In one interview last week, the US official credited with crafting sanctions against Russia called Russian President Vladimir Putin’s countermeasures “desperate”. One such measure is a little-noticed measure to prevent capital from leaving the country. My research on the economy behind Russia’s grand strategy shows that this 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 into Russia, is the predictable consequence of an international financial concept known as the “impossible trinity”, or “trilemma.” According to the trilemma, national economic decision-makers attempt to achieve three objectives.
First, they want to maintain open access to international capital flows. This allows growth-enhancing investments to flow into the country and 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 prevents businesses, investors and households from planning for the future, and uncertainty hampers investment and international trade.
Third, policymakers strive to use their domestic monetary policy to stabilize the economy when needed. When central banks lower interest rates during a recession, for example, more money flows into the economy, which stimulates investment and spending. Or, when prices are rising rapidly, central banks may raise interest rates to pull money out of circulation and keep inflation under control.
But countries can’t achieve all three goals
This act of juggling has a big catch, however. A country can only choose two of the three goals, because trying to do all three at once is impossible. This is why Russia finds itself in such an uncomfortable position.
Most countries prefer to use monetary policy to achieve macroeconomic stability. This explains Moscow’s recent decision to raise a key rate from 9.5% to 20%. The aim was to support the exchange rate of the Russian ruble by “absorbing” the excess rubles on the foreign exchange markets. This reduces the money supply and targets rise in inflation.
Because Russia raised interest rates to control inflation, it means that the Kremlin can now only pursue one of two remaining goals: exchange rate stability or international capital flows.
But the sanctions against the Bank of Russia prevent it from using its foreign exchange reserves to support a stable exchange rate. This is because banks outside of Russia hold over $400 billion worth of Russia’s $640 billion foreign exchange reserves. Most of these funds are now frozen and beyond the reach of the Kremlin, and Western banks are barred from trading these reserves in open markets.
The consequence is that everyone with rubles is scrambling to get rid of a currency that is suddenly worth much less than before. As people flood the market with unwanted rubles, trying to exchange them for dollars and euros, they drive the exchange rate even lower.
The ensuing collapse of the ruble was extraordinary. In mid-February, the currency was trading at around 75 rubles to the dollar. When the sanctions came into full effect, the rate fell to $1 to 150 rublesbefore bouncing back a bit.
Because the economic and political consequences of a collapse of the ruble and a threat of German Weimar hyperinflation are terrifying to the Kremlin, the Russian government must now impose draconian capital controls if it is 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 could flow freely across Russia’s borders, it would upset Russia’s money supply and the ruble’s precarious position. Russia therefore turned to capital controls to insulate its monetary policy from the outside world.
The trilemma effect is already in action – Russia has made extraordinary efforts to block the flow of capital out of Russia, and even restrict the flow of currency inside the country. On Feb. 28, the Foreign Ministry ordered Russian exporters to sell 80% of their foreign currency and buy rubles instead, a measure intended to support the exchange rate.
The Russian government has also foreign investors blocked to collect billions of dollars of investments in Russia, prohibits companies from paying dividends to foreign shareholders and restricts payments to foreign investors on ruble-denominated debt.
Then the government restricted the Russians from withdraw 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 in 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 rigorous controls working? Yes. Although strongly weakened, the ruble has recently stabilized around 100 rubles to the dollar. Moscow has achieved monetary autonomy and exchange rate stability, but at enormous long-term cost.
The Imminent Financial Cold War
Even before the war in Ukraine and Western sanctions rocked the Russian economy, economists expected Russia slow growth. Recent capital restrictions now prevent international investors from investing in the Russian economy for years to come.
Russia’s economic future looks bleak: Economists predict a 15% drop in gross domestic product this year. It is too early to tell whether the pain of the sanctions will force Putin to back down. We also don’t know if the economic difficulties will cause the Russians to protest. But there is no doubt about the long-term economic consequences of the financial war waged against Russia for its invasion of Ukraine.
Robert Person (@RTPerson3) is an associate professor of international relations at the United States Military Academy and director of West Point’s international affairs program. A term member of the Council on Foreign Relations and a faculty member of the Modern War Institute at West Point, Person is the author of a forthcoming volume on “Russia’s Grand Strategy in the 21st Century” (Brookings Press, 2023) .
The views expressed in this article are those of the authors and do not represent the official policy or position of the United States military, Department of Defense, or United States government.