Don't Bank on It
How Western sanctions are cutting off Russian banks from capital for investment and weakening Russia's future economic growth.
Putin can’t say he wasn’t warned. One month before the invasion of Ukraine, Putin’s top economic team trouped out to Putin’s country retreat at Ogarevo. They were led by German Gref, the chairman of Sberbank, Russia’s largest bank, one of the original band of liberal economic advisors who came with Putin to Moscow when he was first elected in 2000.. Alarmed by the signs of a military buildup on the borders of Ukraine, Gref delivered a stern warning of the dire consequences for Russia if tensions escalated further. Putin ignored him.
Then came the invasion. Sberbank was immediately sanctioned by the US, and EU, and the UK. Gref himself is under sanctions, and he has been unable to travel to his favorite vacation spot in Baden Baden in Germany, where he owns property and was previously a frequent visitor.
German Gref, like nearly all of Putin’s economic team, elected to stay on the job. But he has remained a consistently pessimistic voice. In June, at the Saint Petersburg Economic Forum, Russia’s annual showcase for prospective investors (though mostly empty of westerners last year), Gref warned that it would take a decade before the Russian economy recovered to the 2021 level. At another conference in November, he said, “No one yet fully realizes the losses that Russia has suffered.”
Welcome back to the Devil’s Dance. In this episode, #15 in the series, we focus on the effects of the sanctions on Russia’s banks and financial system.
THE STORM OF WESTERN SANCTIONS: WHAT MATTERS MOST?
Much of the attention of Western media and analysts in recent months has focused on the impact of sanctions on Russian oil and gas exports. And for good reason—because the revenues from energy are the largest single source for the Russian federal budget; these in turn pay for investment, for the welfare system (education, health, etc.) and above all for the prosecution of the Ukraine War.
But if the question is about the longer-term impact of Western sanctions on the future of Russia, then the crucial issue is their effects on Russia’s ability to mobilize capital for investment. To answer that, one must look at the financial system, and above all the role of the banks. The banks are the veins and arteries through which hydrocarbon revenues must flow.
The impact of the sanctions on the banks has been dramatic. The top twenty Russian banks have been sanctioned, with only one major exception, Gazprombank (we shall return to the reasons for that in a moment). Foreign banks have left, with only one or two exceptions. Most Western banks refuse to conduct operations with Russian counterparts, and Russia’s access to foreign lending has all but disappeared. Many Russian bank accounts abroad have been frozen or blocked, including about half of the foreign-exchange reserves of the Russian Central Bank, or over $300 billion.
The term, “sanctions,” needs to be interpreted broadly. Many Western banks and other financial players have “self-sanctioned,” refusing to deal even with unsanctioned Russian counterparts, for fear of damage to their reputations or possible secondary sanctions against themselves down the road, which could entail the loss of their access to the US market. In many cases it simply results from the fact that doing careful diligence is costly and time-consuming, and many Western banks simply prefer to avoid it by turning down Russia-related transactions altogether.
THE CONSEQUENCES OF THE SANCTIONS FOR RUSSIAN INVESTMENT
The consequences of the sanctions for Russian investment have already been sizable, and they are likely to worsen as time goes by. The main ones are these:
· The biggest sanctioned banks have been excluded from the SWIFT interbank system, by which banks send payment instructions prior to transferring funds. This has made the settlement of international payments slower and more costly for the Russian banks.
· The access of Russian companies and banks to foreign credit has declined sharply. At the end of 2022, external debt had shrunk by 21% to $382 billion, as existing debts came due. But new borrowing has practically ceased, thus eliminating the largest single source of investment capital.
· Russian banks that had expanded outside the country have been forced to retreat back to Russia, after being sanctioned. In effect, the Russian banking system has been driven back inside Russian borders.
· The role of domestic banks in fixed-capital formation, never large to begin with, has declined still further, as Russian households have withdrawn over $105 billion in foreign-exchange deposits, which are therefore no longer available for investment.
· The foreign banks either left early or now find themselves effectively trapped inside Russia. If they are still operating, they have been barred from paying dividends to their parent companies. If they decide to leave now, they are subject to a 50% cut in their valuations and must pay a further 10% as a fee to the Russian state.
· In response to the sanctions, the Russian banks, led by the Russian Central Bank, are increasingly switching from dollars and euros to Chinese renminbi, and individual savers are being encouraged to hold deposits in renminbi. This is an unsatisfactory alternative, since the renminbi is not fully convertible and is therefore basically illiquid.
The overall result, in short, has been to interrupt or severely impede the connections between the Russian banks and the global financial system. As a consequence, the availability of international capital for investment has been greatly reduced. Instead, the Russian banking sector has been thrown back onto the domestic savings of households and smaller companies, which had never been a major factor in Russian capital formation, and on ad-hoc allocations from the state, which are rapidly growing scarcer as the Russian government finances both the welfare state and the war. The near-certain bottom line is that Russian fixed investment, the essential engine of future growth, will continue to decline, so long as the sanctions are maintained.
In this overall picture of retreat, however, there is one major exception. Russia’s third largest bank, Gazprombank, has not been sanctioned by any of the Western powers, and has not been barred from using SWIFT. Why is that?
GAZPROMBANK—THE LAST BIG BANK STANDING?
Gazprombank’s core function is to make sure that the payments from Russia’s remaining European buyers of Russian gas (now a much-diminished tribe) are conveyed back to Gazprom. The path leads from European buyers to Gazprombank’s international division in Luxembourg, and from there to Moscow via the Luxembourg and Russian central banks.
But since Gazprombank is not under sanctions and is still part of the SWIFT system, other Russian companies have turned to it to handle their international transactions as well. One big question is whether Gazprombank’s useful role extends to repatriating oil revenues, which are now by far the largest source of capital available to Russia. This question is more difficult to track, since the world of oil trading is murky. Many new players have emerged since the imposition of the oil cap system, and there are reports that some of these “shadow traders” have been using Gazprombank to pay for Russian oil cargoes.
The US government is well aware of this, and has been treading carefully, since it is concerned not to disrupt the global oil market. In September 2022, at a hearing before the Senate Foreign Relations Committee, in response to a question about the possibility of imposing sanctions on Gazprombank, Assistant Treasury Secretary Liz Rosenberg “reminded the senators that the oil price cap regime requires ‘channels’ for paying for Russian oil at reduced prices.”
This suggests that Gazprombank is indeed serving as a vehicle for moving oil-export revenues as well as gas. But how much of those revenues make it back to Russia? There are reports that some of the proceeds from oil exports are being dissipated abroad—for transportation and for insurance and services, but also for other less innocent reasons (such as friends and relations of the oil companies) and are thus unavailable for investment inside Russia.
CONCLUSION: AS THE NOOSE TIGHTENS
The two main consequences of the financial sanctions are the increasing isolation of the Russian economy from the Western financial world, and the shrinkage of capital flows available for investment. In 2022, Russia enjoyed a record current account surplus, thanks to high energy revenues. But if those revenues shrink (as they show signs of doing in 2023) and the surplus turns into a deficit, Russia will struggle to find foreign lenders, and investment will decline. As the noose of Western sanctions tightens, Russia’s future growth is increasingly at stake.
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Thane Gustafson is the author and co-author of eight books on Russian affairs, including most recently Wheel of Fortune: The Battle for Oil and Power in Russia (2012), The Bridge: Natural Gas in a Redivided Europe (2020), and Klimat: Russia in the Age of Climate Change (2021), all with Harvard University Press. This series of Substack posts is part of a project for a new book, tentatively called The Devil’s Dance. I am grateful to Simon Blakey, Richard Connolly, Craig Kennedy, Tom Nichols, and Bob Otto for their kind and helpful comments on earlier drafts.
© 2023 Thane Gustafson
'Gref delivered a stern warning of the dire consequences for Russia if tensions escalated further. Putin ignored him.'
Poor old Gref was ingnored. No more trips to Baden Baden. No he wasn't. What happened was that the Russian leadership decided that the situation in Ukraine was too dangerous to ignore any longer despite the likely financial consequences that Putin and other Russian leaders were well aware of. It is obvious that the Russian leadership prepared carefully for financial sanctions. Foreign Minister Lavrov put his finger on it when he said 'sanctions are a tax on our independance.' So he clearly realises that there is a cost for Russia.
'Gref warned that it would take a decade before the Russian economy recovered to the 2021 level.' That warning is already looking like it was too alarmist. The 'military Keynesiasm' being practiced by Russia because of the war is likely to stimulate growth considerably after years of ultra conservative economic policies. Policies that incidentally have allowed Russia to ride out the sanctions onslaught without too much inconvenience.
'At another conference in November, he [Gref] said, “No one yet fully realizes the losses that Russia has suffered.”' And no one will for a number of years. They may be great or minimal. But it has been a choice because Russia could no longer safely live with the easy solutions of Western investment.
Not only are Russian banks and businesses banned from Swift but I understand they have now been forbidden to use it by the Russian government.
Judging by the rocky state of western financial institutions perhaps those future capital investment flows were to an extent illusory anyway.