Only credible deterrence can prevent Russia’s invasion of Ukraine and another war in Europe. The threat of devastating financial, trade and personal sanctions from the West is credible but may not be enough of a deterrent effect. The threat of a Western military response might have a deterrent effect but is not credible. A single deterrent is both credible and sufficient. It is the threat to sanction the Russian Central Bank. It is credible because it carries little risk and is simple to perform. It is a powerful deterrent because it is a weapon of mass economic destruction. This can ruin Russia’s exchange rate, banking system, public finances and the economy as a whole.
Russia relies on the Central Bank’s foreign exchange (FX) reserves of $638 billion to support the exchange rate and the stability of the national currency, the ruble, to ensure the banking system and household deposits, to prevent runs on the banks, to bail out the external market the debt of public and private companies and to manage the sovereign fund of 185 billion dollars for budgetary emergencies. A simple threat of sanctions against the Central Bank would undermine these economic and political foundations of the country.
The reason for this is the unique conjunction in the 21st century of currency convertibility and the digitization of international finance. If Russia were a closed economy with an inconvertible currency like the now-defunct Soviet Union, it would have been insensitive to what happens to foreign exchange reserves. These were held in gold and foreign bonds and cash in Central Bank vaults, just to secure critical imports.
Fast forward to the 21st century. The Russian economy is open and the ruble is convertible, both supported by foreign exchange reserves. But these reserves are largely electronic accounting entries in the Russian Central Bank’s accounts with the Federal Reserve, the European Central Bank and similar Western institutions and clearinghouses. There are no physical bonds or certificates. In the language, Western government bonds and other sovereign securities and deposits with Western central and commercial banks are dematerialized and uncertified.
For example, US Treasury bills held by central banks in 200 countries are book entries on the computers of the Federal Reserve Bank of New York, traded by its authorized dealers, with the proceeds of the sale transmitted electronically via Fedwire to the banks. corresponding.
From this point of view, if the sanctions strike, the foreign exchange reserves of 638 billion dollars are reduced to their salvage value. Of the $638 billion in foreign exchange reserves, only $12 billion is cash denominated in dollars and euros in the vaults of the Russian Central Bank. The gold stored there, worth $139 billion, is difficult to sell en masse, especially if the Central Bank falls under Western sanctions. Another part of foreign exchange reserves, $84 billion in renminbi-denominated instruments, is of little financial use in a crisis. Some $403 billion, or almost two-thirds of foreign exchange reserves, are securities and deposits denominated in US dollars, euros, pounds sterling and other Western currencies, representing electronic paperwork in central banks and Western trade. If sanctions are imposed on the Russian Central Bank, the $403 billion in its electronic FX holdings in the West could not be used. Russia will be left with little Western cash, unsaleable gold and Chinese bonds.
Central Bank sanctions will follow three ruinous races: on foreign exchange, on banks and on supply chains. With only $12 billion available to support the rouble, the exchange rate will devalue and collapse. People will use any foreign currency they can get at any price as a store of value.
That’s the catch. Russian households and businesses prefer foreign exchange to rubles and hold $268 billion in deposits with the State Savings Bank and commercial banks. They will run on the banks to withdraw dollars and euros, the amount of cash that the banks cannot have on hand or obtain from the Central Bank, itself devoid of foreign currency.
The banking system will collapse unless the government forcibly converts foreign currency-denominated deposits into rubles. Either outcome would cause social unrest. It will be exacerbated by the inaccessibility of the sovereign wealth fund to support government social spending. In all supply chains, suppliers will demand dollars from customers, and efficient parts of the economy will dollarize. The rest of the economy will experience bottlenecks and supply disruptions and resort to barter. The economy will collapse and create long-term political instability.
Russian leaders may not realize the destructive power of Central Bank sanctions. The task of diplomacy is to transmit to them this economic reality of the 21st century. There is no risk in making a threat. If the Russians react by dumping their holdings and sending money home, there’s not much they can do. It took more than five years for the US Air Force to send 40 billion dollars to Iraq between 2003 and 2008. If the Russians send a few billion, it will be useless and risks causing a panic which would ruin in advance the financial system.
While it is uncertain if or when the Central Bank sanctions will be carried out, their only threat is a credible deterrent because their potential outcome is so powerful. This raises the stakes far more for Russia than for the West and should prevent war.
Michael S. Bernstam is a research fellow at Stanford University’s Hoover Institution.