It must have looked so simple for Vladimir Putin. Given his military superiority, a lightning strike by Russian forces would quickly overcome Ukrainian resistance and topple the regime in Kyiv.
The Kremlin would have bargained for the invasion being met with sanctions, but assumed these would be a minor inconvenience given the divisions in the west. But even if the measures were tougher than expected, Russia had a huge$630bn war chest of gold and foreign exchange reserves to support the economy.
The 19th-century German military strategist Helmuth von Moltke said no plan survives contact with the enemy and that was certainly true in this case. An increase in interest rates from 9.5% to 20%, the introduction of tough capital controls, the closure of the stock market and the clampdown on dissent all tell the same story: the campaign has not been the pushover Putin envisaged. The stiff resistance mounted by Ukraine was unexpected, as has been the west’s response. Russia’s economy is under siege.
While the targeting of oligarchs has grabbed headlines, by far the most significant sanction has been to limit Moscow’s access to its foreign exchange reserves, there to provide a defence against an attack on the rouble.
Reserves work in two ways. Firstly, they act as a deterrent, because those contemplating a speculative attack think twice if they know a central bank has the ability to slug it out. The bigger the reserves the less likely it is that a central bank will actually have to deploy them.
But if the “come and have a go if you think you’re hard enough” approach doesn’t work, a central bank with deep reserves can actively intervene in the currency markets. In the case of the central bank of Russia, that would involve converting some of the $650bn into roubles. Selling dollars, euros or pounds for roubles would lead to the Russian currency going up in value.
Neither of these options is now feasible. It is unclear precisely how much of the $650bn is frozen but on some estimates pretty much none of it can be used. More than two-thirds of the total – $460bn – is held in foreign currencies or securities, and largely now off-limits to Moscow. Most of the rest is in gold, which is held in vaults inside Russia. Putin could probably find someone to buy a chunk of this gold at a discount but it would be hard to convert the precious metal into ready cash quickly.
As a result of sanctions, the rouble suddenly became vulnerable and it fell by around a third against the US dollar in the past week. It would have fallen still further had it not been for the emergency increase in interest rates to 20% and the introduction of capital controls designed to prevent money leaving the country.
No question, this will hurt. A weaker currency will push up inflation while a doubling of borrowing costs will add to the impact of sanctions and push the economy into a deep recession. Kay Neufeld, the head of forecasting at the Centre for Economics and Business Research consultancy says that in two years’ time the Russian economy could be 14% smaller than it would have been had the invasion of Ukraine not gone ahead. Jobs will be lost. There will be shortages of imported goods. Savings will be worth less.
But as Neufeld points out, sanctions can inflict pain without leading to a change of leadership or a policy shift. Iran suffered a 20% reduction in potential output in the two years following the introduction of sanctions over its nuclear programme but didn’t buckle.
So, 10 days into the invasion, the west has a big decision to make. Does it deploy the biggest economic weapon it has left: adding Russia’s oil and gas exports to the sanctions list?
There are grounds for not doing this. For a start, the EU gets 40% of its natural gas from Russia and finding alternative supplies would take time. Western foreign ministers discussed an energy ban last week but are still at the stage of talking about reducing dependency on Russia rather than sanctions.
The reason for hesitancy is obvious. Wholesale gas prices are already at record levels while crude oil is up by 40% since the start of the year. Western sanctions would result in oil and gas prices being higher – perhaps a lot higher – for longer. That would add to inflation and intensify an already acute squeeze on living standards.
For now, western governments are putting a higher priority on freedom for Ukraine than they are on domestic pressures on their electorates, but they must now weigh up how much pain they are prepared to inflict on their own people. Putin, when he took the decision to invade, presumably took the view that ordinary people in the west did not care about Ukraine. He was wrong about that, yet even so there is a risk that “Ukraine fatigue” will set in, especially as the cost of living crisis intensifies.
Ultimately the west has to decide how badly it wants to defeat Putin. If it is to do so, certain things need to happen. Sanctions will have to be extended to Russian oil and gas exports. Otherwise, Europe’s consumers will be bankrolling the Kremlin’s war machine. Finance ministries need to provide more help with energy bills, treating this crisis with the same seriousness as they did Covid-19. The transition to clean, homegrown energy must be accelerated. Last but not least, the west must not delude itself that sanctions will work quickly. It has to be ready for a long haul because even the toughest of sieges will take time to work.