The knock to confidence from harsher European sanctions on Russia could spoil the eurozone’s budding economic recovery even if it shrugs off the fallout on trade.
Following months of hesitation, the European Union will seek on Tuesday (29 July) to seal the first broad economic sanctions on Russia – its third-biggest trading partner – following the downing of a Malaysian airliner over territory controlled by pro-Moscow rebels in eastern Ukraine.
If endorsed by ambassadors from 28 European Union countries, Europe could limit access to capital markets by Russian state banks, impose an embargo on arms sales and restrict trade of high-tech energy technologies and “dual use” technology that has both civilian and defence applications.
Even if these measures are diluted, they will mark a fundamental change in how Europe deals with Russia, one which carries risks not just for Moscow but for Europe itself.
“The impact on trade is relatively small. The far bigger risk is a knock to overall economic confidence,” said Gregor Eder, an economist with Allianz, one of the world’s largest fund investors.
“A spiral of sanctions together with the loss of overall confidence could be enough to bring the already fragile economic recovery in Europe to a halt,” Eder said.
Previously, EU leaders were reluctant to impose sweeping sanctions on Russia, and with good economic reason. Not only does Moscow supply about a third of the EU’s gas needs, trade ties in other areas between Russia and Europe run deep.
German energy giant E.ON has invested €6 billion since 2007 in Russia while chemicals firm BASF has a joint venture with Gazprom.
In France, defence group Thales owns a stake in a company that sells warships to Moscow, while Franco-German aerospace group Airbus and its suppliers depend on Russia for titanium to make heavy-duty plane parts such as landing gears.
The trade ties help explain why German business confidence fell to its lowest level in nine months in July, with respondents blaming the Ukraine crisis.
The EU has already imposed narrow sanctions since Russia backed rebels fighting Kiev’s forces in east Ukraine. A list of people, including allies of Russian President Vladimir Putin, are subject to asset freezes and travel bans.
These limited measures have already discouraged business – eurozone exports to Russia were down 13% between January and April and foreign investment in Russia has dropped sharply.
Exports from the eurozone to Russia account for less than 5% of the bloc’s total and economists believe Europe could cope with lower Russian trade. But the blow to confidence and knock-on effect on investment could be more serious.
“The German and European economies are already experiencing negative effects from the conflict with Russia. The biggest risk to Europe, however, stems from the enormous uncertainty that the conflict has caused,” said Marcel Fratzscher, head of Berlin-based DIW economic research institute.
“Companies do not know if they can still sell their products to Russia in three months’ time or a year. Banks are uncertain whether loans will be paid back. It is unclear for energy users and consumers what will happen with oil and gas prices.”
The uncertainty comes at a bad time for the 18 countries in the eurozone, whose economy is already in the doldrums.
The currency area is expected to have eked out barely any economic growth in the second quarter of the year with the Bundesbank forecasting that even the mighty German economy flatlined.
Policymakers’ biggest hypothetical concern is about the potential for gas supplies to be interrupted, requiring countries to seek more expensive supplies from elsewhere – which could depress spending in other areas even further.
Given the financial cost to Russia of turning off the taps, industry experts say that may be unlikely. US and EU sanctions so far have avoided targeting Russian gas export monopoly Gazprom. But there are other ways Russia could fight back, short of switching off the gas.
“Russia will retaliate,” said David Gordon of Eurasia research group, predicting that Moscow could erect informal barriers such as stricter health and safety rules to make it harder for foreigners to do business in Russia.
Eder of Allianz fears worse. “How would Russia react if European banks were not allowed to grant credit to Russian companies?” he said.
“There could even be the threat of confiscation of productions sites in Russia from European companies.”
Any counterstrike from Moscow to sanctions would fall heaviest on European countries with the deepest trading ties.
The Netherlands, which bore roughly two thirds of the casualties when the Malaysia Airlines flight was downed over Ukraine, is among those that could lose most.
The Dutch economy, which shrank 1.4% in the first quarter of 2014, depends on its port of Rotterdam, the single largest destination for Russian exports last year, receiving shipments of oil that are then dispatched across the EU.
The Netherlands also needs to safeguard its own energy supply from countries including Russia after earthquakes forced it to cut output from one of its most important gas fields.
Other eurozone countries depend on Russia to buy certain goods and services, even if in most cases it is not a top overall export market. Italy exported €12.7 billion to Russia last year, while France, at more than €10 billion was not far behind. Austria, which has long had close energy and financial ties to Moscow, exported €4.6 billion.
The largest repercussions may be felt from potential restrictions on Russian banks’ freedom to refinance themselves in Europe. This would hit Russia’s two biggest banks, Sberbank and VTB Bank, whose Austrian arms were recently taken under the watch of the European Central Bank.
Any retaliation by Moscow could affect European banks active in Russia, such as Italy’s UniCredit, Austria’s Raiffeisen or France’s Societe Generale.
For some small European countries that offer off shore financial services, flows of funds from Russia have been disproportionately large. Russian individuals moved more than $33 billion into tiny Cyprus, Ireland and Luxembourg last year, according to data from the Bank of Russia.
European banks, meanwhile have lent tens of billions to Russian industry and would suffer if they were not repaid. Russian companies, individuals and banks have borrowed more than $650 billion, according to the Bank of Russia, much of which analysts believe is owed to European banks.
For now, however, it appears that European politicians believe that sending a political signal to the Kremlin is worth the economic cost.
“These sanctions are harder than anything we have ever had before,” said James Nixey of British think tank Chatham House. “It will hurt a little bit but it’s a down payment on the future security of Europe. It’s a question of Western credibility.”
The crisis in Ukraine erupted after its former President Viktor Yanukovich cancelled plans to sign trade and political pacts with the EU in November 2013 and instead sought closer ties with Russia, triggering protests that turned bloody and drove him from power.
Moscow annexed Crimea in March following a referendum staged after Russian forces established control over the Black Sea peninsula in the biggest East-West crisis since the Cold War.
Pro-Russian militants control buildings in more than ten towns in eastern Ukraine after launching their uprising on 6 April. On 11 May pro-Moscow rebels declared a resounding victory in a referendum in Donetsk and Luhansk, which the West called illegal and illegitimate.
The situation has worsened since then. In July, EU resolve to punish Russia strengthened after the downing in Ukraine earlier this month of a Malaysia Airlines passenger plane, killing all 298 people on board. 194 of the passengers were from the Netherlands.
Western leaders say pro-Russian rebels almost certainly shot the airliner down by mistake with a Russian-supplied surface-to-air missile. Moscow has blamed Kyiv for the tragedy.
Wednesday: Possible announcement of sanctions list