Liam Halligan

Europe will reconcile with Russia, and soon. It can’t afford not to

Sanctions over Ukraine hurt Germany and France far more than anyone else – Moscow included

Europe will reconcile with Russia, and soon. It can’t afford not to
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After months of escalating tensions over Ukraine and talk of a new cold war, Russia and the West could soon reach a surprising rapprochement. The eurozone economy is suffering badly and sanctions against Russia are partly to blame. Winter is also upon us, and that reminds every-one Vladimir Putin still holds the cards when it comes to supplying gas.

The clincher, though, is that Ukraine is heading towards financial meltdown. Unless an extremely large bailout is delivered soon, there will be a default, sending shockwaves through the global economy. That’s a risk nobody wants to take — least of all Washington, London or Berlin.

Sanctions against Russia were always going to hit western Europe hard. The eurozone did 12 times as much trade with Russia as the United States did last year — that’s one reason Washington’s attitude towards corralling Russia’s economy has been somewhat more gung-ho.

Most big European economies, particularly Germany, only explicitly backed western sanctions after flight MH17 was shot down over Ukrainian airspace in July, killing 298. After that tragedy, which was instantly blamed on Moscow, it was politically impossible to suggest that sanctions might be counterproductive. The result was the biggest clampdown on Russian trade since the Soviet era — mainly targeting energy, defence and financial services companies — and the deterioration of East-West relations to their lowest ebb since the Cold War.

The western economy that’s suffered most, by far, is the largest one in the eurozone. Germany’s manufacturing thoroughbreds have sunk tens of billions of euros into Russian production facilities in recent years. Volkswagen 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 the specialised manufacturer Liebherr has a big presence too. Numerous ‘Mittelstand’ firms — those are the medium-sized enterprises that account for over half the German economy — have also built lucrative trading links since Russia opened up 20 years ago, selling everything from plaster-board to machine tools. Over 6,000 such of them operate across the country, with 350,000 German jobs directly dependent on Russian trade. And they’re feeling the pinch.

This helps explain why, having grown 0.8 per cent during the first three months of 2014, German GDP shrank 0.2 per cent in the second quarter. The eurozone’s powerhouse is now on the brink of recession. Industrial production dropped 4 per cent in August, the biggest monthly fall since early 2009. Exports were down 5.8 per cent — again, the steepest drop since the Lehman collapse in 2008.

If German industrialists are quietly angry about ‘America’s sanctions’, French farmers are noisily furious. Moscow’s reciprocal 12-month ban on imported western food, barely affecting US farmers, is causing howls of Gallic protest. A third of the EU’s fresh fruit and vegetable exports were sold in Russia last year, plus a quarter of exported beef. Moscow’s carefully targeted embargo has caused a food glut, driving down European wholesale prices. Mobilising in their usual manner, French farmers have been setting fire to regional tax offices. Combined with German manufacturers, they make a powerful anti-sanctions lobby.

The main reason, though, why East-West sanctions could be dismantled quite quickly is that Ukraine’s economy is imploding, raising the spectre of financial ‘contagion’. In June, the European Bank for Reconstruction and Development forecast Ukrainian GDP would shrink 7 per cent this year.

Last month that forecast was downgraded to a whopping 9 per cent drop, with the EBRD warning of ‘formidable difficulties’ if energy supplies from Russia weren’t fully restored before winter. Gazprom generally supplies over half of Ukraine’s still heavily subsidised gas. But with Moscow and Kiev yet to agree a new price, the tap was turned off in June.

The International Monetary Fund’s existing $17 billion Ukrainian support programme was based on a 5 per cent economic contraction this year and a bounce-back in 2015. Under that scenario, Ukraine’s debt, the IMF argues, remains just about manageable.

But these figures, dating from before the worst of the fighting in eastern Ukraine, don’t consider the destruction of factories and transport infrastructure in Donetsk and Lugansk, together accounting for a sixth of Ukraine’s output. Even if the current patchy ceasefire holds, the damage to roads, railways, utilities and airports will take years to repair.

Unrealistic IMF forecasts unravelled in Greece, resulting in a very disruptive €200 billion debt restructuring, made much worse by earlier delays and denial. That’s why IMF supremo Christine Lagarde has just admitted ‘additional funding’ is needed for Ukraine, while adding it would be ‘rather far-fetched’ to assume the IMF can stump up.

Which brings us to the heart of it. In America, and Europe in particular, there’s barely the money and certainly not the political will to help Ukraine. German voters won’t even stomach backing fellow eurozone members. Congress would pay to arm Kiev against Moscow, but the White House has refused. But that makes US politicians even less likely to pay for anything else — not least because Russia holds several huge Ukrainian bonds, and so non-military money would flow straight to Moscow.

The upcoming rescue package, then — an additional $20 billion or $25 billion — will need both Chinese and (whisper it) Russian money. That’s not going to happen until the West drops its sanctions or gives a very clear commitment to do so, allowing Moscow to do the same. For the reality is that the West — or at least Europe — wants sanctions to end much more badly than Moscow.

Russia has so far avoided recession. The ruble has fallen, but that helps manufacturers and boosts (dollar-denominated) oil revenues. Moscow has a fiscal surplus, minuscule government debt and vast stashed sovereign wealth. Oh, and President Putin’s approval ratings remain sky high.

All this explains why Angela Merkel welcomed the Chinese Premier Li Keqiang to Berlin last week — her third meeting with the Chinese government in six months — as she brokers a Ukrainian bailout and related end to sanctions. The US Secretary of State, John Kerry, has since held talks with his Russian counterpart Sergei Lavrov, prior to a meeting between Ukraine’s President Poroshenko and Vladimir Putin in Milan this week.

So we can expect less belligerence between Russia and the West, and a general calming of the diplomatic atmosphere (not least as US intelligence experts have found it impossible to pin the blame for MH17 on Moscow). The global economy is on a knife edge, and a wind-down of East-West animosity would provide some much-needed good news.

Liam Halligan writes the Economics Agenda column for the Sunday Telegraph.