Ludwig von Mises Institute

The situation in Ukraine is at a crossroads after a four-month-long deadlock between Ukrainian protestors and Viktor Yanukovych's government that has degenerated into an international conflict between the US –EU block and Russia. It has been called the Cold War 2.0 and it is now endangering the territorial integrity of Ukraine and the status quo in Europe.

Putin’s Russia appears to have the upper hand after its annexation of Crimea whereas Western countries have opted for deescalating policies. In consequence, many analysts stated that Putin considers these diplomatic responses as weakness that encourages his imperialist endeavour to force Ukraine into a satellite status.^¹ Putin, a former KGB officer during the Cold War, understands Ukraine as a fundamental element in his plans to create the Eurasian Economic Union, a trading bloc to rival the EU as well as a key step to recover the lost Russian greatness and increase his regional influence.

Ukraine’s situation has been identified by Putin as a great opportunity to implement his Great Russia Doctrine. A vision that seems to have recovered some elements of the Brézhnev Doctrine to maintain satellite countries under its control aiming at restoring Russia’s dominance and becoming a major international actor. Nevertheless, Putin’s imperialist plans have a considerable flaw: Russia is an oil-dependent state with weak institutions that has failed to develop its economy and has become too dependent on international markets. Putin certainly is in a Cold War 2.0 mentality, however, Russia is no longer the Soviet Union and the world is thoroughly interdependent.

Vladimir Putin has enjoyed great public support since he first came into power in 1999 for he impersonated the stability and economic recovery that Russia experienced after the misery derived from the collapse of the Soviet Union. It was with Putin that Russian economy started growing as fast as Brazil, India or China as it was with Putin that Russia commenced to regain its role as a major international actor. Many Russians believed that these achievements were due to Putin instead of with him. Also a number of analysts confused correlation with causality. The Russian economic resurgence has been sustained on the increase of prices of mineral fuels, which account for 71.6% of total exports, and of oil in particular as it has quintupled since Putin became President. (See figure 1)

The soaring revenues obtained from oil and gas exports were not reinvested in the necessary modernization of the soviet productive structure though. Instead of using the natural resources to develop new industries and renovating out-dated structures, Putin used them to buy loyalties and, as a result, turned Russia into a petrostate ruled by oligarchs, affected by rampant corruption and highly inefficient industries. Putin’s kleptocratic Russia fell in a sort of Dutch disease^² and became largely dependent on external shocks.

In fact, Russia is more dependent on oil and gas prices than in the 80’s as these exports represent 75% of the total, 8% higher than in 1980. Moreover, in 2005 Russia was able to balance the budget if oil price was around $20 a barrel; in 2013 it was necessary a price of $103. Now it is at $105 and it is reasonable to predict that prices will considerably fall in the next years due to the increase of fracking. Furthermore, under Russian crony capitalist system state-controlled corporations command the economy and 45% of consumed goods are imported.^³ However, this should not be surprising if one bears in mind that average labour productivity in Russia is 17% of the US level. Despite economic growth, Russian industrial production has stagnated or even dropped in the last decade due to highly ineffective business processes and inefficient labour organization as well as the generalized use of out-dated technology derived of the abundance of soviet relics.^⁴

According to the World Bank, Russian economic growth slowed down in 2013 to 1.3% from a 3.4% increase in 2012 as a result of “Russia’s high dependence on oil and gas exports and with it, its exposure to commodity-price volatility” as well as due to structural challenges, such as remaining non-competitive sectors, as the economy seems to operate close to its current capacity limit.^⁵ Feeble economic growth potential comes also as result of the slow down of non-tradable sectors during 2013, like financial services and communications, for those are not compensating anymore for the continuous deteriorating industrial performance. Soaring oil revenues allowed Putin to fuel permanent public wages increases and large investment projects that hid the lack of growth-supporting reforms. Nevertheless, the consequences of Putin’s intervention in Ukraine unveiled the flaws of this economic model and investors’ sentiment is deteriorating as uncertainty grows.^⁶

In fact, the Russian intervention in Crimea has generated significant reactions in investors all over the world: on March 3rd, while European and American markets suffered small losses of around 2-3% and 1% respectively, the consequences at the Moscow Exchange have been enormous. Early fears proved to be right, resulting in a fall of 11,2% of MICEX Index and of 12,8% for the relevant index RTS, a free-float capitalization-weighted index expressed in Dollars and including 50 Russian stocks traded in Moscow. The overall loss this day including all indexes was around the 10,8%, corresponding to the amount of $60 billions. Since the onset of the conflict MICEX has plunged around 15%. This market volatility has also lead to a surge in Russian borrowing costs. The World Bank expects net capital outflows will accelerate during 2014 as a result of political uncertainty, leading to a capital account deficit within the range of US$ 68.0 billion and US$133.0 billion.^⁷ (See figure 2 & 3)

On the same day, the Ruble reached its all time lowest value against the Dollar and the Euro forcing the intervention of the Russian Central Bank that had to burn $12 billion of its reserves to limit the fluctuation.^⁸ With a press release on March 3rd, the Board of Directors of the Bank of Russia announced a 150 basis points increase in the Key Lending Rate, from 5,5% to 7%, to “prevent the risks for inflation and financial stability” arising from the fall in the national currency.^⁹ This measure was announced as temporary but on March 14th the Board of Directors of the Russian Central Bank stated that the Key Rate will be maintained at its actual level of 7% in the coming months to impede the effect of exchange rate dynamics on inflation and to maintain financial stability. The Board of Directors also admitted that this measure will further slow down growth.^¹⁰ In a situation in which the only driving force of growth is consumer demand, which the Bank describes as “deteriorating”, the rise in the interest rate hides a serious concern of the authorities regarding the possibility of uncontrolled inflation growth. (Figure 4)

Furthermore, on March 3rd the two giants of Russian economy, Gazprom and Sberbank each lost respectively 10,7% and 9,8%, which resulted in a loss of $15 billions for Gazprom, the main gas supplier to the EU and with pipeline pass through Ukraine. In the following days, Moscow Stock Exchange showed some recovery, mostly due to investors’ confidence that the crisis was going to be solved soon through diplomatic means, with RTS Index recovering almost half of its value.^¹¹ Nevertheless, the second week that followed the intervention in Ukraine has been even worse than the investors’ first reaction as both indexes lost all the partial recovery and even more, reaching their lowest values since 2009. The more the deadlock lasts, the more unstable the situation for Russian markets.

Despite the losses in Russian markets, the EU might seem to be in the weakest position for Russia is the main gas supplier to many of its Member States (being especially important the dependence of Germany), while the US is advancing towards energy independency due to the fracking revolution. Nevertheless, the situation is quite different than in the past, when the closure of Ukrainian pipelines during winter could seriously threaten EU countries. Russia holds in its territory the largest natural gas reserves of the world, 65% of which are directly controlled by Gazprom, which also has a monopoly for gas exports. The EU accounted in 2013 76% of the total Russian natural gas exports (figures 5, 6, 7 and 8).^¹² Trade flows between the EU and Russia encompass many other goods as Russia is the third trading partner of the EU and the EU is the first trading partner of Russia.^¹³ (figure 9 and 10) Moreover, some 65% of Foreign Direct Investment stocks in Russia come from the EU Member States as 23% of European Foreign Direct Investment goes to Russia.^¹⁴

As a result of the gas crises of 2006 and 2009, the EU has been trying to reduce its excessive dependence on Russian oil and gas supply by finding alternative providers, such as Norway and Algeria, and increasing its gas storage capacity in order to gain more bargaining power against Russia in case of a new gas crisis. Moreover, the EU internal gas market has been further integrated and prepared to deal with external shocks with additional gas interconnectors, reverse flow capacities and LNG facilities.^¹⁵ In fact, Russian recent actions are boosting these efforts to reduce EU dependence on Russian supply. For instance, the EU blocked on March 12th the two big Russian pipeline projects that where supposed to increase Russian gas export in Europe. EU Energy Commissioner, Gunther Oettinger, stated that talks related to the South Steam pipelines are going to be delayed, meanwhile the Commission slowed the procedure for Gazprom to be able to access the pipelines that pass through Czech Republic and Germany, further damaging the unstable present situation of the Russian giant. ^¹⁶ These actions may look too weak than what could be expected by the European Union, but they represent another step towards a reduction in the dependence of Russian supply.

Getting rid of Russian intimidation will not be easy nor cheap but the EU certainly has the possibility of developing alternatives in the medium and long-term, especially if the US decides to invest in LNG export facilities and lift the ban on crude-oil exports. Some even argue that replacing natural gas imports from Russia within a year would be possible.^¹⁷ Russia seems to have fewer alternatives though since most of its export capacities for gas are directed to the EU and there is a lack of major supply routes to Asia. There is no plan B to redirect gas exports for Russia in case of an EU blockade in the short or medium run as the new facilities in Eastern Siberia and Far East regions will not be operative earlier than 2021.^¹⁸(figure 10)

Gazprom is trying to increase its integration in the Asian market and in particular with China since, as shown by Gazprom, both seem to have a lot to gain by increasing gas flows through the Chinese Wall. In Moscow this is seen as a big opportunity to diversify its exports and to foster the investment in the Eastern regions of Siberia, where gas reserves are still not fully utilized. This would also benefit China, where the problem of meeting the increasing demand for energy and the alarming environmental situation might be relieved through Russian pipelines.^¹⁹ This increased integration with China may be seen by Putin as a tool to reduce the impact of international sanctions and isolation. However, even though the Asian market has a great potential for Russian exports, Russian infrastructures are not ready and it arrives already too late to the Chinese gas market.^²⁰ China is already importing cheaper gas from Turkmenistan and has already built pipeline connections leading to Central Asia and Myanmar.

Despite boosting its efforts, the EU remains largely dependent of Gazprom’s supply, thus being highly liable to Russian extortion, a great defect for a major international actor. The problem for Putin is that Russia is even more dependent on oil and gas exports revenues to the EU. Therefore, it seems unlikely that Putin will close the pipelines towards the EU. Shutting down the supply will hurt European economies but it will probably damage even more Gazprom, that has already lost more than 11% of its capitalization since the beginning of the crisis, and the whole Russian economy. In addition, it might further worsen Russian credibility as a reliable gas supplier and boost EU efforts to find alternative suppliers.^²¹

It is impossible to forecast the limits of Putin’s intentions in Ukraine even if Barack Obama’s wise soft response still allows him to save Russia’s face. However, EU leaders cannot fail to understand the importance of this opportunity to find alternative suppliers to reduce their exposure to Putin’s extortion. Despite its considerable limitations, the EU has taken important steps towards becoming a global actor since the entry into force of the Treaty of Lisbon in 2009 but its energy dependence on Russian supply will prevent the EU from playing a greater role even in its backyard. A major international actor cannot be so exposed to its main regional rival’s most important geopolitical weapon. Developing a real EU energy policy and an integrated internal energy market are crucial for the EU to become a global actor and to balance the flaws derived from the political nature of the EU.

The loss of income caused by the shut down of supply in 2006 and 2009 was not an obstacle for Putin then, but the situation now seems very different with a Russian economy suffering stagnant growth, high inflation and a weak currency. Indeed, in 2013, while other economies were starting the recovery from the crisis, Russian economic growth reduced two fold. It is true that due to the different political nature of the EU and Russia, it seems that Russian leaders could bear more economic pain than their EU counterparts, who have to face elections and might feel higher risk aversion now that the EU appears to be in the path of economic recovery. Nevertheless, Russian oligarchs might get tired of the high costs of this expensive nationalistic endeavour now that the hobbled Russian economy is running close to its potential and it does not seem certain anymore that Putin will be able to keep buying their loyalties. Unfortunately for Putin, his geopolitical ambitions are not matched by a powerful economy. Russia’s economy size is equivalent to Italy’s GDP, it is one-eighth of US’ GDP and a quarter of Chinese GDP. Meanwhile Putin actions are pushing the EU and the US towards new policies that will considerably reduce Putin’s main geopolitical lever.

Written by Jesús Elguea Palacios and Alberto Mazzon

Figure 1, historical Europe brent and Russian natural gas prices: