PRESSURING RUSSIA ECONOMICALLY: DIFFICULT CHOICES

C O N F I D E N T I A L MOSCOW 002602

SIPDIS

STATE FOR EUR/RUS, EEB/IFD
TREASURY FOR MEYER, TORGERSON
DOC FOR 4231/MAC/EUR/JBROUGHER
NSC FOR WARLICK

E.O. 12958: DECL: 08/25/2018
TAGS: ECON EFIN ETRD PREL RS
SUBJECT: PRESSURING RUSSIA ECONOMICALLY: DIFFICULT CHOICES

Classified By: Ambassador John Beyrle, Reasons 1.4 (b/d).

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Overview
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1. (C) As Washington contemplates next steps toward Russia
in the aftermath of the conflict with Georgia, including
possible economic punishment, the Mission would like to share
its perspective. First, the U.S.-Russia economic
relationship has been growing fast in recent years and was
showing great potential to continue that trend. However,
that relationship is more important symbolically than in
actual fact. The U.S. trades more with Mexico in a month
than with Russia in a year and bilateral direct investment --
perhaps $20 billion -- is very small relative to the size of
the economies.


2. (C) As a consequence, we have limited direct leverage
over Russia's economy. Europe, of course, has more but the
Russians clearly do not fear they will use it. We have more
leverage indirectly through our influence in the
international economic institutions, but the Russian
government has already written off WTO for the time being,
does not believe we will be able to make good on our threats
to kick them out of the G-8, and has no further need of the
IMF or World Bank.


3. (C) Where we do have real leverage is in the marketplace,
which is proving sensitive to the prospect of an extended
downturn in U.S.-Russia relations. And the markets are
pummeling the Russian economy. The Georgia conflict,
following several other incidents (TNK-BP, Mechel),appears
to be the final straw for many investors' confidence in the
GOR and in its economic policies. It has led to heavy
capital flight and rising risk premiums on Russian equities
and on Russian borrowing. The long-term consequence is
likely to be slower economic growth and lower living
standards.

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Russian Economic "Highlights"
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3. (C) Among the economic consequences of the conflict in
Georgia, we would highlight the following:

-- Russian stock markets fell more than 10 percent following
the invasion. After recovering slightly following the
announcement of the cease-fire, they fell again, on the news
of Russia's delayed withdrawal, and then again following the
decision to recognize Abkhazia and South Ossetia's
independence.

-- Approximately a fourth of the $600 billion loss in
shareholder value since May is directly attributable to the
Georgian conflict. The markets are now at levels not seen
since the fall of 2006 and further losses are likely to
follow absent a resolution to the conflict and an easing of
tensions with the West.


-- Finance Minister Kudrin admitted that $7 billion left
Russia on August 8 alone. One of our contacts estimated a
net capital outflow of $15 billion in the first week of the
conflict. Another said the outflow was closer to $20 billion.

-- We know from one source in the financial community here
that two major institutional U.S. investors decided last week
not to invest in Russia, citing the rising risks. The total
not invested was in the hundreds of millions of dollars.
There are doubtless other examples of opportunity costs to
the Russian economy caused by the conflict that we are
unaware of.

-- We have also been told that many investors in investment
funds active in Russia have given notice of their intention
to withdraw their money at the next available moment, the end
of the third quarter on October 1. We have been told that
the total is likely to be in the billions.

-- The ruble immediately fell 2.5 percent against the dollar
following the invasion, its first drop since 2003, and has
generally continued to drop since. The Russian Central Bank
has already spent $16.4 billion in reserves, that it
acknowledged, to prop up the ruble and provide liquidity to
the banking sector in an effort to avoid a crisis of
confidence.

-- Russia's reserves (which include the Reserve Fund and the
National Welfare Fund) fell from $597 billion to $581 billion
as a result of these interventions, the first drop in total
reserves since 2006, when Russia paid off the last of its IMF
debt. Although still large, the reserves must be balanced
against Russia's roughly $500 billion in foreign corporate
debt, much of it held by state corporations that hope to
avoid refinancing at higher rates by accessing the reserves.

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Sanctions: A Double-Edged Sword
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4. (C) Although the U.S. lacks direct leverage over the
Russian economy, Russia is much more globally integrated than
its government likes to admit. Global markets can punish the
GOR and they have reacted very negatively to the conflict.
We should draw attention to that reaction and what it may
mean for the future of the Russian economy. Moreover, more
general sanctions, such as we deploy for instance against
Iran, in and of themselves are not likely to affect Russia's
commodity exports, which are the foundation of the economy.
They will, however, signal continued U.S. disapproval and
could, therefore, have a further chilling effect on the
global markets' interaction with the Russian economy.


5. (C) In addition, sanctions could, no matter how targeted
on separatist leaders, put American business and commercial
interests at risk. Just one potential example is last year's
$3.5 billion deal for Aeroflot to buy 22 Dreamliners from
Boeing. The GOR could tear this deal up and purchase planes
from Airbus instead, hurting the U.S. and driving a wedge
between the U.S. and Europe. Sanctions could also undermine
our long-term goal of further global integration for a
modernized Russian economy. WTO membership, which would help
the pace of promised reforms, is far from a universal
aspiration here, and sanctions would remove our remaining
moral suasion to pursue accession.


6. (C) Russian officials have clearly signaled that U.S.
sanctions could provoke a counter-response. In an August 27
conversation with the Ambassador, Deputy Foreign Minister
Karasin alluded to "rumors" that Washington may be
considering economic sanctions as a policy response. Karasin
advised that any such approach should be "thought through
carefully" because "certain things will follow" from the
Russian side. He pointed specifically to services provided
by the Russian Volga-Dnepr company (which provides heavy
cargo lift into Afghanistan for the U.S. and other European
allies) in that regard.

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Comment
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7. (C) Our strategic goal should remain a more democratic
and rules-based Russia that is not isolated from, or hostile
to, the West. Further integrating Russia into the global
economy is a major component of that goal. U.S. trade and
investment and related activities (e.g., business exchanges)
have promoted that integration far beyond the modest trade
and investment figures mentioned above. While we should
support actions to target specific entities or individuals
with financial interests tied to Abkhazia and South Ossetia,
we must work to limit the fallout and to avoid broader
sanctions on economic activity that will have limited effect
and, as described above, risk damaging our own interests more
than Russia's. End Comment.
BEYRLE