Russian capital exits as stand-off with West intensifies

With the latest surge in bloodshed in Ukraine and tightening of western sanctions, the country's crisis seemed to lurch, not closer to a resolution but deeper into a cycle of escalation that could become impossible to reverse.

The West had hoped to inflict sufficient economic pain on Russia to make it back down, accept that its "gains" in Ukraine should be limited to the annexation of Crimea, and allow Kiev to retake control of Donbas, the country's eastern industrial heartland.

Once President Vladimir Putin had publicly committed himself to defending Russian-speakers in Ukraine, however, and stirred up intense nationalist sentiment in his country of 140 million, it would have been political suicide for him to bow to foreign pressure and accept any compromise deal offered by Ukraine and its allies.

Since the start of Ukraine’s revolution in November 2013, Putin told his countrymen that his neighbours were not actually revolting against corruption and Moscow’s influence, but were pawns in a geopolitical game orchestrated by Washington, whose intention was to weaken and isolate Russia.

The Kremlin portrays the war in Ukraine’s Donetsk and Luhansk regions as a continuation of that supposed bid to stop Russia regaining its Soviet- era influence, and economic sanctions as another western weapon deployed to the same end.

"When a Russian feels any foreign pressure, he will never give up his leader," Russian deputy prime minister Igor Shuvalov told the recent world economic forum in Davos. "Never. We will survive any hardship in the country – eat less food, use less electricity."

Russians’ resistance to foreign aggression and readiness to endure self-sacrifice are central pillars of the country’s self- image, and Putin is leaning heavily on them now as a decade of economic stability and growth comes to a crashing halt.

With no end in sight to a slump in oil prices that halved the rouble’s value against the dollar last year, Russia has urged its people to tighten their belts, with inflation at 12.5 per cent, state and private companies warning of likely job cuts and the economy predicted to shrink by up to 5 per cent in 2015.

The government has unveiled a crisis plan to cut state spending by 10 per cent this year and 5 per cent in 2016, while freezing most major state-funded construction projects.

"There won't be a fast recovery in oil prices like there was in 2008-2009 . . . this will be a long-term situation," finance minister Anton Siluanov said this week.

He said Russians and their economy “will have to adapt to new conditions” and accept that oil at $100 a barrel, upon which the national budget had been based for several years, was a thing of the past.

“We will carry out a reasonable budget policy and see our goal as reaching a no-deficit budget by 2017, with oil prices predicted at $70 a barrel,” Siluanov said.

Special funding

Putin and his allies are not expecting Russians to survive on patriotism alone, however, and the finance minister made clear that two areas of government spending would be exempt from cuts: social welfare and defence.

Pensions are actually going to be increased by 11.4 per cent this month and Russia’s huge arms industry will receive extra funding to offset western sanctions.

The government also includes provision for special funding of more than €600 million to support the farming sector and €3.26 billion for banks, on top of an €18-billion bailout package for banks that was announced in December.

One condition of that bailout for Russia’s top 27 banks is that they increase their provision of credit to the real economy by 1 per cent each month, in a move the government hopes will soften the slowdown and avert complete stagnation.

Siluanov estimated that the crash in the oil income and western sanctions had affected Russia’s balance of payments to the tune of some $200 billion (€176 billion), and he advised caution in the use of the country’s substantial cash pile to bolster government spending and prop up the rouble.

Russia’s foreign reserves fell from more than €450 billion at the start of last year to €334 billion in January, largely due to failed efforts to halt the rouble’s slide, which ended in it being allowed to float freely in November.

As the East-West standoff over Ukraine intensified last year, so did capital flight from Russia, a perennial problem that drains cash and potential investment funds from the country; the central bank in Moscow says net outflows reached $151.5 billion (€133.6 billion) in 2014, more than double the 2013 figure.

If capital flight continues at such a rate, analysts say Russia could impose capital controls, although officials insist they do not envisage this and expect the outflow of cash to slow this year.

The government may also be called upon to help companies and regions service debt, which is becoming harder to manage as sanctions restrict access to global markets and a cut in credit ratings increases the cost of borrowing.

Standard and Poor’s has downgraded Russian debt to junk status for the first time in more than a decade, a move which could be repeated by the other main ratings agencies and have a knock-on effect for major Russian companies; it could also prompt selling of Russian bonds and a ban on further purchases by funds that are mandated to only buy investment-grade debt.

Will any of this have the effect desired by the US and EU, and convince Putin to stop supplying Ukraine’s separatists with reinforcements and weapons, and allow the country a chance of becoming a stable, pro-western state? Probably not.

Putin insists Russia is being punished, not for annexing Crimea and fomenting war in Donbas, but for defending itself from the encroachment of hostile western powers – the US, Nato and some EU states – via Ukraine.

Having convinced Russians that the stakes are so high, he is unable to disengage from the growing chaos in Ukraine without securing a commensurately large prize.

Kiev has already offered a great degree of autonomy to eastern regions where war has now killed more than 5,000 people and displaced more than one million, but that is not enough for Moscow.

Ukraine’s leaders believe Putin is determined to destroy the country’s nascent post-revolutionary order, to show Russians and people in other former Soviet states that any pro-western uprising is doomed to end in bloody failure.

Millions of Ukrainians will not accept a return to any form of pro-Kremlin rule, however, and would also reject, perhaps violently, major concessions from Kiev that might pacify Moscow, such as a binding pledge not to join Nato.

The leaders of Russia and Ukraine cannot back down and so the Kremlin is focusing on eroding support for Kiev in the EU, where Syriza-led Greece is likely to be the most voluble of several states that want to soften the stance against Moscow.

In response to tighter sanctions, Russia could also use its own economic weapons, such as restricting gas and oil flows to the EU – although this would slash much-needed income; Kremlin advisers have also talked about dumping the country’s US-dollar debt and reserves to roil the US financial system.

When asked about possible exclusion from the Swift global payment system, Russian prime minister Dmitry Medvedev made clear Moscow's anger.

“If such decisions were taken,” he said, “I’d like to note that our economic reaction – and in general all other reactions – would be without limit.”