Putin’s calculus

The Economics of War

President Joe Biden was candid when he said, “Putin cannot remain in power”. It may have been unscripted, and needless, but its context cannot be overlooked. Hung or lost wars that result in economic bankruptcy have led, time and again, to regime change — from the Greeks stretching themselves too thin to the East, to more recently the British Empire, Hitler’s Germany, and well, the Soviet Union.

The economic imperative has always been the backbone of any war campaign — even the East India Company used the finances (two million sterling) of an Indian banker, Jagat Seth, the world’s biggest banker at the time, to bankroll the British to build an army of Indian mercenaries to capture the Indian hinterland in the Battle of Plassey in 1757 when money was not forthcoming from its shareholders in England.

Hitler’s rearmament, which led to his Wehrmacht annexing most of Europe, was built from nothing. With no money or resources, the Reichsbank, under the brilliant Hjalmar Schacht, circumvented the prohibition to rearm by extending to the German government an almost unlimited amount of credit, hiding the accumulation of government debt using a shell company called Metallurgische Forschungs (MEFO). MEFO issued treasury notes that German banks were at will to encash, backed in turn by the Reichsbank.

MEFO would sell over 12 billion Reichsmarks worth of bills by 1938, money that fund the rearmament. US companies such as Standard Oil, DuPont, Ford, IBM, etc., were complicit in funding research and technology transfers to the German war machine, being paid in dollars by Schacht manipulating the international monetary exchange through the repurchase of discounted and existing German debt. But behind the rhetoric, Germany pursued plunder and confiscation in the occupied lands to offset this paper money hole.

More currently, it has been speculated that Putin miscalculated how long his war on Ukraine would take, the extent of the resistance Russia would face from Ukrainians, and the way the West would unify against Russia to make it a ‘pariah’ State. But behind the nationalistic rhetoric of creating an ‘Akhand’ Russia and the ‘de-Nazification of Ukraine’, Putin and his men must have made an estimate of the fallout of this invasion on Russia’s economy and felt confident that the war could yet be funded.

The economics that backed Putin’s decision to go to war is more obvious than, say, the calculus of Hitler’s Germany. For one, Russia is one of the large producers of fossil fuels, contributing 11% of the world’s oil. It is the second-biggest producer of natural gas in the world. It is also a big producer of metals — it is estimated that Russia has, across its wide geography, 30% of the world’s natural resources. Half of its defence budget of $60 billion is spent on development, procurement and R&D, with the advantage of producing most of what the military needs. And finally, Russia has years of stockpiles of Soviet-era military equipment, including 1,000 MIG-29s, over 6,000 nuclear warheads, etc.

But here’s the thing! Daleep Singh may have startled Putin with his dual masterstrokes of locking up $400 billion of Russian dollar reserves overnight and scripting the severest sanctions ever imposed on Moscow by the West. The Russian leadership knows that the US Deputy National Security Adviser may well have set Russia’s economy on the road to recession.

The estimate is that Russia will shrink to being a little over a trillion-dollar economy in 12 months. Already, with a run on its money, interest rates have been raised to 20%, the stock markets were shut for a month, overseas flows of money were banned, and the Ruble has depreciated 30% since January. Rating agencies have downgraded 100 Russian companies to junk status, and 400 Western companies have pulled out of the country. How long does Russia think it has the capital to capture Ukraine, given that the Russian military has to date only flattened two major cities, not taken them, more than a month into the war?

The war, according to Statista, is costing Russia $2.5 billion a day. To put this in perspective, Russia earns $600 million a day from energy sales to the world, largely to Europe and China — just 20% of what it needs to fight this war from its biggest earner. With a shrinking economy (it’ll be a third of India’s economy by the end of the year), and frozen assets and money flows, Russia has very little manoeuvrability. After this, its forces must hold cities, then rebuild them, and then integrate them. Maintaining Chechnya with a pro-Russian government is costing Moscow $5 billion a year. With 10 million displaced in Ukraine, and many dead, winning the hearts and minds is going to be not just expensive but nearly impossible.

Doing the math, it does seem that Russia cannot extend this war beyond a quarter. Already a month in, it is signalling that it will restrict itself to the Donbas region.

Economic imperatives are complicit in any war. The President of the European Council says that the war must be won by the West as the independence of Europe is at stake. Yet, Europe continues to import 40% of its energy needs from Russia amid sanctions.

Further, it is now known that many of the Russian oligarchs knew from their bankers that curbs on their wealth were coming and thus moved their wealth to safer havens before much of it could be frozen. Money is moving to largely the Vladivostok Free Zone, an area set up within Russia to facilitate the return of capital from the oligarchs — there are 120+ Russians who are officially among the world’s richest 2,500 people, according to Forbes. They are said to have a net worth of $1 trillion, almost equal to 60% of the current Russian economy. The West has sanctioned just over 50 of the 120+ oligarchs. The visible assets, such as property and cruise boats, have been seized to the extent possible, but it is a fraction of their wealth. Putin has used the oligarchs’ money to stabilise the Ruble, and will use it further if compelled.

The Russian banks that deal with fuel exports to Europe are still in the SWIFT network. And related services such as logistics, pipeline maintenance, etc., that account for an additional 12% of Russia’s GDP continue to roll. Russian Foreign Minister Sergei Lavrov is in India this week to discuss future oil supplies using a bilateral arrangement. China continues to buy its share of Russian oil, circumventing sanctions.

Is Putin banking on the West to blink on the altar of self-preservation and let Russia off the hook? It is possible when the rhetoric dies down and new lines are drawn. It is perhaps the reason why everyone went out on a limb to play down Biden’s statement.

(The writer runs a Corporate Finance practice headquartered in Bengaluru)