Tuesday, September 30, 2014
8

Putin’s Imperial Road to Economic Ruin

PARIS – The debate around Crimea is no longer centered on international law: Russian President Vladimir Putin has publicly recognized that he does not feel bound by it and does not care if the rest of the world deems Russia’s actions illegal. What is not clear is whether Russia’s economy can bear the burden of Putin’s objectives in Ukraine.

Regardless of the West’s response to the Crimean crisis, the economic damage to Russia will be vast. First, there are the direct costs of military operations and of supporting the Crimean regime and its woefully inefficient economy (which has been heavily subsidized by Ukraine’s government for years.) Given the uncertainty surrounding Crimea’s future status, these costs are difficult to estimate, though they are most likely to total several billion dollars per year.

A direct cost of this magnitude amounts to less than 0.5% of Russia’s GDP. While not trivial, Russia can afford it. Russia just spent $50 billion dollars on the Sochi Olympics and plans to spend even more for the 2018 World Cup. It was prepared to lend $15 billion to former Ukrainian President Viktor Yanukovych’s government and to provide $8 billion annually in gas subsidies.

Then there are the costs related to the impact of sanctions on trade and investment. Though the scope of the sanctions remains uncertain, the effect could be enormous. Annual inward foreign direct investment is estimated to have reached $80 billion in 2013. A significant decline in FDI – which brings not only money but also modern technology and managerial skills – would hit Russia’s long-term economic growth hard. And denying Russian banks and firms access to the US (and possibly European) banking system – the harshest sanction applied to Iran – would have a devastating impact.

In the short run, however, it is trade that matters much more than investment. Russia’s annual exports (mostly oil, gas, and other commodities) are worth almost $600 billion, while annual imports total almost $500 billion. Any non-trivial trade sanctions (including sanctions on Russian financial institutions) would be much more painful than the direct cost of subsidizing Crimea. Of course, sanctions would hurt Russia’s trading partners, too. But Russia’s dependence on trade with the West is certainly much larger than vice versa.

Moreover, the most important source of potential damage to Russia’s economy lies elsewhere. Russian and foreign businesses have always been worried about the unpredictability of the country’s political leadership. Lack of confidence in Russian policymaking is the main reason for capital flight, low domestic asset prices, declining investment, and an economic slowdown that the Crimea crisis will almost certainly cause to accelerate.

Indeed, Russia’s response to events in Ukraine has exceeded the worst expectations of those who were already questioning whether Putin is, as German Chancellor Angela Merkel put it, “in touch with reality.” The move to annex Crimea has reversed any soft-power benefit that Putin might have gained from the Sochi Olympics and the pardons he granted (as recently as December) to imprisoned opponents like Mikhail Khodorkovsky and the members of Pussy Riot.

The sacrifice of these gains suggests that the Crimea adventure was not part of long-considered plan. On the contrary, since the crisis began, Russia’s leaders have repeatedly contradicted their previous statements, backtracked, reversed decisions, and denied easily verifiable facts. All of this indicates that Russian political leaders have no strategy and do not foresee the consequences of their decisions. Even the Kremlin’s own supporters acknowledge that Putin “is improvising.

It is also clear that the decisions to violate international law, despite the risk of economic isolation, were made in an ad hoc fashion by Putin’s innermost circle. For example, Valentina Matviyenko, the chairwoman of the Federation Council (the parliament’s upper house), announced that Russia would not send troops to Ukraine – just two days before she and the Council voted unanimously to authorize Putin to do precisely that. And Matviyenko is one of the 12 permanent members of Russia’s National Security Council, the supreme decision-making authority on such matters.

Regardless of whether the Kremlin is irrational or simply uninformed, its policy in Crimea sends an unmistakable signal to investors: Russia’s political leaders are impossible to predict. This will further undermine Russian and foreign investors’ confidence and increase capital flight, which could not come at a worse time. With credit-fueled consumer spending – the engine driving GDP growth since 2010 – now running out of steam, the economy is stagnating.

Meanwhile, investment is still below its 2008 peak. Despite a wealth of opportunities across the Russian economy, the country’s hostile business climate – including bloated bureaucracies, widespread corruption, and the expansion of state-owned companies – has weakened Russian and foreign investors’ incentive to start new projects or expand existing ones. The realization that Putin has entered, to quote Merkel again, “another world” will only make matters worse.

Will Russians notice the economic costs of the Kremlin’s irrationality? GDP growth has already slowed and may turn negative. The stock market has already fallen sharply and may fall further. Of course, equity ownership in Russia is narrow; most Russians do not even follow market indices. But increased capital flight will also affect something that ordinary Russians know and care about: the ruble’s exchange rate.

On the Monday after Putin’s Crimea adventure began, the Central Bank of Russia reportedly spent $11.3 billion to prop up the ruble. Such support is clearly unsustainable; in fact, the CBR recently announced that it will allow the ruble to float, implying an exchange rate that reflects the market’s expectations concerning oil prices and future capital outflows.

Thus, worries about a Putin who has “lost touch with reality” imply not only a lower (or even negative) GDP growth rate, but also – and more immediately – a weaker currency, driving up prices of imported consumer goods. All Russians will soon feel the effects; whether that will bring their president back from his world to this one is another matter.

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  1. CommentedKhalid Aziz

    Putin planned his Munich very adroitly but then anything done by force comes back to haunt the perpetrator. People in power are on a high and they are more concerned with the image that they wish to have in their own mind rather than the value of an act. The Russian purpose would have been better served through international diplomacy. By the way what about the 3 new gas fields that have been discovered about 2 years ago off the south of Crimea?

  2. CommentedCarol Maczinsky

    Where is the sense ot realpolitique. Russia gets Crimea and loses Ukrainian influence, that is the deal.

  3. Commentedhari naidu

    The Crimean plebiscite will fetch +80% of the vote cast and will eventually allow it to cede from Ukraine. That’s is why Lavrov was not allowed by Putin to discuss with Kerry (in London) any form of diplomatic resolution of the Crimean crisis. Putin must’ve been confident of the plebiscite; otherwise he’d not have rolled the dice in the direction of renewed *cold war*. However, at the end of this process, Russian Duma will be legally obliged to vote and ratify the formal cession of Crimea….

    The rest of the world has expressed its opposition in UNSC vote – Russia vetoed it - China abstained and spoke openly about the violation of UN Charter and national sovereignty and territorial integrity of Ukraine. It’s significant that (emerging) China has finally voted its political conscience principally because of its political implication to Central Asian Republics (Uzbekistan, Kazakhstan, Kyrgyzstan and Tajikistan). Central Asia (CIS) represent the buffer zone between mainland China and Russia…and there are outstanding historical territorial claims from Chinese side against Russia.

    IMHO in spite of draconian sanctions and whatnot, the West will not deliver Crimea back to Ukraine. It’ll become a fait accompli. However not de jure but de facto.

    Iran, Syria and Palestine will remain on the table and Russian acquiescence will be fundamental to finalize any deal, at all. Will Putin deal after Crimea?

  4. Commentedshanmugham anand

    Putin is playing the same game in Crimea, which the west is playing in Ukraine. It appears Russia is reconciled to its loss of sphere of influence in Ukraine, but yet gain in the short term by annexing Crimea. European History in the last 25 years has shown East European Countries have joined European Mainstream only after democratic revolutions. Time has come for Russians to choose whether the transition is to be smooth or at a cost.

  5. Commentedj. von Hettlingen

    Mr. Guriev asks: "What is not clear is whether Russia’s economy can bear the burden of Putin’s objectives in Ukraine". President Putin is confident that Russia would get over any sanctions and persevere. He is willing to accept that "the economic damage to Russia will be vast". Then he knows well life in the past had never been easy for ordinary Russians except for a tiny elite. He had brought them prosperity and stabilty in the last 10 years. Now he expects them to make sacrifice, for the sake of recapturing a small piece of land.
    No doubt "direct costs of military operations and of supporting the Crimean regime and its woefully inefficient economy" would be very high, yet Putin sees an incorporation of Crimea into the Russian Federation as something historic, which he can't miss. He is correcting a mistake, made 60 years ago and wants to go down in history as a restorer of the old order. The Russian soul is awakening and he he can't be logical and rational. He has to defend his quest tooth and nail. No wonder Chancellor Angela Merkel queations whether Putin is "in touch with reality".
    It is notorious that Putin and his innermost circle forge Russia's destiny. The turmoil in Ukraine had taken many of them by surprise. Putin has since then adopted Napoleon's principle: "On s'engage, et puis, on voit". He acts and takes things as they come. This reckless behaviour would be tolerable, if Putin ran a family business. But he is running a country and putting its people's welware and the economy at risk.

  6. CommentedMK Anon

    Sanctions? What sanctions? Some of the kind of those that were used after the abkhasia and north Ossetia events?
    There is one truth here: the west is addicted to russian oil and gas. There will be no sanction that will last longer than next winter. Western europe's production of consumer good is highly energy intensive. Europe's industry would be totally uncompetitive if gas price doubled. It's actually germany who was on another planet when they decided to give up their nuclear power. Let's not forget that in mulitpolar world, with big players like the BRICS, Europe and the US can be passed by. Iran didn't care much about the sanctions - until china and russia enforced them..

    Putin knows all this very well. He is not hesitant in the steps he takes (unlike the west about Syria for exemple). He knows he can retailiate both military and economic sanctions.
    Pr. Guriev is right, FDI will certainly drop, the ruble will fall further, and growth prospects are lower.. but these are issues he will leave for others taking power after him.. However, I don't think the alarmist tune of the article is right and an economc crisis is at the next corner in Russia.

  7. CommentedAdrien HARTEMANN

    Saying that the Kremlin is irrational just show to what extent the West can't get the Russian's thought. Putin is backed by his public opinion, and his gamble appear as beiing a success because of the unability of Europe and the US to understand that what is at stake in Crimea isn't economic at all but geopolitic and diplomatic. And on that matters, Putin won, even if the western media continue their Putin's bashing whatever he could do. Moreover, if Europe isn't able to show a common position into the resolution of its own eonomic failure, thinking that they'll succeed into taking economic sanctions against one of their main supplier in gas ressources and an important partner of the City is a myth.

  8. CommentedJames Edwards

    Valentina Matviyenko, the chairwoman of the Federation Council (the parliament’s upper house), announced that Russia would not send troops to Ukraine – just two days before she and the Council voted unanimously to authorize Putin to do precisely that.
    It should be noted that Putin put pressure in order to exact what he wanted. Using the chaos to justify it when the fact remains that it is the pro Russians are instigating it.
    Over time, Russia's economy will continued to fall behind as sanctions ratches up. From what I heard many in Crimea feel that things will get better if they are part of Russia neglecting the fact it is being subsidized for years and war has begun against anyone who opposes the referendum slated for 3/16.

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