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reflections

Nov 10, 2015 | 01:40 GMT

6 mins read

Russia Faces a Difficult Choice in Ukraine

(Stratfor)
It can be difficult to separate the important from unimportant on any given day. Reflections mean to do exactly that — by thinking about what happened today, we can consider what might happen tomorrow.

On Monday, rumors swirled in European media that the European Union intends to extend its sanctions against Russia during its upcoming summit in December. If true, the six-month extension would come a month before the sanctions were set to expire. The cash-strapped Kremlin has pointed to the significant drop in cease-fire violations in Ukraine over the past two months to lobby certain European countries, including Germany, to lift the sanctions in January. However, German Chancellor Angela Merkel supposedly supports the extension in spite of the rifts that have formed within her government over the issue.

Kremlin spokesman Dmitry Peskov refused to comment on the story during his daily briefing on Monday, but Moscow indicated last Friday that it expected to see the decision after the foreign ministers of the Normandy Four met in Berlin. Following the meeting, Russian Foreign Minister Sergei Lavrov announced that the end-of-year deadline for implementing the Minsk agreement would be postponed until 2016

Naturally, Russia and Europe are looking at the situation in Ukraine through very different lenses. The Germans have noted that all sides are lagging behind in implementing the Minsk deal, while the Russians have instead pointed the finger at Ukraine's inability to develop laws on local elections in the separatist territories or pass other constitutional reforms required by the agreement.

And to be sure, Ukraine's Oct. 25 local elections proved that the Kiev government is too fragile, and the country too divided, for such reforms to be enacted right now. Some Ukrainian elements believe the Minsk agreement gives far too many concessions to Russia and the separatists it backs. Meanwhile, violence within the past week indicates that the withdrawal of forces on both sides of the conflict is no longer on track, and mortars remain on the demarcation line. Given the uptick in exchanges of fire, particularly in Donetsk, both Ukrainian and separatist forces are reluctant to move forward with plans to withdraw and have even suggested returning some artillery pieces to the front lines. Now, Kiev may hold off on making the political reforms needed to adhere to the demands of Russia and the separatists listed in the Minsk agreement.

And so the Normandy Group has pushed back the deal's implementation deadline to give Russia, Ukraine and their proxies time to fulfill the provisions of the agreement. For its part, Russia would rather endure a short extension of sanctions for a chance to make the Minsk deal work than see the talks collapse completely — an outcome that could set all sides back even further.

But even with the deadline now set for sometime next year, there is no indication that Kiev will be willing, or able, to make good on its concessions in the near future. Russia has not completely fulfilled its end of the bargain, and the Ukrainian government's hold on power is at risk with an imminent political reshuffle ahead and fringe nationalist groups allegedly trying to block the progress of peace. Given Ukraine's volatile internal situation, the Europeans can do little to pressure the Kiev government to move forward with its promised reforms.

The question then becomes: How will Moscow respond if Ukraine cannot adhere to the Minsk agreement by next year's deadline? Theoretically, Russia could ramp its military operations in Ukraine back up fairly quickly. However, doing so would likely guarantee not only that the European Union would extend its sanctions even further but also that the United States and Europe could apply additional sanctions that would cripple Russia's economy even more.

Russia could weather the current sanctions for another year if it needed to. The two most damaging measures in place prohibit the transfer of advanced energy technologies and limit the financing of many of Russia's top firms. While these measures have forced Moscow to postpone many of the energy projects affected by the sanctions, Russia can still maintain its current production levels for the next few years. That said, delays in any new projects now will probably start to hurt Russia's output after 2020.

But sanctions will impose an even bigger burden on Russia in the immediate term. The country's largest firms were able to repay their external debts totaling some $30 billion this year, thanks to the postponement of projects, downsizing, and a reliance on the Kremlin and its banks for funds and refinancing. On top of these expenses, the Kremlin also plans to drain nearly half of its rainy day fund, which holds about $70 billion, before the end of the year to continue helping many of those troubled firms. The Russian government has suggested that it will then use the remainder of the fund to prop up large firms and other struggling entities, including Russia's regional governments

So while Russia will likely make it through 2016 without experiencing a major financial collapse or default, it will not be easy, nor will the longer-term picture look any more promising for Moscow. Though Russian firms have a smaller debt repayment coming up next year (approximately $16 billion), some $72 billion in outstanding bills will be due in 2017 and 2018. By then, the Kremlin may have burned through its rainy day fund, although it would have the National Wealth Fund and currency reserves it could draw on. Still, those reserves are meant to spur economic activity and stabilize Russia's currency and markets — not to fund big businesses' debt. At the same time, Russian banks can do only so much to refinance large firms' debt.

The clock is ticking for Russia's economy. Unless the Kremlin is willing to let Russian companies default on their debts or make bigger cuts to their current operations or future investments in the coming years, Moscow will need to convince the Europeans to let at least the harshest sanctions expire. This will create a quandary for the Kremlin in the coming year. Russia needs the sanctions against it to be lifted by 2017, but that would require both Russia and Ukraine to implement the Minsk agreement. Ukraine is already hinting that it may not be able to meet the stipulations of the deal, leaving Moscow to either reduce its demands of Kiev or accept an even bleaker economic outlook in the next few years. In the past, Russia has shown its ability to withstand economic pain for the sake of maintaining its strategic position in the region, but it is unclear how much longer Moscow will be willing to make that trade for its interests in Ukraine.

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