Conflict Economics: Eastern Europe 2021
Policy Pulse - George Anjaparidze - 7 January 2021
Our last year’s forecast on the economics of conflicts in Eastern Europe was broadly on target. As expected, we saw positive momentum through a restart of dialogue between Belgrade and Pristina. We highlighted the heightened risk of conflict in Nagorno-Karabakh as well as continuing tensions in the Russia – Georgia relationship and turbulence in Moldovan politics. Our diagnosis on the intractable situation in eastern Ukraine and Crimea were also accurate.
“Defrosting” of conflicts in Eastern Europe is expected in 2021. Global developments will have a major influence on the economics of conflicts in the region.
First, the economic impact of the COVID-19 pandemic has been uneven across the region. While all countries have suffered, the negative economic impacts from COVID-19 have been more intense in tourism and remittance dependent economies such as Armenia, Georgia and Moldova. Russia is likely to emerge in a relatively stronger position compared to its neighbors. Russia has accumulated vast foreign currency reserves that give it sufficient buffers to manage the volatility arising from the COVID-19 pandemic.
Second, global debt levels have risen sharply and have reached all-time highs. According to International Monetary Fund calculations, global public debt stood at 83% of GDP in 2019 and is estimated to have made an unprecedented jump to about 100% of GDP in 2020. Although absolute debt levels among Eastern European countries are below the global average, the relative increase in debt has been significant. The strained fiscal position implies that countries in the region, with the exception of Russia and Azerbaijan, will be increasingly reliant on external support for sustaining a post COVID-19 recovery.
Third, the change in US administration is likely to translate to a different posture in US-Russia relations. On global issues, the Biden administration is likely to be more cooperative. For example, we expect the US not to pull out of the Strategic Arms Reduction Treaty and instead extend it while it is renegotiated. However, on regional issues within Europe, there is a heightened risk that the US-Russia relationship becomes more confrontational. Russia and Russia based groups have so far been successful in waging asymmetric warfare against western interests through meddling in neighboring states and allegedly launching cyber-attacks further afield. The US has been frustrated by the lack of coherence in policy by its EU allies, Germany in particular, who on the one hand condemn Russian aggression in neighboring states and impose targeted sanctions, but on the other hand sign multibillion euro commercial deals with Russian state companies. The US is especially concerned with the growing dependence on Russian natural gas among some EU countries, particularly in central and eastern Europe. The US Congress recently broadened the application of US sanctions to include any western companies involved in providing services to the NordStream 2 and TurkStream pipeline projects. These proposed pipelines would increase the capacity of Russia to supply natural gas to the EU. Given the advanced stage of construction of the NordStream 2, it is unlikely that these sanctions will derail the project. Nevertheless, it may motivate Russia to retaliate through destabilizing actions targeted at western interests in the Europe region.
Belgrade – Pristina: continued cautious optimism for 2021
The lack of normalization in relations between Belgrade and Pristina prevents people from realizing their potential and slows economic development. Normalization would reduce risk perception which would support much needed investment flows, in particular through implementation of the privatization program. Projects in Kosovo that stand to benefit include: the Brezovica ski resort, mines in extractive minerals such as magnesite and bauxite, communication and transportation infrastructure and real estate development. Normalization of relations between Belgrade and Pristina is also a prerequisite for Serbian EU membership. Overcoming the normalization obstacle, could potentially unlock significant funds during the pre-accession process. With eventual EU membership, Serbia would also gain access to massive amounts of concessional funding through the EU cohesion program, which could translate to about a 21 fold increase in EU assistance.
The EU facilitated dialogue on normalization between Pristina and Belgrade was restarted in 2020. This was made possible through skillful EU diplomacy and suspension of politically motivated tariffs on Serbian goods entering Kosovo. 2020 also marked an increase in activity of US diplomacy. The Trump administration was successful in getting sides to reach a principled agreement on economic normalization between Pristina and Belgrade.
2021 is potentially an opportunity for EU and US efforts to work in concert to ensure the political dialogue and economic incentives for normalization are better aligned. In addition to assistance in managing the COVID-19 pandemic, support from the EU, US and broader international community will be critically needed for the economic recovery. Keeping the normalization dialogue on track could help boost availability of much needed resources. Despite a conducive external environment to support dialogue, there are significant downside risks that could derail the normalization talks. In Pristina, snap elections have been called after the Constitutional Court ruled that the government was illegitimate. This introduces significant uncertainty on the policy of the future Kosovo leadership with regard to dialogue on normalization. Furthermore, the situation at the local level between ethnic Serb and ethnic Albanian communities remains tense. Local incidents are often characterized by rapid escalation. Despite these risks, we think as long as there is broad alignment between EU and US efforts and real economic incentives on the table, there is room for cautious optimism for a continuation of progress towards normalization.
Ukraine – Russia: an uneven fight persists
The conflict in eastern Ukraine imposes significantly higher economic costs on Ukraine (compared to Russia) in both relative and absolute terms. As highlighted in our last year’s analysis, western sanctions are likely to have lowered economic output by 0.5 to 1.5% of GDP in Russia. In Ukraine, factors directly attributable to armed conflict have led to a fall in economic output by about 50% in the Donbass region and about 15% in the rest of Ukraine. This means that in relative terms the conflict has about 10 to 30 times more of an adverse economic impact on Ukraine than it has on Russia.
Since our last year’s assessment, little has changed in strategic terms in the situation in Ukraine. In the absence of a major scale-up of western support for Ukraine, negotiations in 2021 are unlikely to be successful or at best will be extremely unbalanced (disproportionately favoring Russia). Ukraine’s willingness in 2020 to set up an Advisory Council that is comprised of Donbass separatists and Kiev backed authorities is a reflection of Russia’s stronger negotiating position. In the short term, the creation of such an Advisory Council risks giving legitimacy to Russian proxies and creates the mirage of an internal Ukrainian conflict, in effect absolving Russia of meddling in eastern Ukraine. Having said that, closer interaction between Kiev and Donbass has potential to be constructive in the long term but only if it is combined with large scale economic incentives that target closer integration of the Donbass region with the rest of Ukraine. A “Marshall Plan for Donbass” can help align incentives to promote greater cohesion within Ukraine while developing closer ties with the European Union.
To reach a balanced resolution of the conflict, Ukraine needs assistance and support from western partners to rebalance the cost equation. Furthermore, western partners need to support creation of new economic incentives that target integration of Donbass region with the rest of Ukraine. In the absence of such measures, we expect Russia will continue to engage from a position of strength and secure outcomes of negotiations that favor Russian proxies - eventually leading to further erode Kiev’s control and destabilize Ukraine more broadly. Crimea is an even more complex issue, with conditions in 2021 unlikely to be conducive for meaningful dialogue.
Nagorno-Karabakh: an Azeri military victory that is likely to stick
The Nagorno-Karabakh conflict imposes significant economic cost on both Azerbaijan and Armenia. As a result of conflict in the 1990s, about 700 thousand Azeris were internally displaced in Azerbaijan, which has meant that the country has had one of the world’s highest proportion of internally displaced people as a percentage of total population. In recent years, the government has intensified its efforts to rehouse people, leaving about 350 thousand Azeris with internally displaced status. Policies to support internally displaced people create a significant drain on Azeri public finances. In the case of Armenia, the conflict has meant that the country has been under embargo from both Turkey and Azerbaijan. This has led to new logistics and energy infrastructure, connecting the Caspian region to the world, to be developed in a way that bypasses Armenia. Instead, goods and energy resources flow through neighboring Georgia. Georgia is effectively the only unrestricted gateway for Armenia to access global markets as its other neighbor, Iran, faces significant restrictions of its own due to economic sanctions. Furthermore, as a result of the conflict, the people living in the enclave of Nagorno-Karabakh are faced with a life of limited opportunity that constrains their potential and locks many of them into poverty.
As we highlighted in our last year’s analysis, the risk of hostilities in 2020 was likely. Parties were no longer comfortable in continuing dialogue on the basis of previously accepted principles. Azerbaijan’s decisive military victory has reset the situation on the ground in line with Azeri negotiating proposals.
According to the 9 November 2020 ceasefire agreement, Azerbaijan will not control all of Nagorno-Karabakh but will instead retain control of surrounding territories recaptured as part of the 44-day war. The population of Nagorno-Karabakh itself is currently almost entirely ethnic Armenian, their security will be guaranteed through a contingent of Russian peacekeepers. Russian peacekeepers are also tasked with safeguarding logistics connections between Nagorno-Karabakh and Armenia. The ceasefire agreement also envisions the creation of a transport corridor through Armenian territory between the Azeri region of Nakhichevan and the rest of Azerbaijan. The transport corridor through Armenia is a long-standing demand of Azerbaijan as part of previous negotiations. In addition to having local significance for better connecting Nakhichevan to Baku, the transport corridor has potential to improve connectivity between Turkey and Central Asia as well as on-ward destinations. Under the ceasefire agreement, the transport corridor passing over Armenian territory will be overseen by Russian border control officers. Russian influence over traffic on this corridor will be sustained indefinitely given that Armenia is part Eurasian Economic Union. In the years to come, Russia will likely intensify efforts to strengthen this corridor and position it as an alternative to the Georgian route, over which Russia has no control.
The ceasefire agreement is extremely unpopular in Armenia and is largely viewed as a capitulation of Armenian interests. Public sentiment could lead to early parliamentary elections sometime in 2021. So the political viability of the agreement and the extent to which all aspects remain intact is subject to uncertainty. However, conditions on the ground leave Armenia with little room to maneuver.
Georgia – Russia: continue to be stuck playing a lose-lose game
The conflict between Russia and Georgia imposes debilitating costs on the Georgian regions of South Ossetia and Abkhazia. Russia has troops stationed in both of these regions without permission from Georgia. Both regions have had a mass exodus of its pre-conflict population, with more than half of the people (mostly of Georgian ethnicity) being forced to leave. This has resulted in Georgia now having about 300 thousand internally displaced people or over 7% of the total population, which is among the highest ratios in the world. Significant share of government finances are diverted for managing social issues of internally displaced people. Ongoing tensions between Russia and Georgia have also limited economic ties and people to people contact. Poor relations with Georgia have meant that Russia has been limited in its ability to create new infrastructure on Georgian territory to enable export of energy resources. Therefore, Russia has had to forgo cost-effective options for linking with distant markets. For example, instead of expanding existing gas transmission networks, Russia has had to make costly investments in constructing pipelines under the Black Sea to transport natural gas to fuel the rapidly growing Turkish demand. Russia has also systemically imposed trade barriers with Georgia and restricted movement of people. More recently in 2019, Russia issued bans on direct flights between Russia and Georgia, a move that harmed both countries but imposed higher economic costs on Russian airlines and consumers.
On aggregate, we estimate that the cost burden of poor relations between Tbilisi and Moscow results in about 3 to 11 times higher absolute costs on Russia compared to Georgia. However, given the difference in the size of the respective economies this translates to relatively higher costs for Georgia. The lack of predictability in access to the Russian market, has motivated Georgia to improve its goods and services and diversify its economy to compete in other markets through higher value-added products. Nevertheless, there have also been real lost opportunities, particularly in developing energy and logistics connectivity. Russia and Georgia continue to be stuck in a lose-lose game, where geopolitical calculus has clouded economically rational decisions.
2021 is likely to continue to be another difficult year in the Russia-Georgia relationship. Russia may put pressure on Georgia by intensifying “borderization” around Abkhazia and South Ossetia regions. This may be done in an effort to get Georgia to agree to replicate the eastern Ukrainian model of setting up an advisory council or some joint governance arrangement that consists of Abkhaz and South Ossetian separatists alongside Tbilisi backed authorities. Any such governance arrangement is unlikely to be politically palatable if it has official standing or if it is in some way used to dilute exiting formats for dialogue, where Georgia is jointly present with western partners. Nevertheless, setting up such a group may be appropriate if it is given an informal but potentially standing capacity. It can be seen as a form of stakeholder consultation with a remit to advise on ways to promote projects on economic cooperation, human to human contact and capacity building.
Another cause for tension could arise from new initiatives that bring natural gas from the Caspian to the European Union by bypassing Russia. The Southern Gas Corridor project brings natural gas to the EU from Azerbaijan by using the South Caucasus Pipeline (SCP), the Trans-Anatolian Pipeline (TANAP) and the Trans Adriatic Pipeline (TAP). This corridor was operationalized at the start of 2021 and may be further enhanced through the construction of additional modules. For example, feasibility studies are underway for construction of a Trans Caspian Pipeline (TCP) that would connect natural gas supplies from Turkmenistan. Another potential module, White Stream, would offer complementary capacity through a pipeline under the Black Sea. Further study is needed on whether an alternative option may be to develop LNG facilities on the Georgian Black Sea coast for shipping Caspian gas to global markets. In the long term, development of diversified natural gas supplies that are complementary to Russian supply may reduce resistance, among some EU members and the US, to Russian projects such as NordStream 2. By not medaling in projects such as the Southern Gas Corridor, Russia has an opportunity to demonstrate that it is a responsible player capable of functioning on commercial terms in a competitive environment.
Moldova: new economic ties could lead to changes in sentiment
Transnistria, a breakaway separatist region in Moldova is allegedly one of the major European hubs for money laundry and illegal smuggling. So the announced priorities of the new pro-European President, Maia Sandu, to fight corruption, tackle illicit economic activity and restore rule of law, will likely create unease among some factions in the breakaway region. The new president has also questioned the need for continued military presence of Russian peacekeepers in Transnistria and called for renewed efforts to resolve the frozen conflict. Transnistria has expressed a desire to join the Russia Federation and enjoys strong political and material support from Russia. However, officially Moscow recognizes Transnistria as part of Moldova. The Transnistrian economy benefits from strong links with Russia, which includes receipts of concessional Russian natural gas and significant trade turnover. However, since Moldova signed the EU association agreement in 2014 more trade has started to flow with the EU. Finding a solution to the conflict by also focusing on commercial and business interests is likely to be an increasingly important dimension.
However, the Moldovan economy is in a particularly difficult situation. A lack of progress on reforms has left Moldova cut off from much needed international assistance for recovery from the COVID-19 pandemic. Furthermore, the resignation of the government on 23 December 2020, means that parliamentary elections will be held in early 2021. This is likely to bode well for the newly elected pro-European president. However, it also introduces significant uncertainty and potentially exposes Moldova to external meddling.
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