SPECTATOR: Europe will reconcile with Russia – it can’t afford not to

After months of escalating tensions over Ukraine and talk of a new cold war, Russia and the West could soon reach a sanctions rapprochement. The eurozone economy is suffering badly and sanctions are partly to blame. Winter is also upon us, and that reminds everyone Vladimir Putin still holds the cards when it comes to supplying gas.

The clincher, though, is that Kiev is in a deep financial hole and fast heading towards financial meltdown. Unless an extremely large bail-out is delivered soon, there will be a default, sending shockwaves through the global economy. That’s a risk nobody wants to take – not least in Washington, London or Berlin.

Sanctions against Russia were always going to hit Western Europe hard. The eurozone did 12 times as much trade with Russia as the United States did last year – that’s one reason Washington’s attitude towards corralling Russia’s economy has been somewhat more gung-ho.

Most big European economies, particularly Germany, only explicitly backed Western sanctions after the Malaysian airline MH-17 was shot down over Ukrainian airspace in July and 298 innocent people perished. After that tragedy, instantly blamed on Moscow, it was politically impossible to suggest sanctions might be counter-productive.

The result was the biggest clampdown on Russian trade since the Soviet era – mainly targeting energy, defence and financial services companies – and the deterioration of East-West relations to their lowest ebb since the Cold War.

The Western economy that’s suffered most, by far, is the largest in the eurozone. Germany’s manufacturing thoroughbreds have sunk tens of billions of euros into Russian production facilities in recent years. Volkswagen 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 specialised manufacturer Liebherr has a big presence too.

Numerous “Mittelstand” firms – the medium-sized enterprises accounting for over half the German economy – have also built lucrative trading-links since Russia opened-up 20 years ago, selling everything from plasterboard to machine tools. Over 6,000 such companies now operate across the country, with 350,000 German jobs directly dependent on Russian trade. They’re also feeling the pinch, their Russian customers recoiling as geo-political tensions rise.

This helps explain why, having grown 0.8 per cent during the first three months of 2014, German GDP shrank 0.2 per cent in the second quarter. The eurozone’s powerhouse is now on the brink of recession. Industrial production dropped 4 per cent in August, the biggest monthly fall since early 2009. Exports were down 5.8 per cent – again, the steepest drop since the Lehman collapse.

If German industrialists are quietly angry about “America’s sanctions”, French farmers are noisily furious. Moscow’s reciprocal 12-month ban on imported Western food, barely affecting US farmers, is causing howls of Gallic protest. A third of the EU’s fresh fruit and vegetable exports were sold in Russia last year, plus a quarter of exported beef. Moscow’s carefully-targeted embargo has caused a food glut, driving down European wholesale prices. Mobilizing in their usual manner, French farmers have been setting fire to regional tax offices. Combined with German manufacturers, they make a powerful anti-sanctions lobby.

The main reason, though, why East-West sanctions could now be dismantled quite quickly is that Ukraine’s economy is imploding, raising the spectre of financial “contagion”. In June, the European Bank for Reconstruction and Development forecast Ukrainian GDP would shrink 7 per cent this year.

Last month that forecast was downgraded, to a whopping 9 per cent drop, with the EBRD warning of “formidable difficulties” if energy supplies from Russia weren’t fully restored before winter. Gazprom generally supplies over half of Ukraine’s still heavily-subsidized gas. But with Moscow and Kiev yet to agree a new price, the tap was turned off in June.

The International Monetary Fund’s existing $17bn Ukrainian support program was based on a 5 per cent economic contraction this year and a bounce-back in 2015. Under that scenario, Ukraine’s debt, the IMF argues, remains just about manageable, avoiding a painful restructuring.

But these figures, dating from before the worst of the fighting in East Ukraine, don’t consider the destruction of factories and transport infrastructure in Donetsk and Lugansk, together accounting for a sixth of Ukraine’s output. Even if the current patchy ceasefire holds, the damage to roads, railways, utilities and airports will take years to repair.

Unrealistic IMF forecasts unraveled in Greece, resulting in a very disruptive €200 debt restructuring, made much worse by earlier delays and denial. That’s why IMF supremo Christine Lagarde has just admitted “additional funding” is needed for Ukraine, while adding it would be “rather far-fetched” to assume the IMF can stump up.

Which brings us to the heart of it. In America, and Europe in particular, there’s barely the money and certainly not the political will to help Ukraine. German voters, in their current mood, won’t even stomach backing fellow eurozone members. Congress would pay to arm Kiev against Moscow, but the White House has wisely refused. But that makes US lawmakers even less likely to pay for anything else – not least as non-military money would flow straight to Moscow, seeing as Russia holds several multi-billion dollar Ukrainian bonds upon which payment is due.

The upcoming rescue package, then – an additional $20-25bn – will need both Chinese and (whisper it) Russian money. That’s not going to happen until the West drops its sanctions or gives a very clear commitment to do so, allowing Moscow to do the same. For the reality is that the West – or at least Europe – wants sanctions to end much more badly than Moscow.

Russia has so far avoided recession. The ruble has fallen, but that helps manufacturers and boosts (dollar-denominated) oil revenues. Moscow boasts a fiscal surplus, miniscule government debt and vast stashed sovereign wealth. Oh, and President Putin’s approval ratings remain sky-high.

All this explains why Angela Merkel welcomed Chinese Premier Li Keqiang to Berlin last week – the German Chancellor’s third meeting with the Chinese government in six months – as she brokers a Ukrainian bail-out and related end to sanctions. US Secretary of State John Kerry has since held talks with his Russian counterpart Sergei Lavrov, prior to a meeting between Ukraine’s President Poroshenko and Vladimir Putin in Milan.

So, I’m expecting less belligerence between Russia and the West – and a general calming of the calming of the diplomatic atmosphere (not least as US intelligence experts have found it impossible to pin the blame for MH-17 on Moscow). With the global economy on a knife-edge, a wind-down of East-West animosity would provide some much-needed good news. For all the sabre-rattling and finger-pointing of recent months, it’s something everyone should welcome.

http://www.spectator.co.uk/features/9342012/europe-will-reconcile-with-russia-and-soon-it-cant-afford-not-to/

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