Western countries have responded to Russia’s invasion of Ukraine with a slew of sanctions designed to cripple the country’s economy, and economists speculate it could work.

The largest G7 economies have imposed unprecedented punitive sanctions on Russia’s central bank, along with wide-ranging Western crackdowns on the country’s oligarchs and officials, including Russian President Vladimir Putin.

Key Russian banks were excluded from the international payment system SWIFT, which deprived them of the possibility of secure international communication and ostracized them from most of the global financial system.

The sanctions announced by the United States over the weekend also affected the National Wealth Fund of the Russian Federation and the Ministry of Finance of the Russian Federation.

They also effectively bar Western investors from doing business with the central bank and freeze its overseas assets, not least the huge foreign exchange reserves that the CBR used as a buffer against the depreciation of local assets.

In the latest sanctions against Moscow, US President Joe Biden announced on Tuesday that Russian aircraft would be banned from flying in US airspace following similar decisions by the EU and Canada.

French Finance Minister Bruno Le Maire told a French radio station on Tuesday that the aim of the latest round of sanctions was “to cause the collapse of the Russian economy.”

The Russian ruble has fallen since Russia invaded the neighboring country last week and hit an all-time low of 109.55 against the dollar on Wednesday morning. Russian stocks also faced massive sell-offs. Moscow stock markets were closed for the third day in a row on Wednesday as authorities tried to stem the fall in prices for local assets.

Meanwhile, the country’s biggest lender, Sberbank, has halted its European operations and its London-listed shares have fallen more than 95% to trade for pennies. Shares of other major players in the country on the London Stock Exchange, including Rosneft and Lukoil, also collapsed.

The CBR on Monday more than doubled the country’s key interest rate from 9.5% to 20% in an attempt to limit the impact, but analysts say the decision to freeze its foreign exchange reserves is key to blocking its ability to stabilize the Russian economy.

Anders Åslund, a Swedish economist and former senior fellow at the Atlantic Council, tweeted on Wednesday that Western sanctions had effectively “destroyed Russian finances overnight.”

“The situation is likely to get worse than in 1998 because there is no positive end now. All Russian capital markets seem to have been destroyed and they are unlikely to come back with anything less than deep reforms,” he added.

Faced with a “major financial crisis”

“If before the Central Bank could rely on its reserves to smooth out any temporary volatility of the ruble, now it cannot do this. Instead, it will need to adjust rates and other non-market measures to stabilize the ruble,” said Clemens Grafe, chief Russia economist at Goldman Sachs.

Goldman Sachs has raised its year-end inflation forecast for Russia to 17% YoY from its previous forecast of 5%, with risks skewed to the upside as the ruble could continue to sell or the CBR could be forced to hike rates to maintain stability.

Growth is also expected to take a hit, and the Wall Street giant cut its 2022 GDP (gross domestic product) forecast from a 2 percent growth to a 7 percent year-on-year contraction, though Grafé acknowledged uncertainty about those numbers.

“Financial conditions have tightened to 2014 levels and therefore we believe domestic demand will contract by 10% [year-on-year] or slightly more,” Grafe said.

“While exports, in principle, are not yet significantly limited by sanctions, we expect them to decline by 5% year on year due to the physical disruption of exports through the Black Sea ports, which play an important role in bulk exports, and the risk of sanctions reducing other export”.

This scale of decline is similar to the 7.5% fall during the 2008-2009 financial crisis and the 6.8% decline during the 1998 Russian financial crisis.

“Strengthening Western sanctions, along with tighter financial conditions and the prospect of a banking crisis, means the Russian economy is likely to experience a sharp contraction this year,” said Liam Peach, an emerging markets economist at Capital Economics.

While the outlook remains highly uncertain, Capital Economics’ baseline forecast assumes a 5% contraction in Russia’s GDP in 2022 from its previous forecast of 2.5% growth, with annual inflation reaching 15% this summer.

Peach suggested that the worst-case scenario for Russia in terms of international sanctions would include restrictions on the flow of oil and gas, which account for about half of all merchandise exports and a third of government revenue.

“Limiting them would also cut off a key source of dollar revenue for energy companies with foreign currency debt, and possibly cause a much more serious financial crisis in Russia,” he added.

The depth of the recession depends on exports

Stephen Bell, a chief economist at BMO Global Asset Management, said Russia is now facing a “major financial crisis” with the role of China increasingly important to Moscow due to its demand for raw materials and energy.

“Russia has also converted most of its foreign exchange reserves into Chinese currency and switched its payment systems to Chinese banks. China may hold the key to Russia’s ability to sustain the conflict,” Bell added.

So far, there are no sanctions on Russian exports, and SWIFT exemptions target specific banks to allow export payments to continue to be processed. Grafe at Goldman Sachs suggested that this might not last long.

“The willingness of the G7 to bear the costs is growing, and this could ultimately mean that restricting Russian exports and accepting higher commodity prices could become politically feasible,” Grafe said.

The main hurdle for Russia is its inability to use its foreign exchange reserves to back the ruble, but Grafé suggested that this could be overcome by changing the base currency of the ruble to the Chinese yuan instead of the US dollar.

However, creating a cross-currency market would require full cooperation from Beijing, which Goldman Sachs believes is unlikely given the risk of secondary sanctions on China for helping Russia circumvent Western sanctions.

China’s banking regulator on Wednesday said the country opposes financial sanctions against Russia and will not join them. The Chinese Foreign Ministry has so far refused to call the attack on Ukraine an invasion, instead of promoting diplomacy and negotiations.

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