Russia: Economic, and Military, Escalation

Published on July 25, 2014

Deep into a lengthy press briefing yesterday State Department Deputy Spokeswoman Marie Harf stated the US has new information that Russia is firing artillery rounds across the border into eastern Ukraine and that Moscow intends to deliver heavier and more powerful multiple rocket launchers to the rebels.

Beyond the specificity and certainty in those allegations, however, Harf refused to provide precise details to reporters on the sourcing or evidence for the information, although it does appear to be based in large part on human intelligence. That exchange, and counter charges by Russia that the claims are baseless, has sown some confusion among markets and analysts as to whether and to what extent this indicates a new and material escalation in tensions.

It does.

*** Our understanding is that the US has its own military intelligence and advisors in the region, and the reference to human as opposed to just satellite or signals intelligence therefore does not necessarily imply a reliance on Ukrainian sources that have a strong incentive to keep implicating Russia and to pull the West further into their cause. We have no reason to think this is not in fact a significant escalation of tensions – and one that is happening in real time (the present tense in the Harf and then subsequent Pentagon comment is notable and deliberate). ***

*** Under increasing pressure from sanctions, Russia’s President Vladimir Putin would seem to have little incentive to take actions that would harden and accelerate the European Union deliberations already underway to extend sanctions against Russia itself. But that sanctions train has to some extent already left the station, and Kiev’s sudden stepping up of the military offensive against the rebels in Donetsk and Luhansk, with Western support, has now triggered this military escalation from an increasingly embattled Putin, namely a more aggressive and overt shelling and supply of arms to support the rebels whose very survival may now be at stake (see SGH 7/23/14, “Russia: The Hard Press on Putin”). We find reports that Russia has amassed a significant number of troops on the Ukrainian border to be credible. ***

*** Despite its denial of these allegations, Moscow’s public response has been confused, ranging from flat out denials that there is any truth to the US statements and demands the US provide more evidence, to recriminations over mutual skirmishes across the border. And this verbal battle of accusations is now largely moot as Putin has in no uncertain terms lost this public relations war: from what we understand there is strong momentum building within the EU towards the 28-member unanimity needed to follow through next week in the footsteps of the US sanctions with an agreement on a new list of sanctions on individuals and companies close to Putin as well as the start of negotiations over the adoption of specific sectorial economic sanctions on Russia. That will be in addition to the new list of sanctioned Ukrainian and Crimean names threatened to be released tonight. ***

New Details to EU Sanctions

The European Commission and EEAS (European External Action Service) have prepared a list of the potential sectorial sanctions the EU could take, and the broad outlines of those proposals targeting the capital markets, defense, dual use goods, and sensitive technologies sectors, including in energy, have been leaked and reported in the press.

Here, however, are some important additional details we have been provided about those potential sectorial measures. They include:

– A prohibition on any EU person from investing in debt, equity and similar instruments with a maturity of over 90 days that is issued by a state-owned Russian financial institution (defined as banks with over 50% public ownership). A ban on the provision of any trading advice or investment services to these institutions for new instruments. This would choke off new funding but existing shares and bonds would not be covered (EU financial institutions will for example be able to sell them, if they wish).

– EU officials are fully aware of the chill those restrictions would have on these other securities, as well as on non-sanctioned institutions. It is noted that between 2002 and 2012 Russian companies raised $48.4 billion in the EU through IPOs (of which $16.4 was issued by the state-owned institutions) and that in 47% of the 15.8 billion Euros of bonds issued by Russian public companies was issued in EU markets.

– The EU is not, however, looking to restrict investment in Russian sovereign bonds at an initial stage, nor in the equity and debt of private sector operators, or in syndicated loans. That is frankly because Russia itself is a significant investor in several EU member states, and because restriction on syndicated loans could negatively affect EU subsidiaries in Russia.  A next round could extend the prohibition of investments from state owned companies to sectors that are subject to sanctions, such as defense.

– An embargo on arms trade with Russia. It is noted that Russia exports 3.2 billion Euros of arms to the EU while the EU exports one tenth of that amount, 300 million Euros to Russia (it would appear the French Mistral amphibious assault ships have conveniently been excluded out of this calculation). Export licenses are under the competence of individual member states, but a Council common position on arms has introduced harmonized criteria. Deals (ahem) already under contract would be honored.

– It is noted that the EU exports around 20 billion Euros of dual use (military and civilian end user) products to Russia a year. Trade exporters would be required to prove that the goods they are exporting would not end up in the hands of a military or civilian/military company. Restrictions could start with a subset of, for example, special materials, quantum key distribution systems, certain machine tools, and high performance computers and electronics. That would comprise around 20%, or 4 billion Euros, of the total trade.

– A restriction on the export of sensitive technologies, including in the field of energy. It is noted that an embargo of sensitive and sophisticated technologies, as an example technologies used for deep sea drilling, arctic exploration, and shale oil, would only affect long term production and drilling (despite the spike in oil prices on the fear of these sanction today). And it is furthermore noted that gas related technologies would not be touched (for obvious reasons…).

– The EU would also prohibit export credit, re-insurance, or financial services associated with the trade in any of these banned commodities.

These measures would need to be adopted through a CFSP (Common Foreign and Security Policy) Council Decision based on Article 29 (requiring unanimity, based on an EEAS proposal) and then a regulation based on Article 215(1) TFEU (by qualified majority, European Parliament involved, based on a joint proposal by the High Representative and the European Commission proposal).

Meanwhile the military conflict on the ground continues to show no signs of abatement. More alarmingly, we continue not to detect any back-channels at work at this point to de-escalate tensions – but rather appear to be caught in a spiral of retrenchment and rising confrontation on both the military and economic fronts.

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