Briefing Note. EU and Ukraine: What are the limits of Europe? 18 March 2014

Transcription

1 18 March 2014 EU and Ukraine: What are the limits of Europe? SUMMARY If Russia moves to formally annex Crimea, as looks increasingly likely, most measures under the vague plan the EU has agreed, including additional targeted individual sanctions or a potential arms embargo, would be hard to agree amongst the EU s 28 member states and their impact remains unclear. Still, cleverly targeted sanctions on individuals and business interests could hurt Russia. Between 2008 and 2013, $421bn worth of private sector money equivalent to 20% of Russian GDP has flown out of the country, while Russia s Net International Investment Position (NIIP) remains strongly positive. This suggests that there are sizeable amounts of Russian money invested abroad on which sanctions could be imposed, causing significant problems for high-ranking individuals and businesses. That said, the routing of this money through offshore centres makes it very difficult to track. For more information, please contact the Open Europe office on 0044 (0) or Raoul Ruparel on 0044 (0) Follow us on Twitter Therefore, the most effective economic measures could be a combination of targeted sanctions on influential individuals close to the top of the regime, business interests, specific firms wielding power in Ukraine (such as Gazprom) and potentially limiting sales to Russia of products on which they are externally reliant such as machinery, chemicals and medical products. Sweeping energy sanctions would hit Russia the hardest but due to the EU s dependence on Russian gas in some countries as much as 100% of gas imports are Russian this option is politically unlikely and could prove prohibitively expensive for the EU. Such decisions should not be taken lightly and Russia has an array of retaliatory options, including leveraging energy market power to secure favourable bilateral deals with other countries, applying tit-fortat sanctions or, in extremis, wielding its hard power. However, whilst Moscow can use such rogue tactics in the short-term, which the EU, for various reasons can t, in any prolonged stand-off the odds favour the EU, due to Russia s disastrous demographic trends and relatively undiversified economy. For all these reasons, a negotiated settlement still remains the most likely option. Fundamentally, while this is a conflict driven by Moscow, it illustrates the EU s all or nothing approach to its neighbourhood is no longer viable in the 21st Century. If the EU is to extend its influence further, it must be prepared to offer an alternative model of enlargement or association, lowering the political hurdles on the path to Europe.

2 2 1. AGREED EU ACTION TO DATE On 6 March, EU leaders agreed a three-step approach to deal with Russia s actions in Ukraine: 1 Step 1: Immediate suspension of bilateral talks with Russian on visa matters and on the New Agreement 2 for closer cooperation between Russia and the EU. Immediate suspension of preparations for the G8 Summit in Sochi in June. Step 2: Implementing targeted sanctions (visa bans and asset freezes) on individuals in the absence of a diplomatic resolution within a limited timeframe. Step 3: Adopting additional and far reaching consequences for relations in a broad range of economic areas between the EU and Russia, if Russia takes any further steps to destabilise the situation in Ukraine. The EU has implemented Step 1, while Step 2 was initiated yesterday with the announcement of sanctions against a series of individuals close to the Russian regime. 3 However, the debate has essentially moved beyond this point with the plans put in motion for Crimea to formally join Russia and reports of troops amassing along Ukraine s eastern border. At the same time, it seems the EU is seeking to deepen ties with Ukraine, offering financial support, visa liberalisation and pushing to sign the political chapters of the controversial Association Agreement at this week s European Council meeting. All moves which will not be well received in Russia. The combination of these factors could lead to an escalation of the crisis. How are EU sanctions agreed? As a general rule, the EU imposes sanctions through a Decision of the Council of Ministers adopted by unanimity. Economic and financial sanctions (e.g. asset freezes or export bans) require further implementing legislation. The European Commission and the High Representative (Baroness Ashton) lay down the details in a draft Regulation that the Council of Ministers needs to adopt by qualified majority. For arms embargoes and visa bans, a Council Decision adopted by unanimity is enough. The Decision is directly binding on member states. 2. WHAT FURTHER ACTION CAN THE EU TAKE? 2.1 Measures with limited impact Measure What it could involve Effects and/or complications The EU could come up with a Limited impact. Many have already moved far more comprehensive list of assets offshore via tax havens, making them More targeted Russian officials and Kremlin hard to track. That said, large amounts are travel bans and aligned businessmen. held in the EU so could have some impact. asset freezes Targeting Putin or Lavrov Moscow could retaliate against European seems highly unlikely assets held in Russia.

3 3 Measure What seems it highly could unlikely involve assets Effects held and/or in Russia. complications Suspend bilateral ties between Although this would hit Russia s pride and be Russia and NATO symbolic, NATO and its EU members would probably lose out in equal measure to Russia. Without communication there is a risk the conflict could escalate. Impose an Arms Embargo Unclear what the effects would be. Russia is largely self-sufficient in arms and its export markets are mostly non-eu. France could object due to its large pending sale of Mistral class assault ships, though it has recently said it would consider scrapping the deal. 4 Suspension of bilateral and multilateral military and diplomatic ties Suspend Russian membership of the Organisation of Security and Cooperation in Europe Attempt to remove Russia from the Council of Europe Attempt to remove Russia from the World Trade Organisation Suspend Russia from the G8 group of nations Implement a Sports boycott Attempt to remove Russia from the IMF and World Bank Membership is governed by the Helsinki Final Act and stands as a list of mutual commitments and so does not envisage individual expulsions. 5 If, for example, Russia violates Article 3 the prohibition on torture it could be suspended or expelled from the organisation. From 2000 to 2001 Russia was suspended over its actions in Chechnya. Arguably, the effect was limited and it s unclear if this would do anything to alter Russian actions. This could be a blow to Moscow, but it would only be possible to expel Russia if it broke WTO rulings on trade. This would be relatively easy to accomplish and could further damage Russia s international prestige. The Winter Paralympics in Sochi are nearly over but the 2018 football World Cup, due to take place in Russia, would be another opportunity to exert pressure. The EU and US between them have a large proportion of the IMF and World bank capital but as Russia is not a recipient expulsion would again be largely symbolic.

4 4 While it is true that these measures are likely to be limited in impact, as often stated, there is hope that they could have some effect. This is driven by the fact that the Russian private sector has invested huge amounts of cash abroad. As graph 1 below shows, $421bn (20% of Russian GDP) in private sector money flowed out of the Russian economy between 2008 and Furthermore, the country s Net International Investment Position (NIIP) remains strongly positive, showing it continues to invest more heavily abroad than foreigners invest in Russia Graph 1: Ouflows of funds from Russia ($bn) UKRAINE 1% BAHAMAS 2% GERMANY 2% LUXEMBOURG 2% UK 2% -400 SWITZERLAND BRITISH VIRGIN 3% Private sector capital flows NIIP ISLANDS 12% Source: Central Bank of Russia (CBR) (Data on NIIP not yet available for 2013) 7 USA 3% Graph 2: Russian stock of FDI abroad (2012) Total - $406.3bn ROW 20% NETHERLANDS 16% CYPRUS 37% However, there is an important caveat here. It could be difficult to effectively impose the sanctions, since the money may be hard to trace and pinpoint as Russian. As graph 2 shows, much of Russian Foreign Direct Investment (FDI) flows to offshore financial centres and tax havens. It may then make its way to the US and EU, but this makes it significantly more difficult to trace and to impose sanctions on. 2.2 Serious but not critical measures These measures would likely constitute Step 3 and beyond, probably involving broader economic and political sanctions targeted either at specific Russian firms or sectors within the Russian economy. Economic sanctions Limiting exports of specific sectors to Russia (such as technology and medical goods): Adopt more targeted sanctions on specific areas of the economy where Russia is reliant on external trade. As the graph 3 below shows, while Russia is strong on exports of mineral products (such as oil and gas) and almost self-reliant on agriculture, it is less so on things such as machinery and chemicals. Targeting sanctions on limiting exports to Russia in these areas could have a more profound impact, since Russia is self-sufficient in other areas and may find it easier to diversify sales of commodities than source new products. As graph 4 shows, while Russia does have a diversified import base, it still purchases over 50% from the EU and US. This gives them a strong position to leverage, but also highlights the cost of sanctions will likely be decreased exports Graph 3: Russian Trade balance by commodity (% of GDP) S Korea 4% Graph 4: Source of Russian imports (2012) Total - $272.5bn Other 19% foodstuffs & agriculture mineral products chemical products & rubber machinery, equipment & transport Source: Russian Federal State Statistics Service 8 USA 5% Japan 6% China 19% EU 47%

5 5 Target sanctions against specific firms (such as Gazprom): A step up from targeting individuals would be to target specific firms. High on the list here would be Gazprom. The Russian gas giant has significant business in Ukraine and close links to the Russian government. The sanctions could take the form of overt bans on US and EU trading with the firm or could be more subtle involving using EU competition rules to shut out Gazprom. Both suffer potential drawbacks. The first option could fall foul of World Trade Organisation rules though there is some leeway under these rules over security considerations. The second option would effectively involve skewing EU law for geopolitical purposes, which many would say will make the EU no better than the Kremlin. Furthermore, Gazprom has significant market power and could leverage its position to cut prices, especially given low marginal costs. 9 This could allow it to diversify more easily demand for gas remains solid and global supply is not yet abundant or potentially strike favourable bilateral deals by offering below market prices. Limit financial access of Russian firms and government: This would involve targeting sanctions to lock Russian firms and/or government out of US and EU financial markets. Despite its strong current account surplus, low external debt and positive net international investment position, Russia remains reliant on the large liquid financial markets of the EU and US. Shutting out Russian firms from these markets could provide an effective mechanism to squeeze the Russian economy. Russian corporate financing, equities and to a lesser extent government bonds are reliant on external financing due to the huge capital outflows from the Russian economy. As graphs 5 and 6 below show, the external debt of Russian firms is significant, with $121bn (6% of GDP) needing to be rolled over in the next 12 months , , , , , ,000 0 Graph 5: Russia International reserves - sizeable but declining? ($mln) Foreign exchange SDRs IMF reserve Gold Graph 6: Russia External Debt ($mln) General Government Monetary Authorities Banks Other sectors External debt per capita US$ (LHS) 6,000 5,000 4,000 3,000 2,000 1,000 0 Source: Central Bank of Russia (CBR) 11 A ban on financing or financial transactions could be applied to just state-owned firms or all Russian firms (given that the line can be blurred sometimes). That said, this would also be a long-term measure. Russia maintains strong foreign exchange reserves and low overall external debt at 34% of GDP (although this has been rising rapidly in per capita terms, see graph 6). This allows the CBR scope to step in to support the financial base of these companies and the banks in particular. Furthermore, deposit growth has been strong in recent years in Russia, while uncertainty is likely to give a boost to the savings rate. Russia could also retaliate by placing capital controls on its own economy in an effort to limit outflows of capital and boost domestic funding markets.

6 6 Political actions Boost military defences in Russia s backyard: Although decisions on defence are predominantly taken by NATO, EU member states could band together to help encourage and finance military installations in Poland and/or the Baltics. The UK, for example, has already offered to send Typhoon jets to the Baltics (via NATO). One option could be the revival of the missile shield in Poland and the Czech Republic. As with everything, it will be hard to find agreement amongst EU member states, with much of the onus instead falling on the US. Military assistance for Ukraine: NATO and EU members could, for example, provide Ukraine with anti-tank and anti-air missiles to bolster the country s defence against any further Russia threats. That could, however, be seen as an outright return to the Cold War. 2.3 Critical measures These measures would likely be a last resort in the face of a serious escalation on the part of Russia for example through further military incursions into other parts of eastern Ukraine. Full blown energy sanctions: This would see the US and EU banning imports or trading of Russian oil and gas. This would have serious implications for the EU which sources around 30% of its gas from Russia. However, it would hit some countries which rely on Russia for all of their gas (see graph 9 below) particularly hard. The US relies little on Russia for energy so it would have minimal impact, other than creating wider uncertainty in energy markets Graph 7: World total primary energy consumption by region (Quadrillion btu) OECD Americas OECD Europe OECD Asia Non-OECD Europe and Eurasia Non-OECD Asia Middle East Africa Central and South America Source: US Energy Information Administration 12 and Eurogas 13 The pain for both sides would be significant. However, traditionally hitting a large supplier would cause more pain for consumers as prices spike. Both sides could diversify their energy trading links. Finding alternative sources for the EU would take some time and would likely involve cultivating domestic renewable energy to ensure security of supply and meet emissions targets. Given that spare capacity in the global energy market is not huge and demand growth is now steady, Russia would likely be able to survive on a mix of higher prices and alternative bilateral deals. In the longer term though, it remains far too reliant on this single source of income and will need to diversify away from Europe in any case due to limited growth in energy demand (see graph 8 above).

7 7 Full blown trade sanctions: Exactly what it says on the tin. This would see all trade between the US and EU and Russia stopped. This would have a serious economic impact on both the EU and Russia, while the US would see limited impact. Although Russia has a diverse export base, the EU still accounts for over 50% of its exports this is a source of demand it simply cannot afford to lose. In addition, it would lose access to some import sectors (discussed in section 2) and the Russian economy and people would suffer. Equally the hit to the EU would be serious, mostly again on the energy side. Rest of the World 32% Graph 9: Destinations for Russian exports Total $488bn (2012) Netherlands 16% Germany 7% Graph 10: Russia Total Population at constant fertility (thousands) China 7% USA 3% Ukraine 5% UK 3% France 2% Rest of the EU 14% Source: Russian Federal State Statistics Service and UN 14 Italy 7% Poland 4% In the long-run, the odds are in Europe s favour As graph 10 shows, Russia faces some serious demographic challenges with a dwindling population. Combine this with the overreliance on gas and oil exports as well as a lack of deep domestic financial markets and rising external debt (all highlighted above) and it becomes clear that any lasting serious sanctions from the EU and US would have a catastrophic impact on the Russian economy. Europe may also suffer but over the longer term it has a stronger economic base to fall back on. 3. RUSSIA HAS TOOLS FOR RETALIATION Having laid out all the potential measures the EU can take, it should not be forgotten that Russia has some tools of its own to retaliate against US and EU sanctions. These include but are not limited to: Encourage political upheaval elsewhere in the Russian neighbourhood, notably on the borders of the Baltic states. Build alternative financial links, including with China and emerging markets. Diversifying energy partners, in particular striking bilateral deals with China. Attempt to divide and conquer by offering below market price energy deals to some EU member states. Tit-for-tat sanctions on American and European individuals and businesses. In extremis, this could extend to seizing assets of firms operating in Russia. Selling US and European assets and/or currencies to try to provoke market reaction Morgan Stanley has estimated that Russia holds $180bn in US Treasuries. Escalating the dispute by unilaterally cutting off gas and oil supply to Europe. Exercising hard power with further military intervention in eastern Ukraine.

8 8 4. HOW MIGHT A NEGOTIATED SETTLEMENT LOOK? Given the serious consequences for both Russia and the EU from sanctions (though less so the US), the most likely option remains a negotiated settlement within the next few months though we may see some further escalation before this is achieved. Here are some of the possible horse-trades: What might Russia want? 1 Safeguard its Black Sea Fleet position in Crimea 2 Guaranteed rights & federalisation for ethnic Russians & Russian speakers in Ukraine 3 Military neutrality for Ukraine (such as that seen for Finland after WWII) 4 Free trade agreement & visa free travel with the Ukraine 5 Potential for visa liberalisation & free trade agreement with the EU Other points which could be included in a negotiated settlement are: What might the EU want? End to military hostilities, Russian troops return to bases in Crimea Guarantees over oil & gas supplies and prices to EU members Potential for Ukraine to one day join NATO and the EU Guarantees that Ukraine will not join a customs union with Russia Security guarantees for others in Russian neighbourhood A guarantee from the EU and US that Ukraine will not join NATO and/or the EU. Devo Max for Crimea, making it autonomous, or close to it. Both sides agree to pursue looser agreements with Ukraine including some form of free trade agreement potentially creating a tripartite trade deal (ironically this could give Ukraine the best of both worlds from an economic perspective). Given the most recent developments, it may not be possible to prevent Russia fully annexing the Crimea. While this makes a settlement more challenging, there are still potential areas for agreement and does not make one impossible. Could such a deal get full approval from the EU? Any negotiated settlement with Russia will require lifting any remaining sanctions; this would require unanimity, potentially giving any EU state an effective veto over the settlement. 15 Similarly, any trade deal and visa liberalisation agreement would need to be agreed unanimously. EU Trade Agreements include a veto for the European Parliament. In particular, promising to stop any future Ukrainian accession to the EU or NATO could prove a step too far for Poland, Sweden and even the Baltic states. 5. LONG-TERM STRATEGIC CHALLENGE: ARE WE AT THE LIMITS OF THE EU? Even if the crisis deescalates and a settlement is reached, this conflict has illustrated that Europe s approach to dealing with its neighbourhood is in need of a fundamental upgrade. In July 2013, David Cameron said, Our vision of the EU is that it should be a large trading and co-operating organisation that effectively stretches, as it were, from the Atlantic to the Urals. 16 However, there are three problems with the EU s current approach, undermining this vision becoming reality.

9 9 Source: European Commission 17 The EU s now far more than an economic bloc First, the EU is no longer about trade but has been transformed into an economic, political and (theoretically) military power block which purports to have elements of a common foreign policy. Inevitably, this will prompt a hard power response from Russia, which a pure economic bloc wouldn t. All the ex-warsaw Pact countries that have joined the EU have also joined NATO, while the 2009 Lisbon Treaty for the first time introduced an EU mutual defence clause obliging the member states to provide aid and assistance by all the means in their power if a member state is the victim of armed aggression on its territory. Some people may like this, but it no doubt increases the geopolitical obstacles further EU enlargement is up against. Given Ukraine s extensive border with Russia and its political and cultural links with Moscow, this EU/NATO security guarantee presents a major barrier to any Russian acceptance of full Ukrainian EU membership, even in the very long term. Many partner countries are light years from full membership Secondly, what s the realistic level of integration that Ukraine itself, or indeed countries such as Turkey, can muster? There are an ever-increasing number of hurdles to full EU membership such as standards of governance, the free movement of people, complying with the EU s regulatory regime or indeed a single currency which is increasingly starting to dominate EU rule-making. Even if Moscow, hypothetically, would accept Ukraine acceding to the EU, the barriers to EU entry for Kiev are possibly too high for it to join for at least several decades. The EU still does not have a credible offer absent full membership Thirdly, flowing from the above, Ukraine again illustrates the EU s familiar neighbourhood dilemma: how to engage with a neighbouring country that is unlikely to become a full member within even the distant future? The EU s Neighbourhood Policy, aimed at an ever closer but arms-length relationship with participating countries, has had relatively poor results, be it in Northern Africa to the quasi-authoritarian regimes in Eastern Europe. 18 As a Chatham House briefing paper notes, Outside the context of enlargement, the EU has no stronger track record in changing the domestic political calculus of authoritarian regimes than other international organizations or any state. 19 If the EU is to extend its influence further, it may well have to be prepared to offer an alternative model of enlargement or association that dilutes the political, economic and security package. The EU s all or nothing club membership offer is no longer viable in the 21st Century. This has the added value of encompassing other countries on Europe s rim as well as countries in its core struggling to accept the full Acquis Communautaire.

10 10 1 Statement by the European Council, EU Stands by Ukraine, 6 March 2014: 2 See European External Action Service: 3 EU Council Regulation No 269/2014, see: 4 Cited by Le JDD, Fabius évoque une annulation de la vente de Mistral à la Russie, 18 March 2014: 5 OSCE, Helsinki Final Act, August 1975: 6 Central Bank of Russia, Net Inflows/Outflows of Capital by Private Sector in : 7 Central Bank of Russia, Russian Federation: Outward Foreign Direct Investment Positions by Geographical Allocation in : 8 Russian Federal State Statistics Service, External trade of Russian Federation with other countries and by commodity structure: 9 Morgan Stanley Research, Russia Economics and Strategy, 14 March Central Bank of Russia, Payment Schedule of External Debt of the Russian Federation. Between April 2014 and the end of Q1 2015, see: 11 Central Bank of Russia, External Debt of the Russian Federation: 12 US EIA, World total primary energy consumption by region (Reference case). 13 Eurogas, Statistical Report 2013, p.8: 14 UN, Population Division, World Population Prospects - The 2012 Revision, Russian Federation: 15 EU lifting of sanctions on Burma were done unanimously; However, although EU sanctions decisions are taken by unanimity once agreed the detail are decided by Qualified Majority Voting (QMV). If an agreement is taken to end the sanctions imposed on Russia they could therefore be amended by QMV for instance by deleting the existing list of people affected. This would however be politically dangerous and complex Quoted in the Guardian, EU should extend further into former Soviet Union, says David Cameron, 1 July 2013; The EU and the Mediterranean: good neighbours?, Open Europe, May 2011: 19 R. Dragneva and K. Wolczuk, Russia, the Eurasian Customs Union and the EU: Cooperation, Stagnation or Rivalry?, Chatham House, August 2012