Editor’s Note: The following is the fourth and final of a series of articles from the Center for the National Interest’s new report: Costs of a New Cold War: The U.S.-Russia Confrontation over Ukraine. You can read the full report here.  

Preface

The crisis in Ukraine pitting Russia against the West reveals competing narratives regarding precipitants of and reactions to the February ouster of Viktor Yanukovych and the troubling episodes that have since unfolded in Ukraine’s south and east. This paper will assess the economic context of U.S. decision-making in response to the crisis in Ukraine, examining what is at stake economically for both the United States and Russia, the policies pursued and their potential consequences, and options to consider going forward.

Introduction

For nearly a quarter-century since the breakup of the Soviet Union, the United States and Russia have struggled to adapt to changes to the international system brought about by the Soviet collapse, the end of bipolarity, and the departure from the ‘stability’ of the Cold War era. The Cold War may have been expensive and dangerous, but it was also at least somewhat predictable. Analysts and decision-makers grew comfortable operating within a governing framework of organizing principles built over decades.

The purpose and predictability of that framework were not replaced by a set of equally convenient parameters for U.S.-Russia engagement. The bilateral relationship ebbed and flowed through periods of ‘warmer’ ties, which were occasionally buttressed by shared interests, although they were frequently a function of leadership personalities and the relief felt by the absence of conflict. As Russia emerged from a decade of upheaval that was the 1990s, opportunities for more serious common pursuits between Moscow and Washington emerged, yet so too did divergent national interests that were not fully understood without the benefit of hindsight. Cooperative successes were achieved, yet competition and conflict also endured.

A decade ago, in June 2004, the Orange Revolution in Ukraine introduced a new variable into Russia’s relations with the West. The view of the world from Moscow changed suddenly and significantly, and subsequent discussion of a NATO Membership Action Plan for Ukraine ensured that this was not a fleeting concern in Moscow (and the August 2008 Russia-Georgia war confirmed for U.S. policymakers that we had indeed entered a new phase in the relationship). Through electoral gaming, exertion of economic influence, and leverage of energy supplies, Russia and the West competed in a sometimes subtle and lengthy tug-of-war over Ukraine, culminating in the bidding war between the EU and the Russia-led Customs Union (now the Eurasian Economic Union) last fall, which precipitated the crisis in Ukraine.

As pro-EU and anti-Yanukovych protests transformed Kyiv’s Independence Square into the Maidan movement in late 2013, few on either side could have envisioned where U.S.-Russian relations would be in mid-2014, in the midst of the worst crisis since the end of the Cold War, with Ukraine engulfed in a low-grade civil war.

Russia’s Economic Backdrop

Russia’s Ukraine strategy and the annexation of Crimea in particular have been a boon politically for President Putin at home, as his approval rating soared to 72% in March, 82% in April, and 83% in May. But this conflict comes at a time when Russia can least afford it economically. Russian economic performance has deteriorated since its recovery from the global recession, and the country’s economy has been sliding into a period of stagnation for more than a year now. Whereas Russian GDP grew 3.4% in 2012, growth declined to 1.3% in 2013. The projections for 2014 began at an optimistic 2.5%, but the consensus view has since been reduced by half—to approximately 1.1-1.3%, with the OECD’s revised projection on the low end, at 0.5%.

These estimates are not weighted for Ukraine-related risks and impact. Leaving aside the effects of investor behavior and punitive actions taken against Russia, the best-case scenario growth projection hovers around 1.3%. When potential fallout from Ukraine is factored in, this is commonly viewed as enough to tip Russia into recession, with expected performance dropping to -2%. The IMF already considers Russia to be in recession.

Bloomberg recently conducted a survey of 10 economists, who assessed the probability of a Russian recession occurring this year to be 33 percent. This same group of economists largely concurred that the consumption effect supporting Russia’s recent rebound has run its course, and that the primary driver of any near-term economic growth must be investment.

In the second quarter of 2014 (Q2), the Russian economy grew by .8% year-on-year (y-o-y) compared to Q1 2013, the slowest pace in five years since the recession, which followed .9% y-o-y growth in Q1 and a contraction of .5% from Q4 2013. Russian and international observers agree that declining investment is the culprit—Russia’s own Ministry of Economic Development reported that fixed capital investment declined 4.8% in April y-o-y.

Russia desperately needs investment to fulfill the sustainable growth imperative and to diversify away from the dominance of the oil and gas sector. Whether ‘real’ foreign investment or repatriated Russian capital (for example, from Cyprus, perennially one of the top ‘foreign’ investors in Russia), capital inflows are the single largest factor impacting Russia’s economic development in the near term. As discussed below, this is the reality in which policy responses to Russia are being formulated, which in turn has Russian officials devising mitigation strategies and counter-measures.

Interdependence in a Global Economy

The U.S.-Russian economic relationship features only a limited degree of interdependence, at least when analyzed against the likely effectiveness of U.S. sanctions as a strategy in itself—hence the importance of a coordinated multilateral approach with the full support of the EU, in particular.

U.S.-Russian bilateral trade remains relatively small compared to both countries’ trade with the EU or China, for example, but the bilateral commercial relationship has experienced a period of rapid growth in recent years, as American and Russian firms alike have benefitted from expanded ties and the development of new markets. After totaling just $24 billion in 2009, U.S.-Russian trade jumped by one-third, to $32 billion, in 2010, and increased again by a similar proportion in 2011 to $43 billion. Since then, however, two-way trade declined to $40 billion in 2012, and dropped another 5%, to $38 billion, in 2013. This year’s performance to date is roughly in line with 2013 (approximately $9 billion in Q1).

Each country ranks among the top 25 of the other’s trading partners (e.g., Russia is the 23rd-largest trading partner of the U.S.). While these are not huge export markets, it is also true that the trade relationship has historically tilted in Russia’s favor, with the U.S. running a considerable trade deficit due to imports of Russian commodities (including primarily oil, steel, chemicals, and precious metals). As a result, while the Russian market for U.S. goods and services has continued to expand in the first two years of Russia’s WTO membership, it is safe to assume that a smaller swath of Russian companies has more at stake in terms of potential trade disruptions than do their American counterparts, at least in the short run (though many U.S. companies have moved well beyond an initial trading strategy to build market share and are now major strategic investors in Russia for the long term).

By contrast, Europe is Russia’s largest trading partner. The comparisons to EU-Russia trade bring into stark relief the importance of a coordinated policy response between the United States and Europe. Russia’s trade with Europe is more than tenfold the U.S. level, at $440 billion, with the EU representing roughly one-half of Russia’s imports and exports. Three-quarters of Russia’s exports to Europe come from its energy sector, as Europe imports roughly one-third of its natural gas from Russia (and half of that amount transits through Ukraine).

More specifically, Germany has been a driving force behind European policy on Ukraine due in large part to both its economic clout and its commercial stakes in Russia. Russian-German trade was $111 billion in 2012, before declining to $105 billion in 2013. Also, unlike the U.S. trade deficit, German exports nearly equal the imports from Russia. German business leaders have noted that some 300,000 German jobs depend on the country’s economic relationship with Russia. And energy supplies are a primary constraint on decision-makers, as Germany receives three-quarters of its oil and gas from Russia.

Beyond the trade case, equally compelling are the investment data underpinning the EU-Russian economic relationship. Roughly 75% of FDI into Russia originates in Europe, and some 6,000 German companies alone are said to have staked an active presence in the Russian market.

The comparison to the EU’s economic clout vis-à-vis Russia clearly establishes the logical difficulty of enacting a unilateral American sanctions strategy that will achieve its desired objectives.

Vulnerabilities and Costs

Given Russia’s increasing integration into the global economy and the vital link between Europe and Russia, it is not surprising that economic leverage emerged as the primary tool in a coordinated U.S.-European policy response to Russia’s aggression in Ukraine.

The question, then, is how leverage should be applied in a manner that is based upon realistic assumptions; i.e., how can and should influence be exerted, and toward what end(s)? Once the mechanics of inflicting ‘pain’ on Russian targets are confirmed, what are the costs associated with the action, beyond just the intended target scope—how are they felt and by whom?

Just as certain sanctions or the threat of them, if deployed properly, could impose severe costs on Russia, it is also reciprocally true that Russia’s importance to the EU economy and its energy supplies poses serious constraints on how far the EU will move against Russia while simultaneously incurring self-inflicted pain.

As sets of Western sanctions are debated, implemented, and expanded, the calculations then shift to Moscow, where President Putin weighs the perceived costs against his objectives on an issue that he considers to be of fundamental strategic importance. It could be that Russia is willing to incur great costs without immediately changing course, as Ukraine is the centerpiece of regional security from Russia’s perspective.

U.S. Policy: The Path Taken

Ultimately, the goal of U.S. policy should be to elicit changes in Russian behavior, deescalate tensions, and promote a dialogue between Russia and Ukraine in pursuit of a long-term and lasting resolution.

In the run-up to Russia’s annexation of Crimea in March, U.S. policymakers and their EU counterparts decided on a two-track response: international isolation of and economic pressure on Russia. The goal of the Western policy response was to punish Moscow and to deter further Russian aggression. But from the outset, the strategy and tactics have suffered from a lack of clarity in both their overall intention and their intended targets. They have also suffered from a timing problem, in that the United States and Europe are seeking to change short-term behavior by imposing costs that escalate over time and that are most significant for Russia in the medium- to long-term.

The first steps to isolate Russia in the international arena consisted primarily of what the United States and Europe will not do—in other words, to demonstrate that partnership with Russia has become a thing of the past. The first measure, canceling the G-8 summit that Russia planned to host in early June, effectively expelled Russia from the top-table body in favor of reverting to the G-7 format for the foreseeable future. Other U.S. steps included putting bilateral trade and investment talks and military cooperation initiatives on-hold, as well as canceling planned meetings of the U.S.-Russian Bilateral Presidential Commission. On the multilateral front, talks on Russia’s OECD accession were suspended.

Russia’s response to these steps was rather predictable and was primarily rhetorical in nature. It consisted of dismissing the importance of some international forums such as the G-8 while combating attempts to unify the Western position. Russian officials made clear that Russia has many trading partners and interlocutors, and that bilateral “boycotts” of previously planned initiatives were unfortunate unilateral decisions to not further develop economic opportunities in and with Russia.

The second set of measures was seemingly developed as a hybrid of the dual track: to both isolate Russia and prominent Russian individuals and to exert economic pressure. An executive order on March 6 put in place sanctions in the form of visa bans and asset freezes against those directly involved in Crimea; additional Russian officials and other figures close to President Putin were subsequently designated on the list. The visa bans are of limited utility if they merely restrict travel to the United States, but these travel prohibitions constituted a greater nuisance when the EU followed suit within hours and issued its own list. In themselves, these steps would get Russia’s attention but would not influence Russia’s position. They quickly became viewed as a potential irritant, but not as an actual inconvenience. The Russian response, accompanied by derisive rhetoric, came in classic tit-for-tat diplomatic fashion, with American officials and others soon identified as ineligible for Russian visas.

The second set of U.S. responses represented a step up on the severity scale, as the March 6 executive order provided for asset freezes and a prohibition on U.S. persons from doing business with the “specially designated nationals” (SDNs) and entities on the sanctioned list. The initial list of SDNs was quickly expanded within three days to include individuals outside the Russian government and entities whose principals are close to President Putin, including Gennady Timchenko, Arkady Rotenberg, and Bank Rossiya. Additions made to the list in late April included Rosneft CEO Igor Sechin, Rostec CEO Sergey Chemezov, and numerous entities within Gennady Timchenko’s Volga Group.

The Russian response to these sanctions was more worrisome to the U.S. business community. Anti-American sentiment escalated, as reflected in the polling trends—from 44% negative bias in January to 71% in May. Commercial retaliation was proposed in the Federal Assembly in the form of a draft law permitting confiscation of assets of American and European companies in Russia. When Visa and MasterCard declined to process transactions for Bank Rossiya subsidiaries, the Russian government announced an accelerated plan to develop and implement a Russian national card payment system.

Concurrent with the SDN list expansion on April 28, the United States also announced new restrictions on high-tech defense exports to Russia, noting that current export licenses for defense or dual-use technologies that could contribute to Russia’s military capabilities would be revoked and pending applications for export licenses would be denied. The Russian response echoed the Cold War-era rivalry with the U.S., with a reciprocal threat to discontinue sales of Russia’s RD-180 rocket engines for U.S. space launch programs, as well as plans to remove GPS stations in Russia.

The mid-March sanctions list and the April addendum also indicated the direction in which the U.S. administration was heading as it threatened further sanctions if Russia refused to halt destabilizing actions in eastern Ukraine. President Obama’s executive order provided a framework for implementing subsequent sanctions as needed: a third wave of more severe sanctions targeting five key sectors of the Russian economy, including defense/high technology, energy, engineering, financial services, and metals/mining.

The administration proceeded on this path in July, though the third round did not constitute full sectoral sanctions that prohibited U.S. companies from conducting business in these sectors.  Rather, the July steps introduced restrictions on new financing to several banks and energy firms while adding select defense enterprises to the SDN list.  Russia responded in August by banning the importation of U.S. agricultural products for one year.  Though Russian imports of many American agricultural products (especially meat) have declined in recent years, Russia still represents 10% of U.S. agricultural exports, accounting for some $1.3 billion in sales.

Russia’s consumer safety agency subsequently closed 12 McDonald’s restaurants and launched investigations of dozens of others for health and sanitary violations, which was widely perceived as symbolic retaliation (the action against the American fast-food chain included closing the first restaurant opened in 1990 on Moscow’s Pushkin Square).  By early September, Rospotrebnadzor’s initial health inspections resulted in the opening of some 80 administrative cases against McDonald’s across Russia.

Following the NATO Summit in Wales in the first week of September and a tenuous cease-fire in Ukraine, U.S. officials indicated that Washington is “finalizing” new sanctions in coordination with the European Union.[1]  Further measures have since been put in place.[2]

U.S. Policy: What Next and Why?

An assessment of this two-pronged approach should include not only examination of its effect on desired outcomes but also a clear sense of where the policy is heading along a continuum—an if-then matrix of conditionals that prescribe likely next steps and that are understood by various stakeholders.

That concept, at least in its public form, has been lacking in U.S. policy toward Russia in the past few months, specifically with regard to a progression in stepwise sanctions. Policy clarity and public articulation have not kept pace with the rapid developments on the ground and the ongoing fluidity of the situation in Ukraine. In turn, that has made steadfast support more difficult to maintain in American domestic politics, within the U.S. business community, and among transatlantic partners.

There have been several instances when both the trigger for sanctions and their ultimate objective have been subject to differing interpretations. First, in the Crimean case, the initial sanctions were announced in March to hold accountable those responsible for coordinating Crimea’s secession and Russia’s annexation of the territory. These steps were, however, accompanied by public statements and pressure from Congress seeking the reversal of the outcome in Crimea as the goal of U.S. policy. If the failure to undo the annexation and to return Crimea to Ukraine were the trigger for an escalating series of sanctions, then clearly sectoral sanctions would have been implemented much earlier in the spring.

By the time the reality of Crimea’s new status had been absorbed (if not recognized), at least for the short run, unrest in eastern Ukraine quickly spiraled into a similar scenario. The scenario was similar not in cultural and historical terms, but in terms of mechanics and modus operandi—separatist seizure of local government facilities, hurriedly staged votes for independence, pleas for Russian support, and well-equipped forces securing key infrastructure and transport routes.

In the case of eastern Ukraine, the threshold for implementing sectoral sanctions has been specified over the past months in various terms, including, among other things: 1) Russian attempts to disrupt Ukraine’s May 25 presidential election, 2) Russian support for further destabilizing actions in eastern Ukraine, 3) Russia’s failure to withdraw its forces from forward deployment in regions bordering Ukraine, and 4) a Russian cross-border incursion into Ukraine.

When Russia began the process of withdrawing its forces and accompanying equipment from the border and returning them to their home bases, it left the impression that this succession of markers had passed without an overt violation requiring a response. In some sense, then, the policy could be deemed to have been effective, at least insofar as it deterred the worst-case scenarios involving a Russian invasion of eastern Ukraine. It could also be argued that the threat of sectoral sanctions was not a determining factor in President Putin’s decision to withdraw Russian forces from the border. While the spring campaign evidenced rapid rollout of preconceived plans and Spetsnaz-like tactical elements, it is likely that, in strategic terms, President Putin is contemplating a series of long-term moves, as in a lengthy game of chess.

In any event, the presidential election in Ukraine on May 25 was considered a limited success under the circumstances, but the situation on the ground in eastern Ukraine did not improve in the election’s immediate aftermath—if anything, the sporadic separatist clashes evolved into a coordinated, quasi-military conflict. Following a G-7 discussion in Brussels and a series of exchanges among heads of state in France in the first week of June, a window for peace talks and an accompanying ceasefire opened briefly.

Prior to June 10, momentum was building in Europe (and, to a lesser degree, in the U.S.) for recalibrating policy based on a fresh appraisal of the costs and benefits associated with a potential third round of sectoral sanctions. Officials and observers alike pointed to the absence of an overt cross-border incursion, Russian troop withdrawal from the border territories, and the inauguration of President Poroshenko and Russia’s subsequent recognition of him (including a brief meeting with President Putin).

The respite was short-lived. On June 11, a column of Russian tanks reportedly crossed the border into eastern Ukraine through a separatist-controlled checkpoint in the Luhansk region. Days later, on June 14, separatists downed a Ukrainian transport plane, killing all 49 servicemen aboard. On June 16, Gazprom announced the cutoff of gas supplies to Ukraine due to nonpayment issues. Amid sharp deterioration of the conditions on the ground, the United States announced new sanctions in mid-July, only to witness a new and tragic turn in the conflict with the downing of Malaysian Airlines Flight 17 in eastern Ukraine, apparently as the result of an accidental missile attack by separatist forces.

These developments and Russia’s deepening incursion in Ukraine prior to the recent cease-fire led to tougher sanctions to hold Russia accountable, and there is a growing bipartisan consensus in Congress in favor of the U.S. acting unilaterally, if necessary. Given this context, the following section of this paper examines core principles and objectives in sanctions policy.

U.S. Sanctions Policy

Of the several principles underpinning successful sanctions policy, two warrant particular discussion in this case: specific targeting, as opposed to a misdirected or blanket approach; and strong consensus behind a uniform multilateral policy, as opposed to mixed menus based on varying levels of commitment, or—worst of all—unilateral sanctions. Unilateral U.S. sanctions primarily penalize American companies and rarely achieve their intended effect.

The notion of “targeted” sanctions has a dual meaning. In the first, practical sense, it of course means levying a consequence on those responsible for the offense covered by the sanctions—the assumption being that the designated entities are clearly connected to what happened. In a more general sense, though, sanctions should also be tied to a reasonable likelihood of exerting influence, changing behavior, and fostering desirable outcomes (hence the importance of establishing clear goals at the outset rather than retrofitting the goals to sequential steps).

My purpose in writing this paper is not to analyze the specific entries on the sanctioned list; instead, I assume that the SDN lists to date are reasonably accurate. But for purposes of assessing effectiveness and informing policy choices going forward, the cause-and-effect linkage between action and reaction deserves further scrutiny.

While the sanctions implemented thus far will no doubt have more demonstrable results in the longer run, U.S. official statements as to their effect to date have seemed to make convenient use of Russia’s already-declining economic picture. It is true that Russian capital flight amounted to some $50 billion in the first quarter of 2014—equivalent to the annual total in 2013—but there are two important points to bear in mind. First, the sanctions framework was announced on March 6, with additional financial measures following in mid-March, which means the Q1 flight number was likely 75-85% derived by this stage. More notably, capital flight subsequently decreased in April (as sanctions intensified) and further slowed in May, leading some economists to predict net inflows to Russia in June. These data further support the second broader point, which is that Russian capital flight was well underway in Q1 due to investors’ sense of heightened risk brought about by Russia’s actions in Ukraine—not the U.S. policy response.

Similar points can be made with respect to ruble depreciation, as the Russian currency’s value declined by more than 5% against the dollar earlier this year, forcing the Central Bank of Russia to spend tens of billions in reserves (including more than $10 billion in a single day) and to raise interest rates twice, up to 7.5%. However, it is also the case that the ruble has risen by roughly 3.5% since the sanctions were announced in early March.

And finally, U.S. officials frequently cite the decline in Russian stock markets as evidence that the sanctions are having a direct impact on company shares. With a few exceptions, however, the primary sanctions targets thus far have been individuals and not companies, and most of these companies are not publicly-traded. While the two indexes in the Moscow Exchange, the MICEX and RTS, suffered steep declines in February as the crisis took hold, the RTS has risen some 15% since the sanctions announcement, and the MICEX rallied 10% in May alone, enjoying its best month in two-and-a-half years. Russian stocks are now up 20% since mid-March, and in the last week of May alone, investors poured $105 million in new money into the Russian markets.

Thus, in terms of short-term economic impact, the cause-effect policy linkages are tenuous, at best. Put simply, capital flight and currency pressures are primarily a function of risk perception and a reaction to instability—investors did and do flee temporarily. This is a cost to Russia, but one that Russia imposed on itself.

Second, concerning coordinated action among allies, broad multilateral support was difficult to achieve at the outset, though the U.S. administration did an admirable job of cultivating and solidifying European support (particularly British and German) in the face of initial opposition. Also, as concerns spread among American companies that Asian competitors might stand to gain from the evolving sanctions policy, Japan subsequently signed on to the effort, though in more limited form.

As a statement in principle, U.S. and European leaders reaffirmed the possibility of further sanctions during G-7 discussions and D-Day commemorative meetings in France in the first week of June. The trigger most recently identified is a failure by Russia to cease support for ongoing subversive activities on Ukrainian soil. While this is potentially a blurred “red line,” subsequent developments have clarified that line for many in the U.S. and some in Europe, leading to new sanctions in late July. Now the question is the extent to which it will rally support for European shared sacrifice, such that U.S. policy can avoid the quandary of unilateral sectoral sanctions. Without European support, a further series of steps could include the imposition of secondary sanctions on those European countries continuing their economic relationships with Russia in ways that undermine the U.S. effort (as was the case with the Iran-Libya Sanctions Act in the mid-1990s).  Some U.S. Senators have already proposed this in draft legislation.[3]

Given the substitution effect of Russian partners transferring their business to Asian/European competitors, the cost to American business of a go-it-alone approach would be substantial in the near term and staggering over decades to come, and not simply in terms of shareholder profits but also in export-oriented jobs, just as the U.S. regains the jobs lost during the Great Recession.

The stakes in the energy realm are rather obvious; even if the targets are limited to state companies Gazprom and Rosneft, one need only analyze the long-run significance of one project, the Exxon-Rosneft Arctic venture, to advise against the tradeoff. Meanwhile, less attention is paid to potential costs in other identified sectors such as financial services, one that is expected to experience some of the most rapid growth and greatest market-opening opportunity as a result of from Russia’s WTO accession. And the importance of Russian corporate clients to London’s financial community has been a principal concern influencing UK policymakers.

Beyond lost market share, another unintended consequences could be an acceleration of Russia’s version of the “Asia pivot” in its foreign policy orientation. As noted above, Japanese firms acted quickly in March in seeking to exploit opportunities presented by U.S. sanctions policy. And while the groundbreaking $400 billion Russia-China gas deal was the result of negotiations, it is also safe to say that it received new impetus as a strategic priority this spring to solidify a 30-year hedge for Russian exports.

U.S. Policy Options

The crisis has now reached a point where pressure on the U.S. administration to take further steps has reached a boiling point. This pressure is particularly intense on Capitol Hill, and leading Democrats have joined the chorus of Republican lawmakers urging the implementation of further sanctions to inflict damage on the energy and financial services sectors of the Russian economy, as well as the defense, engineering and mining sectors.

How bad could it get? There is no question that the U.S.-Russian relationship has been seriously damaged, at least in the short run. The policy vectors now being debated will influence where the relationship goes from here, but not nearly as much as Russia’s policy choices will impact its relations with both the United States and Europe.

There are three primary scenarios that could unfold in terms of next steps for U.S. policy: a series of measures that stops short of sectoral sanctions (for example, limiting access to international financial markets, stricter enforcement of WTO and other trade rules affecting Russian exports, and a more activist stance on anti-corruption measures); the implementation of the sanctions on the five sectors outlined above; and a “sanctions-plus” variant that would employ sectoral sanctions as the departure point for a multifaceted response.

Some might argue that the recent cease-fire obviates the need for further U.S. sanctions, in that large-scale fighting has subsided and Russia and Ukraine appear to have begun a process of dialogue.  Thus far, however, U.S. (and European) officials appear to take the contrary view, imposing additional sanctions as a means to reinforce Ukraine’s negotiating leverage and to press Moscow to discourage cease-fire violations by rebel forces.

The congressional pressure is evident in legislation introduced to cancel the Pentagon’s current contract with Rosoboronexport (the arms trading unit of the state-owned corporation Russian Technologies) for the purchase of 30 transport helicopters for the Afghan air force, valued at more than a half-billion dollars. The draft “Russian Weapons Embargo Act” would also forbid any new contracts with Rosoboronexport and would prohibit cooperation with any company, domestic or foreign, that conducts arms transactions with Rosoboronexport.

This follows the pressure tactics pursued with respect to the Magnitsky List for human rights violations in Russia. Congress stipulated that additional names be appended to the original Magnitsky List of 18 persons by the end of 2013. With bilateral tensions escalating through the winter, the administration lengthened its review and then acted in May, following the implementation of the initial sets of sanctions.

Sentiment in Congress is squarely behind sectoral sanctions and possibly a sanctions-plus scenario. The push for sectoral sanctions evolved in two important ways in mid-June: the support became bipartisan, with Senate Foreign Relations Committee Chairman Robert Menendez (D-NJ) urging President Obama in writing to act, preferably with European support, but unilaterally if necessary.

The “sanctions-plus” faction is led by Senator Bob Corker (R-TN). An influential group of Republican senators has introduced S. 2277, the “Russian Aggression Prevention Act of 2014.” The bill calls for specific and severe sectoral sanctions on prominent Russian banks and companies, as well as direct military assistance to Ukraine in the form of anti-tank and anti-aircraft missiles and small arms. It further requires the President to accelerate the timetable for missile defense deployment in Europe and to increase U.S. and NATO military support for Poland, Latvia, Lithuania, and Estonia. The bill would also grant Ukraine, Moldova, and Georgia the status of non-NATO ally, similar to that enjoyed by Israel, South Korea, and Japan, and a select group of countries that frequently host U.S. bases. While technically outside NATO’s formal security guarantee umbrella, providing this support would fundamentally alter the geopolitical calculus on Russia’s periphery. In addition to the political-military measures, the bill also requires increased U.S. funding to support civil society and democratization promotion efforts inside Russia, which would clearly pose an irritant to Russia in the wake of increased scrutiny and control exerted by Russian authorities over NGO activities and the expulsion of USAID from Russia a year-and-a-half ago.

While the bill as currently structured may be unlikely to pass as a package, it is conceivable that key components could move forward or that variants of it could be adopted if Russia continues to provide materiel support to the separatists in eastern Ukraine. The Obama administration would face a difficult political dilemma if the Congress imposed measures harsher than its own.

Energy Dynamics

The 2014 Russian Aggression Prevention Act also seeks to enhance Europe’s energy security—and thus reduce Russia’s energy leverage—by providing authority for the U.S. to export gas to Europe (and to WTO member countries more specifically). The inclusion of this provision is but one example of a growing transatlantic consensus that both policy changes and infrastructure investments are necessary as part of a multi-pronged response to change the energy dynamics in Europe.

The early June G-7 discussions demonstrated a new level of resolve to alter the energy dynamics between Russia and Europe, such that initial steps in 2014 are virtually assured, irrespective of other short- and long-term approaches to resolving the crisis in Ukraine. The G-7 leaders discussed a U.S. plan to lift restrictions on the export of shale gas, while European officials outlined support for building several LNG terminals in Europe and substantial investments in reverse-flow technology from West to East. “The diversification of sources and routes for fossil fuels is essential,” the G-7 communique stated. While longer-term solutions are finalized and implemented, the leaders agreed to develop an emergency response plan for the coming winter of 2014-15, the necessity of which became more apparent when Russia halted gas supplies to Ukraine in mid-June.

The twin challenges of increasing supply and diversification of routes have elicited a strengthened commitment to construct new pipelines to transport supplies to Europe from sources other than Russia. The EU is pursuing closer ties to Azerbaijan as it steps up its support for expanding the Southern Gas Corridor for Azeri gas delivery through the Trans-Anatolian gas pipeline through Turkey, as well as the Trans-Adriatic Pipeline running across Greece and Albania to Italy. One interconnector will ship gas from Greece to Bulgaria, and further interconnectors are under discussion.

The G-7 meeting in June confirmed support for building additional energy infrastructure on an accelerated timetable, specifically regional and national interconnectors and metering stations to facilitate “reverse flow” of gas through existing pipelines. The reverse flow strategy began with small shipments from Hungary to Ukraine a little over a year ago. By April 2014, Germany began reverse-flow gas shipments to Ukraine via Poland, and at the end of the month, Ukraine and Slovakia signed a deal for reverse-flow deliveries to begin this fall. Taken together, the two projects could eventually supply one-third of Ukraine’s annual gas consumption. Since Slovakia has the capacity to expand its reverse-flow commitment, the U.S. and EU will no doubt try to persuade the Slovaks to do just that once the project is up and running.

Senior EU officials have also highlighted the need to facilitate gas imports from the U.S., in order to route some of the shale boom production for LNG export. European Council President Herman Van Rompuy has suggested the inclusion of this issue in the U.S.-EU Transatlantic Trade and Investment Partnership (TTIP) negotiations. Though it would take several years to implement given the infrastructure requirements on both sides of the Atlantic, a bold step could be taken this year to amend the U.S. legal framework with bipartisan support. The signal itself, years before the first deliveries would reach the European market, would help facilitate a revamped European energy policy and would alter the equation from the Russian side. Of course, these projects will ultimately succeed only if they are commercially attractive to U.S. and European companies.

Though the European energy dilemma primarily centers on natural gas supplies, calls for action similar to lifting the ban on U.S. oil exports are surfacing frequently, with the obvious endorsement of American energy companies.

These measures to increase and diversify supply will likely be accompanied by stricter interpretation and implementation of the EU’s Third Energy Package and further constraints on Gazprom’s influence, especially as it concerns the unbundling of ownership and transmission capacity.

Conclusion

U.S. and European leaders were quick to recognize that there can be no military solution for the crisis in Ukraine. This made international isolation and economic leverage the primary tools deployed to exert pressure on Russia to change course after assessing the costs associated with its destabilizing activity. Russia may have changed tactics, but it is not at all clear that it has backed away from a strategy of promoting instability to influence the shape and direction of post-Yanukovych Ukraine.

U.S.-Russia relations have been badly damaged by the crisis in Ukraine, and the mutual grievances felt on both sides increase the probability of sharp responses and further setbacks. Proposals in Congress and elsewhere demonstrate the potential for a downward spiral leading to talk of “containment” or “Cold War Lite.” But the damage is not necessarily irreparable. The international isolation of Russia will continue and intensify, though the door to renewed engagement with Russia could reopen if Russia takes concrete steps to deescalate the crisis and facilitates tangible, sustainable progress toward a peaceful and unified Ukraine.

The current challenge for U.S. policymakers is to deploy the tactics of international isolation and economic pressure without sacrificing long-term business interests or encouraging, whether intentionally or not, a form of commercial disengagement from Russia. Stepping back from large markets that take years to penetrate carries with it tremendous costs—when market share is ceded to competitors, it is difficult to regain, both in terms of access to opportunities or of consumer brand loyalty.

Following the first round of asset freezes, Russian lawmakers quickly realized that an upper house proposal to confiscate assets of U.S. and European firms was short-sighted and ultimately harmful to Russia’s investment climate. If the U.S. implements further sanctions, we can expect to see a concrete but measured Russian response—for example, temporary bans on U.S. participation in Russian government tenders. In view of the first two rounds and the possibility of sectoral sanctions, President Putin has further encouraged Russian energy firms to purchase Russian equipment and services rather than entering into contracts with Western suppliers.

These are considerations for U.S. officials as they brief the investment community on increased Russian risk or discuss with American companies the extent of their participation in economic forums such as that held in St. Petersburg in May. Both tactics pose a contrast to typical business-government consultations in European capitals, and they further demonstrate the challenge of a coordinated multilateral approach to limiting collateral fallout.

Though there exist some ambiguities and differing interpretations in the narrative of the past six months, it is clear that Russia’s role in the crisis warranted a Western response. The nature of the response (and the Russian response to the Western response) has put the U.S. business community in a difficult position. Corporate executives understand the dilemma, but many of them also recall previous sharp differences between the U.S. and Russia over Kosovo and Georgia, among others. During moments of heightened political tension, and especially during those episodes involving the use of force, commercial interests on both sides point to the economic dimension of the bilateral relationship as a ballast when other ties are frayed. Corporations obviously seek to preserve and advance their own interests in growing new markets. However, from a strategic standpoint, more robust economic ties and further integration of Russia into the global economy will quite likely alter the context for adventurous pursuits, competition, and conflict in the future.

Blake Marshall is a leading specialist in U.S.-Russia economic relations based in Washington, DC. His experience advising Western companies over the past twenty years includes positions as Senior Vice President and Managing Director of PBN Hill+Knowlton Strategies and Executive Vice President of the U.S.-Russia Business Council. He has worked closely with a broad range of American companies on their investments in Russia and other markets of the former Soviet Union, with an emphasis on market entry and expansion, business strategy, government relations, and stakeholder outreach.

[1] Rebecca Shabad, “U.S. ‘finalizing’ new sanctions against Russia,” http://thehill.com/policy/international/217133-us-finalizing-new-sanctio....

[2] David Jackson and Oren Dorrell, “Obama team unveils new Russia sanctions,” http://www.usatoday.com/story/news/nation/2014/09/12/obama-russia-sancti....

[3] Eli Lake, “NATO Plans New Military Outposts to Stop Putin—Just Don’t Call Them Bases,” http://www.thedailybeast.com/articles/2014/09/03/nato-plans-new-military....

Image: Kremlin website