Russia: 21st Century Empire?

During the last year, the conflict in Ukraine has come perilously close to a state of full-blown though undeclared war.

Looking back over the past 12 months, we’ve seen a seismic shift in the political makeup of the region. Russia has effectively annexed the Crimean Peninsula, which includes the city of Sevastopol, home of the Russian Black Sea Fleet—and critically, the Russian Navy’s only warm-water port. In the political sphere, Ukraine’s unpopular president, Viktor Yanukovych, abandoned his vast estate along the Dnieper River, fled into exile in Russia, and was soon after impeached by the Ukrainian parliament.

Despite these momentous events, the conflict, which began on November 21, 2013 in Kiev’s Independence Square, grinds on. In Eastern Ukraine, Russian separatists—some wearing what appear to be Russian military uniforms—continue to battle the Ukrainian Army, with both sides suffering casualties despite several cease-fire agreements.

But in a larger sense, the crisis in Ukraine represents a metaphor for Putin’s increasingly imperial ambition. While the situation in Ukraine is grave and could escalate into an even more dangerous crisis, it’s still just one piece of a much broader puzzle.

Unlocking that puzzle begins with Vladimir Putin—and what are, by all appearances, his plans for reconstituting the Russian Empire.

Moscow’s Long Arm—A Firsthand Experience

I personally experienced the long arm of Vladimir Putin’s political machine two years ago, just as I was preparing for a trip to Moscow.

In May of 2012, the Financial Times published an op-ed piece I had written with my good friend, the political scientist Ian Bremmer. In the article, Ian and I said we believed that Russia was on the wrong path.

We listed many reasons why: Russia’s intervention in state capitalism; a pervasive sense of authoritarianism; and a population in demographic decline, as well as rampant socially driven diseases like alcoholism. We recognized early on some of the problems—economic, political, and social—that Russia might face.

A few days after the FT ran our op-ed piece, Ian and I were going to meet with senior policymakers in Moscow. When I arrived, half of the people I was scheduled to meet with suddenly decided to cancel.

I suppose there could have been a nasty spring flu going around the United Russia party that May; but more likely, people who hold dissenting views from Russia’s party in power will suddenly have their meetings politely canceled.

This isn’t surprising: corruption in Russia has become endemic to the political system.

Transparency International’s Corruption Perceptions Index, which measures the way public-sector institutions are perceived, ranks the Russian government 127th out of a total of 177 countries rated—which is hardly an endorsement of Mr. Putin’s style of governance.

Empire Building, 21st-Century Style

Russia has always considered itself an empire—even before the Bolshevik Revolution.

In Tsarist days, Imperial Russia was a great power that believed buffer states were necessary to maintain its security and its place in the world. After the Bolshevik Revolution, during the era of the Soviet Union, Russia maintained client states in Eastern and Central Europe to control a sphere of influence far larger than its own national territory.

During the time of the tsars, Ivan the Terrible expanded the Russian Empire by enlisting the support of the Cossacks. Now the organizational complexity of the 21st century has given empire builders a new tool to consolidate their power: the supranational union.

The Creation of the European Union

On January 1, 1999, 11 democratic European countries, including the most economically powerful nations in Western Europe, officially united to create a common currency—the euro.

The eurozone, along with its free-trade counterpart, the European Union, represents a culmination of work toward a united Europe that had begun decades earlier.

 

Perhaps it isn’t surprising that Putin’s latest attempt at empire building has taken on this distinctly modern form, using the European Union and the eurozone as templates for consolidating power.

The Eurasian Economic Union (EEU), which will formally go into effect on January 1, 2015, is Putin’s latest bid to unite the territories of the former Soviet Union. The original territories to be included in the union were Russia, Belarus, and Kazakhstan—but the treaty was amended in October to include Armenia. The nation of Kyrgyzstan may soon follow suit.

Click to Enlarge

The Eurasian Economic Union: A Rival EU?

The Eurasian Economic Union is something economists refer to as a “customs union”—a free-trade zone with a common tariff applied to foreign goods.

But the EEU is still in a gestational phase. The history of the European Union suggests that over time, the integration of a free-trade area expands—which may well be Putin’s goal.

Putin doesn’t want to simply create another North American Free Trade Agreement (NAFTA). His aim is to create another EU—a rival EU—with the Kremlin exercising the real power behind the scenes.

To understand the empire-building project that Putin has embarked upon, it makes sense to think of the EEU as a political union first. Putin’s ability to consolidate power politically was a necessary first step, leading to progressively greater economic integration.

As a customs union grows, it establishes trade, financial, and investment links among its constituent states. Then, as time goes on, member states may stabilize their currency exchange rates, eventually becoming interconnected enough to develop a common currency.

The eurozone experiment suggests that sustaining a monetary union requires banking, fiscal, and full economic union. When you begin to trace the trajectory of the eurozone experiment, the outlines of Mr. Putin’s plan begin to come into focus.

If Russia wants to establish the Eurasian Economic Union as a rival to the EU, then it must include Ukraine, Russia’s largest neighbor to the west.

As Jimmy Carter’s National Security Advisor Zbigniew Brzezinski once wrote: “Without Ukraine, Russia ceases to be an empire, but with Ukraine suborned and then subordinated, Russia automatically becomes an empire.”

And indeed, what started as a customs union is now becoming a broader economic union for the three members of the EEU in 2015. Russia has already heavy-handedly suggested to Kazakhstan and Belarus that they should start to stabilize their currencies and eventually think about a common currency in the future. There are even proposals for the beginning of a banking union, with joint regulation and supervision for banks in the EEU. Kazakhstan has already balked at the idea of a common currency that would be a stepping stone for a fuller banking, fiscal, economic and eventually political union.

But Russia is pressing the issue, and the delicate political transition in Kazakhstan may give Russia an opportunity to “pull a Ukraine” in Kazakhstan, as we will discuss below.

Putin’s rhetoric is that Russia should protect Russian ethnic minorities wherever they are in the former Soviet Union—and about 25 million ethnic Russians live in those former Soviet republics.

What a Sanctions War Would Do

In the geostrategic sense, Ukraine plays a key role in the development of the EEU, but there are additional risks to an escalation of the conflict there.

The nightmare scenario for the West—and for investors—is an escalating sanctions war with Russia.

Thus far, Western sanctions have targeted only key individuals and companies in Russia, and have been limited mostly to specific organizations, such as the energy sector, the military, and state banks. Essentially, the sanctions have tried to encourage financial markets to price in a greater risk premium for Russian investments, but have steered clear of broad trade restrictions.

Russia retaliated with counter-sanctions, specifically a ban on food imports and restrictions on imported clothing, cars, and other products for government ministries. Coupled with a much weaker Russian ruble, which reduces Russia’s purchasing power in the world, Russian imports from Europe have collapsed. The Russian government is now trying to replace these goods with domestic production.

But the real concern is energy. Approximately one-third of Europe’s gas supply comes from Russia—and about half of that gas is transported through Ukraine.

According to Eurostat, the EU’s official statistics reporting agency, Germany gets about one-third and Sweden almost one-half of their imported energy from Russia. Poland, Slovakia, Bulgaria, and Lithuania depend on Russia for 90% or more of their imported energy, excluding intra-EU trade.

Europe’s Energy Imports

Source: New York Times

If the West were to impose stricter sanctions against Russia, Russia might then retaliate with the supreme sanction against the West—cutting off the supply of natural gas to Europe.

If the conflict between Ukraine and Russia were to escalate into a full-blown war, which for the moment at least does not seem likely, the risk of a disastrous energy embargo would rise dramatically—though this would damage the Russian economy as much, perhaps even more, than it would hurt Europe.

As recently as 2009, a pricing quarrel arose between Russia and Ukraine when Gazprom, the Russian gas giant, refused to renew a contract due to concerns over Ukraine’s outstanding debt. The dispute was ultimately resolved by Vladimir Putin and then Ukrainian Prime Minister Yulia Tymoshenko, but not before it threatened real catastrophe.

By the time the two leaders had brokered an accord, gas pressure had already dropped in Poland and the Czech Republic—sending ripples of fear about energy supply through Western Europe that winter and causing waves of selling in European equities.

Russian gas lines crisscross Ukraine

Source: BBC

So in the event of a Russian gas embargo of Western Europe, where would Russia sell its natural gas?

While Putin could attempt to redirect sales of natural gas to his trading partner China, the infrastructure required to transport that gas has not yet been completed, and the construction required to make it operational will take years to complete.

Despite limitations in the transportation infrastructure, the Russians already have a steady agreement in place to sell gas to China—driven in some measure by Russia’s insecurity about its relationship with the West.

On the other side of the equation, tensions with Russia have already led some European countries to sign contracts with the United States for future natural gas delivery. (At present, US law does not allow for the export of meaningful amounts of liquefied natural gas [LNG], but new LNG licenses are being issued.) The US is also increasingly exporting its excess supply of coal to Europe, as the domestic shale gas and oil boom reduce US coal consumption.

It’s Not Just Ukraine

I recently traveled to the Central Asian nation of Kazakhstan, which is a former Soviet republic and founding member of Putin’s Eurasian Economic Union. Russia has deep and longstanding economic ties with Kazakhstan, especially in the trade of raw materials and finished goods.

Kazakhstan is the largest landlocked nation in the world, and the ninth-largest country by overall landmass. Its northern border with Russia is longer than 4,000 miles. Roughly one-quarter of Kazakhstan’s population of 17 million is ethnic Russian—but in the north and west of the country, ethnic Russians account for between 40-50% of the population.

This August, in a disturbing turn of events, President Putin remarked that Kazakhstan has never had independent statehood and was historically “part of the large Russian world.” He also said that Kazakhstan’s citizens of Russian descent needed to be protected—and that they would insist on protection if tensions were rising.

The Kazakhstanis naturally bristled at this rhetoric, made especially ominous by the fact that Putin had made nearly identical remarks about the ethnic Russians in Ukraine. Putin also made special mention of Kazakhstan’s current president, Nursultan Nazarbayev, praising him for having “created a nation” where none had existed before.

This leaves many Kazakhstanis concerned about what Putin’s plans for Kazakhstan may be after Nazarbayev eventually disappears from the scene. Nazarbayev is now in his mid-70s and has run the country since its independence without a clear plan of succession. There are also additional concerns about whether the ethnic Russian population of Kazakhstan will rise to the bait and begin to assert their “rights” with force, as they already have in Ukraine. President Nazarbayev has already responded to this perceived risk by appointing more Russian ministers to participate in his government.

Kazakhstan has played a fascinating balancing act between Russia, China, and to a lesser extent, the West. Indeed, Kazakhstan now sells more than half of its resource exports to China.

I don’t believe there is any reason for great concern about Kazakhstan in the short term—but the uncertainty about succession after Nazarbayev leaves the presidency could make Kazakhstan vulnerable.

Unlike many other countries in the region, Kazakhstan has some significant economic advantages—including sizable resource exports and earnings, the fact that it has managed to save some of its oil earnings in its sovereign wealth fund. All of this gives Kazakhstan some bargaining power vis-à-vis Russia—at least as much bargaining power as a country a tenth the size of Russia can command.

Source: RT

Putin has also engaged in similar bullying tactics in Armenia, Moldova, Kyrgyzstan, and Tajikistan—all of which are relatively poor, landlocked nations, with few resources and limited wealth, and which now seem likely to join the EEU at some point in the future.

While these territorial conflicts may seem distant from Western investors, taken as a whole, they amount to a pattern of behavior in a potentially volatile region of the world that investors should not ignore.

Challenging Global Infrastructure

Also on the geopolitical front, Russia and its BRICS partners—Brazil, India, China, and South Africa—are working on creating a development bank that will serve as a BRICS alternative to the Western-controlled International Monetary Fund (IMF) and the World Bank. This is yet another troubling example of Russia’s apparent desire to turn its back on the West.

In another example, there has been speculation that Russia and China are planning to create an international payment system to replace the SWIFT system in order to limit the capacity of the US and Europe to impose financial sanctions against them. Support for some of these ideas has cooled in China, though, where the notion of replacing the SWIFT system has been rejected, while many analysts in the West think the idea is nothing but a pipe-dream.

In addition, recent revelations of electronic surveillance by the US may lead Russia and other illiberal states to restrict Internet access and create their own nationally controlled data networks.

Creating a full Eurasian Economic Union that is less tied to the West through trade, financial integration, electronic payment, and communication may be a romantic fantasy for Russia given the fiscal costs the project would entail—costs that Russia cannot afford.

Moreover, the recent fall in oil prices—which is perhaps driven in part by Saudi Arabia’s goal of punishing Russia for its role in Syria and the Middle East, as well as the sanctions against Russia by the West—have led to a free-fall of the Russian ruble and a near-recession in Russia this year and possibly next year as well.

Despite these headwinds, Putin is still very popular at home where a controlled media has spun a tale of a strong Russia helping its ethnic cousins in Ukraine. But as the economy falters, the neoimperial goals of Putin will be increasingly challenged.

Nevertheless, for now the Eurasian Economic Union dream is a dream to which Putin dearly clings—and he is nothing if not tenacious.

Final Thoughts

Taken as a whole, Vladimir Putin’s behavior suggests that his endgame is to keep the former member states of the Soviet Union unstable enough to give up on closer ties with the West. His plan is multifaceted—part political, part military, part geostrategic—and focused on maximizing Russia’s influence in the region as well as increasing the power of the fledgling Eurasian Economic Union.

Counterbalancing those risks in the region are the central banks of the G4—the Fed in the United States, the European Central Bank, the Bank of England, and the Bank of Japan—which have kept interest rates low enough to suppress market volatility.

So far, that support from central banks has served as an effective counterweight to the perception of geopolitical risk in places like Ukraine. With a few short-term exceptions, stock market prices have remained relatively stable since the crisis in Ukraine began almost a year ago.

There’s still plenty of risk in the world today. As an investor, you should pay attention to those events, but don’t automatically assume that geopolitical risk will translate into a massive correction in asset prices.

Vigilance and careful observation are a must—panic is not required.