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Putin in Ukraine: Raise, Check or Fold? Brian Pellegrini, CFA, 21 May 2014

Raising the stakes might seem like the most risky option for Putin, but by instigating a short-term confrontation he could get a favorable deal on Ukraine and then send his troops home unused.

While raising the stakes might seem foolhardy in the face of sanctions, we must remember that in poker knowing your opponents is just as important as knowing the odds on the draw.

Defense factories in Ukraine supply key components for some of Russia’s most important weapons systems. Any concerns about a NATO peacekeeping force watching over them would almost certainly trigger an invasion by Russian forces camped along Ukraine’s eastern border.

From a defensive standpoint, Russia is wide open along its border with Ukraine since there is no topographical anchor to build a defense upon. If Russia is able to control the whole of Ukraine it will also benefit from the Dniester River and the Carpathian Mountains acting as natural barriers in western Ukraine.

Russia was extremely worried and disturbed when in 2004 the Baltics joined NATO along with Romania and Bulgaria (although Bulgaria has been edging back towards Russia recently).

We believe it would be a mistake to view Putin’s motivations as entirely tactical. Putin’s March speech made it quite clear that he has strategic designs on uniting the Eastern Slavic populations of Russia, Ukraine and Belarus.

Aside from Germany, the responses coming out of nations that buy natural gas from Russia have been unequivocally that Ukraine is on its own. Even at the EU-level, any appetite for a confrontation with Russia does not extend to the energy sector.

For the oligarchs to consider overthrowing Putin would require the view that economic damage to them was too large to bear and irreversible. Putin can overcome any U.S. opposition in Ukraine simply by continuing to stack chips on the table until Obama gets nervous and folds.

Over the past few weeks we have examined why Ukraine’s economic structure makes it extremely vulnerable to pressure from Russia, particularly in the form of higher natural gas prices. We discussed Putin’s motivations for wanting to control Ukraine in our note “Eagle vs. Bear: Checkers vs. Chess”, 12 June 2013, but a lot has happened since then. In the intervening time Putin’s words and actions have provided more details about his motives. Is Putin the madman that Western leaders are making him out to be, or the defender of helpless Russophones, as he portrays himself? Not surprisingly, we think neither definition is accurate. We believe a more accurate comparison would be to Prince Rurik, who united the Eastern Slavic tribes (through a combination of warfare and statecraft) and in doing so created what would later be called the Kievan Rus’ empire. Putin’s own words imply he sees himself in this way and realizing that will give us insight into his game plan. In this note we will examine the differing motivations of Putin and his “Western” counterparts and discuss what the interplay between them means for Ukraine.

Putin’s Motivations Some of the most consistent talking-points coming out of Washington and Berlin have been about the “lunacy” of Putin. Both Obama and Merkel have described Putin as out of touch with reality and not

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someone capable of negotiating rationally. That suggestion raises a serious issue that will be central to this note. Leaders in the U.S. and Europe have publicly written Putin off as crazy because they have no clue how to deal with him. Western leaders have gotten very used to having proxy rule over the world via multilateral institutions such as the UN and the IMF. As a result, it would seem, they have trouble coming up with an answer other than “because we said so” when someone “interprets” the rules differently than they do.

Far from being the ramblings of a madman, Putin’s March 18th speech marking the annexation of Crimea lays out a clear and cogent mission statement. We will reference the speech extensively in this note and we strongly suggest readers review it themselves. Let’s review Putin’s motivations for bringing Ukraine into Russia’s orbit, largely as he presents them, starting with the tactical and moving towards the strategic.

Defense Industry Suppliers Imports from Ukraine make up only a small portion of Russia’s total trade, but the composition of the import basket makes the issue critical. Defense factories in Ukraine supply key components for some of Russia’s most important weapons systems. Indeed, the SS-18 ICBM missile system (~40% of Russia’s strategic nuclear force) is assembled in Ukraine. Map A below shows the locations of key Russian defense suppliers; these are mission-critical locations for the Russian military. Any concerns about a NATO peacekeeping force watching over them would almost certainly trigger an invasion by Russian forces camped along Ukraine’s eastern border. Note that almost all the locations are east of the Dneiper, making them easily reachable for Russian forces and within the likely borders of any break-away eastern Ukrainian state.

Source: University of Texas Library

Key Russian Defense Imports from Ukraine

Component

Manufacturing

Location

SS-18 Heavy ICBMs Dnepropetrovsk

SS-25 & SS-19 ICBM missile guidance system Kharkiv

Gas-turbine naval engines Mykolaiv

Jet & helicoptor engines Zaporizhia

R-27 & R-73 air-to-air missiles Various

Various Aircraft Auxiliary systems Various

Source: Royal United Services Institute

Natural Barriers As discussed in our note “Eagle vs. Bear: Checkers vs. Chess”, 12 June 2013, Russia doesn’t benefit from any natural barriers along its border with Europe. Russia’s main defense against conquerors from the

A

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West is distance and environment. If you still subscribe to the “End of History” view, then this consideration is nonsense. But it seems that Putin for his part is not willing to take indefinite peace in Europe for granted; this writer is inclined to agree. For most of Russia’s history, it has taken enemies so long to get from the border to Moscow that winter would defeat them before they could make the trip. Indeed, the Cold War border of Eastern Germany marked the westernmost reach of any of Russia’s empires. In contrast, Russia today controls the smallest area of any Russian empire since the fall of the Mongols. Putin is well aware of Russia’s topographical weaknesses and is no doubt looking to put some distance between his front lines and Moscow. Whether this is to be considered paranoid can be left to the reader, the important point is that Putin’s rhetoric and actions indicate that he considers it to be a credible threat. Given he has historical precedent on his side, we expect him to continue seeking opportunities to strengthen and expand his buffer zone with the expansionist EU.

Map B below gives us a view of the topography of Ukraine. Like Belarus and Central Russia, eastern and central Ukraine is a very low and flat plain. From a defensive standpoint, Russia is wide open along its border with Ukraine since there is no topographical anchor to build a defense upon. The closest such feature is the Dneiper River, which cuts through central Ukraine. If Russia were able to control the whole of Ukraine it would also benefit from the Dniester River and the Carpathian Mountains acting as natural barriers in western Ukraine.

Source: GRID-Arendal, Connolly Insight

Encirclement by NATO Policymakers and the media in the West portray the situation in Ukraine as an isolated event and any discussion of a “New Cold War” is quickly laughed off and treated as right-wing saber-rattling. However, when we look at Putin’s own words we see that he sees the fate of nations to be an

B

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evolutionary struggle. His interactions with The West are zero-sum and he believes that Russia has been getting a bad deal since the fall of the USSR. Indeed, as we can see in his statement below, he presents NATO as the aggressors in Ukraine.

“In short, we have every reason to assume that the infamous policy of containment, led in the 18th, 19th and 20thcenturies, continues today. They are constantly trying to sweep us into a corner because we have an independent position, because we maintain it and because we call things like they are and do not engage in hypocrisy. But there is a limit to everything. And with Ukraine, our western partners have crossed the line, playing the bear and acting irresponsibly and unprofessionally.”

As we can see in Map C below showing the various expansions of NATO, Putin has a point. Until 1999, Russia retained most of its intermediate buffer zone. In 1999 NATO was expanded to include Poland, the Czech Republic and Hungary. That brought the border with NATO right to the core buffer of the Baltics, Belarus and Ukraine. Russia’s situation became very disturbing to it in 2004 when the Baltics joined NATO1 along with Romania and Bulgaria (although Bulgaria has been edging back towards Russia recently). The Baltic States joining NATO had two strategic implications. First, nations that had been the frequent victims of Russian expansionism would be protected by a powerful community of nations. This was of course the reasoning highlighted in the public relations campaign. However, there was undoubtedly some negative reasoning behind including the Baltics in NATO as well. Moscow is now 20 minutes flight-time from the border of the nearest U.S. ally. One of the key unfulfilled goals from the Reagan Administration was to render Russia harmless by extending U.S. power into its satellites in Eastern Europe. In 2000, the remainder of the Republican Party’s “Reagan Tribe” put Dick Cheney in his position as Vice President. In 2004, he delivered the expansion of NATO to include the Baltics. He was almost able to deliver Ukraine in 2006, but it was not to be.2

Putin points out that Ukraine’s joining NATO would mean the end of the port of Sevastapol as a strategic asset and that southern Russia would be exposed. This does not seem like a “crazy” position to be taking. How did the US feel when Russia began moving military assets, culminating in nuclear weapons, to Cuba?

Let me note too that we have already heard declarations from Kiev about Ukraine soon joining NATO. What would this have meant for Crimea and Sevastopol in the future? It would have meant that NATO’s navy would be right there in this city of Russia’s military glory, and this would create not an illusory but a perfectly real threat to the whole of southern Russia. …”

“NATO remains a military alliance, and we are against having a military alliance making itself at home right in our backyard or in our historic territory. I simply cannot imagine that we would travel to Sevastopol to visit NATO sailors. Of course, most of them are wonderful guys, but it would be better to have them come and visit us, be our guests, rather than the other way round.”

1 Bernard has often pointed out that it seems there was a quiet agreement in the late 1980s between Genscher

and Gorbachev that Germany would ensure that the Baltics and Ukraine remained within the Soviet Union’s orbit in return for Russian acceptance of German reunification and that Germany apparently used the formal dissolution of the Soviet Union as an excuse for reneging on that deal.

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History of NATO Enlargement in Europe

Source: Wikipedia, Connolly Insight

NATO Membership

Year Joined Member State

1949 (Original Signatories)

Belgium, Canada, Denmark, France, Iceland,

Italy, Luxembourg, Netherlands, Norway,

Portugal, UK, US

1952 Greece, Turkey

1955Germany (West Germany only until

reunification, 3/10/1990)

1981 Spain

1999 Czech Republic, Hungary, Poland,

2004Bulgaria, Estonia, Latvia, Lithuania, Romania,

Slovakia, Slovania

2009 Albania, Croatia

Source: thegreenpapers.com/ww/NATO.phtml, Connolly Insight

Thus we see that, far from being the Mad Dog of Europe, Putin has multiple rational reasons for not being comfortable with a formal relationship between Ukraine and either the EU or NATO. Even if neither of these entities is an imminent threat they are not allies of Russia, which has its own national interests. Given that Putin has rational arguments available to justify his actions, for Western leaders to be effective in thwarting him they will need arguments more solid than “he’s crazy”. We believe that the fact that no cogent argument for halting Putin has been presented by Western leaders makes Putin’s efforts that much more likely to succeed. How can Western leaders stop him if they cannot even explain what they are trying to stop or why they are justified in doing so?

Forging a New Eastern Slavic Empire We should stress that we believe it would be a mistake to view Putin’s motivations as entirely tactical. Putin’s speech makes it quite clear that he is seeking to unite the Eastern Slavic populations of Russia, Ukraine and Belarus. In presenting his pitch he highlights the benefits of being unified within the USSR. The two quotes below are very representative.

Unfortunately, what seemed impossible became a reality. The USSR fell apart. Things developed so swiftly that few people realised how truly dramatic those events and their consequences would be. Many people both in Russia and in Ukraine, as well as in other republics hoped that the Commonwealth of Independent States that was created at the time would become the new common form of statehood. They were told that there would be a single currency, a single economic space, joint armed forces; however, all this remained empty promises, while the big country was gone. It was only when Crimea ended up as part of a different country that Russia realised that it was not simply robbed, it was plundered.

C

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He also reaches out olive branches to the people of Ukraine, presenting Russia as more magnanimous and capable than the Ukrainian government. He addresses the language issue3 by proposing equal treatment of Russian and Ukrainian.

“…it would be right – I know the local population supports this – for Crimea to have three equal national languages: Russian, Ukrainian and Tatar.”

“I understand why Ukrainian people wanted change. They have had enough of the authorities in power during the years of Ukraine’s independence. Presidents, prime ministers and parliamentarians changed, but their attitude to the country and its people remained the same. They milked the country, fought among themselves for power, assets and cash flows and did not care much about the ordinary people.”

“I would like to reiterate that I understand those who came out on Maidan with peaceful slogans against corruption, inefficient state management and poverty.”

In our view, the most important part of the speech is his attempt to pitch a cultural and ethnic affinity between Russia, Ukraine and Belarus. He is appealing to Eastern Slavs that they are better off sticking together, a development that will not be a surprise to regular readers of Bernard’s work.

“[Crimea] is the location of ancient Khersones, where Prince Vladimir was baptised. His spiritual feat of adopting Orthodoxy predetermined the overall basis of the culture, civilisation and human values that unite the peoples of Russia, Ukraine and Belarus.”

“[W]e are not simply close neighbours but, as I have said many times already, we are one people. Kiev is the mother of Russian cities. Ancient Rus is our common source and we cannot live without each other.”

It is important to note his choice of historical reference. By invoking the Rus’, Putin is reaching back to the Eastern Europe’s Dark Ages for a pre-national common link between the three Eastern Slavic countries. The Rus’ territory included all three countries and Ancient Rus’ served as the root language for the three branches of the language. Equally as important, the Rus’ empire was a federation of separate semi-states. Thus, it appears that Putin is pitching to Ukrainians and Belarusians that the three groups share a deep ethnic identity and as such should work for the common benefit of each other in the context of some degree of autonomy.

Map D below shows us the geographic distribution of the three major Slavic groups. As discussed in Brzezinski’s The Grand Chessboard, Russia must control the 40+ million Eastern Slavs in Ukraine and Belarus if it is to control the energy rich Muslim lands to its South without being a majority Muslim empire. As Brzezinski points out, during times when Russia has been able to unite the Eastern Slavic population it has dominated the tribes around it. If Putin is to forge a new Russian Empire, he will need his fellow Eastern Slavs to do it.

3 For further discussion about the language issue in Ukraine, see our note “The Hryvnia: Broken Country, Broken

Currency, Part 2”, 6 May 2014

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RussiaPop: 144 million

UkrainePop: 46 million

BelarusPop: 9 million

Western Slavs

Southern Slavs

Balts

Finnic

Source: Wikipedia, Connolly Insight

Thus, in his efforts to use a historical narrative to tie together modern-day Eastern Slavs, Putin shows that he has more on his mind than simply protecting Russian-speaking Ukrainians. That Putin’s motives extend beyond free-trade agreements and buffer-zones is perhaps the most important point of this note. Based on his own words, we suspect Putin sees himself as a modern-day Prince Rurik. By uniting the Eastern Slavic nations of today, Putin can recreate the Kieven Rus’ empire and dominate the tribes around him. Again, the simple fact that he has a strategy and his western counterparts do not makes him more likely to succeed. In the land of the blind, the man with one eye is king.

Breaking the Multilateralism Monopoly Finally, in his speech, Putin turns the logic of multilateralism against the very Western leaders who present multilateral organizations as a cure to all the world’s problems. The statement below is a direct response to statements made by President Obama. By responding to high-minded comments in kind, we believe Putin is signaling that he isn’t willing to cede moral justification for war to the United States and its allies anymore. And again, while we don’t agree with Putin’s overall assessment, he does make another good point here.

“We keep hearing from the United States and Western Europe that Kosovo is some special case. What makes it so special in the eyes of our colleagues? It turns out that it is the fact that the conflict in Kosovo resulted in so many human casualties. Is this a legal argument? The ruling of the International Court says nothing about this. This is not even double standards; this is amazing, primitive, blunt cynicism. One should not try so crudely to make everything suit their interests, calling the same thing white today and black tomorrow. According to this logic, we have to make sure every conflict leads to human losses.”

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D

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After the dissolution of bipolarity on the planet, we no longer have stability. Key international institutions are not getting any stronger; on the contrary, in many cases, they are sadly degrading. Our western partners, led by the United States of America, prefer not to be guided by international law in their practical policies, but by the rule of the gun. They have come to believe in their exclusivity and exceptionalism, that they can decide the destinies of the world, that only they can ever be right. They act as they please: here and there, they use force against sovereign states, building coalitions based on the principle “If you are not with us, you are against us.” To make this aggression look legitimate, they force the necessary resolutions from international organisations, and if for some reason this does not work, they simply ignore the UN Security Council and the UN overall.

As we’ve discussed previously4, Krugman wrote a piece at the commencement of the Russia-Georgia war in 2008 that perfectly describes the geo-strategic importance of what would seem to be a minor conflict. In truth, that conflict ended the post-Cold War Pax Americana during which only the U.S. and its allies were “allowed” to take offensive military action. Putin set the precedent in 2008 that he doesn’t need permission from the U.S. or the UN to invade another country. In 2014, Ukraine is just another of the world’s unfortunate trouble spots that Russia dutifully assists in achieving “peace”. Thus, a second strategic reason for Russian intervention in Ukraine is to further establish the precedent for Russian freedom to engage in hostilities in its near abroad.

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Far from pursuing irrational objectives, Russia has many tactical and strategic reasons for wanting Ukraine in its orbit. Quite frankly, Putin lays out most of these reasons in what we view as a clear and concise manner in his speech. Indeed, Putin’s statements are noticeably more open than those of his counterparts. More importantly though, we believe one of the main messages this speech was meant to deliver was “words won’t stop me”.

A “New Hitler”? Since the start of the confrontation over Ukraine, Putin has frequently been compared to Hitler; particularly in the British and European press. While we don’t disagree entirely with the analogy, we think one must be careful in interpreting it. Putin’s actions in Ukraine are definitely similar to those used by Hitler in the Sudetenland. Using a combination of incited locals and disguised Russian troops to cause chaos and provoke a violent response is a carbon copy of Hitler’s plan in 1938. Further, it seems reasonable to think that success in Ukraine would only serve to embolden Putin in continuing to pursue his strategic objectives aggressively, as success sin Czechoslovakia further emboldened Hitler.

However, we hesitate to use the analogy because it smacks of reductio ad Hitlerum. First and foremost, any Hitler analogy plays right into the hands of the leadership of the U.S. and Germany. In the United States the two parties have taken decidedly different positions on the implications of Hitler. On the Right, he represents un-checked aggression. According to this view, Hitler is the reason we need a large defense budget and a hawkish foreign policy; best to nip the next Hitler’s empire in the bud. On the Left, Hitler is enraged Right-wing intolerance. He is the reason we need diversity training and powerful multilateral institutions. The UN was (ostensibly) created to provide a venue for discussion and international sanctions, making war a thing of the past; best to teach Hitler better when he is four years old.

4 See our note “Ukraine: Stuck Between a Rock and a Hard Case”, 3 March 2014.

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A second issue is the danger of confusing the end goals of Hitler and Putin, which we believe are significantly different. Hitler wanted direct military control over as much of the world as possible. Whether he actually believed the ideals or not, his leadership model was driven by a pseudo-religious ideology built around Aryan supremacy and eliminationism. Putin’s pitch has always been a more pragmatic one and he does not appear to be seeking the type of control over Europe which Hitler did. Putin’s immediate goal appears to be, like that of Prince Rurik, to unite the three Eastern Slavic nations of Russia, Ukraine and Belarus in some type of political/economic union. Beyond that, we would expect him to continue in his efforts to reconstruct in stages the old power-base of the USSR. However, instead of the Communist political and economic system, Putin’s empire will politically have elements of a thug-ocracy and economically would be a crony-capitalism oligarchy.

Thus, beyond the tactical level we view the link between Hitler and Putin as not significant. Any analogy between Putin and Hitler can potentially fall victim to manipulation or misinterpretation. But of course that is exactly what the propaganda war, on both sides, over Ukraine is about—manipulating and misrepresenting.

The European Response Bernard has discussed the imperialistic statements and maneuvers made at the EU-level recently5 with regards to Russia and Ukraine. Indeed, it is hard not to see Von Rompuy’s statement that, “The whole European territory apart from Russia will in the long term be in some way involved with the EU...” as a “European” empire laying claim to the Russian Empire’s former domain. Thus, if one were to just look at EU-level activity, one might naively think Russia was facing the formidable threat of a united “Europe”. However, when we look at activity at the national level we see a much different picture, as Bernard has pointed out: after all, as France would declare if it were being frank, there is no longer a Franco-German condominium and France will not accept a “German Europe”.6

And the divisions are evident even at a less “grand-strategy” level. Indeed, despite Merkel’s outspokenness her constituents do not stand behind her on serious sanctions or any other type of confrontational stance. Recent polling of German voters has shown that over 80% want a diplomatic solution and less than half support further sanctions. More importantly, prominent members of the business community have also been very vocal about their opposition to an economic confrontation with Russia. Siemens, Volkswagen, BASF and Deutsche Bank have all made public statements against further sanctions. This is all coming out of the nation whose politico-bureaucratic elites stand to benefit the most by sitting at the head of a united expansionist empire.

Aside from Germany, the responses coming out of nations that buy natural gas from Russia have been unequivocally that Ukraine is on its own. Perhaps the Bulgarian Minister of Foreign Affairs said it most succinctly: “We do not have to become hostages of [the] economic political and financial stability of the gas transit states.” Bulgaria has continued the construction of the South Stream pipeline over the objections of the European Commission. Indeed, the Bulgarian government responded with a public criticism of the Commission. Note that Bulgaria is both a member of the EU and of NATO, so it would seem that siding with Russia might be a risky position. However, it is far from alone in its stance. Austria has also been hard at work with the Russians on South Stream. Indeed, in late-April Austria signed a deal with Gazprom to locate the terminus of South Stream at Austria’s Central European Gas

5 See Bernard’s note “Ukraine: Van Rompuy versus Putin – A Worrying Mismatch”, 30 April 2014.

6 See Bernard’s note “The NSU, France, Ukraine, the ECB and the Euro: Plus Ça Change?”, 9 May 2014.

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Hub in Baumgarten. This will mean lower gas prices for Austrian buyers and more business for Austrian financial and gas-trading firms. The deal also stipulates that Gazprom be granted access to gas transmission and storage facilities in Austria. As a result of the deal Gazprom will become an even larger part of European daily life, particularly in Austria. In order to reach a deal, Austria had to outmaneuver Italy, which was also in contention. Given that the situation in the Ukraine was well-underway when the talks concluded, it would be hard to imagine the topic not entering into the negotiations.

Even at the EU-level, appetite for a confrontation with Russia does not extend to the energy sector. Poland has proposed having one single “EU price” for natural gas. On the plus side, this could improve the purchasing power of all EU members with all potential sellers. However, it would also tie the entirety of the EU, including nations that purchase little or no gas from Russia, to relations with Russia. The proposal was immediately shot down by EU Energy Commissioner Oettinger.

Thus, we see that the members of the EU are far from unified in their positions regarding Russia and Ukraine. In our view, Putin has little to worry about when it comes to serious consequences coming out from the EU. How about the Americans?

The American Response Given that the United States has significantly less dependence on Russia for its energy needs than Europe, one might expect the U.S. President to take a decidedly more confrontational stance than his European counterparts. However, in his March 26th speech Obama adopted a conciliatory tone, seeking to offload the problem onto multilateral institutions. Indeed, at end of the speech Obama tipped his hand and the true level of his lack of interest in Ukraine and foreign policy in general. Let’s review what he had to say.

First and foremost, Obama highlighted that he is completely unwilling to acknowledge that anything has changed in the world. We believe this indicates that he has no response to anyone who is not willing to play by the existing set of rules.

“Russia’s leadership is challenging truths that only a few weeks ago seemed self-evident, that in the 21st century, the borders of Europe cannot be redrawn with force, that international law matters, that people and nations can make their own decisions about their future.”

As quickly as he raises the hint of a conflict the President, nearly in the next breath, waves off any suggestion that this is a serious conflict or that anything will come of it. Why would anyone with something valuable to gain be deterred by the statements below?

Understand as well this is not another Cold War that we’re entering into. After all, unlike the Soviet Union, Russia leads no bloc of nations, no global ideology. The United States and NATO do not seek any conflict with Russia.

I believe that for both Ukraine and Russia, a stable peace will come through de-escalation, a direct dialogue between Russia and the government of Ukraine and the international community…”

“Russia leads no bloc of nations, no global ideology…” Isn’t that exactly the point of this whole confrontation, Mr. President? Russia’s goal is to bring Ukraine into its orbit so that it can begin a pitched campaign of international coalition building. A wholehearted participation of some

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portion of Ukraine in the CIS would significantly boost Putin’s ability to expand and deepen the customs union. Of course, Obama made dutiful obeisance to Article 5 of the NATO Treaty:

What we will do always is uphold our solemn obligation, our Article 5 duty, to defend the sovereignty and territorial integrity of our allies. And in that promise we will never waver. NATO nations never stand alone.

But it was safe for him to say that, given that Ukraine is not a NATO member. The world will be a much more dangerous place if he does convince everyone that he would back Article 5 up if/when the time came. Then at the close of the speech Obama tipped his hand and showed what he really cares about.

“In the end, the success of our ideals comes down to us, including the example of our own lives, our own societies. We know that there will always be intolerance, but instead of fearing the immigrant, we can welcome him. We can insist on policies that benefit the many, not just the few, that an age of globalization and dizzying change opens the door of opportunity to the marginalized, and not just a privileged few.

Instead of targeting our gay and lesbian brothers and sisters, we can use our laws to protect their rights. Instead of defining ourselves in opposition to others, we can affirm the aspirations that we hold in common. That’s what will make America strong. That’s what will make Europe strong. That’s what makes us who we are.”

Both friends and foes of the President have acknowledged that the focus of his presidency has been heavily domestic. Does Obama really formulate foreign policy based on income- distribution and sexual-orientation policies, whatever one thinks of their merits or de-merits? Of course not, those statements are meant purely for domestic consumption. In our view, the President views foreign policy as an annoying distraction that he would rather leave to the multilateral institutions7.

Thus, we see that the American response is uninterested and distracted at best. Taken together with the disunited response from “Europe” this is likely to imply an improvement in the probability of success in Putin’s ventures aimed at repositioning Russia as a global power. Over a shorter-term horizon it also improves the chances that Russia will pass through the Ukraine situation without significant permanent economic damage. As discussed in our note “The Hryvnia: Broken Country, Broken Currency Part 2”, 6 May 2014, the default scenario is for Russia to gain greater political and economic control over Ukraine. In our view, the question being decided now is what the price will be. Let’s see how the poker game for Ukraine is progressing.

Raise, Check or Fold? Taking the above discussion and evidence into consideration we see three potential scenarios based on Russia’s next moves. Continuing with our poker analogy, Putin’s options in the current hand consist of: folding, checking (taking no action), or raising the stakes. What are the potential consequences of each of these actions?

Folding

7 And as Bernard has frequently argued, he is egged on in this view by the “world government” advocates in the

American foreign-policy-cum-academic Establishment.

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Under this scenario Putin would stand down his troops and reduce economic pressure on Ukraine by cutting prices for natural gas. This certainly would de-escalate the situation, but at the cost of Ukraine moving into the EU’s orbit and of the loss of natural gas as a bargaining tool. In addition, this would be a serious domestic blow to Putin politically. Putin’s position as pseudo-dictator is heavily dependent on his maintaining a strongman image among the Russian populace. Fleeing from Ukraine with his tail between his legs, for any reason at this point, would seriously weaken him. We see this as the least likely scenario. However, if it does occur the outcome would undoubtedly be a good one for Russian risk-asset prices, at least in the short-term. The threat of sanctions would be off the table and there would be no threat of an interruption of gas supply to Europe. In the longer term though, Russia’s acquiescence to EU demands could put Russian companies at a disadvantage as it would set a negative precedent for future trade disagreements.

Checking Waiting and watching seems to be the tack Putin has taken for the time being. There are definitely some benefits to this strategy. First, it allows economic pressure on Ukraine to accumulate. As discussed in our previous notes, Ukraine is a country very much on the brink economically. Waiting also allows Putin to observe the actions of his adversaries while formulating his next move. However, Putin must choose his actions in the presence of a ticking clock.

Russian units deployed at the border with Ukraine have now been on readiness status for about 8 weeks. That is getting to the point where combat effectiveness begins to degrade. Troops get worn out living in the field, supplies get used up and equipment begins to need replacement. Added to this, a rotation of conscripts is taking place from April 1 to July 15. This date can be postponed, but that would likely only serve to hasten decay of readiness status. Before mid-summer, Putin is either going to need to use his troops or send them back to base.

Another problem with checking is that it continues the current wave of uncertainty for anyone doing business in or with Russia. Until the situation is resolved Russian companies and risk assets will continue to feel pressure. That is undoubtedly a problem for Putin, who maintains his political position by carefully balancing cooperation and coercion with the Russian oligarchs. At a certain point, yet to be determined, the economic pain of sanctions would overcome the oligarchs’ fears of political reprisals and they would likely turn on Putin.

Thus, while stalling for time is an attractive option, Putin can’t stick with it indefinitely.

Raise Raising the stakes might seem like the most risky option, but we believe it is actually the best choice Putin has available in dealing with the current hand in the game. Currently the situation is deadlocked in Ukraine. The election will undoubtedly be contested so it seems unlikely political tension in Ukraine will be subsiding soon. We strongly doubt that Putin wants to invade Ukraine and, as discussed above, we view the forces stationed at the border as a threat and an insurance policy. However, those forces will no longer be a threat by the end of the summer. Thus, if he wants to get more than Crimea, Putin will need to wrap up an agreement in short order.

We believe that through raising the stakes by instigating a short-term confrontation Putin could get a favorable deal on Ukraine and then send his troops home unused. While raising the stakes might seem foolhardy in the face of sanctions, we must remember that in poker knowing your opponents is just as important as knowing the odds on the draw. We believe the Europeans are too divided to pose a threat

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and that, after the Syria debacle, Putin has Obama’s number when it comes to negotiating foreign policy crises.

As we saw above, Obama has made it quite clear that domestic issues are his main focus. However, in Syria he gave away some important “tells” about the way he plays the game of foreign policy. First and foremost, we learned that Obama takes his peace prize very seriously and will only be dragged into a military conflict kicking and screaming8. His carefully-crafted political image is of the guy elected to end wars, not start them. We also learned that while Obama likes to appear on television as being at the heart of global events, he’d rather leave negotiating the details to others.

Finally, and most importantly, we learned that Obama is unwilling to allow foreign policy matters to derail his domestic agenda. This is why we view Putin’s position as more secure than it otherwise might be. For the oligarchs to consider overthrowing Putin would require the view that economic damage to them was too large to bear and was irreversible. Putin can overcome any U.S. opposition in Ukraine simply by continuing to stack chips on the table until Obama gets nervous and folds. Unless Putin was asleep the whole time, this is what he learned from his dealings with Obama in Syria. Thus, the goal would not be an actual confrontation, but rather for Putin to spook his opponents in order to cut a more favorable deal.

Conclusion The situation is complicated and susceptible to being upset by unforeseen contingencies. But we believe in total that the evidence points to Russia and Putin being in more secure positions than Russia-bears give them credit for. Russia’s leader is embarking on a high-risk strategy, no doubt. However, a major determinant of the likelihood of his success is the skill of the other players at the poker table. In this regard, we think Putin far outmatches his counterparts in the U.S. and Europe. As a result, we believe he is likely to come out of the current tension over Ukraine largely unscathed and potentially bearing significant concessions from the West.

For the financial world there are multiple implications. First, don’t be surprised if Putin raises the stakes in Ukraine and Russian risk premiums spike. Second, however, over the medium-term the superior geo-strategic capabilities of Russia’s leader in comparison to his counterparts will significantly reduce the downside of this normally very high-risk strategy. In other words, Putin knows who he’s up against and is wisely playing rough, however much one dislikes what he is doing. Thus, severe market corrections are likely an over-reaction.

Finally, as discussed in previous notes9 the outlook for Ukraine is very negative indeed. Like the cads, Ukraine will need to be given large amounts of money potentially indefinitely to avoid a politically destabilizing economic correction. In the case of Ukraine the need for transfers is driven by its severe full-employment energy deficit. The incentive for oblasts in eastern Ukraine to federalize will continue to grow as long as Putin is able to charge market prices for gas sold to Ukraine. This is why, on a relative basis, we are bullish on Russia and bearish on Ukraine.

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8 “Leading from behind” in Libya is perhaps the best example of this attitude.

9 See our notes “The Hryvnia: Broken Country, Broken Currency Part 1 & 2”,