It is a new kind of war -- economic war. Western allies, led by the United States, United Kingdom and European Union, are imposing trade and financial restrictions on Russia's economic activities. The aim is to freeze Russian assets abroad, paralyse financial transactions, obstruct cross-border trade flow, trigger high inflation and, most of all, provoke massive unemployment.
In my view, there is little doubt the West will win this economic war against Russia in three to six months due to the huge difference in economic size. Russia might rank fourth in terms of military might, but its economy ranked 11th in GDP at a size of 1.3% of world GDP. By contrast, the allied nations of the West have a combined economic force of 40.7% of world GDP or 31 times larger than that of Russia's portion.
Mr Putin knows well that he (and his country) is not well liked by the Western world and its allies, particularly after the annexation of Crimea in 2014. To protect his economy from potential Western sanctions, he built an economic fortress to shield the Russian economy. The fortress consists of: (1) building up large foreign reserves, (2) becoming less dependent on food imports and (3) de-dollarisation.
However, Western allies do know how to destroy the fortress.
They can freeze Russian foreign reserve deposits held in Western-ally banks. Despite Russia's huge reserves of US$630.2 billion (as of February 2022), only 13.8% is free from asset freezing. The safe portion of reserves is kept in Chinese yuan, deposited in Chinese banks. The remaining reserves are in French (12.2%), Japanese (10%), German (9.5%), US (6.6%) and UK banks (4.5%).
Russia's large gold reserves are not usable either. Selling gold for cash will have to be done in Zurich, New York and London. Proceeds from gold sales will be immediately frozen like any other Russian Central Bank assets.
This could be the reason why the Russian Central Bank did not intervene in the market the day the ruble fell 25.7%. It had no access to foreign exchanges to support the currency. Instead, the Bank opted to raise domestic interest rates from 9.5% to 20%. The move is pretty much like the Bank of Thailand's action during the Tom Yum Kung crisis in mid-1997.
Despite an interest rate hike on Feb 28, the ruble fell an additional 17% in the week following the hike. Compared to a month ago, the ruble has lost more than 60% of its value. Bear in mind as well the dollar/ruble exchange rate can fluctuate wildly by the minute making it difficult to find a good reference point.
It is not possible to ignore another key Russian economic weapon -- oil and gas supply. Russia is the world's number two producer of oil with production of 9.86 billion barrels per day or 13% of world oil production. The fear of a supply cut from Russia has caused global oil prices to rise by 23%. It is also feared that Europe might run out of heating gas as Russia supplies 40% of European gas demand.
After careful study of demand and supply data, I've come to the conclusion that any fear of rapidly rising energy prices might be intentionally overstated as a way to get all countries on board in opposing Russia's invasion of Ukraine. Indeed, during Russia's annexation of Crimea in 2014 most countries took a neutral stand, assuming the annexation had nothing to do with them. But with the prospect of higher energy prices looming, this time most countries (141 of 193 UN member states) have denounced Russia's invasion.
I base my conclusion that fears are overstated on three reasons. First, there is no embargo on Russian energy products yet. Even Gazprombank and SBER Bank, which channels funds to Russia's oil industry, are excluded from the Swift lockout.
Second, all countries have oil and gas stocks. An abrupt supply cut from Russia will not lead to immediate energy shortages. According to a stock survey conducted November 2021 by the International Energy Agency (IEA), the world has an average of 159 days of oil stocks. European natural gas stock is also sufficient for heating this winter and into next winter.
Third, there are alternative energy supply sources. Even though Russia is the world's number two oil producer, it represents 10.53% of total world oil imports because of internal consumption. In future, if there should be an embargo on Russian oil exports, the world can turn to Iran which has the capability to produce 2.7 million barrels per day but exports none.
This could be the very reason why the US is now talking with Iran on the nuclear deal and, according to media sources, the deal is near conclusion. With Iranian oil exports, the world can pretty much ignore the Russian oil supply threat.
Russia's latest lot of flagship Urals crude had no taker and had to be sold to Shell at about 20% discounted price with free delivery. While the world might be able to find alternative sources of energy, Russia is desperate for oil money as its energy export revenue is equivalent to 17% of GDP. I do not think Mr Putin has calculated such risk in his plan.
After freezing Russian foreign reserves, the next targets are local businesses and consumers. The strategy is to block Russia from international financial transactions. US and European allies barred seven large Russian banks from the international financial telecommunications network, Swift, which will make cross-border payments complicated, slow, and costly. Furthermore, Visa, MasterCard, and Amex have suspended Russian operations.
Five adverse economic factors could bring Russia's economy to collapse. They are: (1) inflation, (2) shortages of supply, (3) business closures, (4) bankruptcies and, most important of all, (5) unemployment.
Inflation is already an intrinsic problem in Russia. The consumer inflation rate was 8.73% and producer price inflation was 23.1% in January. But one week after the invasion, inflation rose to 9.05%. Deep ruble depreciation could push domestic inflation to be near 25%. Not only prices are high, but products will also be in short supply. A blockade of the Swift payment system and boycotts from shipping companies will result in many product shortages, including raw material, intermediate material, spare parts, and machinery necessary for locally produced products.
Foreign-owned businesses are closing operations in Russia. The biggest concern is the withdrawal of foreign automakers which could result in hundreds of thousands of workers losing their jobs. Locally-owned businesses will be affected by a lack of imported supplies, high-interest rates, and low consumption. Many will go out of business too. The situation will be similar to Thailand's Tom Yum Kung crisis.
In summary, Mr Putin might win the (physical) war over Ukraine but will lose the (economic) war at home.
