A Cost-Benefit Analysis for Russia of the Donbas Economic Blockade

BY BRIAN MILAKOVSKY

At a meeting of the Minsk Trilateral Contact Group in June 2019, representatives of Russia and the unrecognized Donetsk and Luhansk People’s Republics discussed lifting the economic blockade with Ukraine’s representative, former president Leonid Kuchma. After harsh reactions from many Ukrainian commentators, Kuchma hurried to clarify that Ukraine could consider lifting the blockade only if the rublization of the economy in the so-called republics was reversed and the factories and mines that had been seized were returned to their Ukrainian owners.

Kuchma believes that time is working against Ukraine. Some Ukrainian leaders had hoped that the rapidly declining quality of life in the republics as a result of economic isolation would have made the residents realize much sooner the futility of separatism and rise up against their armed rulers. Instead, the blockade set the stage ideologically for the integration of Donetsk and Luhansk into the Russian economy, or at least a simulacrum thereof.

The relative costs and benefits to Ukraine are clear. But what about Russia? How has the blockade altered its economic and geopolitical calculus in the Donbas? Without answers to these questions, a resolution to this crisis is unlikely.

Integration or Exploitation?

Formally, Moscow has taken significant steps toward integrating the noncontrolled territories, beginning with rublization.

This has allowed many Russian companies to expand into the consumer economy of Donetsk and Luhansk. The prospects are lucrative: cigarette sales alone amount to $70 million. But pro-separatist Luhansk journalist Sergey Sakadinsky complains that “the border with Russia is porous only in one direction.” He describes Luhansk filling up with Russian and Belarusan consumer goods, even as industrial chicken farms outside the city export only a small portion of their surplus production to Russia.

One business does have a green light for the large-scale export of coal and metal to Russia, however. The huge Vneshtorgservis holding of Ukrainian oligarch-on-the-lam Sergey Kurchenko controls 70 percent of the economy in the Luhansk and Donetsk People’s Republics. It exports anthracite coal to Russia for re-exporting to global markets at a hefty profit. Ironically, the largest end market is Ukraine, which remains dependent on anthracite to produce electricity.

Former separatist commander Aleksandr Khodakovsky, now a prominent blogger in Donetsk, complains that “our metal is sold at an enormous discount [to Russia], at least 30%.... We’re squeezed from all sides. Just enough is paid to keep the workers on the job and production going, no more.” Some of this metal is also re-exported, but much remains in Russia, where it has inspired some of the first public pushback against the economic integration of Donetsk and Luhansk with Russia.

Production costs in separatist steel mills are kept lower than Russian competitors’ costs through miniscule salaries, the availability of subsidized natural gas, and tens of millions of dollars of free iron ore from Russia (part of an economic relief package). As a result, the director of the Magnitogorsk Iron and Steel Works in the southern Urals has complained that “prices for steel plate are being pushed downward by excessive shipments from the Luhansk and Donetsk People’s Republics at dumping prices.”

In truth, Russia’s own domestic market will always strain to absorb coal and steel from the noncontrolled republics, leaving most of their production capacity unused and rusting.

Profit?

The imposition of the blockade gave Russia semicolonial control of economic resources in the noncontrolled territories. But the resulting profits help Moscow recoup only some of the estimated $2 billion it spends annually to subsidize the region’s budget and pension and welfare payments. Oleksiy Matsuka, a Donetsk native and founder of the Novosti Donbasa news outlet, points out that “Kurchenko is just a manager hired by the Russian Federation. The money that is made selling resources from the occupied territories stays in the occupied territories and is used for reducing costs associated with maintaining the occupied territories.”

Andrey Margolin of the Russian Presidential Academy of National Economy and Public Administration has said, “Our support for the Donbas isn’t an economic proposition. Russia does not look at this as an investment project.” He instead characterizes it as a “noble humanitarian mission.”

In truth, the costs of supporting the separatist project in Donetsk and Luhansk are too small (0.1 percent of GDP) to influence Kremlin decision-making, observes Sergey Aleksashenko, former deputy chairman of the Central Bank of Russia and a nonresident scholar with the Brookings Institution. In the long run, however, these territories are likely to become even less self-sufficient and more dependent on external welfare as the productivity of coal mines and steel plants declines and the outflow of working-age residents intensifies. And alongside these growing costs, Moscow has the much larger losses associated with Western sanctions to consider.

But the bad news for the economic future of the Donbas is that these issues cannot be easily parsed and resolved separately. Enrique Menendes, a Ukrainian humanitarian activist who runs the Donbas Regional Policy Institute, points out that “Moscow could perceive the end of the blockade only as a step to a big plan.… Indeed, Russia will ask ‘What’s next?’ at every step.”

Resolving the blockade issue without full implementation of the Minsk Accords would not lead to sanctions relief and would deny Moscow a powerful weapon in the war for hearts and minds. According to Menendes, some residents in the separatist-controlled territories recognize that the blockade crisis came out of mutual escalation, but the majority lay the blame for the resulting economic pain on Kyiv. Such a rallying cry for the separatists and Moscow should not be underestimated.

Finding a Balance

The blockade is costly for all parties, but not enough for Russia to facilitate the key conditions for ending it without painful concessions. The Moscow-controlled separatist authorities have already stated that lifting the blockade should occur in parallel with the granting of “special status” to Donetsk and Luhansk, the autonomy that Russia hopes will preserve its de facto control over the republics while shifting the economic burden to Kyiv.

There are no easy decisions ahead for Ukraine in this process. Kyiv must find a resolution soon so that an economic future remains for the Donbas, lest it turn into a toxic asset that will drain the Ukrainian budget when it is finally reintegrated. At the same time, Kyiv must avoid rushing into a resolution that would bring the republics back into Ukraine like a political Trojan horse.

Finding that balance is an unenviable task. Ukrainian civil society should remain vigilant but give Kuchma and President Zelenskyy enough breathing room to try.