No winners in a war of sanctions

 March 22, 2014

Vladimir RadyuhinParvathi Menon

It would be a nightmarish scenario for the United States, if western sanctions push Russia closer to China

Beneath their tough political rhetoric, European leaders are still wrestling uneasily over the ambit of punitive economic measures to be used against Russia for its role in the Ukrainian and Crimean developments.

Following the announcement by U.S. President Barack Obama of an expanded list of 21 individuals who will face bank asset freezes and travel bans, European Union (EU) leaders who met in Brussels increased their own list by 12, but postponed releasing the names till March 21 [when this went to print].

The sanctions are, at least for the present, seen as a political reproach of Russian President Vladimir Putin’s facilitation of Crimea’s integration into Russia. Even though the pressure was turned up a notch on March 20 to include several senior Russian officials into the sanctions net, the measures do not match the threatening oratory that has emerged from western capitals against Russia.

The next step — of broad-based economic sanctions including trade embargoes and business asset freezes — is likely to see much less of a consensus between the trans-Atlantic allies, and within the countries of Europe.

Indeed, at the EU Summit in Brussels on March 20, the 28-nation body said that it would go to the next level of punitive measures if Russia were to intervene in eastern Ukraine — an implicit recognition of Crimea’s integration into Russia as a fait accompli.

The EU sought to enhance its profile as a political player during the Ukrainian crisis by its direct engagement with the Euromaidan leaders and its facilitation of the February 21 Agreement between the Opposition and former Ukrainian President Viktor Yanukovich. However, it has moved with considerable caution on the issue of economic sanctions.

At the EU Summit, though tougher sanctions were threatened, the focus was rather on bolstering political and economic ties with Ukraine. Ukraine’s Prime Minister Arseniy Yatsenyuk signed a political agreement on March 21 with EU leaders, which will pave the way for the integration of his country’s interests with Europe.

Fallout of competing sanctions

A full-blown western economic blockade may cripple Russia, but it will also have a singeing, blowback effect on Europe’s economy. Germany is likely to be hit the hardest in such an eventuality, a fact that explains German Chancellor Angela Merkel’s calls for diplomacy — and not sanctions — to resolve the conflict.

Russia is the EU’s third largest trading partner, a major energy supplier, and a hub of European business investment.

“If they go beyond these token measures, Russia will retaliate, and that could damage the European economy,” said Robert Oulds, Director of the Bruges Group, a Eurosceptic think tank based in London.

“Germany is heavily dependent on Russian oil and gas, and if Russia retaliates with its own sanctions, prices will go up, creating an economic shock that could spell disaster. The European economy is already in a deflationary crisis,” he added.

The EU is Russia’s primary trading partner, accounting for over 40 per cent of its trade. European exports to Russia include machinery and transport equipment, chemicals, medicines and agricultural products.

The EU imports nearly 80 per cent of Russia’s oil and natural gas exports, with Germany alone being the single biggest importer of oil and gas.

In an interview to Der Spiegel, Eckhard Cordes, Chairman of the Committee on Eastern European Economic Relations, is quoted as saying that 3,00,000 German jobs could be at risk if a situation of competing sanctions were to arise between the West and Russia.

“I am very worried that we are going to unleash a downward spiral of sanctions and counter-sanctions that won’t help anyone,” Mr. Cordes is quoted as saying.

More than 6,000 German companies are registered in Russia, and together they have invested €20 billion in recent years, the article says. These include corporate entities like Siemens, the German chemical giant BASF (that has holdings in Siberian gas fields), and the energy supplier E.ON, among others.

Russia has shrugged off the first wave of the West’s largely political sanctions.

The West may well be missing the fact that President Putin is willing to pay the costs for regaining Crimea. Moreover, the Russians also seem to be ready to endure the backlash of western sanctions, as more than 80 per cent of respondents in a poll last week said that Russia should embrace Crimea even if this provokes a backlash from other countries.

The assets freeze of select Russian individuals is likely to misfire since Mr. Putin, a year ago, ordered all government officials to close their bank accounts and sell off properties abroad.

However, the political stand-off with the West has increased the outflow of capital from Russia in the first two months of 2014 to $35 billion as against about $60 billion for the whole of last year.

Capital flight may rise to $200 billion this year and push the current account into the red, according to economist Igor Yurgens, deputy head of the Russian Union of Industrialists and Entrepreneurs (RUIE). The Russian stock market has lost 17 per cent of its value in March and the rouble has continued to decline.

Massive economic sanctions would hit Russia much harder, experts have warned.

The threat of financial sanctions has already hampered access to western bank credit for Russian companies.

“Even though foreign markets are formally open, it is impossible for Russian borrowers to get financing,” said Alexei Marey of Russia’s top-league Alfa-Bank. “In the worst case scenario, foreign funding may be closed for Russian entities for one or two years.”

Pinching Russia

Russia is already bracing for possible sanctions. It is reported to have moved out of the U.S. last week more than half of its $200 billion worth of U.S. Treasury bonds.

Bloomberg, quoting U.S. Treasury data, reports that Russia is the 11th largest foreign holder of U.S. Treasury bonds totalling $138.6 billion at the end of last year. Russia has reportedly moved out more than half of these.

A comprehensive ban on financial transactions would freeze the assets of Russian companies in the West, estimated at $500 billion, and cut them off from western credit sources. This could lead to a Russian slowdown, from the expected 2.5 per cent to a mere one per cent or even zero growth, said former Russian Finance Minister Alexei Kudrin.

Trade sanctions would be painful as imports account for 40 per cent of Russia’s consumption. The share of food imports reaches 50 per cent, but even Moscow, whose dependence on imported eatables is higher than the country’s average, says it can compensate for a possible shortfall in western supplies by stepping up purchases in the BRIC countries.

Russia would be particularly vulnerable to a ban on western high technologies that were to play a key role in government plans to modernise industry, including the defence sector. Russian arms exports could suffer, as high-tech weapon platforms, such as the Su-30MKI supplied to India, have key systems and components sourced from western manufacturers.

Moscow responded to the first round of U.S. sanctions with its own symbolic blacklist of U.S. officials who will be denied Russian visas, and the Russian Foreign Ministry said Russia’s response to further sanctions would be “harsh.”

Mr. Putin’s influential economic adviser, Sergei Glaziev, warned that in the event of U.S. economic sanctions Russia would dump American Treasuries, refuse to pay off loans to U.S. banks, drop the dollar as a reserve currency and create an alternative currency system.

In a television interview last week, Russia’s Economic Minister Alexei Ulyukayev confirmed that Russia would work to switch its foreign trade from dollars to national currencies.

“Why should we have dollar contracts with China, India, Turkey?” he asked. “Why do we need this? We must have contracts in national currencies. This should, above all, apply to our oil and gas companies.”

Western investments in Russia are estimated at over $240 billion and borrowing by Russian companies exceeds $700 billion abroad.

There is a consensus among the Russian expert community that sanctions will push Russia closer to China, in what could be a nightmarish scenario for the U.S. Russia may step up defence sales to China and reorient its energy exports from Europe to the East, a policy Russia launched several years ago with the construction of an oil pipeline to its Pacific coast and China.