FACULTY Q&A

The US government and its allies reacted to the Russian invasion of Ukraine with a series of financial sanctions, including freezing assets and banning Russian banks from a key financial messaging system called SWIFT.

What happens now, what are the likely effects and what does it all mean? Amiyatosh Purnanandam, professor and chair of finance at the University of Michigan’s Ross School of Business, shares his perspective on the rapidly changing situation.

Much of the world community has united behind the idea of ​​financial sanctions in response to the Russian invasion of Ukraine. Basically, what is the point of adopting this type of approach?

This is a non-violent nuclear attack on the Russian economic system. The sanctions have limited Russia’s central bank’s ability to access its more than $600 billion foreign exchange reserves and prevented its banking system from accessing the international payments system.

This has a devastating effect on the value of the Russian currency, as we saw immediately after the announcement of the sanction, when the ruble fell almost 30% in one day. Generally, when a country’s currency depreciates, the central bank of that country draws on its foreign exchange reserve to buy its local currency and pay it in foreign currency in order to stabilize the foreign exchange market. Sanctions took that ability away from Russia’s central bank.

With the ruble collapsing and an unstable banking system, the sanctions really crippled the Russian government’s ability to finance the war. The sanctions have also inflicted a lot of pain on Russian companies, as evidenced by the crash in their stock prices. At the same time, the sanctions began to inflict economic hardship on Russia’s elites and ordinary citizens. Simply put, the sanctions attempt to empty the Russian government’s war chest and exert public pressure on the government to end the war.

What is the extent of support for sanctions within the global financial community? What is the effect of having a power like China not participating?

There is broad support among Western powers. Collective actions are more powerful when it comes to financial and economic sanctions. But China’s absence has important implications, both for the effectiveness of sanctions and for the long-term global financial order. It will be interesting to see if and how China facilitates the flow of international funds to Russian entities to circumvent the effects of the sanctions. Perhaps China and Russia can jointly find an alternative payment system to SWIFT, or the Society for Global Interbank Financial Telecommunications.

I think the sanctions could give the Chinese yuan a boost as a global reserve currency. If these two things happen – the emergence of a new payment system and the yuan as a reserve currency – the global financial system will look very different 10 or 20 years from now.

Which sanctions are likely to be the most effective or exert the greatest pressure on the Putin government?

Immobilization of Russian central bank assets held abroad. While one can bypass the SWIFT system with a little work, any dollar transaction must actually go through the Federal Reserve Bank. Therefore, restricting the Russian central bank’s ability to use its dollar funds is a blow to the country. This restriction took away not only their ability to finance the war, but more importantly, their ability to back their own currency. Indeed, this sanction has rendered the Russian central bank ineffective when it comes to defending its own currency.

What is the importance of cutting off Russian banks from the SWIFT messaging system?

The SWIFT ban itself is not so devastating; it’s just a messaging system. Banks can find other ways to send messages, for example via secure emails, but this will be very cumbersome and inefficient. It is the combination of SWIFT and the banning of the Russian central bank and its banking system that cripples them. They can’t get payments; they cannot access their dollar holdings. As a result, they will not be able to participate in the global payments network. Certainly, there are exceptions to this sanction, in particular for payments related to the oil and gas trades.

How will the sanctions affect the global economy?

The one thing we can say for sure about this crisis is that there is a lot of uncertainty going forward and financial markets hate uncertainty. All of this adds to an already high level of uncertainty and anxiety caused by the COVID-19 pandemic. This means there is going to be an increase in risk premia across all asset classes, from equities to risky bonds. Simply put, there is a real fear that the cost of capital for businesses will rise and that we are entering a world where investors are very risk averse.

At the same time, the sanctions are likely to be highly inflationary in nature. Even though the existing sanctions do not focus explicitly on Russia’s energy sector, oil prices have already soared in anticipation of future disruptions. Higher energy prices mean higher inflation. Once again, the moment is very badly chosen because we are already experiencing a very high level of inflation, thanks to the accommodative monetary policy of the last decade. This makes the job of central bankers around the world very difficult.

The worst possible scenario is one of high inflation and weaker economic growth, or stagflation. We are not there yet and I hope we will not get there. But policymakers around the world are thinking about this issue and doing their best to avoid it coming to this.

How will financial sanctions affect ordinary Russian citizens?

They may be the most affected. First, their banking system basically collapsed. You already see long queues of withdrawals in front of Russian banks. While the Russian government will continue to support these banks in the short term, the lack of a robust banking sector is going to be very painful for the average citizen. Moreover, the ruble was an immediate victim of the sanctions. The collapse of the ruble makes imports very expensive, increasing the cost of several items that the average Russian citizen consumes.

Inflation is likely to soar. Not only that, but to stabilize the rouble, the Russian central bank raised its interest rate from 9.5% to 20% per year. Although this decision halted the ruble’s free fall, it comes at a cost to the daily life of an average Russian citizen.

Mortgage costs are skyrocketing, consumer loans are getting expensive, credit is drying up. At the same time, Russian companies will suffer from their inability to access financing from around the world. All of this could end up pushing the country into economic recession and loss of jobs.

What else should I know about penalties?

The global financial order is unlikely to be the same again. In the short term, the sanctions will cripple the Russian government’s ability to finance the war. But in the long run, there will be adjustments to the global financial and political order.

Countries around the world will fear such sanctions and it can be an effective tool for future geopolitical disruptions. This can be a good thing to avoid bloody conflicts. However, countries will also diversify their foreign exchange reserve base, perhaps into currencies like the yuan. There are also discussions about who really controls the SWIFT system. After all, this is a cooperative of over 10,000 banks.

Finally, the sanctions also bring to the fore the question of the independence of central banks vis-à-vis governments. What direct influence should the government have on the policies of the Federal Reserve Banks? These are the questions that will arise in the medium and long term once the crisis has passed.

Written by Bob Needham, Ross School of Business