Warfare 2.0 – Russia, Ukraine and Sanctions

The use of economic sanctions as a tool of punitive foreign policy started about two and a half millennia ago. In around 430 BC, Athens banned merchants from Megara, a town allied to its rival state Sparta, from entering into any purchase or sale transactions in any of Athens’ ports. Since trade was the lifeline of Megara, the decision effectively strangled the Megarian economy. Megara appealed to Sparta and in response, Sparta attacked Athens in what we now call the Peloponnesian War. The war sparked the fall of Athens which was until then, the most powerful city-state of the Mediterranean region.

While economic sanctions have a long history, the world has, over the last three decades seen a transformation in how wars are fought and enemies are suffocated. As economies get increasingly inter-dependent and technology binds continents in an inescapable network, it appears wars of the 21 st century are going to be significantly different from those of the 20th.

As I write, Russia is making swift inroads into the heart of Ukraine. While this invasion is only a part of the larger Russia – Ukraine conflict that has been raging since 2014, the operation is the largest such incursion in the world since World War – II. While Russia blamed the ceaseless expansionist policy of NATO since 1990, the West termed the act unprovoked and unjustified. The US had earlier ruled out US forces fighting Russia in Ukraine. However, what the west did do was impose several new economic sanctions on Russia and tighten the already existing ones.

The first round of sanctions on Russia was imposed after Russia’s annexation of Crimea in 2014. At the diplomatic level, the European Union had, in 2014, cancelled bilateral and multilateral summits with Russia. This directly led to the ouster of Russia from several apex-level agenda items including global financial reforms, trade liberalization, climate change and the Millenium Development Goals amongst others.

At the economic level, the targets of the sanctions were principally energy, defence and finance. The choice was obvious since the oil and gas industry and defence contributed to about 50% of Russia’s GDP and 70% of Russia’s exports. Since effective administration of economic sanctions is a costly and time-consuming, the target of sanctions is often the soft underbelly i.e. the most vulnerable component of a nation’s economy.

Since 2014, the European Bank for Reconstruction and Development (EBRD) which funded several projects amounting to a total of 24 Billion Euros in Russia in sectors like agriculture, small businesses and manufacturing suspended its preferential loans to Russia. In 2014, entities in the European Union were banned from funding the largest energy companies, banks and defence companies in Russia. This was achieved by banning anyone from purchasing bonds or equities issued by these companies. European countries were banned from importing/exporting weapons, selling energy equipment and from providing services for oil exploration to Russia. Maintenance or supply of all military equipment was also banned. A small part of the entire sanctions implemented in 2014 is shown below.

In addition to the sanctions on entities, the EU also sanctioned hundreds of individuals who were claimed to be associated politically to the unrest in Ukraine and Crimea. This list included the Prime Minister, Defence Minister, Commanders and other officials who were appointed in the disputed regions of Donbass, Donetsk, Lugansk, etc and other politicians purported to be close to Putin and the ruling elite in Russia. The sanction firstly banned their entry or transit into/through EU countries. Later, any assets held by these individuals in any EU country were frozen and EU entities were barred from dealing with these individuals.

Simultaneously, the United States bombarded Russia with sanctions. Barack Obama, POTUS in 2014 signed off Executive Orders debarring individuals involved in the Crimean annexation from transit and entry into United States and freezing assets of such individuals and entities maintained by or managed by American individuals or entities. This was followed by sanctions that limited financing to Russia’s largest banks and energy companies. Companies that exported goods or services to Russia were debarred from obtaining credit financing. Funding to economic development projects in Russia was halted. Just like the EU, the US banned all technical support and services to Russia that were connected to oil exploration, extraction and the military.

In 2014, Russia was already experiencing a stagnating economy which was exacerbated by a sudden fall in oil prices. The sanctions were expected to drag the bear down to its knees. Russia however, continued to sell arms to non-EU nations in Asia, Africa and South America. In addition, the western sanctions on oil exploration and oil services were aimed at long-term oil and gas production capability of Russia. However, in the short term, Russia continued to produce and sell gas to countries across the world, most importantly to Europe. The debarment of EU countries from financing large Russian companies meant that Russian companies could not roll over the outstanding loans that they had taken and repayment was necessary. However, these were companies that were generating significant revenue denominated in USD and were thus able to service these debts.

As Russia slogged through sanctions, the US and EU kept adding individuals and entities to their blacklists and extended the sanctions till 2019. All this while, Russia was building its “fortress” economy in the background. Russia perhaps foresaw the likelihood of an armed conflict in the near future. By January 2022, Russia had built foreign exchange reserves of USD 632 Billion and self-sufficiency in certain crucial sectors in agriculture and construction. The intention of piling forex was to protect the Ruble from losing value in the case of war. From about 45 Billion USD worth of Gold in 2013, Russia piled up gold reserves amounting to about 130 Billion USD in 2022. External debt exceeded 700 Billion USD in 2014. Over 7 years, Russia cut it down to about 450 Billion in 2021. Russian holdings of long-term US treasury securities dropped from around 130 Billion USD in 2014 to almost 0 in 2021. These defensive measures took time coming. Consequently, while the sanctions did impact the Russian economy in the years following 2014, whether they gained a stranglehold on the country is debatable.

As Russia was building its fortress brick-by-brick during the last 8 years, the US and the EU too had been continuously sharpening their sanctions toolkit. Russia’s moves in creating a defense mechanism of sorts was being watched by the West. In February 2022, when Russia suddenly moved across the Ukrainian border, it triggered the second round of sanctions. What sets this round apart is the exercise of a new set of gadgets which were hitherto not mainstreamed in the sanctions ecosystem, dubbed by some commentators as the “harshest set of sanctions the West has ever imposed”.

Directly attacking Russia’s foreign exchange war-chest, the G7 Countries decided to freeze the Russian foreign currency reserves that the Central Bank was holding in major banks across the world. Foreign reserves are not stored in physical cash or legal paper in current times. They are essentially numbers that sit in electronic ledgers of central banks like the European Central Bank or the Federal Reserve Bank of New York, etc. The G7 Countries in which these foreign reserves were stored have now decided to cut Russia’s control of its reserves. Out of the major countries, China is the only one not to have announced such an intention. With close to 60% of its assets frozen, Russia’s fortress seems a little less formidable than it seemed to be. This is a measure that has never been multilaterally implemented against a G20 country till date. This means that 60% of the reserve that Russia had painstakingly built over the last 8 years would be incapacitated by the stroke of a pen.

The EU and the US have, for the first time, sanctioned a Central Bank of a large economy. Financial institutions have been barred from participation in the secondary market for bonds issued by the Central Bank of Russia, the National Wealth Fund of Russia and Russian Ministry of Finance. Since transactions with the Russian Central Bank have been banned, the gold reserves cannot be liquidated by Russia.

The most sweeping measure of all taken against Russia by the US is, however, the expanded Foreign Direct Product Rule (FDP Rule). By virtue of this rule, the US can prevent the movement into Russia of products lying anywhere in the world, if the product uses US origin technology or the product is an output of a facility that uses US-origin technology. The place of manufacturing of the product doesn’t matter. When the rule was first used against Huawei, the objective was to choke Huawei’s ability to purchase semiconductor chips. Against Russia, the implementation of the rule could lead to similar devastating consequences considering chips are the basic building blocks of modern day computing infrastructure. In addition, the EU and the US have banned import of goods, loans, credit, joint ventures, investment or the provision of crucial services in respect of the regions of Ukraine now under Russian control.

In addition to all this, the strongest financial weapon with the potential to cause severe damage to Russian trade and banking activities in the short term is the debarring of certain major Russian banks from the SWIFT messaging system. SWIFT can be loosely likened to a Telegram app between banks. 11,000 member banks, identified by their SWIFT Codes continuously talk to each other on this platform using a standard messaging format. This app handles about 10 billion messages every year. While SWIFT does not settle payments, it manages the communication between banks. Governed by Belgian law, SWIFT is amenable to American pressure and from March 12 th , several Russian banks are expected to be removed from this group. Without being part of this group, it would be a logistical challenge for Russian banks to convey details of transactions to the approximately 10,994 banks which are left within the group. Settlement of export and import trades, short term credit, credit card transactions, all get impacted in the short term until Russia comes out with an alternative secure messaging system. This has already caused a run on the banks.

Ukraine was until now, the gateway of Russian gas to Europe. Nordstream 1, which is a gas pipeline from Russia to Europe transits through Ukraine and this costs Russia USD 2 Billion every year. Nordstream 2 was Russia’s masterstroke to bypass Ukraine by running the pipeline across the Baltic Sea and create a large, sustainable demand for its gas production. Nordstream 2 would also fulfill Europe’s dreams of cheap gas. Germany was a strong backer of Nordstream 2 in the face of relentless American pressure to shelve the same. Until the invasion of Ukraine, that is. Germany has now decided to not issue final approvals for the operationalizing the project giving the project a near fatal blow. This move has already been followed by several European countries to increase the production of and dependence on renewable and alternative sources.

The firepower of 2022 is surely more potent and exceedingly diverse than that in 2014. Russia has immediately increased the key bank rate to 20% to control inflation. However, since the situation is evolving, the response of Russia to the sanctions is to be seen. It may be noted that barring Russia from key international financial networks cuts both ways. This move impacts Russia’s ability to honor its payables of close to USD 100 Billion that are going to get due before 2023. The recipient countries being mostly European countries will be impacted if Russian banks are not back on the network. When Russia whiffed the scent of USA weaponizing the SWIFT system in 2014, Russia partnered with China to establish the Chinese Cross Border Interbank Payment Systems (CIPS) to settle international claims in the Yuan. Russia, in addition has also been experimenting with block chain technology and may eventually institute a crypto currency based settlement system.

As other international entities like social media companies, new agencies, sports organizations, media conglomerates, shipping companies and technology giants are hopping on the sanction bandwagon, it may be said that the networks and the protocols that the world had become highly dependent upon are vulnerable to being weaponized. The correctness of Russia’s decision notwithstanding, this invasion has ushered the 21 st century version of global warfare. How Russia handles the sanctions will be a case study in understanding the evolving dynamics of Warfare 2.0.

(The author is an officer of the 2011 batch of the Indian Revenue Service. Views expressed are personal and do not reflect the official position or policy of Financial Express Online. Reproducing this content without permission is prohibited).