As the Ukrainian ceasefire falters what next on sanctions?

UK PM Cameron warns Russia of sanctions ahead of G20

Over the past few days we have seen the situation in Ukraine begin to escalate once again. Both NATO and the Organisation of Security and Co-operation in Europe (OSCE) have said that they have witnessed significant military movements in Eastern Ukraine, most likely from Russian troops. By almost all accounts the ceasefire only continues to exist on paper (although we have pointed out before why both sides might be willing to continue to pretend it is more than that).

Why has the situation suddenly escalated?
In all honesty, it’s not entirely clear how significantly the situation has escalated on the ground in Ukraine, given that there have been continuous reports of fighting since the ceasefire was struck. It could be more a case of attention shifting back to Ukraine ahead of the G20 and EU meetings. That said, Russia continues to push the boundaries with military exercises. Furthermore, the elections (both in Ukraine and the separatist regions) have increased tensions, while Russia is reportedly keen to help further establish the newly elected separatist leaders.

As might be expected, these reports have once again triggered the discussion on whether the US and EU should increase sanctions on Russia. As we reported in our press summary today, numerous leaders have come out warning of the potential increase in sanctions – surprisingly this also includes representatives of Hungary and Slovakia, though both countries remain a bit divided on sanctions.

While there is lots of talk of further sanctions we would not get ahead of ourselves. Crucially, German Chancellor Angela Merkel has already played down the chance of this in the near future as we reported in our press summary earlier in the week. EU officials have also suggested any agreement is unlikely at Monday’s meeting of EU foreign ministers, although a discussion will be had at the meeting of EU leaders in mid-December.

What could be on the table if sanctions are escalated?
We’ve discussed many times before the options for sanctions but below are a reminder of the potential options if they wanted to take the next step up from the current sanctions.

Expanding list of individuals subject to asset freezes and travel bans: This is a virtual certainty and should be agreed at Monday’s meeting. Specifically the newly elected officials for the pro-Russian separatists will be targeted. More broadly, those involved with the elections in the region could be targeted. It’s not yet clear if there will be a broader discussion about adding further people or oligarchs close to Russian President Vladimir Putin to the list (we have pointed out the potential legal concerns on these sorts of sanctions here).

There are a few other options which the EU could consider (many of which we have discussed before):

• Ban purchases of new Russian sovereign debt – this was reportedly toyed with before but considered too harsh a step. As we noted before, this would probably be manageable for Russia given its fairly low government debt level but it would add another difficulty at a time when the economy and state budget is coming under severe pressure.
• Broaden scope of technological sanctions – this would involve expanding the list of banned tech exports to Russia, currently very focused on oil exploration. It could also include expanding the ban of services which European firms can provide to Russia, which again is currently focused on oil exploration.
• Extend financial sanctions – similar to the above, this would involve broadening the existing financial sanctions from just state owned firms to Russian firms more generally, most likely still only in specific sectors such as financial and defence. This would be legally difficult since the ties to the state would become even more indirect and justification would need to be watertight.
• Broaden scope of financial sanctions – related to the above, rather than expanding the number or type of firms subject to the sanctions, the EU could broaden the scope of the sanctions. This could, for example, mean cutting off all euro funding from certain state owned firms, no matter what the maturity or the type of loan (there are probably a few incremental steps or variations between this and where we are now).
• Remove Russia from the SWIFT system – This remains very unlikely and for some very practical reasons. SWIFT is independent and private. Removing Russian financial firms from this system would mean having heavy direct sanctions on them which forces SWIFT (in acts of compliance) to shut them off from the system. This is one of the key reasons it has never really been discussed at the top level as a realistic option so far.

For his part Putin continues to demand a removal of sanctions but if they were ramped up it is likely he would be willing to retaliate with his own sanctions, some of which we looked at here.

In terms of the broader picture it’s clear that sanctions, combined with the falling oil price, are hurting the Russian economy. However, they do not yet look to have impacted Putin’s approach or course of action. As we warned before, the lack of a clear goal or strategy for the sanctions as well as in terms of what Europe actually wants in terms of a future relationship with Ukraine and Russia could well hamper the approach. The EU would do well to discuss this, not least because the continuing downward spiral of the Ukrainian economy will likely (as we warned some months ago) lead to further bailout requests.

Gas talks stall as Russia pushes for EU guarantees on Ukrainian gas payments

Update 11.50 30/10/14:
Reuters is reporting that an EU spokesperson has said a deal is "very close" and talks will continue today, as we note below. As we also say below, a deal is still doable and likely, the question remains whether any form of EU payment guarantee will be needed and if this can get sufficient support within the broader EU member states.

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Despite another round of talks between Ukraine, Russia and the EU which ran late into the night yesterday the negotiations seem to have reached somewhat of a stalemate.

Earlier in the year the halting of gas supply between Russia and Ukraine (for Ukraine’s own use at least) was not seen as too big of an issue and it was hoped Ukraine would be able to leverage the combination of economic pain from sanctions and the Russian government’s reliance on commodities exports for funding to secure a relatively favourable deal. However, on the cusp of the harsh Ukrainian winter the power balance has steadily shifted and Russia has continued to hold firm and even broadened its demands.

What has been agreed so far?
Quite significant progress has actually been made compared to the starting point:

• Ukraine has agreed to pay for previous gas supply at a price of $268.5 per thousand cubic metres. This means $1.45bn will be paid by the end of October and $1.65bn ($3.1bn total) by the end of the year. Ukraine’s Naftogaz has set aside $3.2bn in an escrow account to pay for this.
• Going forward Ukraine will prepay on a monthly basis for its gas this winter at a price of $385 per thousand cubic metres. Russia has agreed to pay transit costs.

Russia has clearly shifted from its original price demand (at least with regards to back dated payments), but Ukraine has also compromised by agreeing to prepay and pay off existing debts.

What are the key sticking points?
There is really only one, but it’s a biggie. While Ukraine has proven that it can afford to pay off its existing debts there is much less certainty about its ability to prepay going forward.

We have noted before the significant downward spiral in the Ukrainian economy. While the fighting has calmed down to an extent, things are still far from normal, not least because the conflict has become frozen in the East with part of the country still de facto cut off.

Ukraine is now totally reliant on external funding from the EU and IMF. As we have seen in the Eurozone crisis the release of such funding is often more complicated than expected and creates a staggered cash flow linked to economic reforms. Such reforms should pick up following the election but remain tricky to implement in a country caught in the proverbial no man’s land in the sanctions war between Russia and the EU.

For these reasons Russia has continued to demand some form of explicit guarantee from the EU that Ukraine will be able to pay for the supplies over the winter – they are expected to cost around $1.6bn, though this could increase if the winter is particularly harsh.

Is a deal likely?
It’s looking difficult as this meeting was earmarked as the most likely one for a deal. Russia seems to be using this arena to flex its muscles given that it believes it has the upper hand. That said, the economic costs of sanctions and a falling oil price are creating problems for the Russian economy, though it’s not always clear whether economic logic is sufficient to alter Russian President Vladimir Putin’s position.

Getting explicit EU support for around $2bn to guarantee prepayment would be difficult. But, so far, the EU has been fairly supportive of Ukraine and may be willing to offer a more tacit agreement to provide further funding rather than outright underwriting of the payments. Furthermore, without a deal there will be a huge temptation for Ukraine to siphon off gas which it is transiting from Russia to Europe. This could cause Russia to halt all gas flow through Russia, something Europe is keen to avoid to say the least.

Talks are set to resume later today according to RIA Novosti. With all this in mind, and the fact that a deal remains in all sides' interests, we would think one could still be struck.

What are the lessons here?
Ultimately, this dispute is teasing out a key question for the EU in the wake of this crisis. It is becoming increasingly clear that Ukraine is economically devastated in the wake of the war and the sanctions. The offer of opening up markets in the EU is unlikely to be sufficient and the EU and IMF will have to face up to the fact that in the short and medium term they will probably have to offer significant amounts of cash to Ukraine to help stabilise its economy, currency and energy supply.

Putin is aware of how politically sensitive this is for the EU – it has just gone through a series of its own bailouts in the Eurozone crisis and now countries are being asked to stump up cash for a country which is not even a member (and is unlikely to be one for the foreseeable future, if ever). As with the sanctions, this narrative is likely to expose dividing lines within the EU and set the tone for the negotiations over the future of Ukraine.

Legal challenges could pose new problems for EU sanctions on Russia

Arkady Rotenberg and Rosneft CEO Igor Sechin

We’ve discussed the economic and political challenges which the sanctions on Russia have caused for the EU. So far the economic pain has been managed (though Germany has been hit quite hard), despite outbursts from a few countries. The long standing political differences over how to deal with Russia have also been exposed.

However, now a new front has opened – a legal one. Both Rosneft and billionaire Arkady Rotenberg have launched legal challenges against the EU sanctions on Russia at the European Court of Justice (ECJ).

While the details of the challenges have not yet been revealed in full (the cases can be found here, here and here), Rosneft will be challenging the grounds for banning them and others from capital markets access, while Rotenberg will be questioning the decision to freeze his assets in Europe and impose a travel ban.

So, why exactly might this be a problem?

Well, the EU does not actually have a great track record of being able to legally enforce its sanctions despite the assumption that the ECJ would always back the EU. There are numerous recent examples:

• In September this year the EU General Court (a step below the full ECJ) ruled that the EU’s sanctions which froze Iran’s Central Bank assets were unlawful since the evidence behind them was so “vague and lacking in detail”.
• Similarly towards the end of 2013 there were a series of cases which saw the sanctions against numerous Iranian banks and companies overturned due to lack of sufficient evidence.
• In fact, there have been countless examples of this over the past few years since the ruling in the Kadi case, which essentially established the ability for sanctions to be challenged and precedent for them to be overturned on insufficient evidence.

The thrust is that the ECJ and EU system for legally enforcing sanctions is actually quite inadequate for a number of reasons:

• The decision to impose sanctions is essentially a political one. This means the evidence or research which goes into deciding who is sanctioned can often be limited. This makes justifying the sanctions in legal terms quite difficult.
• Where there is evidence it can often be confidential and provided by national government sources. However, there is no system for sharing, submitting or even holding confidential information at the ECJ. All evidence submitted to the court must be shared with the other side and is often made public. This makes many governments and intelligent services very uncomfortable. This combined with the point above means that in some cases the court is forced to overturn sanctions simply because it has not been given enough evidence to make a proper judgement.
• Those being sanctioned are often not the real target. The Russian sanctions are a prime example of this – individuals and firms around the Russian government have been hit to try and inflict pain and force a change of approach by the government. But this means that to legally defend the sanctions the link between the two must be conclusively proven and they must be shown to be involved in the activity which resulted in the sanctions.

(For a more detailed discussion we recommend reading this evidence submitted to the House of Lords on the isse).

It has taken a while for this to filter through. The main reason is that the original sanctions, which were focused on those involved in destabilising Eastern Ukraine and Crimea were easier to defend and legally prove. However, as sanctions have broadened and the objective has become causing general economic pain, the legal base has also become more stretched. Clearly, Rosneft and Rotenberg feel they are now at a point of vulnerability.

It’s hard to fully assess at this point in time just what chances they have of succeeding. The hope might be that the cases will draw attention and encourage those EU countries which do not fully support sanctions to apply more political pressure for an easing of the controls. Just today we have seen Hungary speaking out against them.

Even if Rosneft and Rotenberg were to win, history has shown that this is no guarantee of the sanctions being removed permanently. Previously, the sanctions have simply been reworded and instituted under a different legal base. Sure they can be challenged again but it is a very lengthy legal process. Alternatively, better evidence has been collected in due course and a more solid base for the sanctions provided. Of course, the EU would retain the right to appeal against any judgement.

With that in mind we wouldn’t expect any results for 12 – 18 months and in the meantime the sanctions will stay fully in place. In that sense, given the economic and political fallout from the sanctions so far not to mention the increasingly desperate economic crisis in Ukraine, many will hope the situation has reached some resolution before these cases ever have a chance to be resolved.

What impact could this round of Russian retaliatory sanctions have on Europe?

In our continuing effort to bring increased transparency to the murky issue of sanctions we’ve compiled some initial thoughts on the likely Russian retaliatory response to the EU’s latest sanctions – published in full here and which we already analysed in detail here.

There are a few key measures which Russia is said to be considering:

1. Banning or limiting the import of cars (and possibly all automobiles) from Europe.
2. Banning or limiting the import of certain manufactured goods.
3. Banning or limiting the import of certain types of clothing manufactured in Europe.
4. Restricting the access of European flights to Russia airspace, probably over Siberia.

With the previous round of Russian retaliation we saw uproar from the industries involved and some questionable claims for compensation – a process which now looks to have been halted. The response also seemed to weigh on the minds of certain countries, such as Finland and Czech Republic, which in turn played a role in delaying the latest round of sanctions.

With that in mind its worth delving into what impact these mooted measures could have.

In terms of exports of cars, Russia remains quite an important destination for European exports as the graph above from the European Automobile Manufacturers Association shows. In 2012 Russia accounted for 8.1% of EU exports in this sector in terms of value – around €8.7bn. Ultimately, the impact will depend on exactly how the sanctions are structured – we doubt Russia would ban all exports of cars, it could be focused on only used cars or certain types or price brackets. In terms of countries which would be hit the obvious answer is Germany, but other countries such as the UK, France, Belgium and Spain could feel the pinch (albeit on a much smaller scale). Its also important to remember that, even without any sanctions we are already seeing a sharp fall in the level of cars being exported to Russia.

The story for clothing is similar. Russia remains quite an important export market for EU members, with exports to Russia totalling €3.185bn in 2013, making it the second largest destination for exports of EU clothing (graph above from European Fashion and Textiles Export Council). Meanwhile, as the graph below shows, the main countries exposed are Italy and Germany. This area could be particularly sensitive since we have already seen companies such as Adidas warning that the ongoing hostilities between the EU and Russia could severely hamper its business.

Comparing this to the previous round of retaliation, the figures do look a magnitude larger, although it does ultimately depend how broad the sanctions are and how long they last for. The potential sanctions on manufactured goods remains too vague to really assess, however, we can look a bit deeper into the airspace issue.

As the data to the left from FlightRadar24 (compiled by Bloomberg) shows there are lots of flights which use Russian airspace. This map from the Times, highlights that having to fly around Russia would be no small inconvenience and would certainly increase fuel costs and flying times.

So how likely are all these sanctions?

The feeling in Russia seems quite hostile this time around, compared to previously when they have more or less shrugged off the sanctions. This could be because Russia had hoped the ceasefire process would appease the EU, not least after the delay. Furthermore, the EU’s decision to target Rosneft, a key player in the energy market, may be seen as crossing a rubicon, since large energy firms had been largely off limits.

That being said, in the longer term, Russia probably has more to lose out from economic sanctions. Take for example the airspace ban – European firms pay around $185m per year for access to this airspace. Russia would also have to spend additional funds to enforce and police its airspace. Furthermore, the number of Russian flights which use European airspace is far higher, meaning a tit-for-tat sanction in this area would be particularly painful.

Some retaliation seems inevitable but Russia will still need to be cautious of further escalating the growing economic divide with Europe.

EU divisions delay sanctions on Russia, likely to focus on Rosneft

The EU last night finally reached an agreement on the latest round of sanctions on Russia, although the members agreed to delay implementation for a "few days" to allow time for the ceasefire to take hold and to reconsider the sanctions on the basis of whether the ceasefire holds or not.

This is despite the fact that by almost all accounts fighting has continued in Eastern Ukraine over the weekend and into today. However, for now, all those involved seem keen to maintain the ‘ceasefire’ and suggest the deal agreed on Friday remains in place.

First a couple of thoughts on why both sides are so keen to keep the deal in place, despite seemingly flagrant violations:

Ukrainian government: Kiev is keen to push for stability for a couple of reasons. The upcoming election is weighing on thinking and if it is ever to be seen as viable and legitimate it must take place during a calm environment. Kiev may see the ceasefire as first steps towards this. Furthermore, it seems unlikely to be a coincidence that Ukraine found a renewed vigour for the ceasefire just as the IMF warned that the prolonged fighting could lead to another $19bn bailout for the country next year. Lastly, Ukrainian forces had been suffering heavy losses as Russian forces became more involved and bolstered the rebels – this ceasefire allows Kiev to regroup and plan how to deal with this new resistance.

Russia and the pro-Russian rebels: The ceasefire came at a perfect time for Russian President Vladimir Putin – right in the middle of EU sanctions negotiations and NATO meetings – and played on divisions within the two groups. It turned attention away from what was happening on the ground in Ukraine and the potential Russian influence. It allowed the rebels to regroup and prepare to take back some more of the land they had lost in previous weeks. There also seems to have been an increasing shift towards Mariupol which looks to be a new strategic objective for the rebels.

From the EU perspective, while the official line is that they want to give the ceasefire time, the more likely influence is the concern around the economic impact of sanctions and the potential Russia retaliation. The talks over the past week have reportedly seen the reemergence of significant divisions within the EU over sanctions (although they never really went away).

While the official details are yet to be released, the sanctions have been widely reported. We discussed the options in detail here, but the key points are:

• Ban European financing with a maturity of over 30 days to Russian state-owned oil and defence firms. This will include Rosneft, Gazprom Neft and Transneft (the main oil pipeline operator). A large number of Russian defence firms are state-owned but few, if any, look externally for funding.
• Ban European companies from providing services to Russian firms which are associated with oil exploration and production (be it deep water, Arctic or shale).
• Expand the list of banned high-tech energy and dual use goods which cannot be exported by European firms to Russia.
• Reduce the allowed level of financing to Russian state-owned banks from 60 to 30 days.
• One option which is not entirely clear is a potential limit to the syndicated loans to Russian state-owned entities. This would essentially limit loans given by groups of banks (a fairly common practice used to spread the risk of lending over many parties).

Our initial feeling is that this will be a modest increase in the current sanctions. They remain very specific and targeted on a few state-owned firms, and particularly their access to European capital markets. They also remain only forward looking. Below are a few stats to give a feeling of the impact.

Above we have updated a graph we produced previously, which now shows which Russian state-owned banks, defence and oil firms have issued shares on the London Stock Exchange. In this instance, there is only one issuance to be added – the $10.65bn listing by Rosneft in 2006. Let's not forget that Europe gets around 35% of its oil from Russia, and while the global oil market remains much more fungible and varied than the gas sector, hitting Rosneft is probably the main story of these sanctions.

A quick peak at Rosneft’s latest financial statement also hints at why they are so concerned by potential sanctions that they have asked the Russian state for a loan of $42bn (around RUB 1,550bn). Out of RUB 2,179bn ($58.8bn) in loans and borrowings, around RUB 1,536bn ($41.5bn) is in the form of long term bank loans in dollars and/or euros. A significant portion of this is likely to have been provided from foreign banks, meaning Rosneft could face issues rolling over these loans. Furthermore, the amount they have requested almost exactly corresponds to their net debt levels (show in the chart below) with Rosneft even admitting that the main motivation for asking for assistance from the Russia state is to help finance its net debt amid the US and EU restrictions on its market access.

One final point to note here is that the sanctions on syndicated loans could be particularly important for a company such as Rosneft, not least because it is an instrument it has used previously, for example to help finance its purchase of TNK-BP.

 

As with all these sanctions while the direct impact could be limited it will further add to the indirect freezing of business between the West and Russia. Furthermore, Russia looks set to retaliate once again – with the idea of banning commercial flights from the West from Russian airspace being reheated. All of this could of course be offset by positivity if the ceasefire holds – but that remains a big if at the moment.

What further sanctions is the EU considering against Russia?

Given the recent escalation in Eastern Ukraine and the increasingly obvious Russian influence in the rebel forces, the EU looks set to impose further economic and financial sanctions on Russia.

EU ambassadors met yesterday to begin discussing the options and will meet again tomorrow in an attempt to finalise a package to send to EU leaders. They are expected to reach a decision by Friday.

Before we look at the options on the table, we should note that such agreement is not a forgone conclusion. As we have been pointed out repeatedly, there are significant divisions within the EU around sanctions. Slovakian Prime Minister Robert Fico  recently even threatened to veto another round of sanctions if they hurt the Slovakian economy. In short, many EU leaders seem to be becoming increasingly anxious about the economic impact of sanctions and the inevitable Russian retaliation – just see the concern around the Russian ban on EU fruit and veg.

All that being said, with the UK, Germany and France seemingly in favour of further sanctions – and pressure on Italy’s Foreign Minister Federica Mogherini to take a hard line ahead of taking up the role of EU High Representative for Foreign Affairs – the big states seem largely to be backing further action and willing to take on a larger share of the economic burden.

With all that in mind, here are the options that are being touted:

• Expanding targeted sanctions: This looks a done deal with further entities and persons involved in Crimea and Eastern Ukraine being subject to asset freezes and travel bans. The focus has tended to be on smaller firms and regime members directly involved. The measures would have a larger impact if Europe decided to sanction a higher profile firm (such as a state-owned bank), or a big name oligarch with ties to the regime.

• Expanding stage three sanctions: This seems the most likely option, with extensions made to the existing sanctions on finance, defence and energy sectors. This could take many forms but the main ones under discussion are – expanding the restrictions on financing for state-owned banks to any maturity above 30 days (currently 90 days), and expanding the list of banned energy tech exports and dual use goods to Russia.
  
  Other proposals under consideration include, banning a larger number of firms in these sectors from issuing debt in Europe and/or listing on European exchanges – initially this would be focused on state owned firms (of which there are many in Russia). The range in these sanctions remains large, so the impact is hard to judge. For the most part they will be focused on limiting medium to long term financing for state-owned firms. This will have a grinding impact on the economy, but as we have noted before, the Russian state does have resources at its disposal to aid firms hit by these measures.

• Banning syndicated loans to certain Russian entities: This remains a vague option, but could have a substantial impact since many Russian firms are reliant on external loans. For example, the private sector (excluding financial firms) have $142.5bn in outstanding external loans, a key source of financing for them. Given some European banks large exposure to Russia, any movement into this area of sanctions would likely be tentative and limited to very select entities (state-owned banks perhaps), under very specific terms.

• Ban on new purchases of Russian sovereign debt: this would see European entities banned from purchasing any newly-issued Russian sovereign debt. It would be quite a bold measure, and fears remain that Russia, a big investor in European sovereign debt, would retaliate in kind, something struggling eurozone countries would not want to see. In terms of impact, as the graphs above and below show, while Russia does have a sizeable amount of government debt to roll over in the coming year, the amount which is held externally is fairly limited. That said, this could well increase borrowing costs and reduce liquidity in Russia’s sovereign-debt market at a time when its economy is struggling and the state is being forced to take on an even larger role.  

One option which doesn’t yet seem to be on the table is one which the UK has reportedly called for – banning Russia from the SWIFT network. This is not surprising, since it would be a big step and could almost amount to freezing out Russia’s financial sector from Europe – a move which the EU is clearly not ready or willing to make. We will analyse this in a future blog post.

One consideration that seems to be glaringly absent from these discussions is the consideration of how effective the sanctions have been so far. To be fair, Dutch Prime Minister Mark Rutte did call for such consideration ahead of last week’s EU summit. There are already reports of them having some economic impact (both on Russia and Europe), but clearly they have not caused a change in course or approach from Russia or in Eastern Ukraine. Europe would do well to consider why this is the case in order to fully judge and best optimise any future sanctions.

Furthermore, as we have noted countless times before, the end goal and medium to long term strategy of such sanctions and the wider approach to Russia and Ukraine remains unclear. Given that this crisis has already been going for 6 months, and shows little sign of abatin,g some longer term thinking would be welcome.

EU top jobs summit has kicked off: here is a round-up of doorstep declarations

EU leaders have all arrived in Brussels for today's summit. There are two big issues on the table: the appointments of the next European Council President and High Representative for Foreign Affairs; and the worsening situation in Ukraine (although the situation in the Middle East is also bound to come up).

Here's a round-up of what EU leaders said upon arrival. Let's start with the assignment of the remaining EU top jobs. Italian Foreign Minister Federica Mogherini and Polish Prime Minister Donald Tusk are the frontrunners for the posts of High Representative and European Council President respectively. However, Mogherini's appointment looks more like a done deal than Tusk's - at least from EU leaders' doorstep declarations:

#Hollande: Support of centre-left leaders to #Mogherini is guaranteed [acquis]. I think she will be the next EU High Rep. #EUCO
— Open Europe (@OpenEurope) August 30, 2014

#Hollande thinks #Mogherini will be new High Rep, says "consensus solution" needed for new #EUCO President. He didn't name Polish PM #Tusk.
— Vincenzo Scarpetta (@LondonerVince) August 30, 2014

Brief doorstep statement from #Merkel: We should be able to decide on #EUtopjobs and we will discuss Ukraine, it should be an exciting #EUCO
— Pawel Swidlicki (@pswidlicki) August 30, 2014

Belgian PM Di Rupo says there are "several quality candidates" for #EUCO President.
— Vincenzo Scarpetta (@LondonerVince) August 30, 2014

Finnish PM #Stubb: I don't usually bet, but I would put my money on #Mogherini and #Tusk. #EUCO
— Open Europe (@OpenEurope) August 30, 2014

Enda Kenny: Increasingly evident that the Italian candidate [#Mogherini] will be appointed as High Representative #EUCO #EUtopjobs
— Pawel Swidlicki (@pswidlicki) August 30, 2014

Swedish PM Reinfeldt: If Socialists want #Mogherini, deal will have to be balanced to reflect other interests, other parts of Europe #EUCO
— Pawel Swidlicki (@pswidlicki) August 30, 2014

Mogherini has travelled to Brussels herself, and has met European Commission President-elect Jean-Claude Juncker - possibly a further sign her appointment is drawing closer. Tusk walked into the European Council building without saying a word, although reportedly with a smile on his face.

Meanwhile, it seems no decision will be made on the name of the next President of the Eurogroup of eurozone finance ministers:

#Spain's PM #Rajoy says new €-group President won't be appointed today. He's hoping for Finance Minister Luis de Guindos to bag job. #EUCO
— Vincenzo Scarpetta (@LondonerVince) August 30, 2014

As regards Ukraine, a few EU leaders stressed the need for a reaction if Russia does nothing to de-escalate the situation. However, the emphasis has significantly differed from one leader to another: 

Lithuanian President #Grybauskaitė says #Russia "is practically at war with Europe", and calls for "full arms embargo" against Moscow. #EUCO
— Vincenzo Scarpetta (@LondonerVince) August 30, 2014

David #Cameron: Situation in #Ukraine "completely unacceptable", and "consequences must follow if that situation continues". #EUCO
— Open Europe (@OpenEurope) August 30, 2014

#Hollande: There will certainly be a request to the European Commission to prepare new sanctions on #Russia. #EUCO #France
— Open Europe (@OpenEurope) August 30, 2014

Finnish PM #Stubb: Further sanctions on #Russia will be needed absent de-escalation, but we also need to keep dialogue open. #EUCO
— Open Europe (@OpenEurope) August 30, 2014

And that's all for the moment. The summit is under way, and we will continue monitoring it. Follow us on Twitter @OpenEurope, @pswidlicki and @LondonerVince for real-time updates and analysis.

What will the impact of the Russian retaliatory sanctions be?

Russia earlier unveiled the key plank of its retaliation against the ‘stage three’ EU sanctions confirmed last week. It has said that it will now ban all imports of fruit, veg, meat (including fish) and dairy products from the EU (as well as the US, Australia, Canada and Norway).

How will this impact Europe?

This helpful factsheet gives an idea of the overall level of EU agricultural exports to Russia. As the box above shows, agricultural exports are about 7% of total EU exports. Of this, 10% goes to Russia. This means that agricultural exports account for around 0.7% of overall EU exports – it’s important to remember that this figure includes much more than the specific parts targeted in the sanctions.

In terms of specific countries, the chart below highlights that the Baltic countries (Latvia, Lithuania and Estonia) will be hardest hit – in terms of the trade as a share of GDP. In absolute terms, Poland, the Netherlands, Germany and Denmark will also face losses.

How will this impact Russia?
Well, as has already been pointed out, the likely fallout will be higher prices for Russian consumers (driving up inflation more broadly) and reduced consumer choice. As we pointed out previously, Russia does import some agricultural products but only to the tune of around 1.2% GDP per year. This is dwarfed by some of its other imports.

That said, it still accounts for some 13.3% of overall imports. This is a sizeable chunk of imports to replace, but Russia has a few options:

• Expand domestic production. Not impossible given the natural resources and land at Russia’s disposal as well as the state’s resources (although these could take a hit from the escalating sanctions). In terms of security this has long been on Russia’s list of things to move towards.
• Expand production with Eurasian partners. As part of its ongoing response to the crisis Russia is deepening links with surrounding states and specifically members of the fledgling Eurasian Union. Some of these states will have significant agricultural sectors, although they will unlikely be quickly able to help supply a country the size of Russia.
• Look farther afield. Rumours of Russia trying to strike agricultural deals with Latin America abound, while (as is always the case these days) Russia will likely look to China for support. This would obviously undermine any attempt to increase food security, however, would help limit the economic impact.

Does this set the scene for a broader trade war?
Hopefully, not yet. The sanctions on both sides remain quite targeted and specific. That said, it’s hard to see how either side could easily change position. That is feeding into a broader feeling of unease when it comes to the private sectors of both sides doing business together. This indirect or de facto halting of trade is likely to be the largest negative effect from this escalation.

What will the impact of stage three sanctions be and how might Russia retaliate?

Over the weekend we published a new flash analysis looking primarily at the impact of the financial sanctions on Russia and what action Russia could take in retaliation. The key points are below with some key graphs, while the full release is here.

Key points

Impact on Europe: UK to bear the largest burden. Between 2004 and 2012 Russian firms raised $49bn on the London Stock Exchange (LSE), of which $16.4bn was raised by state-owned Russian banks (Sberbank and VTB). The burden will be manageable since revenue from financial services to Russian firms’ accounts for only 1% of UK exports in this area.

Impact on Russia: State-owned banks such as VTB and Gazprom have to rollover at least $6bn worth of foreign currency debt in the next 18 months – funding costs will be increased but other markets likely to remain open. Indirect impact will be much larger as reluctance to do business with Russian firms or in Russia increases. Russian entities have $85.4bn in external debt to rollover in the rest of 2014 alone, while capital outflows have totalled $75bn in the past 6 months alone. The Russian economy could find itself short of credit and liquidity, although its sizeable international reserves ($478bn) will help.

Russian retaliation: Russia will likely further alienate the Ukrainian economy and destabilise the situation on the ground. This could prompt Ukraine to request a further bailout from the West, totalling double digit billions. Russia could also respond with its own sanctions on Western firms and may even consider asset freezes or seizures. Further escalation could also see Russia leverage its position as Europe’s main gas supplier – either through price hikes or disrupting transit through Ukraine – to hurt the EU economy.

More broadly the sanctions will hit other countries, primarily Germany. While German business will be hit directly by sanctions on exports of high tech goods in the oil sector, the much larger impact will be indirect. Declining business between European and Russia will likely hurt Germany since it has the largest level of trade with Russia and one of the more closely linked economies. This will likely be another test for Germany’s ability to diversify its exports, as it has proven to be so adept at doing during the eurozone crisis.

For better or worse, without the UK and Germany showing a willingness to stomach the cost of these sanctions, it seems unlikely that a deal would have been reached.

The EU's possible new sanctions on Russia: What 'burden sharing'?

As we noted in our previous blog on the potential 'Stage 3' of EU sanctions on Russia, the options considered by the European Commission and the EEAS seem heavily focused on financial markets, raising the question of whether London would have to shoulder too much of the burden.

The document notes:

Between 2004 and 2012, a total of USD 48.4 billion was raised through IPOs in the EU by companies incorporated in Russia. Out of those, USD 16.4 billion was issued by state-owned financial institutions.

In 2013, 47% of the bonds issued by Russian public financial institutions were issued in the EU's financial markets (€7.5bn out of a total of €15.8bn).

However, what the memo does not say is that all those deals took place in London - as data from the London Stock Exchange show quite clearly.

As the graph above shows, VTB (twice) and Sberbank have raised $16.4bn from IPOs (and follow on issuance) in London. This seems to correspond (or even outstrip) the figure cited in the EU document. Furthermore, the total value of IPOs from Russian firms also comes from London, since it stands at $48.96bn (between 2004 and 2012).

The spread of debt securities seems a bit wider, and data are harder to find. However, it is a good bet that quite a few were issued or at least cross-listed in London.

Ultimately, this is not 'make-or-break' for London. The fees from debt and/or equity issuance and stock listings are a nice income, but not huge in terms of the City. We would expect the figure to be within the hundreds of millions maximum. It's also worth remembering that any sanctions are likely to be only forward looking so relating to new debt and equity issuance not existing stocks (although this is still up for grabs in the negotiations). 

Hence, as we asked in our previous blog, the real question is why is so much of the burden (even if it is not a massive one) falling on the UK? France and Germany might be talking tougher, but they do not quite seem to be following through with actions.

*(Update: We have seen an updated version of the document which has the exact $16.4bn figure, and so have updated it in the text above). 

Leaked EU memo with options for 'Stage 3' sanctions on Russia highlights underlying confusion

France's Mistral warships seem to be off the table

As Greek daily To Vima and the FT have been reporting, there is a draft going around of the EU options paper on possible further sanctions on Russia that will be discussed at today’s meeting of EU ambassadors. The paper includes potential options for 'Stage 3' sanctions, and the key ones are:

1. Restrictions on access to EU capital markets for Russian state-owned financial institutions
2. Embargo on trade in arms
3. Restrictions on exports of dual use goods
4. Restrictions on exports of sensitive technologies including in the field of energy

We have seen a version of the document, and these are our initial thoughts:

• The section on capital markets is by far the most detailed. This raises the question of whether the UK would be taking a larger share of the burden. This is possible, and the document does not provide national estimates in terms of costs. However, as we have pointed out many times, the links between the City of London and Russia are not as huge as is made out. The draft paper stresses that financial links come from around the EU, seemingly confirming this analysis.

• Reuters notes that the four largest Russian banks with state ownership of over 50% are Sberbank, VTB, the Russian Agriculture Bank and VEB. The first two are listed on the London Stock Exchange. It is not clear what these sanctions would mean for companies such as Gazprombank, which is 100% owned by Gazprom - which in turn is 50% owned by the Russian state.

• That said, one has to question the level of burden-sharing taking place under these proposals. It seems France would put up almost nothing, as it could achieve a specific carve-out to guarantee that previously agreed arms deals – such as its €1.2 billion Mistral warship sale – are exempted.

• Once all the caveats are considered, the arms embargo seems essentially pointless. It would also have little impact on Russia since it imports barely any EU arms.

• The impact of all this on Russia would be mixed. The financial sanctions could have some impact but it would likely be a drawn out one. They would force companies to shift to much shorter financing and force the state to back them up even further – a blow but not a killer one.

• Linked to all this is the issue of international cooperation. For example, refinancing the €7.5 billion of bonds issued (in 2013) by Russian state-owned banks on EU markets would not be prohibitively difficult if markets in Singapore and Hong Kong are still open to these firms. Similarly, in terms of high tech imports, there may be alternatives on offer. At least on this front, Japan, South Korea and others are unlikely to turn against the West. Of course, the role of China is important. Beijing may help Moscow out (particularly on the finance front), but probably not to the extent Russia is hoping. China is keen to keep its holdings and investments diversified, and also has a lot invested in Russia.

• The fact that all of the sanctions are only forward-looking is also a big caveat, and allows both sides time to diversify away.

• Hence, the final question to ask is whether this document will bolster the threat of EU sanctions. In some areas yes, in others no. For example, the detail on financial sanctions will be welcome, although it is unlikely that Putin will be shaking in his boots. On the arms, tech and dual use side, though, the lack of clarity and the number of caveats could actually undermine the EU’s position and would once again highlight how hard it would be to actually reach unanimity to move to 'Stage 3' sanctions.

The document is still being negotiated. We will update our blog as and when we hear of new developments.

Will EU foreign ministers agree on what to do with Russia?

(l-r) The foreign ministers of Italy, Spain and France

EU foreign ministers will meet tomorrow to discuss what to do with Russia in light of last week's MH17 plane crash, where almost 300 people lost their lives. The option of moving to tougher 'Stage 3' economic sanctions will be on the table. While the UK, France and Germany have all warned Moscow that it will face further sanctions if it fails to secure the crash site and guarantee a thorough and independent investigation, all eyes are on Italy and Spain - usually among the most dovish member states when it comes to EU-Russia relations.

After a couple of cautious statements over the weekend, a spokesman for the Italian Foreign Ministry is today quoted as saying,

"If Russia doesn't cooperate with the investigation [into the crash], we are very much ready to support the sanctions."

Belated compared to other big EU countries, but this is the most strongly worded statement coming from Rome to date. One could expect Italy to take a tougher stance this time around, not least because the main objection raised by Eastern European member states to the appointment of Italian Foreign Minister Federica Mogherini as the new EU foreign policy chief is precisely the fact that Italy is regarded as too soft on Russia.

Meanwhile, speaking to the press this morning, Spanish Foreign Minister José Manuel García-Margallo took a milder position. He refused to condemn Russia for the crash, and suggested waiting for the outcome of the investigation by the International Civil Aviation Organisation (ICAO) before considering any further steps.

On top of this, despite presenting a united front, Germany, France and the UK might not yet be on exactly the same page - not least because France continues to look unwilling to put its sale of Mistral ships to Russia on the table, and Germany's prime concern seems to be to preserve cohesion within the EU, rather than driving tougher sanctions. The big EU member states are therefore still not all on the same wavelength - although the fact that Italy might be hardening its stance is an interesting development.

Once again then, it is far from granted that EU foreign ministers will be able to agree on tougher sanctions on Russia tomorrow. However, it is looking the most likely it has been for some time.

Ukraine update – Russian sanctions come to the fore again

We’ve been overdue an update on the situation in Ukraine. Over the past few weeks, as anyone following the news will have seen, the situation on the ground has remained very volatile. The attempted ceasefire was widely disregarded, leading to the Ukrainian government to launch a significant counterattack once it expired.

On the international level though, there seemed to have been some de-escalation: Russia drew back troops from the Ukrainian border, the Russian Parliament removed the government’s right to military intervention in Ukraine (at Russian President Vladimir Putin’s request), Putin welcomed the new Ukrainian President and government and generally softened his tone.

However, in recent days, events seem to be taking a different turn, with several reports suggesting a potential widening of economic sanctions on Russia. Much of this seems down to the fact that many believe Russia has allowed its border with Ukraine to be deliberately permeable and may have directly helped to resupply the pro-Russian separatists both with arms and personnel.

Importantly, Germany has hardened its position on sanctions, earlier this week German Chancellor Angela Merkel said:

“Regarding sanctions against Russia, we have so far reached level two and we cannot rule out having to go further.”

Deputy Chairman of the CDU/CSU Michael Fuchs added:

“If the Russians were to go further on the road which they have recently taken [towards escalation] then we must thoroughly consider whether there should be other sanctions . . . The best sanction is to take less [Russian] gas . . . You don’t even have to call it sanctions, but just don’t buy so much.”

In the meantime, the EU has also completed much of the technical work behind imposing wider economic sanctions, particularly sector specific ones. While, Russia has previously brushed off such threats the WSJ reports today that, according to a leaked document from the Russian Finance Ministry, it is quite concerned. The document argues:

[While Russia] has adequate reserves to compensate (for) the majority of the economic losses caused by sanctions…[they could still have a] substantial impact.”

“The imposition of sanctions on individual sectors of the Russian economy could lead to a worsening of their financial condition, borrowing terms, a rise in the risk premium and an increase in the capital outflow.”

As we noted in our very first report on all of this, sector specific sanctions would certainly hurt Russia, especially in the longer run which is looking increasingly worrisome from an economic perspective.

But while Russia is right to be concerned, as we noted in our Dove/Hawk scale, the EU is incredibly divided over deeper sanctions. While some countries have hardened their stance – notably Germany and the UK – others remain quite opposed, in particular Italy (which fears a restart of economic uncertainty) and France (which remains keen to conclude its military dealings with Russia before any further talk of sanctions). As such, it seems that any clear EU decision on this remains someway off.

On top of this, the standoff over gas supplies to Ukraine continues. Russia continues to insist that all gas from now on must be pre-paid and is demanding an immediate payment of $1.95bn out of a claimed $4.5bn in unpaid bills. Ukraine is refusing to give in, not least because its worsening economic situation means such upfront costs will be very difficult to stomach and may well have to be funded by European bailouts. So far this has avoided blowing up into a Europe-wide issue since transit of gas to Europe has continued but as Ukraine’s reserves dwindle and it seeks to import gas back from the rest of Europe (something Russia said it would prohibit) it could easily quickly spiral into a very serious continent wide problem.

In other areas there have also been renewed tensions. Ukraine finally signed the long awaited Association Agreement with the EU – the factor which essentially started all of this off. Russia remains concerned by such action and has already retaliated against Moldova, with bans on certain imports, which signed a similar deal. Meanwhile, new Ukrainian Defence Minister Valeriy Heletey stressed that the army would retake Crimea, promising, “There will be a victory parade... in Ukraine's Sevastopol.” Whether or not this has publicly manifested itself yet, you can be sure such comments and actions are antagonising Putin and Russia.

The situation in Ukraine remains very fragile but more worryingly little real progress seems to have been made. Russia, Ukraine and the EU remain at loggerheads over the association agreement and gas supply. Ukraine and Russia continue to disagree over the future for eastern Ukraine and Crimea. Despite these longstanding disputes which intermittently flare up and recede, Europe as a whole seems no closer to finding a clear stance or unified position on how to deal with what is happening. 

Russia suspends gas flow to Ukraine as talks fail to yield compromise

As has long been feared, negotiations between Russia, Ukraine and the EU over Russian gas supplies to Ukraine have ground to a halt.

Despite last ditch negotiations over the weekend a deal did not materialise and the two sides remain some way from reaching a deal. Ukraine is willing to pay a price of $326 per 1,000 cubic metres, however Russia continues to demand $385. Russia also insists that Ukraine owes debts of $4.5bn, of which it wants $1.95bn paid immediately. Reports over the weekend suggested Ukraine (pushed by the EU) was willing to offer a $1bn payment immediately – an offer which was swiftly rejected.

What does this mean for Ukraine?

• Reports suggest that Ukraine has sensibly built up sizeable gas reserves – around 14 billion cubic metres, enough to last the country until December. This reduces the immediate pressure on the negotiations.
• However, both sides are now playing hardball and have filed lawsuits at the Stockholm international commercial arbitration court. Russia is also refusing to countenance any further talks until a sizeable chunk of the outstanding debt is paid. The hope of a quick solution then seems to be fading

What does this mean for the EU?

• So far, the direct impact will be limited. Russia has said it will continue to transit gas through Ukraine to the rest of Europe and Ukraine is obliged to ensure all gas is delivered. This is vital given that Europe receives just over 30% of its gas from Russia, 16% of which comes through Ukraine (according to the EIA).

• That said, this assumes Ukraine will not siphon off any gas for itself (although as pointed out above it does have sufficient reserves), as it did back in 2009 when a similar situation arose. That time Ukraine's decision was driven by mostly by simple economic necessity. Even though it has sufficient reserves this time around it does not guarantee it will not adopt a similar approach. Any disruption in supply to Europe would force the EU to become more involved, possibly to the benefit of Ukraine – clearly, if the situation continues to worsen there may be an incentive for such action (although of course the political fallout in Europe would not be positive).
• In the longer term the indirect impact could be that this because another area of Ukraine where the EU has to become more involved. At the very least, future bailout funds could be primarily earmarked to prepay for Russian gas, something Russia seems intent on enforcing. This could either increase the cost or reduce the impact of the bailout.

In the end, despite the current intransigence of both sides, it remains in their interests to strike a deal. Russia seems to have the upper hand at the moment but equally Ukraine remains an important market for it and pushing the country further away may only exacerbate the original issue it took exception to – Ukraine moving closer to the EU.

However, this state of affairs only holds as long as the gas continues to flow through Ukraine. If this stops, then the volatility of the situation would increase significantly and the incentives would shift radically (as we have said before, neither side would want a breakdown in energy relations between the EU and Russia). This is the key point to watch in coming days and months.

Have Cypriot deposits finally hit bottom?

Last year, we covered the Cypriot crisis extensively, and the steep decline in Cypriot deposits in particular. As we reported back then, the problem was likely to continue for some time, and did.

But now, just over twelve months on (data from end of April), Cypriot deposits may have hit bottom after increasing by €266m in April - the first increase since December 2012.

• As the graphs above show (click to enlarge), the increase was driven by money flowing in from monetary financial institutions (MFIs) from the Rest of the World (i.e. outside the eurozone), but mostly in euro currency.
• Given the well-established links between Russia and Cyprus, it is possible that some Russians could have begun moving small amounts of money back into Cyprus amid the threat of economic and financial sanctions on Russia. Of course, this is speculative, since the data is not detailed enough to see conclusively, while the continuing existence of capital controls would make moving large amounts almost impossible.
• Domestic deposits continued their slow creep downwards. As the economy continues to struggle, this is likely to continue as wages fall and people eat into their deposits.
• The headline figures remain bad. Total deposits are 34% below the level in December 2012. Given that much of this has fled the country and/or been written off, it is unlikely to return anywhere close to that level anytime soon.

Does Russia’s gas deal with China change things for the EU?

News just out is that Russia and China have finally signed a gas deal, the negotiations of which have been going-on for a decade. (As the picture above, taken from a Gazprom investor presentation showed, this is something Gazprom has been targeting).

This is a pretty surprising turnaround given that every news outlet was reporting overnight that Russian President Vladimir Putin had failed in his attempts to finalise the deal in his current trip to China which ends tonight.

The key points of the deal are follows:

• The contract will be over 30 years and is unofficially estimated to be worth $400bn (19% of Russian GDP).

• It will see Gazprom supply up to 38 billion cubic meters (bcm) of gas to China per year from 2018. Once further pipelines are complete, this could be expanded to 61 bcm per year. As a comparison, over the past four years Gazprom has exported an average of 157 bcm per year to Europe (including Turkey).

• No official price has been revealed but the biggest sticking point has been that China believed Russia’s price demands were too high. It will be interesting to see if Russia gave in on this point.

• This deal has proved increasingly important for Russia as it looks to shift it’s away from relying on European demand for its energy exports.

What does this deal mean for the EU?

• In the short term, not too much. The economic links between Russia and Europe will continue to be significant and they will continue to be reliant on each other when it comes to energy (the former to sell the latter to buy).

• The deal will not be in place until 2018 and even then will only see Russia selling a fraction of its gas exports to China every year, exports to the EU could still well be two to four times the size.

• For these reasons, it is unlikely to change the potential impact which EU sanctions would have on Russia. Although of course Russia remains relatively unconcerned by such threats when it knows of the huge divides within the EU on the issue.

• All that said, it is symbolically important and could have longer term impacts. It highlights Russia’s desire to move away from links with Europe. Combine this with Europe’s desire to increase energy security and the relations between the two sides could become increasingly cold and distant. Although, some countries due to geographical proximity (Bulgaria/Hungary) or due to long standing economic links (Germany) will surely continue to have good relationships with Russia.

• It also raises questions over future tie ups between Russia and China. Areas such as payments systems, broader financial markets, transportation and machinery have all been touted as sectors for potential cooperation between the two countries. Again while a long term issue, such ties up may concern the West since Russia and China are currently reliant on their exports in many of these areas. Both the EU and US will need to figure a clearer policy for how to deal with such changes, with the EU in particular in need of updating its policy towards its eastern neighbourhood.

EU states struggle to find common ground for sanctions on Russia

As we laid out in our Divided We Stand briefing, agreement among the EU 28 on how to respond to Russia's role in the Ukraine crisis is not easy to come by. And if the doorstep remarks of EU Foreign Ministers arriving in Brussels this morning is anything to go by -- that trend won't be changing any time soon.

UK Foreign Secretary William Hague, urged the EU to begin preparation of broader ('Stage Three') economic sanctions saying:

"I hope...we will continue and intensify our preparations for a third tier of sanctions, and other additional sanctions if the circumstances require it."

He was echoed by Lithuania's Foreign Minister, Linas Antanas Linkevičius, who said that Stage Three sanctions were necessary to send a 'clear signal' to Moscow, adding that unrest in Eastern Ukraine was due to "Russian-sponsored insurgency."

Meanwhile, Austrian Foreign Minister, Sebastian Kurz, took completely the opposite line arguing that the red line for Stage Three of sanctions had not been reached.

"We should definitely not, at this point, move to Stage Three [of sanctions]...We are definitely not on Stage Three of economic sanctions, and in my opinion, this is good."

On where the red line would be to step up the EU's response, Kurz argued:

"[The EU agreed that] the third step of sanctions would be unleashed if Russian troops moved into Ukraine...economic sanctions would not just hurt Russia, but they would definitely hurt us too...If we went a stage further on sanctions with every provocation, then we would already be at war."

Luxembourg Foreign Minister Jean Asselborn found himself somewhere between the two, although he remained very cautious on sanctions:

"The referendum has no legal basis so we can’t burn too much energy on this… President Putin clearly spoke out last week that the referenda should be delayed…So we will see. I think Russia is starting to think about what the big problems will be… I think Russia will return from the brink. We will not have the sanctions as the main point today."

Once again then, as Russia essentially endorses the result in the self-rule referendum in Eastern Ukraine, the EU struggles to find a clear line on how, if at all, to respond to recent events.