Vladimir Putin, Sanctions and the Ukraine

Roy C. Smith and Ingo Walter
 

Vladimir Putin, a martial arts enthusiast, must be an admirer of Muhammad Ali, master of the famed “rope-a-dope” strategy in boxing. Putin’s antics are a mirror image of Ali’s in-and-out style, but in a different arena. Annexation of territory, soldiers losing their way on somebody else’s property, cross-border artillery barrages, anti-aircraft missiles that aren’t there but leave 297 passengers blown out of the sky, solemn agreements unremembered after lunch.

Many observers think Putin’s strategy is working. The Obama Administration’s reliance on sanctions and world opinion seem too weak to derail Putin’s aggression - which suggests a tougher, military alternative that would fall largely on the US. But supplying and supporting the Ukrainians militarily in Russia’s back yard could easily lead to escalation.

Reliance on military involvement may well be unnecessary. In the long run, Putin’s actions are self-destructive on several important economic fronts that are likely to be powerful enough to moderate them sooner rather than later. Each relies on the disciplining force of economics and markets.

Despite Putin’s periodic interventions, Russia’s economy has become highly linked to the global economic and financial system - to the great benefit of the Russian people. Exports (mainly oil and gas) account for 43% of its GDP and more than 50 percent of its fiscal revenues. Rising oil prices and increasing global involvement enabled Russia to achieve an average annual GDP growth rate of 7.1% from 2004 to 2008 and attain prominence as an emerging market economy - something that was unthinkable a couple of decades ago. While Russia’s growth rate declined after the global financial crisis, like most other countries, it was still able to attract $94 billion in foreign direct investment in 2013. At the beginning of 2014, Russia even broke into Bloomberg’s list of the top 50 countries for doing business.

Putin’s bellicose initiatives have resulted in modest sanctions which, limited and recent as they are, have already had a significant effect on markets. Russian GDP growth in 2013 dropped to 1.3%, down from 4.8% in 2012, and is expected to be zero or less for 2014. The ruble and stock prices are down around 15% for the year, the 10-year Russian government bond, reflecting an increase in inflation to 7.5%, now yields 9.7%. Capital outflows exceeded $100 billion in the last year. Access to foreign financial markets, from which Russian banks have obtained the majority of their funding, has been denied and inward investment has effectively been brought to a halt. Oligarchs are getting their money out as best they can while Russian banks and industrial groups are repatriating theirs to avoid future sanctions.

New sanctions now being considered by the EU at America’s urging could limit non-contractual oil and gas sales and the use of the dollar and euro payments systems, as well as blocking access to funds held externally by Russians. In combination, these would substantially constrict the Russian economy and most likely drive it into recession.

Today’s financial reporting requirements and payments tracking technology make it very difficult to evade sanctions, and their enforcement by determined regulators is relatively simple - as was demonstrated in the recent $9 billion BNP Paribas settlement with the US government. Sanctions take time, but they can work.

Putin’s actions have frightened Russia’s most important customers. Already the EU is accelerating efforts to find alternative suppliers and sources of energy – Europeans may restart nuclear reactors, invest more in conservation or in fracturing, recommit to wind or solar sources, or import LNG from the US. Technology has increased their choice of practical alternatives, certainly over the longer term, and Putin has provided an excellent reason to move ahead with greater urgency.

Russia’s European customer base formed a steady, safe, lucrative and growing market for its energy exports. Now it will increasingly have to replace these customers with less dependable and less profitable markets elsewhere. Russia’s recent 30-year ($400 billion) deal with China is an example, but it will take years before shipments flow and much can change in the relationship between Russia and China over the life of the contract.

The Ukraine conflict began a year ago with a domestically popular effort by Kiev to link more closely to the EU in order to expand economic opportunity. It was halted by Ukrainian President Viktor Yanukovych apparently at the behest of Vladimir Putin, who did not want to “lose” the Ukraine to the West. Demonstrations on Maidan Square ended with Yanukovych’s forced departure and the formation of a new, much more westward leaning government that was soon opposed by Russian-backed separatists in the East.

When forced to choose between the kind of prosperity common in Poland and other Eastern European countries and reverting to political and economic subservience to Russia, it is not surprising that the majority of the Ukrainians selected Europe. Their willingness to endure hardship and violence to move in that direction may be surprising, but their actions did not go unnoticed by others in the Russian Federation, or within Russia itself.

Putin’s rope-a-dope tactics aimed at preserving the Russian sphere of influence appear to be popular in Russia, where national pride and honor have been revived. Russians have long suffered economic hardship in the past, but, having tasted prosperity, will they tolerate losing it? Could the next Ukrainian-style demonstrations happen in Red Square?

Over time, Putin’s actions threatens to isolate Russia from the world free-market economy, which operates on the basis of maximizing growth and opportunity. A retreat into a Soviet-style shell will have consequences he may not be able to endure for long. He needs a political solution that creates an effective “reset.”

Mr. Obama’s job is to keep his eye on the long-term prize – turning things around with Putin to get him back on-message in the global economy. Global economic pressures -- workable new tools of the 21^st Century that are preferable to Cold War saber rattling -- can be very powerful in helping to shape national behavior.