External Financial Dominance Under Sanctions: Financial Fragmentation and Exchange Rate Determination in Russia

This paper examines whether prolonged sanctions and major geopolitical episodes associated with financial fragmentation alter exchange-rate dynamics and weaken the explanatory power of domestic macroeconomic channels and strengthen external financial dominance of traditional exchange-rate transmission mechanisms. Standard exchange rate theories are based on the concepts of Purchasing Power Parity (PPP) and Uncovered Interest Parity (UIP). However, the application of continuous sanctions could weaken this explanatory power and change exchange rate dynamics. The present study applies a combined framework of Autoregressive Distributed Lag (ARDL), Error Correction Modeling (ECM), Vector Autoregression (VAR) and structural break analysis to study the exchange-rate behavior in response to repeated geopolitical shocks using monthly data for Russia from 2005 to 2025. The results indicate that external variables such as the US dollar index and oil prices are important determinants of exchange rates, while inflation and interest rate differentials associated with PPP and UIP have little explanatory power. Structural break tests detect major regime shifts associated with the Global Financial Crisis, Crimea-related sanctions episode, COVID-19 pandemic and Russia–Ukraine conflict. The error correction process indicates that the speed of adjustment to equilibrium is slow, which means that traditional exchange-rate relationships will continue to diverge. In general, the results suggest a regime-dependent exchange rate environment in which external financial factors tend to dominate domestic adjustment mechanisms. Our study contributes to the literature on exchange rates, sanctions and financial fragmentation by providing evidence on how geopolitical shocks shift the relative importance of domestic and external determinants in a highly sanctioned economy.