Theresa May Should Go After Putin's Debt

The British government appears to have backed down against Russia in the Skripal affair. It's the wrong move. The U.K. government should have hit back harder, and can still do so.

The United Kingdom has already expelled 23 Russian diplomats and secured a joint statement with France, Germany and the United States that the attempted murder on British soil of Sergei Skripal, a former Russian spy, and his daughter, Yulia, using a military-grade nerve agent on March 4 was "highly likely" to have been perpetrated by Russia. This might have been the start of a serious response, with tougher measures to follow depending on Russia's reaction.

Russia's response, as it turns out, was defiant. The headline was the Kremlin's decision to expel 23 British diplomats, close the British Council in Russia, and close the U.K. Consulate in St. Petersburg. The move that got far less attention, however, was more significant: a brazen flaunting of the Western sanctions regime imposed on Russia since 2014 for its annexation of Crimea and its destabilizing activities in eastern Ukraine. Last week, in the middle of the U.K.-Russia diplomatic row, Russia issued $4 billion in Eurobonds, half of which were purchased in the United Kingdom.

The failure to sanction the issuance of new Russian sovereign debt has been a key weakness in existing EU and U.S. sanctions for at least two reasons.

First, existing sanctions target Kremlin-linked banks and energy companies to pressure the Russian government but not the state itself, whose sovereign debt can be bought by EU and U.S. entities. While Russia has relatively low public debt levels ($122 billion in domestic debt and $38 billion in Eurobonds as of the end of the third quarter of 2017), it still needs to issue hard currency debt to service its external debt obligations.

Second, while the sanctions regimes prevent targeted banks and energy companies from issuing their own debt in European and U.S. capital markets (with some narrow exceptions for short-term debt), sanctioned banks such as VTB Bank have been able to act as book runners (that is, the main organizers) for the issuance of Russian sovereign debt that can be bought in the European Union and the United States.

On Tuesday, as the U.K. national security council met to decide on what steps to take next, the reality of the country's diplomatic isolation was hitting home, with President Donald Trump and President of the European Commission Jean-Claude Junker both having sent oleaginous congratulations to Putin for his recent re-election win. On Wednesday morning, the U.K. government announced it would ask for no further sanctions against the Russia state, but rather take action against Putin's cronies and their dirty money in the United Kingdom. And the actions mentioned - "more security checks on private flights" and the like - will hardly keep those cronies awake at night.

The problem with the U.K. government's response is that they are trying to use ordinary law enforcement to push back against the Russian hybrid threat. Of course, the government should move against dirty Russian money in the United Kingdom, but this is just to say that it should move against dirty money in the country in general: being a Russian national in the United Kingdom isn't a crime, and nor is being a wealthy Russian national.

The crux of the matter is that the U.K. government is wrong to think it can push back against the Russian hybrid threat by focusing narrowly on the private actions of Putin's entourage. This follows from the plain fact that these people occupy key positions in the Russian state, and state-linked companies. To counter the Russian hybrid threat, the United Kingdom and its Western partners need to hit back against the Russian state itself. In the immediate term, while it's clear that there won't be new sanctions, London should at least push to fix the weakness in the existing sanctions regimes against Russia as regards new sovereign debt issuances.

The easiest way to do that is to break the link between Russian sovereign debt and key Western clearing houses, such as Euroclear and Clearstream. At present, Russia can borrow in EU and U.S. capital markets despite Western sanctions and then can support the sanctioned Kremlin-linked banks and energy companies that can no longer do so. For instance, in July 2016, two months after Russia issued its first Eurodollar bond since the 2014 sanctions, it was made available on Euroclear. If Russian bonds were no longer available on such clearing houses, they would effectively be untradeable on the secondary market, which would deter the majority of EU and U.S. investors from buying them.

This can be achieved though re-interpretation, or slight modification, of the exiting sanctions regimes, which were ambiguous on the question of whether clearing houses would make Russian sovereign bonds available. Clearstream was well aware that it had been burnt for breaking the Iranian sanctions regime, and had to pay a $152 million fine to the U.S. Treasury in 2014. Nevertheless, in July 2016, two months after Russia issued its first Eurodollar bond since the 2014 sanctions, it was made available on Euroclear, surmounting the final obstacle to the Russian state accessing EU and U.S. capital markets.

Tightening existing sanctions in this way would also serve to strike against Russian dirty money in the United Kingdom. Last week's Russian Eurobond week was different from previous issuances in the way it was designed to allow Russian investors to repatriate money held abroad and was expressly advertised as such by the head of VTB Bank, which acted as the book runner, and Putin himself.

Of course, the main problem remains that the U.K. is unlikely to get support from the United States or the EU at this time (note that London's sanctions works within the EU sanctions regime).

On the U.S. side, the Trump administration is clearly reluctant to toughen existing sanctions on Russia. One reason for this is that it would disrupt financial markets, which would harm U.S. investors as well as the Russian state, as a key U.S. Treasury report stated in late January as part of a justification not to sanction Russian sovereign debt. One could argue this simply puts the interests of the U.S. economy first. But it also represents a spineless refusal to stand up to a mafia state. Indeed, it all but confirms Putin's assumption that Western leaders are so nervous about upsetting financial markets that they will forfeit the only serious weapon they have to push back on illegal Russian activity short of military means. Of course, there is also President Donald Trump's own strange deference to Putin in the background and links between his businesses and VTB Bank to consider.

On the European side, the U.K. has less influence given its imminent departure from the EU, and the EU itself is internally split on whether to upgrade or tone down Russian sanctions. However, while the sight of a President of the EU Commission congratulating a dictator on his election victory presents a vision of decay, there are braver voices willing to stand up for democracy against the Russian hybrid threat. For example, European Parliamentarian Guy Verhofstadt tweeted that "This is no time for congratulations. We will always need dialogue with Russia, but closer ties must be conditional on respect for the rules based international order & fundamental values". Exactly right.

Realistically, the United Kingdom might not be able to get the existing sanctions regimes tweaked to cover new Russian sovereign debt issuance this time around, given the wider diplomatic situation. But London would be wrong to think that pushing for this now would display the London's isolation, and the West's disunity in the face of the Russian hybrid threat. Rather, it is the right moment for the United Kingdom to stand up for the move, and place the burden of explanation on those who think that it is fine for the West's financial system to be used to finance a mafia-state that clearly presents a threat to Western democracies. The U.K. should lead the way in rejecting the passivity that has characterized Western enforcement of sanctions against Russia since 2014, and puncture Moscow's assumption that the West will ultimately put financial interests before its public values.


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