Ukraine war - big picture thinking

I have done various media and podcast interviews in recent weeks related to my views around the outlook for the war in Ukraine, so I thought it perhaps best to summarise these in a Q&A format.

Here goes:

Q? What is your base case now in terms of the prospects for peace talks between Russia and Ukraine?

Answer - I have long argued that a long war does not suit either side, it comes with risks for both, and after close to three years of war, both sides would favour a negotiated settlement at this point. Talks have been stalled by U.S. elections - I think both sides saw different outcomes as improving their negotiating position, hence wanted to await the outcome to then determine their negotiating path forward. A Trump win was seen to favour Putin, a Biden/Harris win Ukraine and Zelensky. So I think both sides wanted to get US elections out of the way. The stage is now set for those negotiations, and we are just waiting for President Trump to focus on the issue - amid the flurry of other pressing issues (migration, tariffs, DOGE, Gaza, et al).

Talks are going to happen, that is clear, the only question is what the outcome will be.

Q? Russia has been making incremental progress on the front line in Donbas in recent months, surely time is on Putin’s side?

Answer - Yes, Russia has had some formward momentum in Donbas, and I think here Russia has been escalating to secure extra leverage in the run up to talks. But look at the map, Ukraine is a huge country and Russian territorial gains, even though they have accelerated in recent months, are marginal when compared to the enormity of Ukraine. And to take this additional land in recent months, Russia has suffered enormous losses. I doubt that Russia can sustain the pace of its recent counteroffensive without very significant losses. Russia still seems unlikely to secure any sort of defining victory on the front line any time yet. And the longer the war goes on the larger the casualty count, the risk that Trump changes tack and doubles down on military support for Ukraine, and sanctions on Russia, and then the harder hit to the Russian economy. And the longer the war goes on the greater risk of social and then political unrest in Russia - given the huge human cost, enormous economic cost and deteriorating macro situation in Russia. Remember no one expected the Prigozhin mutiny, and while I don’t think Ukraine should plan/wait for such another similar eventuality, Putin surely cannot entirely discount it as long as the war continues. And surely, the longer the war goes on, the greater the risks of a Prigozhin II scenario.

Q? So what state is Russia’s economy in? Is it in the brink of collapse?

Answer - A collapse is unlikely but overtime Russian buffers are being eroded by sanctions, and this is forcing difficult policy choices on Russian policy makers. They are making mistakes/sub optimal choices - as there are no good choices at this stage with resources being eroded.

In explaining all this I would just cast your minds back a decade to the first imposition of sanctions on Russia after the annexation of Crimea and first invasion of Donbas by Russia in 2014. At that time Russia did not expect Western sanctions - however moderate they were at that time - in response to its actions. But lessons were learned by the Kremlin. They understood that with a looming larger conflict with Ukraine, and the West, and likely much deeper Western sanctions, that they needed to build defences/buffers. And they did. The CBR accumulated over $630 billion in FX reserves just prior to the full scale invasion of Ukraine in February 2022. Russia ran tight fiscal and monetary policy over this decade, much tighter than would have been suggested by its underlying balance sheet/economic outlook, unless war was expected. I called this Fortress Russia economic policy settings. Russia ran budget and current account surpluses, and sacrificed growth to enable deleveraging. This deleveraging helped build up buffers. The result was when the “mother of all sanctions” hit in response to the full scale invasion, Russia was well placed to ride out the impact - drawing down these buffers, and responding to the shock to the balance of payments, from capital flight, by hiking policy rates and allowing the ruble to adjust weaker. The policy response was orthodox and credible. That response further helped durability in response to the tightening sanctions regime.

In all this also we need to remember that sanctions are not a silver bullet - they are just one tool in the West’s armoury, and their impact depends on our own willingness to take some pain. There are no pain free sanctions options - there will always be some backdraft on the country imposing the sanction. And I think one conclusion from all the above has been that the West has been too slow and too soft in its sanctions actions - too careful to move in unity across the Western alliance, but this has dulled their impact. And remember here that sanctioned countries or entities often do not stand still they attempt to avoid/circumvent sanctions - its a moving target. And the other big lesson from our sanctions imposed on Russia is that we have been too slow to impose secondary sanctions - to penalise those helping Russia circumvent sanctions. The result has been that all too often it has paid third parties, and countries, to help Russia circumvent sanctions. Again it shows an unwillingness on the part of the Western alliance really to pay a price for imposing sanctions and ultimately supporting Ukraine. I would argue that the reluctance to be willing to pay a price reflects a fundamental lack of understanding of the threat to the West posed by Russia - for a decade or more we have underestimated the threat from Russia, and overestimated our own strength. There has been an arrogance in our approach and response to the threat from Russia. If we correctly gauged the risks from Russia, and costs of not responding in a correct manner, then a simple cost benefit analysis would have rightly concluded that costs borne now, or as far back as 2014, in imposing tougher sanctions, or spending more on our own, and Ukraine’s defence, where well worth the investment. The benefits of a harsher sanctions response would more than outweighs the costs.

So in answer to questions about the durability of the Russian economy I would argue that a) Putin was the only guy who knew war was coming, and long prepared, building Russia’s buffers; b) The West’s sanctions response has been insufficient, too slow, not aggressive enough and too much focus on the optics of showing Western unity than the actual impact on Russia.

All that said, three years in and there is much to suggest that, finally, sanctions and the long war are beginning to wear the Russian economy down. Perhaps partly this reflects the tightening in sanctions from the Biden administration just before leaving office - sanctioning MOEX, Russia’s biggest FX exchange, Gazprombank, and hundreds of energy and financial entities, plus many ships in Russia’s so called “shadow fleet” in the final weeks of the Biden administration. This seems to have tightened the balance of payments, forcing a weaker rouble, pass thru to inflation (close to 10% now) and then a response by the CBR to hike policy rates to 21%. Notable when I talk here about the difficult policy choices and trade offs facing Russia’s economic policy officials, in the last MPC meeting of the year, actually the CBR held back from doing the orthodox thing and hiking policy rates again. This was in response to business complaining about high rates crippling the real economy. The CBR paused, and I think the result of this obvious policy mistake will be further pressure on the rouble the longer the war goes on, higher inflation, a risk of accelerated capital flight and potential bank runs. And in the interim the CBR will have to expend now scarce FX reserves to defend the rouble - that means less FX reserves available to buy imports of military equipment to sustain the war.

And yes the Russian economy is proving durable in terms of growth, but that is because it is being run as a war economy, with resources diverted from consumption to defence. That is suboptimal surely from a societal point of view, unless that is Russia secures a huge win in Ukraine which makes its population think the sacfrice was all worthwhile. More likely Russia fails to secure anything close to its objectives and its population will eventually question whether the costs were all worth it - that will come back to haunt Putin, eventually, hopefully.

And invitably the trade off towards more military spending at the expense of consumption will mean higher prices, and declining real living standards, and then the potential for social and political unrest, which could just challenge the Putin regime.

Q? So what about the peace, what is Trump planning?

Answer - well Trump has already failed to deliver on his brag that he could end the war in 24 hours of entering the White House. He has since pushed this back to 6 months, and his Ukraine war special representative, Keith Kellogg, has suggested that we should expect to see some progress in more like 100 days.

I am not sure Trump himself has much specific to bring in terms of solutions on key points. Kellogg and Fred Fleitz did though author a paper for the America First think tank which seemed like an attempt to put words in Trump’s mouth in terms of suggesting a route map for a Ukraine war peace. In summary his key points were a) No NATO membership for Ukraine; b) Acceptance of the validity of Russian security concerns - and a need to take these into account; c) A ceasefire is agreed around the current line of contact, de facto, Russia gets to keep what it that’s taken by invasion/conquest.

https://americafirstpolicy.com/issues/america-first-russia-ukraine

The above all looks like a big win for Russia. It is less clear what Ukraine gets in all this.

I have argued in another post in this substack site that Trump has all the negotiating cards with Putin. The argument herein is that a long war has little negative impact on the US - actually there are benefits including increased arms sales for the US - while a long war only has costs for Putin. No US troops are dying in Ukraine, and the longer the war goes on the greater the erosion of Russia’s conventional military capability - Ukraine is eroding the military power of a U.S. adversary for the US. Meanwhile, Trump can significantly increase the costs to Russia of the war, by upping arms shipments to Ukraine (even financed by Ukraine, by Europe, or even by Russia via use of immobilised Russian assets in Western jurisdictions), or by increasing sanctions on Russia - again with little real impact on the U.S. The question is why Trump would not use this leverage to the full to ensure a fair settlement of this war for Ukraine, and Europe? Surely the US and Trump understands here that only a settlement that leaves Ukraine with security will ensure Ukraine is sustainable long term, and with it that European security is similarly ensured. Maybe not.

In recent days Trump has suggested some progress in, presumably, back channel talks with

Moscow - seemingly affirmed by the Kremlin only this morning.

And then we have the quite extraordinary statement by Trump at a WH press conference that while the US was spending a large amount of money supporting Ukraine it was working on an agreement whereby Ukraine would pay the US back in agreements allowing it to secure access to an estimated $11 trillion of rare earth resources. I have covered Ukriane in a professional capacity for close to forty years now and I have never seen such focus, or hope, around its rare earth resources. But perhaps Zelensky really is the master salesman to hook Trump in on this one. We have also seen assurance in recent days of the US, under Trump, continuing to deliver military supplies to Ukraine - reports here suggest excess Patriot missiles were delivered from Israel to the US, then on to Ukraine.

Q? Ukraine, what is in it for Trump?

Answer - Great question. Trump is clearly transactional and I think Zelensky, and the Ukrainian team figured that out with the rare earth play. But I would also link Trump’s pitches to secure Greenland, control of the Panama Canal, and Canada as the 51st state, to a potential settlement in Ukraine. I think in Trump’s world he is planning to sit down with Putin in a Yalta II summit - which Putin has wanted all along - and carve out the world. Trump likely agrees with Putin that great powers have spheres of influence - and beggar the rest. If Putin gets Donbas, as is suggested from the Kellogg-Fleizt paper, then what is in it for Trump? In Trump’s world I think he expects Putin to sign off on the US getting Greenland, and to hell with the Europeans. That’s just the way Trump thinks - just look at his mind/box blowing thoughts now on Gaza.

Q? Can a peace work for Ukraine then?

Answer - it all boils down to the security assurances given to Ukraine. Here is the way to think about it. As is, Kyiv controls 80% of the territory just prior to the Russian annexation of Crimea. The loss, potentially of Crimea, Donbas, et al, is painful, but the rest of the country is still economically viable if there is security sufficient to ensure a) the return of the 10 million plus Ukrainians displaced overseas; b) to ensure private investment returns to help with the heavy lifting on the estimated $500 billion plus in reconstruction costs. Ukraine has some great industries in agro-food, IT, and its military industrial complex will surely be a mainstay of European security for decades to come. There are also great opportunities in the energy sector - and perhaps rare earths. But key is security herein, in that the population and investors must be assured that Russian will not attack/invade again. Key also to Ukraine’s long term successful economic development and recovery and reconstruction is EU accession - which will be a vital anchor for reform and investment.

How to provide that security?

Well Kellogg-Fleitz, and presumably Trump, have taken NATO membership for Ukraine off the agenda - that seems like a rookie move, gifting Putin a win before talks have even begun. Talk of bilateral security guarantees is surely not credible - what’s the difference between NATO membership and say the UK and France providing these bilateral security guarantees if in reality their trigger would draw in NATO into war with Russia? More credible in my mind is the US and its allies giving Ukraine a similar State of Israel guarantee, that is it will provide Ukraine with whatever arms it needs to defend itself. Think here F16, even F35s, and the full array of long range missiles, short of nukes. Ukrainians have amply demonstrated their ability to defend their country against a much better armed adversary, well then give them the military/Tech advantage to assure that. Perhaps herein that is what Trump is thinking about with this rare earths deal - Ukraine pays the US, in cash or kind, for the military supplies to be provided by the US. I, and others have argued something similar in that either Europe writes the cheque to buy US weapons to be given to Ukraine to defend itself, and Europe. An alternative - my favourite - is Russia pays the price tag, via the allocation of the $330 billion in immobilised Russian CBR assets to Ukraine to fund its own and recovery and reconstruction.

Q? What could possibly go wrong?

Answer — Indeed. Well I think Trump just does not really understand Ukraine, Russia or the challenges. The whole world is really not some big real estate opportunity. There are people involved here. And in Putin, Trump faces a truly evil operator.

I worry that Trump does not understand the importance of ensuring Ukraine’s security - does he really understand that Putin wants the whole of Ukraine, is a really bad guy, and absolutely will try and invade again, if he has the opportunity? I fear not.

If Ukraine fails to be guaranteed security there is a scenario where Ukraine collapses, and Putin gets the whole of Ukraine. That is obviously disastrous for Ukraine, but also the whole of Europe. Imagine tens of millions of Ukrainians moving West - the migrant crisis then fuelling more far right populism in Europe, which will fuel centrifugal forces further undermining the whole European project (maybe Trump wants that, Putin certainly does). European defence spending would have to massively increase, perhaps to double the current 2% of GDP NATO target, which would mean an extra €500 billion a year. Remember here that Russian tanks would be up close and personal to even more of NATO’s border, and with NATO much weakened, who could argue that Putin would chance further forays West into Moldova, the Baltics states and even Poland? Note here that Russia now has the largest military industrial complex in Europe, and Ukraine the second. Imagine the two combined - they would massively outgun Europe’s military industrial complex and pose an existential threat to Europe. Whither the Euro in an environment of insecurity in Europe, centrifugal political forces acting within Europe, and the EU, and then massively increased defence spending, higher budget deficits and debt as a result. The resulting higher taxes would just crimp growth, pushing Europe into a growth, debt doom loop.

I really fear her for Ukriane, but also Europe. Trump clearly has no cares.