Latvia – a potential target for Russian economic aggression?

 

rigaPolitically, Latvia is firmly anchored to the West through its membership of the European Union and NATO. Economically, however, the country still remains under significant Russian influence. The Kremlin has several economic instruments at its disposal which could be used to cause significant negative impact on Latvian economy. The key ones would include restricting imports of Latvian goods, banning future and liquidating existing Russian FDIs in Latvia, reducing volumes of Russian freight transit through Latvian ports, halting supplies of natural gas to Latvia, and withdrawing non-resident deposits controlled by Russia-related entities from the Latvian banking system.

 

Restricting imports of Latvian goods

 

One of the most basic instruments that Moscow could use against Riga is to further close access to the Russian market for Latvian goods. In 2016 Latvia exported to Russia goods worth 0.78 billion euros (7.6 per cent of the total) an amount equivalent to 3 per cent of Latvian GDP. Therefore, any measures resulting in significant trade reduction would have a noticeable negative impact on Latvian economy.

 

However, the potential short-term impact of trade disruption needs to be seen in a broader economic context. The trade in goods between both countries has been already significantly reduced by sanctions and counter-sanctions in the aftermath of the start of the Ukrainian crisis in 2014. The value of Latvian goods exported to the Russian market decreased by 32 per cent from its 2013 peak of 1.16 billion euros to 0.78billion euros recorded in 2016.

 

Over the same period, the total value of Latvian goods exported has managed to slightly increase. This means that exporters succeeded in finding alternative markets for their products, thus compensating for the reduced access to the Russian market. Therefore, if the Kremlin decided to impose additional trade restrictions it is likely that after initial negative impact Latvian businesses would manage to re-orient themselves, at least to some extent, towards other markets. The process of diversifying away from the Russian market is ongoing as businessmen in Latvia are fully aware of the inherent level of political risk. Therefore the risk of additional sanctions is part of the strategic calculus.

 

Banning future and liquidating existing Russian FDIs in Latvia

 

Russian direct investments in Latvia constitute another economic instrument through which Moscow could try to exert pressure on Riga. In a stark contrast to the faltering trade exchange, the cumulative level of direct investments from Russia in Latvia has grown from 850 million dollars in the beginning of 2014 to 1.3 million dollars at the end of 2016. Russia is nominally the second-largest investor in Latvia, following Sweden, representing around ten per cent share of the FDI total. However, if one were to add investments from other countries (e.g. Cyprus) which are made by entities de facto controlled by Russians, the overall amount would likely make Russia the number one investor in Latvia. Russian FDIs targeted mainly Latvia’s financial, energy, transport and real estate sectors.

 

The Kremlin could punish Riga by forbidding Russians from making further direct investments in Latvia and, in more extreme circumstances, pressure current investors to liquidate their existing investments. Such measures would likely be ineffective if not counter-productive. Firstly, the share of Russian investments constitutes an important, but not critical factor in Latvia’s economic development. The impact would cause some disruption but would not affect Latvia structurally as the country relies primarily on Western capital. Secondly, by reducing its economic footprint ‘on the ground’ Moscow would also reduce its influence, both economically and politically. Thirdly, the decision would draw the ire of relatively influential circles (e.g. oligarchs, senior managers, businessmen, civil servants, politicians) who are using investments in Latvia for their own, not always completely legal, business purposes.

 

Reducing volumes of Russian freight transit through Latvian ports

 

Latvian ports, due to their geographic location and availability of access during the winter, have historically served as important trading hubs in the Baltic Sea region. After the collapse of the Soviet Union, Latvia maintained its role as Russia’s transit corridor and maritime outlet. Russian goods, primarily coal and oil products, represent the majority of both international rail freight in Latvia and cargo transhipped through Latvian ports. In addition, Russia is also using pipelines for the transit of oil products.

 

The entire transport and storage sector represents roughly nine per cent of Latvia’s GDP. Activities directly and indirectly related to rail freight and port services are an integral part of it, with Russia being a pivotal economic actor. A significant decrease in the volumes of Russian cargo transiting through Latvian ports would undoubtedly have a serious and immediate negative impact on the Latvian economy. Experts have already warned that the Kremlin may implement such economic sanctions under the guise of business decisions (e.g. simply refusing bookings for Latvia bound routes) or unscheduled repair works affecting key sections of railways leading into Latvia.

 

The risk of further decline in Russian transit is well understood by Riga. Unlike in the case of exporting goods, Latvian business would find it difficult to compensate the missing volumes in the short or even medium term due to geographic and infrastructural constraints. The process of reducing Russian transit through Latvia is ongoing and Moscow makes no secret of its desire for further reductions. In 2016 Transneft, the Russian state-owned pipeline operator, announced that by 2018 it will discontinue the use of Latvian port terminals for transhipment of oil products.

 

The volume of Russian rail freight in Latvia declined during 2016 by almost nine per cent. Over the same period the total amount of cargo processed in Latvian ports in 2016, majority of which is represented by Russian goods, was down ten per cent. Both figures are now around 15 per cent below their respective historical peak levels.

 

The declining volumes are due to several factors: strategic decisions made by the Kremlin to strengthen Russian ports (e.g. Ust-Luga, Primorsk) by redirecting some of the cargo flows from Latvia, the imposition of economic sanctions and counter-sanctions which reduced the volume of trade between Russia and the EU countries, and changes in global macroeconomic factors which have affected the transport industry (e.g. cheap oil, currency devaluations).

 

Given its strategic intention to strengthen its own transport infrastructure, Russia is expected to further reduce the volume of cargo transit through Latvia. However, complete discontinuation of the transit business between Latvia would come with a price tag for Moscow. The current situation allows the Kremlin to wield significant leverage, both through official and unofficial channels, over an important segment of the Latvian economy, which translates into a certain degree of political influence. Thus, significant reduction will also deprive Moscow of a potentially useful instrument.

 

Halting supplies of Russian natural gas to Latvia

 

Energy sector constitutes another domain through which Moscow may potentially try to apply political pressure on Riga. The most critical aspect is related to imports of Russian natural gas. On the surface the Kremlin enjoys a very advantageous position vis-a-vis Riga. Latvia has relied entirely on imports from Russia to satisfy its domestic demand for gas. In addition, Gazprom exerted significant influence over Latvijas Gaze, country’s largest and most dominant natural gas company, through a long-term supply contract (in force until 2030) with a 34 per cent equity stake.

 

Natural gas plays an import role in Latvia’s economy, but its overall share in the country’s energy balance has been falling from roughly 30 per cent a decade ago to around 25 per cent currently. Approximately 60-70 per cent of gas consumption comes from heat and power production, with the remainder being used by the industrial, residential and municipal sectors. Gas-fired CHP power plants play a major role in the provision of electricity (between 25 and 30 per cent of the total) and are the key source of heat for country’s capital (around 70 per cent of the total). Thus, a potential halt of gas supplies by Russia would entail significant negative consequences for the Latvian economy and cause hardship for the population.

 

However, this threat needs to be seen in a broader strategic context and take into account ongoing structural changes. Latvia’s model of gas consumption relies extensively on the use of Incukalns underground storage facility. As the feasibility of using pipeline gas transmission is restricted in periods with low temperature, the actual imports from Russia take place between March and October. During that period, the gas received via pipeline is used to cover the current demand while the surplus is injected into a storage facility. The reserve thus created provides gas supply for Latvia during the winter period. Such model means that Latvia will typically have a sufficient amount of gas in storage by the end of summer to last at least until spring.

 

Even if the Kremlin decides to introduce an embargo at the optimal moment when gas reserves are at their annual minimum following the winter period, the impact would be mitigated by several factors. Firstly, there would be the emergence reserve which, at the very least, should provide Latvia with enough gas to last at least 14 days without additional supplies. In this context, one needs to remember that the Incukalns facility has an active capacity of 2.3 bcm which is almost twice the amount of country’s expected annual gas consumption (1.3 bcm – 1.4 bcm). The question of how large the reserve should be is a function of financial cost rather than technical constraints. The Latvian government has started this year to actively implement legal and administrative frameworks for creating a more significant strategic gas reserve.

 

Secondly, Latvia would be in position to arrange gas supplies from alternative sources. The game changer in this respect was the opening of the Lithuanian LNG terminal in 2014. Additionally, there is a significant effort underway to develop new and enhance existing interconnector pipelines in the region. It is expected that key projects will be finished by 2020. Once completed, the new network would ensure enough capacity for Latvia to source sufficient amounts of gas from non-Russian suppliers to cover its entire annual demand. From the legal point of view the diversification of supplies has been enabled by recent liberalisation of the Latvian gas market and resulting loss of the monopolistic position by Gazprom over the transmission network, which will now be owned by a separate new company.

 

Thirdly, Riga would likely be able to temporarily reduce domestic demand by making adjustments in the power generation sector which represents roughly two-thirds of annual gas consumption. During the spring and summer months, the hydro power will typically generate a larger share of domestic electricity production due to favourable atmospheric conditions, while gas-fired power plants are used more during the autumn-winter period when they are operated in a cogeneration mode (i.e. they produce both electricity and heat). In addition, Latvia is a member of the Nord Pool power market which allows it to actively trade large amounts of electricity within the Baltic region, mainly with Lithuania, Estonia and Sweden. The market is precisely designed to serve as a balancing mechanism for the member countries which will allow Riga to buy large amounts of electricity to cover potential deficits arising on the domestic market.

 

The strategic calculus doesn’t look attractive for the Kremlin. Given the factors outlined above a potential gas embargo would not only require time to take effect but also would offer limited probability of inflicting sufficient pain on Latvia to bend it to Moscow’s political will. In addition, a politically driven disruption of supplies would open Gazprom to litigation and further loss of reputation as a supplier.

 

Withdrawal of Russia-related non-resident deposits from the Latvian banking system

 

The banking sector could constitute another vector through which the Kremlin could try to exert economic pressure upon Latvia. Approximately 40 per cent of deposits in Latvian banks belong to non-residents. Most of these deposits are controlled by Russian and Russia-linked entities. Furthermore, majority of them are considered on-demand, which means they can be instantly withdrawn by the owner.

 

In theory, Moscow could try to pressure Russian deposit owners to withdraw their money from the Latvian banks in a sudden and coordinated fashion. Such action would be disruptive for Latvia’s financial sector and might catalyse a nationwide run on banks. Such panic could lead to collapse of the Latvian banking sector and result in potentially significant impact on country’s GDP.

 

However, if we look more closely the situation does not look all that dramatic. Firstly, the fundamentals of the Latvian banking system are relatively robust. The recent stress tests conducted by the Central Bank of Latvia indicate that banking system can fully absorb a withdrawal of up to 60 per cent of non-resident deposits. A severe impact is expected only if the 90 per cent threshold would be exceeded. Therefore, the Kremlin would have to orchestrate a massive campaign of simultaneous withdrawals to inflict significant economic damage on Latvia. In this instance, practically, the overwhelming majority of Russian and Russia-linked entities would have to participate in such an operation. It is a possibility, especially given the psychological incentive involved (i.e. withdrawing before others do), but not a given.

 

Secondly, Latvia’s banking system is de facto divided into two clusters of banks: one focusing on Latvian residents, the other concentrated on servicing foreign clients. It is the latter that is primarily vulnerable to the withdrawal scenario. The exposure among the domestic-oriented banks to the non-residents is low and therefore their deposit base would not be directly affected. Ripple effects, such as panic contagion resulting in deposit withdrawals by Latvian residents, may constitute a risk but one which is secondary in nature. Overall, Latvian authorities would have administrative instruments at its disposal to limit the scope of potential financial panic (e.g. imposition of temporary constraints on the amounts which can be withdrawn) and a quick stabilising support from external actors (e.g. from Sweden – the key investor in Latvian banking system, EU, IMF) would be very likely.

 

Thinking the unthinkable – the economic “nuclear option”

 

There is no doubt that Russia has several economic instruments which could be used to pressure and punish Latvia. The extent to which their individual use would produce desired effect is debatable as outlined above. However, the Kremlin could theoretically decide to pursue a “nuclear option” of activating all key economic instruments to inflict maximum pain on the Latvian economy. Undoubtedly a sudden and coordinated ban on Latvian exports to Russia, suspension of freight transit, halting supplies of natural gas, and withdrawal of non-resident deposits would produce a punishing effect.

 

However, the overall impact might be less catastrophic than expected. As discussed above, in case of each individual threat Riga will benefit from existence of mitigating factors and countermeasures. There is also a difference in terms of time required for each instrument to produce an impact; the withdrawal of deposit will deliver an instantaneous effect while trade embargo would take time to have an impact. Therefore, there would be a risk for Moscow that even such extreme measures would fail to produce a catastrophic effect within the desired time-frame.

 

More importantly such massive economic attack on Latvia would also prove very costly for Moscow. Firstly, Russian companies will lose revenue from sales not made to Latvia, with Gazprom being the primary victim. This would likely lead to structural loss of market share as Latvian businesses, though hit in the short-term, will seek to adjust and structurally reduce their overall exposure to Russia. If the attack does not break Latvia politically, the country would emerge in a much better strategic position vis-à-vis Russia with the number of economic links, and thus potential future pressure point, greatly reduced.

 

Secondly, such a blatant use of economic instruments for political coercion would further tarnish Russia’s international reputation as a business partner. It would also open Russia to litigation and potential third-party counter-sanctions.

 

Thirdly, apart from general economic cost the likely loss of official and unofficial access to the Latvian market would generate a degree of dissatisfaction among influential circles in Moscow. Russian oligarchs, politicians, managers and civil servants who used Latvia, particularly its banking system, to facilitate their own (both legal and illegal) business operations would no longer be able to do so. The scope and scale of interests negatively affected will likely be significant. For instance, in recently investigated “Russian Laundromat” mass money laundering scheme it was discovered that roughly half of its 20 billion dollars illegal proceeds were processed through the Latvian banking system.

 

It is reasonable to expect that the impact of the “nuclear option” might result in disruption of financial system and likely retaliatory measures from Latvian authorities which may then seek to eradicate Russian business interests, as potential hostile factors, from the domestic economy. There is a real risk that the result would be significantly reduced Russian business footprint in Latvia with all negative consequences for the influential Russian actors. The economic disruption would also destroy the network of formal and informal links on microeconomic level through which more subtle forms of influence, such as bribery, could have been used. The Kremlin-inflicted economic hardship will also affect the Russian minority living in Latvia. This could result in alienation of this group and possibly even produce a hostile attitude towards Russia.

 

What will Moscow do?

 

Russia has several economic instruments which can be used to inflict pain upon the Latvian economy. However, the instruments are unlikely to have a devastating impact on Latvia if used individually. Only a coordinated use of several, or all of them, over an extended period of time could possibly produce the desired devastating effect.

 

The impact of the economic “nuclear option” would come at a significant cost to Moscow which may make the use of this strategy unattractive from a cost-benefit point of view. However, while the consequences of this option are likely to be severe, they may not necessarily be catastrophic. It could be enough to punish Latvia but might not translate into bending Riga to Moscow’s political will. The Latvian population have recently survived a genuine economic catastrophe in the aftermath of the 2008 crisis and may well have what it takes to survive one induced by Russia.

 

Time is in Latvia’s favour as the country works on limiting its dependence on Russia and enhance its overall economic resilience. It is likely that within the coming two – three years, all instruments described above will lose most of their current ability and will no longer pose, even if applied collectively, a significant threat to Latvia.

 

The application of the economic “nuclear option” before the window of opportunity closes would be justified only if Latvia threatens Russia’s vital interests in the region. Only then could Moscow consider using such extreme measures. After that, this strategy is likely to be deemed too costly. Finally, the use of the most extreme measure would also likely require significant changes in the broader political environment, namely the isolation of Latvia from its political allies within the EU and NATO. However, in such circumstances, applying military pressure would likely be a cheaper and more effective choice.

 

Taking all that into account, the most likely course of action is that the Kremlin will not seek, in the foreseeable future, to inflict a massive economic punishment on Latvia. Instead Moscow will reduce exposure in areas where it serves its broader strategic interests. For instance, by re-directing cargo flows from Latvia into its own ports. At the same time, the Kremlin will cultivate selected economic dependencies on the macro-level by entangling individuals and companies into a network of business dealings, which would be of questionable legality. The macro-level economic instruments described above might still be used, but likely selectively and more for short-term political signalling than for causing lasting harm to the Latvian economy.

 

Adam Klus works as a consultant advising public and private clients on issues related to economic security. He has an extensive professional background in the financial industry where he worked in variety of roles, including; equity analyst, portfolio manager and alternative investment specialist. His PhD research is focusing on exploring strategy and instruments of modern economic warfare. He is also an active participant of a multi-national project focusing on countering hybrid threats. Adam's articles were published among others in New Eastern Europe, Intersection Pro and Small Wars Journal. He can be followed on Twitter @klusadam.   

 

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