10 essays analyzing the strengths and weaknesses of the Russian Federation were released by the Center for New American Security (CNAS): “Identifying Russian Vulnerabilities and How to Leverage Them”
Vulnerability 4: Russia’s Financial Sector
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Vulnerability 1: RUSSIA’S DEFENSE INDUSTRY
Vulnerability 2: RUSSIAN ARMS SALES
Vulnerability 3: RUSSIA’S TECHNOLOGY AND CYBER INDUSTRIES
With sanctions limiting the government’s room for maneuver in the monetary and fiscal policy domains, Russia’s financial system will have to play a much bigger role in funding the government and boosting the economy. At the same time, authorities will not be able to provide the support banks need to effectively carry out these functions.
By Elina Ribakova and Benjamin Hilgenstock
Despite the unprecedented sanctions that the United States, EU, and other countries imposed on Russia following its full-scale invasion of Ukraine on February 24, 2022, the sanctions have not triggered a financial crisis in Russia or had significant spillover effects on its economy. This is in part due to high commodity prices in 2022, which increased Russia’s foreign exchange inflows and budget revenues. In 2023, however, Russia faces a more challenging economic outlook given lower export earnings, a weakening ruble, and widening budget deficits. These challenges mean that the Russian government has less room to manage the economy and that many of Russia’s underlying economic challenges could become more severe. Although Russia’s financial sector has been more resilient than Western policymakers had hoped, it remains riddled with vulnerabilities that Ukraine’s allies could exploit in ways that would exacerbate Russia’s economic challenges and make it more difficult for the Kremlin to sustain its war of aggression in Ukraine.
International sanctions have, thus far, failed to undermine Russia’s macroeconomic stability and the ability to sustain its aggressive war for several key reasons:
- the United States’ and EU’s gradual approach to implementing crucial measures, especially concerning energy exports;
- the highly favorable external environment characterized by surging commodity prices, which led to record-breaking export earnings and substantial budget revenues in 2022;
- Russia’s robust macroeconomic buffers, including relatively low government debt compared to the size of the economy, significant reserves (although some are currently immobilized), and funds saved in Russia’s sovereign wealth fund;
- and prudent Russian policies, such as recent fiscal consolidation efforts and the Bank of Russia’s (CBR) credible inflation-targeting regime.
As a result, Russian authorities have been able to increase government spending, provide ample liquidity to banks to prevent spillovers into the real economy through the credit channel, and stabilize the ruble exchange rate via capital controls. However, the economy and financial system’s overall resilience in the face of international sanctions should not conceal the fact that Russia’s underlying economic vulnerabilities continue to exist and could resurface quickly. The United States and its allies could amplify Russia’s following economic vulnerabilities, which are long-standing and tend to reoccur during crisis episodes in the country. These underlying vulnerabilities include:
Bank liquidity.
The initial impact of international sanctions on liquidity conditions in the banking system shows the potential for significant stress. In addition, while the CBR was able to inject sufficient ruble liquidity, the simultaneous expansion of liabilities to and claims on the central bank suggests that Russian banks do not have enough trust to lend to each other on the interbank market. Lack of trust among Russian banks makes the system more dependent on the central bank to address liquidity shocks stemming from deposit runs. If the central bank must pursue multiple objectives (e.g., stabilizing foreign exchange, meeting inflation targets, and ensuring financial stability), addressing liquidity shocks becomes more challenging. As a result, monetary and financial systems overall become less stable.
Household behavior.
As in previous Russian economic crises, households have shifted assets into short-term instruments, such as cash and current accounts, given a lack of trust in the banking system. Households’ lack of trust in the banking system is also driving a shift of foreign currency from domestic banks into cash and accounts with foreign institutions. This may also be an indication of people leaving or planning to leave Russia and needing access to their money from abroad. These developments were pronounced in the immediate aftermath of the full-scale invasion and imposition of initial sanctions as well as during the partial mobilization in the fall of 2022.
Budget deficit.
With the deficit rising, access to foreign financing essentially gone, and macroeconomic buffers, such as Russia’s sovereign wealth fund, being depleted, banks have to bear most of the burden for government financing by buying sovereign debt issued in the domestic market. As they already hold substantial amounts of Russia’s government debt, this could crowd out credit to the private sector and, thus, spill over into the broader economy.
Economic management.
Russia’s banking system is dominated by state-owned institutions, and any nonstate institution has little choice but to comply with Kremlin demands. This means decision-making is highly centralized and the system is exposed to substantial risk from a sudden change in economic management. If Vladimir Putin were to decide to replace his still-technocratic current team—which is not yet the case, although some officials, such as Central Bank First Deputy Governor Ksenia Yudaeva, have opted to step down—ripple effects could lead to significant stress in the financial sector.
External conditions.
In 2022, Russia’s central bank competently managed the stress created in the financial system and the broader economy. However, the supportive external environment created the policy space to do so. For instance, the CBR was able to simultaneously address financial stability concerns through the provision of liquidity to banks, and monetary stability concerns (e.g., rising inflation and ruble depreciation) through interest rate hikes and the imposition of capital controls. Higher foreign exchange inflows from trade in commodities helped stabilize the ruble. However, the environment has changed dramatically: the trade surplus for the first half of 2023 ($54.3 billion) was 70 percent lower than in the corresponding period in 2022 ($179.8 billion). Russia’s currency has lost one-third of its value.
Fiscal stimulus.
Since sanctions were initially introduced in 2014 after the illegal annexation of Crimea, Russia underwent a period of substantial fiscal consolidation, especially through expenditure cuts. As a result, the country had a low debt-to-GDP ratio, which allowed authorities to meaningfully increase spending last year. This has provided critical support to the economy and partially explains why Russia’s economy has outperformed expectations. However, with deficits widening quickly and financing becoming more challenging, there are fewer policy options now and cuts to nondefense spending are likely. Aside from the escalating costs of the war, lower export earnings from oil and gas—and, thus, lower budget revenues—are the key driver of such cuts.
Reserve assets.
Another important development in Russian authorities’ available resources for economic management is the immobilization of central bank assets by Ukraine’s allies. An estimated $310 billion in such funds are likely no longer accessible, leaving largely yuan and gold in usable reserves. According to a recent analysis by the EU, around $215 billion is frozen in EU member states alone. However, sanctions have only addressed the issue of reserve stocks, not reserve flows. In 2022 and the first quarter of 2023, Russian banks and corporations accumulated $158 billion in assets abroad due to the country’s large current account surplus. These may not formally belong to the government but could effectively be used to generate budget revenues or pay for imports.
Russian Efforts to Mitigate or Offset the Vulnerability
In 2022, Russia accelerated many of the efforts it had undertaken since 2014 to reduce vulnerabilities in its financial sector, especially reducing its reliance on international financial architecture and shifting the currency composition of cross-border transactions away from the dollar and euro. In taking these actions, the Kremlin has sought to limit the impact of existing and potential future sanctions, which leverage the West’s still-dominant position in global finance. Here, the sense of urgency has only grown due to the further deterioration of relations with the West since Russia’s invasion of Ukraine.
Russian authorities have spent considerable effort in recent years, especially since 2014–15, establishing alternative domestic systems for many types of financial transactions, including information exchange, payments infrastructure, credit card payments, and rapid transfers. In addition to increased reliance on domestic systems, Russian authorities have been attempting to strengthen links to China’s Cross-Border Interbank Payment System in recent years to reduce dependence on Western financial infrastructure. This has proven to be challenging, but the current geopolitical environment will undoubtedly lead to intensified efforts in this direction. It would allow Russia to insulate its ability to conduct cross-border transactions from existing and future sanctions.
Russia is also increasing its use of currencies such as the ruble and yuan in its international trade. Since the ability to restrict access to the dollar and euro—and the corresponding financial markets—is a critical tool in the West’s sanctions toolbox, such shifts could significantly impact the effectiveness of sanctions going forward. Since the start of the full-scale invasion, the combined share of dollars and euros in Russian goods trade—exports plus imports—has fallen from around 80 percent to slightly below 50 percent, according to data from the CBR. In contrast, the ruble’s and yuan’s shares have grown. The dollar and euro played a more significant role in exports than in imports before the full-scale invasion, but such differences have now largely disappeared. On the exports side, the ruble has seen the most significant gains—35–40 percent versus 10–15 percent previously—while on the imports side, the yuan’s share has expanded most—from 5 percent to 20–25 percent. The share of yuan on the domestic market has also increased from less than 1 percent pre-February 2022 to over 30 percent now.
Although Russia has been able to reduce its reliance on international financial architecture and diversify away from the dollar and euro, it has not been able to address the growing vulnerability posed by its budget deficit. Russia’s federal government deficit reached 2.6 trillion rubles in the first half of 2023, with substantial month to-month swings triggered primarily by the accounting of war spending. This is already close to 90 percent of what the government had planned for the entirety of 2023 in the original budget. Government revenues derived from oil and gas have declined—they are sharply lower than in the corresponding period in 2022. At the same time, expenditures are rising as a result of wartime spending. Without adjustment, the fiscal deficit could reach 5–6 percent of the GDP, although it is likely that the Kremlin will further cut nondefense spending instead of risking high deficits. Such cuts would certainly be painful for the population, but Russian authorities have demonstrated a willingness and ability to consolidate public finances via spending cuts before.
Given that Russia’s financial system is essentially a closed circuit now, with foreign investors unlikely to return, this leaves the government with only two main financing channels: withdrawals from the country’s sovereign wealth fund (National Wealth Fund, [NWF]) and issuance of ruble-denominated debt (so-called OFZ) in the domestic market. Their use was somewhat muted in the first five months of 2023, as Russia benefited from “overfinancing” in the fourth quarter of 2022, when more funds were brought in than needed for the deficit. However, the government will have to increasingly rely on NWF withdrawals and increase OFZ issuance because deficits will use up Russia’s macroeconomic buffers (e.g., NWF assets) and burden domestic banks, as they are the only remaining major buyer of Russian sovereign debt. Banks already hold about 10 percent of their total assets in government paper; while they could purchase more, it would crowd out other consumer and corporate lending.100 And they will ask the government for higher interest rates to do so, which will increase medium- and long-term debt service costs.
Opportunities for the U.S. and its Alies to Exploit the Vulnerability
Given these growing macroeconomic vulnerabilities, there are several opportunities to meaningfully increase pressure on the Russian financial system. These steps would undermine the Russian financial system’s ability to provide credit to the private sector and finance the government; limit Russian entities’ ability to conduct cross-border transactions; allow for more effective enforcement of sanctions in other areas; and restrict the Russian state’s access to foreign assets. These measures are unlikely to lead to a full-blown economic, financial, or fiscal crisis. However, they would target key areas of concern, such as Russia’s ability to pay for its war of aggression in Ukraine through its energy exports and acquire important components needed for military production. Ultimately, sanctions can only achieve their objective of bringing the war to an end in conjunction with robust military, financial, and political support to Ukraine. To undermine the financial system’s ability to provide credit and finance the government, the United States and its allies should:
Align and expand sanctions on systemically important banks.
Measures taken regarding Russia’s largest financial institutions should be aligned across jurisdictions by imposing comprehensive restrictions (i.e., Specially Designated Nationals and Blocked Persons [SDN] listing or equivalent measures). The 10 largest banks in asset terms are of particular importance, but measures should ultimately cover other banks, as these can partially substitute for sanctioned entities. To limit Russia’s ability to conduct cross-border transactions and allow for more effective enforcement of sanctions in other areas, the United States and its allies should:
Limit channels through which Russian entities conduct cross-border business.
Banning transactions with additional Russian banks will allow for better monitoring of transactions—and, thus, more effective enforcement of measures, such as the G7/EU oil price caps or military and dual-use goods export controls. The financial system’s critical role in facilitating trade can, thus, be leveraged to reduce violations as well as circumvention, and to make existing sanctions more impactful.
Disconnect additional Russian banks from SWIFT (Society for Worldwide Interbank Financial Telecommunication).
Cutting off additional financial institutions from the SWIFT financial messaging system—while not eliminating their ability to interact with the outside world due to the existence of alternative systems as well as non-cut-off intermediaries—would increase transaction costs. However, new restrictions should be targeted and ensure that their ability to track financial flows—and, thus, enforce sanctions— remains intact.
Set deadlines for the exit of remaining foreign banks.
Several Western banks (e.g., Raiffeisenbank and UniCredit) remain engaged in Russia, supporting the Russian economy through their activities and functioning as a key remaining channel for cross-border business. Regulators, including the European Central Bank, should establish clear processes and timelines that lead to the exit of any banks under their respective jurisdictions.
Consider measures targeting third-country institutions.
Existing restrictions on Russian banks have already led to attempts to circumvent sanctions via financial hubs outside the sanctions coalition’s jurisdiction, and new sanctions will accelerate such developments. Accordingly, governments should consider targeted measures to address this issue. This could involve threats of secondary sanctions by the United States to encourage third-country institutions to end relationships with Russian banks. In other jurisdictions that do not support extraterritorial application of sanctions (e.g., the EU), other types of measures should be considered to achieve the same objectives. For instance, the EU’s 11th sanctions package has created a mechanism that allows for the imposition of sanctions on third country entities that contributed to sanctions violations by EU actors.
To restrict the Russian state’s access to foreign assets, the United States and its allies should:
Track official reserves and residents’ foreign assets.
Sanctions on the CBR and the NWF have immobilized more than $300 billion in official reserves. Still, Russia has accumulated additional assets abroad due to the large balance of payment inflows since the start of the full-scale invasion. Governments that are part of the sanctions coalition need to identify these assets and their geographic location to keep them out of reach of the Russian state. The authors appreciate recent efforts by the EU to track state assets under its jurisdiction, and the authors encourage other governments to follow suit and urge authorities to closely follow newly accumulated foreign assets in addition to pre invasion reserves.
More effectively enforce energy sanctions.
Russian entities’ foreign assets include profits from attempts to circumvent energy sanctions and capture oil market arbitrage. The ownership structures of entities involved in oil trade are opaque, and Russian energy companies may employ third-country shipping companies, oil traders, and refineries to generate revenues in excess of the price cap. More vigorous enforcement would further limit the flow of revenues to Russia and indirectly put pressure on macro-financial stability. In addition, governments need to ensure that Russia cannot establish alternative channels to access assets abroad or engage in other transactions that could generate foreign currency inflows.
