IS PUTIN IN A FANTASY WORLD?

Russia risks a wave of capital flight and a shattering economic crisis as the West prepares a package of sanctions over the seizure of Crimea.

Chancellor Angela Merkel spelled out the danger for Russia in a speech to the German Parliament yesterday (3/13) that silenced pro-Kremlin voices in her own coalition and left no doubt that Europe is now fully behind the US on punitive measures.

"If Russia continues on its course of the past weeks, that will not only be a great catastrophe for Ukraine. It will cause massive damage to Russia, both economically and politically," she said. "None of us wants it to come to this, but we are determined to act. Let me be absolutely clear; the territorial integrity of Ukraine is not up for discussion."

The West has threatened visa bans and an asset freeze on individuals as early as next Monday (3/17) unless Russia steps back from the brink on the annexation of Crimea. This now looks certain since Russian troops are continuing to dig in across the peninsula before this Sunday’s vote on secession.

"It can get ugly fast if the wrong choices are made, and it can get ugly in multiple directions," said John Kerry, US Secretary of State.

The US and the EU will escalate to "additional and far-reaching" measures if the picture deteriorates, a likely outcome since Ukraine’s premier Arseniy Yatsenyuk has vowed to resist any loss of sovereign soil.

Russia has threatened to retaliate with "symmetrical sanctions" but Tim Ash, from Standard Bank, said it is a one-sided contest that Moscow cannot win. "Russia is facing the entire West. Its economy is already very weak and this could end up being as bad as 2008-2009, when GDP contracted by 9%," he said.

Russia cannot suspend oil and gas exports without cutting off its own source of foreign revenue. Any such move would destroy its credibility as a supplier of energy, accelerating Europe’s long-term switch to other sources.

Recall that Russia has only a $2 trillion GDP economy.  Russian companies have $653 billion of foreign dollar debt, and must roll over roughly $150 billion this year.

Yields on five-year bonds have already spiked 200 basis points, even for blue-chip firms. The ruble has fallen 11% this year after dropping 8% last year, making dollar debts harder to repay. "It is going to be very difficult to roll over these bonds, and it will be at much higher cost," said Mr. Ash.

Capital flight reached $63 billion last year. Former finance minister Alexei Kudrin said this could reach $50 billion per quarter as the crisis deepens. The central bank has already raised interest rates sharply to stem outflows, pushing the economy into recession.

Russia has $480 billion of foreign reserves but these cannot easily be used in a downturn since it entails monetary tightening. The Kremlin caused a drastic fall in the money supply and a banking crisis when it ran down reserves by $200 billion after the Lehman crisis.

Standard Bank said Washington is determined to make Russia pay for tearing up the post-Cold War settlement and undermining the architecture of nuclear non-proliferation. It is drawing up stealth sanctions to freeze Russia out of global finance.

These will be spearheaded by the US Securities and Exchange Commission, which will enforce compliance of the Foreign Corrupt Practices Act. The next step is to place Russia on the "grey list" for money laundering. "This would prevent global banks from dealing with Russian counterparts. Washington is tightening the noose. No bank is going to mess with the SEC," said Mr. Ash.

Chris Weafer, from the Moscow-based group Macro Advisory, said the Russian elites are becoming "extremely nervous" but it is a two-way risk. "There could be contagion back into the West. There are a lot of things Russia can do short of the nuclear option of cutting off gas. It could ban exports of titanium, inflicting severe disruption on Airbus and Boeing," he said. Both jet makers rely on titanium supplies from the Russia firm VSMPO-Avisma.

"Russia could cut off 2.5 million barrels a day of refined products such as diesel that are hard for Europe to replace since it has run down its refineries," he said.

Germany is in an awkward position since it exports $50 billion of cars, machinery and industrial goods to Russia each year. There are 6,200 German companies in the country with vast sunk costs. Last year alone they invested $105 billion.

However, Germany’s trade group BDA said a tit-for-tat sanctions war would be "painful" for Germany but "life-threatening" for Russia.

Igor Rudensky, head of the Duma’s Economics Committee, said sanctions will boomerang. "They are a double-edged sword, and Western states should be very careful," he said.  Brave talk.

With emotions running high, it is impossible to know whether Russia will act in its own economic self-interest or choose to bring the temple crashing down on everybody’s heads. Mrs. Merkel said Vladimir Putin was becoming hard to reason with after her latest telephone conversation with him. "He is in his own world," she said.

Perhaps he won’t be for much longer.

Ambrose Evans-Pritchard is the International Business Editor of the London Telegraph.

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