Global Market Brief: An Escalating Russian Tiff's Economic Implications

11 MINS READMay 3, 2007 | 19:00 GMT
Estonia and Russia are locked in a diplomatic dispute that threatens to spiral out of control. It all began in the wee hours of April 27, when the Estonian government forcibly broke up a group of some 500 Russian protesters who had hoped to prevent the removal of a monument commemorating Soviet World War II dead. The Estonian police used tear gas; looting and one death resulted; and the statue was carted away. Condemnations out of Moscow have come fast and furious, with Duma representatives openly calling for the Estonian government to resign. Ongoing violence in Estonia has been reminiscent of the aftermath of World Cup games, while in Russia, Kremlin-organized youth groups have launched "unofficial" sieges of the Estonian Embassy, which resulted in the roughing up of Sweden's ambassador to Russia. In the most recent threat, those youth groups are calling on Russians to help them "dismantle" the Estonian Embassy on May 9, Russia's national celebration of victory over the Nazis.
The United States, NATO and the European Union already have put their diplomatic support behind their ally, Tallinn, and registered protests with the Russian Foreign Ministry about the problems the Estonian Embassy in Moscow has suffered. The canned Russian response is that Moscow cannot control the situation, a claim that rings hollow in the aftermath of the violent breakup of small protests against Russian President Vladimir Putin in April. Similarly ironic are Russian calls for investigations into human rights violations in Estonia. The dispute also has started to leak over into the economic sphere. The Russian state railway system has suspended all shipping to or from Estonia, ostensibly for repairs, and talk is rife about enacting a broad diplomatic and economic blockade of Russia's diminutive neighbor. The problem the Russians face, however, is that any substantial economic actions against Estonia would have far greater consequences for Moscow. Take, for example, the rail blockade. Estonia exports very little to Russia. But Soviet-era connections mean Russia depends on the Estonian ports of Tallinn and Muuga to transship roughly one-quarter of its refined energy product exports — mostly fuel oil, gas oil and gasoline — as well as a substantial amount of coal. The cutoff obviously will deny Estonian transport firms some transit fees, but reaching alternate export points is expected to cost the Russian firms about one-third more. At issue is that the Russians have used economic pressure against the three Baltic states — Estonia, Latvia and Lithuania — with regularity ever since the trio gained independence in 1991. Lithuania also is currently in a dispute with Russia over Moscow's "repairs" of an oil export line scheduled after a transport spat over rail connections to the Russia Baltic enclave of Kaliningrad. Such pressures have given the Baltic states the economic impetus to diversify their economies away from Russia — a process that has been moving lightning fast since all three gained EU membership in 2004. The net effect is that the Baltic states now have the most nimble and dynamic economies in the European Union with the possible exception of Ireland. In the case of Estonia, Russia now only ranks as its fourth-largest trading partner, accounting for a grand total of only 6.5 percent of total gross domestic product, with the bulk of that trade being energy imports. More important, and much to Russia's chagrin, is that Estonia is not a tiny, isolated state — it is a full member of the European Union. That means it enjoys full veto power over all EU foreign policy issues, so for the foreseeable future all EU-Russian relations will remain frozen at their current levels, and as deals currently in effect expire, they will be left to lie. For example, European-Russian relations currently are governed by a treaty called the Partnership and Cooperation Agreement first signed in 1997. Most of the agreement is fluff that encourages cooperation on issues such as energy, trade and investment with little, if any, practical application or legal weight. The real meat of the treaty lies in provisions wherein signatories grant each other most-favored nation trading status, free movement of capital and nondiscrimination against each other's workers and firms. The treaty expires in November 2007. Poland and Lithuania already are vetoing launching talks on a new treaty, and now Estonia is all but certain to toss its veto into the ring, too. If the treaty is allowed to lapse, any EU state can take any action it deems prudent against any Russian citizen or company without fear of legal retaliation. The Poles and the Balts undoubtedly would use such leverage against the Russians, but they would not be the only ones. Many other European states are a bit nervous about allowing Russian firms — particularly Russian energy firms — to buy up assets they think of as strategic. Now, they will be able to discriminate against Russian interests — legally. Estonia's EU membership also drastically reduces Russian room for maneuver in the economic field in which Russia holds real leverage: energy. Russia supplies Estonia with the bulk of the oil and natural gas Estonia consumes, and should Moscow choose to flip the appropriate switch, Tallinn would — at a minimum — face a massive headache. But though the energy hammer is an excellent tool, it is a very blunt one that would certainly rebound. Cutting off energy supplies to Estonia constitutes enacting sanctions against an EU member, the economic equivalent of invading a NATO state. This certainly would provoke the union to make its own economic response. The collected economic might of the European Union is more than 10 times that of Russia, so any economic conflict would be as brutal as it would be one-sided. If Russia is going to escalate this fight, it will not play on a field in which its weakness is so apparent; Russia is in fact playing on a wider stage. Across the (largely state-controlled) Russian media, the Estonian issue is being proclaimed as a test of Russia's national strength, a defense of Russian history, and a continuing fight against so-called fascism. Ever since the Orange Revolution in Ukraine, Russia has been adjusting its policies and raking back lost Soviet influence. Its outrage against Estonia — while genuine — also fits snugly into an evolving policy of a more internationally activist Kremlin. And those who remember the Cold War will be the first to tell you that they were never really scared of Moscow's economic might. But the Kremlin had — and has retained — other tools it can bring to bear. NORTH KOREA/SOUTH KOREA: North Korea and South Korea are preparing to hold military talks to finalize details for a planned May 17 test of the inter-Korean rail lines. The lines are a critical part of South Korea's long-term plans for Korean integration and building a unified Korea as an economic and trade hub in East Asia, and Seoul has stepped up efforts to test the lines since they were reconnected two years ago. In addition to working directly with North Korea, Seoul is coordinating with China and Russia. South Korean President Roh Moo Hyun recently requested a summit meeting with Russian President Vladimir Putin to discuss the Trans-Siberian Railroad and its link to the Koreas. Pyongyang, meanwhile, is less interested in the rail lines than changing the maritime border, and will use Seoul's interest in rail tests to press for easier access to North Korea's southwestern port of Haeju. CHINA: Foreign direct investment (FDI) flowing into Shanghai's property market decreased 42 percent from January to April, while FDI across all sectors grew 2 percent, the South China Morning Post reported May 2. This decline can be attributed to recently tightened restrictions on luxury residential developments and to the September 2006 central government crackdown on Shanghai's political elite. The Chinese government is trying to rein in ballooning property prices, especially in its largest cities. Beijing believes that both local and foreign speculators have been using the property market as a location in which to accumulate yuan-denominated assets to bet on further yuan appreciation. The real test for Shanghai now will be to see whether property asset prices fall in line with FDI-funded demand. If they do not, then Beijing will likely order Shanghai to impose additional administrative measures on domestic property investment. NIGERIA: The militant group Movement for the Emancipation of the Niger Delta (MEND) kidnapped six foreign workers May 1 from the Funiwa oil field off the Bayelsa state coast in the country's Niger Delta region. The group said it will hold the workers until May 30, a date that follows the inauguration of President-elect Umaru Yaradua and Vice President-elect Goodluck Jonathan. MEND also claimed responsibility for a May 3 kidnapping of six oil workers from the Okono/Okpono field, but released them the same day, saying it did not intend for the second kidnapping to happen. The MEND kidnappings are believed to be political in motivation to pressure the outgoing government of President Olusegun Obasanjo to ensure the handover of power takes place as scheduled May 29. The incoming administration is expected to prioritize addressing the political and socio-economic grievances in the Niger Delta region, relying on Jonathan in particular to lead this effort because of his Ijaw tribal and Bayelsa state governorship credentials. RUSSIA: Russian oil firm Rosneft acquired Tomskneft, Yukos' largest remaining production unit, for $6.8 billion at a Yukos bankruptcy auction May 3. Rosneft competed with only one other, relatively obscure company called Yuniteks, for the bid and won the asset for a mere $370 million above the initial $6.4 billion bidding price. The money will come from a more than $20 billion loan that Rosneft took out in January ahead of the Yukos auctions — of which Rosneft will receive around $11 billion in reimbursement from Yukos debt. The latest purchase makes Rosneft Russia's largest oil firm as its production rises 80.6 million barrels to 707.6 million barrels in 2007, just above LUKoil's forecast production of 700.3 million barrels. Rosneft also will triple its refining capacity to around 293 million barrels. Russian natural gas monopoly Gazprom had said that Tomskneft was the piece of Yukos in which it was most interested. However, its absence from the auction signals the Kremlin's continued political wrangling in maintaining a balance between its two state-controlled energy giants, Rosneft and Gazprom. EU: The European Commission approved the 2008 EU draft budget May 2, consenting to $77.58 billion (44.2 percent of the 2008 budget) for "sustainable development" and $76.35 billion (43.6 percent) for the Common Agricultural Policy (CAP). This is the first time in the history of the EU budget that more money will be spent on economic programs than on the CAP. Although the actual budgetary change is minimal, the fact that the percentage of the CAP in the budget changed is significant in itself. VENEZUELA: The Venezuelan government assumed control of oil operations in Orinoco on May 1. Officials from the United States' ExxonMobil and Chevron Corp., the United Kingdom's BP, France's Total and Norway's Statoil have all signed memorandums of understanding, agreeing to give state oil firm Petroleos de Venezuela a majority stake in each project. U.S. firm ConocoPhillips has not yet signed a deal with Venezuela, but did participate in the actual handover of operations. Venezuela has threatened to eject ConocoPhillips if it does not submit. Venezuelan President Hugo Chavez will not accept any deal with ConocoPhillips that does not meet his standards of full operational control, and the threat to eject the company will be fulfilled if ConocoPhillips does not comply. The firms have until June 26 to negotiate final terms of the takeover, including compensation, their new stakes and operational control for the projects. BOLIVIA: Bolivia began enforcing newly negotiated contracts May 2 with foreign oil and natural gas firms operating within the country. The new contracts award the government an average of 82 percent revenues for natural gas and oil operations in Bolivia over the next 20-30 years. The Bolivian government has classified these firms as "service providers" to the Bolivian state energy firm Yacimientos Petroliferos Fiscales Bolivianos (YPFB). Brazilian state-run energy company Petróleo Brasileiro (Petrobras) describes the contractual arrangements differently, saying it is a "production partner" with YPFB. This divergence in the way the contracts are publicly portrayed has not become an open argument between the two, but it suggests the possibility of conflicting interpretations in later disputes. On a separate but related note, there are ongoing negotiations between Bolivia and Brazil over the sale of two Petrobras refineries to Bolivia. Bolivia has threatened to expropriate the refineries if Petrobras does not accept a price it says is significantly below market value. Brazil in return has threatened to freeze investment in the country if such expropriation takes place, but the settling of the new overall contracts May 2 suggests this dispute will be resolved without escalating and Brazilian investment in Bolivia will continue.

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