War’s high toll on the Russian economy

Historically, currency collapses and bank-runs generally do not end well for economies that experience them. The currency collapse and bank-run now occurring in Russia will prove to be no exception. As occurred during the 1998 Russian financial market crisis, Russians should brace themselves for a deep economic recession and high levels of unemployment as a direct result of the invasion.

Over the weekend, the United States and Europe substantially escalated financial market sanctions on Russia as the price for its Ukraine invasion. These sanctions included freezing assets of the Russian central bank and excluding certain Russian banks from the SWIFT banking system.

Anyone doubting that these sanctions have precipitated a Russian currency crisis and provoked a bank-run need only look at what has been happening on the ground in Russia.

With the Russian central bank now hobbled in its ability to defend the currency by international reserve sales from its $630 billion foreign exchange stockpile, the Russian ruble has plunged by more than 40 percent over the past few days. As a result, the ruble now only buys around 1 U.S. cent. This represents among the largest currency collapses on record and exceeds Russia’s 1998 currency collapse. That collapse in turn has contributed to the Russian stock market losing about half of its value since the invasion.

At the same time, as the public’s trust in the safety of their bank deposits has evaporated, long lines of people desperate to withdraw their deposits have been seen at banks around the country. This has forced the central bank to have to assure depositors that the banks are sound and to more than double interest rates to 20 percent.

Normally a country in Russia’s dire financial market straits would approach the International Monetary Fund (IMF) for an economic adjustment program that might help restore lost credibility. By doing so, it would hope to receive the IMF’s seal of approval of its policies and its financial support. But with the country effectively at war with the West, this is hardly an option open to Russian economic policymakers. 

One way that the Russian central bank could quell a bank run is by printing all the rubles that depositors might demand to take out of the banks. However, printing money on such a scale would be a sure recipe for further currency weakness and for putting the country on the path for an economically destructive bout of hyperinflation.

Another way that Russian economic policymakers can respond to the crisis is in the way that they now seem to be choosing to do. They can let the currency find its own level and they can sharply increase interest rates. But this runs the risk of bankrupting many domestic companies and households by substantially increasing their debt servicing costs, especially of dollar-denominated debt. A wave of bankruptcies is hardly likely to restore confidence in the banks or to help stabilize the currency. 

This leaves Russian policymakers with the less unpalatable but still costly option of imposing exchange rate controls and strict limits on the amount of money that depositors can withdraw from the banks. While such measures can stabilize the currency and quell bank runs, they will do so at the heavy long-run economic cost of preventing a properly functioning financial system.

All of this suggests that whatever foreign policy objectives Russian President Vladimir Putin might achieve by his Ukraine invasion, they will come at a very heavy economic cost for the average Russian household. It is far from clear that the Russian citizenry will think that Putin’s war was worth their having to pay those economic costs.

Desmond Lachman is a senior fellow at the American Enterprise Institute. He was formerly a deputy director in the International Monetary Fund’s Policy Development and Review Department and the chief emerging market economic strategist at Salomon Smith Barney