Russia sanctions and the EU: What went wrong?

In mid-September, the Obama administration and its European allies went further still with their sanctions.

Now Washington, Brussels and Moscow are stuck in a vicious circle, which has the 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 was offering de facto membership to Ukraine to limit Russia’s economic influence, to undermine Putin’s proposed Eurasian Union and to bring 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 US 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 US 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.

Sanctions debacle

Seen from Moscow, the West has betrayed its promises to Russia. So when Putin drew his red line in Ukraine, it reflected the views of most Russians – from Putin’s 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 broadened and deepened, that rating has soared to some 85-87 percent.

Without the sanctions, Putin’s rating might have declined to around 50 percent - 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 firmly behind its president.

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 US markets.

The 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 ailing Europe that has the most to lose in the sanctions scenario.

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 Schaeuble acknowledged that, amidst the Ukraine crisis, the growth of Europe’s largest economy has been stunted. This will further adversely affect the region’s weak recovery.

If the West tightens current sanctions incrementally, global economic prospects are still manageable. If the West takes the sanctions to still another level, the consequences could prove particularly severe in the key economies.

In Russia, that would test Putin’s popularity and turn the contraction into a more serious recession. In Europe, it could push the region into a triple-dip 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 no longer achieve their objectives, but could drastically diminish global economic prospects.

Sanctions must be replaced by a diplomatic solution. The time is running out.

The writer is the research director of international business at the India, China and America Institute (USA) and a visiting fellow at the Shanghai Institutes for International Studies (China) and EU Centre (Singapore)