As Russia’s economy teeters on the brink of collapse, its fallout could prove even more consequential than perhaps initially thought.
The freezing of the Russian Central Bank’s assets and the weaponisation of the US dollar has not only caused Vladimir Putin’s “Fortress Russia” plan to crumble, but also stoked worries that the world economy has crossed the Rubicon.
Some in global finance, including the International Monetary Fund, fear the onslaught of Western sanctions means the global economy is splitting into camps in the wake of Russia’s invasion, one led by the US and the other by China, with disastrous consequences.
They believe the world economy is fracturing into two parts. Russia will be forced to move away from Western finance, tech and the US dollar, perhaps into Chinese President Xi Jinping’s arms, while others could follow to avoid being next.
“The war also increases the risk of a more permanent fragmentation of the world economy into geopolitical blocks with distinct technology standards, cross-border payment systems, and reserve currencies,” IMF chief economist Pierre-Olivier Gourinchas said last week as he delivered a grim set of global economic forecasts in the wake of the invasion of Ukraine.
He said this “tectonic shift” where trade and standards separate into blocks would be a “disaster” for the global economy. It would be “a major challenge to the rules-based framework that has governed international and economic relations for the last 75 years”, Gourinchas added.
While the big thinkers in economics appear to agree that a fundamental shift is underway in the global economy, they remain divided over what kind of post-Covid, post-Ukraine war world will emerge. Some believe the war will cause economic fragmentation and the demise of the dollar as the world’s reserve currency; others swat away the idea that such a seismic shift is underway.
Dario Perkins, managing director of global macro at TS Lombard, says: “We always thought this splintering of the global economy into different trade blocs – the US, Asia and Europe in the middle – was going to happen but we’ve had that accelerated.
“Some of these trends will be accelerated, particularly [given] you are drawing Russia, China, India and other countries closer together. They’re starting to use the renminbi in bilateral trade instead of the dollar.”
Government-imposed financial sanctions taken against Russia by the West have been sweeping and devastating, while individual companies have delivered a blow by pulling their operations out of the country. There are worries this could force Russia and others to seek alternatives to a global financial system dominated by the West and its financial heavyweights.
In addition to personal sanctions against Putin and his inner circle of oligarchs and ministers, the West targeted its lenders and central bank.
Once considered a “nuclear” option, a number of Russian banks were ejected from the Swift global payments messaging system, making it far harder for them to do business and make cross-border payments. Visa and Mastercard also suspended their operations in the country, blocking access to new cards issued by the payment giants.
Meanwhile, following the invasion, the West froze half of the Russian central bank’s foreign currency and gold reserves, hindering Moscow’s ability to prop up the rouble and its banking system.
Under Putin’s Fortress Russia plan to insulate it from sanctions, Moscow had built up a $640bn war chest of foreign reserves. The freezing of these reserves was considered a game-changing move, in an unexpected and powerful escalation of the financial siege on Russia. It prompted a plunge in the rouble and the introduction of capital controls in the country.
Some fear this weaponisation of finance and the US dollar has long-term consequences, perhaps luring countries to a new rival sphere headed by China.
Russian banks are turning to alternatives to the Belgium-based Swift in order to smooth cross-border payments. Its central bank has its own system it has already offered India for rouble payments, while China also has an alternative that could rival Swift.
Moscow’s lenders have turned to China’s payment giant UnionPay to help them issue debit and credit cards after Visa and Mastercard joined the mass exodus of Western brands from Russia. The two American payment heavyweights accounted for 70pc of the Russian debit card market but the Kremlin created its own system, Mir, following the Crimea annexation.
Following the departure of Visa and Mastercard, Russian banks and Mir hoped to team up with UnionPay, which has been fast gaining ground outside of China in recent years, to issue cards. However, reports suggested last week that UnionPay is getting cold feet, fearing that it will be dragged into Western sanctions.
Fears of a split have also rekindled the long-running debate over whether the US dollar is at risk of losing its status as the world’s reserve currency.
“After this war is over, ‘money’ will never be the same again,” said Zoltan Pozsar at Credit Suisse as he declared a “new world (monetary) order” following the freezing of the Russian central bank’s reserves.
The US dollar has been dominant across the globe since the second world war, becoming the world’s reserve currency. This is the currency held most by central banks as part of foreign reserves and financial institutions to help facilitate global trade.
Countries, including China, have amassed almost $13 trillion in foreign reserves – around 60pc in dollars. As the sanctions on Russia have shown, however, those reserves could suddenly become useless if they are paralysed by the West.
Dollars have also been vital for global trade, being used for everything from invoicing in international business to buying commodities, such as oil.
Russia, however, claims several buyers have agreed to pay for its gas in roubles, while Saudi Arabia is reportedly considering accepting China’s currency instead of dollars for oil sales to Beijing amid tensions with Washington.
“This was a weapon that the US had been increasingly using,” says Perkins. “There’s always been warnings going back at least a decade, saying ‘you can’t keep doing this over and over again’ because eventually you get to a point where you change the status of the dollar. It’s just this is so high profile.”
He says there is now a “turning point”, but highlights that any move away from the dollar would be slow moving.
Others are sceptical that such a major transformation is in the works, however.
Prof Barry Eichengreen, an expert at University of California, Berkeley, says the odds of this weaponisation threatening the dollar’s status are low given the lack of a credible alternative.
“The US was joined by the euro area, the UK, and Japan, among others, in imposing financial sanctions,” he says, adding that the Chinese renminbi is “an unattractive alternative to most countries”.
“Only governments in extremis, such as Russia’s, are likely to significantly increase their reliance on China’s currency.”
Meanwhile Paul Donovan, chief economist of UBS Global Wealth Management, says the concept of a reserve currency will become less important as world trade “is likely to become less global over time”.
“If you are doing less global trade, then the importance of a global invoicing currency is less and central banks don’t need to hold quite so much in foreign exchange reserves.”
He believes the global economy is not going through a splintering but a localisation effect where digitisation reduces the need for physical trade and production moves closer to consumers, such as clean energy over imported gas.