Russia – from aggression to ruin

Why the dollar will remain a central reserve currency of the remaining dollar-based system and that the role of the dollar and the demand for dollars will increase

09:00 | 2 септември 2022
снимка: Bloomberg LP
снимка: Bloomberg LP

by Yulian Voynov

On 24.02 the regime of Vladimir Putin started a war against Ukraine. This was an unprecedented act of aggression that the Europeans did not expect will experience again 77 years after the WWII

The reasons – establishing the “Fortress Russia”

The reasons for this aggression are many, including the romantic vision of Germany and of the West in general that the import of Russian energy will encourage peace in Europe. Unfortunately these expectations were not met and in the last years Vladimir Putin uses the West’s indecisiveness to establish an impregnable fortress, according to the Kremlin's terminology, the so-called "Fortress Russia", which would withstand any external shocks. The purpose was the Russian economy to diversify away from the petrol and gas and to reduce its dependency to the Western technologies and trade. And despite the successes achieved, Russia remained extremely dependent on Western technology and financial systems.

The sanctions and the consequences

Thus this imaginary fortress, existing in the mind of the Russian rulers, suddenly fell into complete chaos when the West, led by the USA decided to impose sanctions as a consequence for the unprovoked military aggression. These sanctions range from freezing individuals' assets and banning Russian banks to banning Russian investors from trading in EU bonds. In the energy sector, Germany suspended the Nord Stream 2 certification process and subsequently liquidated the management company. The latest sanctions imposed by the EU concern the ban on trade in Russian oil and coal.

Russia's relatively large foreign exchange reserves of $630 billion have been frozen since the imposition of sanctions and de facto Russia is left with a foreign exchange reserve of 65% of which is effectively worth $0 and the remaining 35% is mainly in gold and yuan and cannot be used to protect the ruble. The problem with gold is that it cannot be traded freely, and international gold trading markets have also closed to the precious metal held by Russia.

The investors began to sell their Russian assets as fast as they can and over 1000 foreign companies left the country and stopped operating in it. The ruble lost one-third of its value before the attack. The stock exchange market in Russia collapsed with 50% which forced the Central bank to halt trading in securities and shut down the stock market entirely for several weeks in an attempt to stop the collapse in prices. However, the London registered Russian companies couldn't escape the pain, with the depository receipts of Sberbank, Tinkoff Bank and many others seeing their shares fall by more than 80%.

Russia’s exclusion from the SWIFT international payment system cut the country off from the financial markets and eventually became the basis for its bankruptcy, which officially took place on 27.06. Russia defaulted on its foreign currency sovereign debt for the first time since 1918. The country's foreign debt had long traded at levels around 20% of par in anticipation of the inevitable default.

The reaction of the government and the Russian central bankruptcy

The Russian central bank acted immediately and raised their main interest to 20% from 9,5% and imposed a requirement that exporters must sell 80% of their foreign exchange earnings to it. Prohibitive 12% bank withdrawal fees on foreign currency deposits were imposed and Russia effectively closed its capital account. At the same time, it obliged importers of Russian resources, mainly oil and gas, to pay for supplies in rubles. These measures proved successful and the ruble began not only to recover, but it de facto revalued to twice its pre-war level and became the fastest recovering currency in the world. However, it is clear that these measures distort the ruble's exchange rate and it is not traded at a market price. If there was free financial flow in both directions, the ruble would be much weaker. However, the strong ruble has its price, which is paid by Russian exporters, as companies' foreign exchange earnings in rubles decrease, which in turn negatively affects their operations and revenues. These factors forced the Central Bank to loosen restrictions and cut its key interest rate several times, with the last reduction in July dropping it to 8% - that is, to a lower level than before the start of the war.

Gas a weapon

For years Russia uses gas exports as geopolitical weapon. The gas shutdown in the winter of 2009 proved to be a prelude to what followed in the summer of 2021 and beyond. Gazprom is currently supplying around 20% of the gas it normally supplies to Europe, forcing the company to burn the output while trying to collapse European economies and create internal discontent. The reduction of gas supplies to Europe is actually at the root of high inflation not only in Europe but also in the world. According to a Bloomberg Economics study based on data from the Bureaus of Labor Statistics and Eurostat, about 40% of inflation in the US and about 60% of that in Europe is due to high energy prices – a direct consequence of Russia's policies.

An IMF study shows that Europe could cope with a reduction in Russian gas supplies of up to 70%, although such a step would be too negative for some countries. A complete shutdown of gas, of course, will significantly worsen the situation. Most affected will be the countries in Central and Eastern Europe – Hungary, the Slovak Republic and Czech Republic where there is a risk of a 40% deficit of the gas consumption and shrinking GDP by up to 6%. Italy also will face significant impacts due to its heavy dependence on gas for electricity production. The effects on Austria and Germany would be less severe, but still significant, depending on the availability of alternative sources and the ability to reduce household gas consumption. Economic impacts would be moderate (probably less than 1%) for other countries with sufficient access to international LNG markets. Bulgaria is relatively little affected, especially if the gas market in Europe really remains integrated, which there are strong reasons to believe it will be.

The damage for Russia itself

This Kremlin's policy harms the European economies a lot, but it is even more harmful for Russia itself. High prices have until recently compensated for falling energy exports from Russia, but the situation is already beginning to change and revenues are falling, as Europe is currently managing to cope with reduced Russian exports by substituting supplies – mostly with gas from other countries sources, which normalizes prices, and this boomerangs back to Moscow. In the end of July the Bloomberg tracker showed that the Russian petrol export has been dropping for five weeks in a row. The decline is 13% since mid-June as customers in Asia cut back on purchases. The four-week average shows supplies have fallen by 480,000 barrels per day since mid-June. Russian crude oil supplies to China and India have fallen by 30% from previous peaks since the war began. As a result, Moscow's revenue from export duties fell from $168 million to $155 million.

Petrol income accounts for 30% of the tax income in Russia's budget, and the gas only for 12%. For this reason, Putin has decided to cut gas supplies to Europe, sacrificing sales to Gazprom, whose production has fallen by 35% year-on-year. As an annual volume – 72 billion billion cubic meters – Russian gas exports have collapsed to the levels of the first half of the 1980s. But this policy will have its long-term cost on the Russian economy. As gas storage fills quickly, wells begin to be shut in, many of which will not be able to be reopened. At the same time, with reduced gas flows to Europe and the real absence of other ways to export gas, Gazprom will not have a serious incentive to invest in additional production in the foreseeable future because it will be difficult to sell. And that means less work for service and construction companies in Russia's energy industry in the coming years. This is especially the case with the northern region of the Yamalo-Nenets Autonomous District, where much of the gas destined for Europe comes from.

According to the simulations of the Institute for World economy in Kiel, Russia’s GDP will drop with almost 3% if the whole import and export of gas stops. Just in 2020 Russia produced approximately 639 billion cubic meters natural gas – quantity that put the country on second place after the USA. Around a third or 197 billion cubic meters from this quantities are being exported with which Russia definitely ranked first in the world in this indicator. It is also the world's third-largest producer of crude oil, which explains the 1.2% drop in GDP if a total freeze on imports and exports of this resource is imposed.

Kremlin's dream for alternative political and economical world led by Russia

After Russia's invasion in Ukraine the debate rages on how much the world finance system, dominated by the dollar, can be changed in a way that the Chinese yuan to become the main reserve currency – together, of course, with the Russian ruble. Even leaving aside the economic perspective for a moment, the political restrictions imposed in Russia and China are actually the biggest test of the prospects for the yuan or ruble becoming a world currency. The Chinese Communist Party, as well as the Kremlin leadership, have been grumbling against the US-led global order for years. It is reasonable to assume that if the Chinese or Russian authorities had been able to come up with an alternative, they would have introduced it by now. However, the dollar system is their "Hotel California" and Beijing understood this long ago, which is why it simply cannot leave this system.

A group of economists, led by Michael Dooley, David Folkerts-Landau and Peter Garber claim that the right way to think of currency reserves is as collateral for private sector investments made by wealthy global companies and financial institutions in developing countries. In fact, depending exactly on the opportunity that the rich countries or those that find themselves in the so-called Economical and political development center of the world will seize the assets of governments on the periphery, allows institutions and countries in the developed world to send money and invest in otherwise risky places. Meaning: it is precisely the presence of dollar dominance in financial markets and the associated legal framework for settling disputes at the inter-firm and inter-state level that allows investment in such closed economies as Russia and China to take place at all.

According to a research by three scientists, published from the National Bureau of Economic Research, the dollar is the dominating reserve currency because the USA is the only country with enough power to impose this kind of sanctions when a country as Russia is acting aggressively and is violating the international rules. USA win the “excessive privilege” to own a world reserve currency daring to impose sanctions when justified by the behavior of reserve owners'.

A series of asset seizures should boost confidence that peripheral countries will be punished – giving investors confidence in putting money into emerging markets that are part of the dollar system. Although some countries may choose to opt out, the economists' main conclusion is that "the dollar will remain the central reserve currency of the remaining dollar-based system and that the role of the dollar and the demand for dollars will increase."

Can Europe replace the Russian gas?

The answer is categorical and it is positive. The entire export of LNG in the world is about 500 bcm. About 70% of this volume is believed to be reserved under long-term contracts, while the remaining 30% is free, making 150 bcm of free volume. At the same time, Europe imports about 155 billion cubic meters of gas from Russia – that is, as much as the entire free volume of LNG on the market. Outside these volumes, Europe has the opportunity to deliver additional quantities from Algeria, Azerbaijan, Norway etc. Usually it is impossible even within a year these volumes to be delivered to Europe. Of course, there is a need for serious investment in terminals and pipelines. At the moment in Europe are being built 18 new gas terminals and after they are done, the problem with delivery will be entirely solved.

Also, if steps are taken to reduce gas consumption, according to the proposal of the European Commission, the necessary amount can be reduced to below 100 billion cubic meters. In the current situation, this is no longer a choice, but a mandatory direction of development.

Ruin as a path

Several more detailed analyzes of the state of the Russian economy and its future have come out in recent months. One of the most detailed and in-depth analyzes that came out in the end of July is from the Yale University in which the authors conclude that leaving the Western businesses and the imposed sanctions crush the Russian economy in a short and long-term. The authors challenge nine widespread but misleading myths about Russia's alleged economic resilience.

In their view, pessimistic headlines claiming that Russia's economy has recovered simply do not match the facts. And the facts are that by any measure and at any level, the Russian economy is collapsing, and now is not the time to hit the brakes by saying that sanctions are not working.

In summary, the following conclusions can be drawn:

1. Russia's strategic positioning as an exporter of raw materials has been irretrievably ruined. Orientation towards Asia will not be able to replace Russia's largest and payment market, which is Europe.

2. Russian imports have largely collapsed and the country faces serious challenges in securing important raw materials, parts and technologies, resulting in drastic shortages of imported components and materials for its domestic economy

3. Russian domestic production is completely unable to replace the output of the departing Western companies, their products and know-how, and the lack of domestic innovation threatens the existence of Russia's production base at all and will lead to a surge in prices and a collapse in consumption

4. The companies that left Russia produced approximately 40% of its GDP. Such an outflow of businesses and capital cannot be recovered and de facto erased almost all foreign investments in the country in the last three decades as the mass exodus from businesses was also accompanied by a huge mass of workers who preferred to emigrate rather than remain living in an increasingly terrifying dictatorship

5. The enormous fiscal and cash stimulus of the government and the central bank for saving the Russian economy from collapse have already sent the state budget into a deficit for the first time in years and the currency reserves of the Russian central bank are melting with a rapid pace despite the high prices of energy and, accordingly, the proceeds from exports, which speaks of a much more difficult financial situation of the Kremlin than is assumed and seen at the moment

6. The collapse of the Russian stock market is startling and is the worst performing market in the entire world this year, despite strict capital controls. Moreover, Russia is completely isolated from international financial markets and does not have access to the fresh financing needed to revive its crippled economy. And this is an indicator of both the current conditions and the future prospects for the Russian economy, which speaks clearly enough about the future economic activity in the country.

7. As long as the international community, and especially the West, is united in maintaining and imposing sanctions, Russia's exit from the economic prison will not be possible.

The scary prognosis of the Russian central bank

In conclusion, in order to fully understand the dire situation in which Russia finds itself and the prospects for its future, it is necessary to quote Elvira Nabiulina, who is the head of the Russian Central Bank, in her first speech after the beginning of the war on 18.04:

“The period in which the economy can live on reserves has its end. In the second or third trimester we will enter a period of structure transformation and searching of new business models. Until now the sanctions mainly affected the financial market, but now they will start to affect the economy more and more. The main problems will be related to import restrictions and foreign trade logistics, and in the future also to export restrictions. The Russian manufacturers will have to look for new partners, logistics or to switch to the production of products of previous generations”.

In a word, the Russian economy is faced with the production of products of previous generations, which means that slowly and slowly the Russian economy begins to make a reverse transition to the analog past.