The Fiscal Cost of War Financing
The invasion of Ukraine has taken a significant toll on Russia’s finances. At 6.4%, the Consumer Price Inflation (CPI) is higher than it was during the 1998 Asian Financial Crisis and the 2015 invasion of Crimea. Economists predict that the country’s GDP would plummet by 7% while others predict 0ver double the decrease at 15%. The Russian rouble has depreciated 70% against the dollar since the invasion. The ban of Russia from the SWIFT network and withdrawal of companies such as Visa, Mastercard, etc. is making it difficult to sustain the economic costs of war.
Monetary Policy Choices for Russia
Russia must devise a strategy that can help sustain the costs of the war and save the economy from going into shambles. The theoretical monetary policy trilemma- The impossible trinity can be used to explain Russia’s strategy. The impossible trinity is a trilemma between free capital flows, monetary policy independence, and fixed exchange rate. At any given time, an economy cannot have all three outcomes simultaneously and must choose either of the two objectives. Post the invasion, Russia has chosen to give up on free capital flows by managing its interest rate and exchange rate.
According to an article by the Financial Times, the draconian capital controls enforced by Russia have prevented foreign investors from pulling out of the country. This has prevented a potential capital flight that could have had devastating consequences for the rouble. The currency which had slipped to 150 against the dollar is back up to being traded for 81.7 against the dollar. The interest rates have also been more than doubled to 20%. This is expected to increase the propensity to save instead of flooding the rouble in the market.
Oil and gas exports, Russia’s economic strong point, are also helping the stabilisation of inflation and exchange rate in the economy. The soaring energy prices are making up for the loss of trade revenue due to Western sanctions. Oil sales have increased by 30% and the country is currently running a balance of payments surplus.
Penalising ‘Unfriendly’ Countries
Putin has issued a list of ‘unfriendly’ countries that have condemned Russia’s invasion of Ukraine. This list includes Ukraine, the EU, the UK, and the US among others. The categorisation has monetary advantages. While paying the Russian government or Russian entity, these countries need to open a special account with the Russian bank and convert the amount payable into roubles at the exchange rate mandated by the Russian central bank. This would ensure that Russia gains due to the managed overvaluation of the rouble vis a vis other currencies such as the dollar and the euro. This would be beneficial for the balance of payment situation.
Hence, Russia’s economic strategy of heavy capital controls and the managed exchange rate is an attempt to salvage its financial stability during times of geopolitical distress.