Russia's financial crisis must come sooner

WASHINGTON, DC: A diplomatic standoff between European countries over the price cap to set for Russia’s oil exports threatens to hobble efforts to limit the Kremlin’s resources to wage its war of aggression against Ukraine. It’s time to break the impasse.

On one side are Poland, Estonia, and Lithuania, pushing for a price of no more than $30 per barrel. On the other side are Greece, Crete, and Malta, which would prefer a price in the range of $60-70. The European Commission reportedly has proposed $62 as a compromise. The United States is urging the Europeans to agree among themselves ahead of the December 5 deadline, when the cap is supposed to go into effect.

Most of the argument is about the price cap’s possible effect on global oil prices. When the cap was first announced by the G7 in the summer, JPMorgan predicted that oil prices would soar – perhaps as high as $380 per barrel. In fact, Brent benchmark oil prices have declined steadily since that time, falling from about $100 per barrel to close to $80. (Russia currently receives around $60 per barrel, a discount that reflects the stigma of supporting the Kremlin war machine through oil purchases.)

This is an important discussion, but, as Robin Brooks, the chief economist at the Institute for International Finance, points out, it misses the main point of forcing down the price received by Russia for its oil exports. The goal is to cause a financial crisis that will severely impede the Kremlin’s ability to run a wartime economy.

The key first step in this direction was actually taken in late February, immediately after Russia invaded Ukraine, when the G7, the European Union, and others agreed to freeze Russia’s foreign reserves. This unprecedented stroke removed Russia’s buffer against economic and financial shocks, and the result was an initial depreciation of the ruble.

But then it quickly became clear that the Kremlin had been handed an enormous loophole: Russia could continue to export oil and gas, routing payments through Gazprombank and other approved financial institutions. As a result, Russia has continued to record strong foreign-exchange earnings, most of which are spent on the military effort, buying “sanctioned” Western goods, and stabilizing the currency market. By late April, the ruble had recovered.

Foreign-exchange markets are forward-looking. If the oil price cap is set at $60, market participants will shrug, and Ukraine is in for a long and painful struggle. An oil price at $30, by contrast, would bring intense pressure for further ruble depreciation. The Russian central bank’s ability to maintain a stable exchange rate would be called into question. Interest rates would rise. The solvency of the banking system would be jeopardized. And Russia’s ability to buy weapons from abroad would be greatly weakened.

Is it possible that such a dramatic step would drive up world prices? In part, the reaction will depend on how much production Russia is willing to shut down. This is hard to predict – Putin makes belligerent noises about that, as he does about everything. But some simple math says the balance of risks does not favour the Kremlin

Russia currently exports about eight million barrels per day. The price cap will apply to about six million barrels of oil and petroleum product shipped daily by sea (no cap is being considered for the rest, which is transported by pipeline). Let’s say Russia shuts down two million barrels of production, exports two million at the cap, and finds a way to divert two million onto grey markets at world prices. Today Russia receives about $360 million per day from its oil sales ($60 per barrel for six million barrels). Under a low cap ($30), Russia would receive $60 million for the capped sales, plus whatever it can get from the grey market.

How high the grey-market price rises will depend partly on the response from OPEC (and Saudi Arabia in particular), as well as the recent US initiative to allow Venezuela to increase its exports. The threat of global recession looms large in all commodity markets currently. And China’s “zero-COVID” policy shows no signs of unwinding in a calm manner – not while most elderly Chinese remain unvaccinated. If the net reduction in world supply is one million barrels, a world price of $100 is possible – adding $200 million to Russian revenues every day.

The world price would need to rise to $150 per barrel for Russia to break even under the cap (selling two million barrels for $300 million). Even if oil prices spike, the uncertainty about how much cash Russia could receive will be enormous, with the threat of future secondary sanctions putting real pressure on grey-market players who handle Russian oil that is trading above the capped price. All oil shipped by sea travels in tankers that are tracked, by transponder and satellite, every inch of the way. The professionals in this sector are very good at knowing who is doing what.

And what if Russia refuses to ship any oil? The fastest falling number in the world would be Russian GDP: no oil sales, no tax revenue, no foreign exchange, no economy.

Simon Johnson, a former chief economist at the International Monetary Fund, is a professor at MIT’s Sloan School of Management and a co-chair of the COVID-19 Policy Alliance.

Copyright: Project Syndicate, 2022.

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