Faisal Islam: Russia's war economy could not last but bought time

It's March 2022. The Russian ruble has crashed, and corporate giants Gazprom and Sberbank have plunged 97% in London. Queues began to form at cash machines in Moscow. The oligarchs' yachts, football teams, mansions and even their credit cards were seized.

Russia fell into the Great Depression.

It was the immediate result of the most unusual attempt by the West to control Russia's finances since Russia's invasion of Ukraine.

At its heart was the seizure of the Russian state's official foreign exchange assets and, in particular, the unprecedented freezing of the central bank's $300bn (£238bn) of reserves.

Western governments have shied away from using phrases like „economic warfare,” but there certainly seemed to be a financial arena with the Kremlin. It was better than a direct confrontation between nuclear powers.

Two years later, much has changed in this economic backdrop.

In a long and rambling interview this week, President Putin gleefully claimed that Russia was the fastest-growing economy in Europe.

Last week, the International Monetary Fund (IMF) underlined the resilience of the Russian economy when it raised its growth forecast for this year from 1.1% to 2.6%.

According to IMF figures, the Russian economy grew faster than the entire G7 last year and will grow again in 2024.

These are not just numbers. Last year's stalemate in Ukraine and the growing prospect of a frozen conflict on the ground for the rest of this year have prompted Russia to rebalance its economy to its military effort, building defense lines, particularly in Ukraine's east and south.

Western leaders argue that this model is completely unsustainable in the medium term. But the question is – how long can it last?

Russia has transformed its economy into a mobilized war economy. The Russian state is spending a record in the post-Soviet era.

Military and defense spending of up to 40% of the budget harkens back to the late Soviet era. Occupied Ukraine has been squeezed for tanks, missile systems and other areas of public support to fund those defenses.

Moreover, despite Western restrictions on Russian oil and gas, hydrocarbon revenues continue to flow into state coffers.

Tankers now go to India and China and are paid in Chinese yuan rather than US dollars.

Russian oil production stands at 9.5 million barrels per day, well below pre-war levels. The country has imposed sanctions by buying and using a „shadow fleet” of hundreds of tankers.

Last week, its finance ministry announced that hydrocarbon taxes in January were higher than those seen in January 2022.

The continued flow of foreign exchange into Russian oil, gas and diamonds helped ease pressure on the ruble's value.

Western leaders are adamant that it cannot last, but its impact cannot be ignored.

One world leader recently said privately: „2024 will be more favorable for Putin than we thought. He has managed to restructure his own business more efficiently than we thought.”

But this pattern of economic growth has greatly increased Moscow's dependence on oil revenues, on China, and on non-productive war spending.

Russia will be exposed as demand for oil and gas peaks in the coming year, and production from rivals from the Arabian Gulf is on the rise.

The statistical increase in gross domestic product (GDP) is also far from manufacturing, from the production of tanks and bombs exploded in the Donbass in eastern Ukraine.

Meanwhile, Russia experienced a brain drain of some of its most talented citizens.

Western strategy is not to blockade Russia's economy, but to engage in a cat-and-mouse game to control access to technology, drive up costs, control revenues, and make the conflict unsustainable in the long run.

„We want Russia to use its money to buy tankers [for oil] than tanks,” one US official told me. In the oil market, the policy's aim is not to prevent India, for example, from buying Russian oil, but to limit the profits from that trade going to the Kremlin's war machine.

But this lull and stalemate will last the rest of the year. This feeds into the Kremlin's clear strategy of waiting for a possible replacement of the US president and reducing Western funding for Ukraine's defense.

That is why attention has now turned to the central role of hundreds of billions in frozen Russian financial assets.

UK Prime Minister Jeremy Hunt and Foreign Secretary David Cameron supported the move.

Lord Cameron told me: „We have frozen these assets. The question is are we going to use them?”

He said, “If you want to make a down payment, use some of this money [Russian] reparations for its illegal occupation of Ukraine”, and could be used to „help Ukraine and save Western taxpayers money at the same time”.

The G7 has asked its central bankers to come up with a technical and legal analysis. Central bankers are understandably uncomfortable. One top financier told me that what he called „weaponizing the dollar” would have risks. Traditionally, central banks have enjoyed sovereign immunity from these types of actions.

The plan being developed uses the funds to raise tens of billions of dollars for Ukraine, or profits from investments.

But it's a balancing act. If Russian assets are seized like this, what message does it send to other countries, perhaps in the Gulf, or Central Asia or Africa, about the security of their safe-haven reserves in Western central banks?

These relationships are some of the central arteries of global finance, recycling hundreds of billions of dollars spent on energy around the world. Putin certainly wanted to convey that China is now emerging as an alternative, if not to the West, to emerging economies.

The Russians have indicated that they will take court action if any seizures are made, and in turn take similar assets from Western companies frozen in Russian banks.

So the shadow war on Russia's economy is essential to understanding where this conflict and the world economy is headed.

Russia's war economy couldn't last long, but it bought the country some extra time. After Russia showed this unexpected resilience, the West was going to step up.

The precise shape of this financial expansion will have consequences beyond Russia and Ukraine.