Calm before the storm as Europe poised to join economic war

The author of the Daily Telegraph essay exaggerates the 'danger' for journalistic effect. As we've noted before, Russia is weak. Russia was similarly weak in the late 19th Century, but could always compensate with manpower. Today, it cannot. 

If Putin insists on fighting Ukraine the Russian populace won't unconditionally back his losses and the unavoidable decline in economic prosperity. He is not Tsar Alexander III nor are his people the economic or military slaves of Tsarist Russia. They want better lives. 

If we supply the Ukrainians and keep up the pressure on the Russian economy Putin will back off or go down for it. In his heart Putin knows it too. 

The Daily Telegraph 25 July 2014   [with my italicisation added]
 
Calm before the storm as Europe poised to join economic war 

By Ambrose Evans-Pritchard Last updated: July 25^th, 2014

Russia is battening down the hatches. The central bank was forced to raise interest rates this morning to 8pc to defend the rouble and stem capital flight, $75bn so far this year and clearly picking up again.

The strange calm on the Russian markets is starting to break as investors mull the awful possibility that Europe will impose sanctions after all, shutting Russian banks out of global finance.

Yields on 10-year rouble bonds jumped to 9.15pc, the highest since the emerging market "taper tantrum" last year. The cost of insuring against a Russian default through CDS contracts surged by 17 points to 225. The MICEX index of equities fell to a three-month low.

Lars Christensen from Danske Bank said the inflexion point will come if the EU does in fact impose “Tier III” measures aimed at crippling the Russian banking system, as now seems likely. “That is when the lights will turn off for the Russian market. We will see face capital flight of a whole different nature,” he said.

This moment of reckoning is suddenly drawing closer. The EU’s 28 ambassadors met for a second day this morning to grapple with draconian proposals put forward by the European Commission.

They appear to have reached broad agreement. A cell at the Commission will draw up the legal acts over the weekend.

There will be haggling over compensation for those on the front line when the package goes to foreign ministers for final ratification early next week. The sanctions may yet unravel. But the message from diplomats this morning was that even Cyprus, Bulgaria, and Hungary seem to be acquiescing, however reluctantly.

There is no longer a rift between Britain and Germany. The two powers are working in tandem, backed by the Dutch, Swedes, Danes, Poles and Baltic states. The French are not as dovish as might have been inferred from the debacle over Mistral warships sale to Russia, seen in Paris as a painful embarrassment.

It would be foolish for anybody to assume that little will come of these sanctions. Drastic action is now more likely than not, yet if it happens the implications are explosive. We are at a dangerous juncture.

The proposed sanctions will target both the debt and equity of Russia’s major banks, effectively severing access to global capital markets. It also targets the technology for drilling in the Arctic and for opening up the Bazhenov shale basin, both needed to replace Russia’s depleting oil reserves.

Russia has a lot of gas, but gas trades at an oil-equivalent price of $60 a barrel in Europe. It is not very profitable. Analysts suspect that Gazprom’s pipeline deal with China is at or below the break-even cost of production, assuming it ever happens.

The International Energy Agency says Russia needs $750bn of fresh investment over the next 20 years just to stop oil and gas output declining. This has already become unthinkable. Who is going to wager so much money, for such questionable returns, in the face of so much political risk?

Russia’s $478bn reserves (less if you deduct swaps) are not as large as they look. The central bank burned through $200bn of reserves in six weeks after the Lehman crisis in late 2008, before abandoning FX intervention as a hopelessly misguided.

The reserves proved a Maginot Line in any case. Deployment entailed automatic monetary tightening, causing a collapse of the Russian money supply and drastic fall in GDP (from which Russia has never really recovered).

The latest central bank data shows that Russian companies, banks, and state entities owe $721bn in foreign currencies, mostly dollars. Roughly $10bn must be rolled over each month. The oil group Rosneft must repay $26bn by December next year, with peak refinancing this winter.

You might think that with so much at risk, the Kremlin would seek to cut its losses in eastern Ukraine, but that is to misunderstand the elemental nature of this battle, and all the evidence points the other way in any case.

Mr Putin’s proxy forces are continuing to shoot down Ukrainian aircraft at a rate of one or two a day in systematic effort to ground the Ukrainian air force, even since the Malaysia Airlines disaster. Some 20 aeroplanes and helicopters have been shot down.

Nor are they merely proxy forces any more. Convoys of heavy artillery, rocket launchers, and T64 tanks have been flowing to Novorossiya and the Donetsk People’s Republic across a border that has already ceased to exist.

The region is already a military department of the Russian Federation in all but name. The Cossacks and rebel militias are already integrated units of the Russian armed forces, under Russian military officers, as is all too clear from the intercepts released after the air crash.

The rebel leaders are mostly Russian citizens, either from the old KGB, the FSB, or the GRU. Alexander Borodai, the head of the Donetsk People’s Republic, is a political operative from Moscow.

The whole of Nato knows this movement is a Kremlin front. The White House knows this. Every European diplomat in Kiev knows this. The Russian invasion of eastern Ukraine has in a sense already occurred.

It seems highly unlikely that Mr Putin will now let Kiev crush the rebellion. The resisters are already vowing a “second Stalingrad”, a block by block defence of Donetsk.

It is equally unlikely that Mr Putin will accept a pro-Western sovereign Ukraine that has entirely slipped Russian control. If there is near consensus about anything in Russia – from top to bottom of the society – it is that the Russian people were victims of their own Versailles injustice and enforced diaspora at the end of the Cold War and are now victims of another Western plot. Whether or not you think this view of the world border has any grounding in reality – or any legitimacy given that half Europe was under Soviet occupation until 1989 – is irrelevant. This is the national view.

Ukraine is not a member of Nato. It enjoys no Article V protection (one-for-all and all-for-one). Mr Putin knows that the West will not go to war over Ukraine. It is true that Serbia’s Slobodan Milosevic made such a calculation in Bosnia/Kosovo and found that he had misjudged, but Serbia is tiny and has no nuclear weapons.

The only constraint in strict military terms is how difficult Mr Putin thinks it would be to occupy further territory (perhaps the whole of the Donbass, perhaps up to the Dnieper, perhaps all the way to Moldova), and to avoid a guerrilla quagmire of his own.

There must be an extremely high risk that the Kremlin will defy Western sanctions and launch “asymmetric retaliation” on the ground, overthrowing the post-Cold War settlement altogether.

Markets seem strangely insouciant as the geopolitical order of Europe unravels before their eyes. The US launched economic warfare against Russia a week ago. Europe is just days away from following suit.

You can applaud the actions of the West, or condemn them, but you can hardly ignore them.

 In the 30 years or so that I have been writing about world affairs and the international economy, I have never seen a more dangerous confluence of circumstances, or more remarkable complacency.