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Moscow is preparing to prolong retaliatory measures against the EU, after the bloc extended for six months economic sanctions against Russia, raising the prospect of a frozen conflict in Ukraine that analysts say will damage both sides.

Following the expected June 22 extension decision by the EU foreign ministers over what they termed  “Russia’s destabilising role in eastern Ukraine”, Moscow ministries were instructed to draw up proposals for renewing counter-measures for submission to President Vladimir Putin.

In response to a first wave of EU sanctions last year, Russia in August banned imports of fruit, vegetables, meat, poultry, fish, milk and dairy products not just from the EU but also the US, Australia, Canada and Norway. The imports were valued at $9bn.

The latest embargo approved by the EU Foreign Affairs Council was formally enacted with its publication in the European Union's Official Journal on June 23, extending the sanctions until January 31, 2016.

Underscoring the tit-for-tat pattern of recent months, Kremlin spokesman Dmitry Peskov reiterated Russia’s position that "the principle of reciprocity in the sanctions dialogue is a universal constant", meaning that Moscow intends to give as good as it gets.

The market reacted calmly to the developments. “The market has long assumed this outcome, so the news is neutral for Russian equities,” Sberbank Investment Research analysts wrote.

The EU and US used sanctions imposed last summer to cut off Russia from international capital markets, while restricting access to modern technologies in the defence and energy sectors. Isolation of Russian banks and companies from the global capital markets has been painful, Andrei Belousov, an aide to Putin, told the Wall Street Journal on June 20. But the Russian financial system was fast adapting to new realities, he added.

Russia and Western countries are set to maintain a “status quo” in sanctions and counter-sanctions for the foreseeable future, according to Belousov.

Wild card

However, analysts warned of a dangerous aspect to the perceived new balance amid the sanctions. “What Belousov didn’t mention in his comments [on June 20] was that the status quo is only a temporary remedy, and that Russia needs more sanctions lifted if it is to avoid an economic meltdown in two years’ time,” commented Zenon Zawada, an analyst with the Kyiv-based investment bank Concorde Capital. “This is the big wild card in the conflict, the outcome of which can’t be predicted. Putin will either have to find a way to back out of Donbas and Crimea and admit defeat, or expand the conflict.”

The West and Russia are reaching compromises behind the scenes that are oriented towards freezing the conflict in Donbas, Zawada added. “A frozen conflict acts as a drain on both the Ukrainian and Russian economies, both of which will be severely damaged by the time it’s resolved, which could be many years down the road,” he wrote.

Economic effects of the embargo on the sides in the Ukrainian conflict are becoming more pronounced, according to the latest data of Russia’s Rosstat state statistics office. Russia’s trade turnover in Ukraine dropped 60% y/y in the first five months of 2015, the statisticians said on June 23. Food imports to Russia overall were down 40.7% y/y in January-April, while trade turnover with the EU shrank at the fastest rate out of all non-CIS partners in January-April, contracting 37.5% y/y

Game of two halves

The EU has complained that Russia has been dragging its heels and failed to implement its side of the Minsk ceasefire agreements. The first version was signed in Minsk in September 2014 between France, Germany, Russia, Ukraine and rebel leaders of the Donbas region. The second version (Minsk 2) was signed in February 2015. 

Recent fighting close to the coastal city of Mariupol earlier in June included the use of heavy artillery by both Russian and Ukrainian forces, according to reports, in clear violation of the new accord, but it remains unclear who brought their heavy guns back up to the front line first. However, it is clear that the Kremlin is continuing to supply the rebel forces and a genuine and full ceasefire seems as far away as ever.

The Russian side has counterclaimed that Ukraine has not met its commitments under Minsk II. During the question and answer session at the recent St Petersburg International Economic Forum (Spief), Putin told moderator Charlie Rose: "We believe that the settlement should be, as I said, to fulfil the Minsk agreement. And the key point here, of course, are the elements of a political settlement."

"The first is [Ukrainian] constitutional reform, that is included in the Minsk agreement, and includes the granting of autonomy or, as Ukrainians say, 'the decentralisation of power'," Putin said.

"Secondly, it is necessary to extend the previously adopted law on the special status of these territories, Luhansk and Donetsk, the unrecognised republics, to use it and to begin to apply the law. It is accepted but has not yet been realised. To do this it is necessary to adopt a resolution of the Verkhovna Rada - the Ukrainian parliament - and this condition is also included in the Minsk agreement," the Russian president said. He added: "The third thing you need to do - it is necessary to adopt a law on amnesty. It is impossible to conduct a political dialogue with the people who are at risk of criminal prosecution."

Votes in the Rada are due this autumn, but the form of the autonomy or decentralisation of power in the disputed regions remains unclear. Putin was suggesting that Russia will not withdraw its interference in the region until there is some sort of political resolution to these two questions that the Kremlin likes. That leaves Ukrainian President Petro Poroshenko in a difficult position as he cannot afford to be too generous on any of these counts, whereas Putin was making it clear he is expecting a lot before Russia withdraws. In the meantime, the military stalemate and sporadic clashes will continue, with more than 6,400 people killed since the conflict began in April last year.

Meanwhile, the meeting of the "Normandy Quartet" (Russia, France, Germany and Ukraine) foreign ministers met in Paris late on June 23, confirming in a declaration their adherence to the Minsk 2 agreements and calling for a de-escalation and ceasefire in Donbas..

Ukrainian eye of the storm

When the Council of the European Union on June 22 approved a prolongation of the sanctions, thereby increasing pressure on Moscow to use its influence to halt the insurgency in East Ukraine, it blamed the move on Moscow’s failure to implement Minsk 2.

The "EU has extended economic sanctions against Russia until 31 January 2016, with a view to complete implementation of Minsk agreement," Foreign Affairs Council press officer Susan Kiefer tweeted.  

The Russian Foreign Ministry responded in a statement that it was “deeply disappointed that once again in the EU, the view of the Russophobic lobby has prevailed” through the prolongation of the “illegal restrictions”. It stressed that Russia should not be held fully responsible for the implementation of the Ukraine ceasefire and that Kyiv held the key to a settlement.

The ministry also said the decision to extend the sanctions on June 22, the day Russia commemorates the invasion of the USSR by Nazi Germany in 1941, looked “particularly cynical”.

Tying sanctions against Russia to implementation of the Minsk agreements was doomed to failure, added Konstantin Kosachev, chairman of the foreign affairs committee in the Federation Council, the upper house of Russia’s parliament. "Linking sanctions to actions of third persons is a no-win and senseless tactics," Kosachev wrote on his Facebook page.

Actually, thanks for the sanctions

Russian officials have mounted a brave front in recent weeks over the sanctions, which they say have encouraged Russia to become more self sufficient and strengthened ties with international partners to the East.

"Thank you to those countries who adopted sanctions against us, I mean this absolutely honestly," Prime Minister Dmitry Medvedev said on June 11. "In economic terms, all the sanctions imposed have of course led us to cooperate with the Asiatic countries more actively."

Alexander Brechalov, secretary of the Russian Public Chamber, said that "extension of sanctions by our Western partners is only positive for us so far". He added: "The longer the sanctions stay in place, the better it will be for businesses, especially those operating in the sphere of import substitution," he said. 

But while Russia may be becoming more self-sufficient with its import substitution programme and boosted its ties with China, the fear of international isolation has spurred on capital flight. According to Kremlin aide Belousov, the outflow will reach around $100bn in 2015, or $50bn excluding paying debt to foreign banks.

Compounding warnings of a harmful economic backlash in both directions, a new study by the Austrian Institute for Economic Research (WIFO) estimates that sanctions against Russia and counter-sanctions endanger 2mn jobs in the EU and will cost the union as much as €100bn in lost trade.

The report is based on the results for the first quarter of 2015, during which many previously existing export contracts expired without renewal. Estonian and Austrian exports to Russia fell by nearly 50% and 37.2% respectively, while the study recorded a one-third overall drop in EU exports to Russia.

Extrapolating these results, Germany could face the loss of around half a million jobs and €27.6bn in value compared to 2013. Europe's agriculture has been especially hard hit by Russian retaliatory sanctions against food imports, which put at risk around 265,000 jobs, according to the study.

However, the drop in trade is not just a result of the sanctions, say the authors, but also a result of a contraction in the Russian economy because of a nearly 50% drop in oil prices, as well as a corresponding devaluation of the ruble.