Since Western governments imposed unprecedented sanctions against Moscow in response to Vladimir Putin’s invasion of Ukraine, the Russian economy has been in free fall. Russia’s central bank has been frozen out of its foreign reserves held abroad, and Russia’s oligarchs have been cut off from their lavish lifestyles in Europe and the Mediterranean. Some Russian banks have been barred from international financial networks.
In an interview last week, the U.S. official credited with designing sanctions against Russia described Russian President Vladimir Putin’s countermeasures as “desperate”. One of those measures is a little-noticed move to prevent capital from leaving the country. My research on the economics behind Russian grand strategy shows it is a tactic that will undermine Russia’s economic growth in the long run, but the Kremlin has few other options.
Countries seek the “impossible trinity” in international finance
Russia’s decision to limit the flow of money out of Russia, and even within Russia, is the predictable consequence of an international finance concept known as the “impossible trinity”, or “trilemma”. According to the trilemma, national economic policymakers try to achieve three goals.
First, they want to maintain open access to international capital flows. This allows growth-enhancing investment to flow into the country — and allows capital to flow out of the country in search of profitable investment opportunities abroad.
Second, governments want to maintain stable exchange rates. A volatile currency makes it hard for firms, investors and households to plan for the future, and the uncertainty hinders investment and international trade.
Third, policymakers strive to use their domestic monetary policy to stabilize the economy when they need to. When central banks lower interest rates during a recession, for instance, more money pumps into the economy, which stimulates investment and spending. Or, when prices are rising fast, central banks can increase interest rates to pull money out of circulation and tame inflation.
But countries can’t achieve all three goals
This juggling act has a big catch, though. A country can only choose two of the three goals, as trying to do all three at once is impossible. This is why Russia is in such an uncomfortable position.
Most countries prefer to use monetary policy to achieve macroeconomic stability. That explains Moscow’s recent decision to raise a key interest rate from 9.5 percent to 20 percent. The goal was to support the Russian ruble exchange rate by “soaking up” excess rubles on currency exchange markets. This reduces the money supply and targets rising inflation.
Because Russia raised interest rates to check inflation, that means the Kremlin can now only pursue one of the remaining two goals: exchange rate stability or international capital flows.
But sanctions on the Bank of Russia prevent it from using its foreign reserves to support a stable exchange rate. That’s because banks outside Russia hold upward of $400 billion of Russia’s total $640 billion in foreign reserves. Most of those funds are now frozen and out of the Kremlin’s reach, and Western banks are barred from exchanging those reserves on open markets.
The consequence is that everyone who has rubles is scrambling to get rid of a currency that’s suddenly worth much less than before. As people flood the market with unwanted rubles, trying to exchange them for dollars and euros, they further drive down the exchange rate.
The ensuing collapse of the ruble has been extraordinary. In mid-February, the currency was trading at about 75 rubles to the dollar. As sanctions came into full effect, the rate fell to $1 to 150 rubles, before rebounding somewhat.
Because the economic and political consequences of a ruble meltdown and threat of Weimar Germany-style hyperinflation are terrifying to the Kremlin, the Russian government now has to impose draconian capital controls if it wants to achieve its goal of exchange rate stability.
Russia’s financial Iron Curtain
Having chosen monetary flexibility and exchange rate stability, Russia has no choice but to sacrifice capital flows across its borders. Under current conditions, if dollars, euros and rubles were allowed to flow freely across Russia’s borders, this would upset Russia’s money supply and the ruble’s precarious position. So Russia has turned to capital controls to seal off its monetary policy from the outside world.
The trilemma effect is already in action — Russia has gone to extraordinary lengths to lock down the flow of capital out of Russia, and even restrict currency flows domestically. On Feb. 28, the Foreign Ministry ordered Russian exporters to sell 80 percent of their foreign currency and buy up rubles instead, a move designed to prop up the exchange rate.
The Russian government also blocked foreign investors from cashing out billions of dollars of investments in Russia, barred companies from paying dividends to overseas shareholders and restricted payments to foreign investors on ruble-denominated debt.
Next, the government limited Russians from withdrawing more than $10,000 from existing dollar accounts. More troubling for ordinary Russians was the simultaneous announcement that they cannot exchange their rubles for dollars within Russia. Instead, they are forced to hold on to their rubles, come what may, as part of the government’s attempt to prevent a massive ruble sell-off.
Are these tough controls working? Yes. Though greatly weakened, the ruble has stabilized recently to around 100 rubles to the dollar. Moscow has achieved its monetary autonomy and exchange rate stability, but at a tremendous long-term cost.
The looming financial Cold War
Even before the war in Ukraine and Western sanctions sent the Russian economy careening, economists expected Russia’s growth to slow. The recent capital restrictions now leave international investors unwilling and unable to invest in Russia’s economy for years to come.
Russia’s economic future looks bleak: Economists predict a 15 percent drop in gross domestic product this year. It’s too soon to tell whether the pain of sanctions will force Putin to back down. Nor do we know whether economic pain will spur Russians to protest. But there can be no doubt about the long-term economic consequences of the financial war being waged against Russia for its invasion of Ukraine.
Robert Person (@RTPerson3) is an associate professor of international relations at the U.S. Military Academy and director of West Point’s International Affairs curriculum. A Council on Foreign Relations term member and faculty affiliate at West Point’s Modern War Institute, Person is the author of a forthcoming volume on “Russia’s Grand Strategy in the 21st Century” (Brookings Press, 2023).