Russia counteracts impact of sanctions with currency controls and averts crisis (for now)
May 31, 2022
The United States and its allies imposed unprecedented trade and financial sanctions on Russia after its invasion of Ukraine. Russia’s central bank responded with tight capital controls that stabilized the value of its currency – the ruble – and prevented a monetary or financial crisis.
The Russian ruble/US dollar exchange rate remained stable in 2020 and 2021, except for a depreciation at the height of the COVID-19 crisis in March 2020. However, within two weeks of the invasion of Ukraine by Russia at the end of February 2022, the ruble depreciated sharply. from 80 rubles/dollar to 120 rubles/dollar.
The United States, the European Union and their allies have imposed unprecedented economic and financial measures punishments on Russia a few days after the start of the conflict.
Their goal was to cut Russia off from world financial markets and make it impossible to finance the war. The sanctions have prevented Western banks from transacting with their major Russian counterparts and have shut several Russian banks out of the global interbank payment system. The sanctions also froze Russian central bank accounts denominated in allied currencies, rendering half of the central bank’s foreign exchange reserves unusable.
The Russian central bank responded by raising interest rates sharply and imposing strict capital controls which appear to have prevented capital flight and stabilized the rouble. Less than two months after the economic and financial sanctions, the ruble and the financial system have avoided collapse and the currency has returned to its pre-invasion level (Chart 1).
The Russian balance of payments crisis in 2014
To understand central bank actions and the ruble’s dramatic fall and subsequent rebound, we take a step back to examine the Russian balance of payments crisis of 2014. It was also driven by Western sanctions in response to actions in Ukraine, including the annexation of Crimea. These sanctions were not as severe as those imposed in 2022, although previous restrictions were aimed at reducing capital inflows into Russia.
Chart 2 represents the Russian balance of payments since 2014: gross capital inflows (net purchases of Russian assets by foreign residents), gross capital outflows, excluding reserves (net purchases of foreign assets by Russian residents, excluding reserves central bank exchange rate), reserve outflows (the central bank’s purchase of foreign reserve assets) and the current account (net capital outflow, gross outflow plus reserve outflow minus gross inflow).
The chart starts with the onset of the balance of payments crisis—gross inflows fell sharply between the first quarter of 2014 and the first quarter of 2015. Gross inflows as a percentage of GDP fell by more than 11 percentage points. This is a two standard deviation drop in gross inflows, meeting the definition of a “sudden stop” in capital inflows.
As in many cases of sudden stops, such a sharp drop in foreign capital inflows precipitates a monetary or financial crisis – Russian businesses and individuals have struggled to obtain the foreign financing needed to refinance existing debt and finance imports.
The Russian central bank responded with two policy actions. The first (as shown in Chart 2) was a massive sale of foreign exchange reserves. The second was a sharp rise in domestic interest rates (Chart 3).
The central bank raised its policy rate by a total of 1,150 basis points (11.5 percentage points) in 2014. The first of these interest rate moves took place at an unscheduled meeting in the days after the annexation of Crimea in late February, and the most dramatic of these interest rate moves was a 650 basis point hike at an unscheduled meeting in December.
The sale of foreign exchange reserves reduced the total gross capital outflow. Similarly, the increase in the domestic interest rate would encourage Russian residents to hold domestic rather than foreign assets, which would again reduce gross outflows. Between the first quarter of 2014 and the first quarter of 2015, gross outflows as a percentage of GDP (outflows excluding reserves and central bank reserves) fell by more than 12 percentage points, a “fallback” of gross outflows which compensated for the sudden stop in gross fundraising.
Responding to sanctions during the 2022 crisis
Eight years later, Russia again faced sanctions for actions in Ukraine that will lead to a sudden halt in gross capital inflows into Russia.
The sanctions are tougher and include a freezing of Russian central bank accounts, effectively removing foreign exchange intervention as a central bank tool to offset falling gross inflows. If successful, these sanctions would lead to a currency crash – global ruble dumping and de facto devaluation – making it impossible for Russia to finance its war in Ukraine.
Russia’s central bank raised the domestic interest rate by 1,050 basis points in an unscheduled meeting three days after the invasion of Ukraine in late February. Since the sanctions prevent sales of foreign exchange reserves, the central bank has responded with strict controls on capital outflows. Russian residents are prohibited from transferring foreign currency abroad and face a strict limit on the amount of foreign currency they can withdraw from Russian banks for the next six months. Russian companies that earn income in foreign currencies must exchange 80% of this foreign currency with the central bank for rubles.
In a recent article, we have shown that, in theory, central bank foreign exchange intervention is equivalent to capital controls—the two instruments substituting for the prevention of a balance of payments crisis. In 2014, the central bank sold foreign exchange reserves to reduce total gross capital outflows. In 2022, the central bank uses capital controls to directly suppress non-reserve capital outflows.
The daily turnover in the Russian ruble and US dollar spot market in Russian banks and on the Moscow Stock Exchange illustrates how limited access to foreign currencies in dollars has been (Chart 4). This daily turnover collapsed to almost zero at the end of February/beginning of March. This is the impact of sanctions (preventing ruble asset purchases by non-residents) and capital controls (preventing dollar asset purchases by residents).
The cost of war can determine the currency of sanctions and the impacts on the financial system
Capital controls seem to have prevented capital outflows and stabilized the value of the ruble in the short term. Whether capital controls will hold in the future is uncertain, but if they do, Russia’s balance of payments will have found a stable equilibrium with financial autarky.
At the end of 2021, Russia posted a large current account surplus. This is foreign capital entering Russia through its trade surplus. Before the war, Russian exports, such as oil and natural gas, were more than enough to finance Russian imports and maintain monetary and financial stability.
A big unknown is the cost of war. If the cost is high, Russia could not fund the war with export earnings alone. But if the cost of the war is less, the Russian currency and balance of payments will remain stable despite the severe foreign financial sanctions.
About the Author
The opinions expressed are those of the authors and should not be attributed to the Federal Reserve Bank of Dallas or the Federal Reserve System.
CurrencyCapital FlowsTradeEconomic Conditions