The US and Europe have unveiled extraordinarily powerful sanctions against Russia in response to its invasion of Ukraine. In addition to the formal sanctions, we've seen numerous companies announce voluntarily that they are ceasing doing business in or with Russia. On This episode, we speak with sanctions researcher Edoardo Saravalle about how the sanctions work. What more might be done. And the potential impact to the Russian economy. Transcripts have been lightly-edited for clarity.
Joe Weisenthal:
Hello, and welcome to another episode of the Odd Lots podcast. I'm Joe Weisenthal.
Tracy Alloway:
And I'm Tracy Alloway.
Joe:
So Tracy our last episode was of course with Zoltan Pozsar, and we talked quite a bit about the sanctions, the economic pressure that the U.S. and Europe are putting on Russia over the war. However, it really seems like there's a lot more to dive into with respect to the mechanics and power of the sanctions themselves.
Tracy:
Oh my gosh, I'm getting flashbacks to doing international relations stuff at university, but yes, there is a lot to do and say when it comes to sanctions and of course the overarching question has always been, do they actually make much of a difference and on the one hand, what we've seen in the past I guess week or so is that they can be very dramatic and clearly in the space of a few days, the U.S. and its allies have basically created a financial crisis in Russia, but on the other hand, Russia is still invading Ukraine. And there's a question of what happens next, now that you've ratcheted up this kind of financial pressure.
Joe:
And there is the fact that even with the sanctions, Russia is getting tons of cash every single day, largely from Germany and other central European players who are deeply reliant on Russian energy and particular natural gas, but also coal, which of course raises the question of can European countries, can the U.S. impose effective sanctions that accomplish something against Russia when at the same time, particularly Europe is so dependent on Russian exports?
Tracy:
Absolutely. I think having a big commodities exporter involved here obviously complicates everything, especially at a time when people are worried about inflation. But the other thing I will say, and I think I mentioned this on the episode with Zoltan, but the other interesting thing here is people have been reacting preemptively to the threat of sanctions – so sort of voluntarily self-sanctioning themselves and in fact on the day after the invasion officially began, we saw a lot of people in the market just step away from Russian assets altogether, simply because they didn't know what was and wasn't going to be impacted. And to some extent that's continued today. So yes, we still have Europe -- in particular Germany -- importing a lot of energy, but we've seen some other players, you know, some commodities traders in Singapore, for instance, voluntarily step away from the market.
Joe:
Yeah, absolutely. And then there's another element which is also sort of voluntary, which is just not necessarily fear of sanctions, but companies just deciding, you know what, we're going to wash our hands of anything to do with Russia.
Tracy:
Too much paperwork.
Joe:
And yeah, it's pretty striking this sort of like domino or cascading effect of companies saying we just don't want to have any involvement. We want to completely walk away. You know, I don't think the Russian economy has boomed in recent years. So it's not as though, you know, perhaps this is not a huge source of revenue and profits for a lot of these companies, but it is really striking to see so many corporate interests abandoning the Russian economy right now, even apart from like formal sanctions related activity.
Tracy:
Absolutely, so many different threads to pull here.
Joe:
That's key. And as long as the U.S. and the the rest of NATO does not want to get involved directly militarily for obvious reasons, then of course, sanctions and other related things become the primary means of putting pressure on Russia. So we have to dive into the sanctions and how they work and what they accomplish further. We're going to be be speaking with a sanctions researcher who has a lot of background in this area. We're going to be speaking to Eduardo Saravalle. Eduardo, thank you so much for joining us.
Edoardo Saravalle:
Thank you so much for having me.
Joe:
So why don't we start off big picture, you know, what in your view of key elements, there have been tons of announcements really over the last week. What are the key, most important things in your view that have been announced so far?
Edoardo:
I'd say there are a few of them. I think the big one to start is the action against the Russian central bank that was initially discussed as kind of a final escalatory move. And the fact that it came so early in the escalation is a sign of how serious governments on both sides of the Atlantic were about sanctioning Russia. But I think the other big ones, the other biggest one I'd say, are the banking sanctions. Those are the ones that have the most immediate effect and they have been quite aggressive and there's still room for escalation there, but Sberbank and VTB were the two biggest targets there. And they were the kind of most extreme type of, especially on the VTB side, the most extreme type of sanction that the United States can impose. I'd say there are other ones that are very notable, but their effect isn't going to be the overnight panic that we're seeing.
But I think there's other notable steps, which are remarkable in terms of how the United States thinks about sanctions. So for example, things like the United States is currently leading this global export control initiative basically meant to cripple the arrival of inputs for Russian industry. Each country is doing this slight differently, but it's kind of a remarkable thing, because we tend to think of U.S. sanctions as primarily focused on financial mechanisms, but here from the start they've targeted kind of physical inputs and supply chains as well.
Tracy:
So this actually brings me to the question that I wanted to ask you. And I think it's kind of a basic question, but one of those basic questions that probably has an extremely long answer, but how does sanctions policy-making actually happen? So, you know, someone sits in a room, presumably there's a committee or something and they look at the available suite of previous sanctions actions that they've done on regimes like Iran or Hong Kong or whatever, and try to decide about what would be most effective or most applicable to the Russian situation? How exactly does it work?
Edoardo:
Yeah I think that's an accurate description. In the United States sanctions, the kind of two offices, the two agencies that handle sanctions are the Treasury Department and the State Department. The Treasury Department I'd say is the more in the weeds technical department. So you probably heard in these days about OFAC, the Office of Foreign Asset Control. That is within the Treasury Department, whereas the State Department handles it has sanctions it specifically handles. So for example, the decision to sanction Nordstream the other day, it was actually taken by the State Department rather than Treasury Department. But that's kind of a quirk of U.S. sanctions though, but I'd say it's a kind of trial and error and discovery process.
So people are describing the sanctions these days as unprecedented. I wouldn't say they're unprecedented in the sense that they have never been done before. What's unprecedented is kind of the speed and impact and kind of how it close together they've been and how much they've shaken the Russian economy. There are precedents for what the United States has done. So for example, the central bank of Iran has previously been sanctioned. So this isn’t the first time a central bank is sanctioned. So there are, in that sense, there are, I would say there is kind of a sense of escalatory measures you can take. If you think of sanctions, the most traditional kind of basic form of sanctions is the individual, especially the so-called SDN sanctions. So it's against an individual. And so that basically means they don't have access to their assets. Their assets are frozen. So in a basic sense, your bank accounts are frozen and you probably can't come to the United States. And that's for example, what they did against the Putin the other day, that's kind of the most basic building block. And usually that's what you see when you hear in the news sanctions are being imposed in response to crisis.
That's more likely than not what people are talking about because they're pretty easy to impose and they don't have massive macroeconomic effects. And then from there you can kind of move up. You can put these so-called blocking sanctions where you block the assets on corporations and that can have a significant effect. So for example, that kind of depends on the target. So if you're sanctioning VTB, which is a major Russian bank, it'll clearly have a massive effect. If you're sanctioning in the Iran case, they would often sanction small kind of satellite entities that were doing something in the nuclear program, that doesn't necessarily have a macroeconomic dislocation. And then from there you can kind of move on and people, there is a lot of innovation in sanctions from program to program. So for example, the Russian sanctions that had been imposed in 2014 were an attempt to break out of the normal escalation ladder.
So the sense there was these blocking sanctions were, would be too blunt and would have too much of a backlash. And the idea there, for example, is they imposed sectoral sanctions. So rather than targeting an entire company, they just imposed limitations on what those companies could do. Americans couldn't buy certain forms of debt and equity from those companies or couldn't provide certain services. And so that's just a way you can refine it. But I would say more generally, there is a sense of depending on the seriousness of the situation, you can kind of move up the ladder and I'd say, central bank and then the Swift measure that has been in the news would be toward the upper end, at least on the financial sanction side.
Joe:
So, you know, obviously there was perhaps there was some hope that sanctions or the threat of sanctions at least would have some sort of deterrent effect against this war. It hasn't happened. The war has happened in general. It feels as though sanctions often get placed and stay for a long time and often don't seem to, it's not obvious what the effect is, but what is the theory of what the sanctions are supposed to accomplish and how?
Edoardo:
So the basic theory, especially now that kind of the deterrent theory is off the table, is that sanctions are a bargaining tool. You impose certain costs and say, if you accede to our demands, we will stop imposing these costs. So the basic theory is pretty simple, but it gets very complicated, very fast. A) because the, the ask is not always clear and I think, or the off ramp is not always clear. So people will kind of make up new goals and new asks as they go. So it's very hard, especially in kind of a live conflict to know what you're asking for. So in the Russia case, now, one of the big challenges will be what would we consider enough for us to impose the sanctions? And as of now, I truly don't know. I feel, in fact, there isn't a unified transatlantic view on what would be enough for lifting the sanctions.
And the other thing which is sometimes ignored is that you have to hold up your own end of the bargain. So say we said, in order to lift sanctions, Russia would need to return to the situation we had on Jan. 1, 2022. Then the United States and Europe will need to actually deliver the relief from sanctions effectively, and basically try to restore Russia's economy to Jan. 1, 2022. And that is very challenging because sanctions -- the United States issues these regulations, but then it's the businesses that decide how to react with them. So for example, BP has decided to exit Russia. The United States can't necessarily make BP return to Russia if Russia complies. So it often can be very challenging. The private sector is hyper challenging to the carrot side of the sanctions. Whereas the stick is very quick.
Companies are much more responsive to the threat of U.S. punishment than they are to kind of requests by the United States to rekindle relations. During the Iran deal, when the Iran deal was passed, then Secretary of State [John] Kerry would actually go around Europe and speak to banks and say, we've lifted the sanctions, please rekindle your business in Iran. And the banks kind of balked at it for all sorts of reasons, because it's very difficult to convince the other side that you are doing your best. And then they feel like they kind of got a raw deal because they complied and they didn't necessarily get all the benefits they were promised.
Tracy:
So this is exactly what I wanted to ask you, because again, even before a lot of these sanctions were formally announced, we did see various companies, financial institutions start to step away from the market. And, you know, suddenly you have Russian companies, whether they're logistics networks or commodities exporters, things like that, unable to get credit from their banks, even though technically nothing has happened yet. How much of that friction is I guess, beneficial to sanctions actually being implemented and enforced, versus how much of it is unhelpful in the sense that it sort of accidentally escalates the situation and may, as you just pointed out, be difficult to reverse if a deal is actually reached.
Edoardo:
I think it's very much a double edged sword. It's definitely how helpful because it's difficult to fully calibrate one's actions. And in that sense, you can kind of maximize the shock and awe, in that sense. And in that sense, it's a positive, I guess. I mean, it's nice to know that the United States doesn't necessarily… if everyone imposed the sanctions to the exact letter of the law, sanctions would be kind of an unwieldy measure because you would actually have to think through every single thing you're trying to block. So in that sense, it would be impossible to administer a program where you did that. There have been cases where companies are extremely forward leaning in terms of interpreting things exactly. And that can be counter-productive. On the other hand, I think it's a big concern, the over compliance concern, as you said, first of all, because things can very quickly spin out of control.
I mean, in a sense it feels there was all this kind of excitement about how much was happening in Russia, but Russia kind of, I would say in this situation it warranted because it continued with its advance, but in a situation where Russia had paused and the bank runs had continued, you would've had a difficult situation. And I think it's very hard on the back end to credibly deliver the relief. So I think it's very difficult. I think the current situation is kind of a unique one because at least for now, everyone is hoping that this confrontation will be fairly short. People don't see this as necessarily an attrition, like multi-year Iran type situation. So I think over-compliance can be a good way to very quickly dial up and then dial down. But if you're trying to be more calibrated and negotiate, I think you would be concerned. So I think it's a huge problem and it's always easy to welcome over-compliance at the front and then forget that you'll have to deal with it at the back.
Joe:
So at this point, because obviously the deterrent element didn't work, and so in theory, you know, you continue to apply stress and continue to offer out the chance of, okay, hopefully in theory, this gets reversed if Russia reverses its actions, what about just the persistent damage? I mean, yes, Russia is going to continue to have at least for now cash coming in through the energy market. Could it be that the sanctions just impose such weakness that it has to backtrack in some way, because the damage compounds to its economy, compounds to its banking system and so forth. Could it be that the penalty, the sanctions weapon is so harsh that it essentially forces Russia is forced into some sort of reversal?
Edoardo:
It definitely could. I mean, I think that's the hope that it forces some sort of reversal. And as far as everything that's happened up to now, I'd say that if you're trying to impose pain to force a reversal, you're getting what, what you wanted then, I mean, there's still more one could do, but it has been very successful. The sanctions, I feel as if it's kind of like people talk about kind of the economy in general, bad things happen to economies all the time but they don't just stop existing. They kind of adjust and muddle along -- like Russia defaulted in 1998, but it kind of picked up the pieces. It was bad and they keep going. So sometimes I think during sanctions conversations, but in general, there's this sense that there's like a final blow you're going to deal, right? Or some moment, some point of no return.
I read recently some really interesting comparisons of the Russia sanctions to the Iran and the Venezuela sanctions. And in that sense, those are concerning precedents because in those cases, the countries kind of muddled along. So for example, Iran lost access to 90% of its reserves. And it still kind of, it had to consolidate, the economy shrink, but it kind of muddled along. Energy became a smaller part of its economy. Manufacturing, mostly domestically focused became a bigger one. And it was able to kind of build some semblance of an economy that could work. In the Venezuela case, there were aggressive oil sanctions and that really harmed the Venezuelan oil sector, but eventually the oil sector kind of came back. So in that sense, it's hard to imagine a situation where you kind of deal some final blow in which case the country has no chance or no option but to negotiate.
But at the same time, you can inflict a lot of pain. And at least in the Iran case, the country has been willing to negotiate to get outside of sanctions. So in that sense, you can definitely use sanctions to get to a deal. I would just say that the economic pain itself is not the only factor, that it ultimately comes down to politics. So what are the kind of internal constituencies that are willing to bargain and are you willing to accept what they have to offer? And can you give them what they want?
Tracy:
So just on this note, you mentioned the idea of the U.S. actually targeting specific sectors while trying to leave others, you know, relatively untouched, such as enter energy or commodities. How does that change, I guess, the efficacy of sanctions and what kind of impact would you expect that to have on the Russian economy? Would that be something like what we saw in Iran where energy starts to become -- well, I guess in this case, energy would become an even more important factor in the economy -- or would you start to see Russia try to, I don't know, offset some of the impacts of the sanctions.
Edoardo:
First of all, it's true that the U.S. and Europe have stayed away from directly targeting energy. And they've tried to be pretty explicit about it. So for example, in the United States case they've added licenses, which are basically exceptions to sanctions saying certain transactions are allowed. And for example, within the Russian central bank sanctions within VTB and Sberbank, they've allowed energy transactions. But I think in terms of kind of the over compliance and all that, I think it's very hard to say the current sanctions aren't hitting energy. I think I was just seeing right before the show that Russian oil’s trading at a discount. Financial institutions dealing with commodities aren't as forthcoming with letters of credit. And there was an announcement from shipping companies too, that they're not, they might be peeling away from energy.
So in that sense, I think there will be an effect directly. I mean, compared to Iran, Russia has about 30 or so percent of its government budget comes from energy, whereas in the Iran case, it was in the sixties. So the interesting thing about thinking about the reliance on energy is that I mentioned kind of the big ticket sanctions, but some of the other ones that have been imposed are meant to target long term energy production. Some of these started actually in 2014 and the idea there in 2014, was exactly, let’s not target energy right now because we wouldn't be able to withstand it, but let's make it so Russia has more trouble getting the technology it needs getting the funding it needs for its kind of frontier project. So in that sense, Russia might struggle with replacing its reserves and in that sense, energy might decline as a part of its economy, just because it's not able to put in the investment. In that context, the departure of companies like Shell and Equinor and BP might potentially further the loss of kind of human capital or expertise that could harm the energy prospects of the Russian economy over the medium- to long-term.
Joe:
So I want to talk a little bit more about that. Because at the introduction you said one of the things that you found striking, it's like, okay, we all expected the financial sanctions, but this sort of export controls, limiting Russia's access to factors of production, perhaps some intermediate stage goods that would really undermine Russian industry. What specifically has been announced in that respect? What are the areas of sort of Russian economy maybe be the energy or elsewhere that'll really be affected by some of these new limitations?
Edoardo:
There's some differences between the U.S. and the EU here. The United States said it's mostly focused on defense and aerospace. So it specifically mentioned so far that it planned to kind of limit inputs like semiconductors and lasers and other parts to defense and aerospace. The European ban seems more focused on a broader variety of components targeting the energy sector as well.
Tracy:
We've been coming at this very much from the external side, like from the perspective of the U.S. and Europe, but what can Russia actually do here to offset sanctions impact? And of course there's been a lot of talk about what role China could play, if an, in all of this, and the idea that maybe Russia can look to for, for some type of credit. So what sort of response might we expect here?
Edoardo:
The short-term response is kind of what we saw the other day with the raise of rates and kind of the capital controls. Over time, I think it'll be primarily about turning inward, kind of finding domestic sources of demand. And I mean the energy side of it may change, but kind of encouraging capital to stay in. I think other sanctions we've seen in these days has been the targeting of the oligarchs and people close to Putin. One potential scenario would be kind of a full repatriation -- to the extent that they're able to -- of their assets and kind of like new sources of capital within the Russian economy, all looking inward in terms of relationships with China. I think something that was interesting in the context of the comparison with Iran that I saw was Russia right now is much less exposed to China than say Iran was just because Russia historically has been very tied to the west compared to Iran.
So in that sense, there is like an opportunity to kind of reorient the entire economy east, rather than west. And so that could be one way to kind of break the connection with Europe. But at the same time, I think, well, two things, first of all, these things take time. And right now we're still in the adjustment phase. It seems like Russia will have ways to stabilize the ruble in the short term. It seems difficult to me from a sanctions perspective what you don't want is the so-called Cuba scenario where sanctions stay in place forever. The United States has been admirable in the fact that it's been able to be extremely multilateral. And so bring on countries like Switzerland that are historically neutral, for example. The risk is the longer this goes on, the less multilateralism there is, and more kind of countries start to break away, start to reengage with Russia.
And then you kind of have the situation where there's a complete blockade against Russia from one part of the world, but it's not enough to completely undo, kind of unmake Russia's economy, or bring it to the bargaining table. And the economy kind of readjusts, like Europeans go to Cuba all the time. Soo that's, I think the thing everyone really wants to avoid. So my sense of the goal right now is to try to impose so much pain that there isn't the ability to remake oneself and kind of adjust because otherwise the adjustment, you could kind of end up in this worse of both worlds where you don't necessarily achieve your goal, you don't achieve your goals. You're cutting off a major part of the economy and you're kind of reorienting a major part of the economy away from you. So for me, I struggle to imagine anyone wanting the current situation to be long term. And I think the hope is to reach a deal.
Joe:
So how, as of right now, and we're, you know, we're barely a week into this war and the announcement of sanctions, how surprised are you by the level of unity and the completeness of the, I mean, as you mentioned, even Switzerland -- neutral Switzerland -- is involved by this sort of the unanimity on the part of European powers and the U.S. in the sanctions. And how does that compare to other ones in terms of unanimity versus say, when, you know, dealing with Iran and others.
Edoardo:
I think it's extremely impressive. I think it was unexpected. I mean, both the Switzerland and Singapore’s joining, which have kind been kind of unique cases, but in general, if you think about the way sanctions work within the European Union is that you need unanimity of all 27 countries. It's not a majority decision. So even with getting the Europeans on board for anything really requires getting 27 members on board, and you saw it over this weekend where there'd be kind of one off reports, Italy okay with Swift cutoff, Hungary not opposed to Swift cutoff. So in that sense, it's a really challenging diplomatic struggle. And I think it's been amazing to see how much the United States was able to get everyone on board.
In terms of kind of looking at it precedent. First of all, I would say there are small differences between the sanctions. This isn't necessarily a bad thing, but I think everyone does minor adjustments or carve outs, I think, in some cases. And some of these, just the way kind of the way these work is every country sits in a room and kind of writes out their, the same press release and then releases it. Everyone does it a bit at the same time, a bit differently. The United States say released the central bank sanctions. They agreed to them over the weekend, but then the United States rules came out before the European world. So for example, the United States have a carve out that Europe doesn't have, it's kind of a funny process in that sense in t hat it kind of all comes together on the fly and even more so now where it's not a multi-month or multi-year escalation process, but it's a matter of hours, everything changes.
So in that sense I think it's been pretty amazing. I think it's kind of a speed run of the Iran sanctions in that sense. So the classic dynamic during the Iran sanctions tended to be that someone wanted to escalate, some party within United States wanted to escalate Iran sanctions, that they would push it. And usually it was something at that point unprecedented. And so the administration, which tended to be more concerned about things like dollar dominance or getting along with allies would push back, but eventually there'd be enough momentum for the kind of hawkish next step. So targeting the Iran central bank or trying to target Iranian oil exports. And so eventually the United States would kind of get onboard with it. And then there'd be kind of friction with the EU that you would complain about overreached by the United States or lack of engagement with EU equities, etc.
And then eventually the EU would kind of either fully join or kind of make itself comfortable with it. And so that's kind of how it would go. And then the kind of final step was the working with China. So China would not necessarily fully agree with the sanctions. It definitely wouldn't say it was complying, but China would maybe make some adjustments and kind of conform or not overtly go against U.S. goals. Now you're kind of seeing this extremely fast. So someone floats an idea with the Russia thing last week. So say before the invasion fully started, you had all these ideas central bank and the correspondent banking targeting oligarchs, and they were kind of in the ether. And then the United States does something, Europe balks, but then it moves faster. In the central bank sanctions, actually initially it seemed like the United States was gonna take a softer approach.
And in that case, it was actually the Van der Leyen speech that seemed to be a bit more forward leaning. So in that sense you're seeing everything move very quickly. And I think the current, like the final decision on Swift is kind of an example of this gradual campaign, all building up to kind of a big decision. So I think it's been admirable. It's kind of interesting, you see how much diplomacy matters, but you also see how much the technical questions matter because so much of it is kind of getting, it's making the details compatible, but also ensuring that domestic politics are feasible by carving out what you need to carve out.
Tracy:
You used a phrase just then – ‘for the sake of dollar dominance’ -- and this is something that has come up in our episode with Zoltan Pozsar and I've also seen some comments from other commentators about it, but on the one hand, you have the U.S. using its position in the global financial system to heap enormous amounts of pressure on Russia, to try to get it to do something that it wants. On the other hand, it seems to have given rise, I guess, to a question of whether or not people are going to want to either do business with the U.S. or maintain assets in dollars, if they know that if they get into a situation of tensions with the U.S., they could actually lose control or access to those various assets. So I guess my question is what does all of this mean for the long term position of the United States and the dollar in the financial system?
Edoardo:
This is kinda the million dollar question that has been one of the ongoing questions in sanctions among sanction practitioners. Two of the current people in government working on the sanctions actually wrote a report on will sanctions threaten the result of the dollar. So everyone in the government is very much thinking about this issue. I tend to be very skeptical about the sanctioned threat to dollar dominance. I mean, first of all, I will say like the way dollar dominance usually comes up in these conversations, isn't because of some like empirical threat to the dollar, but it's more of a way of kind of arguing against the sanctions without arguing against the sanctions. So you're not saying, I think this, this measure is bad because it won't achieve its goal. You kind of have this bang shot argument where you say, actually we shouldn't do this measure because of dollar dominance.
So I tend to kind of be skeptical of the argument just because it's not often very informed, I think, it's mostly informed by kind of policy differences within the sanctions community. I mean, it's something people have been worrying about for a long time. Like Jack Lew, when he was [Treasury] Secretary, gave a speech saying if we keep using this, it'll be a threat. And it's, I mean, the United States keeps on. It does keep escalating in its use of it. I mean, there've been kind of all these things. There was one point in the kind of 2010s, there were all these massive fines against foreign banks and people would complain. At one point, President Hollande asked President Obama not to define BNP Paribas too much. So like in a sense, it is like a big liability in a sense that the United States has this control and it almost doesn’t know what to do with it day to day.
Edoardo:
So for example, in the Afghanistan example, you recently saw the United States made that decision about the Afghani assets held at the New York Fed. In a sense, dollar dominance itself is kind of a huge imposition on the United States because it needs to make these decisions that it might not want to make. So for example, the Biden administration having to choose between sending money to Afghanistan and keeping it in the United States, because technically the money's in the United States and so 9/11 victims families could sue and take the money from the New York Fed. I guess more generally, I would say that dollar dominance has been, people have been worrying about it for a long time. I'd say the last biggest worry was during the U.S. unilateral exit from the Iran deal. And that, to me at the time, there was all sorts of fears because the Iran sanctions really leveraged it.
Like the biggest thing they do is they don't allow Iran to export oil. And so you really have to lean on dollar dominance to pressure third already countries not to import the Iranian oil. And so there was a sense that that might be the breaking point and it really wasn't in that case, Swift is like the Belgian payment messaging service. They even complied with U.S. sanctions during this whole escalation. People keep saying, it's up to the EU to decide on Swift, not the United States . And actually the EU very much did not want the Swift to cut off the Iranian banks, but they did it anyway. So in the short term, the sanctions do not pose a threat to dollar dominance. I would say mostly because well, sanctions are a huge deal and they can really remake economies as we're seeing right now.
That's not what dollar dominance means day to day. It seems, it feels to me like the most important aspect of dollar dominance isn't the fact that the United States can kind of turn off the spigots of certain capital flows when it sanctions countries. The biggest thing is that the Fed can provide liquidity in a crisis. And in that sense, if you think of that as there’s this historic kind of sanctions, the geopolitical side of the dollar system, and like the normal day to day side is coronavirus crisis in the United States doing swap lines or things like that. And so a country that might not be interested in or might want alternatives to sanctions also would need to create a parallel world where there is one entity that in a crisis can step up and keep the entire financial system afloat. And so from that angle, it just seems like the kind of benefits, or at least the kind of security provided by a world of dollar dominance and kind of the United States being able to singularly prop up the global financial system outweigh for most countries the negatives.
Joe:
Yeah. I mean, I think like we've definitely seen in the wake of the financial crisis and then more acutely starting in March 2020, the sort of benefits to being in the club or being under the umbrella that can get the benefit of Fed liquidity, is pretty powerful. I want to go back to Swift for a second. And I feel like, you know, on Twitter, Swift gets talked about in hushed tones. Like, no, this is the thing that they can't touch. And then of course they sort of did it not entirely, but it has been employed. How powerful is that, what are the sort of misconceptions? What do people get wrong about what it means to lose access to Swift?
Edoardo
Yeah, I definitely agree about the hushed tones. I feel like on Thursday or Friday after President Biden gave this conference call, he was asked something like, are you really on and willing to do the two most destructive things for the Russian economy, sanction Putin, and disconnect Swift. And kind of both of them were beside the point as has been proven by the fact that all the damage hasn't been caused by those two. Swift the is this like payment messaging service, has 11,000 banks. It's based in Belgium. So technically it's not responsive to U.S. requests, although in practice, it tends to very much be responsive. In part it's responsive because its board member banks are, they have extreme exposure to U.S. jurisdictions. So its board member banks will tend to kind of align themselves with U.S. goals.
I mean, ultimately the thing is Swift is a messaging service. I mean, it's very well networked, it's secure. So in that end, it's standardized. So in that sense, it has the perks of a really good messaging service. But if someone shut down WhatsApp, you could use something else. If you really wanted to communicate with people. And it's kind of the same with Swift. There's nothing that Swift does that itself couldn't be replicated. But I think the reason Swift is such an up appealing kind of example, is so much of sanctions depend on kind of the concept of like interdependence. So like there's these few choke points or places in the global economy that if you can, if you can exert your pressure on them, you'll be able to control all sorts of other things. So, and in that sense, Swift really is like a good symbol of that.
Because it’s like the one messaging service and every bank depends on them. And with one stroke you could cut off these banks and they would lose their connection to the global economy. In practice, that's not now what would happen, but I think in that sense, it's very symbolic. I think that's why it became such a symbol. And there was this talk about Europe can only be a global player if it's willing to cut off Russia from Swift. I think more generally though, it's the kind of infrastructure that use Swift are more important. So you're sending the messages, but what matters is kind of -- there've been a bunch of analogies people have used. The one I think of is like, what matters are the train tracks between towns. You don't necessarily need like a Telegraph system communicating that the train arrived, but without the telecommunication system, your trains will probably have to go a bit slower because you don't know who else is on the track. So ultimately what the United States did with the Sberbank when it basically denied the correspondent bank accounts, it just uprooted the train tracks. So no messaging service can make up for that.
Tracy:
Just when it comes to the oligarchs, so we do have sanctions in place now, you know, possibly belatedly when it comes to the U.K. And you pointed out earlier that to some extent, extensions on individuals, are almost the, the original, like plain vanilla sanctions. So you say these people can't go to the U.S., they can't access their U.S. bank accounts and things like that, but what exactly is it supposed to accomplish here? Because there, there does seem to be a thought process that, well, we're gonna sanction the oligarchs and then they're gonna call up Putin and complain about everything that's happening. But how realistic is that? What is the thought process behind this?
Edoardo:
I think that is the thought process, in a sense, like the basic one, which is Russia's not kind of a fully traditional, like responsive electoral democracy. And so what matters is convincing the elites who might have access to Putin, and that might change things. I feel if that is the basic theory of the case, I don't think necessarily it would work that way just because these are oligarchs depend more on Putin than Putin depends on them. Some of the ones that have recently been hit in the EU are people who were Putin’s KGB mates in Germany. So they're not successful businessmen who placed Putin an office. So in that sense, it might just drive them closer to the government. In one sense, I read an interesting comparison to the Venezuela sanctions and in the Venezuela sanctions going after Venezuela and corruption, especially given they have all these kind of state owned businesses.
One of the things the United States did was really target these high profile corrupt individuals. And for example, or say, take over their assets in the United States, and that tended to push them closer to Maduro. So in that sense, it could cut the other way. Before the invasion, there was the whole thinking of sanctions as deterrents. And then now we're talking about, you know, sanctions as bargaining, but there's another theory which is sanctions as kind of a signaling message. And so you do sanctions to say, we disapprove of this. In some cases, so for example, the United States will sanction people who have no assets in the United States, never plan to come to the United States, but the United States still does it as a way of saying this won't fly for us. And I mean, I think there is some value kind of signaling this approval. So I will say that.
One thing I would note though, is that these oligarchs do control often very large businesses and different sanctions do things differently, but sometimes depending on how you do it, sometimes sanctioning the head of an individual can lead to the sanctioning of a firm he controls. And in that sense, it can have very large ripples. I just recently, the EU just released its own sanctions, its own oligarch sanctions, and those could lead to dislocations because it has, I mean, we'll see how it plays out, but it seems to have a capacious definition of control, which could mean major Russian companies get sanctioned as well, companies that haven't been sanctioned so far. So that could be a thing.
And sometimes they can have kinda crazy knock on effects. In 2018, the United States sanctioned Oleg Deripaska, the metals magnate. He controls one of the top producers aluminum in the world. And then that esd sanctioned and then the London Metals Exchange freaked out because that was a big player there. And so overnight the price of aluminum went up 20%. So even the individual ones can have crazy knock on effects, but kind the day to day sanctioning like they sanctioned the son of the Rosneft CEO, that I would say is primarily a way of signaling, a hope that he might intercede with Putin, but also more simply a signal that this won't fly and especially in the UK, but also in the United States, there's this sense that, you know, the United States has been turning a blind eye to Russian dirty money that flows in. And so this is also a way to kind of eliminate charges of hypocrisy, I would say, which is kind of a signaling thing, but there's value to it.
Joe:
So this next question is actually going to be a subject of an entire, you know, I'm sure multiple episode and certainly one imminently, but, you know, we talked about, okay, the one area that's not going to really be touched at least directly, although maybe implicitly, is the energy sector. And of course we all know that Europe, particularly Germany, highly dependent on Russian natural gas and to some extent, coal, how did you know, what's the short version of how in your view Europe got into this situation where it became so dependent, you know, even after 2014 with the annexation of Crimea, which is sort of, well sort of telegraphed what Vladimir Putin was willing to do, how did it let itself get so vulnerable on this front, such that at least within it has very little leverage.
Edoardo:
First of all, energy imports in Europe have been kind of a long term source of friction. Even in the eighties, there was tension between the Reagan administration and Europe because of a European pipeline to Russia. So this has been very long, I think if I'm not mistaken, Antony Blinken wrote a book about this in 1987. So this is kinda of a long term source of friction. There's differences between gas and oil, but the political economy of Europe and energy is very challenging in terms of unwillingness to invest has made it very hard for Europe to diversify. I think that kind of was one of the big things. Then you kind of have the freak events like Fukushima and getting rid of German nuclear in the German energy mix. But I think the biggest thing I would say is, and I think this kind of is a goes to the shortcoming of sanctions more generally, is that sanctions can only shut off certain economic activity.
They can't do the opposite and like foster it. So the United States, they imposed these sanctions in 2014 and there was a sense of geopolitical risk attached to Russian gas, but it wasn't enough to create, say an alternative to Nordstream, you know? So I think that's kind of a big problem. You need more active measures. Sanctions are relatively cheap in terms of imposing them. They can have their costs, whereas building interconnections in Europe so gas from Spain can get to Germany, which seems to be one of the concerns in terms of like the geography of gas interconnection in Europe, that wasn't enough. So in that sense, I just don't think there was enough forethought and I think unwillingness to invest and kind of think long term was able to diversify.
I mean, we'll see what happens now. I think there's a bunch of enthusiasm about potentially the changing political economy of Germany, or at least a greater willingness to invest in spend. I mean, there's been talk about nuclear and LNG, but those are long term things, I think in the short term without kind of an impetus to invest and instead kind of, I guess, chronic consolidation, and that's how you end up without are options. And I don't know if people in 2015, if they've been told that in 2022, the most effective measure against Russia would've been off the table because we hadn't built the infrastructure. It's hard for me to imagine that they would actually have followed through and built the infrastructure just because there's all sorts of other domestic problems that have halted it.
Tracy:
So I'm very aware of the time and it feels like we could probably, we could easily go on…
Joe:
I know I had the same thought yeah.
Tracy:
… For another hour. So I'm just going to try to squeeze in two very important questions in one, which is one of the big criticisms of sanctions is obviously the impact on the general population who may not themselves have decided or supported the invasion of Ukraine. So what's the impact there? And then secondly, you mentioned escalation earlier in the conversation, how much more could the U.S. and Europe do on this front when it comes to sanctions?
Edoardo:
On the humanitarian front, I think it's a huge problem. In the late 90s, there was a complete revulsion at sanctions and there was a sense that it didn't work. They didn't work. And the main damage was inflicted on the population. Since then, there kind of was this evolution in thinking of the creation of smart sanctions and the idea there was, more targeting. So for example, going off after oligarchs and other measures, that type of measure, and other ways to kind of limit the humanitarian impact. Right now, I think this conversation has continued. I think for example, there was frustration with say the way Iran sanctions limited the access to healthcare in Iran in coronavirus. And so I think there is a lot of willingness to think more about the humanitarian impacts. The Treasury Department at the end of last year actually issued this kind of comprehensive sanctions review.
So when the Biden administration came in, they said we're gonna rethink how we do sanctions. And one of the things that they did was much more focus on limiting the humanitarian impact. And I think you've seen it in some way with a measure so far that have carve outs say related to Covid. At the same time, ultimately when you're cause these massive slides in a country's currency or targeting its biggest banks, or even a central bank and resulting in massive capital controls and interest rates going up to 20%, there's no way to contain the humanitarian impact. My hope is that these sanctions are short enough that the humanitarian impact doesn't kind of ripple through or set in. It will undoubtedly leave long term scars on the Russian economy, which I think is very troubling. I mean, even some things like you can't undo these things overnight, if there was some administration officials have talked about how one of the goals of the sanctions is causing inflation.
And so these things really do have long term effects. And there’s I guess it’s kind of hysteresis, or something where like, it's very hard to undo. So for example, if you cut off a bank's correspondent bank accounts, the banks will cut them off, but then reestablishing them like a one by one, re-signing the deal. And so these things will have long term effects. And so people will feel them.
Your question on escalation. So I'd hope there were, there'd be ways one could mitigate them, but unfortunately, with the speed of escalation so far, those haven't been as top of mind, but we'll see . There's a lot that could be done. So far, the United States has targeted banks, but it has the banks that has targeted it hasn't necessary target to the fullest extent. So for example Sberbank, the biggest bank, it's only had correspondent bank accounts, hasn't done the full blocking sanctions. And other banks it just hasn't targeted. So for example Gazprom Bank hasn't been targeted with any measure so far. So in that sense, you can target those, more banks.
There's potentially space… On the central bank, they actually haven't done the full blocking sanctions. So potentially they could do a full blocking sanction, So that could be a way to kind of tighten the screws. And there's the energy sanctions as we talked about. So those, you could just say, you can't buy Russian oil and you probably couldn't do that in practice. What they did during Iran deal is they kind of said, they required every country to gradually decrease its purchases in Iranian oil.
So you would probably have to do something like that because otherwise it would be kind of, I don't think any economy or kind of the global oil market could necessarily react that easily to a complete cutoff. And there's also other sectors you could target or other companies. Right now, because finance is so pervasive. You kind of like you can hit you're hitting other targets. So for example, I saw the Swift cutoff and some of these finance cutoffs are making it harder for Russian airlines to pay for the leases of their aircraft. And so that's harming the Russian airlines, but I'm not necessarily advocating targeting Russian airlines, but you could also just target Russian airlines directly. You know, like there's like ways right now because of the effect of the financial sanctions is the sense that the entire Russian economy is in turmoil, but you could also just target direct sectors.
And there's other sectors that kind of have this ripple effect through the economy. For example, insurance is one of them. So for example, targeting Russian insurance companies could make it harder for companies that need insurance to carry on their business. For example, like in case the United States made it harder for oil tankers to get insured, but you need insurance to kind of dock in places in case something happens. And so then the Iranian government had to insure its own boats. And so you kind of, there are ways you can kind of escalate by targeting more and more sub sectors of the economy. So I'd say those are some of the main areas that you could target.
Joe:
Well Eduardo, as Tracy noted, I feel like that went by in the blink of an eye and we could talk for hours, but that was fantastic. I learned a lot. I really, really appreciate you coming on Odd Lots.
Edoardo:
Oh, no, thank you so much for having me.
Joe:
That was extremely informative. And, you know, we just said it, I feel like we could have talked for like two more hours very easily on this topic.
Tracy:
Absolutely. I mean, there are a number of things to, to pick out there, but I mean, one, I thought it was really interesting what Eduardo said about the idea that even if you throw all this stuff at an economy, you can't just turn it off. And of course, I mean, there's the original sanctions question when it comes to dictators, which is if they're not answering to a population, which is actually feeling the economic pain, do they even care and will sanctions have any policy impact? That's there as well. And then the other thing was this idea that it's difficult to turn these things off once you get them going, I thought that was really interesting.
Joe:
I think that is a really important dimension to all of this because, you know, obviously what we've seen over the last week, like in theory, the hope is that, okay, this imposes significant pain, that at some point Putin decides to turn around, removes forces from Ukraine. That's the hop, that there's some sort of peace and end of fighting. Even if you start to turn these off, however, we've seen such a dramatic move over the last several days of companies just saying you know, we talked about in the beginning washing their hands, well, not wanting to do business. It seems very hard to imagine what restoring the status, you know, getting back to 10 days ago, not just of the legal regime, but of the various corporate that was taking place in Russia. It seems essentially unfathomable almost at this point to go back. So then the question is like, well, how much of a carrot is there still to offer? If it's gonna be such a long haul just to get back to, you know, what the middle of February looked like?
Tracy:
Absolutely. And I mean, we haven't even touched on ESG considerations, but it does feel like, okay, you can't necessarily turn sanctions on and off with the switch of a button because people have compliance departments and, you know, the people who work in compliance tend to be cautious people. And then secondly, what does this actually mean for ESG? Because even if you remove sanctions, there could be plenty of investors and companies out there who still don't want to invest in Russia because of previous behavior. And we're already seeing some inklings of that in the market.
Joe:
Yeah, companies have compliance departments, they also have PR departments and I think that's going to be -- no, for real -- that's going to be another big factor of like, well, do we want to go back in after this for PR reasons alone? Or is it better to just not have anything to do with the country number of companies, maybe having to ask themselves that question? I also thought it was interesting, like even on like, the sort of like the technical of financial sanctions, the loss of correspondent banking for Sberbank as he noted, it's like easy to turn them off, but then you need to write new deals to bring them back on. And so to the extent that the sanctions, the removal of sanctions is hopefully a carrot to end the war in a short period of time. There's got to be something that, you know, could realistically be regained for them to have that effect.
Tracy:
Yeah, exactly. Well, I mean, either way, I feel like we're going to have a lot more episodes on this topic. Okay. Shall we leave it there?
Joe:
Let's leave it there.
You can follow Edoardo Saravalle on Twitter at @esaravalle.