How will Russia retaliate as Western sanctions take hold?

While the battle for Kyiv rages, the economic war between Russia and the nations of the West has barely begun.

The US, the EU and their allies are concentrating their economic attacks on Russia’s financial system while exempting the energy sector.

Russian President Vladimir Putin’s initial response to what he termed ‘illegitimate Western sanctions’ of putting nuclear forces on high alert effectively threatens world war.

If he pulls back from that brink, Putin is likely to exploit European dependence on Russian energy supplies to retaliate.

The financial and energy battlegrounds carry the most obvious risks for the global economy, but other, less obvious, economic threats lurk in the shadows, among them the dependence of microchip manufacturers on rare gasses sourced from Ukraine.

After several days of prevarication, Western powers announced that sanctions would be applied against the Russian central bank and that ‘selected’ Russian banks would be ejected from SWIFT, the secure global financial communications network used by the world’s banks for their international transactions.

The decision to sanction the central bank is stunning: on the eve of its invasion, Russia held US$643 billion in international reserves, the fourth largest in the world behind China, Japan and Switzerland.

Credit Suisse analyst Zoltan Pozsar told Bloomberg that about US$300 billion of that was held offshore. He estimates that about half is held in US dollars. There would also be a large holding of euros.

The joint statement on sanctions by the US, the EU, the UK, France, Germany, Italy and Canada did not detail how comprehensive the restrictions on dealing with the Russian central bank would be but said they would be designed to ‘prevent the Russian Central Bank from deploying its international reserves in ways that undermine the impact of our sanctions’.

When the Trump administration sanctioned the Iranian central bank in 2019, it placed it on the ‘specially designated nationals’ list, which meant that not only was the central bank banned from dealing in US dollars, but so too was any organisation around the world that transacted with it.

The Credit Suisse analyst said the freezing of Russian funds held offshore would have a destabilising impact on world financial markets, pushing the margin between borrowing and lending rates higher.

It will make it difficult for Russia to defend its currency, which could suffer a sharp depreciation, pushing up prices and forcing interest rate increases.

Russia would likely characterise moves to freeze its foreign exchange reserves as theft—the country sold down its holdings of US Treasury bonds in 2018 precisely to avoid such sequestration.

China, which still holds a third of its US$3.3 trillion foreign exchange reserves in US Treasury bonds, would be shocked by any freezing of Russia’s reserves. The financial ructions that would be caused by the Chinese quitting their Treasury bond holdings have often been the topic of speculation. Any such move would come at great cost to China, whose interest is in a stable global economy, but Chinese authorities would doubtless be considering their options.

If the Russian central bank is put on the US specially designated nationals list, it would be difficult for China to provide financial assistance because it would risk being sanctioned. China largely abided by US sanctions on Iran.

The G7 leaders didn’t specify which Russian banks would be ejected from the SWIFT network; however, it’s assumed they won’t include the institutions that European nations need in order to pay for their Russian oil and gas imports.

A note from the German statistics bureau last week estimated that Germany alone spent €19 billion ($A30 billion) on Russian oil and gas last year.

US President Joe Biden said the toughened sanctions package was designed to enable energy payments to continue. ‘We are closely monitoring energy supplies for any disruption,’ he said.

There are echoes here of the early 1970s, when a burst of inflation, which started with excessively easy monetary policy, was pushed far higher by the 1973 OPEC oil embargo that followed the Yom Kippur War.

Facing congressional elections later this year, the Biden administration desperately wants to avoid an energy crisis. However, provoking such a crisis is Russia’s most obvious means of retaliation for Western sanctions.

When Germany cancelled the certification of the huge Nord Stream 2 gas pipeline from Russia last week, former Russian president and chair of the Russian Security Council Dmitry Medvedev tweeted, ‘Welcome to the new world, in which Europeans will soon pay €2,000 euros per 1,000 cubic meters of natural gas!’

In fact, Europeans were paying €2,200 euros, or double the rate of the previous week, by last Tuesday as markets conjured the implications of losing a third of the EU’s gas supplies. The oil price spiked to US$106 a barrel, the highest level in eight years.

Russia has leverage because energy markets are already tight—all fossil fuels are in short supply because investment in the energy sector has been so weak over the past two years amid the pandemic and concern about climate-change abatement policies. It would not take much of a cut from Russia, which is the world’s third biggest oil producer and the largest exporter of gas, to send oil and gas prices spiralling higher. Markets are already talking about US$150 a barrel for oil.

The last time prices approached that level was in 2008 as Russia was preparing its invasion of Georgia.

Until early this year, many central banks, including the Reserve Bank of Australia, were viewing rising inflationary pressure as a ‘transitory’ response to supply pressures, but an energy crisis would cement it, raising the risk of 1970s-style ‘stagflation’ with both rising unemployment and rising prices.

While instability in financial and energy markets is the most obvious global economic risk from the crisis, there will be other disruptions. Russia is the biggest source of wheat exports globally, while Ukraine ranks fifth, just ahead of Australia. If Russia gains control of Ukraine, it will control up to 30% of global wheat exports. Like many commodities, wheat was already in short supply with fast rising prices before Russia invaded. It’s not clear whether the Western nations will exempt wheat sales from their sanctions, as they have with oil and gas.

Russia is also an important exporter of aluminium, nickel, titanium and palladium—all metals with crucial high-tech applications—and, along with Ukraine, is a major supplier of gasses used in the manufacture of microchips.

While neither Russia nor Ukraine is deeply integrated into global value chains in the way major Western and Asian economies are, both are advanced nations with links to the rest of the world that can only be broken at a cost to both themselves and the global economy.