Conflicts Forum’s Weekly Comment 9 – 16 May 2014

Conflicts Forum

It seems set for escalation towards another round of sanctions on Russia:  The ‘round table’ talks in Kiev bore no fruit.  But rather, as we see happening now quite regularly, badly-formulated mediation efforts (albeit sometimes well-intentioned), often make matters worse, rather than better. Moscow had endorsed the OSCE roadmap as presented – a gesture welcomed warmly in parts of Europe (but received grudgingly and suspiciously in Washington).  However the talks – the round-table chaired by the German Foreign Minister in Kiev - were not the roadmap.  The representatives from the regions were not invited, as per the roadmap, and instead ‘representatives’ chosen by Kiev alone, sat in their stead).

Kiev may claim that it had held the talks according to the OSCE’s round-table format, but Lavrov has been plainthat the US and Kiev had blocked the use of the originally agreed text – and Russia, in its turn, was refusing to have the text subsequently meddled with  as the US and Kiev were demanding. So the round-table mediation ended by worsening the already ‘bad blood’ and mutual suspicion existing between Washington and Moscow.

Evidently, the OSCE’s actual proposals would have admitted duly elected representatives from the dissident regions to the negotiations, but Yatsenyuk rejected sitting with those he termed ‘terrorists’. After meeting with European Union officials in Brussels, Yatsenyuk and Turchynov in a joint statement, simply said they refused to talk with those “who have blood on their hands.”  And Turchynov promised that the ‘anti-terrorist’ drive would continue.

So the Putin ‘gambit’ to de-escalate tensions has effectively been declined by Washington (State Department spokesman Carney made this clear when he said “we understand certainly the unwillingness of the Ukrainian government to have participants in these round-tables who literally have blood on their hands”).  This unqualified endorsement of the Kiev ‘line’ will have signalled plainly enough to Moscow that official Washington is not ready to de-escalate. For now, the US remains fixed on pursuing elections that they expect will give legitimacy to a pro-western regime in Kiev. So, where to now?

A US official said recently: “over the past days, Putin’s acceptance or otherwise of the election (and by implication the end of Ukraine’s traditional buffer role) has become the touchstone of our attitude to him.”  The mood at State Department remains one of intense suspicion. In the White House view, the hard test of Putin’s intentions is the elections. “If this takes place successfully without disruption or manipulation from the Russian side, US officials will regard this as evidence that Putin is looking for a way out. Otherwise, a new round of sanctions will be enacted”, a well-placed commentator has noted.

In short, Putin’s OSCE gambit got in the way (and distracted) from what Washington saw as the true ‘litmus’ for dealing with President Putin. And now that Lavrov has publicly questioned the feasibility of holding the May 25 elections in a near-civil war situation (plus warning too of Russian retaliation against any imposition of sanctions), the ground seems set for new type of war: the next shots in this ‘new generation war’, Treasury officials are privately telling US investors, will cause ‘real pain’ to Russia’s financial sector.

It is unlikely that what US Treasury officials have in mind is an old-style trade war. Europe with its extensive commercial investments in Russia would likely suffer more pain than Russia by such a counter-productive campaign; nor are the US Treasury men and women likely to be talking about boycotting Russian gas: such rhetoric is hot air — there are no short term alternatives for Europe to Russian energy supplies. What Treasury officials are talking about is their financial ‘neutron’ bomb.

As a leading British economics commentator, Ambrose Evans-Pritchard, notes: “for the past 12 years an elite cell at the US Treasury has been sharpening the tools of economic warfare, designing ways to bring almost any country to its knees without firing a shot. The strategy relies on hegemonic control over the global banking system, buttressed by a network of allies and the reluctant acquiescence of neutral states. Let us call this the Manhattan Project of the early 21st century”.

“It is a new kind of war, like a creeping financial insurgency, intended to constrict our enemies’ financial lifeblood, unprecedented in its reach and effectiveness,” says Juan Zarate, the Treasury and White House official who helped spearhead policy after 9/11.

“The new geo-economic game may be more efficient and subtle than past geopolitical competitions, but it is no less ruthless and destructive,” he writes in his book Treasury’s War: the Unleashing of a New Era of Financial Warfare. 

The stealth weapon is a ‘scarlet letter’, devised under Section 311 of the US Patriot Act.  Once a bank is tainted in this way – accused of money-laundering or underwriting terrorist activities, a suitably loose offence – it becomes radioactive, caught in the “boa constrictor’s lethal embrace”, as Mr Zarate puts it.

“This can be a death sentence even if the lender has no operations in the US.  European banks do not dare [to] defy US regulators — they sever all dealings with the victim.  Mr Zarate [said] that the US can “go it alone” with sanctions if necessary. It therefore hardly matters whether or not the EU drags its feet over Ukraine … Washington has the power to dictate the pace for them”, notes Evans-Pritchard.

“Mr Zarate said the Obama White House had [already] waited too long to strike in earnest: “They should take the gloves off. The longer the wait, the more maximalist they may have to be,” he said.  This would be a calibrated escalation, issuing the scarlet letter to Russian banks …”If the US Treasury says three Russian banks are ‘primary money-laundering concerns’, do you think that UBS, or Standard Chartered will have anything to do with them?””.

“The new arsenal was first deployed against Ukraine – of all places – in December 2002. Its banks were accused of laundering funds from Russia’s organised crime rings. Kiev capitulated in short order.  Nairu, Burma, North Cyprus, Belarus and Latvia were felled one by one, all forced to comply with US demands. North Korea was then paralysed”, continues Evans-Pritchard. “The biggest prize yet has been Iran,  finally brought to the table: A hidden war is under way, on a very far-reaching global scale”.  (Evans-Pritchard is too polite to add that this toolbox has also been deployed against Europeans too, to no mean effect, viz to punish France for opposing the Iraq war, and to remove Berlusconi from office).

So far, this ‘hidden war’ has been both effective and costless (to US financial interests).  President Putin will be aware of this and must be making his own assessments of its possible implications for Russia.

What is striking however is the sanguinity reigning in Europe towards the risks inherent in the US even thinkingof initiating any such ‘hidden warfare’ against a major power and trading partner, Russia, with its $2 trillion economy.  It constitutes an entirely new type of ‘war’, intended to overturn President Putin, by use of the ‘Scarlet Letter’. There seems to be a relaxed presumption in parts of Europe that the financial neutron bomb will indeed succeed in exploding President Putin – with little collateral damage to America or Europe – and there seems to be little, if any, serious questioning of the possibility of unforeseen consequences arising from this type of warfare.

What is clear, however, is an appetite for taking revenge on President Putin in certain quarters of the US Administration – as there is too, amongst certain of the newer EU member states.  There are other heavy pressures on the US President too that mitigate against his splitting the differences over Ukraine with President Putin: Mid-Term elections loom, the Democrats are vulnerable to a drubbing in the Senate, the President’s foreign policy is counted as a weakness for him, America’s leadership is deemed to be waning, and – more than all these factors (and unmentioned ‘interests’), the struggle with a resurgent Russia is coming to be perceived as the point of inflection which will determine whether America is trending upwards – or alternatively downwards – in terms of its power and standing in the world.  There is a strong sense that the West mustprevail.

It appears that Obama is trying to float above these pressures, uncommitted to any line of action, and is hoping that a serious confrontation with Russia can be avoided (i.e. that the threat of sanctions somehow, in itself, will cause Putin to back off) if, and only if, he, Obama, can emerge electorally strengthened from the tussle. In practice, his options are limited by the domestic considerations mentioned above (that is to say, they prevent him from running with Putin’s OSCE gambit, for example). While publicly adopting harsh language, the US President probably is trying to slow down the runaway crisis, but in a real sense, US foreign policy is being jostled this way and that by interests too powerful for the President, willy-nilly, to override or counter.

It is of course entirely true that defending itself from the attacks of the Scarlet Letter will not be easy for Russia: For all the talk of building an alternative financial system coming from the BRICS, China, Iran and others, little has emerged in real terms.  New financial payments systems and banking networks do not emerge overnight; the technologies are not in place, and it is not certain how many other states might take the risk of joining the new system – if the cost is almost certain exclusion from the US-controlled Bretton Woods global dispensation. But this does not mean that Russia lies impotent and wide open to America’s financial ‘neutron bomb’.

On May 20th President Putin visits China. The speculation is that that major oil and gas contracts will be signed, and that these mega contracts will be denominated in roubles and yuan – and not in dollars. In a recent interview, the Russian deputy Finance Minister, Alexey Moiseev, mentioned a legal mechanism that can be described as “currency switch executive order”, explaining that the government has the legal power to force Russian companies to trade a percentage of certain goods in roubles.  Referring to the case when this level may be set to 100%, the Russian official said that “it’s an extreme option and it is hard for me to tell right now how the government will use these powers”.

De-dollarisation has been dismissed as an improbable aim by most western commentators, but Jukka Pihlman,Standard Chartered’s Singapore-based global head of central banks and sovereign wealth funds (who formerly worked at the International Monetary Fund advising central banks on asset-management issues), notes that at least 40 central banks have invested in the yuan and several others are preparing to do so, putting the mainland currency on the path to reserve status - even before the yuan reaches full convertibility.

The IMF does not disclose the percentage of reserves held in yuan, but the emerging market countries’ share of reserves in “other currencies” has increased by almost 400 per cent since 2003, while that of developed nations grew 200 per cent, according to IMF data.  Pihlman notes the rising popularity of the yuan among central bankers is mainly due to Beijing’s extremely favourable treatment: “Central banks and sovereign funds have special treatment,” Pihlman said. “They have the ability to invest in a way that any other investor does not have. When it comes to convertibility, there is nothing formally out there, but it is fully convertible. The [yuan] has effectively already become a de-facto reserve currency because so many central banks have already invested in it”

Whilst the extent to which other states, such as China or Iran, may be willing to join Russia in any de-dollarisation campaign is open to question, Russia’s own ‘second-strike’ nuclear option however, may prove just as devastating as America’s first strike ‘neutron’ capacity.  It consists of the option to mount an asymmetric response to a war of Scarlet Letters.  Former Director of National Intelligence, Mike McConnell, said in 2010, “If we were in a cyber war today, the US would lose”. Leon Panetta spoke in 2012 of the possibility of America facing a “cyber-Pearl Harbour”.

One senior western expert in cyber warfare described Russia to us as strategically ‘superb’ in the cyber field: “They are brilliant”. They possess unrivalled cyber capabilities, he said, but their real strength lies with the way that cyber warfare has been cleverly integrated into an overall strategy – adding that the West lags way behind in this aspect.

Asking himself the rhetorical question “why then are these capabilities not more widely taken into account in setting foreign policy objectives?”, he surmised that it all comes down to global mutual dependency.  So long as there is this interlocking global financial nexus, it is not in anyone’s interest to rupture it.  But, let us say, were Russia or China to be deliberately excluded from the global financial system, why should the target of exclusion not retaliate by cyber attacks on that very system from which it is deliberately excluded — taking its exclusion from the global financial nexus to amount to an act of economic war.

The point here is not to develop theoretical hypotheses about the course or possibility of such a conflict, and certainly not to say that this is what will happen – it is truly unknown territory – our purpose rather is to underline the unknowns inherent in such warfare, and the possibility of unforeseen blowback.  We simply do not know how such a conflict might evolve.  But, to take just one example of possible blowback – one long-standing economic commentator has been musing in just such a vein:

“I will not claim to be an expert in geopolitics. My macro expertise is more in the realm of Credit, financial flows, Bubbles and associated financial and economic fragility. But these days I discern an extraordinary interplay between the geopolitical and the markets. If I’m on the right track with the geopolitical, the world is quickly becoming a more dangerous place. [And] geopolitical risks compound the vulnerabilities associated with mounting “Terminal Phase” Bubble excesses [in asset markets].

“Egregious Fed and central bank monetary inflation has ensured mispricing for tens of trillions of dollars of financial assets. In particular, I fear central bank policies have incentivised enormous amounts of speculative leverage (certainly including myriad global ‘carry trades’). This means the leveraged speculator community is once again a source of major instability … And here’s where things get really interesting. Whether things blow up soon or not (in Ukraine or the China Seas), [these] newfound geopolitical uncertainties have unexpectedly elevated market risk … But with the Fed now in the waning months of its [Quantative Easing] operations, the markets are increasingly susceptible to a bout of “risk off” … A scenario where the hedge funds bound for the [market] exits as a spooked public clicks the ‘sell button’ doesn’t these days seem [to be] such a longshot [i.e. to be so improbable. QE, or quantative easing, is the flooding of the financial system with electronically created, virtual money.  The Federal Reserve is committed to easing back on the flood of dollar liquidity being poured into the global system.]

“Yet I over-simplify things. The geopolitical backdrop has surely turned incredibly complex and nuanced. I believe Russia and China have increasingly serious issues with U.S. dominance over global finance. Both have serious domestic problems that might incentivize them to act out – and perhaps even [to] act [jointly] as partners. At the same time, the U.S. and the West are hoping financial and economic sanctions (as opposed to military confrontation) will alter Putin’s behaviour. A weak rouble and faltering Russian stocks and bonds are seen as pressuring Putin and his inner circle. As things unfold, I would expect officials from Russia and China to demonstrate resolve of steel against Western pressure (financial and otherwise).

“And it would seem reasonable that the performance of Western stock and bond markets now also [will] play into the new Cold War calculus [that is, become much more wary of risk]. [Now] would appear to be an especially inopportune time for a bout of serious market tumult [because of the risk of deflating asset bubbles crashing the market]. From a game theory perspective, perhaps this even reduces the odds of a near-term market blow-up. [But] personally, I wouldn’t want to bet on stability”.

Again, what is so puzzling is how Europeans generally (Germany being the exception) seem so unfazed by the prospect of a Scarlet Letter War exploding. Europe already is teetering at the brink of further systemic economic turmoil: can it survive a further economic ‘shock’? Yet Europe does not seem overly concerned at what this unknown new type of warfare might wreak on its teetering economies. or what its populations might do to their political leaderships in consequence of a further economic slide.

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