To prevent an invasion of Ukraine, threaten to sanction Russia’s central bank
Only credible deterrence can prevent Russia’s invasion of Ukraine and a new war in Europe. The threat of devastating Western financial, trade and personal sanctions is credible but may not constitute sufficient deterrent. The threat of a Western military response could present a deterrent but is not credible. One deterrence measure is both credible and sufficient. It is the threat to sanction the Russian Central Bank. It is credible because it carries low risk and is simple to execute. It is a strong deterrent because it is a weapon of massive economic destruction. It can ruin Russia’s exchange rate, the banking system, public finance and the economy at large.
Russia relies on the Central Bank’s foreign exchange (FX) reserves of $638 billion to support the exchange rate and stability of the national currency, the ruble, to insure the banking system and household deposits, to prevent runs on banks, to bail out the external debt of state and private corporations and to manage the sovereign wealth fund of $185 billion for fiscal emergencies. A mere threat of sanctions against the Central Bank would undermine these economic and political foundations of the country.
The reason is the unique 21st Century conjunction of currency convertibility and the digitalization of international finance. If Russia were a closed economy with a non-convertible currency like the now-defunct Soviet Union, it would have been impervious to what happens to FX reserves. The latter were held in gold and foreign bonds and cash in the vaults of the Central Bank, just to ensure critical imports.
Fast forward to the 21st Century. The Russian economy is open, and the ruble is convertible, both backed by the FX reserves. But these reserves are largely electronic book entries in the Russian Central Bank accounts with the Federal Reserve, the European Central Bank and similar Western institutions and clearing houses. There are no physical bonds and certificates. In the language, Western government bonds and other securities and sovereign deposits with Western central and commercial banks are dematerialized and uncertificated.
For example, U.S. Treasuries owned by central banks of 200 countries are book entries on the computers of the Federal Reserve Bank of New York, traded by its authorized dealers, with the sale proceeds transmitted electronically via Fedwire to correspondent banks.
From this vantage point, if sanctions hit, the $638 billion FX reserves shrink to their salvage value. Of the $638 billion FX reserves, only $12 billion are dollar and Euro-denominated cash in the vaults of the Russian Central Bank. The gold stored there, worth $139 billion, is hard to sell en masse, especially if the Central Bank falls under the Western sanctions. Another part of FX reserves, $84 billion in Renminbi-denominated instruments, is of little financial use in a crisis. Some $403 billion, almost two-thirds of the FX reserves, are securities and deposits denominated in U.S. dollars, Euro, British pounds and other Western currencies, representing electronic book entries in Western central and commercial banks. If sanctions are imposed on the Russian Central Bank, the $403 billion of its FX electronic holdings in the West could not be used. Russia will be left with little Western cash, unsaleable gold and Chinese bonds.
Central Bank sanctions will ensue three ruinous runs: on foreign currency, on banks and on the supply chains. With only $12 billion available to prop up the ruble, the exchange rate will devalue and collapse. People will run on whatever foreign currency they could obtain at whatever price, as the store of value.
There’s the rub. Russian households and businesses prefer FX to rubles and hold $268 billion in deposits with the state-owned Savings Bank and commercial banks. They will run on banks to withdraw dollars and Euros, the cash quantity the banks cannot have on hand or obtain from the Central Bank, itself barren of FX.
The banking system will fold unless the government forcibly converts FX-denominated deposits into rubles. Either outcome would cause social unrest. It will be exacerbated by the inaccessibility of the sovereign wealth fund to support government social expenditures. Across the supply chains, suppliers will demand dollars from customers, and efficient parts of the economy will dollarize. The rest of the economy will incur supply bottlenecks and stoppages and resort to barter. The economy will break apart and beget long-term political instability.
The Russian leaders may not realize the destructive power of Central Bank sanctions. The task of diplomacy is to convey to them this 21st Century economic reality. There is no risk in making a threat. If the Russians respond by unloading their holdings and shipping cash home, they cannot do much. It took the U.S. Air Force more than five years to ship $40 billion to Iraq in 2003-08. If the Russians ship a few billions, this won’t help and may cause a panic that would ruin the financial system in advance.
Even if it is uncertain whether or when the Central Bank sanctions will be executed, their threat alone is a credible deterrent because their potential outcome is so powerful. This raises the stakes much higher for Russia than for the West and should prevent war.
Michael S. Bernstam is a research fellow at the Hoover Institution at Stanford University.