In the geopolitical arena, do the ends always justify the means? Is it wise to inflict damage on yourself and your institutions to hobble an enemy? The relationship between the West and Russia over the last few years offers an illustrative case.

Even if we assume that Western promotion of the Maidan revolution was absolutely correct and noble, and that Russian resistance is indicative of the re-emergence of the “evil empire,” questions remain as to what types of punishment are appropriate and what level of damage to Western society and institutions are acceptable. Specifically, many Western actions vis-à-vis Russia have damaged constructs as fundamental as the rule of law and disrupted many economic innovations, which in no small measure contributed to the higher quality of life and level of development of the West. In other words, in an effort to punish Russian “misdeeds,” two of the major forces that helped the West win the Cold War, namely capitalism and its necessary prerequisite, democracy, have been jettisoned when deemed expedient. Is this an appropriate sacrifice?

This work examines sanctions and other actions that can undermine economic relations and contract law. The question of appropriateness is addressed not in terms of any moral right, which this author believes in international politics to be subjective and short-lived at best, but rather in terms of rational self interest:

1. Does the action do more harm to the initiator than the victim in the short run?

2. Does the action result in changes or damage to systems harming the initiator in the long run?

3. Does the action lead to a decline of Western (U.S.) dominance in global affairs, economic and otherwise?

4. Does the action elicit the desired change in the victim, or does it reinforce the current undesired behavior? Similarly, in third parties does the action stimulate the desired behavior?

The Underpinnings of Capitalism

By the time Mikhail Gorbachev had become general secretary of the Communist Party, the superior strength of the capitalist system, specifically, market allocation of capital to more productive uses, and/or uses that satisfy consumer demand (a stark contrast to the planned economy of the USSR) had become plain to see. Half measures under perestroika failed to materially improve the situation, leading to the demise of the USSR.

After a chaotic and violent start in the 1990s, Russia adopted capitalism, albeit with pronounced local features. After the turn of the millennium, Russia became more and more involved in the global financial and trade system. The West exported excess capital due to a dearth of attractive investment opportunities, and Russia, faced with insufficient capital for attractive investments, imported it. This was mutually beneficial as it allowed Russia to modernize and expand capacity, raising the standard of living and well-being of the people, and Western financial institutions and investors were able to receive higher returns on capital. Russian commodities and products enjoyed high demand from the global (particularly Chinese) economic boom and in turn helped fuel this boom. Such integration and comparative advantage is part and parcel of capitalism and has been known to be beneficial to all parties at least since the time of Ricardo’s work, two centuries ago.

The strengthening and reassertion of Russia was met with disquiet in some quarters and led to push back, such as the color revolutions and attempts to provoke confrontation in Ossetia. This push was mostly political and military, not economic. After the ousting of the colored revolutionaries by the local populations and Russian intervention to prevent a Western attack on Syria, efforts to move Ukraine out of the Russian sphere of influence and under the control of the West were stepped up and the demonization of Russia in the eyes of the Western public was accelerated. Still, it was only after the revolution in Ukraine, and after events there dragged on and did not follow the Western script, that economic sanctions were unleashed to isolate and destroy the Russian economy.

The most damaging economic sanction has been shutting Russia out of Western capital markets. In other words, the West convinced Russia to switch to capitalism, borrow money, and then pulled the rug out. Although strictly speaking sanctions lock out a relatively small number of companies and banks, either with State ownership or perceived closeness to the State, de facto they closed Western capital markets to nearly all companies, since prudent risk management precludes taking Russian credit risk under circumstances where exogenous government actions could prevent service and repayment of debt, all questions of ability and willingness to pay aside.

What does our rational self-interest framework say about this economic sanction? In the 12-month period commencing August 21, 2014, roughly corresponding to the effective closure of Western capital markets, some $160 billion in Eurobonds and bank credit principal was repaid that otherwise would have been rolled over. The weighted average spread of this debt ex ante was some 300 bp. At moments when the crisis was particularly sharp, spreads blew out even past 900 bp, and spent long periods over 600 bp, compared to 100 bp for similar Western credit risk. If we use a figure in the middle to account for the fact that, even in the absence of sanctions, the perception of Russian risk would have increased somewhat due to events in the Ukraine, we can estimate that the cost in decreased rent to owners of capital was some 450 bp. In today’s ultra-low (even negative) yield environment, this is a palpable, particularly to retirees and pension funds that are unlikely to meet targeted returns.

Is it worth it? What is the damage to the Russian economy? Some of the debt was rolled over into more expensive ruble facilities. The rest was simply redeemed. All else equal, debt redemption leads to lower economic activity, and this no doubt has and will continue to be a factor in lower economic growth (or contraction) in Russia. However, given slowing global economic growth and thus demand, Russian economic growth would have slowed anyway as evidenced by commodity producers’ lower CAPEX and thus demand for credit. In other words, these sanctions would be much more damaging in an environment of strong and rising demand than it is today. Moreover, given that annual Russian GDP is over $2 trillion and the capital stock exceeds $7 trillion, this amount of principal repayment, which will decrease going forward, is not a major impediment. Furthermore, Russian Sovereign and corporate debt loads are low by Western standards.

(It should be noted that there are other types of financing that have dried up and will have an adverse effect on the Russian economy, such as vendor financing, which now is becoming a problem. However, such financing has a lesser effect on the economy and is more qualitative in nature, i.e. imported consumer goods become scarcer, and less quantitative, that is, reducing economic activity. Also, substitution of domestic credit facilities has contributed to ruble weakness, but whether such weakness is good or bad for the economy on balance is very nuanced, and beyond the scope of this work. Deterioration in the credit quality of Russian loan books given refinancing problems is also best addressed elsewhere.)

In the long run, denying access to Western capital markets, the deepest and most liquid in the world, undermines their attractiveness to borrowers from other regions: Imposition of these sanctions was a wake-up call that borrowers can be shut of markets if they refuse to toe the line. The damage is amplified as currently the world is awash in capital, and profitable opportunities to employ it are limited. Such opportunities are more likely to be found in developing economies, not stagnating Western ones.

As a result, foreign countries are likely to seek out other sources of financing, particularly domestic. Although the death of Western capital markets in the foreseeable future is nearly impossible, such sanctions are likely to decrease its relative importance and market share and thus reduce its contribution to economic activity. Furthermore, free trade and movement of capital have been major drivers of global economic growth. Restricting access to and/or increasing the cost of capital will have a negative impact on the global economy, decreasing wealth, albeit in differing amounts.

This brings us to our fourth criterion, namely, will Russia change its ways to regain access to Western credit markets? Simple game theory leads to the conclusion that since the West has played this card once, it stands to reason that it will play it again. Thus, giving in to such pressure cannot result in a long-term optimum solution for the entity upon which sanctions have been imposed. No doubt other countries have taken notice of this too.

Post-USSR, the Russian political and economic landscape has been driven loosely by two camps: The first, often labeled as liberals, favor increased global economic integration and private ownership (capitalism), and a more democratic government and society; the second, the siloviki, favor less integration, greater State ownership, and a more authoritarian government and society. During the economic boom of the first decade of this millennium, the liberals seemed to be in the ascendency as trade and capital flows between Russia and the West increased. Over the last several years, the trend has been reversing as government involvement and control of the economy has increased. Western involvement in the Ukraine only strengthened the siloviki’s hand, as did sanctions that seek to damage the economy and are thus tantamount to warfare. Thus, sanctions actually reinforce the behavior that the West is trying to stamp out.

Past as Prologue - Cyprus and Violation of Seniority of Claims

Problems of the Cypriot banking system were largely due to ill-advised investments in Greek assets, complicated by the unusual capital structure of Cypriot banks. A “typical” bank’s capital is 15 percent equity, 25 percent debt and 60 percent deposits. When the bank gets into trouble, the first losses are taken by equity holders, followed by debt holders and only then depositors if the value of the first two stakes is insufficient. Deposits at Bank of Cyprus and Laiki comprised 83 percent and 86 percent of the capital structure, with nearly all the rest equity. (This should have been a major red flag for anyone exposed to these banks.)

By 2013, the banks were in trouble and it was clear that someone had to take losses. Insured deposits were paid in full. But uninsured deposits are senior creditors, and receive compensation together with other senior creditors insofar as assets remain after insured depositors have been paid. (This differs from the situation in the United States and other jurisdictions where uninsured deposits are super-senior and paid ahead of senior creditors. Contrary to some conspiracy-minded Internet musings, this is nothing new and is not confiscation but merely the seniority of claims.)

However, in 2013, Cyprus confiscated nearly half of uninsured bank deposits while over €9bn in liabilities to European National Central Banks (NCBs) was not touched. NCB loans were collateralized by Greek debt instruments. Any deficiency in collateral is an unsecured claim with the same standing as other claims, including uninsured deposits. Thus, funds remaining after paying insured deposits should have been divided among remaining claims, including uninsured deposits and NCB loans, not preferentially funneled to the latter.

Additionally, as a reward for expropriating uninsured deposits, the Troika extended €10bn on easy terms, and various other financial incentives were granted, allowing Cyprus to avoid default on its bonds. Thus, not only did the NCBs get paid in full, but also holders of Cypriot bonds, such as European banks and hedge funds, were made whole at the expense of depositors, since failure to redeem liabilities to NCBs would have led Cyprus to default.

Strictly speaking, this was not a sanction because it occurred before events in the Ukraine. Nevertheless, it is strikingly similar.

Returning to our four criteria, in this case the short-term damage was greater to the victim, namely depositors in Cypriot banks. Indeed many have justified this expropriation due to the shadowy source of the deposits (Russian mobsters) although in the 20 prior years no such qualms were expressed and many depositors were ordinary people and businesses. In any event, this does not validate violation of the rule of law and the sanctity of contracts.

In the longer term, the damage to the system is likely to be far greater. Not only is it a disincentive to deposits but also questions the role of banks as capital intermediaries, especially in an age where access to markets and innovations such as crowd sourcing are on the rise. The zeal of central banks to defend the financial system is understandable, since disruptions can have profound economic repercussions, including depression and even war, but at what cost? A very dangerous precedent has been set. If depositor funds are regularly used to recapitalize banks, the depositor base will quickly erode, which is in and of itself disruptive to the financial system.

These actions were perpetrated to protect the European banking system and unelected EU and ECB officials who made a conscious choice to inflate collateral values, violate the rule of law and sanctity of contracts to prop up Cypriot banks. Furthermore, there is strong evidence to suggest that Central Bank of Cyprus officials played down problems in the banking sector until after the 2013 presidential elections. Thus, on multiple levels infrastructure crucial to the functioning of capitalism was damaged to achieve short-term political goals.

Clearly this does not advance Western dominance in global economic affairs and gives pause to those considering entering economic relations with these institutions. If Cyprus becomes a template for resolution of problematic banks in the future, as many central banks and international financial institutions have suggested, the perceived safety premium of Western institutions will dissipate further. (One shudders to think what would have been the consequences if there was a levy on all deposits, as was originally proposed.) If confiscation of all deposits is insufficient to the task at hand, do we move on to senior secured debt to protect a more junior but politically favored creditor? If so, if contractual stricture and the rule of law are disregarded when convenient, who would ever make a deposit or loan to a bank?

Lastly, such actions do nothing to discourage the behavior that led to the problem in the first place. If anything, the takeaway is that such behavior, reckless lending in this case, is in the economic actor’s self interest, since he retains the upside and the downside is pushed onto depositors, creditors and taxpayers.

Economic Sanctions and Credit Cards – Destroying Financial Innovation

Thanks to subprime mortgages, MBS and other derivatives, financial innovation today has a negative connotation. However, this is due to misuse of the innovations, which in and of themselves offer great benefits in efficiency, allocation of risk and cost of capital.

A great financial innovation is the credit card. It allows you to buy almost anything, anywhere in the world, obviating the need for cash, which has negative carry and the risk of loss (and perhaps bodily harm) and drastically cuts down frictional costs, e.g. prepayment, guarantees and currency conversion. They have increased the people’s wealth as well as the quantity and quality of leisure time. Credit cards have become so ubiquitous, with 7.5 billion outstanding and 149 billion transactions per year, that it is hard to imagine modern life without them, although they only appeared a half century ago and achieved widespread use only in the 1980s.

On March 20, 2014, the U.S. government imposed sanctions on Arkady and Boris Rotenberg for “providing material support to Russian government officials,” i.e. being part of Putin’s inner circle. (Interesting to note that neither has been charged with any crime and were not involved in the Ukraine at all. If using political influence to gain economic advantage is a crime then legions of Western businesses and businessmen should be in the dock. Is K Street to be razed?) The next day, Visa and MasterCard stopped processing transactions of cards issued by SMP Bank, which was majority owned by the Rotenbergs. The bank itself was not sanctioned until later. More importantly, all but a handful of the bank’s 170,000 cards were issued to ordinary people, largely employees of the brothers’ construction and other companies.

Thus, in this case, the greatest harm was inflicted on ordinary Russians who have nothing to do with the government of Russia, Ukraine or the United States, but nevertheless lost access to their money as a result of sanctions. Those hawking sanctions try to make the case that the anger of ordinary people suffering will be directed at the government and the inner circle, but it is clear that they blame those who approved and implemented the sanctions.

In the longer term, damage to the initiator can be much greater, and in this case erodes U.S. credit card dominance. As it is, the fastest growing credit and debit card company in the world, both in terms of transactions and cards issued, is China’s UnionPay, which was already set to be a major challenger to Visa and MasterCard due to its dominance in settlement and payment services in the world’s largest market. Western readiness to sanction credit cards no doubt served as a wake call to China and others and will lead them to redouble their efforts.

Globally, UnionPay is likely to be a major beneficiary of the sanctions. In Russia, its plan to reach 2 million cards by 2016 from under 100,000 currently look more realistic given the external environment and that several top 20 Russian banks have already begun issuing UnionPay cards. Even if required by law, such suspensions of service should help UnionPay eat into Visa and Mastercard’s 90 percent Russian market share.

Russia is even launching its own credit card, “Mir.” Although it would likely be limited to domestic use for the foreseeable future and is unlikely to capture significant market share, it is negative for Visa and MasterCard, which have invested heavily in Russia due to low penetration (only 30 million cards issued) and high GDP per capita. While Russia is unlikely to expel Visa and MasterCard, they will face more scrutiny and costs, whether in terms of compliance and audit, or requirements to deposit cash at the Russian Central Bank (RCB), all of which will adversely affect the bottom line. Additionally, the RCB now requires all domestic transactions to be cleared through the National Payment Card System (NPCS), depriving Visa and Mastercard of an important source of revenue and information.

SWIFT – The Nuclear Option

The last sanction to be mentioned is one that has not been implemented but threatened widely in the UK and EU: Disconnecting Russia from the SWIFT system.

From humble beginnings in 1973, SWIFT has grown to become the dominant network for the secure exchange of payments and securities orders, reaching 5.6 billion messages among 10,805 users in 215 countries last year. Russia is a major user, with 360,000 messages daily from over 400 institutions and 90 percent of all foreign transfers. (This has led to a Russian recently joining the SWIFT board of directors for the first time.) Thus, disconnecting SWIFT would be catastrophic for the Russian financial system and economy.

Proponents of this measure point to success in Iran. To be sure, Russia would encounter difficulties in receiving payment for its exports of 7 mbpd and 190 bcm of gas annually. But this is yet another illustration of the pipeline fallacy, namely that the EU is at the mercy of gas imports from Russia when it is logically equivalent to say the Russia is at the mercy of EU gas exports. In other words, without SWIFT customers would have difficulty in paying for imports, possibly leading Russia to curtail exports. Thus, in the short term both the EU and Russia would suffer pain (although the United States would be relatively immune).  

Furthermore, exclusion from SWIFT was easier in Iran as it is less integrated in the global economy. As mentioned above, Russia has become very integrated in the global economy. Also, at $500 billion annually, exports are an order of magnitude greater than those of Iran, and are largely directed to Europe, not China, India and Turkey. It is also worth noting that by using physical gold and Turkish Lira, Iran was nevertheless able to continue exporting, albeit at added cost due to such cumbersome settlement.

(The effect on domestic financial transfers is likely to be very limited. The RCB has already tested old, low-tech systems involving telexes and faxes. While less efficient, they are certainly functional and robust. This author remembers the start of stock trading in Russia, when all quotes were indicative and deals were consummated by phone on a recorded line, followed by fax confirmation.)

In the longer term, the desire to create an alternative to SWIFT will only increase. Currently, many countries, particularly Russia and China, would like to end the ability of the West (United States) to inflict such financial damage to achieve policy goals. Progress on this front has been glacial, since the economy is truly global and a wide variety of participants would have to accept the new system for it to work. Also, the costs of building it are enormous.

Still, as time goes by and this sanction is more often used, or at least threatened, causing consternation in foreign countries, the desire to develop an alternative and bear the associated costs will no doubt increase. Already, modifying or creating an alternative to SWIFT has become a frequent topic for discussion at BRICS meetings. This would be a major blow to the current Western-dominated system for several reasons. First, in the interim, as the current system degrades and the new system is not in place, global trade will suffer. This will affect all, but the largest trading economy is likely to suffer the most.

(SWIFT itself, “a neutral global cooperative,” recognizes this risk, and has stated that it “will not make unilateral decisions to disconnect institutions from its network as a result of political pressure” since this would “risk undermining the systemic character of the services that SWIFT provides.”)

Second, although the West may be threatening to use financial isolation too much, and/or to achieve policy goals that are not primary, and/or destroying its own institutions to do so, such sanctions do have a place. Specifically, control over SWIFT has helped greatly in the fight against terrorism, trafficking in drugs and humans, and tax evasion. If an alternative system were to arise, the West would lose this ability, to the detriment of all.

Third, SWIFT and nearly all major global economic systems require at least the submission of a great number of countries and other economic actors. Many give grudging consent because there are no viable alternatives. The appearance of an alternative might lead many to jump ship, thus reducing the reach and effectiveness of existing systems. Plainly, undertaking actions that lead to the destructions of systems that you created, that benefit you and your goals (and hopefully the world’s too) is not acting in rational self interest.

Lastly, it seems unlikely that shutting off SWIFT would lead to Russia pursuing different policies. As we have seen with credit cards and other sanctions, the people come to the conclusion that the pain is being inflicted by Brussels and Washington, not Moscow. Even in the cast of Iran, where the expulsion from SWIFT may be a factor leading to resolution of the standoff, it was by no means the only one and the situation persisted for many years. (It also generated considerable ill will among ordinary Iranians toward the West, something that is happening in Russia today.)  Additionally, as discussed above, basic game theory indicates that capitulation in the face of such sanctions will only lead to them being used (or at least threatened) again. As Joshua said, “the only winning move is not to play.”

Conclusion

Policy goals, however well-intentioned, reasoned and moral they may be, or seem to be, should not trump cost-benefit analysis. Policy levers, such as sanctions, that hurt the country or economic actors imposing them should be avoided, and rejected outright if the damage inflicted on the initiator of such actions is greater than that inflicted on the target. The same is true for actions which lead third parties to engage in behavior that is not conducive to our well-being.

To achieve political ends, many actions undertaken by the West over the past few years, particularly against Russia, have impaired the value of societal and economic institutions that have helped the West achieve a higher degree of prosperity. This trend may intensify if policies and the means to achieve them are not scrutinized more carefully.

This is not to say that our policy goals vis-à-vis Russia or any other part of the world are wrong per se, but simply that they are not worth pursuing at any cost, particularly at any cost to ourselves and our systems, which necessarily affect the happiness and well-being of ourselves and our children. If we believe policy goals are necessary and just, then appropriate means to achieve them must be found. Swinging a bigger stick in a crowd is not always the answer.

Scott Semet has been working on global and Russian financial markets since the latter’s inception over 20 years ago, in many different capacities, including establishing and running the research department of major financial institutions. He has an MBA from Columbia Business School, an MA from Yale University and is a CFA charter holder.

Image: Wikimedia/Petar Milošević