EXECUTIVE SUMMARY

  • Against initial expectations, comprehensive sanctions did not plunge Russia into a currency crisis. Unlike other emerging market currencies during times of stress, the Russian ruble experienced a short-lived depreciation. After plummeting in the early days of Moscow’s invasion of Ukraine, the ruble has staged a remarkable comeback and has more than doubled against the US dollar from its March slump, becoming the best-performing emerging market currency so far this year.
  • Several factors explain why Russia averted a currency crisis despite the freeze of most of its central bank reserves. The current account surplus soared to a record USD58bn in the first quarter of 2022, and could climb as high as USD250bn (in the absence of a comprehensive embargo on energy exports and a sanctions-induced compression of imports). The Russian authorities also took timely countermeasures to orchestrate an “FX intervention by delegation,” including stringent capital controls, a temporary gold-fixing of the ruble and asking energy importers to switch payments to rublestogether with  a steep policy rate rise to stabilize the ruble after it plummeted.
  • However, the ruble’s rapid ascent might have reached a turning point and could eventually backfire. Since the ruble trades in a very thin market (and mostly domestically, given the dramatic drop in demand outside Russia due to sanctions), its recent appreciation belies a struggling domestic economy, which is expected to slump into a severe recession this year - but it has real consequences. Since most energy exports remain FX-denominated, a stronger ruble hurts the government’s budget balance by lowering the local currency value, which could be further impacted by the potential for EU tariffs on Russian energy exports during the phase-out of oil imports. Last week, the central bank responded with the third rate cut since April to tame the currency’s appreciation. Going forward, the current upward pressure on the ruble is likely to subside over time as some of the Russian countermeasures expire, Russian energy exports become less competitive and the deteriorating economic outlook begins to weigh on the FX rate.
  • Beyond the effects on Russia’s currency, the “weaponization of finance” aimed a paralyzing Russia’s economy could also have long-lasting consequences on the global financial system. While some of the sanctions, such as the freezing of almost two-thirds of Russia’s FX reserves, were politically expeditious, they also raise questions about financial sovereignty in a strongly USD-dominated monetary system. We could reasonably see some countries start diversifying away from the US dollar and/or the Western-dominated global financial architecture over time, especially those that feel they could be targeted by sanctions at some point. Furthermore, Russia’s short-lived gold-fixing might serve as blueprint for a more serious attempt by countries that have sufficient gold reserves (or commodities exports) to depart from the current system of fiat currencies.

Russia has managed to avert a currency crisis despite heavy sanctions.

While the concept of the “weaponization of finance” is not new,  it reached an unprecedented scale in the wake of Russia’s invasion of Ukraine. Overnight, about 55% of Russia’s USD630bn of pre-war FX reserves (Figure 1) were frozen and therefore unable to be used, leaving the Central Bank of Russia (CBR) mostly with domestically held gold reserves. In addition, the exclusion of most Russian banks from the international SWIFT payment messaging system, which was eventually broadened to also include the termination of correspondent bank relationships, made it virtually impossible for Russian banks to transact with their Western peers (Annex, Table 1).  These financial sanctions were accompanied by export bans across different sectors, the blacklisting of certain supplies and targeted restrictions on economic activities by companies and individuals, including a partial embargo on energy exports.  However, sanctions did not completely close Russia’s external account. Key commodities-related companies and banks were not affected by the sanctions, which has allowed the gas and oil flows to continue, but also money inflows into Russia.

Figure 1: Russia - International reserves by currency (January 2022, USD bn)

Figure 1: Russia - International reserves by currency (January 2022, USD bn)
Sources: CBR, Allianz Research. “Other” composition is not known, but comprises inter alia SDRs and reserves held in “friendly” countries.
Sanctions seem to have been very effective at first. The ruble depreciated by up to 40% against major reserve currencies during the initial phase of the war in Ukraine (Figure 2); this development was expected, given past currency crises in emerging market economies (Annex, Table 1). However, after two months, the exchange rate volatility started declining, and the ruble broadly returned to pre-invasion levels – even though the CBR’s hands were partially tied due to the freeze of FX reserves, which left it with a smaller margin for maneuver.

Figure 2: Russia – FX development and comparison with historical sudden stop crises
Figure 2: Russia – FX development and comparison with historical sudden stop crises
Sources: Refinitiv, Allianz Research. Note: 1/ based on exchange rate to the U.S. dollar, 2/ 100 = day before the sharp depreciation started.

How has Russia managed to avoid a currency crisis? In response to the sanctions, the Russian authorities adopted a set of mutually reinforcing counter-measures. First, they imposed stringent capital controls (adding to slowing capital outflows due to trade sanctions on imports to Russia) by asking banks, exporters and households to cede most (80% ) of their FX holdings to the CBR. The aim of “rubelizing” the current account surplus was to prevent an excessive depreciation of the ruble while building – whenever possible – FX reserves that could substitute for the frozen ones.

The CBR also more than doubled (from 8.5% to 20%) the reference policy. Faced with comprehensive sanctions, monetary tightening was needed to discourage financial outflows (not covered by existing capital controls) - rather than reining in a surge of imported inflation (by reducing aggregate demand). Unlike during the last crisis in 1998 (and compared to other central banks during currency crises in the past), the CBR responded decisively and quickly.   Since then, the CBR has lowered the policy rate to 11%, with two subsequent rate cuts, the latest one on 26 May.

Although short-lived, fixing the currency to gold provided additional support for the ruble. Russia had increased its gold reserves significantly since 2005 but stopped buying gold after Q1 2020 when the ruble weakened and the gold price soared. At the onset of the invasion, the CBR announced that it would resume its gold purchases  to shore up its reserves in case monetization would be needed. However, it soon had to halt its purchases from banks, which had to satisfy increasing retail demand for gold amid a dramatically depreciating ruble. With domestic demand easing by the end of March, the CBR re-started its gold purchases from banks at a temporarily fixed price of 5,000 rubles per gram (which, at the prevailing RUBUSD exchange rate and international gold price was expensive, i.e., the fair value of the ruble in gold terms was lower; Figure 3). This arrangement (which was supposed to be in effect until end-June) was soon abandoned (on 08 April), and the price is again negotiated based on money demand. A closer analysis of Russian monetary aggregates and gold reserves suggests that it would have been challenging for the CBR to permanently install the gold-fixing of the ruble (Figure 3).

Figure 3: Russia-Gold-fixing of the exchange rate and monetary aggregates

Figure 3: RussiaGold-fixing of the exchange rate and monetary aggregates
Sources: CBR, Refinitiv, Allianz Research.

In a complementary move to support the gold-fixing, the Russian authorities have tried to re-denominate gas exports into rubles. Since lower money demand reduces the flow of FX revenues from energy exports to the central bank, Russia required customers from unfriendly countries to directly pay for their gas imports in rubles. In combination with the gold-backing of the ruble, the measure effectively pegged Russian gas exports to the gold price. This way, the CBR could also mitigate the freeze of its foreign-held reserves due to sanctions by effectively delegating an FX intervention to banks providing rubles to energy importers.

The “rubelization” of Russian gas has likely contributed to a recovering FX rate. While the mandatory payment rule was announced in April, the exact timing remained unclear until two weeks ago. However, the announcement itself already had an immediate impact on the currency. Since reaching its trough in April, the ruble has appreciated by more than 50% against the euro, thanks to rising external demand for rubles through energy trade, and the exchange rate now stands at pre-Ukraine war levels. Note that the Russian ruble has become the best-performing currency year-to-date against the USD (+30%).

Most European countries have adopted a payment solution that would allow them to meet the Russian demand without falling afoul of current financial sanctions. The current arrangement foresees hard currency payments of “unfriendly importers” being intermediated by Gazprombank (which, in turn, provides rubles to Gazprom) .  The European Commission issued a recommendation last week stating that such payment would not run afoul of current restrictions if “EU operators […] make a clear statement that they consider their contractual obligations to be completed when they deposit EUR or USD with Gazprombank [rather than after the payment is converted into rubles]”. At the same time, the EU operator should seek confirmation from the Russian side that the payment is finalized as soon as the EUR / USD transfer is made; this implies also that no fee for the FX transaction is due from the EU operator (Figure 4). This way, importers steer clear of dealing in rubles, which would violate current sanctions.   

Figure 4: Proposed procedure by the CBR for RUB payments

Figure 4: Proposed procedure by the CBR for RUB payments
Sources: Bruegel, CBR, Allianz Research

However, the first dominoes have already fallen in Russia’s gas “rubelization” gambit. Almost one month after announcing that “unfriendly” countries would have to pay for imported gas in rubles, Russia’s state-owned gas giant Gazprom cut off gas supplies to Poland and Bulgaria on 27 April after the countries refused to agree to new payment terms. Several weeks later, on 21 May, Finland was also cut off after applying for NATO membership. Refusing countries cited concerns that the “two-accounts payment arrangement” (via Gazprombank) proposed by the Russian central bank might still run afoul of current sanctions. Nevertheless, the combination of all three measures have amounted to a de facto “FX intervention by delegation” through Russian banks, satisfying the external demand for rubles (given the constrained firepower of the CBR).

Could the appreciation of the ruble backfire?

The recent ruble rally astonished financial analysts, who were speculating on further selling pressure.
The ruble even strengthened briefly to 51 to the US dollar, a level last seen in 2015, having briefly slumped past 150 in early March. However, the liquidity of ruble trading has decreased dramatically, with a considerable amount of rubles changing hands at prices outside the CBR’s official ruble fixing (Figures 5 and 6). Since the ruble trades in a very thin market (and mostly domestically given the dramatic drop in demand outside Russia due to sanctions), its indicative price could be misleading and belies a struggling domestic economy, which is expected to slump into a severe recession this year. Since most energy exports remain FX-denominated, a stronger ruble hurts the government’s budget balance by lowering the local currency value. Given that the US sanctions’ carve-out of coupon payments of Russian government debt has expired, a deteriorating fiscal balance could provide incentives for Russia to default on its outstanding debt, especially given its rapidly declining dependence on international capital markets.

The CBR has stepped in to tame the recent appreciation of the ruble by loosening its monetary stance.
Last Thursday, Russia’s central bank slashed its main interest rate by 3pp to 11% (down from 14%) on the back of slowing inflation. The stronger ruble has made imports cheaper, helping to keep a lid on inflation, which has begun to ease in recent weeks. Annual inflation slowed to 17.5% as of 20 May, from 17.8% in April amid a noticeable decrease in inflationary expectations. The third rate cut since early April helps further unwind the initial rate hike to 20% at the end of February to stabilize the ruble after it plummeted during the initial phase of the war in Ukraine.

Figure 5: Russia – Volume of next-day settlements at official exchange rate fixing

Figure 5: Russia – Volume of next-day settlements at official exchange rate fixing
Sources: Central Bank of Russia, Allianz Research
Figure 6: Differential between officially fixed (CBR) and traded RUBUSD exchange rate
Figure 6: Differential between officially fixed (CBR) and traded RUBUSD exchange rate
Sources: Central Bank of Russia (CBR), Global Trade Information Services, Refinitiv, Allianz Research
Our FX valuation models suggest that the ruble is now fairly valued (Figure 7). During the initial phase of the war in Ukraine, the steep depreciation of the ruble made it one of the most undervalued currencies. The subsequent strong nominal exchange rate appreciation has reversed this trend. Even though current sanctions prevent the normal interaction between supply and demand and thus make it difficult to derive an accurate external assessment, we find that the recent recovery of the ruble exchange rate is broadly consistent with fundamentals, notably via terms of trade gains, boosted by high oil and gas prices. The large current account surplus (thanks to continued energy exports amid contracting imports due to trade sanctions) makes Russia a special case compared to past currency crises in EMs (when countries ran current account deficits before rebalancing to surpluses over time; Annex, Table 1).

Figure 7: FX internal valuation assessment of RUBUSD exchange rate
Figure 7: FX internal valuation assessment of RUBUSD exchange rate
Sources: Refinitiv, Allianz Research. Note: Purchasing Power Parity (PPP): deviation of the real effective exchange rate (REER) from its long-term average; Behavioral Equilibrium Exchange Rate (BEER) model: takes into account key cyclical drivers, such as terms of trade and productivity, as well as fiscal variables, such as debt-to-GDP ratio, affecting changes in the REER; Fundamental Equilibrium Exchange Rate (FEER) model: links changes in REER to dynamics of balance of payments, which captures all the financial flows and transactions among residents and non-residents. The “Final” score is based on the weight of each model for the Russian ruble, obtained by root mean squared error (RMSE). This means that models with largest errors are penalized.
In the absence of a comprehensive embargo on Russia’s oil and gas exports, a strong external balance will provide support for the ruble going forward (Figure 8). Russia’s current account surplus has even increased, thanks to a partially unintended, sanctions-driven import contraction. Unlike in previous currency crises, Russia has been able to accumulate reserves through restricted but continued energy trade in combination with tight capital controls, while strong sanctions have led to an unavoidable reduction of imports (thus also taming imported inflation).  Russian hopes rest on increasing exports to non-Western countries (mainly China and India). With sanctions in place, Russian commodities trade at a discount as of today (even in ruble terms), which can be a price incentive. India is allegedly increasing its purchases, while China is considering the possibility, too. Other countries, although with a smaller weight on total oil consumption, could also follow, especially as looming food crisis risks threaten social stability (e.g. Pakistan).

Figure 8: Russia – Changes in the balance of payments and reserves
Figure 8: Russia – Changes in the balance of payments and reserves
Sources: Refinitiv, Allianz Research. Note: “Fin. Account”=financial account.
However, economic conditions in Russia have continued to worsen in recent weeks as the war in Ukraine drags on and the country’s economic isolation grows due to an escalation of sanctions. We expect the Russian economy to experience a deep full-year recession in 2022 (-8% in 2022, followed by a further -3% decline in 2023; Figure 9). The next package of EU sanctions, including an oil embargo and cutting off Sberbank, Russia’s top bank, from SWIFT, seems probable and will isolate the economy further. The potential for EU tariffs on Russian energy exports during the phase-out of oil imports could significantly affect government revenues. Soaring inflation and higher interest rates will adversely affect consumer spending, while an exodus of foreign capital combined with higher rates should hit investment activity. As restrictions remain in place, the current upward pressure on the ruble is likely to subside as energy exports become less competitive and the deteriorating economic outlook begins to weigh on the FX rate. In the event of a sudden re-opening of the capital account, the ruble could severely lose value.

Figure 9: Russia - Decomposition of real GDP growth
Figure 9: RussiaDecomposition of real GDP growth
Sources: Refinitiv, Allianz Research estimates.
The scope of financial sanctions could have lasting implications on global economic policy.
The freezing of the FX reserves of a major economy is an unprecedented move and might be legally contestable – with the odds of a successful challenge being probably shorter in the EU than in the US.   They could also cause some central banks to insulate themselves from the political risk of financial sanctions by shifting reserve holdings away from the reach of US and EU policymakers and regulators. Political convictions aside, the fact that entities have lost access to their reserves – not being able to fulfill their obligations as lender of last resort and settlement agent for FX – raises questions for other countries that could be at risk of financial sanctions in the future.

Figure 10: Distribution of central bank reserves (by currency).
Figure 10: Distribution of central bank reserves (by currency).
Sources: BIS, IMF, Allianz Research.

While the current developments are very unlikely to create near-term damage to the current USD-centric financial system (or the USD’s dominant status), they play into the narrative of a potential transition towards a different monetary regime in the long run.

While its share in central banks’ reserve assets has been declining over the last decade, the US dollar remains by far the dominant reserve currency globally (Figure 10). As the largest and most open economy with the largest financial system, the US is the world’s foremost importer of capital (with two thirds of global assets denominated in US dollars). In addition, more than 40% of global trade is invoiced in US dollars (Figure 11). Even the euro is not a close substitute for the US dollar. Nonetheless, the emergence of China and the rapidly evolving financial system, including the digitalization of payment systems, beg the question of whether if the dominance of the US dollar and its anchoring role in the post-Bretton Woods monetary system could decline over time (Box 1).

Figure 11: Financial openness

Figure 11: Financial openness
Sources: Australian Bureau of Statistics, GeoNames, Microsoft, Navinfo, OpenStreetMap, TomTom, Chinn and Ito (2021), Allianz Research. Note: Chinn-Ito index (1= fully open; 0 = fully closed). The upper charts indicate the evolution from 1970-2019 of a selection of countries, while the maps (lower charts) show the contrast between both dates of all reporting countries.

In particular, the following developments could risk providing an impulse for such a transition, due to a confluence of stalling globalization in favor of regionalization or bloc building and rising divergence between advanced and emerging market economies:

  • Geo-strategic onshoring and mercantilism. After the Covid-19 crisis, the war in Ukraine has not only ruptured energy markets and raised commodity prices but also triggered a re-thinking about the vulnerability of global trade through efficient yet complex supply chain relationships. The painful lessons from the Covid-19 crisis of disrupted global supply chains have been amplified by the economic fallout of trade sanctions and Russian countermeasures. Going forward, “paused” globalization or even the risk of de-globalization could result in a challenging adjustment process for monetary policy to manage inflation dynamics in the face of negative supply side shocks and higher prices due to onshoring.
  • Emergence of regional blocs and divergence between advanced and emerging market economies. The war in Ukraine has accentuated geo-political tensions, which might result in regionalization or bloc-building. A further deterioration of the US-China relations, including the recent rhetoric regarding the status of Taiwan, could lead to a self-selection of countries that are strategically better positioned to protect their trade channel by aligning more closely with either the US or China.
  • Diversification of reserve currencies and side-stepping the US dollar. Countries that are at risk of potential sanctions in the future (or perceived as such due to their geo-political ambitions) are likely to be concerned about the scale of sanctions imposed on Russia, especially with regard to the freezing of FX reserves held abroad. Diversifying reserve currencies – something which has already started (Arslanalp, Eichengreen, and Simpson-Bell, 2022) – and the development on alternative payment systems could evolve as a viable alternative as countries seek safeguards. This also includes, using local currencies in bilateral exchanges that do not include any of the reserve currencies’ countries, which would take place mainly among large emerging market economies (e.g. the use of RUB and INR in India-Russia transactions), but also the invoicing of key global commodities in other currencies (e.g., rubelization of gas, petroyuan instead of petrodollar).

Overall, we think that the USD will continue to be the main global currency in the foreseeable future. However, its influence is likely to diminish over time in favor of alternative reserve assets, including cypto-assets, and beyond the scope of other major currencies in the SDR basket (Japanese yen, euro, pound sterling, and the Chinese yuan).