The Russia sanctions will transform the global economy

The economic and financial sanctions imposed on Russia after its illegal invasion of Ukraine will fundamentally change the international economic system with lasting implications for the way the global economy operates.

The sanctions are designed to weaken the Russian government’s ability to pursue the war in Ukraine by denying it access to essential global markets for finance, technology, goods and services. The package adopted so far has three main components: blocking access to financial markets; measures against wealthy individuals who support President Vladimir Putin; and restricting involvement in international markets for goods and services.  The search is on to find a way to reduce the Russian government’s ability to sustain itself from hydrocarbon revenues, while minimizing the economic cost to European consumers.

The sanctions have been substantially amplified by voluntary steps taken by many western multinational corporations, suspending their activities, or withdrawing completely from the Russian economy, sometimes at considerable financial cost to themselves.  The measures have also been adopted by a range of countries going well beyond the G7. Both Switzerland and Singapore have dropped their traditional neutrality and adopted sanctions of different kinds against Russia.

Given the scale of Ukraine’s human suffering and its physical losses to date, it appears highly unlikely that the sanctions on Russia will be eased in any significant way so long as Russia continues to occupy substantial parts of Ukrainian territory.

Nor will western governments place any future reliance on Russian assurances of energy supply security. And once firms have invested in new supply arrangements, they will face significant costs in reverting to the previous arrangements. As a result, the changes under way now are likely to be in place indefinitely.

Arising from these developments are at least six major implications for the international economic system in the medium to long term.

Weaker global economic governance

Russia’s attack has put multilateralism under enormous strain, as seen in the walkouts by western countries from the International Monetary and Financial Committee and the G20 at the last IMF/World Bank spring meetings.  Western countries are baulking at being required to work collaboratively within a group that includes a major country which is undermining the entire international governance system. At the same time, other major economies are not prepared to expel or suspend Russia from the G20.

In the short term, more reliance will need to be placed on the G7 and ‘G7 plus’ groupings, although there are limits to how far this can go given the G7’s limited legitimacy and capabilities. But if the G20 fails to find a way to effectively freeze Russia’s participation, the world may be forced to move to a new ‘balanced’ grouping, such as the G2 (China and the United States), or a G4 (US, the European Union, China and India).

Individual component institutions of the international economic architecture where the West dominates through its voting weights should be able to continue to function within their existing mandates, but the move towards making these institutions more representative may be stalled.

Pressure on the currency system

The West’s action against the Russian central bank means that Russia has been un-able to deploy about 50 per cent of its liquid foreign exchange reserves. Meanwhile, the US veto means Russia will have no access to IMF facilities designed to support countries facing foreign exchange difficulties.

Russia may find this manageable while it enjoys substantial external revenues from its hydrocarbon and mineral exports. But without this, the consequences would be devastating.

For any authoritarian government responding is not at all easy given that the only genuinely convertible currencies are provided by western liberal democracies. Using cryptocurrencies and international payments systems for non-convertible currencies may help mitigate the impact of restrictions on the use of convertible currencies to some degree, but the extent of relief is far from clear. In any event, pressure on the international currency system – with the risk of sudden and destabilizing shifts – appears likely to increase.

Hard choices in development finance

Even before the Ukraine war, there were enormous challenges for international development finance, such as the struggle to reach the annual $100 billion of climate finance or the difficulties encountered in funding the relatively modest needs for pandemic preparedness and response.

But the need to fund military and economic support for Ukraine, its refugees, higher defence spending and the eventual reconstruction of Ukraine have greatly increased the prioritization dilemma facing western donors which are also trying to respond to the sharp rise in their own public debt caused by the pandemic.

Alongside this is a growing risk that the impact of the war in Ukraine in raising food and energy prices, combined with the legacy of the pandemic, will trigger a systemic debt crisis affecting a substantial number of low-income and middle-income countries.  Such a crisis might have the positive side effect of triggering enhanced collaboration between China and the West to come up with a solution, but it could also further exacerbate the demands on western development finance.

Increased global finance corruption risk 

Achieving a net zero world economy by 2050 will require some $5 trillion of investment each year to be allocated and invested in a very short time, often in countries with weak governance. But the experience from Afghanistan and the response to the Covid-19 pandemic shows the enormous risk of corruption that arises in these situations.The war in Ukraine will lead to a stepping up of state-led efforts by Russia and possibly other authoritarian governments to undermine international mechanisms to control illicit financial flows. This will be highly damaging in its own right, but it could open the way for organized crime to further undermine the system.

Accelerated market fragmentation

Stronger controls on technology exports to Russia have added to the trend of western governments stepping up their monitoring of trade and investment links with China over national security concerns. At the same time, both western and authoritarian governments are looking at supply chain security with increased urgency.

While the economic arguments for an open trade and investment regime remain very strong, it looks inevitable that the world economy will face greater fragmentation in global markets for goods and services in future, as well as more constraints on sharing technology internationally and undertaking joint research and development.

Impetus to stakeholder capitalism

The voluntary measures taken by multinational companies that have amplified western official sanctions in part reflect the fear of inadvertently conflicting with US and EU sanctions. But they also reflect the extraordinary threat Russia’s action in Ukraine poses to collective international security arrangements and the rapid evolution of the Environmental, Social and Governance movement, reflecting the rising expectations of investors, customers and employees. This will have long-term implications for how multinational companies behave in future as well as the way the ESG movement develops.

The full implications of these emerging trends for the international economic system are very uncertain. But it is critical that western policymakers assess and, if necessary, act on them both to mitigate the downsides and benefit from any new opportunities created. This is true, even in circumstances where the immediate policy priority remains support for Ukraine.

Source: Chatham House