Calling Putin's Bluff

April 12, 2014 Topic: Great PowersSecurity Region: Russia

Calling Putin's Bluff

Russia relies on Ukraine more than you think.

The U.S. response should encompass a broad range of political, economic and military measures. These should include:


Economic Sanctions

The sanctions announced on March 20th provide a good start. They are directed at officials and supporters close to Putin and are designed to promote internal fissures between the regime and its close supporters. They can be progressively expanded to “target Russia’s trading connections with the West, its use of global capital markets, and its reliance on the international banking system”, says Tom Keatinge, a former investment banker at J.P. Morgan.

The sanctions are not likely to compel Putin to change his behavior immediately, but over time, they can increase the economic costs to the Russian economy. Even before the Ukrainian crisis, Russia’s economy had begun to show signs of stagnation. Keatinge states, Russia’s GDP growth fell from 3.4 percent in 2012 to 1.3 percent in 2013. Even without significant sanctions the Russian economy is sliding toward a recession.

Capital flight from Russia has spiked dramatically since the annexation of Crimea and is anticipated to reach $65-70 billion in the first quarter of 2014, far higher than initially expected. This has prompted fears that Russia may have to impose capital controls to stem the loss.

Since the sanctions were imposed, the Russian economy has shown further signs of stagnation. Stock prices have fallen and the ruble has weakened, increasing the costs of imports and dealing a sharp blow to companies with foreign currency denominated borrowing. Inflation is expected to rise even higher than the seven percent predicted by the Russian Ministry of Economics.

Taken as a whole, these indicators suggest that the impact of the sanctions on the Russian economy is likely to be considerably higher than initially anticipated. This is because Russia is much more closely integrated into the international global economy than the Soviet Union.

The energy market is undergoing important changes that will increase the economic dilemmas Russia will face. The price of oil is expected to drop as low as $70/barrel – well below Russia’s break-even price of slightly above $110/barrel. The development of US shale gas and tight oil, European efforts to reduce their dependence on Russian gas and Iran’s expected return to the international energy market will reduce demand for – and income from -- Russian energy imports. Thus Putin cannot rely on the type of large revenue windfall from high oil prices that contributed to a visible improvement in Russian living standards during his first two terms as president while dramatically increasing the size of the military budget.

Russia has about $494 billion in foreign currency and gold reserves in the central bank that can be used to defend the ruble and prop up its banks. However, as Ambrose Evans-Pritchard of the Telegraph states, “the central bank cannot easily deploy this money in a recession since foreign exchange intervention entails money tightening.” At the same time, Evans-Pritchard asserts that it is risky for Russian authorities to allow the ruble to continue to decline “since Russian banks and companies owe $650 billion in foreign currencies”. The ruble has already fallen 8% this year, making it harder for struggling Russian companies to repay dollar debts.

Putin’s popularity and power are closely tied to Russia’s economic success. If the economy seriously declines, he could face growing social discontent at home that could constrain his ability to rebuild Russia into a powerful and influential Eurasian actor.

The Obama administration needs to work closely with our European allies, especially Germany, to coordinate an effective sanctions regime. Germany is Russia’s most important European trading partner and investor. Its voice carries weight in Moscow. Thus ensuring Washington and Berlin’s policies are closely politically and diplomatically synchronized will be important.

However, getting Germany to sign on to a robust program of sanctions will not be easy. Germany has a strong economic stake in trade with Russia. German companies have invested over $20 billion in Russia and 300,000 jobs in Germany depend on the economic relationship with Russia. Germany also is heavily dependent on the import of natural gas from Russia. Chancellor Angela Merkel has strongly condemned the annexation of Crimea, but she is likely to be reluctant to impose robust sanctions against Russia, especially if Putin does not escalate the crisis beyond the annexation of Crimea. The position that Germany adopts will have a significant impact on EU policy. If Merkel refuses to impose robust sanctions on Russia, the EU is not likely to support imposing them either. This could provoke a serious split between Washington and Berlin and strengthen Putin’s view that he will not pay a high price for his aggression in Crimea – or elsewhere in Ukraine.

A Robust Economic Assistance Package for Ukraine

The Ukrainian economy is in dire straits. Ukraine will need significant economic assistance in order to stave off bankruptcy. In 2013, the budget deficit increased to about 8 percent of GDP while the current account deficit reached almost 9 percent of GDP. Economic growth has been unusually low for the last two years. Washington should coordinate a package of economic assistance with the EU and the International Monetary Fund that enables the Ukrainian government to stabilize its economy. This assistance should be conditioned on a commitment by the Ukrainian government to implement a coherent program of economic and political reform and to reduce corruption.

Bilateral U.S.-Ukrainian Bilateral Defense Cooperation

TheUnited States should upgrade and expand defense cooperation with Ukraine. This should include a military assistance package with emphasis on programs designed to modernize and reform the Ukrainian Armed Forces and improve their capacity to defend the country’s borders. Washington and its key NATO allies will have to be very careful. Too vigorous an effort at military engagement could provoke Moscow to take quick military action. Finding the right balance in this regard will be very important.

Ukrainian Relations with NATO

Defense cooperation with NATO in the immediate future should focus on strengthening Ukraine’s capability for self-defense and enhancing civilian control of the military. The issue of NATO membership should be put on the back burner. Ukraine is not ready militarily or politically for NATO membership. Pushing for Ukrainian membership in NATO now would be counterproductive. It would only antagonize Russia and could prompt Moscow to take military countermeasures that could exacerbate the current crisis.

Regional Reassurance

In the wake of Russia’s annexation of Crimea, greater attention needs to be paid to measures designed to reassure the new allies from Eastern Europe, especially the Baltic states and Poland, that the alliance takes their security concerns seriously. In March, six F-15 and two air refueling tankers were sent to Lithuania to reinforce the air patrol of Baltic borders. The United States also sent 12 additional F-16 fighter jets to Poland to bolster the U.S. aviation detachment there in an attempt to reassure the members in Eastern Europe.

In the past, NATO has not permanently deployed allied troops in Eastern Europe. However, in the wake of the annexation of Crimea, it is time to reconsider this decision. Many East European allies fear that the United States is losing interest in Europe. They see a permanent stationing of NATO troops on East European soil as a tangible indication of the U.S. commitment to their security and an important deterrent against Russian aggression. Polish officials, for instance, have indicated that Warsaw would like the alliance to deploy two combat brigades in Poland. The Baltic states and Romania have also expressed an interest in having “boots on the ground.” Additional air power assets such as combat aircraft, tankers and Intelligence, Surveillance, and Reconnaissance (ISR) aircraft could also be part of this reinforcement.

The annexation of Crimea has also given new impetus to internal debates within Finland and Sweden about the possibility of NATO membership of one or both countries. While neither country is likely to apply for membership soon, this could change if the security environment in northern Europe deteriorates further. From a purely military perspective, Swedish membership in NATO would significantly improve NATO’s ability to deter any Russian aggression against the Baltic states.

Global Impact of a New Cold War

As highlighted above, the comfortable strategic assumption that Europe would remain an island of stability has been shattered by Russia’s annexation of Crimea and the near-term prospect that Moscow may dramatically escalate the Ukraine crisis. At the moment, Putin’s end game is not clear. If Putin were to take military action in eastern Ukraine, then this could result in a dramatic deterioration of relations with the West, and a new Cold War. Such a development would have serious strategic implications in a number of important foreign and defense areas. A key strategic assumption of the Quadrennial Defense Review (QDR) is that the modernization of the USAF and USN can be paid in part by the substantial downsizing of the U.S. Army to accommodate a secular downtrend in defense spending. That downward trend in defense spending will likely be reversed, but a large increase during this decade is unlikely due to the heavy federal budget demands made by the retiring “baby boomers” on the national health care system and domestic demands for major increases in infrastructure spending. This suggests that any reinforcement of NATO Europe, especially Eastern Europe, will be modest unless the Ukraine crisis breaks out into a full-scale regional war.