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BIG PICTURE TAKE OUTS
FROM RUSSIA'S WAR ON UKRAINE
Commentary & Analysis
Timothy Ash, Bluebay Asset Manager
London, UK, Wednesday, August 17, 2022
LONDON........More than six months into the all out war now being waged by Russia against Ukraine and while we might not be able to predict the endgame I think we can draw some broad conclusions into longer term consequences. Here is my go therein.
First, whereas on February 24, and the days immediately after, there was real doubt whether Ukraine would exist as a sovereign and independent state, I think it is clear now that Ukraine will exist and will likely prosper once the war ends.
The concern back on February 24 was that either Russia would take Kyiv and the bulk of the country and run it as a proxy state, even incorporate it or annex it to Russia. But what we now know is that the Russian greater ambition failed with its devastating defeat in the battle for Kyiv. Russia tried and failed to take the whole of the country and the Kremlin has now had to fall back on the lesser ambitions to take the whole of Donbas, the land corridor to Crimea, and to force Ukraine and the world to accept the annexation of Crimea.
But even these latter ambitions now appear overly ambitious, as Ukraine fights on, and even takes the war to Russia, with fresh offensives planned in Kherson, and attacks on Russian occupied Crimea. The question is can Russia even hang on to what it has got?
Indeed, Russia looks to be at its maximum reach in Ukraine, holding just less than 20% of Ukrainian territory, but that means Ukraine holds sway over the vast majority of the country and its peoples. All the main population centres, side from Kherson, remain in Ukrainian hands, and Ukraine still has access to the sea through Odesa, which will be critical for the recovery and development of the Ukrainian economy.
Now in terms of the outlook for Ukraine, once peace comes, I see new positives.
a) The country is united now more than ever before - opinion polls shows more than 90% of the population are against making territorial concessions to Moscow. And by Putin’s shear brutality, bombing civilian targets indiscriminately even in the East, regions historically more favourably inclined towards Russia, he has destroyed any remaining pro Russian sentiment in Ukraine. The country is now united as I have never seen it, in my 30-odd years covering the country, in its determination to move West, and push out of Russia’s grasp, permanently.
b) The incredible innovation and motivation used by Ukrainians in this war in a truly David versus Goliath battle suggests that the outlook is positive if this same energy can be diverted to reconstruction and development once peace comes. This bravery and resolve has been a hugely positive advert for Ukraine and one hopes that international business will reward Ukraine with huge investment flows once peace is secured.
I would describe points a) and b) above as Ukraine’s “State of Israel” moment, the point at which the country faced annihilation, with backs to the wall but had no choice but to fight. The country came together and pushed back Russia, against overwhelming odds, and I think we will see the same unity and resolve in the reconstruction. I think this will prove to be a real turning point for the country in its post indepdence journey.
Imagine, facing overwhelming military assault, but Ukraine has kept the utilities working, railways, roads, the banks functioning, the economy ticking over. In any other country one would have expected everything to stop working and institutional collapse. This has not happened, and this bodes well for peace.
c) Ukrainians’ bravery has embarrassed the West and forced it to provide financing and military support, at levels unimaginable before the conflict. Better late but never. But given the realisation that Russia and Putin are a clear and present danger to the West there is an understanding now in the West that we must help Ukraine win this war but also win the peace. An economically strong Ukraine is central to it being able to defend itself in the future, and in so doing acting as a key defensive bulwark for the West against future and inevitable aggression by Putin.
Ukraine has, meanwhile, succeeded in winning EU candidate member status, something that proved elusive for the past thirty years. But if we look at the experience across the rest of Emerging Europe, what is clear is that the anchor of EU accession provided a critical blueprint and anchor for reform. Ukraine never had that over the past thirty years which explains in my mind why it’s development was stunted.
The EU accession anchor, a wall of Western financing, the low base, the State of Israel moment, and Ukrainian innovation and the desire now to beat Russia by making Ukraine economically successful gives the dountry real hope now once peace ensues.
Second, and as noted above, Russia, and Putin has reached its limit in Ukraine. It tried it best to take Ukraine and subdue the Ukrainian people, but has failed. There is no way back now for Russia in Ukraine. The Ukrainian people have seen what Russia has to offer - brutality - and want something different, they want to live in a Western style, liberal market democracy with the rule of law, and basic human rights, not in a police state and fascist dictatorship which is what Russia now is.
It’s ironic that Putin set this war as a historical war to bring Ukraine back into the Russian family, but actually through his actions he has likely lost Ukraine for ever.
There is no scenario where Russia has some say in/over Ukraine and the de-Russification process in Ukraine rather than being halted will now accelerate. Ukrainians will not want to identify with Russia or anything Russian, but they will now look to their own separate Ukrainian and European identify.
How could Russia expect anything different after being responsible now for hundreds of thousands of Ukrainian deaths? What possible way back is there for Russia? None.
Third, and for Russia it is hard to see a scenario where it is not made to pay a high price for a very long time for its war on Ukraine.
Unless there is a total climb down by Russia on Ukraine, in peace talks, and also likely there is regime change in Russia, it is hard to see a significant moderation in Western sanctions on Russia.
Herein what is important is that the war in Ukraine has crystalised opinion in the West that Putin is a threat to our very system of Western liberal market democracy. Putin is out for us, to destroy our system, and I think that is now evident from the war in Ukraine but the array of malign Russian actions against the West over the past decade and half, from the war in Georgia, to Litvinenko, Skyrpal, election interference, cyberattacks and now the energy war being waged by Putin against Europe.
This is a battle of systems, of Western liberal market democracy against Putin’s kleptocractic, power vertical/sovereign democratic model. Simply put we are in a new Cold War with Russia, so why on earth would the West lighten up sanctions to strengthen Russia economy to the point that it can fight us better in the future? The West’s agenda now should surely be to weaken Russia economically, hence maintaining the sanctions grip on Russia.
Fourth, and on a similar vein, we must reduce our own vulnerabilities and dependencies on Russia which again means that irrespective of the outcome of the war on Ukraine, the West must cut Russia, as far as we can, out of our supply chains. Surely this is now obvious with the energy war being waged by Putin against Europe this year.
So while the focus this winter is ensuring Europe has enough energy to survive, and that might mean in the short term still buying Russian energy, surely we cannot now give Putin the weapon to continue to wage war with us thru the energy channel in the future. Russia has proven an unreliable energy and economic partner, and we have to accelerate the diversification away from Russia in our supply chains as a result. This is happening and it will only accelerate, again unless there is regime change in Russia.
Fifth, the outlook for the Russian economy is dire over the longer term.
There is obviously lots of debate about the short term impact of sanctions, and the fact that the supply chain disruptions they have caused have elevated commodity prices to the advantage of Russia. That may well be the case, but over the long term as the West cuts Russia out of its supply chains, in energy by focusing on energy efficiencies and renewables plus LNG imports, Russia will suffer from both the fall in the volume and price of commodity exports.
Energy prices will fall once the war ends as the war risk premium is priced out - and actually the global recession that Putin’s use of the energy card will ensure in Europe at least will also curb energy prices ultimately. Meanwhile, sanctions will limit its ability to import technology and critical imports to sustain production.
Financing any such imports will be constrained by financial sanctions, and if it can still buy these imports on international markets it will have to pay top dollar, depleting its FX reserves in the process. And again, whatever happens in the sanctions front, because of its conduct of this war - genocide and war crimes against Ukraine - international business will limit its interactions with Russia, for fear of reputational damage. Again that means a dearth of finance and technology for Russia to rebuild. The outlook for Russia will be one of stagnation, likely accentuated by the brain drain that will result as the young and liberal see better opportunities and freedoms outside the country.
Sixth, Russia’s military capability is years behind the West
The war in Ukraine has revealed that the Russian military is a version of the Potemkin village. In recent years Russia has celebrated its military prowess in small scale, low tech conflicts, like in Syria or Libya, and Donbas, and used this as a marketing ploy to sell arms the world. The message has been that Russian military kit is capable, cheap and huge value for money. But the war in Ukraine, and earlier the war in Nagorny Karabakh, has laid bare that Russia’s conventional military technology is still years behind the West and often obsolete in the modern battlefield.
Despite selling sophisticated air defence systems to Turkey, Egypt and India, the S400, Russia proved incapable of defending the flagship of its own Black Sea Fleet, the Moskva, because of inadequacies in its air defences. We are seeing this again pan out after recent likely missile strikes against Russian bases in Crimea. Meanwhile, Russia’s tanks have been destroyed en-masse by relatively cheap hand held Western anti tank weapons. And now Russia’s superiority in Ukraine in artillery is being devasted by the use of HIMARS in limited numbers by Ukraine.
Russian military performance in Ukraine has been nothing but an utter embarrassment. Russia sold itself as a peer power with the US but has struggled to win against a country that is a David to its Goliath. In technology, tactics, planning, logistics and motivation Russia has been humiliated. Surely as a result Russian military sales will now lag, and will no longer be such a boon to its economy.
Meanwgile, the huge losses now suffered by the Russian military in Ukraine, the rebuild needs will be huge, which will be a chain around the economy’s neck. This comes as Putin, through his invasion of Ukraine, has fired the starting gun in an arms race with the West which he surely cannot win. The West will now boost defence spending to at least 2% of GDP, on a $40 trillion plus Western economy - that’s at least $800 trillion, likely more like $1.5-2 trillion in annual defence spending, which is on par with Russia’s entire GDP. Russia simply cannot compete, which means it will fall further behind in terms of defence capability relative to the West.
And it also likely means that the strain on the Russian economy will be even greater, as it is forced into guns versus butter choices. The population will get poorer because of the choices being made by Putin, as defence spending is prioritised over consumption. Likely social and political pressures will build. We have though seen this movie before in the late 70s/early 80s after the Soviet Union’s invasion of Afghanistan and then the arms race with the West which eventually wore the USSR out, and it ended in perestroika and the collapse of the Warsaw Pact and then the USSR in 1989-1991. Surely the end game is the same for the Putin regime, and all because of Putin’s disastrous decision to wage all out war with Ukraine.
Seventh, China will be slow to bail Putin out
I think Russia assumed that Chinese support for his war in Ukraine could be taken for granted, given China’s simmilar ambitions with respect to Taiwan. But in the end I think Putin miscalculated on this as on so May things over Ukraine. I think Beijing views it’s relations with Putin through the primary prism of its relations with the West. They now see Putin as a disruptor of the status quo, a loose canon, whereas the Chinese likes the status quo, where over time, if they can avoid getting dragged into a military conflict with the West, eventually they get economic and then military hegemony and superiority.
But by attacking Ukraine, Putin complicated things for Xi. And Xi does not want to worsen relations with the West, but wants to get back to the pre Trump status quo. Putin threatens that. So I think Beijing is handling Putin with extreme care, and not doing anything to worsen relations with the US. So no significant munitions supplies to Moscow, and Chinese banks and companies are not going out of their way to break Western sanctions.
Perhaps worrying for China here is just how poorly Russian military kit has performed, and it is still Russian kit that is the mainstay of the Chinese military. It must now be nervous whether it could actually win a war over Taiwan quickly, as if the war in Ukraine is anything to go by, then Russian military kit is not what is written on the packet. So China I think will be now questioning the value of Russia as a military ally. For Xi personally he must also be annoyed with Putin as just coming out of the Covid crisis, from which he has failed to cover himself in glory, and facing a leadership congress at year end, he now faces a cost of living crisis at home because of Putin’s actions in Ukraine.
All told for China, Putin now appears as a rash, unpredictable and untrustworthy partner. Surely the Chinese should have expected some kind of heads up over Russia’s looming actions in Ukraine, whereas they appear to have been kept in the dark.
So I see Sino - Russian relations damaged because of this war, and I think the Chinese actually see the war as an opportunity to build back bridges with the US, by holding back from providing significant military support to Russia, or helping Russia significantly bust sanctions.
Eighth - Western liberal market democracy is not dead, yet.
The war in Ukraine appears to have breathed new life and purpose into Western structures, such as NATO, if not necessarily the EU. But on NATO, whereas Macron famously called it brain dead, I think Putin’s attack on Ukraine has amply revealed a common enemy for NATO to rally its efforts around, Putin’s Russia. Few nations in NATO are now questioning the commitment to spend 2% of GDP on defence, and I think there is now clear understanding that Russia poses a clear and present danger to our very system of government, and is an existential threat therein. Indeed, it is encouraging that unity on sanctions in the West is pretty solid/strong - and even the likes of Orban in Hungary has been forced to sign off on the various EU sanctions packages in response.
Arguably Putin is making it easier to rally the West to the cause by the extremity of his actions in Ukraine, but also by attacking the West in plain view through the European energy channel. All those who sought to appease Putin in the prior two decades have now been revealed as totally and utterly misguided. This is not about NATO enlargement, this is about Ukraine, and Putin’s problem with us, and our very system of governance, Western Liberal Market Democracy, which he has been attacking for at least the past decade and a half.
Notable though the unity in purpose, and the ability of NATO and its allies to put such shear amounts of equipment and financing in the field in Ukraine, shows its strength, and the vast economic resources of the West. Western technology is proving light years again of that of Russia. And it is successful because our system of government works better - checks and balances, rule of law, effective governance. There is a reason why Russian kit and equipment has failed - corruption is engrained in the Russian system, and we have seen that with worn tyres and money wasted on corrupted Intel by the FSB.
But those failings are because Russian kleptocracy works only for a small elite, but it fails the wider economy, the military and the population at large. What has been eye opening in this conflict, and the dismal performance of the Russian military, is that actually very little has changed from the period of central planning under Communism, this is a top down, command, power vertical. Ukraine is winning as it has a flat command structure and decentralised decision making to commanders in the field. It result in a dynamic, innovative, flexible military machines as opposed to her flat footed, mind dead Russian military.
But let’s hope the system of Western Liberal Market Democracy survives the next US election, and let’s see if Putin gets involved therein again.
Ninth, the power of ESG is one other big take out from this crisis for me, in terms of something new and significant with wider implications for other countries/credits. There has been lots of focus on the impact of formal sanctions, but actually the big new thing which has been mega impactful has been self sanctioning against Russia by Western business because of fears of reputational damage if they continue to do business with a thug like Putin. Many of the businesses fleeing Moscow formally do not have to as their activities are mostly not sanctioned.
But companies like Macdonalds have decided that it is not worth the reputational damage by staying. They don’t want to be named and shamed by campaigners for remaining in Russia, while Putin is inflicting war crimes on Ukraine. But actually this self sanctioning has perhaps been more impactful on Russia than formal sanctions. And I think many of these companies, having suffered losses in extracting themselves from Russia, will be very slow to return. Their message will be “been there, done that, suffered the losses, and not going back”. And this will continue to have a huge long term drag on the Russian economy, irrespective again of what happens to formal sanctions.
In summary, Ukraine looks like ultimately emerging victorious from this conflict, and strong and better able to defend itself as a result. NATO and Western Liberal Market Democracy likely will be energised, with new focus. But the outlook for Russia is nothing but grim. It will remain an international pariah, subject to sanctions and with its economy in decline, and on the losing end of an arms face with the West, which will diminish its military and international prowess. Putin has accelerated Russia’s decline as a result of this war. Let’s see how long Russians come to this realisation and opt for regime change at home.
Commentary and Analysis distributed for information purposes only.