What Went Wrong? Russia Sanctions, EU, and the Way Out

Without a diplomatic solution, the sanctions against Russia will have an adverse impact on its economy, but could also push Europe to a triple-dip recession. 

Last March – after months of escalation in the Crimea and Eastern Ukraine – President Obama initiated sanctions against Russia in financial services, energy, defense and related materials sectors.

New sanctions ensued in July, when Washington launched unilateral restrictions targeting powerful interests in Russia’s financial, energy, and military technology sectors. After Malaysia Airlines Flight 17 was shot down in Ukraine and 300 people perished, Brussels joined in the sanctions against Russia.

In mid-September, the Obama administration and its European allies further expanded their economic battle against Russia.

Today, Russia and Ukraine linger in a deadlock, while the friction points and surrounding areas are ridden by Russian and Ukrainian forces, pro-Russia rebels, pro-Ukraine militias, and other proxies.

Washington, Brussels and Moscow are in a vicious circle, which would spare none of them and which has potential to undermine global recovery.

A series of misguided moves

The wrestling between Moscow and Brussels began over four years ago, when Brussels proposed an “Eastern Partnership” with Ukraine, along with five other Central European states. Basically, the EU offered free trade and financial contributions, in exchange for democratic reforms.

In Brussels, the eastern partnership was seen at par with former German Chancellor Willy Brandt’s policy of Ostpolitik in the 1970s.

Seen from Moscow, the EU seemed to offer a de facto membership to Ukraine to limit Russia’s economic influence, to undermine Putin’s proposed Eurasian Union and to bring the NATO into Ukraine.

As Moscow saw it, Brandt’s rapprochement sought to improve relations with East Germany, Poland, and the Soviet Union, whereas the motives and goals of the Eastern Partnership were very different.

Seen from Washington, the Obama administration had allowed Brussels to take the lead in guiding the westward political and economic drift of Russia, with the U.S. in a supporting role. The stance reflected the Obama foreign-policy doctrine, which aimed to give America’s allies more responsibility, after a decade of costly U.S. wars abroad.

Seen from Kiev, the EU promised that Ukraine’s growth would soar to 6 percent after a challenging reform period and substantial financial support by the IMF and the EU. Yet, in the short-term, Ukrainian GDP could shrink by 10 percent this year, while growth is likely to remain less than 1 percent in 2015. As Keynes used to say, in the long-term we are all dead.

What made a bad situation worse was the return of neoconservatives in Washington. Emboldened by America’s shale gas revolution, they saw the Ukraine crisis as an instrument for regime change in Russia. Some were particularly concerned about the rise of Russia as an arms exporter. In the past decade, the U.S. has dominated arms exports globally, but last year Russian weapons exports surpassed the U.S. by over $2 billion.

As the attitudes in Brussels and Washington hardened before the NATO summit in early September, a group of U.S. intelligence veterans sent a memo to German Chancellor Merkel challenging the reliability of Ukrainian and U.S. media claims about a Russian “invasion.”

In 2003, the group had sent a similar memo to President Bush warning him about politicized intelligence that was used to legitimize the U.S.-led attack on Iraq.

Undermined goals

Seen from Moscow, the West has betrayed its promises to Russia and the hopes of Russians too many times since the end of the Cold War; from the presumed blessings of the “shock-therapy reforms” to Russia’s concern about the eventual expansion of NATO ever closer to its western border. This is why the advocates of realpolitik, including Kissinger, insist that Ukraine should not join NATO.

So when Putin drew his red line in Ukraine, it reflected the views of most Russians; from his most loyal supporters to his most embittered critics.

Washington and Brussels had hoped that the Ukraine crisis and the sanctions would quash Putin’s domestic popularity. In reality, the net effect has been precisely the reverse.

Before the onset of the Ukraine crisis last October, worsening economic conditions caused Putin’s approval rating to plunge to 61 percent. As the US-EU sanctions have been broadened and deepened, that rating has soared to some 85-87 percent.

Without the sanctions, Putin’s rating might have declined to low 50s. At least, that was the trend line. With the sanctions, the realities are different.

While Putin’s rating may now have plateaued, the results of Russia’s recent regional elections suggest that Russia remains behind its president. These trends cannot be explained away simply because many Russians rely on state media for news on Ukraine and Crimea. Today, they, too, have access to alternatives. Rather, it is the distrust with the West that is the key challenge and that the sanctions are compounding.

Ironically, sanctions have achieved the very scenario that they were supposed to mitigate: a unified Russia behind Putin and a delay in economic reforms, a potential new recession in the Eurozone, and rising volatility in the U.S. markets.

Adverse spillovers

In Russia, growth forecasts are being downgraded, the ruble is plummeting, and economic worries are mounting. Despite efforts at diversification, energy resources accounted for some 70 percent of total exports in 2013. Assuming de-escalation later in the fall, Russia will suffer a mild contraction in 2014 and less than 1 percent growth in 2015-2016 – but with inflation around 5 percent.

But it is the ailing Europe that has the most to lose in the sanctions debacle. In the financial sector, European banks had 75 percent of Russia’s foreign bank loans in late 2013. Russia supplies Europe with a third of its oil imports and over two-fifths of its natural gas imports.

Recently, German Finance Minister Wolfgang Schauble acknowledged that, amidst the Ukraine crisis, the growth of Europe’s largest economy has been stunted, which will penalize the region’s weak recovery. Even worse, Italy’s debt challenges are likely to deteriorate, which will have broad implications in Europe and elsewhere.

If, in these conditions, the West will tighten current sanctions incrementally, global economic prospects are still barely manageable. If the West takes the sanctions to still another level, the consequences could prove particularly severe in the key economies. In Europe, it could push the region into a triple-dip recession. In Russia, that would test Putin’s popularity and turn the contraction into a more serious recession.

How bad could it get? In downside scenarios, new sanctions could accelerate capital outflows from Russia to amount to some $150 billion. If, meanwhile, oil supply would increase in Saudi Arabia and nuclear talks with Iran would prove successful, oil price would decrease. That, in turn, would further weaken the Russian ruble and thus reduce Moscow’s revenues.

In the nascent multipolar world, Cold War era sanctions have the potential to drastically diminish global economic prospects. Sanctions must be replaced by a diplomatic solution. Time is running out.

A slightly different version of this commentary was published by EUobserver on September 23, 2014

One Response to "What Went Wrong? Russia Sanctions, EU, and the Way Out"

  1. Ed Dolan
    EdDolan   September 26, 2014 at 10:24 am

    Replacing sanctions with a diplomatic solution might help EU economies in the short run, but the big question is, what kind of diplomatic solution? So far Putin has gotten everything he wants–Crimea plus a frozen conflict in Donbass, threatening permanent economic weakness and instability for Ukraine. Both moves clearly violate not just implicit post-WWII norms, but also explicit commitments made by both Russia and the West in Budapest. A diplomatic solution that ratified those Russian gains and went back to business as usual would be a high price to pay for any potential economic benefits to the West.