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Battling for Ukraine with Capital Instead of Combat

The West’s strongest weapons against Putin’s power play are capital flows, marking a new frontier in international conflict.

President Vladimir Putin seized Crimea with forces loyal to him barely firing a shot in the process. He also faces little armed resistance in eastern Ukraine, at least so far, as he seeks to foment instability in the region, possibly as a pretext for carving off more of his southern neighbor. Yet the Russian president does confront opposition of an unconventional and asymmetrical kind. The battle for Ukraine marks a new frontier in international conflict, one in which capital flows ­— not tanks or planes — are the West’s strongest weapon.

The biggest factor restraining Putin from further military action is the threat of swift punishment by financial markets. Russia has already paid a big price for its annexation of Crimea: The country’s stock market and currency swooned in February and March, and capital fled the country at a near-record rate in the first quarter. Even senior officials in Moscow admit that the problem is likely to get worse in coming months without an easing of the underlying political crisis.

At the same time, Russia could inflict some serious financial pain on the West. The European Union, the U.S. and the International Monetary Fund have promised more than $25 billion in aid to help Kiev cope with its debts and attempt to jump-start its economy. But Russian efforts to destabilize Ukraine, including manipulating natural-gas prices, could dramatically increase the cost to the West of keeping the country afloat.

Although the conflict has stirred fears of a revival of the cold war, the stakes involved today pale in comparison with those of a generation ago. Russia does not pose an existential threat to the West, and both sides have been eager to avoid direct armed confrontation ­— hence the lack of identifying insignia on the uniforms of Ukrainian insurgents, which allows Moscow to claim they are “pro-Russia activists.” Yet the Ukraine crisis in many ways presents a more complex challenge than earlier examples of cold war aggression: how to manage a Russia that is deeply connected with Europe economically but severely at odds with it strategically and ideologically. U.S. Secretary of State John Kerry criticized Putin for using 19th-century behavior to try to dominate Ukraine in the 21st century. The real question for the West is whether its threat of 21st-century economic warfare can stop the Russian leader.

“There is global interlinkage these days, and that is true for Russia as well,” Chancellor Angela Merkel said in late March at a news conference in Berlin with Canadian Prime Minister Stephen Harper. “They too can lose a lot in all this.”

The surface narrative of events in Ukraine since president Viktor Yanukovych fled his post in late February has been one of Russian triumph countered by toothless rhetoric from the U.S. and the EU. Russian troops took over the southern Ukrainian peninsula of Crimea, allowing Putin to revel in a “mission accomplished” moment, proclaiming the territory’s annexation to Russia and hinting at more to come. “The residents of Crimea and Sevastopol turned to Russia for help in defending their rights and lives,” the Russian president told a joint session of Parliament in March. “Naturally, we could not leave this plea unheeded.”

Putin massed troops and armor along Russia’s 1,200-mile border with the rest of Ukraine just in case a similar plea came from ethnic Russians in the industrial heartland of Donbass, in southeastern Ukraine. Russians rallied around their chief, and Putin’s approval ratings shot up to 80 percent, according to the Levada Analytical Center, an independent Moscow polling organization.

Washington and Brussels responded with largely symbolic sanctions that barred travel by and froze the assets of some 60 Russian and Ukrainian individuals who are believed to either shape Kremlin policy or be close to Putin personally. Political opponents made hay of their leaders’ perceived weakness. At a Capitol Hill hearing, Republican Senator John McCain excoriated Kerry for “talking strongly and carrying a very small stick, in fact, a twig” — the inverse of Theodore Roosevelt’s famous maxim on foreign policy.

A very different view of events, however, comes from one well-informed group: the officials who run the Russian economy. “The accumulation of external political risks and instability negatively affects the confidence and mood of investors and the population,” Alexei Ulyukayev, Russia’s minister of Economic Development, tells Institutional Investor in an e-mail response to questions. “This of course creates a complicated situation for economic growth.”

Capital flight from Russia, an endemic problem over the years as oligarchs and even smaller savers have moved money to perceived safe havens offshore, has intensified as a result of the Ukraine crisis. The outflow of capital hit $50.6 billion in the first quarter of this year, according to data from the Central Bank of Russia. That was the highest quarterly outflow since the fourth quarter of 2008, in the midst of the global financial crisis. The figure approached the $62 billion that left the country in all of 2013 — a number that was inflated by the $16.7 billion that state-owned Rosneft paid to BP for its 50 percent stake in Russian oil joint venture TNK-BP.

The financial hemorrhage threatens to bleed an already weak economy. Russia’s output grew by a mere 1.3 percent last year. Before the Ukraine crisis the Economic Development Ministry forecast a rebound to 2.5 percent growth in 2014, but Ulyukayev says that if capital flight hits $100 billion this year, the economy will be lucky to eke out a 0.6 percent improvement. Former Finance minister Alexei Kudrin, who still sits on Putin’s economic council, predicted similar results from the “mild sanctions” the West has imposed so far. Escalating economic conflict could keep capital flight at the level of $50 billion a quarter for the rest of this year, with more dire consequences, he told a St. Petersburg business conference in March. The current Finance minister, Anton Siluanov, predicted last month that the economic growth rate would be just zero to 0.5 percent this year.

Capital’s rush for the exits has taken a toll on the ruble, which slid by 8.5 percent this year to stand at 35.4 to the dollar on April 21, even as most other emerging-markets currencies have rallied. That weakness prompted the Central Bank of Russia to raise its key interest rate from 5.5 percent to 7 percent. As a currency defense, the tightening may have helped stem the tide, but any such gain came at a significant economic cost. Higher rates squeezed a Russian credit market that was already exhibiting nervousness about a possible withdrawal by foreign lenders. German Gref, CEO of the dominant state-controlled lender, Sberbank, told Putin as much during a televised meeting in early April. “We are moving to scenario B, which is a crisis scenario where we see a very large number of debt restructurings,” the banker informed the president.

The West, meanwhile, made a bold stroke of its own in Ukraine: In late March the IMF announced an aid package that could pour as much as $18 billion into the country’s Treasury over the next two years. The Fund said its pact could unlock an additional $9 billion from the EU, the U.S. and the European Bank for Reconstruction and Development; that multilateral bank set a lending target for Ukraine of as much as €1 billion ($1.4 billion) annually.

“Ukraine has embarked on a new path,” EBRD president Suma Chakrabarti said in a statement posted on the bank’s website in March. “It is our duty to stand by this important country’s side, and we are ready to do so.” The EU also signed an Association Agreement with the nation of 46 million — the same one whose rejection ignited the protests against Yanukovych in November — and promised to slash trade barriers after Ukrainian elections have taken place in May.

These moves have inspired a quieter counternarrative of the crisis, which maintains that in netting the Crimean minnow (the peninsula’s population is about 2 million), Russia relinquished the whale of Ukraine. “Russia has already lost the war,” Chrystia Freeland, a Canadian parliamentarian and writer of Ukrainian extraction, exulted on the opinion pages of the New York Times. “Democratic, independent Ukraine, and the messy, querulous European idea ... have won.”

Most observers view such optimism as premature. The West is venturing to rescue a chronically dysfunctional economy. Ukraine was about as rich (or poor) as neighboring Poland when the Soviet Union collapsed in 1991. Today, Poland has nearly three times Ukraine’s per capita GDP: $21,100 versus $7,400, according to the CIA World Factbook. And Ukrainians have seen their high hopes dashed before, notably after the Orange Revolution of 2005, which unfolded much like this year’s rebellion but quickly degenerated into infighting between former president Viktor Yushchenko and his prime minister, Yulia Tymoshenko. They failed to reform the government’s bloated budget or combat a culture of graft that relegated Ukraine to 144th place out of 178 countries in Transparency International’s Corruption Perceptions Index last year. (Russia was only slightly higher at No. 127.)

The IMF’s current partner is a self-described kamikaze interim government that has promised to yield power after the May 25 elections. The package’s success hinges on the new government’s ability to adopt economic reforms of the kind Kiev has ducked for years. Those measures would inflict severe short-term pain upon a population that includes a sizable minority whose allegiance is already in doubt. Among the most difficult reforms, the government has committed to doubling or tripling residential fuel prices. Energy subsidies currently consume a staggering 8 percent of GDP. “The package is very unpopular, with complex, difficult reforms,” Prime Minister Arseniy Yatsenyuk noted in a Twitter post.

Russia has the economic power to make those difficulties even more daunting, and it is proceeding to do just that. Gazprom, the state-owned Russian monopoly that provides nearly all of Ukraine’s heating fuel, summarily hiked its price by 80 percent in early April, to $485 per 1,000 cubic meters; European customers pay about $380. Putin followed this increase with a threat to cut off supplies unless Ukraine pays arrears that Moscow puts at more than $2 billion.

What’s more, Russia is Ukraine’s largest export market by far, accounting for more than 25 percent of foreign sales, giving Moscow plenty of chances to wreak further havoc with ad hoc trade restraints. “Handing out pies on Maidan will not be enough to preserve this country from economic chaos,” Putin told a mid-April meeting of his security council, referring to the moral support that Western diplomats lent to protesters in Kiev’s main square during the winter.

Eventually, the West will have to acknowledge Ukraine’s economic dependency on Russia, says the head of a Brussels think tank with close ties to the EU’s trade and foreign policy establishment. “Ukraine is too huge a problem for the EU to solve on its own,” he says. “Brussels will be looking for a signal from Moscow on how to share it.”

THE EAST-WEST STANDOFF over Ukraine may look like a return to the bad old days of the cold war, but the choreography of the crisis underlines how much has changed since Mikhail Gorbachev launched perestroika 28 years ago. Despite opposing the West on foreign policy flare-ups from Kosovo to Libya, post-Soviet Russia has pursued a steady path of economic integration. It joined the Group of Eight leading economies in 1998 — a membership that the other seven promptly suspended after the seizure of Crimea. In 2012, Russia took an even bigger step toward the global economy by joining the World Trade Organization, which has not moved to revoke its membership. Moscow has dismantled capital barriers and allowed the ruble to float, for the most part freely. The Central Bank of Russia plans to complete its transition away from currency management to Western-style inflation targeting next year.

The open door between East and West has yielded Russia enormous benefits, both material and psychological. The country’s corporate sector has tapped international funding — equity and debt — on much better terms than fledgling domestic markets could offer. Ordinary citizens have transformed their everyday lives with high-quality imported consumer goods. Roughly one in six Russians regularly travels abroad, according to a 2012 survey done for German trade show ITB Berlin. The country’s elite have snapped up real estate in London, Tuscany and Nice in search of legitimacy, refinement and safe places to raise their families. Russian expatriates own 7 percent of all the homes in nine upscale West London postal codes, a 2013 study by U.K.-based Fathom Financial Consulting found. “Russia’s invasion of Ukraine will end when senior officials’ children lose their visas for U.K. boarding schools,” quips one Moscow-based Western executive who spoke on condition of anonymity.

But the growing internationalization of the Russian economy brings vulnerability. Most trading in the stocks of Russia’s biggest companies takes place on the London Stock Exchange, and foreigners own an estimated 70 percent of the free float of Russian equities, according to Sberbank research. The Micex Index of Russian stocks has slumped by 10 percent since Yanukovych’s ouster in Ukraine, compared with a 6 percent rise in the broader emerging markets.

A more immediate concern for policymakers is the sea of foreign credit upon which Russia’s economy floats. Russian banks and corporations owe some $650 billion, or 31 percent of the country’s gross domestic product, to international banks or bondholders, with as much as $90 billion due this year, according to Alexander Danilov, who heads financial institutions coverage at Fitch Ratings’ Moscow office. With the threat of tougher Western sanctions in the air, some foreign lenders may be unwilling to roll over those loans, says central bank governor Elvira Nabiullina. “Our banks and companies are encountering limits on the possibility of refinancing on Western markets,” she told a meeting of the Association of Russian Banks last month. “That could affect financial stability negatively.”

Fear of a pullback by Western lenders has spooked Russians with money. The capital flight has hit Russia’s economy in one of its weakest spots: fixed capital investment, which languishes at 22 percent of GDP, compared with 30 percent in India and 46 percent in China, according to CIA data. With oil prices at an extended plateau and credit-based consumer spending showing signs of overheating, officials had been hoping for an investment surge that would modernize Russia’s ramshackle infrastructure, stimulate growth and boost productivity that sits at just 40 percent of U.S. levels. The fallout from the Ukraine crisis has pushed that agenda off the table for now.

Yulia Tseplyaeva, Sberbank’s chief economist, says she had been expecting capital flight to subside to some $38 billion this year, near the $25 billion to $30 billion “equilibrium level” for a petrostate that racked up a $170 billion trade surplus in 2013. Instead, the Finance Ministry now projects that the exodus of capital will hit $70 billion to $80 billion this year. Tseplyaeva estimates that each extra $20 billion beyond her forecast will translate to a 1-percentage-point decline in GDP growth.“A recession scenario cannot be entirely ruled out,” Tseplyaeva tells II.

Russia’s foreign economic relations center on Europe, the market for most of its raw materials and its biggest source of finished goods and investment. Secretary of State Kerry may be leading the diplomatic dialogue with Russia over Ukraine, but U.S. two-way trade with Russia amounted to just $40 billion in 2012, compared with $467 billion for the EU. Europe accounts for some three quarters of all foreign direct investment in Russia, having poured in a cumulative €167 billion, according to the European Commission. The FDI figure includes EU member Cyprus, the leading offshore portal for Russian investors’ money.

Russia has been trying to pivot its economic relationships away from Europe and toward Asia for a decade, with limited success. The country’s combined trade with China, Japan and South Korea amounts to about $150 billion annually, Economic Development Minister Ulyukayev reports. The simplest way to raise that total is to finally conclude an agreement with China on a 30-year deal to supply natural gas, something Gazprom has been negotiating since 2004. The Russian gas monopoly is likely to do that as a hedge against deteriorating relations with the West, says Maxim Moshkov, an analyst at UBS in Moscow. But the cost will be assenting to China’s idea of a fair price.

China National Petroleum Corp. has been pushing Gazprom for a price of about $10 per million BTUs, Moshkov says. That is below the $11 or so that European customers pay and does not account for the estimated $27 billion cost of building the necessary pipelines. Gazprom has been holding out for $14, but Ukraine increases the pressure for it to meet state-owned CNPC more than halfway. “I think the company is quite concerned about the situation in Europe, and we will see a China deal as a means of diversification,” the analyst says.

Russia is a much less dominant economic partner for Europe than vice versa. The EU now trades far more with China — some $600 billion a year — than with Russia, and European FDI in the Chinese market is rapidly catching up at about €100 billion. Nevertheless, Russia has been a conspicuous business bright spot as Europe has struggled in recent years: EU exports to Russia jumped by a third between 2010 and 2012, to €213 billion.

Key corporate investors have quietly stuck up for Moscow during the Ukraine crisis, pledging to stay the course. “In Russia margins are generally higher than in the euro area,” says Karl Sevelda, chief executive of Vienna-based Raiffeisen Bank International, in a written response to questions from Institutional Investor. “We have achieved a return on equity before tax in excess of 30 percent. Russia continues to be one of the most important markets for us, even in the light of recent events.” RBI’s Russian affiliate is the country’s 12th-largest bank. At BP, the U.K. oil giant that gained a 20 percent stake in Rosneft as part of the TNK-BP deal, CEO Robert Dudley told a shareholders’ meeting that the company would continue playing “an important role as a bridge” between Russia and the West.

Most important, Russia looks irreplaceable as a bedrock supplier of European energy for the foreseeable future, Gazprom’s talks with China notwithstanding. After the winter of 2009, when the Kremlin briefly cut gas supplies to Ukraine and shortages were felt downstream in Central Europe, the European Commission drafted a plan on energy security. But five years later that blueprint has had little impact on Russia’s sales. Moscow accounted for 36 percent of EU gas imports in 2012, down from 39 percent three years earlier, says Arno Behrens, chief of energy research at the Brussels-based Center for European Policy Studies (CEPS). That figure translated to 23 percent of all gas used in the EU and 6 percent of total energy consumption.

The post-2009 reforms did increase Europe’s resilience to short-term energy shocks by improving connections among member states so a shortage in one might be eased by a surplus elsewhere. The bloc also built six new liquefied-natural-gas terminals with sufficient capacity to cut Russian imports by one third to one half. But LNG currently sells at a 40 percent premium to Gazprom’s pipeline fuel thanks to voracious demand in Japan, which has had limited nuclear energy production since the meltdown of its Fukushima plant in 2011.

Other possible large-scale LNG providers, like Algeria or Middle Eastern producers, look potentially more volatile and less reliable than Russia, which has been delivering on its contracts almost without a hitch since Soviet times. A big bump in supply from liquefied U.S. shale gas or shale deposits in Poland and Ukraine seems speculative for the moment. “The only alternative to Russian gas in less than a ten-year time frame is more coal, which would further blow EU CO2 emissions targets out of the water,” says Jonathan Stern, chairman of the natural-gas research program at the Oxford Institute for Energy Studies. “All other options are longer term and higher cost.”

The European Commission is due to produce an updated energy security blueprint in June, but the incentive to maintain business as usual with Russia is strong. Even as Putin grabbed Crimea, Gazprom proceeded with plans to take over Germany’s No. 2 gas distributor, part of an asset swap with Wintershall Holding that will see the German company, a subsidiary of chemicals giant BASF, increase upstream holdings in Siberia. “I see no impact from the Ukraine crisis on the process,” Wintershall CEO Rainer Seele said at a news conference in March.

If Europe is moving to cut any country out of its energy supply chain, that would be Ukraine. Half of all Russian gas supplies already skirt the country via Belarus or the Nord Stream pipeline that runs beneath the Baltic Sea. That proportion could climb much higher if Russia constructs the South Stream pipeline, which is planned to run under the Black Sea and enter the EU through Bulgaria. The project was due to be completed in 2018, but the European Commission has put regulatory approvals on hold since the annexation of Crimea.

Against this background Brussels insiders doubt whether Europe would act decisively against Russia even if Putin did send his troops further into Ukraine. EU leaders announced back in March that they were formulating a third level of sanctions for this eventuality, but no specifics have been offered. “I’m afraid that European unity would only be forged in the event of direct aggression against a NATO or EU state,” says Steven Blockmans, a University of Amsterdam professor who heads the EU foreign policy unit at CEPS. “It’s a sobering thought that Europe could not unite in the face of Russia trampling on the international order, but I’m afraid it’s true.”

FOR THE MOMENT, PUTIN seems content to pursue war by other means, cheering on if not fomenting pro-Russian civil disobedience across eastern Ukraine and tightening his powerful economic screws on the rest of the country. “Moscow’s preference is to achieve its objective of destabilizing Ukraine without military force,” says Christopher Chivvis, a senior political scientist at Rand Corp. in Arlington, Virginia. “Putin would like to avoid the risk of level-three sanctions, though it’s not certain that the EU will get its act together.”

What Europe is to Russia economically, Russia is to Ukraine, only more so. Whereas Moscow entered the current crisis macroeconomically strong, with nearly $500 billion in central bank currency reserves and $170 billion stashed away in two national savings funds, Kiev limped into it barely breathing. The revolutionary government seized power with no visible means of repaying some $13 billion due to foreign creditors this year and next. It inherited a current-account deficit equal to 9 percent of GDP, a budget gap of 6.5 percent and reserves that cover a mere two months’ worth of imports, according to the IMF.

Ukraine has significant points of leverage against Russia, notably the fact that Moscow cannot cut the country’s natural-gas supply without freezing customers further along the pipeline, in the EU. Indeed, the Crimean peninsula depends on the Ukrainian mainland for all of its heat, power, water and transportation. Still, the balance of power, economically as well as militarily, is heavily tilted to Russia.

The West attempted to even the scales with two large gestures announced in March, but they fall short of a full commitment to bankroll Ukraine’s future. The IMF package, unveiled on March 27 and due to be approved by the Fund’s board by early May, includes a two-year standby arrangement for the Ukrainian government worth between $14 billion and $18 billion, depending on how other donors step up. That’s a substantial number, albeit a smaller one than the €28 billion the IMF has pledged to Greece, which has one quarter of Ukraine’s population.

Earlier in the month the EU outlined its own blueprint for pumping €11 billion into Ukraine over five years, although that number overstates the real policy response, as much of that aid is a continuation of existing programs. The spearhead of the EU effort is a commitment of €1 billion a year from the EBRD, which already was lending to Ukraine at a similar pace. The bank committed €934 million to the country in 2012. Going forward, the EBRD will focus on easing the pain of phasing out energy subsidies with efficiency-related investments and building a new competitive champion out of Ukraine’s underdeveloped agribusiness sector, says András Simor, the bank’s London-based vice president for policy. “Ukraine needs to go through the same processes as Central and Eastern Europe in the 1990s, diversifying from the Russian market by developing sectors that can compete in Europe,” he tells II.

The EU offered direct aid and loans to Ukraine of just €3 billion, with another €3 billion funneled through the European Investment Bank, which focuses on infrastructure development. The U.S. so far has put little money where its mouth is, offering Kiev only a $1 billion loan guarantee, which was held up for several weeks because the Obama administration tried to link it to a funding increase for the IMF that congressional Republicans had already rejected.

A CLICHÉD ANALOGY used to describe the cold war competition as a chess match. The cold peace descending on Eurasia might be better imagined as a poker game. Russia’s cards — its army, gas and deep financial pockets — are largely on the table and pretty strong. But Putin runs the risk that Europe and the U.S. can pull out a winning hand. Western sanctions that would constrict Russia’s financial oxygen in earnest would not be hard to design technically, though they would be challenging to enact politically. The Russian leader can gamble that the EU, which requires the approval of all of its 28 member states for such formal measures, is bluffing and push for bigger gains in the form of further dismemberment of Ukraine, even if that means military combat and bloodshed. Or he can gather the winnings he already has — namely, Crimea and verbal commitments by Kiev to decentralize power within Ukraine — and leave the table. “The EU is telling Putin that if he doesn’t go beyond Crimea, we can swallow it, but if he does go beyond Crimea, we cannot control the response,” says the Brussels think tank head.

Pragmatism would dictate that Putin cash in his chips with his popularity surge at home intact. Neither side has enough to gain in deeply troubled Ukraine to justify risking the profitable Russia-Europe symbiosis.

Yet the conflict could escalate beyond the bounds that hardheaded realism suggests, owing to clashing ideals and different understandings of recent history. To the West the post-Soviet decades have been an epoch of liberation, when free nations across the old Eastern bloc freely chose the twin blessings of European Union and North Atlantic Treaty Organization membership and lived in unprecedented security and prosperity as a result. If Russia has not gravitated toward the common house of Europe, that is the fault of some darkness within its leadership.

But Putin has made abundantly clear that he sees the post–cold war era in a very different light, one in which a weakened Russia has faced steady encroachment by an unprincipled and mendacious Western coalition with the U.S. as its ringleader. Russian media have harped on a series of broken promises, from former secretary of State James Baker III’s putative pledge not to expand NATO eastward if Russia acquiesced to the reunification of Germany in 1990 (which Baker has denied) to the abrogation of this year’s February 21 agreement on Ukraine, in which the EU assented to president Yanukovych’s staying in power until early elections. Yanukovych fled Kiev the next day. “They are constantly trying to sweep us into a corner because we have an independent position, because we maintain it and do not engage in hypocrisy,” Putin proclaimed in his Crimea victory speech. “But there is a limit to everything. If you push the spring too hard, it will recoil.”

These are not just Putin’s sentiments. They strike a deep chord in the Russian public, and any future leader is likely to tap the same emotional well, all the more so if the economy continues to disappoint. Even if the current crisis recedes following the Ukrainian elections, in which pragmatic tycoon Petro Poroshenko seems to be the favorite for president, Europe will sooner or later have to decide between appeasing or confronting an aggrieved Russia. The current asymmetrical engagement looks like just the first skirmish in an extended era of cold peace. • •

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