Ukraine’s frozen war brings dramatic changes to world economy

Pro-Russian separatists from the Chechen “Death” battalion take part in a training exercise in the territory controlled by the self-proclaimed Donetsk People’s Republic, eastern Ukraine, Dec. 8, 2014. REUTERS/Maxim Shemetov

The “day of silence” observed this week by the Ukrainian army and its pro-Russian rebel opponents was an event of enormous economic importance for global economics as well as geopolitics.

The cease-fire’s success confirmed that the truce in Ukraine, agreed to on Sept. 5, is mostly holding, despite some local fighting and Western pundits’ virtually unanimous predictions that the war would quickly resume. The durability of September’s truce suggests that relations between Kiev and Moscow are gradually reverting toward an uneasy form of peaceful coexistence.

If so, then last summer’s civil war in Ukraine will probably evolve into a broadly stable “frozen conflict,” similar to the stalemates that have prevailed for years, even decades, in Georgia, Moldova, Armenia, Azerbaijan, Kosovo, Cyprus and Israel, to name just the frozen conflicts closest to Europe.

Though nobody can be fully satisfied with this outcome, Ukraine, Russia and Europe should all heave sighs of relief. So should anyone concerned about the outlook of the global economy.

Let us begin with Ukraine. The loss of Crimea is irrelevant because much of that peninsula was already leased to Russia and was not even part of Ukrainian territory until 1954. Losing Donbas is more serious because it is one of the country’s main industrial regions. But normal economic relationships could soon be reestablished because Russia needs to sell Donbas’ coal and steel as much as Ukraine needs to buy it.

Because the profits from these activities were largely misappropriated by corrupt officials and oligarchs, it will make no great difference to Ukraine if they are stolen by pro-Russian rebels instead.

Meanwhile, Ukrainian national identity has been strengthened by the conflict. Although Ukraine is unlikely ever to be admitted to either the European Union or the North Atlantic Treaty Organization — given the opposition in Germany and France, as well as in Russia — an EU association agreement, similar to Turkey’s, could help reduce corruption and encourage economic reform. A dual trading relationship with both Europe and Russia could ultimately offer Ukraine the only possible route to economic viability. This sort of relationship should become possible once this year’s conflict is definitively “frozen.”

Now consider Russia. Assuming that Kiev and the West reluctantly accept the status quo in Crimea and Donbas — and nobody seems to have any ideas about how to wrest this territory back from Moscow — President Vladimir Putin seems unlikely to attempt any further territorial expansion, at least without some new geopolitical pretext. In that case, the EU sanctions against Russia may well expire automatically in March and July. They have been set for a one-year term, and a consensus to extend them will be hard to muster if the fighting in Ukraine dies down.

Whether or not the sanctions are lifted, Russia is already undergoing an economic transformation.

With oil prices and the ruble collapsing, Russia’s political and business leaders are realizing that the post-Soviet economic model of full-scale financial liberalization and integration with the global economy has condemned them to overdependence on energy exports and industrial imports from Western Europe. Partly as a result, Russia has succumbed to the classic symptoms of the “natural resource curse”: an overvalued currency, deindustrialization, conspicuous consumption, excessive government spending, weak domestic tax collection and extreme vulnerability to international capital flows.

In response, Russia is starting to restructure its economy. It is moving away from the classical free-trade model that it adopted in the 1990s, which encouraged Moscow to export raw materials and import industrial goods because that was implied by the Ricardian law of comparative advantage. The alternative development model, which Russia will now favor, is the one followed by other big emerging economies, including China, India and Brazil, and before them, South Korea and Japan.

This Asian model will mean more protection for domestic industries, more control over international capital flows and less reliance on imports — even if that means lower quality and higher prices for Russian consumers.

To the extent that Russia remains a major resource exporter, its trading and financial strategies, as well as its geopolitical alliances, will be redirected toward China and Asia. This strategic realignment will, over time, increase China’s economic dominance in Asia. It may also strengthen the influence of China’s authoritarian Confucian politics as a counterweight to the liberal democratic model promoted by the United States and the European Union, a philosophical shift that Putin would welcome.

What about the implications of a “frozen conflict” for Europe and the world? The good news is that a definitive end to the fighting in Ukraine would remove the biggest single obstacle to economic recovery in Europe. The threat of all-out war in Central Europe was probably the most important cause of last summer’s sudden slump in the eurozone, especially in Germany. If war were to break out again, the shock to business confidence would certainly overwhelm any stimulus efforts by the European Central Bank.

The bad news is that a frozen conflict in Ukraine will weaken the postwar assumption that European borders cannot be changed by force, as German Chancellor Angela Merkel lamented again this week. The fact is, however, that European borders have been violently redrawn throughout the past 25 years, after the breakup of the Soviet Union and Yugoslavia.

The principle of national sovereignty has been breached repeatedly — not least by the United States, Britain and France in Afghanistan, Iraq, Libya and Syria, as well as in Israel and Cyprus. Such breaches will doubtless continue from time to time, whether or not the sanctions against Russia continue.

More worrying to the West than the diplomatic precedents set by a frozen conflict in Ukraine should be the global implications of Russia moving into the Chinese geopolitical and economic orbit. But given the intensity of Western interactions with China, peaceful coexistence and economic cooperation should also be possible with a Russia that decides to follow the Chinese models of economic management, business transparency and nondemocratic government.

Anatole Kaletsky is an award-winning journalist and financial economist who has written since 1976 for The Economist, the Financial Times and The Times of London before joining Reuters.

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