Cutting Off Your Nose

Making Russia an enemy in the fight against criminal finance could be costly.

Barack Obama's administration has spent weeks threatening tough sanctions against Russia, only to impose modest measures like visa bans. The White House has good reason to proceed carefully: Targeting Moscow for its invasion of Ukraine could undermine the ongoing U.S.-led efforts to crack down on the financing of everything from drugs to nuclear weapons.

President Obama has authorized the Treasury Department to prepare for potential sanctions that would freeze the assets of Russian officials linked to the invasion, but it's unclear how far the White House will actually be willing to go. Obama used a meeting with acting Ukrainian Prime Minister Arseniy Patsenyuk this week to again warn Russia that there would be "a cost" for the incursion into Ukraine, but so far the United States has posed only visa bans on a limited number of Russian and Ukrainian officials.

The West has powerful tools at its disposal for use against Russia, including potentially levying sanctions against certain Russian banks and companies. That would be a huge, and dangerous, gamble. Russia has promised to retaliate for any Western sanctions, perhaps by seizing the assets of American firms operating in Russia. The bigger risk, though, is that Russia could do everything in its power to prevent the United States and its allies from using the global financial system to combat other foes.

Russia has been instrumental in isolating North Korea and Iran by refusing to veto hard-hitting United Nations Security Council sanctions resolutions. Those measures have been credited with hobbling the Iranian economy and bringing Iranian negotiators back to the table to talk about dismantling the country's nuclear program. American sanctions against Moscow could persuade Russian strongman Vladimir Putin to retaliate by ignoring current sanctions, expanding his commercial dealings with Tehran, and vetoing any new effort to impose new sanctions if the current nuclear talks end without a deal.

Earlier this year, reports that Russia was negotiating an oil deal with Iran fed fears that Russia is more foe than friend. U.S. lawmakers questioned whether Russia was taking the interim nuclear pact with Iran as a free pass to ignore the sanctions that remain in place and buy more Iranian oil. U.S. officials responded by warning Russia that it could be sanctioned for buying or trading goods for Iranian oil, and so far the deal hasn't gone through.

Russia would have a multitude of ways of responding. It could stop helping the U.S.-led effort to ferret out financial transactions of drug kingpins, weapons traffickers, and terrorist organizations like al Qaeda. Russia has signed on with international efforts to combat money laundering, bribery, and nuclear weapons proliferators by stepping up oversight of the financial system, isolating bad actors, and freezing their assets. If Russia becomes a target of those same efforts, it will likely be less enthusiastic about enforcing them against others.

Over the past 10 years, the United States has pushed, prodded, and cajoled the rest of the world -- including Russia -- into doing a better job of monitoring the global financial system to prevent it from being used for criminal activity. In 2000, the Financial Action Task Force (FATF), a standard-setting body that pushes countries to rein in illegal activity by reviewing their regulatory systems, named Russia as a haven for money laundering due to its lack of laws and proper oversight. Russia joined FATF in 2003, and the following year the Russian Central Bank started shutting down lawless Russian banks, including one that accepted $1 million in ransom money after two Russian executives were kidnapped and killed.

Although Russia's record for enforcement is far from spotless, it has improved over the past few years. An October 2013 FATF review found that Russia had corrected problems uncovered in an earlier probe. "Russia has taken sufficient measures to be removed from the regular follow-up process," FATF concluded in its report. It's an effort that Putin has championed as a way of arguing that Russia deserves to be known as a legitimate, honest place to do business. On March 4, he applauded Russian law enforcement for identifying more than 42,000 financial crimes in 2013, according to Russian state-run media. Russian authorities have been particularly cooperative when the effort impacts Russian interests, like cracking down on international criminal organizations that operate within Russia's borders, according to current and former U.S. officials.

If the United States tries to isolate Russia financially, Juan Zarate, formerly a senior Treasury Department official charged with overseeing the Bush administration's sanctions program, said the effort could backfire. If Russian banks are cut off from the financial system by sanctions, they could react by slacking off on enforcement of those rules or creating financial havens for sanctions-breakers and criminals.

"Russia begins to serve more as a repository for financial flows that we would normally want isolated," said Zarate. "Suddenly Russian banks are doing more business with Iranian banks."

In his book Treasury's War: The Unleashing of a New Era of Financial Warfare, Zarate describes the ways that other countries might use financial weapons pioneered by the United States against it. In an example that illustrates how this could happen, Zarate writes that Russia approached China with a proposal to sell its stakes in U.S. government-backed mortgage giants Fannie Mae and Freddie Mac in the middle of the 2008 financial crisis. Suddenly putting hundreds of billions of dollars' worth of the Fannie and Freddie debt up for sale could have prompted a market panic that would have required Washington to put more money into the bailout of the U.S.-backed finance giants. Although Chinese officials declined, the plan could have cast a pall over the U.S. financial system and deepened the global financial crisis. The idea was never realized, but some saw it as evidence of Russian interest in upending the U.S.-dominant global financial system, an effort that could accelerate if Moscow decided to retaliate for potential U.S. sanctions.

The Obama administration has been slowly ratcheting up the sanctions rhetoric, but some lawmakers have sought to compel the administration to respond more forcefully. The Senate is considering legislation that would require the president to impose sanctions on anyone who undermines Ukrainian security or sovereignty. The provision is attached to an aid package lawmakers are trying to put together for Ukraine, but it's unclear what will become of the effort after it stalled this week.

European support for sanctions is also growing in the face of Russian intransigence. After moving troops into Crimea nearly two weeks ago, Russia has refused to budge and the diplomatic efforts initially favored by key German leaders have floundered. German Chancellor Angela Merkel, who had been reluctant to use financial and economic tools against Russia, said Wednesday that sanctions would be "unavoidable" if Russia didn't move to de-escalate the Ukraine conflict. A Russian-backed secession vote in Crimea set for Sunday could provoke the West to finally make good on sanctions threats.

While U.S. policymakers are divided over whether Russia is a crucial partner or an antagonist, some see Russia's less-than-perfect enforcement of financial rules as a possible opportunity: The United States could go after money-laundering violations or sanctions-busting without launching a campaign of broad sanctions against Russian banks or companies.

Tim Ash, a financial analyst who has been watching the Ukraine situation closely, calls this approach "stealth sanctions." He said that tightening the regulatory environment on Russian banks and companies could make it harder for Russia to find buyers for its government bonds, which could create a whole raft of problems for Moscow. It could also further turn investors away from Russia and prompt more of them to pull their money out of the country.

Ash, head of emerging markets research at Standard Bank Group, said the move has another advantage -- it might evoke a "less severe" response from Russia. After all, the United States wouldn't have to create any new rules, just tighten the screws on the old ones.

Filippo Monteforte / AFP / Getty Images


All Hail Shale

As Putin's army masses in the East, Europe starts to rethink its opposition to fracking.

Russian leaders, especially Vladimir Putin, have spent years trying to persuade European countries to hold off on expanding shale gas production for the simplest of reasons: Such a shift would pose a long-term threat to Russia's energy dominance over Europe. But the Russian invasion of the Crimean peninsula is giving Europe new enthusiasm for fracking -- and potentially bringing about the exact outcome Russia has spent years trying to avoid.

The Old Continent has been largely reluctant to use the drilling technology that has enabled the U.S. energy boom despite indications that Europe sits atop plentiful shale gas reserves. Only a handful of countries, led by Poland and the U.K., have seriously considered it, while several have banned fracking altogether. There are growing signs, however, that Russia's heavy-handed antics could be changing Europe's energy calculus in fundamental ways.

On Wednesday, the European Parliament passed energy legislation that included tougher environmental rules for oil and gas exploration -- but specifically excluded shale gas projects from the new regulations. This week, Poland passed tax breaks meant to juice shale gas exploration there. Big European business lobbies, including steel-makers and the EU employers' association, just called for the continent to embrace shale gas as a way out of its energy straitjacket.

"Given the absolute necessity for Europe to diversify its sources of supply of gas and to find solutions to the huge energy price differential with its main competitors, we see no alternative but to proceed as rapidly as possible with shale gas exploitation as part of the energy mix in Europe while retaining all the precautions necessary in pursuing this approach," Gordon Moffatt, director general of European steel lobby Eurofer said in a statement Thursday, a day after the group sent an open letter to all European heads of state and government urging a shift in energy policy.

Europe's growing support for fracking isn't entirely new. Business groups across the continent were calling for more shale gas production even before the Russian invasion of Ukraine triggered fears that Moscow could use energy as a weapon to prevent European powers from intervening. Even in France, home to some of the continent's most ardent environmentalist groups, fracking's high-profile defenders include Industry Minister Arnaud Montebourg.

But in the past, fracking proponents zeroed in on economic arguments, namely the fear that European industrial firms are losing ground to their U.S. counterparts, which are blessed with relatively cheap and abundant natural gas that serves as both fuel and a key ingredient of petrochemicals like plastics and gas-derived diesel. Now, though, energy security fears unleashed by Russia's aggressive behavior have joined economic arguments in fracking proponents' arsenal.

"It's been a shot in the arm for Europe, in a way it wasn't in the previous two gas cutoffs" in 2006 and 2009, said Elizabeth Rosenberg, director of the energy security program at the Center for a New American Security (CNAS). "This is a significant reinvigoration of efforts that are already under way, but has served to make the public and policymakers to think more creatively about the energy options they have."

Putting the focus on the security of energy supplies, as Putin's approach to Ukraine seems to have done, could make it easier to muster support across Europe for the controversial practice. That's because the economic arguments business groups brandish to advocate for fracking -- bringing energy prices closer to U.S. levels -- don't pass muster.

Even if Europe developed its abundant shale gas resources, most studies suggest that Europe's different geology, including deeper shale deposits, would make European shale gas a much more expensive proposition than U.S. shale gas. Other differences with the United States, such as the regulatory framework, access to capital, and supply of drilling rigs, also make a European repeat of the U.S. shale gale an uphill struggle.

Still, worries about energy security, fueled by Russia's behavior, are reshaping the debate. And that is especially ironic because Putin and top Russian energy officials have spent years trying to discredit fracking, calling it environmentally risky and financially unsustainable. Most industry observers say Russia's attitudes toward fracking are less about genuine environmental concerns and more about the threat that it poses to the country's energy-export business.

Putin impressed foreign observers at an annual dinner in 2011 with a detailed diatribe against the practice, sketching out the perils of fracking on dinner napkins. Alexander Medvedev, deputy chairman at state-dominated energy company Gazprom, has also railed against the environmental dangers and higher costs associated with fracking. Alexey Miller, Gazprom's chief executive, famously called the U.S. fracking boom "a bubble that will burst soon."

"Lots of the largest conventional oil and gas producers have tried to pour cold water on fracking technologies and raise concerns about its environmental impact. And you can see the obvious reason why, particularly if they're in a precarious fiscal position like Russia where more supplies on the market potentially erodes their pricing power," Rosenberg of CNAS said.

Until now, environmental concerns about fracking, including possible threats to groundwater and the environmental footprint of intensive drilling in densely populated areas, have ruled it out in many countries with potentially promising shale resources. France, for instance, has banned fracking, while Germany has essentially done so. Bulgaria, reliant on imports of Russian gas, also outlawed the practice, ostensibly on environmental grounds.

Other countries, notably the U.K., Poland, Romania, and Ukraine, have all promoted shale gas exploration to varying degrees. Polish Prime Minister Donald Tusk has been especially vocal about the risk Europe faces from relying on too much Russian gas; Polish tax reforms this week are meant to make domestic gas production easier.

Ukraine's hopes of using its own shale reserves to minimize reliance on Russian energy imports have been hit hard precisely by the crisis. Kiev signed a pair of multibillion-dollar deals with Chevron and Shell last year to explore for shale gas, but the unrest, change of government, and Russian incursion have put those plans on hold for now.

Given the political, financial, geological, and regulatory challenges Europe faces in its quest to replicate the U.S. shale boom, even Russian aggression may not be enough to kick-start fracking in Europe. But as the continent prepares to revamp its energy policy for the next generation, security of supply is looming ever more important.

AFP - Getty