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NATO Parliamentary Assembly

ECONOMICS AND SECURITY COMMITTEE

SANCTIONING THE RUSSIAN ECONOMY: COSTS AND IMPACTS

GENERAL REPORT

Diego LOPEZ GARRIDO (Spain)General Rapporteur

www.nato-pa.int 10 October 2015

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TABLE OF CONTENTS

I. INTRODUCTION....................................................................................................................2

II. US SANCTIONS.....................................................................................................................3

III. EU SANCTIONS.....................................................................................................................4

IV. THE COSTS OF RUSSIAN SANCTIONS AND RUSSIAN REPONSES................................7

V. THE POLITICS OF PUTIN’S ECONOMIC VISION...............................................................10

VI. THE ECONOMIC DIMENSION OF PUTIN’S EURASIAN AMBITIONS................................11

VII. WEAKNESSES AND VULNERABILITIES OF THE RUSSIAN ECONOMIC MODEL..........13

VIII. OIL AND GAS: RUSSIA’S WEAPON OR VULNERABILITY?..............................................15

IX. GOAL OF SANCTIONS AND THEIR RELEVANCE.............................................................16

X. CONCLUSIONS...................................................................................................................18

BIBLIOGRAPHY...................................................................................................................19

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I. INTRODUCTION

1. The narrative of Russia’s illegal annexation of Crimea and its role in militarily supporting armed rebellion in Eastern Ukraine, including secretly deploying Russian forces to that theater, is well known. This report will not focus directly on those events. Instead, it will address the question of economic sanctions and the broader economic and diplomatic challenge Russia now confronts as a consequence both of the crisis and of an increasingly irrational economic system that has left it highly vulnerable to falling energy prices.

2. It was initially difficult to achieve trans-Atlantic agreement on an appropriate response to Russia’s illegal annexation of Crimea, and the first round of sanctions seemed more symbolic than economically consequential. As the crisis spread from Crimea to Eastern Ukraine, and with mounting evidence that Russia was secretly sending troops and equipment into the Eastern Ukrainian theatre just as it had done in Crimea, Europe and North America along with several other key countries found a greater unity of purpose. It has become clear that Putin’s ambitions were not limited to Crimea and that his real intent may be to challenge the established European order. Indeed Crimea itself had never been the fundamental point. Putin’s efforts were infused with a desperate sense that Ukraine was about to “be lost” to the West. The Kremlin, he suggested would not back down unless the Ukrainian authorities willingly accommodated Russia’s broad interests in the country—something which now meant no privileged trading relationship with the European Union (EU) and which accorded Russia a guardian-like status limiting Ukrainian autonomy. Russia’s vision was made very clear in the draft Friends of Ukraine text Russian Foreign Minister Sergei Lavrov handed to US Secretary of State John Kerry on 15 March 2014.

3. After long denying that it had sent troops, Russia justified its actions in Crimea in a manner that Western governments immediately characterized as fundamentally misleading. Russian authorities argued that Ukraine’s post-Maidan government was an illegitimate product of a coup d’état inspired and even led by the West. It claimed that the Ukrainian government had failed to implement the 21 February 2014 agreements between Yanukovych and the opposition, even though Yanukovych had mysteriously fled the country the day after signing that agreement. President Putin next claimed that the intervention was, in fact, an act of self-defense as Russians in Crimea as well as the Black Sea Fleet were under threat of an armed attack. From this perspective the intervention was to prevent a humanitarian catastrophe engendered by attacks on ethnic Russians. The Kremlin thus began using Russian identity as what one expert calls “a coercive resource” (Allison). Many of these same arguments have been used to justify Russian interference in Eastern Ukraine.

4. From the perspective of European and North American countries, what transpired in Crimea and is ongoing in Eastern Ukraine are straightforward violations of international law. Article 2(4) of the UN Charter prohibits states from engaging in any threats or uses of force against other states. There are three recognized exceptions in this regard: when the Security Council authorizes it under Chapter VII; when the territorial state consents to such an intervention; or when the state employing force is acting in self-defense. Russian officials absurdly cited self-defense to justify their decision to send troops into Crimea. It is important to note here that Russia had previously issued passports to 143,000 Ukrainians, making it much easier for Russia to point to sizeable numbers of “Russian citizens” who might come under threat. But here as well, there is no credible evidence that ethnic Russians or Russian citizens were under any threat in Crimea. Western governments thus see this as a prevarication intended to make Russia’s offensive action appear defensive. Military analysts suggest that the Crimean occupation had been planned years ahead of the event (Allison). It is also worth noting that since Russia invaded Crimea, the Tartar

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community and other opponents of Russian aggression have been subject to sustained harassment, summary arrests and disappearance.

5. In the face of this illegal and unwarranted violation of Ukrainian sovereignty, the European Union, the United States and Canada along with Australia, Japan and Norway have imposed a set of economic sanctions on Russia to express their opposition to Russian actions, to signal that there would be a price to pay for these actions and to pressure Russia to come to the negotiating table to settle the matter. In very broad terms, these sanctions have included the following elements: bans on travel by key Russian leaders and asset freezes; bans on transactions with banks and businesses operating in Crimea; restricted access to Western capital for targeted Russian state-owned banks and companies; asset freezes on state-owned defense technology companies; and restrictions on weapons sales and exports of dual-use technologies and energy-extracting technologies.

II. US SANCTIONS

6. In 2009, the Obama Administration had announced its intention to “reset” relations with Russia and initially, it seemed, great progress was made in this direction. Then president Medvedev agreed a new START Treaty, enacted sanctions against Iran in a joint effort to pressure that country to abandon its nuclear weapons program, and expanded supply routes for US equipment and provisions moving into Afghanistan. The United States had also agreed to support Russia’s candidacy to accede to the WTO, and the two governments established a bilateral Presidential Commission for co-operation on a range of other matters of mutual concern including nuclear energy, counterterrorism and the establishment of a more liberal visa regime.

7. Putin’s return to the presidency coincided with a sharp degradation in bilateral relations well prior to the Crimean crisis. Putin revived reflexively anti-American and anti-Western political rhetoric, challenged the right of countries like Ukraine and Georgia to freely establish diplomatic, economic and security relations with the West, and took measures like the occupation of Abkhazia and Southern Ossetia in Georgia to check any such ambitions. He overtly employed Russia’s leverage in European energy markets for political purposes, and in so doing, rang alarm bells throughout Europe about its high level of dependence on Russian gas supplies. Russia strengthened ties with Syria and blocked a range of international efforts to pressure that regime to come to some accommodation with its domestic opponents (Zargham). Putin seemed dedicated to building an authoritarian political-economic model that expressly rejected Western liberal democratic precepts as both weak and inappropriate to Russia’s conservative traditions. The government’s vicious campaign against already marginalized groups like the LGBT community was cast, in part, as an expression of Russian virtue versus Western decadence. Soviet style agitprop came back into fashion as the government increasingly limited media freedoms and conducted a propaganda onslaught that cleverly blended fact with politically expedient fantasy. But sanctions are not a consequence of these trends.

8. In response to the illegal annexation of Crimea, the United States launched its first sanctions in March 2014. The Executive Orders issued that month restricted the travel of certain individuals and officials directly engaged in the Crimea actions. As the conflict worsened over time, the United States ratcheted up the diplomatic and financial penalties. On 28 April 2014, the US government imposed a ban on business transactions within its territory on seven Russian officials and seventeen Russian companies. Then in response to the escalating war in Donbass, on 17 July 2014 it extended its transactions ban to two major Russian energy firms, Rosneft and Novatek, and two major state-controlled banks, Gazprombank and Vnesheconombank (VEB). VEB is a state-owned bank underwriting a range of critical economic projects both in Russia and beyond its borders. Gazprombank is a financial arm of the state-run energy giant Gazprom. These are two of Russia’s largest lenders. The executive order prohibits US citizens and

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institutions from providing financing to these two banks, which significantly limits their access to capital markets.

9. On 11 September 2014, President Obama announced that the United States would join the EU in imposing even tougher sanctions on Russia's financial, energy and defense sectors. It then sanctioned Sberbank, Russia's largest bank in terms of assets, and Rostec, a Russian conglomerate working in the arms, automobile and metals sectors. The sanctions meant that Sberbank and Rostec would have very limited access to US debt markets. The United States also sanctioned Russia’s largest energy companies - Gazprom, Gazprom Neft, Lukoil, Surgutneftegas and Rosneft. These sanctions dramatically limited US co-operation with Russian energy firms. These restrictions had immediate implications for companies such as Exxon Mobil Corporation and BP Plc., which have had extensive dealings with Russia’s energy sector. Kalashnikov Concern, the armaments manufacturer was also among the 13 defense companies on the US sanctions list. The United States now denies these companies access to dual-use technology.

10. On 19 December 2014, the US Administration imposed sanctions on Russian-occupied Crimea. The United States now prohibits exports of American goods and services to the region, excludes Russian state banks from raising long-term loans in the United States and bans the exports of dual-use equipment. The executive order prohibited all new investment in Crimea by US persons; direct and indirect imports, exports and re-exports into and from the United States of any goods, services or technology from Crimea; and any approval, financing, facilitation, or guarantee by a US person of a transaction by a foreign person that would be prohibited if performed by a US person, significantly extending the reach of U.S. sanctions. The US has suspended credit finance for exports to Russia and economic development projects in Russia. The sanctions also prohibit the provision, exportation, or re-exportation of goods, services or technology in support of exploration or production for deep water, Arctic offshore, or shale projects that have the potential to produce oil in the Russian Federation, or in any maritime area claimed by the Russian Federation and extending from its territory.

11. These measures, taken in close co-ordination with the EU and other international partners, have sent a progressively more emphatic message to the Russian government that business as usual is impossible as long as Russia continues to undermine the sovereignty and territorial integrity of Ukraine. Both the United States and the EU have underlined their readiness to impose further political and economic costs if Russia does not abide by its international obligations, while remaining very open to discussion with Russian officials over these matters. Indeed, both US and European officials emphasize the need to keep the door open so that a solution to this crisis can be found.

III. EU SANCTIONS

12. In response to the annexation of Crimea and apparent efforts to destabilize Ukraine by supporting separatist elements in Eastern Ukraine, the European Union has also imposed a series of progressively harsher economic restrictions on commercial and financial relations with the Russian Federation. The EU’s central goal has been to de-escalate the crisis in Ukraine, and it has called on all sides to engage in an inclusive and substantive dialogue to find an enduring solution to the crisis. It strongly defends the notion of the unity and territorial integrity of Ukraine and a democratic and prosperous outlook for its citizens. Along these lines, it has advanced a range of projects supporting Ukrainian political and economic reform, including a deeper partnership with Ukraine itself. 13. At a meeting of the Council of the European Union on 3 March 2014, member states condemned Russia’s violation of Ukrainian territorial integrity and the Federation Council’s 1st of March authorization of the use of force. The EU called on Russia to withdraw its forces from

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Crimea and to adhere to the 1997 Agreement on the Status and Conditions of the Black Sea Fleet. The EU suspended bilateral talks with Russia on visa issues and a proposed EU-Russia Agreement. If Russia failed to de-escalate, the Council indicated that it would introduce a second stage of measures with serious consequences for the bilateral relationship.

14. Accordingly, in light of Russia’s illegal annexation of Crimea on 17 March 2014, the EU imposed travel bans and asset freezes on a number of Russian and Ukrainian officials. It also supported the decision not to hold a G8 summit in Sochi in early June and suspended negotiations over Russia’s accession to the OECD and the International Energy Agency. It cancelled all regular bilateral summits and began to reassess a litany of bilateral regional co-operation programs, many of which have since been suspended. The EU identified 132 individuals and 28 entities subject to asset freezes in the EU. It named 126 of these people and 15 of these entities as being responsible for acts undermining Ukraine’s territorial integrity. It listed six people who provided support to or benefitted Russian decision-makers and identified 13 entities in Crimea and Sevastopol as confiscated property or having undergone an illegal transfer of ownership under Ukrainian law.

15. The EU has also prohibited any imports originating from Crimea and Sevastopol unless accompanied by a certificate of origin from Ukraine. It has outlawed investment in Crimea and Sevastopol and forbidden the purchase of real estate there. No European firms can offer tourist services in Crimea or Sevastopol, and cruise ships may not call on ports there. The EU now forbids the export of a range of transport, telecommunication and energy-related products to the region or the provision of technical, brokering, construction or engineering services there. The costs of incorporating Crimea into Russia have been extraordinarily high and the Russian state now accounts for 80% of its GDP. President Putin has said that the peninsula must be self-sustaining by 2020 but it is certainly not moving in that direction. Tourist revenues, for example, fell by 45% in 2014 despite a nationalist drive to encourage Russian holidays there. Crimea like the Donbas has thus become a financial albatross for the Russian state. Putin seems determined to make Crimea part of Russia but probably wants Donbas only to have a hand in Ukrainian politics, although some analysts worry that he actually has his eye on is the military industries of Eastern Ukraine which have long been key suppliers of Russian radar, rocket equipment, helicopter engines, antiballistic missiles, naval ships and transport planes (Aslund).

16. EU nationals and companies cannot purchase, sell or broker bonds, equity or other financial instruments with maturity exceeding 30 days issued by five major state-owned Russian banks, three major Russian energy companies, and three major Russian defence companies, their subsidiaries or those acting on their behalf. Moreover, EU nationals and companies cannot lend to these banks.

17. The EU has embargoed the import and export of arms and related materials from or to Russia, covering items on the EU common military list. It has prohibited export of dual-use goods and technologies with military applications to Russia. These items are listed on the US list of dual-use goods. Exports of dual-use goods to nine mixed defence companies are now prohibited. After a sustained debate in France, the French government suspended the delivery of two Mistral warships Russia had ordered even though the Russians had already paid US$1.6 billion for the ships.

18. The export of some energy-related equipment and technology to Russia is now subject to prior authorization of member states and export licenses are to be denied if these are slated for deep water oil exploration and production, arctic oil exploration or production and shale oil projects in Russia.

19. The EU has undertaken other measures restricting economic co-operation. On 16 July 2014, the European Council asked the European Investment Bank to suspend approval of new

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financing operations in Russia. Member states also agreed to co-ordinate their positions on relations with Russia within the European Bank for Reconstruction and Development (EBRD) Board of Directors with a view to suspending any new operations there. The EU will broadly reassess EU-Russia co-operation programmes including bilateral and regional initiatives and decide upon their status on a case-by-case basis. The Council did, however, decide to continue co-operation on a range of civil society programmes.

20. At this writing, the United States and the European Union are outlining an array of further sanctions that they would implement if Russia continues to take military action in Eastern Ukraine in violation of the Minsk agreements. Renewed separatist shelling near Mariinka and Mariupol in direct contravention of the Mink Agreements put the questions of sanctions on Russia in the center of discussions at the G-7 meetings in Bavaria in June 2015. Speaking to his fellow heads of state, President Obama asked, “Does he continue to wreck his country’s economy and continue Russia’s isolation in pursuit of a wrong-headed desire to recreate the glories of the Soviet empire? Or does he recognise that Russia’s greatness does not depend on violating the territorial integrity and sovereignty of other countries?” German chancellor Angela Merkel added, We are “ready, should the situation escalate – which we don’t want – to strengthen sanctions if the situation makes that necessary but we believe we should do everything to move forward the political process of Minsk”, Merkel said (Conolly).

21. Among the measures that could be taken would be adding additional names and companies to the current sanctions lists and more substantial measures to penalize Russia's financial, energy and defence sectors. There have been some calls in both the United States and Europe to deny Russian banks access to the SWIFT bank transfer system. A similar measure, for example, has had a very serious impact on Iran’s banking sector and may have helped bring Iran to the negotiating table. Some Russian officials have suggested that to enact such a ban would be an act of economic war. To prepare itself for any future restrictions to the SWIFT system, Russia’s Central Bank is now offering a new service to credit institutions for domestic financial transfers (Pravda). In any case, western countries are closely monitoring the situation in Eastern Ukraine and have grown very sceptical about Russian claims that its forces are not engaged in the fight. The separatist arsenal consists of recently procured Russian equipment, including its most advanced T-72 tanks with reactive armour, encrypted radio and aerial drones, an arsenal that belies Russian claims that separatist forces are using only garrisoned Ukrainian equipment.

22. There is also significant evidence that Russian military units are deployed without insignia in Eastern Ukraine. Western governments will need to judge if and when Russia has yet again crossed a threshold warranting a response of even more serious sanctions and other heretofore unidentified responses. At the time of this writing, the situation appears to have calmed down although NATO’s Supreme Allied Commander, General Philip Breedlove, has expressed concerns about signs that Russia is building an effective supply system to strengthen its capacity to conduct military operations inside Ukraine.

23. The G-7 discussions unfolded just before the European heads of government were to consider renewing the sanctions already in place. European sanctions were to expire on 31 July unless member governments agreed to their renewal. Vladimir Putin has looked to sow dissension in European ranks on the matter and recently travelled to Italy to see if Italy might break with its fellow EU members on the matter. In a press conference in Italy, President Putin noted that the sanctions are costing Italian defence firms €1 billion in lost income (Rettman). Prime Minister Renzi, however, gave no indication that Italy would consider not renewing sanctions, and Europe appears to be united on the matter. The European Parliament recently passed a resolution calling on EU governments to sustain the current regime and to end the strategic partnership with Russia (European Parliament News).

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24. Despite the current sanctions regimes, a number of companies continue to do business in Russia. Europe’s largest energy firms have adjusted to the current sanctions regimes and appear to be seeking legal work arounds in order to position themselves for future opportunities. BP is negotiating to acquire a 10% share in a Siberian oilfield owned by Rosneft and both ENI and Statoil are working on joint ventures with that Russian state owned company. Shell continues to work on a joint venture with Gazprom Neft and is seeking approval from the Dutch government for other projects. European energy firms have received approval to transfer some technology and services to Russian joint ventures but financing is judged on a case by case basis. This activity has become a source of some tension between Europe and Washington. US firms, in particular feel that the Europeans are gaining an unfair advantage in the Russian market as a result of the stricter sanctions regime Washington has imposed (Farchy).

25. The business environment in Russia is certainly riskers and more legally complex but as one observer noted “legal, semi legal and illegal ways” are being employed to get around some of the restrictions. Rerouting of exports to Russia through third countries like Brazil is one way to navigate around the restrictions. Off shore plants located in countries like China and India have helped some firms get around prohibitions on the export of dual-use technologies. Russian firms also appear to be circumnavigating restrictions by using firms that are not on sanctions list to import goods on their behalf. The problem here is that Western firms engaged in this kind of trade may illegally breaking sanctions. Ignorance is not an excuse and wilful ignorance is clearly criminal (Hille, Farchy, Weaver).

IV. THE COSTS OF RUSSIAN SANCTIONS AND RUSSIAN REPONSES

26. There are signs that Putin has overplayed his hand and is now caught in a serious economic and strategic quandary. Putin’s deployment of weaponry and troops in Eastern Ukraine has effectively produced yet another frozen conflict in Russia’s backyard. From his perspective, this ensures that Russia will continue to have a say in Ukraine’s future and, by implication, bolster Russia’s leverage more broadly throughout Europe. But it could be argued that Putin’s opportunism has backfired. He has failed to stymie Ukraine’s European ambitions and has also managed to isolate Russia from Europe rather than bolster its influence over it. If anything, Ukraine is now far more united in its desire to link its economy to the West, while other CIS member states are now showing signs of alarm about Russian ambitions and reliability. The question is whether that alarm will foment resistance to Russian ambitions or resigned acceptance. Putin is counting on the latter. Much depends on how the West responds.

27. Although many of the sanctions on Russia initially targeted an elite closely associated with the illegal annexation of Crimea and military activity in Eastern Ukraine, subsequent sanctions are having broader consequences. Most important, perhaps, are the restrictions on lending to a series of Russian banks. This has exacerbated the soaring cost of capital in Russia and is worsening already difficult financial conditions in that country. Russian authorities are now pumping capital into vulnerable banks albeit at a very high cost to the state. 28. Perhaps the greatest cost to Russia, however, has been to its reputation as a place for doing business. That reputation was hardly stellar to begin with, given the weak rule of law, pervasive corruption, confusing regulations, opaque and often corrupt corporate governance, an energy sector riddled with kickbacks, oligopolistic and monopolistic pricing, politicized decision-making, arbitrary law enforcement, a range of trade barriers, and the tendency of the state to the seize assets of those not aligned with Putin or those simply competing with favored oligarchs. A recently published book by Karen Dawisha suggests that ambiguous and contradictory regulations were not incidental, but rather fundamental to Putin’s political system. No business could possibly operate in that country without breaking some regulations, and this left all market operators vulnerable to prosecution, albeit at the discretion of the Kremlin and state

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officials. Such a system might help concentrate political power, but it is a very poor way to administer an economy (Dawisha). Poor governance conditions were thus already exacting a high toll on Russia’s economy prior to the Ukrainian crisis, although high energy prices obfuscated that damage. The failure to foster a reliable rule of law, business justice and a genuinely open and competitive economy has only worsened the impact of plummeting energy prices.

29. Investment in Russia’s highly inefficient non-energy sectors has been extraordinarily low and Russian investors tended to move capital offshore to safe havens rather than invest in the country’s uncertain and poorly regulated domestic economy. Net capital outflows rose to US$72.9 billion in the fourth quarter of 2014, bringing the total to US$151 billion for the year or roughly 10% of GDP according to Russia’s central bank. The World Bank projects a capital outflow of US$105 billion in 2015, while Fitch Ratings, which has downgraded Russia to its lowest investment grade, foresees outflows of US$130 billion. This outflow is a long-term problem and reflects a clear lack of investment opportunities in Russia’s crony capitalist order (Hanson). Significantly higher levels of investment are needed to counteract the fact that the number of young people entering the labor market is rapidly falling and Russia needs to bolster its productivity. As a result of sanctions, Russian companies are finding it difficult to roll over or refinance debt and many are moving money offshore. This has both driven down the value of the ruble and injected greater instability into the financial system as a whole. Capital flight has left the Russian economy ever more dependent on the energy sector at a time of very low energy prices.

30. When energy prices were high, the Russian state and favored oligarchs were positioned to reap huge earnings, a portion of which were set aside to underwrite consumption, pensions, public salaries, and social welfare. That largess helped trigger a significant increase in Russian living standards over the last decade, and was a key source of President Putin’s popularity. Oil and gas revenues also underwrote military modernization and projects like the Sochi Olympics, which cost Russia an estimated US$ 50 billion. The energy sector’s share of Russia’s budget revenue rose from 9.3% in 2000 to 50% in 2012, when that sector accounted for 30% of Russia’s GDP and 68.7% of its exports (Bradshaw). The government premised its 2014 federal budget on an oil price of 93 US$/barrel, while the 2015 budget assumed a price of 95 US$/barrel (Nardelli, et.al.). While Russia has substantial reserves to compensate for shortfalls in the short to medium-terms, budget cuts are nevertheless inevitable given that oil prices are likely to remain low over the medium term.

31. Russia may have already experienced the worst moments of the current downturn, but there are serious questions whether its economy is sufficiently robust to sustain these increased defence outlays. If it is not, then it would be reasonable to expect that this spending will become a source of tension in Russian society as the military and the war in Ukraine starts to crowd out other budget items. When Russian defence spending rose over the 3% threshold in 2011, a number of Russian economists and financiers protested that the country could not afford to embark on a military spending spree. Then-Finance Minister Alexei Kudrin challenged then-President Dmitri Medvedev on the matter and eventually lost his job as a result. Kudrin argued at the time that Russia simply could not afford such massive outlays and this was when at a time when Russia was enjoying a windfall from very high oil prices and rapid growth (Guriev). Russia’s capacity to go to global lending markets to finance budget shortfalls is now seriously constrained due to Western sanctions so it will have to continue to draw down its Reserve Fund to underwrite this level of spending. That fund currently amounts to 6% of GDP and the budget deficit is slated to be 3.7% this year. This suggests that in two years Russia’s budget problem will be extraordinarily serious if energy prices have not risen and Western sanctions are still in place. But if Russia continues to allocate 9% of GDP to defence outlays and 16.5% to non-defence spending as it has in the first quarter of 2015, it will exhaust its reserve fund by the end of this year. Its other sources of reserve funds, such as national gold holdings are far less liquid while its access to international capital markets is now very constrained, in part, because so much bank

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activity goes through the United States and the US has imposed very tough financial sanctions on Russia (Aslund). 32. Russian leaders tend to harbour a very mercantilist view of trade. Most economists would argue that a substantial reduction in foreign trade tends to be immiserizing, as trade generates domestic efficiencies, allows the country to focus its investments on those industries in which it enjoys potential comparative advantages, expands the range of consumer goods available to a society and keeps prices in check. President Putin, however, now seems to have conveniently embraced the import substitution model of development and has even welcomed the reduction of trade with the West as presenting an opportunity to develop its domestic industries. This logic is hardly consistent with contemporary economic thinking about the very strong link between trade and dynamic development and might be seen as simply dressing up a bad situation.

33. Russia’s aggression in Ukraine and its ever-poorer governance record at home has fully alienated several key trading partners. When the United States and EU imposed sanctions on Russia in July 2014, less than three percent of the EU’s exports went to Russia. The EU, however, took more than 45 % of Russia’s exports (Humphreys, 2014). The EU is Russia’s most important trade partner while Russia is the EU’s third largest commercial partner. In 2013, EU-Russia trade was valued at over €326 billion, which is roughly the GDP of Austria or Denmark (Giumelli, 2014). While on the surface these numbers suggest that Russian retaliation could harm EU members, the difference in scale of the EU, US and Russian economies is vast. At the time of the imposition of the sanctions, exports to Russia constituted only eight-tenths of 1% of European Union GDP and only one-tenth of 1% of US GDP. In comparison, Russian exports to the European Union and the United States comprised 13% of Russia’s GDP. Furthermore, the Russian economy is largely dependent on the oil and extractive industries, while the EU and US economies are significantly more diverse and resilient (The Moscow Times).

34. Germany is perhaps the most important of Russia’s Western trading partners and ranks as Russia’s largest market for imports and third largest market for exports after China and the Netherlands. An estimated 6,000 German companies had established operations in Russia, but a number of these have begun to reduce or roll up their operations. Chemical giant BASF, for example, has cancelled a planned deal with Gazprom involving natural gas extraction and distribution, Opel has laid off workers at its plant in St. Petersburg and Volkswagen has closed down a car factory in Kaluga. The German-Russian Chamber of Commerce estimates that at least one third of German companies with operations in Russia are likely to cancel investment projects there in 2015 (The Local.de, 2015). According to one expert, the German automobile sector is slated to lose €15 billion in Russian sales and €600 million in profit through 2017 (Ewing and Smale). German exports to Russia fell by 22% in 2014 through October compared with 2013.

35. German business has also expressed dissatisfaction with sanctions, but even before the Ukrainian crisis had begun to lower expectations for the Russian market because of very serious governance problems there. Allianz, a large German insurance firm, for example, stopped selling automobile policies in Russia in 2013 because of problems with arbitrary and opaque Russian court adjudication on a range of cases. German firms, however, are globally diversified and resilient and in a position to adjust adroitly to the loss of any given market. The impact of corporate flight on the less globally diversified Russian economy is likely to be more consequential. Some German companies, however, are actively looking to mitigate risk by focusing on the Asian market. The President of the Association of German Chambers of Commerce and Industry (DIHK), Volker Treier, has stated that some ten percent of German companies' time-tested Russian partners are already reorienting to Asian market (The Local.de, 2015).

36. Germany is not the only EU country with significant commercial ties with Russia. Spain, Austria, Poland, Lithuania, and the Czech Republic have also confronted adjustment costs as a

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result of Russia’s shrinking market and sanctions (Giumelli, 2014). In 2013, the Netherlands had €37 billion worth of business in Russia, followed by Italy (€30 billion) and Poland (€26 billion) (The Economist Intelligence Unit ViewsWire). Foreign nationals are also fleeing Russia in significant numbers. In January 2015 there were an estimated 417,000 fewer foreigners living in Russia than in January 2014 with, for example, a 31% fall in the number of Germans, a 36% decline in the American population, 38% fall of British subjects, and 41% for the Spaniards (Hille, 2015.) This outflow reflects Russia’s slowing growth, a falling ruble, generally poor economic conditions, and mounting political and economic uncertainty.

37. In response to Western sanctions, Russia has slapped its own sanctions on Western products and has particularly targeted the agricultural sector, banning most food imports from all countries sanctioning Russia. Here again Russian officials have suggested that this will open an opportunity for Russia, a country which, despite its great agricultural potential, imports 40% of its food, to develop a higher degree of food self-sufficiency. Russian agriculture has never recovered from the dire legacy of Soviet collective farming, but it is very unlikely that introducing a highly protectionist import substitution regime will solve the problem, particularly as the sector is characterized by chronic underinvestment and serious organizational deficiencies. Western agriculture concerns are a very important potential source of capital and know how so it is hard to reckon how Russian sanctions will result in any long-term benefit to the country’s agricultural sector (Hille, 2014). Russia has also reached out to a range of countries willing to continue closer commercial relations and to broaden agricultural trade including India, Argentina, Brazil, South Africa, and Egypt, but in many instances these are second best options for Russia.

38. Russian farming also looks set to suffer a serious credit crunch, and given the rising level of uncertainty, it hardly seems an opportune moment to recapitalize this very under-capitalized sector. This is particularly the case at a moment when the very countries that possess both the technology and organizational know-how to help Russia increase yields are effectively cut off from the market. The net effect of Russia’s agricultural sanctions will therefore be to drive up food prices in Russia, while lowering the selection and quality of food in Russian stores. Russia’s Central Bank believes that the impact of counter-sanctions will reach beyond the agricultural sector by pushing up Russia’s already high inflation rate and thereby eroding the overall purchasing power of Russian citizens (Reuters). This will undoubtedly impose a degree of hardship on Russian consumers, particularly those at the low end of the economic scale. Of course, some Russian food manufacturers stand to benefit as key competitors essentially disappear from the market but these benefits will not outweigh the consumer losses associated with significantly higher food prices at a moment when incomes are falling.

39. By comparison, the EU as a whole has not been hurt significantly by Russia’s counter sanctions. Before the sanctions were put in place, the EU exported about 10% of its food products to Russia at a value of about €11 billion a year. However, the counter sanctions do not include soft drinks or alcohol, which reduces the volume affected to €5 billion per year. Of the affected trade, €1 billion is from Lithuania. The other countries significantly affected are Poland, Finland, Greece and Spain. The European Commission is attempting to mitigate some of the impact with stopgap measures to help producers in these countries (Giumelli, 2014).

V. THE POLITICS OF PUTIN’S ECONOMIC VISION

40. One of the problems at play in this crisis has been the very different views of economics held by president Putin and those closest to him. President Putin and his advisors have expressed deep suspicion of European economic integration, Western market rules, and, over time, have grown more skeptical about the possibilities for co-operation with the West. Their vision is very different from the win-win liberal economic outlook, which undergirds Western thinking about trade and investment flows. Putin’s vision is more zero-sum and he seems to

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understand Western liberal economic rhetoric as purposefully masking its Realpolitik ambitions. This view has only hardened with time, and it lies at the foundation of his efforts to build a Eurasian regional order as a counterweight to the European Union and the trans-Atlantic economic system. From this perspective, it is no coincidence that the event which triggered Russia’s invasion of Crimea was a public revolt against a Ukrainian government that had, under intense Russian pressure, reneged on a public promise to deepen economic and political ties with the European Union.

41. Ukraine was key to Putin’s regional aspirations, and it was for this reason that he has done all in his power to complicate its further integration in the West. Putin’s motives were not only security related. In 2013, there were growing signs of political discontent in Russia. Elements of the educated middle class were agitating for greater democracy and transparency in government. A number of large demonstrations in Moscow and elsewhere expressly protested the direction in which president Putin was leading the country. The Kremlin very quickly ascribed these demonstrations to Western meddling. President Putin summoned several forces in Russian society as part of a sustained crackdown on dissent: the Orthodox Church, social conservatism, nationalism, Russian traditional values, a long-held sense of grievance against the West, and the central role of the state in defending social and political order. These values were increasingly trotted out to justify not only domestic political repression but also the consolidation of critical national economic assets in the hands of a very narrow elite close to Putin.

42. This has been particularly problematic for the Russian economy as it has undermined the sense of opportunity and entrepreneurial spirit in the country. It is interesting to note that of 69 countries surveyed in 2012, Russia stood at 67th in terms of the number of entrepreneurs relative to the working age population (Hanson). In Russia, informal rules and power relations have an outsized impact on the allocation of capital. Everyone is subject to the decision making of the Kremlin and those with close links to it. Patronage represents the quickest path to economic success. This so called “Sistema” hardly reinforces a culture of excellence, entrepreneurism and long-term investment but seems rather to foster cautious compliance, fear, and both low level and systemic corruption (Ledeneva).

43. Many experts believe that the arrest of one of Russia’s leading industrialists, Vladimir Yevtushenkov, on charges of money laundering, represented yet another step in an ongoing effort to weaken Russia’s more autonomous economic actors. Although Yevtuschenkov was subsequently released, a Moscow court gave the state permission to seize Bashneft, the oil company his firm, Sistema, had recently purchased. The arrest was generally seen as the first step in turning Bashneft over to Rosneft, the state-owned oil company led by Igor Sechin, a very close associate of Vladimir Putin. But it has also served notice to Russia’s business leaders that they would face serious problems if they were even to contemplate challenging the Kremlin’s policy. That arrest was the latest indication of the degree to which economic liberals have fallen out of favor. It is the so-called Siloviki faction of Putin associates from the national security and intelligence realms who are now on the ascendant (Business World News).

44. The Kremlin has used similar structures and practices in its foreign relations. The corruption of Ukraine’s energy industry, for example, provided the Kremlin with a very high degree of leverage over that country’s decision makers. It employed that influence to keep Ukraine in its economic and diplomatic orbit. For that reason Russian leaders saw the public rebellion on the Maidan against the Yanukovych government as a direct challenge to the Kremlin’s East European ambitions, and, by implication, a repudiation of the Russian Sistema. This was something Putin could not tolerate.

VI. THE ECONOMIC DIMENSION OF PUTIN’S EURASIAN AMBITIONS

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45. As suggested above, it is no coincidence that President Viktor Yanukovych’s decision to abandon a trade pact with the European Union triggered the crisis in Ukraine and Russia’s response to it. On the verge of signing a trade pact with the EU, Yanukovych ultimately gave in to enormous Russian pressure to back out of the deal, thereby, triggering the mass street protests in Kyiv that culminated in his flight to Russia. Putin ascribed these events to Western meddling in Ukrainian affairs. He responded by openly supporting those who opposed the Maidan revolution first in Crimea and then in Ukraine’s Donbas region. The effort was not only designed to keep Ukraine in Russia’s orbit, but also to warn off those CIS states that might be tempted to chart a Western-oriented policy course.

46. Galvanized by its civil society-led revolution and refusing to heed Russian warnings, Ukraine has now signed a trade pact with the EU and announced its clear intention to deepen ties with the West. Russia’s startling violation of Ukrainian sovereignty has also made several of its trading partners extremely wary. Belarus, a key Eurasian partner for Russia, recently reestablished border controls and is working to change the settlement of bilateral trade with Russia into dollars rather than rubles. Russia has brought increasing pressure to bear on Minsk to prevent the government from undermining the Russian import ban of Western food products. Belarussian President Alexander Lukashenko recently said “Yes Russia is our brother and our friend. But you see how they sometimes behave. Therefore we need to be sure to diversify, whatever the costs” (Hille, 2015). Tellingly both Lukashenko and the President of Kazakhstan, Nursultan Nazarbayev, have refused to endorse Russia’s actions in Ukraine.47. When close allies of Russia speak in these terms, it is very evident that Putin’s actions in Ukraine are not only undermining trust with the West, but also confidence in Russia’s so-called “near abroad”. It seems increasingly likely that Putin will resort to overt pressure on countries like Belarus, Armenia and Kazakhstan to hold fast to a system that seems increasingly held together by compulsion rather than free choice. One eastern diplomat characterized Putin’s dilemma this way: “We have been staring at the Ukraine crisis as a geopolitical game which Putin was winning. In fact, he has gambled all his geopolitical chips away. Putin has undermined the little soft power Moscow had left in the post-Soviet space, and now economic crisis is finishing off the rest” (Hille, 2015). That assessment may well be premature, but Putin’s hand does not seem nearly as strong as it did when he initially invaded and annexed the Crimea. His short term opportunism appears to be fashioning a long-term strategic quandary that could in itself pose dangers to stability.

48. The impact of the Russian economic slowdown has spread to a range of countries far more closely linked to it in commercial and geopolitical terms that is the EU. Many of these countries, for example, rely on remittances from nationals working in Russia to bolster scarce foreign exchange reserves. Net migration to Russia has been plummeting in recent months, and this trend will likely persist in conjunction with the slowdown. The collapse of the ruble has also meant that the value of wages for those foreign nationals working in Russia has fallen significantly. Tajikistan, for example, normally generates roughly half of its GDP from migrant remittances and these earnings have declined significantly as a result of the downturn in Russia (Hille, 2015).

49. Beyond his ambitions for a Eurasian Union, Putin has other geo-economic cards to play including China and the BRIC countries, none of which have chosen to follow the North American and European line on sanctions. In May 2014, Russia and China signed a 30-year US$400 billion supply deal under which Russia is to sell China up to 38 billion cubic meters of gas a year for 30 years beginning in 2018. Gazprom will invest US$55 billion in a new pipeline to the Chinese border and develop the Kovykta and Chayanda Siberian gas fields. For its part, China will provide an additional US$ 20 billion in infrastructure investments. The deal nominally provides Russia with an alternative to European markets on which it is highly dependent. But the China deal will only cover 16% of Russia’s gas exports, and the overwhelming share of Russia’s energy export infrastructure remains oriented in a westward direction. This is not likely to change quickly even as Europe looks to reduce its dependence on Russian gas and oil.

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50. The problem from Russia’s perspective is that it concluded the deal with China precisely when relations with the West were in free fall, and this probably helped the Chinese secure a better deal than originally anticipated. In other words, although Russian officials will never admit it, the working relations previously enjoyed with a number of Western countries had accorded them a certain degree of leverage with the Chinese. Russia has now sacrificed that leverage and China was quick to exploit this in negotiating a favorable long-term price for Russian gas. Chinese banks have also agreed to provide loans into the Russian market, although this only partly compensates for the role Western banks were playing in the Russian market prior to the introduction of sanctions.

51. Although China is not prepared to join Western sanctions and would like to see more checks on U.S. global power, it is equally unprepared to sacrifice vital commercial relations on Russia’s behalf. China’s bilateral trade with the United States is three times greater than it is with Russia, and it also has extensive commercial and financial ties with Europe. With its share of global GNP constantly on the rise, China’s economic star is clearly on the ascendant, although it currently finds itself in the midst of a serious crisis in its still under-developed financial markets. Russia is moving in precisely the opposite direction and its demographic challenges and political-economic orientation suggest that this relative decline is likely a long-term phenomenon. China is also profoundly uncomfortable with the precedent Russia has just established for unilaterally changing international borders - a sacrosanct principle for Chinese officials, particularly given the instability and latent separatism they confront in Tibet and Xinxiang. Moreover, Russian and Chinese commercial interests in Central Asia are likely to be geopolitically competitive. The Chinese, for example, would be interested in developing rail lines linking them to Europe through Kazakhstan rather than through Russia (Hille 9/1/15). They also want access to Central Asian energy production unhindered by Russian interference. Kazakhstan, Kyrgyzstan, Tajikistan and Uzbekistan are all set to join the Chinese-led Asian Infrastructure Investment Bank. This should help advance China’s vision of a Silk Road Economic Belt, which Russia rightly sees as a challenge to its own influence in the region. Finally, the Chinese are keen observers of what has transpired in Europe and recognize the downside of becoming overly dependent on Russian energy supplies. Russia’s clear proclivity to treat its critical energy assets as geo-political tools has inspired no small amount of circumspection among China’s strategic thinkers who worry about intertwining their country too deeply in Russia’s economic schemes. Unlike their colleagues in the Kremlin, Chinese leaders do not tend to see the global economy in zero sum terms and this alone places limits on their willingness to buy into Russia’s grand strategic vision.

VII. WEAKNESSES AND VULNERABILITIES OF THE RUSSIAN ECONOMIC MODEL

52. There has been a tendency in the West to see Putin’s Russia as a rising power now claiming its stake in the European order. This is a view that Russia’s media has promulgated but it belies the very serious problems Russia confronts. These problems are both self-induced and conjunctural and, looked at collectively, they suggest that Russia is in a far weaker position than it broadcasts. Russia’s problems include: a significant overreliance on the energy sector to underpin household and government income—a problem that has grown acute with falling global energy prices; the rise of new energy competitors most notably in North America; a governance system and political order that limit economic competition and discourage investment; a rapidly aging society plagued by surprisingly short life spans which are eroding productivity; slowing European economic growth which, combined with the current sanctions regime, is significantly reducing European demand for Russian goods; the rising costs of conducting a semi-secret war in Ukraine; the related series of sanctions and counter-sanctions that are isolating Russia and generating investor uncertainty; and finally pervasive corruption and cronyism.

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53. Russia remains essentially an energy-driven economy and its great growth spurt between 1999 and 2008 was driven by rising energy prices, growing energy production and a related increase in household consumption. Russia’s failure to develop a significant non-energy economy has meant that household spending remains tightly bound to energy prices. Energy price rises allowed the growth of real income (which grew 11% a year during this period) and consumption to outpace the growth of output. This state of affairs could only endure as long as energy prices were rising. When they fell precipitously last year, the Russian economy was automatically in trouble. Falling energy prices have exposed many of the fundamental weaknesses of the Russian economy that high prices had long managed to obfuscate.

54. Russia’s problems extend into the monetary realm. The precipitous fall of the ruble has exacerbated the decline of Russian energy earnings, triggered further capital flight out of Russia and increased inflation. The ruble depreciated more than 50% against the dollar over the course of 2014. As it did, Russia’s economy moved from the world’s 6 th largest to the 16th largest in dollar terms and is now roughly the same size as the Spanish economy (Aslund). Russia’s annual inflation rate last year stood at 11.4%, the highest level since 2008 and significantly above the Central Bank’s 4.5% target. By May 2015, inflation had risen to 16.9% but fell to 15.8% in May leading to a recent Central Bank decision to ease interest rates from 12.5% to 11.5%. The Central Bank now expects that the economy will contract by 3.2% (BBC News, 15 June 2015) although this seems optimistic. After a decade of household income growth, Russians today face declining real wages and the government embargo on food imports from Europe has further undermined consumer purchasing power. Year on year inflation in food prices in February 2015 hit 23.3% (Hanson).

55. Russian Finance Minister Anton Siluanov reported in early January that the 2015 budget deficit will be no more than 3% of gross domestic product. (Hille, 2014). Russia’s international reserves, including two significant sovereign wealth funds, had bottomed out at US$350.5 billion by mid-April 2015 but by the end of May had risen to US$362 billion. Russia, however, will need to keep the brakes on public spending as long as oil prices remain low (Adomanis). Russian debt to the rest of the world on 1 October 2014 was only US$64 billion or roughly 3.3% of GDP. The ruble has subsequently halved vis a vis the dollar but this debt burden is still quite small at 6%. The bigger problem is the debt of state-owned banks and companies, which in October 2014, was as high as US$614 billion. And it is precisely here that sanctions are having an outsized impact as these firms have lost or partly lost access to international capital markets. The Russian state has been compelled to use its National Welfare Fund, which had served as set aside for the national pension program, to lend on favorable terms to capital-starved Russian companies. The initial outlay was US$2.65 billion, but this is far less than will be needed (Kolyandr and Ostoukh). Rosneft alone is requesting a loan of US$42 billion which it says it needs because sanctions have limited its access to international credit (Hanson). In light of these developments, on 26 January 2015, Standard & Poors cut Russia’s foreign current credit rating to junk status, putting it below investment grade for the first time in ten years, while Moody’s and Fitch ratings continue to rate Russian credit status at just above junk status.

56. As of 17June oil prices had risen slightly to US$64.69/barrel, although a year before the price for Brent Crude surpassed US$115/barrel (Reuters, 17 June 2015). The World Bank has recently adjusted its economic outlook for Russia for 2015 and 2016. The most likely scenario assumes an average oil price of US$58/barrel for 2015 and 63.6 for 2016. On this basis, real GDP is expected to contract by 2.7% in 2015 and then grow 0.7% in 2016 and 2.5% in 2017. This revised forecast factors in very recent oil price rises and a recent slowdown in inflation that theoretically provides more room to the Russian Central Bank to ease monetary conditions. The World Bank is also projecting a phasing out of sanctions in 2017 (The World Bank,1/6/15).

57. Sharp fluctuations in interest rates have also buffeted the Russian economy. In December 2014, the Central Bank dramatically increased interest rates to 17% from 10.5% in order to

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defend the ruble, which at that moment was plummeting in value. The move essentially acknowledged that the estimated US$75 billion the bank had spent buying up rubles had been for naught. Alexei Kudrin, a respected former Finance Minister, recently suggested that the recent “fall of the ruble and the stock market is not only a reaction to lower oil prices and sanctions, but also distrust in the government’s economic measures”. High interest rates have obviously undercut prospects for a short-term recovery and have hit the cash reserves of many smaller and medium-size Russian companies. Market players are thus anticipating a rise in bankruptcies and defaults despite the suggestions of a very incremental recovery in 2016.

58. This past December, there were signs of a run on Russian banks as panicky consumers pulled cash out of the system and sought to turn rubles into assets that were more likely to hold value. In late December 2014, bank withdrawals soared to 700 billion RBS. That month, Trust Bank essentially collapsed, and Russian authorities provided a bail-out and encouraged the large private bank Otkritie to merge with that institution (Hille, 2014). The state subsequently reinforced the banking system by compelling state-owned exporters to convert dollar earnings into rubles. In June several of the country’s major banks were appealing for substantial mortgage subsidies as a substantial aid package ran out. Sberbank has requested a US$3.6 billion mortgage loan subsidy—more than triple the current subsidy it receives. The current subsidies were established after the Central bank raised interest rates to 17% to prop up the falling ruble.

59. Of course, Russia’s financial woes are not simply a Russian problem. The collapse of the ruble in late December 2014 precipitated a short-term sell-off of risky assets in Western capital markets, recalling the kind of patterns in evidence during Russia’s 1998 default. Fortunately, global equity and bond markets quickly recovered from that shock, but it does suggest that what happens in Russian markets is not entirely a Russian matter. There is a risk of contagion, and given the diplomatic and security tensions between the West and Russia, the capacity and will to co-ordinate potential responses with Russia is currently much diminished. On the other hand, Western markets have had time to insulate themselves from exposure to Russian instability and this may be one reason markets recovered so quickly from the shock of the ruble’s recent instability. Simply put, many Western as well as Russian investors have been lowering their exposure in Russia for months, not simply because of the sanctions, but also because of the poor business and regulatory climate in what is increasingly seen as a very risky market.

VIII. OIL AND GAS: RUSSIA’S WEAPON OR VULNERABILITY?

60. Although sanctions have exacted a toll on the Russian economy, plummeting energy prices have proved even more costly. World oil prices fell 49% from June 2014-January 2015 (Adams, Hume) and this has had a dramatically negative impact on the Russian economy. The price falls are the consequence of several factors. Slow economic growth has substantially lowered global fossil fuel demand as have long-term efforts in key European and North American markets to incorporate renewables into the energy mix and to increase energy efficiency across the board. Asian economic growth has also substantially slowed, and this has driven down energy demand growth on a continent, which remains the most dynamically expanding energy market in the world. On the supply side, the massive increase of oil and gas production in North America and the related crash in coal prices there have helped create a global energy glut, which along with slow demand growth has helped drive global prices downward over the past year.

61. OPEC, which produces one third of the world’s oil, failed to agree supply reductions in November 2014 to stem price falls, and Saudi Arabian oil officials have said that output reductions are simply not in the cards at this juncture. The Saudis clearly want to drive high-cost producers, including those operating in the North American non-conventional gas and oil sectors, out of the market. The Saudis seem quite willing to suffer the short-term consequences to achieve this strategic aim and they have very deep pockets. (Mazzetti, Schmitt and Kirkpatrick).

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While Saudi policy is clearly striking at energy-producing regions in the United States like Texas and North Dakota, the US economy as a whole is highly diversified and many US industries and consumers stand to benefit from substantially lower energy prices. This, however, is not the case in Russia, which is highly dependent on its oil and gas sectors both in terms of its overall GDP and in terms of government revenue. Russia essentially needs oil prices at US$107 a barrel to keep its extensive government budget in balance.

62. Adding to Russia’s dilemma has been the growing recognition among its European customers that overreliance on Russian energy has become strategically risky. European governments, for example, are now working to diversify energy imports in order to reduce the capacity of large suppliers like Russia to exploit market position for diplomatic and strategic purposes. There has also been a structural change in energy demand in Europe, which after a decade of very high energy prices, has become a far more efficient energy consumer. The same can be said for the United States. Even before the Crimea crisis, Russia had alienated many of its customers after it cut off gas supplies to Ukraine in January 2009.

63. Europe’s quest to build up its renewables capacity has represented one response to this over-reliance on Russia, but a number of European countries have has also demonstrated a mounting interest both in liquefied natural gas (LNG) and coal (despite its adverse environmental impacts). Europe’s slowing economy and a glut of global oil have together helped lower Russian market leverage, although it remains a critical gas supplier for a number of European states. The invasion of Crimea and the conflict in Easter Ukraine crisis have galvanized efforts to further diversify the supplier base, and have even spawned renewed interest in hydraulic fracturing in parts of Europe.

64. In December 2014, president Putin halted the much-discussed US$40 billion South Stream pipeline project that would have brought Russian gas directly to Southern Europe while bypassing Ukraine. Russian officials and gas industry representatives long maintained that in bypassing Ukraine, South Stream would allow Russia to meet southern European energy needs in a more reliable fashion. Critics countered that it would also leave the region vulnerable to Russian political suasion and price setting at a moment when Europe is seeking to move to hub-based rather than oil index pricing. South Stream was a central plank in Putin’s energy and geo-political strategy, and Russia had dedicated a great deal of diplomatic energy and money to promoting the project in several EU member countries despite mounting EU concerns that Gazprom’s administration of the pipelines represented both a violation of European competition law and a strategic risk.

65. President Putin will not abandon his energy ambitions in South Eastern Europe, and the South Stream decision represented only a momentary tactical retreat. Indeed, soon after the announcement, he visited Turkey to announce a series of initiatives to deepen energy relations. President Putin also made a quick visit to Hungary which would also be a key player in a southern European pipeline arrangement. In April Greece and Hungary as well as Serbia, and the former Yugoslav Republic of Macedonia* endorsed plans for a pipeline to deliver Russian natural gas under the Black Sea to Turkey and onward to a number of countries in Central and South Eastern Europe. Maros Sefcovic, the EU Energy Commissioner, has called this a project designed to undermine Ukraine and increase EU dependence on Russia (Rettman).

IX. GOAL OF SANCTIONS AND THEIR RELEVANCE

66. There has been a long-standing debate among international relations scholars and policy makers about the efficacy of economic sanctions as a tool of foreign policy or, more specifically,

* Turkey recognises the Republic of Macedonia with its constitutional name.

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as a means to inflict costs and pain on states in order to compel change in their behavior. For some, sanctions are little more than posturing when military action or other more severe action is judged injudicious or impossible. For others, they can be an effective coercive tool to compel change. There is a vast difference in these two concepts, and history is littered with examples that might confirm one or the other concept. The case of South Africa is often cited as an effective international sanctions campaign which ultimately fostered conditions that led to the end of apartheid. The decades of US sanctions against Cuba are frequently cited as an example of sanctions only contributing to the calcification of the status quo.

67. Clearly, the efficacy of sanctions depends on a number of factors including the willingness of a wide swathe of countries to participate, the specific groups that are targeted by the sanctions and their likely response, and the nature of the diplomacy that might move the situation toward the ends sought by those governments that launched the sanctions. The possible impact of counter-measures, including methods for circumnavigating the sanctions regime and sanctions initiated by the target country are also relevant. But the diplomacy surrounding sanctions is also critical. In other words, is there a viable diplomatic pathway to come to an agreement that, among other things, will lead to an end to the dispute and, by extension, to an end to the sanctions? The sanctioning countries need to spell out the specific nature of those conditions while identifying possible vehicles for negotiation.

68. The nature of the targeted regime is also significant. More open societies and state structures accord the public greater leeway to inflict costs on leaders, who have violated critical international norms and invited costly sanctions as a result. Less open societies and governments that have unchecked authority to crack down may confront less open resistance. When repression is high, the cost of resistance to the state may prove too daunting. But repressive regimes can also trigger more violent forms of protest simply because citizens lack non-violent means of expressing dissent. On the other hand, sanctions can also engender patriotic defiance and cement an “us against them” political climate that only hardens the resolve of the leadership to defy the international community. To some extent, this has been one impact of sanctions on Russia to date. With a media that he essentially controls, Putin has sought to blame Russia’s economic difficulties on the West. The question is whether the public will continue to accept this logic over the longer run, particularly as the lion’s share of Russia’s economic difficulties are due to low energy prices and very poor governance and have less to do with the sanctions. From the Russian perspective it is hard to disaggregate cause and effect as Russia’s economy has so precipitously fallen in coincidence with the sanctions rather than because of them. In any case, there is no simple relationship between economic pain and political or diplomatic change. The evidence of research on the matter suggests that much depends on specific domestic and international circumstances. Efforts that really target those responsible for the transgression in autocratic states, however, sometimes have more success than those that impose a cost on the society in general (Allen).

69. Putin’s Russia has less comprehensive repressive tools than did the Soviet Union, but the state certainly appears to be increasing its stockpile. This is not surprising given the privileged place Russia’s security apparatus has assumed in the country’s leadership. Years of economic growth and the government’s effective deployment of nationalist symbolism has endowed President Putin with a very high popularity rating which, in a sense, has provided him with the capacity to embark upon greater levels of repression against dissenters. The question today is whether Putin’s approval rates will endure as the economy enters a period of recession and the country’s last autonomous economic actors are picked off. The urban middle classes, in particular, are likely to feel the impact of the economic crisis most severely and this could shape their view of the Russian president, although criticism is increasingly met with repression and countered with propaganda issued by the state-controlled media (Kolesnichenko). As the economy weakens, Putin may only have imperial dreams to offer his people. This is hardly the goal of the West.

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70. As this report has suggested, it is very difficult to disaggregate the economic impact of the sanctions from the more powerful forces shaping that economy today - namely the collapse in the price of oil and fundamental and self-inflicted governance problems which have done so much to undermine investor confidence in Russia’s economy. North American and European sanctions initially sought to target those figures and military industrial institutions which have played a central role in driving and conducting Russia’s assault on Ukraine. But as the crisis grew, the target of sanctions also expanded to include the critical financial and energy sectors. While those sanctions have become more substantial, their greatest economic impact perhaps has been not so much their direct costs, but rather to the blow they have struck to Russia’s reputation as a place for doing business. But here again, the Russian government has done far more to tarnish that reputation.

71. Finally, it is worth noting that the costs of sanctions obviously are universally if not equally borne. Any policy measure that impedes market trading relations is sub-optimal in economic terms. The lost trading opportunities with Russia as a result of Western sanctions and Russian counter-sanctions are generally immiserizing and Western businesses, farmers and consumers are also paying a price. Western businesses are also burdened by the need to take administrative measures to ensure that they are in compliance with often complex rules although some have suggested that Ukraine related sanctions are more coordinated and coherent than other sanctions regimes Western governments have imposed in the past.

72. Efforts have been undertaken to mitigate some of these costs. In August 2014, the EU announced the provision of an additional €125 million in farm support to compensate some European farmers for lost sales to Russia as a result of Russia’s one-year embargo on European meat, fish, vegetables, fruit and dairy products. The Russian action contributed to a glut of several key food products during the peak of the summer harvest. Russia’s decision hit several countries particularly hard. Greece typically sells 60% of its peach production in Russia and that market vanished in the summer of 2014. Overall, roughly 10% of the EU's agricultural exports, worth around €11 billion go to Russia every year (Smith). Lithuania’s dairy industry has also suffered a major blow as a result of the lost Russian market. The recession in Russia, however, will have a far greater impact on Western business interests than sanctions or counter sanctions, as this downturn has had negative implications for a range of business including tourism, real estate and banking.

X. CONCLUSIONS

73. The Western goal in imposing sanctions on Russia is not to affect regime change, but rather to impose a price on Russia for undermining the sovereignty of Ukraine and putting the European security order at risk. In President Putin’s narrative, western sanctions are just the latest example of Western anti-Russian aggression. This is not at all the case and it is very important that the countries of NATO make clear what their objectives are.

74. At the same time, the lines of communication with the Russian state should be kept open. Ultimately dialogue will be essential to resolving or at least easing what have become serious tensions and to ensuring that these not escalate into more serious conflict. The prospects for this dialogue are not now very good but circumstances could well evolve over time.

75. A comprehensive Western energy strategy is clearly needed to deny Russia the kind of political leverage it is seeking to exercise over Europe. The best way to achieve this is to quickly and efficiently diversify the continent’s energy supply base. The cost of overdependence on Russia is certainly greater than the price of diversification.

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76. Russia has a long history in asking its people to underwrite its international ambitions and to some extent this dynamic seems to be once again in play. Military expenditure in Russia rose substantially between 2011 and 2014 but this was a period in which the country could afford to pay for both guns and butter. Its choices are now starker. If current spending trends persist without substantial change in Russian economic growth, Russia will face serious fiscal pressures that would prove very difficult to finance and could prove increasingly problematic politically in Russia with so many groups competing for ever scarcer resources. If such a struggle were to emerge, there seems little doubt that President Putin would side with the security and intelligence officials who now constitute the inner core of his inner circle. The West accordingly needs to gird itself for a period of very difficult relations with a Russian regime that seems to be growing increasingly militarist, revanchist and authoritarian. The Ukrainians are not the only victims here. The Russian people themselves will also suffer as the Kremlin moves down this path.

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