“How could our government have been so stupid?” one Russian acquaintance of mine wondered, after the West imposed sweeping sanctions that froze around $300 billion of the Russian government’s foreign exchange reserves held in Western banks.
Over the past few weeks, the US, EU, UK, Japan, and other allies have hit Russia with a package of restrictions targeting its access to foreign financing and technology. Russia’s currency has plummeted, inflation is rising, living standards are slumping, and many factories across the country have stopped work due to shortages in components. Russia now faces the deepest economic crisis since post-Soviet collapse in the Nineties — a downturn so severe that it may eventually threaten Vladimir Putin’s hold on power.
Only one month ago, analysts were focused not on Russia’s vulnerability to sanctions but its supposed “sanctions-proofing” strength. The Russian government has dealt with Western sanctions for decades, from the technological restrictions the West imposed on the USSR to the most recent restrictions on oil drilling technology and access to capital markets imposed after Russia’s first attack on Ukraine in 2014. However, the strength of the latest came as a surprise to Russia’s leaders. They thought they had taken adequate steps to defend their economy and that Western leaders would be too worried about domestic prosperity to risk tough measures. Neither assumption proved correct — and now Russia is paying the price.
Like many adversaries of the United States, from North Korea to Iran to Venezuela, Russia sees American sanctions as a fact of life. Almost every year over the past decade, the US has slapped on a new set of sanctions, sometimes unilaterally, sometimes in conjunction with allies in Europe. Some have been linked to domestic human rights violations, such as those implemented under the Magnitsky Act, named after a Russian lawyer who died under suspicious conditions in jail after uncovering a government-linked fraud. Some have been sparked by Russian meddling in American elections. Others were motivated by Russia’s use of a nerve agent in an attempted assassination in the UK. As Putin said just before announcing his decision to attack Ukraine: “They will never think twice before coming up with or just fabricating a pretext for yet another sanction attack … their one and only goal is to hold back the development of Russia.”
From the moment Putin announced that Russia was beginning a “special military operation” to “denazify” Ukraine, more sanctions were inevitable. The Biden administration had threatened “devastating” sanctions, though after endured many rounds of not-very-tough Western sanctions, most Russian leaders thought America was bluffing. The fact that European leaders were divided about sanctions — and that Germany, Europe’s most important player, was putting the finishing touches on a new Russian gas pipeline — led the Russians to believe that the West wasn’t ready for full-scale economic warfare. The Kremlin, therefore, began the war expecting measures that were costly but survivable. In a public meeting right before the invasion, Prime Minister Mikhail Mishustin briefed Putin that “we have thoroughly reviewed these risks” and that “we have been preparing for months”.
In fact, Russia had been preparing for years, knowing that sanctions were always a risk. America’s sanctions campaign against Iran, which cut off its ability to export oil, was a worrisome precedent — though Russia was a far more important oil producer than the Islamic Republic. The 2014 sanctions against Russia, meanwhile, showed that when the US, UK, and EU joined forces, they could sever Russian firms from financial markets in ways that no other country — not even China — could equal.
In response, Russia developed a five-pronged strategy to steel its economy. The first step was to build up a substantial war chest of foreign exchange reserves, including major currencies (Euro, sterling, dollar, yen, and renminbi) and over $100 billion worth of gold. These reserves, equivalent to over twice the value of goods Russia imports in a typical year, were supposed to give Russia financial flexibility in case the West tried imposing restrictions on its ability to export goods and earn foreign currency abroad.
The second prong in Russia’s “sanctions-proofing” strategy was to reduce its use of the US dollar, the currency in which most commodities — and thus most of Russia’s exports — are priced. Russia managed to substantially reduce the scope of dollars in its foreign trade, largely by shifting its trade with China to Euros. The Kremlin also cut dollar holdings in its foreign currency reserves, choosing to hold more of other currencies, including renminbi, instead.
Third, Russia tried developing internal payments systems in case it was severed from Western-dominated platforms. Many purchases in Russia are made using Visa or Mastercard, which are subject to US sanctions legislation. Most international banking transactions are mediated by SWIFT, a Belgium-based organisation subject to EU sanctions. Russia has rolled out a domestic card payment system, called Mir, and an interbank payment system modeled on SWIFT, trying to prepare itself for a potential future without access to these Western platforms.
The fourth strategy was to intensify economic cooperation with China. The more China’s economy grew, and the more ties that Russia had with it, the more Russian leaders felt secure. The Kremlin knew it could rely on China to vociferously object to any Western sanctions that were applied extraterritorially to Chinese firms.
Finally, Russia counted on the West’s energy dependence to limit any willingness to apply economic pressure. The fact that the Germans were afraid of even mentioning the Nord Stream II pipeline demonstrated timidity that emboldened the Kremlin. However, though Germans were uniquely supine in their energy relations with Russia, they weren’t alone in their dependence. America liked to condemn Germany over Nord Stream II, but American politicians were and are highly sensitive to gasoline prices. Restrictions on Russian oil exports were, therefore, guaranteed to be a matter of acute domestic political concern, because such a move would drive up gasoline prices worldwide. The Kremlin assumed this was a price Western leaders would be unwilling to pay.
When Russian forces rolled into Ukraine, however, the West was jolted out of complacency. Though US and UK intelligence had been warning for several months that Russia was ready to invade, most people — and most Western European leaders — simply didn’t believe it. Images of Ukrainian cities aflame left them shocked. So it was Europe that led the drive during the first week of war for tougher economic sanctions, culminating in an almost unprecedented freeze on Russia’s central bank reserves.
This was a level of sanctions escalation that Russian policymakers had never seriously contemplated. On its own, the move — grabbing control of around $300 billion worth of Russian foreign exchange reserves stashed in Western financial institutions — constituted the biggest bank heist in world history. The fact that these moves were multilateral meant that “de-dollarising” didn’t matter. The Euro, pound, and yen were no more accessible to the Kremlin. And it didn’t matter what payments system was used, Russian or otherwise, if a substantial chunk of the world economy simply refused to transact with you.
The Chinese — supposed allies in “sanctions-proofing” — were no less shocked than the Russians by this display of financial firepower. China has already announced that it is cutting off certain Russian industries under special sanctions, such as aviation. China’s banks, meanwhile, continue to undertake some non-sanctioned transactions with Russia, but according to reports they are broadly following the West’s lead. The Moscow–Beijing entente is more a marriage of convenience than a sanctions-busting partnership.
The only part of Russia’s sanctions-proofing plan that is proving somewhat effective is the bet that Western leaders can’t stomach a full energy cut off. The US and UK have announced bans on importing Russian energy, but this only has a minor impact. The EU has announced plans to cut Russian energy imports to zero — but only after several years. The move that would really hit Russia would be to block all its energy exports, via an Iran-style regime that severed its ability to sell to third parties such as India and China. This would dramatically escalate pressure on Russia. It would also push oil prices far higher.
For now, therefore, energy remains the one major loophole in the sanctions regime. Nevertheless, the Russian state faces a deep economic crisis. The ruble has slumped and prices are rising. Unemployment is set to spike as factory closures cause industrial bankruptcies. Living standards will fall far behind inflation, which will accelerate over the coming months. Foreign companies of all types, from BP to McDonald’s, are fleeing.
“I understand that rising prices are seriously hitting people’s incomes,” Putin admitted in a speech on Wednesday. What he didn’t say is that he has neither a plan nor any resources, to deal with this. On the battlefields of Ukraine, Russian forces have demonstrated incompetent organization and a horrible command of logistics. Despite much talk of “sanctions-proofing”, the Kremlin’s efforts to protect itself from economic warfare have been just as inept — and, for Russia, disastrous.
Lessons for Pakistan from Sri Lanka
Sri Lanka defaulted on its external debt of $51bn on April 12, and the country is now grappling with the economic consequences of insolvency. Access to foreign capital markets to raise much-needed loans to finance imports has been cut-off. The country’s finance ministry has asked international creditors, including foreign governments, to capitalize any interest payments or receive repayments in Sri Lankan rupees. Meanwhile widespread protests continue across the country against power blackouts and acute shortages of food, medicine and fuel.
Pakistan does not presently face the grim meltdown seen in Sri Lanka, but policymakers would be unwise to ignore the lessons to be learnt from the island economy. As the international institutional investor, Mattias Matterson of Tundra Funds noted, “Sri Lanka tried to defy economic realities, maintain a fixed exchange rate, refuse IMF support and instead chose capital controls. The result was pent up demand for US dollars, scarcity of essential goods, which caused havoc in the society and the local currency to plummet.” He observed that Pakistan has so far handled the situation better than Sri Lanka.
However, the delinking of the petroleum prices from the international market rates on February 28 this year harmed the stabilization process that the previous Pakistani government had been following until then. The PKR10 per litre cut in petrol prices and announcement of other subsidies, led to the Extended Fund Facility (EFF) program agreed upon with the International Monetary Fund (IMF), being put on hold. The Oil and Gas Regulatory Authority (OGRA) has proposed to reverse the cuts and raise petroleum product prices by PKR21 to PKR50 per litre, but Prime Minister Shehbaz Sharif rejected the proposal on Friday. He appears wary of the “mountain of inflation” that could as a result be unleashed on the public, which may also erode the political capital of the newly formed government. Ironically, while in opposition, senior members of his party, the Pakistan Muslim League (PMLN), criticized the fuel price cuts as being fiscally irresponsible.
Irrespective of OGRA’s recommendation being politically unpalatable, the government is likely to eventually comply with them in order to impose the fiscal discipline required for renewing the EFF program. With foreign exchange reserves depleting and more than USD50bn of external financing required over the next couple of years, support from IMF and bilateral loans from friendly countries, as well as access to international debt markets is vitally important.
Although the Pakistani Rupee has appreciated in the last couple of weeks from a low of almost 189 against the US dollar back to around 180, the perception of default risk in the international money markets persists. Credit Default Swap (CDS) premium for Pakistan – an instrument that is indicative of the risk of a country defaulting – that had risen from around 4 percent to 10 percent with the submission of a no-confidence motion, further increased to 12 percent soon after the formation of the new government.
With CDS at an all-time high, the implied rating by the international bond markets for Pakistan is at CC/Ca or two notches below the official rating of B-/B3, and only two notches above D default. Most institutional investors in the international money markets, including many hedge funds, are mandated not to invest in “hooks”, that is, countries with ratings that are CCC or lower. As things stand, Pakistan is effectively shut out of the international debt markets and in dire need of the support of allied countries.
The new government would be well advised to avoid raising public servant salaries and pensions, and providing other sops to the public that are not only unsustainable, but also likely to worsen public finances.
Pakistan must complete the EFF program in order to access international credit markets. The new government may want to seek better terms in the seventh review with the IMF, but it should avoid trying to depart from the broad outlines already agreed upon. Since timing is of essence, any extended period of negotiations would worsen Pakistan’s external position.
The Fund has indicated its support for Pakistan in pursuing policies that provide inclusive and sustainable growth, and are consistent with the EFF program. These include fuel price increases as proposed by OGRA, but so far rejected by the PM; power tariffs hike of 5 rupees per unit as agreed with IMF in the last review; no tax cuts; avoidance of imposition of import duties to control imports; and a firm commitment to continued SBP autonomy and a policy of inflation targeting. The new government would be well advised to avoid raising public servant salaries and pensions, and providing other sops to the public that are not only unsustainable, but also likely to worsen public finances.
The measures that need to be taken to move ahead with the EFF program may be politically difficult, but are necessary for Pakistan to avert the dire consequences of defaulting on external debt. There must be consensus across the Pakistani political spectrum to reject short-term political expediency in favour of policies that are based on robust economic fundamentals.
Imran Khan’s graceless exit
Leaders come and go, but the manner in which Prime Minister Imran Khan was ousted from power through a parliamentary vote of no confidence has no precedent in Pakistani history.
After the opposition had mustered the necessary support of the members of the National Assembly, Khan could have resigned and exited from power with grace. Instead, he chose to cling to power until the last moment by sabotaging the vote of no confidence proceedings, despite a clear verdict from the Supreme Court to complete the voting process on Saturday. A cricket legend who played politics like a T-20 match; he kept the nation on its toes until midnight. His ego seemed bigger than the country he led.
Khan promised to build a new ‘Naya’ Pakistan, a thriving nation free from corruption beyond the dynastic politics of the past. But his nearly four years of narcissistic rule have been so nightmarish that ultimately public representatives opted to vote for Old Pakistan.
Khan leaves behind a nation with deeply polarised politics, an economy nearing collapse, and a foreign policy that has ruptured relations with major powers and trusted allies. Challenges that will be difficult to surmount by his successor, Shehbaz Sharif, the leader of Pakistan Muslim League-Nawaz.
Pakistan has a chequered political history. In the past half century, long military rules have been followed by unstable civilian eras. This instability is often the result of the military’s intrusion into politics. The current impasse is no different, except that the alternative leader the generals tried to cultivate eventually became a Frankenstein.
To be sure, the post-Musharraf transition to democracy is different from the previous two such transitions of the 70’s and 90’s in the sense that rapid urbanization in the past couple of decades has produced a middle class that is no longer apolitical. Khan’s personal charm galvanised this class, especially its youth segment, leading to the emergence of PTI as a potent challenge to mainstream political parties, including the PMLN and Pakistan People’s Party.
Instead of focusing on the economy, Khan pursued a vengeful accountability drive against the leaders of PMLN and PPP. Their character assassination by trolls on social media, with unfounded accusations of corruption and treason, has introduced a level of toxicity in politics never seen before.
In the PTI’s rise, the military saw an opportunity to discredit both parties. Thus began the unique experiment of a regime built on the premise that civilian and military leaders would remain on the ‘same page.’ The bargain was that Khan would receive unwavering support from the military leadership and his government would, in return, deliver tangible economic outcomes through better governance. Keeping the opposition at bay was a shared interest.
But this bargain took no time to flicker due to the bad economic start of the Khan regime. It wasted almost a year in negotiating a bailout package with the IMF worth $6 billion, which devaluated the rupee. The subsequent period has seen further economic mismanagement amid the global pandemic, curtailing the GDP growth rate from 5.9% in 2018 to 3.4% this year. IMF conditionalities have led to double digit inflation. Foreign borrowing has raised the debt burden significantly. The economic corridor project with China is derailed. Unemployment has also skyrocketed. There is deep public disillusionment as a result.
Instead of focusing on the economy, Khan pursued a vengeful accountability drive against the leaders of PMLN and PPP, who were hounded and jailed on alleged corruption charges that remain unproven in any court of law. Their character assassination by trolls on social media, with unfounded accusations of corruption and treason, has introduced a level of toxicity in politics never seen before.
Islam has been a convenient tool for both military and civilian leaders to divert public attention from real socio-economic issues. But the way Khan has used his religious narrative to cultivate support among the population has no parallel.
Under no circumstances does the military allow civilian leaders to play with its chain of command, but Khan crossed this red line. He also played the American conspiracy card, using a diplomatic cable from the ex-envoy in Washington to claim the no confidence motion was a US ploy to change his regime. All his opponents, he dubbed traitors.
Without the military’s support, Khan could not have made it to the premiership. Its top brassindeed bet on the wrong horse and may have learned a hard lesson. His reckless subversion of the constitution to keep himself in power has also annoyed the judiciary and, perhaps, a significant chunk of his urban middle class supporters who have already borne the brunt of indirect taxes under PTI rule.
Despite his disgraceful exit from power, Khan retains a cult following among the youth. But with key PTI financiers drifting away and his own accountability about to begin, Khan’s political fate now hangs in the balance. The emergence of PTI as an alternative political force to cater to the rightful aspirations of the middle class was a good thing in the patronage-driven politics of Pakistan. Its demise – at the hands of its own leader – will be quite unfortunate.
Back to Square One
The consequences of the agitation started by the opposition from day one could not have been different from what the legal and constitutional crisis we are having today. We have made every institution controversial. The fairness and transparency of no subsequent election after the fateful elections of 1970 have been recognised. The Armed Forces of the country, the superior judiciary, the Accountability Bureau, the law enforcing agencies, the election commission all have been mauled at the altar of our petty political controversies.
This is not the time to lament our disappointing tryst with democracy in the past. It would be in order to review the current political crisis in correct perspective. The elections of 2018 were held under interim governments in the centre and provinces, chosen by both the ruling party and opposition by the election commission headed by a consensus chairman. The law and order was maintained by the army and rangers. The election results were, as usual, challenged by the loosing political parties. They even announced to not take oath.
However, this controversy resulted in the formation of PDM for political agitation. This agitation intensified with the increasing pace of the accountability of the known political leaders finding its way in the parliament with the ruling party and the combined opposition trading barbs and using highly provocative, vituperative and derogatory sobriquets against each other. The National Assembly practically remained dysfunctional. Even issues of national importance got obscured in this political hostility and bitterness though the deadly Covid-19, the tottering economy, Modi Sarkar’s cruel raid on the autonomous state of Jammu and Kashmir, the fast-changing situation in Afghanistan, and the Gulf Region all demanded a concerted national move.
The armed forces, the superior judiciary, the accountability bureau, the law enforcing agencies and the election commission have all been mauled at the altar of our petty political controversies.
This was not the first time the politicians have landed this country into such a legal and constitutional absurdity. The second half of 1970s was marred by a more absurd political controversy culminating in the overthrow of an elected government by a dictator, the ominous slogan of accountability first and elections later, the arrest, mock trial and execution of the most popular leader of the country, the eleven years of absolute dictatorship and a renewed cycle of agitation for restoration of democracy. The years of 1990s witnessed the repeat of the earlier political controversies paving the way for another extra constitutional takeover. Can our worthy politicians tell us how long this vicious circle of political intolerance, immaturity and hostility will last?
The Prime Minister Imran grossly erred in handling the heightening political move against him. Though the political controversy has sent his public popularity soaring to the sky as revealed by his recent mammoth public meetings, he could not muster the courage to face the No Confidence Motion with grace. In my twitters one day before the fateful session of the National Assembly, I had advised him to try to win the No Confidence Motion and then get the Assemblies dissolved for a new mandate. And that if he fails to win the NCM, he should make a graceful exit speech and go to the people. As a political martyr free from incumbency, and his surging public popularity, he will have clear majority in any fair and transparent election.
He followed a bad advice getting the National Assembly dissolved under controversial circumstances. The opposition seems unwilling to go for quick elections. Firstly, they are daunted by the sudden and unexpected surge in the popularity of Imran Khan. Secondly, they have plans to repeal certain laws relating to electronic voting machine and right to oversee Pakistanis to vote in general elections. Thirdly, they want to prune the wings of the Accountability Bureau and get relief in cases against leading opposition leaders from courts and facilitate the home coming of the senior Sharif. Fourthly, they also want to use their new-found political power to dent the popularity of their lone opponent probably by implicating him in some concocted cases.
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