Parv Aggarwal: How U.S. Sanctions are Fostering Innovative Strategies for Resiliency in Russia

Regardless of whether one views U.S. and EU sanctions against Russia as a justified response to sovereignty violations, or disproportional economic provocations as part of the “West’s Unilateral Cold War,” it is hard to dispute the consequences they have had on the Russian economy.  The ruble dropped 41% against the dollar in 2014, causing compounding inflation and falling real wages. Coupled with falling oil prices, capital flight, and global operational restrictions, this triggered a prolonged recession which is only recently showing signs of recovery. This rebound was achieved by lowering deficits, repatriating foreign reserves, and maintaining balanced budgets by allowing the ruble to float; thereby, passing inflationary costs on to consumers.

Despite the recent recovery, it is in Russia’s strategic interest to immunize its economy from sanctions, as U.S. sanctions have only increased in intensity. Russia has taken a deep-dive examination of its institutions’ exposure to international banking systems prone to sanctions, and successfully implemented innovative strategies to minimize these exposures and maintain an inflow of capital.

The U.S. has enforced its sanctions on Russia through three core means: asset freezes, business embargoes, and transaction blockages. The Office of Foreign Assets Control (OFAC) is able to freeze any dollar-denominated assets or block any dollar transaction that passes through U.S. financial institutions even momentarily, which severely caps capital flows to Russia due to the dominance of dollars as a preferred reserve and trade currency. U.S. has increasingly employed a Specially Designated National (SDN) list targeting perceived members of President Putin’s inner circle, and blocked transactions from any organization with SDN majority ownership. Additionally, the US and the UK have considered blocking Russia from nearly all major international financial transactions in the form of pressuring the primary global transaction clearinghouse SWIFT to leave Russia altogether as it was forced to with Iran in 2012.

Employing legal maneuvers, Russian organizations under SDN ownership and hence sanctions have been able to “self-certify” themselves with deliberate ownership separation and bilateral incentive strategies. The Russian Direct Investment Fund (RDIF) was able to reorganize itself as a separate “state stock company” sovereign wealth fund; thus, escaping sanctions jurisdictions on its parent development bank VEB. This move further allowed RDIF to deepen bilateral ties with Saudi, Kuwaiti and Qatari sovereign wealth funds and raise $20 billion in investments for major domestic infrastructure projects, doubling its seed fund amount. In the private sector, companies have been able to similarly separate themselves from Russian SDN ownership in order to avoid sanctions. Industrial conglomerate Sulzer was able to continue operating by excising ownership of SDN-owned Renova Group. Other firms have been able to follow traditional legal strategies, such as Russian internet and transport service giant Yandex registering in the Netherlands. Though such strategies have successfully maintained business operations and capital flow until now, their long-term viability will depend on a competition between bilateral cooperation strategies and OFAC’s pressuring tactics.

The broad reach of U.S. financial institutions as sanctions-enforcing bodies coupled with a potential SWIFT ban have created a need for Russia to pursue alternate solutions to safeguard its banking needs. In 2015, after Visa and Mastercard disconnected Russian banks due to sanctions, Russia developed and introduced the Mir Credit card payment system. Less than two years from launch, 90 percent of ATMs in Russia were accepting the Mir payment system. Simultaneously in 2014-2015, Russia developed the SPFS system for financial transactions on its CyberFT backbone network as a SWIFT alternative and began phasing implementation throughout the country. As of April 2018, SPFS was in use by all major Russian banks and major commodities exporting companies which made Russia’s Deputy PM boast the country was “ready to switch off SWIFT.” Despite this positive outlook, SPFS has been facing significant challenges with implementation including messaging formatting, security requirements, system availability, and high transaction costs. As the Russian Central Bank mulls migrating SPFS platform to the Blockchain network, its distributed ledger advantages need to be weighed with regulatory and security risks. Blockchain may not help SPFS avoid sanctions, as U.S. claims “blockchain technology owned or developed in the U.S. or by U.S. persons is subject to U.S. jurisdiction and may also be subject to U.S. export controls,” and may further subject SPFS to cyber threats such as the hacks that occurred with SWIFT in 2016. It remains to be seen how these challenges are managed as SPFS expands, but Russia’s successful development and deployment of these innovative alternative financial backbones in two years’ timeframe puts it well on a path of domestic financial resiliency to sanctions.

Russia’s ultimate path to restoring stability in light of sanctions lies in not just using Mir and SPFS as stopgap domestic measures, but rather internationalizing them as standard payment systems outside of OFAC’s sweeping jurisdiction reaches. Towards this end, Russia has launched efforts to integrate SPFS and Mir with China’s CIPS and UnionPay counterparts, integrate SPFS across the Eurasian Economic Zone, and expand Mir inter-operability in Europe. These efforts are part of Russia’s regional strategy to “eliminate the U.S. dollar and the euro from trade” which began with Russian and Chinese Central Banks signing a three-year currency swap agreement worth $23.5 billion in 2015. Similar efforts of alternate payment system integration are being explored under the BRICS trading bloc with the creation of a $100 billion currency exchange pool in conjunction with BRICS’ New Development Bank, which is already financing $1 billion infrastructure projects in Russia.

The Russian perspective, at least in academia which I experienced at HSE’s US-Russia Relations Conference, is sanctions will inevitably remain in place and at most be tweaked, notably citing the decades-long Jackson-Vanik Amendment turning into Magnitsky Act in 2012. Russia’s survival strategy thus rests on sanctions exposure minimization and de-dollarization. Despite the technological, regulatory, and political challenges that lie ahead, Russia has so far successfully turned sanctions lemons into domestic resiliency and regional integration lemonade.  Its long-term integration efforts’ network effect will ultimately depend on how much its cooperating partners involved perceive U.S. exposure minimization and alternate exchange participation as incentives or liabilities.