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Outside the Box: Sanctions against Russia contain a crucial exemption that lessens the pain

While Ukraine fights with guns and Molotov cocktails, the West is deploying a different kind of weapon. Financial sanctions can break a country’s banking system and destroy its currency, severely damaging its economy and inflicting hardship on its citizens.

But financial sanctions can also hurt those who deploy them. And avoiding that pain can render them useless.  

Last week, the U.S. fired its opening salvo in the sanctions war. It excluded several of Russia’s banks, including its two biggest, Sberbank and VTB, from the international dollar clearing system. U.S. correspondent banks have 30 days to terminate their relationships with those banks, after which they will be unable to make or receive dollar payments.

Cutting off a bank from international dollar payments can be fatal. When the U.S. Treasury cut off the Latvian bank ABLV from U.S. correspondent banking in 2018, it failed within a week. Sberbank and VTB are unlikely to fail, since they are backed by the Russian government. But they are certainly going to feel severe pain — though as Adam Tooze has pointed out, perhaps not quite severe enough, since the U.S. government has exempted transactions involving oil, gas and other forms of energy from the dollar payments ban.

But despite its harshness, many people were distinctly unimpressed with the U.S.’s sanctions package. They had hoped the U.S. would broker an agreement with Europe to suspend Russian banks from the Belgium-based SWIFT telecommunications network.

SWIFT plays a vital role in international payments. It transmits the payment requests, instructions, notifications, confirmations and other messages that keep money flowing through the global financial system. Banning banks from SWIFT, therefore, would cut them off from these money flows.

SWIFT ban

But it’s not quite that simple. SWIFT isn’t a payments system. Payments are actually made by correspondent banks and central banks. Without SWIFT, banks could still use correspondent banks and central banks, though they would have to find other ways of communicating with them. So banning banks from SWIFT would not prevent them making international payments. But the disruption and inconvenience might drive development of alternatives to SWIFT. Indeed, Russia and China have already developed fledgling interbank communications systems. A comprehensive SWIFT ban might encourage banks to adopt these systems.

Banning banks from correspondent banking networks, however, does prevent them from making payments. For dollar payments, therefore, a SWIFT ban is unnecessary.

Ideally, the EU and other countries would also implement correspondent banking bans. Failing that, a SWIFT ban would disrupt international payments in their currencies, though with the attendant risk that banks would disintermediate SWIFT.

The EU’s member states have now agreed to exclude “certain Russian banks” from the SWIFT network, though this has still to be negotiated with SWIFT and we don’t yet know which banks will be excluded. The noose round the neck of Russia’s banking system is being tightened a little more.  

But the SWIFT ban’s real importance lies in the fact that 27 countries all agreed to implement it. It is a remarkable exhibition of common purpose and solidarity with Ukraine, which very much wanted the ban. 

Central bank freeze

Alongside the SWIFT ban, the EU announced its intention to freeze the foreign assets of Russia’s central bank. These are assets held on the books of other central banks, including European national central banks, and perhaps the Bank for International Settlements. Freezing them is legally problematic, since central bank assets often qualify for sovereign immunity, but there is precedent: In 2019, the U.S. froze the assets of the central bank of Iran.

Freezing the foreign assets of the Bank of Russia could have severe effects on the Russian economy. It would prevent the Bank of Russia from supporting the ruble by intervening in foreign exchange (FX) markets, and it would also prevent it providing FX liquidity to Russian banks and businesses. The result could be very high inflation, widespread debt defaults and the collapse of external trade. 

But the EU, like the U.S., wants to protect its citizens from energy shortages, which means exempting Russia’s energy sector from the sanctions. And if it does, they will be much less effective. While the West continues to buy oil and gas from Russia, Russia will not run out of dollars and euros. There will still be some economic pain for Russia — but will it be enough to make President Putin want peace?

Frances Coppola is the author of the Coppola Comment finance and economics blog. She’s on Twitter @Frances_Coppola.

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