INVISIBLE HAND: The East-West trade war kicks off

By bne IntelliNews August 25, 2014

Liam Halligan in London -


After three rounds of US-inspired sanctions against Russia, Moscow has retaliated. We stand on the brink of a full-blown East-West trade war.
Since March, the West has imposed successive travel bans and asset freezes on various lawmakers and other prominent individuals - the most wide-ranging restrictions on Russian commerce since the Soviet era. In late July, the screw was turned even tighter, as the US and then the EU limited Russian state-owned banks' access to international capital markets.
President Vladimir Putin snapped. A 12-month ban on food imports from the US, EU, Australia, Canada and Norway was imposed in early August, and there's talk of stronger measures to come. Diplomacy having failed - having barely been attempted - the economic gloves are now off. Will tit-for-tat sanctions between Russia and the West escalate, worsening the commercial and political damage?
While Russia has so far avoided recession this year, recording a 1.1% GDP expansion during the first six months of 2014, growth over the second half will surely be lower - if not due to the direct impact of sanctions, then their effect on the broader business climate. A weaker ruble, though, is helping manufacturers, partly compensating for lower consumer spending. Russia's fiscal surplus remains strong at 1.5% of GDP, there's miniscule government debt and vast stashed sovereign wealth. The Kremlin, if need be, can turn the spigot on more infrastructure and budget spending should sanctions weigh too heavily on the domestic economy.
Inflation, though, is a problem. Already 7.8% in July, price pressures are likely to be aggravated by the agricultural import ban - not least because Russians spend around a third of household income on food. The Central Bank of Russia has hiked borrowing costs three times in the last five months, pushing the main refinance rate to 8%, in a bid to contain inflation; further rate rises threaten to curtail bank lending and growth.

Ironically, though, the West - in particular, Europe - may be suffering more. The Eurozone was always going to bear the brunt of the sanctions against Russia, given its $460bn annual cross-border commerce with its eastern neighbor, twelve-times more than the US. The sanctions have contributed to the stalling of the Eurozone economy's recovery, with region-wide growth flat between March and June.
Germany looks to have been hit hardest. In June, factory orders in the Eurozone's largest economy dropped the most in more than two and a half years, with the German government citing geopolitical tensions as a major reason. The following month, in the aftermath of the downing of MH-17 over territory held by anti-Kiev fighters in eastern Ukraine, the bellwether ZEW indicator of economic sentiment plunged to a two-year low, down for the third straight month.
Germany is by some margin Russia's biggest EU trading partner. The country's manufacturing thoroughbreds have sunk hundreds of billions of euros in Russian production facilities. VW, for instance, now has several full-cycle Russian plants and is the middle-class brand of choice in what will soon be Europe's largest car market. Siemens is central to the upgrade of Russia's vast rail network and Liebherr has a big presence too.
Beyond these household names, numerous firms from the "Mittelstand" - the medium-sized enterprises that account for over half the German economy - have built lucrative trading-links with Russian counterparts over the last 20 years. Many have set up shop across Russia's far-flung regions, making everything from machine tools to plasterboard. Such companies are now feeling the pinch, their Russian customers canceling orders as the geopolitical tensions rise and sanctions bite.
These trends help explain why, having grown 0.8% during the first three months of the year, German GDP contracted 0.2% in the second quarter. The implications for the broader Eurozone are obvious. Italy, another large West European economy with big trading ties to Russia, just tipped back into recession. There's now a very real danger that heightened geopolitical tensions, aggravated by sanctions, could mean the same fate befalls the entire Eurozone.
I'm hopeful, though, that East-West sanctions will remain relatively limited, at least from the Western side, given the existence of powerful business lobbies that will help keep gung-ho governments in check. While the Kremlin's choice of a targeted food import ban seems strange given the domestic inflationary pressures, it may be smarter than it looks. There are, after all, few interest groups European politicians fear more than the farm lobby.
With EU farmers complaining of $16bn of lost commerce and warning of domestic price falls given the resulting food glut, Brussels is now under intense pressure to negotiate a reversal of Russia's import ban or, at the very least, make sure it's limited to a single year. Russia's fast-growing food market is extremely attractive and, with foreign competitors looming and domestic producers finding their feet, Western Europe's food industry doesn't want to lose out.
A potential beneficiary of the Kremlin sanctions is Brazil - Russia's peer in the Brics group of leading emerging markets. Since the ban was imposed Brazil has moved quickly, authorizing the immediate export of chicken, beef and pork to Russia from almost 100 meat plants. This will seriously annoy European farmers, as will the fact that while Russia accounts for a chunky 10% of EU food exports, it takes just 1% of the food the US sells aborad. Few Russian sanctions will more effectively split the US and Europe.
The EU itself is also deeply split, of course, with Britain talking tough about further sanctions, while France and Germany, despite some occasionally fiery rhetoric, remain more cautious. French farmers and German manufacturers could now combine to push the debate their way - not least as the UK, petrified of jeopardizing the City's Russia-related business, is looking for an excuse to back down.
Even in the US, while Russia accounts for just 3% of total trade, there is now a considerable group of powerful corporations that have ploughed serious foreign direct investment into the country. The likes of Ford, GM, Boeing, Procter & Gamble, Pepsi and John Deere have between them built a myriad of Russia-based production facilities, keen to tap into what will soon be Europe's largest consumer market. As have several US oil majors, of course. 

Defense industry lobbyists will forever play up the "Russia threat". That will never stop. But any US President now has a growing corporate lobby in the other ear, stressing the "Russia opportunity" and the importance of protecting existing investments.
No halt to politics

Commercial imperatives won't, however, stop the political posturing and rhetorical finger-pointing on both sides. But they should help keep sanctions within reasonable limits. Another reason the West may avoid further turning the screw is that the event that provoked the latest crackdown - the downing of MH-17 - may start to lose political significance.
This disastrous crash, in which almost 300 civilians perished, was clearly a horrific tragedy. Of that, there can be no doubt. Yet while Western politicians were quick to blame Russia in the immediate aftermath the accusations have lately gone quiet - not least as US intelligence officials have quietly admitted they have no evidence of Russia's involvement.
It is entirely possible, of course, that anti-Kiev fighters used a Russian-supplied surface-to-air missile, either purposely or inadvertently, to shoot down MH-17. But in the absence of compelling proof, which America seems not to possess, that narrative will become harder to sustain. Mainstream media outlets, in continental Europe at least, are now voicing doubts, pointing out that the Ukrainian army also uses Russian-made missiles, while highlighting conflicting evidence suggesting MH-17 was shot down by a second plane, which the rebels don't have.
This plane crash, with its ghastly human impact, was a turning point. After MH-17, the EU toed the line, immediately agreeing to much tougher sanctions. That provoked Moscow's response, putting us in a tit-for-tat that could now escalate. But the longer question marks remain regarding Russia's involvement in the MH-17 incident, and the more food sanctions hit Europe but not the US, the more nuanced the EU's views could become.
If Ukraine's civil war spreads, or Russia becomes extremely belligerent, then obviously all bets are off. But the base case is that sanctions have reached their high point, even if the rhetoric continues to spiral.

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