Fortress Russia on Shaky Ground: EU Finds Its Footing and Unleashes Its Economic Might

The rouble took a pounding of note, losing almost a third of its value as soon as forex markets opened Monday morning. Equity trading was suspended whilst Russian financial authorities pondered the extent of the sanctions imposed over the weekend. In a nutshell: The Central Bank of Russia is unable to rally its formidable reserves – a hoard estimated at $630 billion – to defend the battered currency which promptly fell off its perch and plummeted to depths unvisited.

The much-touted ‘Fortress Russia’, thought unassailable just days ago, is crumbling as the planned swift advance on Kyiv and Kharkiv stalled in the face of stiff Ukrainian resistance and the world united in relegating President Putin’s Russia to pariah status – no different from the reputation enjoyed by North Korea and Iran. Meanwhile, President Volodymyr Zelensky of Ukraine rose to the occasion to become an instant cult hero and the admired embodiment of indomitable tenacity.

Ducks Lined Up

The European Union sprang a major surprise by getting its 27 ducks neatly in a row to enact three successive sanction packages that not only had considerable bite but effectively crippled Russia. Brussels revealed its hawkish side when it decided to provide €450 million in ‘lethal’ military hardware to embattled Ukraine under the off-budget and curiously (Orwellian?) named European Peace Facility, a financing instrument with a ceiling of €5 billion.

EU Foreign Policy Chief Josep Borrell seemed himself much surprised at the union’s resolve: “Yes, we are doing it… providing arms to a belligerent! Another taboo has fallen. This war requires our engagement to support the Ukrainian army.” Former German minister of Defence and current EU Commission President Ursula von der Leyen called the bloc’s newfound resolve a ‘watershed moment’.

Ms Von der Leyen closed EU airspace to Russian aeroplanes, including private jets, and announced the silencing of Russian state-owned or -controlled media outlets such as Sputnik and Russia Today. She also joined a number of member states in a call to fast-track Ukraine into the EU. Remarkably, not a single EU member objected to her emotional appeal.

Special Track

Earlier, Prime Minister Eduard Heger of Slovakia suggested a ‘special track’ to quickly usher Ukraine into the union: “On Thursday, we woke up to a new world. Ukraine fights for itself, they fight for us, they fight for freedom. We must understand that they fight to protect our system, our values, and we must stand by them.” The sentiment is widely shared in Europe with the entire ensemble of eastern member states – with the notable but unsurprising exception of Hungary – clamouring for Ukraine to be forthwith welcomed into the European family.

President Putin may have seriously miscalculated the West’s response, resolve, and concord after he saw the US and its allies ejected rather unceremoniously from Afghanistan. He also seems to have underestimated Ukraine’s determination to fight for its freedom – forging a nation in the process. His plans for a walkover went awry and now he lacks a ladder to climb down. Instead of sowing division amongst NATO allies and EU member states, Russia’s aggression, and Ukraine’s spirited and heroic defence, have sparked an almost unheard-of sense of unity that inspires and reminds Europeans of their shared values – and the urgent need to protect them.

Dramatic shifts in policy followed in quick succession. Germany mobilised its financial firepower and earmarked €100 billion to re-equip its armed forces. The country also promised to spend at least 2% of its GDP – equivalent to some €68 billion – on its defence as of 2024, an increase of €15 billion.

No Way Out

President Putin, earlier confident that he could pay his way out of any sanctions with his country’s forex reserves, may have had a rude awakening when Russia’s central bank was effectively defenestrated and kicked out of the global financial system, rendering it impotent. Though the central bank offered ‘unlimited rouble liquidity’ to commercial banks, it also jacked up the interest rate to 20% – up from 9.5%.

Counting on China to offer solace remains an iffy proposition. Chinese banks, which hold 14% of Russia’s forex reserves, are already showing considerable reluctance to provide financing of Russian (oil) exports fearing secondary sanctions could cut off their access to euros and dollars. For the same reason, Chinese banks are unlikely to buy any of Russia’s 2,299 tonnes of gold. The full-scale deployment and thundering of Western financial firepower is keenly being followed in China as many lessons are to be drawn.

Thanks to sanctions imposed in the wake of the 2014 invasion and annexation of Crimea, direct exposure of Western financial institutions to Russia is limited. Foreign investors are estimated to hold about $20 billion in dollar debt and another $37 billion in rouble-denominated bonds.

Plane Trouble

Under EU sanctions, aircraft lessors have just thirty days to recover hundreds of planes from Russia. Irish leasing companies such as AerCap and SMBC Aviation Capital have 238 commercial aircraft flying in Russia with a combined market value of $4.1 billion. Even more worryingly for Russian operators is the decision by engine manufacturer Rolls-Royce to ‘pause all activities’ in the country as of 25 February 2022.

Jet engines are monitored and have their settings adjusted remotely by the manufacturer in real-time. Moreover, most engines are operated on a pay-per-use basis. Without constant monitoring, affected engines are flying essentially unmaintained. A ban on the export of spare parts needed to keep planes aloft adds to the complication.

Bad news kept piling up for President Putin as the $1.3 trillion Norwegian sovereign wealth fund – the largest in the world – announced that it would freeze investments in Russian assets and begin divesting from the country. In the UK, energy group BP, promised to ditch its 20% stake in Russian state-owned oil company Rosneft.

Just before the weekend, rating agency S&P Global demoted Russia’s debt to junk status. The cost of credit-default swaps (CDS) almost doubled to 37%. On Monday, CDS issuers swapped to an ‘upfront’ basis – demanding full payment for insurance against a sovereign default – in a sign that they consider fears of severe financial stress justified.

Traders worry that the sanctions regime could prevent Russia from meeting its financial obligations. However, the eventual pay-out level of CDS contracts may be hard to determine as the actual value of the underlying Russian bonds becomes an incognito due to a likely ban on secondary trading.

Whilst echoes of Dr Strangelove reverberate around Moscow, stocks retreated across Europe with the Stoxx 600 share index falling 1.6%. The Stoxx Euro Bank Index fell by almost 6% on concerns over the fallout of the exclusion of select Russian from the Swift payment messaging service. The dollar gained 0.5% against a basket of six major currencies whilst the yield on two-year T-Bills dropped slightly to 1.5%.

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