Crisis? What Crisis?

The contentious vote on Sunday in Crimea to secede from Ukraine and join Russia prompted the US and Europe to impose limited sanctions and restrictions on Russian officials, but markets yesterday shrugged off the event. Apparently the risk tied to Russia’s annexation of Crimea—an act that the West decries as illegal—is already priced into assets. But while the first act in this provocative narrative has been surprisingly calm, it’s a mistake to assume that the worst has passed. One side has to blink eventually, but at the moment the odds are low for expecting someone to back down. That raises the likelihood that a long, slow grind in a new East-West standoff is coming, with all the trimmings, including the threat of economic turmoil that’s lurking just below the surface.

This much is clear: there’s no going back. Russia is rushing forward to secure Crimea, sending a potent signal to the West that there’s zero chance of backtracking. Indeed, Russian President Vladimir Putin today officially notified the parliament of his plan to annex Crimea, just hours after the West announced sanctions. The message, of course, is that the Kremlin will ignore the warnings coming out of Washington and Brussels.

One theory for why the markets yawned in the face of Russia’s provocative act: the West’s sanctions so far are mostly symbolic. Some analysts question if the US and Europe have the stomachs for imposing a deeper round of sanctions with a bigger economic bite. The fear is that going down this road will invite macro blowback in the West. It’s also understood that Russian natural gas is still crucial to many regions throughout Europe and so the risk of turning off the supply in a tit-for-tat sanctions war is considered by many policymakers as too extreme to even consider.

Putin, of course, knows this, which affords him wide leeway to defy the West’s warnings. But it’s also true that there are real costs to Russia’s actions, which may prove to be a mitigating force on Moscow’s decisions going forward. The research firm Capital Economics estimates private-sector outflows from Russia amount to $50 billion so far this year and more of the same could trigger a recession at some point.

For the moment, however, both sides are signaling that the tensions will escalate before they ease. Here’s the near-term plan for the European Union, according to William Hague, the EU Foreign Secretary:

We propose to move to a further stage of the European response, with travel bans and asset freezes on individuals. The important thing is that we are prepared to move to further measures so there will be long term costs and consequences for Russia if they continue to approach things in this way. I would not describe it as a new cold war, but that will depend on the course of events over the coming days.

The White House is also moving ahead with something similar, starting with sanctions on a handful of top Russian officials. “If Russia continues to interfere in Ukraine, we stand ready to impose further sanctions,” President Obama warns.

So far, however, Russia isn’t terribly impressed, nor is it likely to be without a bigger threat. “U.S. sanctions on Russia are unlikely to have any impact on trade and, most importantly, on Moscow’s position in relation to Crimea and Ukraine,” says Wolfango Piccoli at Teneo Intelligence, a risk consultancy.

The critical issue, then, is related to how this standoff evolves in the days and weeks ahead. Will Washington and Brussels raise the stakes by imposing a deeper round of sanctions on Russia by targeting trade?

Alternatively, might the West bid a quiet retreat and let the issue fade, preferring only to talk tough? Russia is betting on no less. One Russian official named in the sanctions effectively dared the White House to do more. As Fox News reports:

One of the Russians named openly mocked the sanctions.
“Comrade Obama, what should those who have neither accounts nor property abroad do? Have you not thought about it?” Deputy Prime Minister Dmitry Rogozin tweeted. “I think the decree of the President of the United States was written by some joker.”
Game over? Not quite. Both sides have much to lose, starting with diplomatic credibility and geopolitical influence. The current stalemate is set up as zero-sum game: if one side backs down, the other wins most if not all of the marbles. A face-saving compromise that satisfies both sides isn’t impossible, but it looks highly unlikely at this point.

Meantime, the markets are happy with the current geopolitical equilibrium. But it’s a precarious balancing act because the stakes are so high. Something will give, and when it does the risk dynamics will shift dramatically, for good or ill.