BNE INVISIBLE HAND: A lasting Ukrainian ceasefire? Temporary sanctions?

The partial ceasefire in Donbas and Lugansk has done little to ease the East-West information and diplomatic argy-bargy relating to Russia and Ukraine. If anything, the rhetorical exchanges have become more testy during September, after the EU and US expanded their sanctions program. This happened after the ceasefire – patchy, but thankfully still holding – was agreed between Kiev and rebel-fighters in East Ukraine.

The new measures are designed to target top state-owned energy, defence and financial services companies – including Gazprom, Lukoil, Rostec and Sberbank. The list of Russian officials subject to asset freezes and travel bans has also been extended. “Given Russia’s direct military intervention and blatant efforts to destabilize Ukraine, we’ve deepened our sanctions, in concert with our European allies,” said US Treasury Secretary Jacob Lew.

Vladimir Putin’s verbal retort was spiky. “Even when the situation is moving towards a peaceful settlement, they take steps aimed at a breakdown of the peace process – Why?” asked the Russian President.
At the time of writing, Moscow has yet to respond with counter-measures to this second wave of EU/US sanctions. But the 12-month ban on Western food imports, introduced over the summer, remains in place. Barely affecting American producers, Russia’s carefully targeted agricultural embargo is now causing howls of protest from the EU’s powerful farming lobby.

A rapid growth in consumer purchasing power over the last decade means Russia has become a very significant market for West European food producers. A third of the EU’s fresh fruit and vegetables exports were sold in Russia last year, plus a quarter of exported EU beef. If there was previously little awareness among Europe’s political classes of this huge eastward trade in perishables, Moscow’s food sanctions mean commercial realities are now hitting home.

EU exports to Russia of foodstuffs now banned amounted to €5.2bn last year, according to recent calculations by the European Commission. Brussels controls a compensation fund, set up under the Common Agricultural Policy for farmers facing potential ruin, of just €420m – miniscule compared even to official estimates of the losses. It’s unclear how much of this emergency fund will be available for compensation related to sanctions.

For some European farmers, the Russian market is now vital. Some 75pc of EU cabbage exports went to Russia last year, together with 63pc of tomatoes, 57pc of pears, 54pc of peaches and 52pc of apples sold abroad. The ban on exports to Russia has caused a mighty food glut in Western Europe, driving some wholesale prices down as much as 80pc. The single market, of course, means EU countries reliant on selling to Russia have diverted produce to member states that aren’t, depressing farmers’ prices throughout the 28-country block. Across the EU, fruit is withering on trees and vegetables are rotting in the ground, having become uneconomic to harvest. European farming groups put total sanctions-related losses at well over €10bn, far beyond the official numbers.

Even prior to Moscow’s food-export embargo, it was clear EU/US sanctions were seriously impacting Western Europe’s economy. Having grown 0.8pc during the first three months of the year, GDP in Germany, which has by far the most business-links with Russia among the large EU members, contracted 0.2pc in the second quarter. Italy, also with big trading ties to Russia, has just gone back in recession. There’s a real danger that heightened geopolitical tensions, aggravated by sanctions, could mean the same fate befalls the entire Eurozone.

Inflation across the Eurozone was just 0.3pc in August, a fraction of the 2pc level targeted by the European Central Bank. Falling food prices are now further stoking deflationary dangers. This fruit and vegetable glut, and related downward pressure on wholesale food prices, could push the Eurozone into outright deflation, as the region struggles to find new markets or consume more of its own food.

Having shaved interest rates again in early September, ECB supremo Mario Draghi has pledged to start buying asset-backed securities – otherwise known as overt quantitative easing – later this autumn. So, the US Federal Reserve is attempting to wean America off its monthly dose of QE just as the ECB is about to start mainlining the same drug. An extremely risky process, this monetary switchover is already in danger of serious unnerving fragile global equity and bond markets. A lurch into headline Eurozone deflation, which Moscow’s food ban could quite easily generate, may result in financial panic.

Invisible Hand has previously argued that Western sanctions on Russia would be short-lived as Europe wouldn’t be prepared to take the commercial pain – not least because far greater trade exposure to its giant Eastern neighbor makes that pain so much greater than that of America. With the Eurozone on the cusp of recession, that pain threshold is near. German industrialists are quietly angry at the impact of sanctions on their extensive Russian business interests. French farmers, meanwhile, are vocally furious at the impact of Moscow’s food ban. Mobilizing in their usual manner, and incensed by recent prices falls, they’ve already set fire to several regional tax offices in France.

There’s another reason East-West sanctions could be dismantled quite quickly – or, at least, not extended further. Ukraine’s economy is a mess, and getting worse. This increasingly indebted country’s upcoming schedule of bond repayments means that, if a deeply damaging default is to be avoided, a default that could send shockwaves across an already shaky Eurozone, an enormous additional bail-out will be needed.

In America, and Europe in particular, there’s barely the money and certainly not the political will to provide the necessary funds to Ukraine. The upcoming rescue package, then, will need both Russian and Chinese money. That’s not going to happen until the West drops its sanctions or gives a very clear and public commitment to drop them, so allowing Moscow to do the same.

In June, the European Bank for Reconstruction and Development forecast the Ukrainian economy would contract by 7pc this year. That was changed to an even more crushing 9pc GDP reduction in September – with the EBRD pointing to “significant downside risks” to that already disastrous outcome if there’s any further fighting in East Ukraine or more damage to trade with Russia. The bank’s economists also warned, ominously, that Ukraine would face “formidable difficulties” if gas supplies from Russia weren’t fully restored before the winter. Gazprom supplies over half of Ukraine’s still heavily-subsidized gas. With Moscow and Kiev yet to agree on a new price, the spigot was closed in June.

The International Monetary Fund’s existing $17bn Ukrainian support program was based on a 5pc economic contraction in 2014 and a bounce-back the following year. Under that scenario, Ukraine’s debt to GDP ratio climbs from 40pc to 62pc – which the IMF has argued is manageable, allowing Ukraine to avoid a painful debt restructuring.

These figures date from before the worst of the fighting in East Ukraine. They don’t consider the massive damage done to factories and transport infrastructure in Donetsk and Lugansk, which together account for almost a sixth of Ukraine’s GDP and a quarter of all industrial exports. Even if the ceasefire holds, and peace is quickly restored, the damage to roads, railways, utilities and airports will take years to repair.

The IMF has recently revised its numbers and now foresees a 6.5pc contraction this year. But there’s still a high chance the existing program will fall apart, implying a default. That would compound Ukraine’s economic turmoil, endanger Eurozone stability and further discredit the IMF. Unrealistic forecasts also unraveled in Greece, resulting in a painful and extremely disruptive €200 debt restructuring, made far worse by earlier IMF delays and denial.

The EU can’t and won’t bail-out Ukraine. Germany, isn’t even prepared to fund other Eurozone members. Congress would pay for President Obama to arm Ukraine against Russia – but the White House has wisely refused, making US lawmakers even less likely to pay for anything else.

In particular, Washington hawks would be loath to give serious non-military money to Kiev given that the cash would go straight to Moscow. Russia, after all, holds several multi-billion dollar Ukrainian bonds upon which payment is soon due.

Kiev will soon need another, much bigger bail-out. Europe and America have neither the money nor stomach to finance that alone. That’s the main reason sanctions will soon come to an end. And that’s before you consider the gas.

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