BNE INVISIBLE HAND: East-West Trade war kicks off

After three rounds of US-inspired sanctions against Russia, Moscow has finally retaliated. We’re now on the brink of a fully-blown East-West trade war. Since March, the West has imposed successive travel bans and asset freezes on various lawmakers and other prominent individuals – the most wide-ranging restrictions on Russian commerce since the Soviet era. In late July, the screw was turned even tighter, as America and then the EU limited Russian state-owned banks’ access to international capital markets.

President Putin then snapped. A 12-month ban on food imports from America, the EU, Australia, Canada and Norway was imposed and there’s talk of stronger measures to come. Diplomacy having failed – having barely been attempted – the economic gloves are now off. Will tit-for-tat sanctions between Russia and the West escalate, worsening the commercial and political damage? Or will they be contained?

While Russia has avoided recession this year, recording a 1.1pc GDP expansion during the first six months, growth over the second half will surely be lower – if not due to the direct impact of sanctions, then their effect on the broader business climate. A weaker ruble, though, is helping manufacturers, partly compensating for lower consumer spending. Russia’s fiscal surplus remains strong at 1.5pc of GDP, there’s miniscule government debt and vast stashed sovereign wealth. The Kremlin, if needs be, can turn the spigot on more infrastructure and budget spending if sanctions weigh too heavily on the domestic economy.

Inflation, though, is a problem. Already 7.8pc in July, prices pressures are likely to be aggravated by Putin’s agricultural import ban – not least as Russians spend around a third of household incomes on food. The Bank of Russia has hiked borrowing costs three times in five months, pushing the main refinance rate to 8pc, in a bid to contain inflation – and further rate rises could curtail bank lending and growth.

Ironically, though, it’s the Western world – in particular, Europe – that’s suffering more. The Eurozone was always going to bear the brunt of sanctions on Russia, given its $460bn of annual cross-border commerce with its Eastern neighbor, twelve-times more than America. Sanctions have contributed to the stalling of the Eurozone’s recovery, with region-wide growth flat during between March and June.

The imposition of Western sanctions, and the related ratcheting-up of geopolitical tension, has most significantly hit Germany. In June, factory orders in the Eurozone’s largest economy dropped the most in more than two and a half years, with German government citing geopolitical tensions as a major reason. The following month, in the aftermath of the downing of MH-17 over territory held by anti-Kiev fighters in eastern Ukraine, the bellwether ZEW indicator of economic sentiment plunged to a 2-year low, down for the third straight month.

Germany is, by a considerable margin, Russia’s biggest EU trading partner. The country’s manufacturing thoroughbreds have sunk hundreds of billions of euros in Russian production facilities. VW, for instance, now has several full-cycle Russian plants and is the middle-class brand of choice in what will soon be Europe’s largest car market. Siemens is central to the upgrade of Russia’s vast rail network and Liebherr has a big presence too.

Beyond these household names, numerous firms from the “Mittelstand” – the medium-sized enterprises that account for over half the German economy – have built lucrative trading-links with their Russian counterparts over the last 20 years. Many have set up shop across Russia’s far-flung regions, making everything from machine tools to plasterboard. Such companies are now feeling the pinch, their Russian customers canceling orders as geo-political tensions rise and sanctions bite.

These trends help explain why, having grown 0.8pc during the first three months of the year, German GDP contracted 0.2pc in the second quarter. The implications for the broader Eurozone are obvious. Italy, another large West European economy with big trading ties to Russia, just tipped back into recession. There’s now a very real danger that heightened geopolitical tensions, aggravated by sanctions, could mean the same fate befalls the entire Eurozone.

I’m hopeful, though, that East-West sanctions will remain relatively limited, at least from the Western side, given the existence of powerful business lobbies that will help keep gung-ho governments in check. While the Kremlin’s choice of a targeted food import ban seems strange, given domestic inflationary pressures, it may be smarter than it looks. There are, after all, few interest groups European politicians fear more than the farm lobby.

With EU farmers complaining of $16bn of lost commerce, while warning of domestic price falls given the resulting food glut, Brussels is now under intense pressure to negotiate a reversal of Russia’s import ban or, at the very least, make sure it’s limited to a single year. Russia’s fast-growing food market is extremely attractive and, with foreign competitors looming and domestic producers finding their feet, Western Europe’s food industry doesn’t want to lose out.

A big beneficiaries of this Kremlin sanction is Brazil – Russia’s ally in the Bric group of leading emerging markets. Since the ban was imposed, Brazil has moved quickly, authorized the immediate export of chicken, beef and pork to Russia from almost 100 meat plants. This will seriously annoy European farmers, as will the fact that while Russia accounts for a chunky 10pc of EU food exports, it’s just 1pc in the US. Few Russian sanctions will more effectively split America and Europe than a ban on imported food.

The EU itself is also deeply split, of course, with Britain talking tough about further sanctions, and France and Germany, despite some occasionally fiery rhetoric, more cautious. It strikes me that French farmers and German manufacturers could now combine to push the debate their way – not least as the UK, petrified of jeopardizing the City’s Russia-related business, is looking for an excuse to back down.

Even in America, while Russia account for just 3pc of total trade, there is now a considerable group of powerful US corporations that have ploughed serious foreign direct investment into the former enemy. The likes of Ford, GM, Boeing, Procter & Gamble, Pepsi and John Deere have between them built a myriad of Russia-based production facilities, keen to tap into what will soon be Europe’s largest consumer market. As have several US oil majors, of course. Defense industry lobbyists will forever play up the “Russia threat”. That will never stop. But any US President now has a growing corporate lobby in the other ear, stressing the “Russia opportunity” and the importance of protecting existing investments.

Commercial imperatives won’t stop the political posturing and rhetorical finger-pointing – from both sides. But they should help keep sanctions within reasonable limits. Another reason the West may avoid further turning the screw is that the event that provoked the latest crackdown – the downing of MH-17 – may start to lose political significance.

This disastrous crash, in which almost 300 innocent civilians perished, was clearly a horrific tragedy. Of that, there can be no doubt. Yet while Western politicians were quick to blame Russia in the immediate aftermath, using the related outrage to crank up sanctions even more, the accusations have lately gone quiet – not least as US intelligence officials have quietly admitted they have no evidence of Russia’s involvement.
It is entirely possible, of course, that anti-Kiev fighters used a Russian-supplied surface-to-air missile, either purposely or inadvertently, to shoot down MH-17. But in the absence of compelling proof, which America seems not to possess, that narrative will become harder to sustain. Mainstream media outlets, in continental Europe at least, are now voicing doubts, pointing out that the Ukrainian army also uses Russian-made missiles, while highlighting conflicting evidence suggesting MH-17 was shot down by a second plane, which the rebels don’t have.

This plane crash, with its ghastly human impact, was a turning point. After MH-17, the EU toed the line, immediately agreeing to much tougher sanctions. That provoked Moscow’s response, putting us in a tit-for-tat that could now escalate. But the longer question marks remain regarding Russia’s involvement in the MH-17 incident, and the more food sanctions hit Europe but not America, the more nuanced the EU’s views will become.

If Ukraine’s civil war spreads, or Russia becomes extremely belligerent, then obviously all bets are off. But my base case is that sanctions have reached their high point, even if the rhetoric continues to spiral.

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