Russia vs. the West: The Economic Battle for Ukraine

July 2018

From: JUPS #1, 2018 (pp. 1-26).

Opening of the first McDonald's restaurant in the USSR; Moscow, 31 January 1990. Source: mcdonalds123.ru

Russian Economic Power and Ukraine

The West, then, has significant economic leverage which it can use to influence both Ukraine and Russia.  Yet unlike in many past cases of sanctions, Western nations here face an opponent who can fight back—militarily and economically—both against Ukraine and against the West itself.

As many observers have noted, Russia’s most important economic tool is its control over the energy supply of its neighbors, especially through natural gas exports (Stuhlberg 2007; Goldman 2008; Newnham 2011b).  Yet Russia has many other tools at its disposal; for example, like the West, it can offer financial credits and raise or lower its trade barriers.  As we shall see, many of Russia’s neighbors—including the E.U. states as well as Ukraine—have some degree of dependence on Russia as an export market, which the Kremlin can exploit.

Ukraine has lived with the reality of Russia’s economic influence since it became independent at the end of 1991.  Since the Russian economy is over ten times larger than Ukraine’s, any given economic sanction (or incentive) is relatively much cheaper for Moscow than Kyiv.12 Accordingly, the Russians have continually tried to use economic levers to either promote friendly governments or punish unfriendly ones.  The shifting winds from the Kremlin have been clear.  Before 2004, President Kuchma was seen as relatively pro-Russian.  Thus, for example, Ukraine was able to buy natural gas for only about $50 per thousand cubic meters (TCM) and was able to export freely to Russia, shipping many uncompetitive manufactured goods and agricultural products.  Ukraine’s accumulated debt to Russia was pursued in only a desultory fashion.  Suddenly, however, with the Orange Revolution bringing the pro-Western Yushchenko government to power, the Kremlin turned hostile.  Gas prices soared by a factor of five, to about $250 per TCM.  “Customs problems” mounted for Ukrainian goods.  And debts were pursued fiercely.  Most dramatically, Moscow cut off Ukraine’s gas supply twice, in 2006 and 2009, both times in the depth of a cold northern winter.  As I have argued elsewhere, Russian economic pressure played an important role in wrecking Ukraine’s economy at this time, helping to pave the way for the election of the relatively pro-Russian President Victor Yanukovych in 2010 (Newnham 2013).

Yanukovych soon was rewarded by the Kremlin.  He quickly signed an agreement with Moscow extending the Russian Navy’s lease on key bases in the Crimea, which Yushchenko had long resisted.  In return, the Russians immediately cut Ukraine’s gas cost by 25% (Levy 2010).  Pressure to pay past debts eased, and access to the Russian export market improved.  However, when the Yanukovych regime announced in 2013 that it would sign an Association Agreement with the E.U., the economic temperature suddenly cooled again.  No stone, large or small, was left unturned.  For example, ‘chocolate Czar’ Petro Poroshenko—at the time merely a prominent Ukrainian businessman—found that his products were unwelcome in Russia, due to alleged quality issues, including contamination with carcinogenic chemicals (Flintoff 2014).  Many other threats were reportedly made—for example, that Ukrainians might lose the right to work in Russia.  And in August 2013, Moscow tightened enforcement of every trivial customs rule it could find, delaying or rejecting many trade shipments from Ukraine (2013, ‘Ukraine and Russia:  trading insults,’ The Economist, 24 August).  Yet when Yanukovych suddenly decided to skip the November 2013 Vilnius summit with the E.U., refusing to sign the planned Association Agreement, the Kremlin again instantly warmed to him.  Poroshenko, for example, was told that all difficulties experienced by his factories would end quickly.  On a grander scale, the Kremlin quickly negotiated a 'Ukraine-Russia Action Plan' with Yanukovych, offering a variety of economic incentives.  The tightened customs rules imposed in August were abruptly dropped.  Gas prices were further reduced, from a rate then above $400 per TCM to $268.  And most importantly, a loan of some $15 billion was offered, although only $3 billion was provided immediately (McElroy 2013).

When the Yanukovych regime fell in February 2014, Russia’s economic incentives again morphed instantly into economic sanctions targeting the new, pro-Western government.  Russia refused to pay out the remaining $12 billion in loans which it had offered Yanukovych only two months earlier.  In fact, it has demanded immediate repayment of the $3 billion which had already been disbursed (Schearf 2015).  Kyiv also quickly faced trade sanctions and even the outright seizure of Ukrainian assets in Russia.  Outspoken political opponents of the Kremlin were singled out for particularly harsh treatment.  For example, Petro Poroshenko, now President of Ukraine, saw his Roshen candy factory in Russia face a series of legal actions, culminating in a police raid and the court-ordered seizure of the entire business, allegedly for tax violations (Yakovenko 2015).

Russia also resumed the use of its most potent weapon, its control of Ukraine’s energy supply.  Moscow again drastically increased the cost of Ukraine’s natural gas.  First, it cancelled the 25% reduction linked to the lease renewal for Crimean naval bases.  With the seizure of Crimea in March 2014, Russia claimed, that agreement was now null and void.  Next, Moscow threatened to vastly increase even that price, demanding almost $500 per TCM, far above the rate charged to even the wealthiest West European countries.  In the ten years since 2004, then, Moscow had raised the gas price ten-fold—from about $50 to $500 per TCM.  In addition to the vast price increases, Moscow also demanded immediate cash payments of all accumulated energy debts.  Alleging that Ukraine might not pay for gas after delivery, the Russians also asked for advance cash payment for any future shipments.  These conditions had never been demanded of the Yanukovych government.  When Kyiv would not comply immediately, Moscow simply turned off the country’s gas supply, on June 16, 2014—and left it off (Walker 2014).  This time, the embargo was to last not for a few days, but for four long months.

In the end, the threat of a ‘cold winter’ for Ukraine was avoided at the last minute, as the E.U. was able to broker a deal with Russia on Ukraine’s gas supplies.  The deal which was finally reached on October 30, 2014, called for Kyiv to pay from $268.50 to $378 per TCM for various parts of its winter supply.  This was a painful increase from the roughly $250 it paid when Yanukovych ruled the country, although less than the nearly $500 price initially demanded by Moscow (Kanter 2014).  And to make matters worse, Russia still insisted on payment of past gas debts; it was to receive $3.1 billion by the end of 2014 for debt payment, in addition to about $1.5 billion for current supplies.  With Ukraine relying on foreign loans, the West ironically found itself effectively paying Moscow for Ukraine’s gas.  By supplying almost $5 billion to Russia, the deal also significantly undercut the Western sanctions policy. 

This episode is a good example of how advocates and opponents of sanctions can view the same incident differently.  While some focus on the harshness of Russian policy in the unprecedented four-month gas embargo, others such as Adam Stulberg (2015) stress that the Kremlin ultimately showed restraint by agreeing to a compromise solution.  And the question of Russia’s motivation remains open.  Part of it was certainly that the pain from Western sanctions was already beginning to be felt, and Gazprom (and Russia as a whole) needed the payments associated with the deal.  At the time, Russia’s Energy Minister, Alex Novak, stated that Russia was acting 'to show it was a reliable commercial partner for the E.U.,' likely hoping that this might help to motivate the E.U. to show similar flexibility by rescinding its sanctions (Kanter 2015).

In all, though, Russia’s sanctions—and military action—against Ukraine have had a devastating effect on the country.  As noted earlier, Ukraine’s economic growth slowed down, dropping by an estimated 6.6% in 2014 and 9.8% in 2015 before a slight recovery in 2016 and 2017 (CIA World Factbook: Ukraine Economy).  Inflation was estimated at 48.7% for 2015, a crippling rate.  And the government struggles to borrow enough to stay afloat.  The economic problems are very ominous for the Poroshenko government.  While the government did briefly enjoy popular support, in a patriotic response to Russia’s invasion of Crimea and Eastern Ukraine, it has had difficulty maintaining this as the economy slides.  By late 2016 Poroshenko’s approval rating was abysmal.  For example, in a poll reported in November in the Kyiv Post, 73% of respondents had an unfavorable view, with only 20% favorable (2016, ‘Survey Shows Poroshenko Not Supported by 73% of Ukrainians,’ Kyiv Post, 2 November).  As noted above, Russian sanctions and the resulting economic problems played a role in discrediting President Yushchenko and the Orange Revolution, helping to lead to his electoral defeat in 2010 (Newnham 2013).  The Kremlin now seems to hope that history will repeat itself.

Russian Economic Power and the West

From the beginning of the Ukrainian crisis, Russia made it clear that any Western economic sanctions would be met with retaliation.  In fact, Moscow had already sanctioned some individual American citizens after the U.S. passed the Magnitsky Act in 2012. 13With each stage of the Ukrainian crisis, Moscow’s list of sanctioned individuals grew, encompassing not only Americans but a number of Europeans.  It now includes, for example, 89 prominent European political leaders, some of whom have been stopped at airports and denied entry into Russia (2015, ’89 European political and military leaders banned from Russia,’ The Guardian, 30 May).

The E.U. was also threatened by possible interruptions in its supply of Russian natural gas.  Unlike Ukraine, the E.U. could pay its bills.  But it still faced possible Russian gas sanctions, for two reasons.  First, in its effort to evade Moscow’s gas sanctions, Ukraine could supply its own needs by siphoning gas in transit to the E.U., as it had done in gas disputes with the Kremlin in 2006 and 2009.  This could not only directly impact the E.U. by reducing its supply; it could lead to Moscow cutting the amount of gas put into the pipelines to discourage siphoning.  Thus, if siphoning continued, the amount reaching the E.U. could fall even further—possibly to zero.  However, there was also a second reason for the E.U. to fear gas sanctions—the issue of reverse gas flows.  In an effort to help Ukraine, several E.U. countries had resold Russian gas to Kyiv, starting in summer 2014 when Russia cut off the Ukrainian supply.  Since resold gas helped Kyiv to resist the Russian embargo, Moscow frowned on this practice.  As a result, within a short time mysterious temporary supply cuts were felt by such countries as Poland (DeFotis 2014) and Slovakia (Carney 2014).  While Russia did not confirm this, many observers believed the cuts were carefully calibrated signals, warning these states that if reselling continued they could face full-scale gas embargoes.

However, the main area which Moscow targeted with its sanctions was food products.  For many years the Kremlin had used this "food weapon" against former Soviet states, which it wished to punish.  For example, Georgia had been targeted for years with sanctions against its wine and mineral water producers (Newnham 2015).  Now the same method was turned against the E.U. and other Western states.  In October 2013 Moscow halted imports of dairy products from Lithuania.  This measure was officially for 'safety reasons,’ but was universally seen as punishment for that country’s decision to host the November summit at which Ukraine, Moldova and Georgia were to sign the E.U. Association Agreements.  As the Ukraine crisis deepened in 2014, the food weapon was again trotted out.  In January, all pork imports from the E.U. were stopped, allegedly because of disease concerns.  In July, Poland—one of Russia’s strongest critics in the E.U. – was informed that its lucrative fruit and vegetable exports to Russia would be stopped.  However, the most serious counter-sanctions were announced on August 6, 2014, just after the West imposed its ‘Phase 3’ sanctions, detailed above.  The Kremlin decided to cut off most food imports from all Western states participating in ‘Phase 3.’  This included not only the E.U. and US, but also Norway, Canada, and Australia.  These sanctions have been renewed regularly since then, most recently in June 2016, at which time they were extended until the end of 2017.

Impact of Russian Sanctions on the West

As was the case with the Western sanctions against Russia, the effects of these sanctions will now be considered in three areas:  their economic impact, their effect on the domestic politics of the targeted states, and their impact on the foreign policy of the West.

The economic impact of these sanctions varied.  The U.S. exported $1.3 billion in agricultural products to Russia in 2013, while the E.U. exported $15.8 billion (2014, ‘Russia hits West with food import bans in sanctions row,’ BBC News, 7 August).  For some Western states, such as the U.S., the impact of Russian counter-sanctions seemed small.  Since overall U.S. exports were $1.575 trillion in 2013, including $145 billion in agricultural products, the sanctions would affect less than one percent of agricultural sales and a miniscule 0.08% of total U.S. exports (CIA World Factbook). However, for some countries, especially in Western Europe, the losses loomed much larger.  Norway, for example, faced the loss of its largest purchaser of fresh seafood—accounting for $1.06 billion in annual sales—a significant blow to an economy only about three percent as large as the U.S.’ (Tallaksen 2014).  For countries with weak economies, the loss of exports was even harder to bear.  Greece, for example, looked to Russia as an important market for fresh fruit exports.  Given the state of its economy, even small economic losses loomed large politically.  And Lithuania, an agricultural country traditionally linked to the Russian market, faced the worst blow of all—2.5% of its GDP was reportedly made up of sanctioned products. (2014, ‘Russia hits West with food import bans in sanctions row,’ BBC News, 7 August).  Particularly upsetting for the Europeans was the fact that many of the affected exports—such as fruit, seafood, and cheese—were highly perishable.  Thus, in the short term, it was well-nigh impossible to find alternative buyers.  When the Russian boycott was suddenly imposed, trucks were literally turned away at the border with nowhere to go. 

The Russians, then, like the West, were wise enough to use ‘smart sanctions,’ targeting their opponents’ most sensitive economic sectors.  It must also be remembered that the agricultural sector has huge political clout in Western Europe, as President Putin was well aware.  Thus, it no doubt seemed plausible to the Russians that agricultural sanctions would lead to a speedy outcry from farmers, and perhaps to concessions from the E.U.  Indeed, the E.U. did respond very quickly to placate the farmers.  Within days of the Russian action it offered special agricultural financing, amounting to about $167 million (Ruitenberg 2014).  European leaders tried to promote a ‘buy local’ campaign.  For example, the German agriculture minister, Christian Schmidt, promoted German apples with the slogan “An Apple a Day Keeps Putin Away” (2014, ‘An apple a day keeps Putin away,’ Der Spiegel, 27 August).

Threats to areas such as agriculture and energy, however, are far more than sectoral problems:  they can drag down the whole E.U. economy.  This gives Russia’s counter-sanctions much more impact.  The E.U. is vulnerable to these sanctions, because its economy, while large, has been mired in recession since 2008.  Facing slow or no growth at home, the E.U. had looked to exports to buoy itself—and was starting to make some progress.  Russia’s sanctions, while not all-encompassing, have helped cause the E.U.’s recovery to stall.  The E.U. itself estimated that the conflict with Russia would cost it 0.2% in regional GNP in 2014, and 0.3% in 2015 (Norman 2014).  This economic slowdown is far less than that faced by Russia.  As noted above, the Russian economy fell by almost 4% in 2015. 

However, even a small downturn can have a strong domestic political impact on the E.U. and its partners, since the Western states are democracies.  And as was discussed in the theory section of this paper, studies have shown that democratic states may be more vulnerable to sanctions, since affected sectors can quickly and easily react politically to any economic pain.  Dissent can be voiced very cheaply, without consequences (in contrast to the situation in Russia), and dissenters are easily able to support alternative political parties and vote them into office.

This has proven the case in the E.U., for example.  First, dissent over the ‘sanctions battle’ with Russia has been quite visible.  For example, both farmers and business leaders linked to the Russian market have spoken up forthrightly.  They first opposed the sanctions as they were being imposed, then began to lobby for them to be lifted if Russia made even minimal concessions.  Germany, for example, saw its exports to Russia fall by almost half, from 38 billion Euros in 2012 to only 21 billion in 2015, with a further 10% drop in 2016 (2016, ‘German exports to Russia set to fall to ten year low,’ AFP, 19 February).  It is thus not surprising to see that the President of Siemens would meet with President Putin even as his country was imposing sanctions on Russia, and that leaders of companies such as Adidas and ThyssenKrupp would echo his concerns (Czuczka 2014).  Similarly, former Chancellor Gerhard Schröder—now chairman of the German-Russian gas pipeline company Nord Stream—said that Russia’s land grab in Crimea was just as legitimate as Kosovo’s secession from Serbia, echoing the Kremlin’s line (Paterson 2014).  Schröder has continued to lobby for the Russian viewpoint in Germany; for example, he was among the few prominent Westerners to attend the St. Petersburg Economic Forum in June 2015, at which Putin delivered a blistering attack on Western policy.

Finally, then, have Russian sanctions had an impact on Western foreign policy?  This seems to many to be most likely in the E.U.  The E.U. has a very unwieldy decision-making model, in which all 28 member-states must consent to important policies.  Observers were very impressed that the Union managed to agree on three rounds of sanctions—this is an achievement.  The Union was even able to maintain unanimity in renewing the sanctions for a further six months in both June and December of 2015 and 2016.  However, the E.U. now faces the harder task of maintaining that solid front for an indefinite time in the face of Russian intransigence.  If even one state defects from the policy, sanctions cannot be maintained.  And a number of states are buckling.

Within a few weeks of the imposition of ‘stage three’ sanctions, some states in the Union were sounding dissonant notes about how long they should last and when they should be lifted.  The election of the seemingly pro-Russian Tsipras government in Greece in early 2015 strengthened the dissension.  Tsipras hastily visited the Russian embassy soon after his victory.  He followed up with two trips to Russia in his first few months in office, asking the Kremlin to give Greece loans and exempt it from Russia’s sanctions on Western food exports (Hille & Weaver 2015).  In addition to Greece, a number of other E.U. states are questioning the sanctions policy.  Cyprus, for example, has long hosted a number of Russian banks and corporations.  Bulgaria, too, has extensive economic ties with Moscow, and has also long been seen as pro-Russian politically, from the days when Russia helped to create the country after its wars with Ottoman Turkey in the late 1800s.  Like Greece, Cyprus and Bulgaria also share the Orthodox faith of Russia, and thus often sympathize with the Kremlin’s worldview.  Italy and Spain, both distant from Ukraine and both among the Union’s laggards economically, are also seen as sympathetic to lifting sanctions.  Like the struggling Greeks, even a small boost to their economies would be of great political importance for their governments.  Hungary, too, under its Euroskeptic leader Viktor Orban, has loudly questioned the need for ongoing Western sanctions (Byrne 2017).

In the most direct vote yet in the West on Ukrainian policy, the voters of the Netherlands on April 6, 2016, voted against the E.U.’s Association Agreement with Ukraine.  Opponents of the agreement were able to force an advisory referendum on it.  With a low turnout of only 32.28%, they were able to receive 61% of the votes, with only 38.2% of voters favoring the accord (2016, ‘Dutch referendum voters overwhelmingly reject closer E.U. links to Ukraine,’ The Guardian, 7 April).  Opponents argued the agreement was too costly to the Netherlands, opening the country to more economic competition and more migration from Ukraine.  While this vote did not directly concern the E.U.’s sanctions policy, it was an ominous sign that support for Ukraine was weakening.

Thus far, the smaller Western countries have reluctantly gone along with continued sanctions, but this may not continue.  And ominously, larger states are now also weakening in their commitment.  As predicted in the theory section of this paper, elections are vulnerable points for democracies, where new leaders can exploit economic grievances to come to power and change a country’s foreign policy.  Recently three such elections in major Western countries have shaken the West’s commitment to defending Ukraine with sanctions. 

First, in the summer of 2016, the world was shocked by the ‘Brexit’ vote, as Britain voted to leave the E.U. This vote was driven by white working-class voters who were uneasy about economic decline and an influx of immigrants.  Ukraine did not seem to be a major issue in the campaign directly, but some Brexiteers, like the Dutch, condemned the E.U. agreement with Ukraine as being costly to the British economy and opening the door to more immigration.  The Brexit vote may have a serious impact on the Union’s sanctions policy, since Britain has in the past been a strong advocate of sanctions.  Even if its government does not change its views, by leaving the Union, Britain will weaken the pro-sanction forces in the E.U. A recent House of Commons report notes that after Brexit 'it may be increasingly difficult to sustain a unified Western position on Ukraine-related sanctions' (Reitman 2017). 

Second, in November 2016 the world was stunned again by the election of Donald Trump in the U.S.  His support, like that of Brexit, was driven by working-class white voters who felt left behind economically and were eager to support any policy which promised to bring more jobs.  Trump was quite open in his desire to improve relations with Russia, and both he and many of his allies questioned sanctions.  In January 2017, for example, he hinted at finding a way to revoke sanctions, stating 'they have sanctions on Russia—let’s see if we can make some good deals with Russia' (Gordon & Chokshi 2017).

Finally, in spring 2017 the E.U. had a close call in a third vital election, for the President of France.  Marine Le Pen, the National Front candidate, was stridently pro-Moscow, calling loudly for the end of sanctions on Russia and the acceptance of Russia’s annexation of Crimea (2017, ‘France’s Marine Le Pen urges end to Russia sanctions,’ BBC News, 24 March).  Economic stagnation in France allowed her to mobilize the same sort of working-class voters who had backed Brexit and Trump.  The National Front, formerly a fringe movement, thus was able to come within striking distance of victory.  The E.U. leaders openly feared that a victory for Le Pen would bring an end to sanctions on Russia, since France would be a strong enough player to openly veto the expected sanctions renewal in June 2017 (Baczyska 2017).  While Le Pen fell short in the final run-off election on May 7 against the moderate candidate Emmanuel Macron, it was stunning that she was able to make it that far, achieving her party’s best showing in history.

With each election, it seems, the ‘sanctions fatigue’ in the West grows, and the risk of the West making concessions on Ukrainian issues increases.  President Putin and his minions will be sure to remind Western leaders at every opportunity that sanctions are costly to their economies.  As shown in the theory section of this paper, every 1% decline in a democratic country’s economy results in a roughly 2% decline in the vote share of an incumbent party.  This fact makes it difficult for Western countries to keep pace in a ‘sanctions battle’ with an opponent like Moscow, who is willing to fight back strongly.

Finally, another problem is perhaps even bigger for the E.U. and for the West in maintaining its policies in the ‘sanctions battle’ with Moscow:  its commitment to Ukraine is limited.  The issue is not central to many Europeans—to say nothing of Japanese, Australians, and Americans—in the same way it is to Russians.14 This gives Moscow an advantage in its struggle with the West over Ukraine:  although the West can impose higher costs on Russia than Russia can on the West, the West may not be willing to bear even limited pain.  As the British Prime Minister Neville Chamberlain infamously said in 1938, when he allowed Hitler to dismember Czechoslovakia, 'why should we go to war for a faraway country about which we know nothing?'  Many in the West may quietly feel the same about today’s ‘economic war’ with Russia over Ukraine.  Until now Western unity has been maintained, but the Kremlin has good reason to think that in the medium term it may begin to buckle.

 

 

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