Are we in a Financial War?
The meaning and possible consequences of an 'all-out financial war' for investors
Hi! It’s George from Investorama.
Thank you for joining me in the exploration of the future of investing. In this newsletter, I’ll be looking at alternative assets, blockchain, investment technology and trends - without the hype.
Today’s topic is a bit different, as we talk about the war in Ukraine. Although it’s a critical topic for investors right now, the only truly important part is that the Ukrainian people are fighting for their lives and their country.
On March 1, French Finance Minister Bruno Le Maire declared an:
"All-out economic and financial war" against Russia to bring down its economy as punishment for invading Ukraine
and then quickly backtracked, explaining the language was inappropriate. Western countries do not want to be engaged in an actual war.
On the other hand, Putin repeatedly stated that sanctions against Russia are akin to an act of war while dismissing their effect.
Commentators talk a lot about financial warfare1, which means ‘the practice of war’. But it’s probably used metaphorically: the sanctions are compared to physical attacks.
Clausewitz, a famous military theorist, defined war as ‘an act of violence intended to compel your opponent to fulfil your will.’
The level of sanctions applied by the West against Russia is unprecedented. Is it an act of financial violence? Maybe. Is it war? Probably not.
Instead of debating what it should be called, I’m trying to assess:
What could be the outcome of Western financial actions against Russia
And if there could be further escalations with even more dramatic consequences.
What’s different?
Since World War II, sanctions are the most popular tool short of military intervention.
Cuba has faced U.S. trade sanctions and embargoes since 1960. Yet, the Communist regime is still in power. Syria’s Bassar Al Hassad faced multiple U.S. sanctions following the brutal repression after the Arab Spring uprising in 2011. Hundreds of thousands have died, yet Assad is still in power.
There have been ongoing economic sanctions against Russia since it invaded Crimea.
South Africa is a rare example of success largely credited to sanctions, and it took three decades.
Sanctions do not always produce meaningful or timely change.
A new financial power
Since the World Trade Center attack, the US has developed a new way to inflict pain on its enemies by leveraging its financial power.
By harnessing the forces of globalization and the centrality of the American market and dollar, Treasury developed a new way of undermining America's foes. (Treasury’s Wars)
The US accounts for only 10% of world trade, but the US dollar dominates exchanges:
It accounts for 50% of international trade invoices
Countries making up 70% of global GDP use the US dollar as an anchor currency
In the first wave of financial sanctions, Russian banks were shut out of the correspondent banking system for US dollar transactions. Given that most global trade is in US dollars blocking Russian banks’ access is a severe sanction.
Europeans make their move
SWIFT is the global messaging network used by banks is subject to Belgian law and controlled by Europeans. They decided to exclude some Russian banks, restricting their ability to transact globally, in a move that took the world by surprise.
Although this move affects only 7 Russian banks, it must have contributed to “shock and awe” as it weaponized a benign part of the financial infrastructure.
Targeting the core of the Russian financial system
The most potent attack was on the Central Bank of Russia (CBR). Russia was prepared for conflict and had accumulated an arsenal of foreign exchange reserves,
These reserves, $643 billion in total, could serve a dual purpose:
Keep the imports flowing into the country: As the Ruble devalues, they can pay with USD.
Prop up the Ruble by selling foreign currency and buying the national currency.
But these assets are held with correspondent banks around the world. The US, European Union, UK and Canada prohibited transactions related to the management of reserves and assets of the Central Bank of Russia. They instantly froze around two-thirds of the Central Bank’s reserves.
Most of the rest comprise gold which is harder to sell. (I’m curious to see if that could have a negative impact on gold prices, but that’s another topic.)
There is visible damage:
The Ruble is collapsing
Some Russian companies will likely default
Russia may not pay its debt, which could trigger a default like in 1998
And there could be more financial stress that we don’t see.
It’s not an ‘all-out’ war
The West will not get militarily involved in Ukraine, which is not a member of NATO. It will not close the Ukrainian airspace as this could mean an outright war, and nobody in the West wants to experience that.
With the unprecedented sanctions, they appear to be in a comfortable position, as Russia can’t retaliate effectively.
But is it enough to win the war for Ukraine?
One could imagine a scenario where Russia can’t import essential goods anymore; the government machine struggles to function; ultimately, it can’t pay salaries, including that of its soldiers, and therefore seeks de-escalation of the conflict.
Wouldn’t that be nice if it happened quickly? Highly unlikely, but a possibility nonetheless.
A partial war
While Europeans and Americans try to stop financial transactions with Russia, they keep buying its oil and gas. It means that the West is still transacting daily with Russia, exchanging dollars against commodities. Although there are private intermediaries in the process, you could say that an ongoing commercial relationship is sustaining Russia’s aggression.
The fact that energy has been excluded from sanctions can seem odd, and many are calling for more actions:
The second point refers to the fact there are only seven banks disconnected from SWIFT out of the 291 Russian members of SWIFT. This ban does not apply to two of the largest, Sberbank or Gazprombank because these two banks are the primary payment channel for Russian oil and gas imports. So it’s the energy sector that holds the key to the Russian coffers.
The power of connection
If NATO members take further steps, they would implement measures directly impacting their economy.
There are talks of banning the import of Russian oil. The risk is obvious. Oil prices already at record levels could spike higher and trigger a recession. But, politically, it would be a brave move with far-reaching consequences.
As for gas, it’s not something that is on the table. The only European country which has stopped importing Russian gas is… Ukraine.
The European Union now imports nearly 40% of its natural gas from Russia. This dependency dates from the first pipelines installed in the 60s and has increased as the Cold War unfolded.
The past 50 years have seen energy shocks and gluts; major political crises from Poland to the former Yugoslavia; the fall of the Soviet Union and rise of Russian President Vladimir Putin’s authoritarian state; outright warfare in Ukraine and elsewhere; massive experiments in deregulation; and the rise of environmentalism. Yet relations between Europe and Russia in the natural-gas sector have remained nearly constant. This is because change is slow in three factors: proven reserves of gas, aggregate demand for energy and investment in physical infrastructure to link the two. (Nature, Dec 2019)
National-security specialists have recommended that Europeans reduce their dependence on these imports for decades. Yet, the first reactions only appeared after the Ukrainian conflict started (Germany shelving Nord Stream 2 pipeline)2, and it will be years before any material changes occur.
If the Western economies are in a financial war, it’s not an all-out war until it includes the energy sector.
Where we are today
Western countries have gone as far as possible without directly affecting their economy. The measures are stronger than any other sanction regimes from the past. Yet it still looks like the outcome of the conflict will be decided on the ground.
Going further would mean touching the energy sector, with the risk of an energy-driven recession in the Euro area and without guarantees that the escalation on the financial front could be decisive.
It would take a lot of political courage. In other words, as citizens, we may need to think of how much economic wellbeing we are willing to sacrifice. As investors, we need to understand the risks.
PS: Please donate to support Ukraine if you can, useful links.
In the longer term, the sanctions have potential consequences on the balance of global powers, here is an interesting take.
To lighten up the mood and keep up with a tradition that I started with this newsletter, here is a legendary cinema moment: ‘You can’t fight in here, this is the War Room’.
Forbes: the first financial war; Kyla Scanlon, Net Interest: Financial Warfare;
https://www.politico.eu/article/germany-to-stop-nord-stream-2/