This is a long-form post on Ukraine. The big news, however, is from the European Union where the PMIs and a slew of other economic data came out today. The data showed the European economy improving broadly from its weakened recovery status. This will give the ECB room to take a wait and see approach. At the same time, the EU foreign ministers met yesterday and, according to reports are ready to impose heavier sanctions on Russia in the wake of the downing of Malaysia Airlines Flight 17 over Ukraine. There’s a lot data to digest here so let me start off with the EU – Ukraine – Russia narrative.
Impact of the Ukraine crisis
There are a lot of figures floating about regarding the crisis in Ukraine and its potential economic impact if sanctions are imposed. And the numbers vary considerably depending on whether one supports economic sanctions or not. Because the situation is volatile and the decision tree is very large as a result, we cannot discount outlier events. However, that said, I think the economic impact from the Ukraine crisis – though much bigger than conflicts in Iraq, Gaza or Syria – is likely to remain limited as policy makers want to avoid recession.
The Guardian’s Larry Elliott came out with an aggressive storyline on Tuesday that claimed an economic meltdown scenario piles pressure on Russia and the west. He pointed to the impact of oil as a trigger for major financial crises in the post-Bretton Woods era to remind readers that Russia has the oil card. It could try to engineer an embargo along the lines of the 1973 oil embargo. Adam Slater, senior economist at Oxford Economics, said that sanctions could be met with a tit-for-tat response that ends up in Russia deploying its oil and gas reserves as a weapon the way the US and the EU are attempting to employ financial warfare through sanctions. Slater estimates that UK growth in 2015 would be 1% lower if Russia stopped gas supplies through Ukraine this winter. He thinks Russia could cut energy exports by as much as 80%. “In such a scenario, world oil prices could soar above $200 per barrel and gas prices would also rise steeply.”
Now I think that’s pretty far-fetched but we cannot rule it out. It was interesting that RIA Novosti’s German-language offering picked up on this storyline, saying sanctions could cost the leading developed economies 2.4 to 3.5% of GDP. The article goes on to say this scenario would be comparable to the global crisis in 2009, making the impact for sanctions look as gloomy as possible. (German text here). I saw another German-language post from a Russian media outlet that said sanctions could cost Russians up to 1/5th of their incomes.
Propaganda war
This is propaganda of course. And we are already in the midst of a brutal propaganda war over Ukraine. As I indicated on Monday, the verifiable data already point to the likelihood that the MH17 disaster was the result of a pro-Russian Ukrainian rebel surface-to-air missile launched in a case of mistaken identity. And the data since then has only made this scenario more obvious. However, in the Russian press, the concept that the pro-Russian separatists did it is almost never mentioned, except to show how the west immediately jumped to conclusions and started blaming Russia for the crash. To the degree the Russian media speculate that rebels did fire the missile that killed 298 civilians, they always ask why the Ukrainian air traffic controllers allowed the flight to go on that course. And that question is actually a good one as this graphic from the Wall Street Journal shows (see relevant tweet here)
So the slant is clear.
But, of course, the western media is playing the same game. The British tabloids are the worst. Look at the Daily Mail headline here fore example: “The selfish cowardice of Germany, France and Italy whose leaders have done so little to bring Putin and his Kremlin gangsters into line” While you might agree with the basic premise that tougher sanctions on Russia are necessary, you also have to admit that the headline is pure propaganda, aimed at inflaming tensions. The British tabloids, with their inflammatory headlines like “Putin’s Missile”, written in big letters, are trying to sell newspapers and also drum up war fever.
That’s where we are now.
Proxy war
And the reason for this is because the conflict in Ukraine is a proxy war like so many others before it. I thought Russian military expert Alexander Golts said it well when he spoke to the Christian Science Monitor about the situation in Ukraine. He said:
“All of our experience in these matters – and American experience as well – testifies that you can get these things started, arm and train people, send them in to stir up trouble for your adversaries, but you cannot control them afterwards. Proxy wars are a very risky enterprise. There will be blowback. We are getting a stiff dose of it right now. I don’t see what Putin can do right now to extricate Russia from this. It’s a total deadlock.”
But, of course, the vested interests here are huge. And so the proxy war will escalate with propaganda, sanctions and then we will just have to see where that leads.
Putin doesn’t want problems
Sanctions
Now, let’s talk about sanctions. Before we get into exactly what kind of sanctions are coming and how effective they will be, I want to say something about likely responses from Vladimir Putin. As unpredictable as Putin has been, the interesting bit about his denial of Russian responsibility for the missile attack and the blanket Russian media denial is the signal it sends. What Putin is in effect saying is that, even though it may seem obvious to you that the rebels attacked that civilian jetliner, we are going to say they didn’t. The question is why. I believe the most logical answer is that Putin knows that admitting the rebels did it, will make thew west impose more onerous sanctions, limiting Russia’s manoeuvrability. So, the denial is in essence an admission that Putin cares a lot about the Russian economy and that, he therefore, is less likely to move to economically destructive tit-for-tat scenarios like the ones Oxford Economics invoked.
On Tuesday, the Wall Street Journal reported that the EU foreign ministers had agreed to tougher targeted sanctions.
The ministers gathered in Brussels decided to impose sanctions on people and organizations who have provided support to Russian decision makers, agreeing to name specific targets as early as Thursday. Targets are expected to include for the first time penalties against prominent Russians close to President Vladimir Putin.
The ministers said they would go further if they don’t see “full and immediate cooperation” from Russia and pro-Russia separatists on handling the crash aftermath and limiting the arms flow into eastern Ukraine. That could include trade restrictions on defense, energy and high-technology items, as well as limiting Russia’s access to credit markets, they said.
So, we are going to see more sanctions here. Moreover, if Russia takes an uncooperative stance, even more sanctions are coming. On Tuesday, the EU Observer reported on what the sanctions escalation regime looks like via a leaked document it received on planning.
There are low-intensity sanctions
The first, a “low-intensity” scenario, contains seven steps.
They include: “restrictions” on imports of Russian “luxury goods (diamonds, precious metals, furs, vodka and caviar) and of food products”; restrictions on “selected … intermediate and processed goods (fertilisers, chemicals, tyres, vessels” but not “steel or nuclear components”; restrictions on “imports and exports of arms”; and restrictions to “export financing” for the listed industries.
They also include: blacklisting more Russian individuals and some companies; suspending EU grants for Russia projects; and stopping loans from the European Investment Bank.
The latter three measures were agreed by EU countries last week before MH17, in what some diplomats at the time called “stage 2.9 sanctions”.
The additional names on the blacklist are to be published by the end of the month.
Then there are medium-level sanctions.
The “medium-intensity” scenario designates eight more steps.
They are: a ban on imports of all intermediate and processed goods; a ban on imports/exports of “all sensitive technologies and dual use and arms”; blacklisting still more Russian individuals; “restrictions” on “trade and investment and related financial services”; restrictions on “free movement of capital”; restrictions on “maritime and road transport (not air transport)”; “holding up Russian investment/acquisition in the energy sector”; an “import ban on coal (no ban on electricity)”; and “cancellation of all co-operation activities”.
While France’s plan to deliver a “Mistral” warship to Russia in October has attracted attention, the ban on “dual use” items could hurt more.
And then there are serious sanctions
The commission’s “high-intensity” option contains five steps.
It calls for: “capital market restrictions”; “prohibition of new investment in Russia”; “strict application of EU regulatory rules to Russian assets in EU companies”; an “import ban on gas”; and “an import ban on oil”.
Putting the oil and gas ban in perspective, according to US figures the EU buys 84 percent of Russian oil exports and 76 percent of its gas exports.
A back-of-the-envelope calculation indicates an EU ban would make a $300 billion hole in Russia’s $420 billion annual budget.
With some large EU countries, including Germany, Italy, and Poland, dependent on Russian gas for at least one third of their needs, it would also shock the European economy.
The commission paper says EU officials carried out macro-economic impact assessments for each member state. The results were sent in a “country fiche” to each capital.
Where are we now? According to the FT we are now about to see medium-intensity sanctions get imposed. And note the part I have highlighted in bold.
EU diplomats will weigh sweeping Russian sanctions on Thursday that include a proposal to ban all Europeans from purchasing any new debt or stock issued by Russia’s largest banks, according to a proposal seen by the Financial Times.
The sanctions measure, contained in a 10-page options memo prepared by the European Commission and distributed to national capitals, also proposes barring the Russian banks from listing new issues on European exchanges, preventing them from using London or other EU stock markets to raise funds from non-Europeans.
The proposal would not initially include a similar prohibition for Russian sovereign bond auctions out of fear the Kremlin could retaliate by ordering an end to Russian purchases of EU government debt, the document states.
But it would still be far more extensive than sanctions imposed by the US this month which only targeted two Russian banks, Gazprombank and VEB, since the EU proposal would hit all banks with more than 50 per cent public ownership.
State-controlled financial institutions account for the majority of banking assets in Russia, and the document estimates €7.5bn of the €15.8bn in bonds issued by Russian public financial institutions last year were in EU markets.
“[T]he measure would consist in prohibiting any EU persons from investing in debt, equity and similar financial instruments with a maturity higher than 90 days, issued by state-owned Russian financial institutions . . . anywhere in the world,” the document states.
So Europe is now prepared to get serious about sanctions. The MH17 disaster has changed the complexion of the Ukraine conflict completely.
Europe
The interesting bit here is that, while the worry is the boomerang effect of sanctions, especially as the European recovery has been so weak, the data out today were good for Germany and Spain in particular.
- UK: Retail Sales +3.6% y/y in June vs +3.9% y/y in May
- Germany: Flash Germany Services Activity Index rises to a 37-month high of 56.6 (54.6 in June); Flash Mfg PMI is at a 3-month high of 52.9 (52.0 in June)
- France: French private sector output contracts again,but at slower pace; PMI at 49.4 (June: 48.1). Rise in French Composite Output Index driven by service sector (50.4). Manufacturing PMI at 7-month low of 47.6 (48.2 in June). French manufacturing PMI came in at 47.6 vs. 48.1 expected. Services was good at 50.4 vs. 48.2 expected
- Italy: Italian consumer confidence in July at 104.6 vs 105.6 prev.; lowest in 4 months
- Spain: Q2 unemployment fell from 25.93% in Q1 to 2-year low of 24.47%; biggest addition in jobs since 2006
- Finland: Retail sales drop at -1.7% y/y v -0.5% last month.
My read here is that the snap back in Germany from previous data weakness will give the ECB room to stand pat on measures like QE. And the data out of Spain will bolster the belief that structural issues are the big impediment in the periphery, meaning the call for stimulus is going to fall on deaf ears. Spain and Ireland are doing relatively better in the periphery while Italy and Portugal are doing relatively poorly. Greece is coming off a basing effect.
From a macro perspective, the big problem is Italy because of the 135% government debt to GDP figure. That is a level of debt that is just not sustainable in a fixed currency area when the economy is not growing without some sort of fiscal and monetary support. Italy’s debt mountain will continue to grow due to anemic economic growth and when we have a new downturn, the sovereign debt crisis will return. To the degree we do think sanctions on Russia will boomerang, this is where we should look first, not Germany.
I would also mention that Eurozone public debt is still rising and is now 93.9% of GDP. Only two countries have seen their debt through Q1 2014 fall compared to Q1 2013, and that’s Germany and Luxembourg. Everyone else is seeing public debt grow. Greece, with Q1 2014 debt of 174.1%, cannot possibly get its debt down without a restructuring. Growth alone will not work, especially without monetary policy support.
So Europe is going to have another debt crisis down the line. However, the economy may be just resilient enough to tough out harsh sanctions against Russia. If the Ukraine crisis escalates, however, I would look to Italy as the weak link in the eurozone.