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The sanctions on Russia, in our judgement, were prepared in advance and were previously known to the Russian leadership. They didn’t have to wait for the war to find out that the ‘west’ and its allies were going to impose further sanctions on Russia.

The United States, along with other members of the international community, is imposing “unprecedented” sanctions on Russia in response to last week’s invasion of Ukraine.

To some extent, believes Russia is prepared for the sanctions, and that the Swift onslaught on Russia may be mitigated. But we will discuss that another day.

The Institute of International Finance believes these sanctions will have a significant impact on Russia and will force President Vladimir Putin to adopt extreme measures.

With the most recent set of actions—selected institutions being excluded from the global financial messaging system SWIFT and restrictive restrictions being placed on the Russian Central Bank (CBR)—the international community’s resolve is evident.

Understanding the consequences of these acts, on the other hand, is critical. The simple conclusion is that these sanctions will have a considerable impact on Russia’s entire economy, and ordinary Russians are already bearing the brunt of the burden.

The sanctions are aimed against Russia’s domestic financial system, creating bank runs and compelling Russia’s central bank to raise interest rates and/or spend foreign exchange reserves.

“Furthermore, we believe that the CBR will have to institute strict capital controls and possibly declare a bank holiday as bank runs accelerate and demand for foreign exchange continues to rise sharply. As a result, we anticipate seeing negative growth in an economy that has already been hindered by increasing isolationism,” says the IIF.

Scaling up the sanctions

According to IIF, there is still room for the US and its allies to scale-up the sanctions against Russia in the coming days.

These could include removing energy transactions-related exceptions from sanctions against the Russian banking system, shutting down further Euro-based transactions, and prohibiting transactions in the secondary market for existing Russian debt.

Economic and financial impact

IIF says it expects sanctions imposed in recent days to have a dramatic effect on Russia’s financial system as well as the country’s economy as a whole.

Strong depreciation pressure on the Ruble will force the Bank of Russia to hike interest rates significantly in order to limit FX passthrough to inflation.

“Furthermore, we believe that the CBR will have to institute strict capital controls and declare a bank holiday as bank runs accelerate and demand for foreign exchange continues to rise sharply. Altogether, these developments will lead to a sudden and meaningful decline in economic activity,” economists say.

Gold surpasses Dollar

Since the onset of international sanctions in 2014, Russia has pursued a deliberate risk reduction strategy, including diversification and geographical relocation of reserve holdings, shifts in the currency composition of trade transactions, and domestic “de-dollarization.”

The Bank of Russia has reduced the share of its reserve assets in U.S. Dollars and its holdings of U.S. Treasuries markedly (Exhibit 2).

Gold now surpasses the U.S. Dollar in Russia’s reserves, accounting for over 20%, with the Dollar’s share down sharply from 43% in early 2014 to 16% in mid-2021 and the Renminbi’s up to 13%. Furthermore, the geographic distribution of reserves has shifted significantly—from Europe and the U.S. to China and Japan (Exhibit 3).

As a substantial share of the country’s external debt is denominated in U.S. Dollars ($209 bn out of $478 bn at the end of 2021) and households as well as corporates have FX deposits of around $200 bn, it remains necessary to hold on to a certain amount of liquid Dollar-denominated assets.

However, it appears that Russia has eliminated its holdings of U.S. Treasuries almost entirely (Exhibit 4). It is possible that some were transferred to other jurisdictions and are held indirectly, but reliable data on such dynamics do not exist.

The introduction of the Digital Ruble and continued development of domestic payments systems will likely also support further de-dollarization.

“We expect the cumulative effect of sanctions on the Russian economy to be strong, leading to a sizable contraction of output this year.

“In our view, the CBR will be forced to hike interest rates significantly as Ruble depreciation passes through to already-elevated inflation, impose strict capital controls, and declare a bank holiday. Financial conditions will also tighten as banks struggle with loss of access to FX, with important implications for the real economy,” says IIF.

Swift is limited

On February 26, the United States, together with the European Commission, and other countries announced that several Russian banks would be removed from the global financial messaging system SWIFT.

Sanctions on Iran in the aftermath of the U.S.’ departure from the nuclear deal in 2018 illustrate the potential impact of measures related to global payments systems (see Box 1).

In response to the introduction of sanctions in 2014 and in anticipation of additional measures in the future, Russia began to create domestic wholesale and retail payments systems and has made substantial progress in this area. Partially motivated by economic sovereignty concerns, Russia is embracing digitalization, including in finance, faster than other countries, and the implications of the COVID-19 pandemic have only accelerated this process.

In 2014, the Bank of Russia (CBR) began to develop its own Financial Communications System (SPFS), and, as of now, more than 400 primarily domestic institutions are linked to it. In 2020, the number of messages almost doubled to two million and more than 20% of total traffic is already executed via SPFS, with the CBR actively trying to increase the share (Exhibit 8). While it is less flexible than existing international systems, SPFS could handle all domestic messaging traffic.

Similar to SPFS, Russia, in 2014, launched a domestic alternative to U.S.-based card payment companies called MIR, which is operated by the National Payment Card System Joint Stock Company (NSPK JSC). About 95 million MIR cards have been issued—representing over 30% of all such cards in Russia—and the share of MIR cards in total payments stood around 24% in 2020 (Exhibit 9). MIR cards are also accepted in some Russian tourist destinations, but the system’s overall reach outside of Russia remains small. Additionally, the central bank introduced a rapid payments system, through which consumers can transfer money and execute payments almost instantaneously via a phone number or QR code (Exhibit 10). This has also contributed to the sharp rise of cashless transactions in Russia (Exhibit 11).

The Digital Ruble pilot is scheduled to begin in 2022, following a period of extensive consultations regarding its potential impact on monetary policy, financial stability, and financial infrastructure. The CBR hopes that the Digital Ruble will make payments cheaper and faster, and selected twelve banks covering over 60% of Russia’s financial system to be involved in the launch. Following the pilot, Russia plans to publish the roadmap for its rollout, which would theoretically put the country ahead of many countries as far as central bank digital currencies (CBDCs) are concerned.

Russia is following in the footsteps of China’s central bank— which started testing the Digital Renminbi in 2021—and is implementing a two-tier system in which the CBR will open wallets for financial institutions and these, in turn, open wallets for their customers. At this time, the Digital Ruble is only intended to serve for payments, i.e., as a medium of exchange, rather than to store value, as wallets will not be interest remunerated. This way, the CBR aims to avoid creating a risk of disintermediation for the banking system.

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