Tuesday, November 25, 2014

Putin’s Dilemma

PARIS – Many critics argue that the sanctions imposed on Russia for its actions in Ukraine are ineffective, because they are too limited in scale and scope. Moreover, sanctions are seen as allowing President Vladimir Putin to blame the West for Russia’s internal problems. Indeed, some of Putin’s supporters within Russia welcome the sanctions as a means to compel Russian autarky – and thus strategic independence from the West.

These arguments are wrong. Though the sanctions are not backed by China, they are already having a powerful effect, and the expectation that they will be tightened further is a huge concern for investors and the Russian government. Full autarky, meanwhile, would imply a dramatic decline in Russian living standards – the foundation of Putin’s domestic support.

The latest sanctions are unprecedented. The European Union went even further than the United States. Exposure to Russian markets varies widely among EU countries – and between the EU and the US. But, after the downing of Malaysia Airlines Flight 17, Russia can no longer pursue a divide-and-rule strategy that leverages these differences.

Both the EU and the US have now sanctioned Russia’s highest officials and leading companies and banks. The EU list includes all of the main state-owned banks (the country’s largest). Most important, the EU added Sberbank, a cornerstone of Russia’s financial system, with assets totaling almost 30% of Russian GDP and about half of Russian retail deposits.

Currently, the sanctions only limit Sberbank’s access to European capital markets. In the immediate future, Sberbank – and other sanctioned banks – will be able to replace European funds with liquidity provided by the Central Bank of Russia (CBR) or Asian sources. But the fact that Sberbank is on the list has created enormous anxiety for all foreign investors in Russia.

They are right to be worried; Russia’s financial system is highly vulnerable. The banking sector’s total external debt is $214 billion, of which $107 billion is due within a year (and $129 billion within two years). Non-financial firms’ external debt totals $432 billion, with $128 billion due within a year (and $175 billion within two years). These are large numbers even for Russia, with its currency reserves of $480 billion.

Likewise, though the ban on exports to Russia of technology for the oil and gas sector holds no immediate implications for the Russian economy, over the course of the next few years, Russia will have to use Western technology to develop new oil fields. Otherwise, its oil output will stagnate or even fall, hitting the ruble and living standards hard.

Financial markets and Russia’s government understand the gravity of the medium-term risks. To avoid ruble depreciation and inflationary pressure, the CBR raised its benchmark interest rate to 8% (from 5.5% before the Crimea crisis). But this may not be enough, given that Russia’s recently introduced “counter-sanctions” – an embargo of food imports from the EU and the US – will contribute significantly to price growth.

Since January, Russian stocks have lost 16% of their value on the MSCI index, after already trading at a 50% discount in 2013, while Brazilian and Turkish equities are up by 13% and 27%, respectively. With MSCI now set to offer investors emerging-markets indices that exclude Russia, a massive sell-off of Russian stocks by index funds will drive down prices further. Indeed, the net capital outflow is expected to grow from $60 billion in 2013 to at least $100 billion dollars this year, with some estimates as high as $200 billion.

One consequence of all of this is that the government can no longer balance its books and has started to discuss spending cuts and new taxes, in particular a sales tax. Over the last ten years, the question has been whether to keep the existing 18% value-added tax or replace it with a sales tax. Now the debate is whether to introduce a sales tax on top of the VAT or to raise the VAT rate.

In addition, Finance Minister Anton Siluanov has said that the government must use this year’s pension contributions for projects in Crimea, while some highway construction has been postponed indefinitely. The government now says that it will expropriate next year’s pension contributions as well (Deputy Minister of Economic Development Sergei Belyakov was fired after publicly apologizing for the move). In a leaked letter, Deputy Prime Minister Arkady Dvorkovich explicitly acknowledged to Prime Minister Dmitri Medvedev the impossibility of fulfilling Putin’s spending promises, and proposed a radical revision of current fiscal plans.

Apparently, fear of even more serious economic troubles – for example, further capital flight when taxes are raised – has precluded an open invasion of eastern Ukraine. Russian leaders seem to understand that, despite rising support for “self-sufficiency,” autarky has never worked for Russia. Even in the Stalin era – when the economy was much more closed than in Czarist times – industrialization required the import of Western capital and knowhow.

More important, Putin’s popularity rests on historically high living standards. Annual household consumption is now double the level achieved in the Soviet Union’s dying days. Consumption growth has been driven largely by Russia’s integration into the global economy – and cannot be sustained without it.

The last generation of Soviet leaders well understood the importance of maintaining living standards, which is why they used revenues from oil and gas exports to import consumer goods. When oil prices collapsed in the mid-1980s, household consumption collapsed; soon after, so did the Soviet Union.

Today, though oil prices remain high, Russia’s budget and financial system face severe problems over the next 2-3 years. If the West introduces full-blown sanctions against the largest Russian banks – as the US has already done against relatively small banks – those problems may become insurmountable.

How will Russia’s government respond? Putin cannot afford to return to the pre-Crimean status quo, which would be viewed domestically as a major political defeat. This implies that sanctions will remain in place. But, having already deployed political repression, censorship, and propaganda, Putin’s tools for maintaining control as Russians’ living standards decline will be limited. The nature of that dilemma makes it impossible to predict what he will do next.

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    1. CommentedPierre Deruelle

      US and Nato are just bringing chaos through the world. The USA are a declining empire with no more perspective than making billions by stealing resources from.other countries. US conglomerates planned to steal natural resources from Siberia. Putin was absolutely right to kick them out of his country. The EU made a very dumb move to please the US in Ukraine. Ukraine can't live without Russia - ask to thep iron workers inDombass if they prefer to produce iron for Russia or if they prefer to close their manufactures to please IMF and european commissionners standards. Go home Yankees! For our dignity we don't need you, we don't want you in our lands.

    2. Commentedj. von Hettlingen

      Mr. Sergei Guriev, "Putin's dilemma" is whether to put his personal quest ahead of national interests! Should he invade Eastern Ukraine Russia would have to bear the brunt of international sanctions. Yet he is tempted to take advantage of the momentum the annexation of Crimea had generated by moving forward and grabing Eastern Ukraine. This would create a corridor to Crimea and allow Russia to have better access to the peninsula.
      While it's a matter of time that sanctions start to bite "Putin’s supporters within Russia welcome the sanctions as a means to compel Russian autarky – and thus strategic independence from the West". Apart from economic development, a strong state role, independent foreign policy and development of Russia's "unique civilisation", autarky was Putin's distant goal. Yet thanks to oil revenues, Russia had become a booming market for Western consumer goods. "Full autarky" means Russia's elite would have to give up high-end products from the West. "Putin’s popularity rests on historically high living standards", even for ordinary Russians.
      "Though the sanctions are not backed by China", Beijing may benefit from the "economic Cold War" between Russia and the West, as Moscow may turn to China to compensate the shortfalls. Beijing could strengthen its strategic partnership with Moscow to counter the Washington's "pivot" to Asia. Yet Putin still prefers to do business with the West, as Russia relies on "the import of Western capital and knowhow" to spearhead growth and development. Although it takes time to assess the damage Western sanctions imposed on Russia, its international standing suffers as a result of the bad press the whole crisis generates.
      For the first time EU sanctions target directly Russia's state finances, energy and arms sectors. These are sectors managed by the powerful elite in Putin's circle. They are now excluded from raising long-term loans and will find it hard to access US and EU capital markets. An asset freeze and travel ban mean people close to Putin will not be allowed to travel to and touch their bank accounts and sell their assets and property in the EU. Putin himself is not on the list, as Western leaders do not want to treat Russia as an international pariah and they still want to be able to meet him face-to-face. They may need Russian co-operation on a range of issues, including Iran and North Korea. Despite isolation Putin knows he is indispensable. So the "nature of that dilemma makes it impossible to predict what he will do next".

        CommentedDouglas Costello

        What point is there in having such a Russian Autarky when your capacity for trade and finance is restricted to the extent that it serves no purpose.

        This quest for a return to the historic Russian empire represents a disservice to the Russian people. Trade may pick up in the future but Russia will always be seen as unreliable and untrustworthy as a neighbour. China will be supportive as long as the outcome is favourable to themselves but that also is a two edged sword for them.

        Putin's dream is just that, a fantasy image of a powerful nation created by brute force and subjugation, we have seen in recent times that such nations or empires are unstable and disintegrate. The chances of this Autarky surviving post Putin is zero, the cost of it's existence is one I don;t think Russia can afford especially if Europe moves rapidly to be energy independent of Russian fossils. Russian economic integration into the Global economy is now being restricted and if this continues the future is grim and certainly nothing like North Korea but one where Russia has deliberately through its actions emasculated its economy for a geopolitical fantasy that was originally only achieved via conquest. The rest of the world i think is past seeing nations subsumed on such pretexts as put forward by Putin it doesn't contribute to world order.

        Reliance on China to cover the shortfall from the West weakens Russian independence they become a vassal state in short. Whether China would see a long term future linkage with Russia as being beneficial as they too need the West and internally China faces massive issues that the anti corruption drive is window dressing and a distraction for the West.

    3. CommentedCelt Darnell

      Yes, yes because Russia is a rotten structure that will collapse the second you kick the door in.

      That's what a certain Corsican artillery officer thought in the nineteenth century and an Austrian corporal thought in the twentieth century.

      You're like the Bourbons -- you forget nothing; you learn nothing.

    4. Commentedsandi pigg

      do you think Russia will not pull a strategic default on all of this debt as they move towards autarky,out of Europe's orbit and into the BRICS orbit...the bloc that already has its' own development bank that is larger than the world bank...the bloc that wishes to dump the dollar?

    5. Commentedsandi pigg

      You discuss autarky like it's a distant possibility. Kleptocraps lost conscience long ago. Should we spell it out? They're THIEVES. The have absolutely no regrets about what they've done and they will do the same in the future in order to secure their position in the world. BRICS will provide lost import/export opportunities. They have a lot more than just 480 billion in cash reserves. They also have gold and FX. Russia will not hesitate to default strategically,if they feel that it will boost BRICS and bring down the west. They are playing this pragmatically. Realpolitik. better wake up!

    6. CommentedNathan Weatherdon

      It is easy to understand that nations will want to be assured of some basic ability to self sufficiency given the fact that we are not yet confidence in an eternally peaceful future.

      However, the tradeoffs bring real costs. It is a standard part of indoctrination in training in economics to learn simple demonstrations of how autarky does not stack up well against trade. However, this does not mean that ever more and ever freer trade benefits all, or even many, people.

      Sanctions are a relative gains game, and theoretically they can only be effective in a relative sense if we hold some economic advantage, whether due to size, efficiency or other.

      Assuming this is the case, Russia is shooting itself in the foot, but in so doing, signals a willingness to do so if we return to containment.

      Knowing that Russia is willing to go down that road doesn't mean that we should immediately back off sanctions, but we should be exploring alternative strategies which do not lead down the road of containment, stalemate, and failure to exploit mutually beneficial gains.

      The current strategy makes it easy to make a bogeyman of the West. Putin and other top dogs will not take the blame. As has been observed time and time again, sanctions are more likely to reinforce the influence and domestic authority of the very people whose influence we explicitly wish to reduce.

      The current sanctions likely have greatest impacts on very wealthy, and few impacts on the population. Putin's sanctions are more likely to have negative impact wrt consumer prices of basic foodstuffs, but for a time they will buy it as necessary, and moreover this will stimulate employment in the rural economy.

      How do we all back down without losing face or being suggestive that any of what anyone did was OK?

      What started the revolution in Ukraine? Until there is a widely accepted answer to this question, I do not think there is a right and wrong. The president tilted towards Russia and decided not to sign the agreement to get closer with EU, in response to which other people revolted with backing of real guns and ammo, so far as to occupy Kiev and essentially hold the government hostage.

      Are we moving towards an East/West Ukraine, or will we force Ukraine to continue to play buffer between major powers? Perhaps, post-1991, the lines were drawn excessively in reflection of who "won" the Cold War. Long sober thought should be given to the levels of autonomy that local populations should be afforded in self determination, with explicit consideration of that historical analogy.

      Let us lead by example. Self determination of local populations is a real threat to Russia political oppression as a means of ensuring unity. But it will almost assuredly imply the return of many border areas into explicit Russian control or spheres of influence. Is it worth it? There is no need to answer that question definitively today, tomorrow, or even this year.

    7. CommentedAndrew Zimin

      Появление рубрики "юмор в коротких штанишках" не может не радовать.

    8. CommentedJim Nail

      Thanks for an excellent, thoughtful article. Have you considered the class implications of the recent import bans? I wonder whether Putin might be seeking a policy that will be divisive, setting his potential opposition (young, tech-savvy urban middle classes) at odds with his natural supporters (rural or heavy industrial workers, "lumpen" etc). Is this a factor, in your opinion?

    9. Commentedhari naidu

      Sanctions will impact Russia's integration into the global economy, as you argue, is central to medium and long term perspective. Putin may not understand the fundamentals of globalization, under WTO, but he has the political capacity to undermine (Russian) per capita GDP...and therefore create political backlash domestically. That's not in the interest of EU/US; Russia is a huge country; but can they and China simply watch Putin destroy Russian economy?