Deciphering the mechanisms for the uninitiated.

FEBRUARY 27, 2022

Note: this article was written before the announcement of the exclusion of some Russian banks from the SWIFT secure payment messaging system. This does not change the explanations aimed at informing the reader about the mechanisms underlying the envisaged sanctions.

Statements by political leaders as well as media programs or publications make numerous references to the unprecedented and severe nature of the sanctions that are aim to inflict maximum damage on the Russian economy in the medium and long term and whose effects could weaken President Putin’s authoritarian regime. The citizen, if he is not a technician of financial circuits, is obliged to accept with confidence the declarations concerning the sanction’s expected effects. I suspect that this is also the case for a large majority of the decision-makers who have to endorse the measures politically, of the political scientists who do their exegesis and of the commentators who often venture beyond their field of expertise.

The emblematic example of this phenomenon is the controversy that is developing around the exclusion of Russian banks from the SWIFT messaging system. This is a network of more than 11,000 banking institutions in 200 countries that allows the issuance of secure payment instructions on behalf of themselves or their clients. In his speech on 24 February, President Biden said that no agreement had been reached “at this point” to implement this measure. He added, however, that the United States, together with the European Union, Britain, Japan, Canada and Australia, was putting in place a series of measures to exclude or restrict Russia’s access to their respective financial markets that would be significantly more damaging than a simple exclusion from the SWIFT system. Since then, EU MS have unanimously decided to exclude certain banking institutions from the network.

For the benefit of the reader’s understanding, it is useful to digress a little on the notion of territoriality of bank assets, as many people take offence that a country is able to sanction transactions negotiated between parties located in third countries (a supposed unwarranted “extraterritoriality”). To comprehend this debate, it is necessary to understand that any currency can only exist (apart from its physical form in banknotes) within the physical boundaries of the country issuing it; its “possession” is represented by an accounting entry crediting an account held in a bank located in the country issuing the said currency. Thus, the € cannot exist outside the Eurozone, or if you think you have a dollar account with a Belgian bank, those dollars are actually parked in your bank’s account with its subsidiary or with another bank in the United States.

The consequence of this peculiarity is that if the settlement of a transaction involves – at any stage of its execution – the use of the currency of any particular country, that country automatically acquires jurisdiction over the transaction, thereby precluding the charge of extraterritoriality. This explains why BNP was fined some $9 billion by the United States for settling transactions, denominated in dollars, between non-US domiciled parties, because the country of one of the contractors was subject to American sanctions.

Let us return to the proposed financial sanctions against Russia. Like the vast majority of countries around the world, Russia has for years used the US dollar to settle the vast majority of its cross-border financial and commercial transactions; even if the counterparty was not American, most national currencies were not suitable for use as a means of international payment without the intermediation of the US currency. Thus, the settlement of an import transaction by Russia of a South African product involved a double exchange transaction between the Ruble and the Dollar followed by another between the Dollar and the Rand because there were not enough transactions between the two countries to justify a Ruble/Rand market. Such a transaction involves a plethora of actors: the importer, his bank and his correspondents to carry out the transfers related to the import operation and the foreign exchange transactions, the exporter and his bank which receives the final payment as well as the banks of the two intermediaries which execute the foreign exchange transactions. It is the coordination of the payment instructions at each step of this chain that SWIFT secures and accelerates; it is both costly and slow to substitute any alternative settlement method.

This example demonstrates, in passing, that despite the importance of SWIFT in the transmission and facilitation of payment instructions, foreign exchange market intermediation as well as national financial market regulation play a much more fundamental role.

The effectiveness of the concerted measures taken by the West will be all the more penalizing if Russian banks have to finance their clients’ trade in one of the currencies of a country participating in the sanctions. Indeed, these countries have decided to freeze the assets of the main Russian banks, to limit the access of the Russian Central Bank to its accounts (freezing its foreign exchange reserves) as well as the assets of a series of persons (oligarchs), held in banks located on their territories; moreover, they intend to exclude or limit their access to their respective money markets. If Russian banks are unable to “refinance” the “foreign currency” loans made to their customers because they are unable to finance themselves in the corresponding money markets, they risk bankruptcy. This type of risk arises for any bank financing assets denominated in foreign currencies; to mitigate its impact, a network of currency swap agreements was significantly strengthened during the 2008 financial crisis between the main Central Banks; the latter can thus substitute themselves to the banks they supervise in accessing foreign exchange in the event of disruption. Russia is not part of this network and its banks are therefore particularly vulnerable to the envisaged sanctions.

Therefore, the coordination of sanctions between the countries whose currency is mentioned above is, as President Biden states, much more damaging than a simple exclusion from the SWIFT network. It understandable why this would be the case, especially if this limitation affects the access of Russian banks to the money and the foreign exchange markets concerned. Indeed, whatever preparations Putin may have put in place to circumvent a foreseeable exclusion from the US dollar market (since 2014, Russia’s dependence on the $ has been reduced from 80 to 10%), a similar measure affecting the €, £, Yen and the Canadian and Australian dollars would render inoperative the “de-dollarization” measures he has put in place ahead of the anticipated consequences of his military aggression. Imposing on the rest of the world, as a way of trading with Russia, an obligatory transit through the Chinese Renminbi – a currency notoriously manipulated under the control of an authoritarian regime – is likely to hinder trade considerably, and would require the active cooperation of the Chinese authorities, which is not necessarily in their best interest.

The possible consequences of such sanctions remain to be assessed. With gold and foreign currency reserves in excess of $630 billion and very limited external debt, Russia is not immediately vulnerable to a shortage of financial resources, although sanctions could severely limit their availability (apart from Yuan and gold reserves) if they are held, as is likely, in one of the other main currencies mentioned (as the Taliban discovered with the freezing of $ reserves belonging to the Afghan state).

Secondly, Putin can introduce compensatory sanctions in the form of a suspension of gas, oil, raw materials or grain deliveries, which can impose significant shortages and price increases on Western countries (but which will also deprive him of his main source of income). These measures, taken at a time when the post-Covid economic recovery is making its own demands on the restructuring and transformation of the economy, will make the management of social cohesion all the more complicated. Nevertheless, the short-term disadvantages of sanctions, which will inevitably require painful sacrifices from the European population, must be weighed against the long-term risks of endangering the Western democratic values, the consequences of which on the daily lives of citizens would be immeasurably more devastating.

Moreover, there is nothing to prevent the implementation of sanctions in a gradual manner, as is already the case (third set of sanctions in eight days), or the introduction of a system of prior authorizations to validate foreign exchange transactions or commercial exchanges that benefit both parties.

The main risk, however, remains the unpredictability of the Kremlin master’s reactions and the unmeasurable possibility of an untimely reaction that would trigger a nuclear confrontation. This risk can be mitigated by several options: a negotiation that should lead to the guarantee of Ukraine’s independence within its current borders (the use of force cannot be rewarded under any circumstances). Secondly, an initiative by the Russian people to overthrow the current government. Finally, a stalemate in the situation, which would be costly for all the populations concerned and would eventually lead to the fall of the Putin regime.

The European Union and its population must be prepared to face the difficulties that lie ahead, or risk suffering even more serious effects in the future, similar to the consequences of the policy of appeasement attempted against Hitler in the 1930s. Putin has made a losing bet on the West’s lack of political will to resist him and maintain its unity. However, Europe cannot let this episode pass without learning the fundamental lessons that its future, its values, its prosperity and its freedoms are inextricably linked to the implementation of a deeper Union, capable of ensuring its security and autonomy in a globalized and interdependent world.