Bll o w b acc k

Financial Mirror (Cyprus) - - FRONT PAGE -

Western cap­i­tal mar­kets could af­fect the en­tire Rus­sian econ­omy, not just the banks them­selves. And the cen­tral bank’s de­ci­sion to raise in­ter­est rates to but­tress the ru­ble may lead to much tighter credit con­di­tions for com­pa­nies and house­holds, push­ing the Rus­sian econ­omy into re­ces­sion this year and next.

The prob­lem with fi­nan­cial sanc­tions is that no one knows pre­cisely how they will un­fold – es­pe­cially in an econ­omy as large as Rus­sia’s. If they prove to be more effective than in­tended, they will pose a se­ri­ous threat to global fi­nan­cial sta­bil­ity.

The re­stric­tions on Rus­sian banks op­er­at­ing in Europe and the US ap­pear mod­est. The banks can still ac­cess money mar­kets, cover their short­term fi­nanc­ing needs, and count on the cen­tral bank for sup­port. But in­vestors’ risk ap­petite could eas­ily shift, spurring them to with­draw large amounts of cap­i­tal. Though Rus­sia’s public debt is mod­est, its for­eign-ex­change re­serves large, and its econ­omy much stronger than in 1998, once the herd is run­ning, it is im­pos­si­ble to stop it.

Europe’s banks have ex­tended al­most 200 bln eu­ros ($268 bln) in loans to Rus­sian in­sti­tu­tions and firms, and hold a sig­nif­i­cant share of Rus­sia’s euro-de­nom­i­nated as­sets, mak­ing them es­pe­cially vul­ner­a­ble. More­over, the eu­ro­zone’s cur­rent stress tests may well re­veal sig­nif­i­cant cap­i­tal holes in ma­jor Euro­pean banks in the com­ing months. Having just emerged from a deep re­ces­sion, fi­nan­cial dis­rup­tions could eas­ily cause Europe to slide back into re­ces­sion, par­tic­u­larly given the eu­ro­zone econ­omy’s close links to Rus­sia via trade and en­ergy.

Com­pound­ing the prob­lem, no one truly un­der­stands the pre­cise con­nec­tions among Rus­sian and Euro­pean in­sti­tu­tions and mar­kets. The col­lapse of LTCM in 1998 was com­pletely un­ex­pected. Is Europe to­day pre­pared to deal with a sim­i­lar fail­ure of an im­por­tant fi­nan­cial in­sti­tu­tion?

The fi­nan­cial sanc­tions on Rus­sia are not tar­geted, tem­po­rary, or fully cred­i­ble. If they af­fect Rus­sia’s en­tire econ­omy, hit­ting or­di­nary cit­i­zens the hard­est, pop­u­lar sup­port for Putin’s regime may so­lid­ify fur­ther. Of course, an economic slow­down could erode Putin’s pop­u­lar sup­port, which is based on the gains in liv­ing stan­dards made un­der his lead­er­ship. In that case, Putin’s re­sponse could be even more dam­ag­ing.

An­other prob­lem is that im­ple­ment­ing sanc­tions that can­not be re­versed quickly re­moves the in­cen­tive for Rus­sia to re­turn to the ne­go­ti­at­ing ta­ble, es­pe­cially be­cause the threat of an es­ca­la­tion of fi­nan­cial sanc­tions lacks cred­i­bil­ity, given the risk to Euro­pean and US fi­nan­cial sta­bil­ity.

Once th­ese sanc­tions be­gin to bite, no one can say who will be hurt – or how badly. And, as Rus­sia’s ex­pe­ri­ence in 1998, and Ar­gentina’s af­ter 2002, demon­strated, the process of restor­ing con­fi­dence among mar­ket par­tic­i­pants is a long and painful one.

Th­ese con­cerns do not mean that the US and the EU should not im­pose sanc­tions on Rus­sia for its il­le­gal an­nex­a­tion of Crimea and con­tin­u­ing ef­forts to desta­bilise east­ern Ukraine. But sanc­tions that hit the real side of the Rus­sian econ­omy – such as en­ergy, nat­u­ral re­sources, and the mil­i­tary – could pro­vide a bet­ter so­lu­tion. Though such sanc­tions may not work as quickly, they would be tar­geted, tem­po­rary, and cred­i­ble, en­abling the US and Europe to con­trol – and ad­just – the im­pact on the Rus­sian lead­er­ship and econ­omy.

In any case, US and Euro­pean lead­ers must recog­nise that all sanc­tions will have costs – many of them un­ex­pected – for both sides. If they are not will­ing to risk global fi­nan­cial sta­bil­ity in an un­pre­dictable game of chicken with Putin, per­haps it would be wise to re-think the com­po­si­tion of the sanc­tions that they im­pose.

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