The implications of sanctions against Russia

On 29 July the European Union (EU) imposed so-called tier three sanctions against Russia. The real effect of these measures is only starting to be felt now, yet the implications are far deeper than many had imagined. At stake is not only Europe’s geopolitical and regional stability; businesses and individuals on both sides of the table are starting to feel the impact of sanctions as well.

Uncertain ground

The new round of sanctions imposed on Russia is in many respects unprecedented. The EU has restricted Russian banks' access to long-term loans, it has imposed an embargo on the export of dual-use equipment for military use, and it has banned the export of a wide range of items and technology related to the oil industry. The gas sector, however, has been left untouched so far. These measures go far beyond the visa-bans and assets freezes that were already in place against certain individuals involved in the destabilization of Ukraine.

But sanctions are also unprecedented for another reason: the EU had never before imposed economic sanctions against a country with which it shares so many commercial, energetic, and security ties. While the EU has had some experience - and some would even argue success - in the use of economic sanctions against Iran, this time it has entered into unchartered waters.  And few seem to have thought thoroughly through the consequences of these measures.

Far from forcing Putin to back down and put a break to his ambitions in Eastern Ukraine, sanctions have contributed to harden his position. Moreover, and even though unintended, they have sparked a nationalistic flare in Russia, with polls registering a spike in Putin's popularity. Yet while Putin rallies support at home, the EU and the US are unwilling to go back to business as usual with him after the traumatic redrawing of Europe's borders by an ever assertive Russia. Escalation has thus led to a political deadlock were neither Putin nor the West are willing to make unilateral concessions to solve the crisis. And given the unlikely prospect of a direct military confrontation between the two parts, a war of economic attrition seems the only scenario left. With a solution to the regional crisis slipping away, the coercive effect of sanctions is starting to be felt on both sides.

The economic costs of sanctions

Although no one knows for sure what the real cost of sanctions is, one thing is certain: they are imposing a huge economic burden on Russia. The flow of international investment into Russia has stalled, and the European Bank for Reconstruction and Development has frozen all new projects in the country. Moreover, Russian banks have seen their access to Western capital cut. This has increased the refinancing costs of banks, making it increasingly difficult for Russia to pay its debt and limiting the Kremlin’s capacity to invest and modernize infrastructure, especially in the extraction sector.

Furthermore, the rouble has kept falling against the dollar increasing the cost of imports. These difficulties add to the shortages of products in supermarkets caused by Putin’s ban on imports of food and agricultural products from the EU, which has backfired forcing businesses to struggle for substitutes in an underdeveloped domestic market. To make things worse, inflation is expected to soar in the coming year.

Yet the most daunting task Putin has yet to face is an uncertain future with increasingly low oil prices. With more than half of Russia’s revenues originating in the export of oil and gas, financing the budget deficit is likely to become challenging. Also, if prices remain low in the longer run, Russia is likely to have a bigger problem, as its economy is stagnating and its budgetary estimations are based on high oil and gas prices.

However, sanctions are having their toll in Europe as well. Most importantly, sanctions have generated an immense uncertainty amongst business circles. European firms are trying to make sense of the limitations and scope that sanctions impose on their commercial activities, including trade, investment and insurance operations with third parties operating in Ukraine and Russia. Due to the legal consequences that businesses could face in case of violation of sanctions, concerns have arisen regarding the extent to which it is possible to carry on with their regular activities.

Unfortunately, complying with sanctions is not a straightforward task. Besides the difficulties to understand what it is allowed and what is not due to a lack of clear regulatory provisions and national or European guidelines, other issues such as linguistic differences between EU and US provisions - i.e. concepts like "derivatives" mean different things in the US and the EU - posit further challenges for private companies. As a consequence, businesses are devoting increasing economic and human resources to make sure they comply with current EU and US legislation.

However, the biggest concern for EU policy-makers is the fear of Russian retaliation. Putin's ban on food and agricultural imports from the EU has already had a very negative impact on Southern European farmers. And whilst the European Commission has reacted swiftly by setting up a compensation fund to pay for export losses, new retaliatory sanctions are looming in the horizon that might generate bigger disruptions for European economies.

The most obvious concern for some EU member states relates to a potential cut of Russian gas supplies during the winter. Putin has warned EU countries and Ukraine that they could see the flow of gas stopped if the latter does not manage to pay its debts. Since the most important pipelines connecting Russia with EU countries cross Ukrainian territory, anxiety amongst member states that are heavily dependent on EU gas have grown.

But the Kremlin has also threatened to impose other countermeasures. First, it has insinuated that it could close its airspace to EU commercial flights. This would substantially increase the cost and duration of European flights to Asia, as airlines would have to divert to longer routes, consequently requiring larger amounts of fuel. And second, Putin has remained passive to a legislative action in the Russian Duma that would allow to nationalize foreign assets to pay for the losses of Russian companies.

The geopolitical implications of sanctions

Whilst the current deadlock between the West and Russia over Ukraine remains, other actors have taken advantage of the situation. Latin American countries have been keen to replace the EU's exports of food and agricultural produce following Putin's ban on EU imports and have ignored EU pledges not to do so.

Most strikingly, and even though the EU has managed to convince most of the countries on the path to EU membership to align themselves with its sanctions regime, Serbia has refused to do so, rolling out the red carpet for Putin's visit to Belgrade last week instead.

The EU's incapacity to convince its allies to support its sanctions regime has also been evident in Asia, where Japan has only imposed mild sanctions on Russia and where South Korea has refrained from imposing any measure whatsoever.

Yet the indisputable benefiter of Western sanctions has been China. Since the beginning of the crisis, China has played an ever important role, with Russia moving closer to its eastern neighbour. The relation between both countries has improved substantially in the last months, leading to a historic agreement on the construction of gas pipelines from Russia to China.

Regional tensions are also mounting in other parts of Europe, as the Swedish government has been involved in the chase of an (allegedly) Russian submarine in its territorial waters and as Russian spy planes have repeatedly violated Estonia's and Sweden's air space.

A way out?

The mutual trust that has been built between the West and Russia since the end of the Cold War has vanished. Undoubtedly, sanctions stand in the way to improving the relationship with the Kremlin, yet the EU is not willing to lift them without prior changes in Russia's behaviour. Sanctions are thus likely to remain in place for the foreseeable future, with all the uncertainty that this implies.

However, the political deadlock should not be read as a new version of the Cold War. Russia is now much more integrated into the world economy, it has become a member of the World Trade Organization and it largely depends on its exports of oil and gas to keep its economy afloat.

Moreover, it is questionable that Russia's new economic and political opening to Asia, and especially to China, constitutes a feasible long term alternative, as it will lead to an uncomfortable asymmetric relationship for the Kremlin. Whether this shift actually takes place remains to be seen, but it is more likely that Russia veers again towards Europe in the next few years.

The current uncertainty makes it hard to predict what will happen next or how long the conflict is likely to persist. The only thing that seems clear is that Crimea's annexation by Russia is now an irreversible process. Russia will struggle to find international recognition for its action, and the West is likely to keep sanctions against the peninsula in place until a solution is eventually found in the future. But for the time being, this is likely to become yet another frozen conflict in the heart of Europe.

While many questions remain unanswered, Western analysts are starting to accept that the standoff is going to last longer than initially expected. A solution to the crisis is however not impossible, but it will require huge doses of imagination, patience and, above all, time. As time passes and sanctions impose higher costs on both sides, incentives should emerge to normalize relations with the parts. The signing of a gas deal between Russia, Ukraine and the EU is a step in the right direction, yet it needs to be backed by a strong legal and political commitment by all parts. This could then lead to more compromises regarding the situation in Eastern Ukraine.

The EU’s ‘tougher’ sanctions against Russia must be used as a step toward greater engagement, not simply as a punishment

After months of discussions, EU leaders have finally agreed to impose the so-called “tier three” sanctions against Russia, which will target broad sectors of the Russian economy. Although this decision responds to the failure of repeated threats to deter Putin from supporting Pro-Russian rebels in eastern Ukraine, EU leaders only reached agreement after the commercial air carrier MH17 from Malaysia Airlines was allegedly shot down by the rebels.

Sanctions are expected to have an important economic cost for Russia, yet it is far from clear that this will automatically lead to a solution to the conflict. In fact, as happened with Iran, broad economic sanctions could also contribute to a further isolation of Russia. This would be highly detrimental to efforts to solve other problems worldwide, as Russia is still a key player in the United Nations and in the Mediterranean (e.g. with regard to issues like Syria).

It is also unclear whether Russia will yield to the pressure of sanctions. In fact, as the Sino-Russian meeting at the end of May showed, Putin is likely to turn to China to strengthen the economic ties with the Asian giant and to find alternative markets for Russian exports. This could undermine the effectiveness of sanctions in changing Russia’s stance towards the Ukrainian conflict.

Moreover, economic pain will not automatically translate into a change of Russian attitude. After all, Russia’s economic and security interests are not going to change in the short term. To make this point clear, the Kremlin has already threatened Ukraine with a food import ban if it ratifies the Association Agreement that it has already signed with the EU. A similar ban is likely to follow against EU fruit exports to Russia. Most worrying of all, EU and Ukrainian leaders can also expect an interruption of gas supplies to Europe this winter.

Nevertheless, economic sanctions might succeed in halting the flow of Russian arms over the Ukrainian border and in bringing an end to violence. As Jan Techau has argued, the only way of establishing a good relationship with Russia is by showing a firm position: ‘Weakness invites Russia’s disdain and aggression. Robustness creates a constructive atmosphere’. Hence, the failed Geneva talks in April might have been more successful if the threat of strong economic sanctions had accompanied the EU’s negotiating delegation.

However, the EU’s need to show resolve in its relationship with Russia points to another problem that looms on the horizon: how should the EU engage with Russia in the long term? Although sanctions might enhance the EU’s position in the current crisis and force Putin to the negotiating table, the EU needs to make clear what it expects from its eastern neighbour in the future and to design a strategy accordingly.

The EU cannot afford to repeat the mistakes of its accommodating approach to the Kremlin. This has not only failed to integrate Russia into the club of democratic nations of Europe; it has also contributed toward sustaining and strengthening an increasingly assertive, corrupt and repressive state that is willing to revise the existing sovereign order by force. Dealing with such a country will be difficult as long as the EU and its member states tolerate the authoritarian excesses of Putin.

Sanctions will strain the relationship with Russia even more. But they will also open new spaces for accommodating the interests and concerns of the two parts. The EU needs to use these opportunities to set clear and specific goals about its ambitions and expectations regarding Russia. In particular, it has to be certain that its relationship with the Kremlin can only improve if it is based on political reciprocity. This implies that the EU should be ready to back its words with economic coercion if necessary, but also that it should offer Russia incentives to co-operate.

Most importantly, the EU cannot continue expanding eastwards without expecting some political fallout in its relations with Russia. Although its promotion of Association Agreements with former Soviet countries responds to the latter’s sovereign desire to join the EU to foster economic growth and prosperity, the EU cannot simply ignore Realpolitik considerations when it proceeds with these agreements.

Finally, the EU has to reassess the possibilities of integrating its eastern neighbour into the legal and institutional framework of Europe. Change in Russia will only occur slowly and from within, but the EU can help by making its help and co-operation conditional on the achievement of specific targets. This could be achieved through the revival of existing institutional frameworks like the Organization for Security and Cooperation in Europe (OSCE).

Inevitably, the implementation of tier three sanctions is likely to occupy the minds of EU leaders in the foreseeable weeks. However, EU policy-makers would be wrong to conceive of these sanctions as a goal in themselves. Rather, they should start thinking of sanctions as a means to engage with Russia, and not simply as a punishment. Only in this way might sanctions be of help to address the “Russian problem”.

 

This article was first published at the LSE EUROPP blog on 30 July 2014

Will Eastern Ukraine become Crimea 2.0?

After weeks of speculations, the phantom of separatism in Ukraine is back. Heavily armed gunmen have stormed various official buildings in the main cities of the country’s east. The striking similitudes with the tensions experienced in Crimea in the last month are by no means coincidental. First, unidentified paramilitary troops have occupied several public buildings to then proclaim the independence of the region. At the same time arms depots are being stormed, weapons are distributed amongst the rebels and key strategic positions are being taken control of. Presumably, the next step will entail the call for a referendum on independence that will eventually lead parts of Eastern Ukraine to join the Russian Federation.

Whilst tensions in Eastern Ukraine rise, the rift between the West and Russia is also increasing. The last meeting of the UN Security Council resulted in an exchange of accusations between Western powers on the one hand, and Russia on the other. EU foreign ministers met to discuss the new crisis on Monday, while the US is increasing the tone of its discourse and has accused Russia of destabilizing Ukraine. In the meantime, Russia has warned the West that it is in its hands to avoid a civil war. In light of this, Ukraine seems yet again condemned to an imminent break-up of its territory.

Many observe the situation with perplexity and a feeling of impotence. What, if anything, can be done to avoid this crisis to escalate even further?

Somewhat disconcertingly, both the West and the government in Kiev have again been taken by surprise by the speed of the events, even though analysts have been speculating with the current scenario for weeks. Many in the West are reluctant to pursue a harder line against Russia due to fears of Russian retaliation. This is especially evident in countries like Germany, Hungary, Slovakia or Greece that are heavily dependent on Russian gas, but not so in Poland or the Baltic states who have instead opted for a firmer stance vis-à-vis Russia. Moscow is also successfully blackmailing the West, reminding it of its own inconsistencies in Iraq, Kosovo or Libya. The decisions made by the West in the past are thus backfiring in a crucial moment that requires proactive involvement and leadership, not remorse.

However, past mistakes should not stop the West from finding creative solutions to the crisis. In fact, the US and to a larger extent the EU can still contribute to a peaceful outcome, but this will require more than good faith. Most importantly, it will demand a clear roadmap that leads to an immediate de-escalation of the situation in the short term and to the stabilization of Ukraine in the longer run. And this, in turn, involves pragmatism towards Russia.

Yet de-escalation should not be confused with backing down. Indeed, the West’s reluctance to oppose Putin’s moves in Crimea has largely contributed to the current crisis. While the US has been keen to impose sanctions on Russian officials and entities, the EU’s response has been very mild so far. As could be expected, yesterday’s EU Foreign Affairs Council only agreed to add new names to the EU’s sanctions blacklists. Such strategy will hardly impose any costs on Russia, who is anyways willing to go further in its destabilization efforts. The West’s division and its symbolic response to Russian expansionism are sending an unmistakeable message to Putin, who is currently putting the West under a new stress test.

Paradoxically as it might be though, de-escalation might only be achieved through a combination of carrots and sticks. Sanctioning Russia without offering it any incentive to solve the current crisis is, simply put, a waste of time. Conversely, buying time for negotiations while imposing symbolic yet ineffective sanctions such as visa bans and assets freezes won’t do the trick either. In fact, these measures might simply look absurd and obsolete when the foreign ministers of the US, Russia, Ukraine and Catherine Ashton meet this Thursday in Geneva.

The West needs to understand that the stakes are high for Russia and that any coercive act will lead nowhere unless the concerns of Moscow are taken into consideration. Yet at the same time it needs to accept that the only way of negotiating with Putin is by levelling the playing field. This implies two things. First, the US and the EU need to get Russia on the negotiation table and make sure that it is part of the solution, not the problem. Although many would like to leave Russia out of the equation, this is neither possible, nor desirable. At the same time, the West needs to tell Putin that not playing along will have severe economic and political costs for Russia.

Finally, de-escalation will entail a huge diplomatic effort to make sure that Russia takes part and actively supports the elections of the 25^th of May. After all, only a newly elected government can claim the legitimacy that the acting Ukrainian government lacks. Ideally, the elections should be supervised by the Organization for Security and Cooperation in Europe (OSCE) – that is, with Russia on board – and give way to a government of national unity to avoid exclusionary politics. In turn, the new government should commit to respect the rights of Russian and other minorities, promote decentralization and grant more autonomy to certain regions and, most importantly, generate economic growth and political stability. EU financial assistance could be a stepping stone in this direction.

However, the 25^th of May is still far away. Until then, the situation could deteriorate quickly and Eastern Ukraine could become Crimea 2.0. Whether this will be the case will largely depend on the West’s capacity to act swiftly and convincingly to anticipate Putin’s moves and take the diplomatic initiative. Unfortunately, time is not on the West’s side.