Using frozen Russian assets for Ukraine reconstruction

A cost benefit analysis

I attended an excellent session this week run by IISS on the issue of frozen Russian assets and their use in Ukraine reconstruction. On the back of that I thought it useful to perhaps use a cost - benefit approach over the debate as to whether to use  frozen Russian assets for Ukraine’s reconstruction.

But in the end we have to make a decision here - delaying is also a decision, as a delay is as good as not using the assets, as Ukraine needs the resources now, not in five years time. By then it will be too late, and Ukraine’s recovery and reconstruction could well have failed if we have not moved quickly to identify resources to fund Ukraine’s recovery and reconstruction.

So here goes.

Costs of using frozen Russian assets

1. Risks debasing the rule of law in the West

A generalised consensus (at least within the establishment) at present is that existing laws in Western jurisdictions do not provide for currently “immobilised” Russian assets to be “seized” and “transferred” for the benefit of Ukraine. The fear therefore is that by seizing and transferring these assets, without a credible legal basis, that somehow this will undermine the rule of law in Western jurisdictions. The case is then made that while Russia has so clearly rode roughshod over international law by invading Ukraine, two wrongs don’t make a right and by stooping to similarly unlawful action in seizing and transferring these assets without a firm legal basis would make the West no better than Russia. It would also allow Russia and its allies and supporters to argue that the West only abides by the rule of law when it so suits.

But in rebuttal:

a) While we put the Western rule of law on a pedestal, where was it in first accepting the inflow of receipts which were so obviously the proceeds of kleptocracy and an absence of the rule of law in giving jurisdictions in the first place? Where was the KYC when the money came in? Indeed, so often the West complains about corruption in Emerging Market countries but facilitates it by accepting the receipts from that very same corruption and Kleptocracy all too easily. So I guess let’s not be on our high horses about the sanctity of our rule of law in the West. We talk about the rule of law when it suits us.

b) We are at war - needs must. We need to win this war as if we lose, there will be no rule of law to defend. So we need to do whatever it takes to give Ukraine the resources to win the war and peace, otherwise we all lose, and debating the erosion of the rule of law will be academic.

c) Laws can be changed to facilitate the seizing and transfer of assets, to make such action lawful. This can take time but requires political will. Canada has already made such changes to facilitate seizing of frozen Russian assets, albeit only limited sums are in Canada. In most jurisdictions these changes can be made by executive order or an act of Parliament.

d) There already is a compelling case that the basis already exists to seize Russian assets under the “countermeasures” as opposed to “sanctions” argument. See work done by Philip Zelikow, Yuliya Ziskina, and the New Lines Institute, see “Multilateral Asset Transfer, a proposal for ensuring reparations for Ukraine”.

e) It’s ridiculous to put on the same level a Western action to freeze and seize Russian assets, in response to blatant Russian aggression, invasion, war crimes and even genocide, as those same extreme actions by Russia. The bar for taking such action has been very high, and is entirely morally, politically, financially and legally understandable. This is not something being considered, and hopefully done, lightly. But it’s a case of weighing the pros and cons, or costs and benefits. But we have to take action.

2. Risks eroding the principal of sovereign immunity putting at risk Western assets in Russia and globally.

Rebuttal - see piece as above by Zelikow, Ziskina, et al.

There is concern that the West could be subject to a tit for tat process by Russia where it seizes Western assets in retaliation. The reality though is that this is already happening and the Russian state is already seizing and taxing Western owned assets in Russia. So by following suit the West would only be retaliating for existing Russian actions.

Admittedly, there is broader concern that the erosion of the principal of sovereign immunity could create difficulties in other jurisdictions for Western assets. But note that the case made by Zelikow, et al argues that the suspension of sovereign immunity, allowing for seizing Russian assets, is a temporary state while Russia is so obviously acting itself in a illegal and harmful way to Ukraine and the West. The states following the same defence for overriding sovereign immunity would have to prove a similarly blatant action as is now the case with Russia. That is a high bar in reality.

And the practical reality is which states would in fact pursue such actions against the West, which would in effect be all but put them at loggerheads with the West and the Western financial system, which could more likely cause more damage to them than the other way around? Any such state would risk being subject to painful and perhaps terminal sanctions from the West. It’s an asymmetrical tool/instrument for the West which still reflects its disproportionate economic and financial power vis a vis the rest of the world. The West is able to do this because it can, and no other state has yet the power to pursue a similar policy.

3. Risks global financial stability and the global dominance of the U.S. dollar & Euro.

The arguement goes that other autocratic states, would be shocked by the seizing of Russian assets and would take countermeasures, by moving their own assets out of Western jurisdictions. This action, it is argued, could destabilise Western financial markets, and over the longer term undermine trust in the US dollar, euro and pound as reserve currencies.

Rebuttal - the reality is that by already freezing/immobisling Russian assets, the message has clewrly been sent to other authoritarian regimes that their assets are at risk in Western jurisdictions if they act unlawfully or so aggressively against Western interests. That said the message should be clear - don’t conduct illegal invasions of other countries, commit war crimes and genocide and then your assets will be safe. But the reality is the risk to the stability of Western financial systems from now moving from freezing to seizing Russian assets is minimal as I would argue that other authoritarian regimes have already reduced exposure to Western jurisdictions from the freezing of Russian assets. The damage, if any, has already been done. And when it comes to the sanctity of the dollar or Euro and pound as global reserve currencies, the reality is where else would such regimes park their surplus reserves? Western reserve currencies are still the great weight of reserve currencies, and the likes of the renminbi, dirham or Turkish lira just don’t touch the sides, and are unlikely to be in a position to touch the sides for many years, or decades to come, in terms of providing alternative places for large countries to park reserves (most of which have been made in trading with the biggest global economies, the Western economies). Moving from immobilising Russian assets to seizing them will just not move the dial.

4. Risks giving away leverage in future peace talks with Russia

The argument goes that the West can dangle the prospect of Russia getting its frozen $400bn back to encourage Russia back to negotiating table. The reality though is that frozen Russian assets are a small slice of Russian inc assets (perhaps as much as $2 trillion in FX assets offshore and in Russia) and in terms of what Putin cares about, I just don’t think they will move the dial in terms of Putin’s ultimate decision on all this. He is not going to come back to the negotiating table because we offer to give him back the $400bn - he has plenty of other stashed cash - as arguably his decision will be more dependent on his military calculation and his determination as to whether his own survival is at risk.

5. Risks embittering Russia for years to come - the Weimar factor

The argument goes that we should worry about being overly punitive on Russia so as not to risk the Weinmar effect drawing comparisons to the post WW1 settlement on Germany. The line is that overly onerous reparations imposed on Germany drove its own subsequent economic collapse and then the rise of Nazi Germany, so be careful doing the same to Germany. I would argue that the cases are very different. Importantly, Russia is no Weinmar, as it’s economy is much stronger and its asset base much larger. Set against potential war reparations - costs to Ukraine - of anywhere from $400bn to $1 trillion, Russia has an annual GDP of around $1.8 trillion and annual energy export earnings of around $250bn. CBR FX reserves are reported at close to $600bn with close to $200bn in its National Wealth Fund. The sovereign is not highly leveraged, with a general government debt to GDP ratio of less than 20%. So assuming a peace deal is eventually agreed it has ample FX reserves to pay substantial reparations, could stand a levy on energy export earnings or could even borrow to fund any such reparations without putting undue strain on its underlying credit worthiness. Increasing its overall leverage by thirty percentage points would at a stroke generate $600bn for Ukraine reparations.

Just on the issue of Russian offshore assets, much is made of the $330bn in frozen CBR assets and other Russian assets, including frozen oligarch assets in Western jurisdictions. Russian CBR assets in total are though around $600bn, with the balance held on shore or presumably in juridicafions beyond the reach of the West, as in China. On private sector Russian offshore assets, previous research I have done has suggested private sector capital flight out of Russia of around $1.3 trillion since 1991 which, with sovereign assets, makes the total number of Russian assets which could be attached, frozen, and seized of close to $2 trillion. Hardly a poor country, and more than sufficient to cover a weight of the up to $1 trillion Ukraine rebuild and likely reparations costs.

Benefit

1. Provides ample source of finance for Ukraine’s reconstruction

As noted above, Russia is a rich country, and has ample financial reseources to pay for Ukraine’s reconstruction and reparations.

But those arguing that it is too difficult to use frozen Russian assets should have the starting point as what is the alternative, and what is the likely consequence of not using them?

As a starting point here, I would just highlight that Ukraine’s recovery and reconstruction is a strategic priority for the West. More, it is the most important strategic project for the West since the end of Communism in 1989/91. The West has an interest in rebuilding Ukraine to make it economically self sustaining and resilient against inevitable future Russian attacks. As has been proven over the past 18 months, Ukraine is now the front line for NATO and the West against Russian expansionism and aggression. Shoring up Ukraine’s defence and, required therein it’s economy, is absolutely a necessity for the West, and we don’t have that much time. And unlike after the fall of communism in 1989/91 when the peace dividend provided a tail wind for transition and reconstruction, this time we face the headwinds from an aggressive Russia, trying to stop that process.

And what is also clear is that the costs are huge - a recently KSE/World Bank report put the costs at $411bn as of Q1 2023, and they have grown since then. But this is not just the physical rebuild costs, what about reparations for the hundreds of thousands of Ukrainians killed, maimed, kidnapped and tortured.? That could easily take the overall cost to closer to $1 trillion.

As noted above, Russia has the financial resources to pay, but who will pay, if Russia does not?

The West has thus far provided around $100bn in financing for the war effort and to fill Ukraine’s budget financing needs to date. EC President Von der Leyen recently committed another $54bn for Ukraine recovery for the period 2024-2026. But the latter likely will cover Ukraine’s likely large budget shortfall over this period, not back filling reconstruction costs. Similarly there is talk about another $60bn US support package to get Ukraine thru to the next US elections, albeit much of this likely will be for defence spending, not reconstruction.

Frankly, I cannot see the political will in the West, once the war actually ends, to fund Ukraine’s reconstruction from tax payer dollars, Euros or pounds. Once the war ends, likely other priorities and draws on Western tax payer monies will surface. Likely Western official financing resources will fall off a cliff.

Perhaps understanding this, recent donor conferences, including the London Ukraine Recovery Conference earlier this month, have focused on getting the private sector to do the heavy lifting of Ukraine reconstruction and recovery. But the hard reality is that while the private sector might provide single digits billions annually to fund Ukraine reconstruction, it will not provide the tens of billions needed annually. And it won’t because of:

* War related security risks;

* Pre war concerns over rule of law in Ukraine, which will not disappear overnight when the war ends;

* Lack of international market access for Ukraine. When the war ends, likely Ukraine will have an unsustainable debt burden (~ 100% of GDP), and likely will require debt relief. But why should private sector creditors agree to a speedy restructuring when Russian assets remain untouched? Any such restructuring forced on the private sector by the Western official sector will essentially be a case of our governments screwing over their own pensioners (most of the debt is held by funds investing on behalf of Western pensioners) to safeguard the assets of a murderous Russian regime? There will inevitably be holdouts. It will be complicated unless very light treatment is applied.

With no market access, high perceived risks, the cost of capital to invest in Ukraine recovery will be precipitously high.

In the end our governments should realise that Ukraine reconstruction is a classic public good, and the privete sector will not invest in a scale and pace as needed in this instant.

Recovery and reconstruction will fail if our governments erroneously think that the private sector will fund reconstruction, and fail to realise quickly that the only readily available source of funds is using frozen Russian assets.

Perhaps useful to think here what if Ukraine reconstruction fails?

Well, Russia will likely come back again with another invasion which might work better second time around. And then if Ukraine is beaten and Russia’s borders pushed up to NATO’s current Eastern flank, the West will be much less secure and will have to spend many more hundreds of billions on its defence.

Even if Russia does not further attack, what will a failed Ukrainian recovery and reconstruction look like?

I would argue that with millions of Ukrainian troops and migrants returning to Ukraine, with high expectations for the peace, a failed recovery and reconstruction would risk major political, social and security instability, in a country which has now the largest and most effective military in Europe. How would future instability in Ukraine impact on the broader European continent? Huge migrant flows would be the least of the risks.

In summary here when we think of the benefits of using frozen Russian assets for Ukraine reconstruction the key point is that it offers the prospect that we can actually do this well, and in a timely manner. The benefits are:

* Western and Ukrainian security is best assured;

* The risks of future instability in Ukraine is reduced;

* The risks of a populist backlash in the West over their tax payer dollars being used to fund Ukraine reconstruction is also moderated - our politicians will head off the risk of major political scandals/fallout as electorates ask why they are being charged to protect frozen Russian assets. Their property rights (tax payers or pensioners) are being attacked/taken away because our politicians think that it’s more important to protect the property rights of a murdererous regime. Imagine that;

* Succesful Ukraine reconstruction also offers the prospect of upside in Western economies, benefitting from involvement in the rebuild.

2. Deterrence to others

Quite obviously use of frozen or immobilised Russian assets for Ukraine Reconstruction will send a powerful message to other regimes that are thinking of riding roughshod over international law, invading other countries, conducting war crimes and genocide, that the crime does not pay. It will be a powerful deterrent.

In the end, policy makers have to look at the above cost - benefit analysis and figure out what makes best sense. But as noted above, doing nothing is itself a decision, not to fund Ukraine’s reconstruction adequately and dooming that to failure. And it worries me that some of the people making this decision, in central banks and Treasuries, are not those who much understand the security risks, and even if they do, they have not covered themselves in glory over the past decade or so in actually correctly gauging the security risks from Russia. They should input into the decision for sure, but they should not be the key decision makers.