’s decisions much more rapidly visible to every power
sector in Russian society. It’s not the full blow, but it might hurt enough—and
of course, the full blow could be applied later.
The
central-bank-sanctions tool will also deliver a humbling but indispensable
lesson to Putin. Putin launched his war against Ukraine in part to assert
Russia’s great-power status—a war to make Russia great again. Putin seemingly
did not understand that violence is only one form of power, and not ultimately
the most decisive. Even energy production takes a country only so far. The
power Putin is about to feel is the power of producers against gangsters, of
governments that inspire trust against governments that rule by fear. Russia
depends on the dollar, the euro, the pound, and other currencies in ways that
few around Putin could comprehend. The liberal democracies that created those
trusted currencies are about to make Putin’s cronies feel what they never
troubled to learn. Squeeze them.