Angela Merkel wasn’t in a hurry to inflict economic pain on Moscow. Cautious, pragmatic, and mindful of her country’s business ties to Russia, the German chancellor doggedly tried to defuse the Ukraine crisis through back-channel diplomacy and frequent phone calls with Russian President Vladimir Putin.
Those efforts failed—and now Merkel looks ready to embrace the hit-’em-where-it-hurts sanctions that some U.S. politicians have been pushing for. In mid-April, Germany stopped granting licenses for arms exports to Russia and put on hold a plan for Airbus Group (AIR:FP) to sell $973 million worth of satellite technology to Moscow. Europe “shouldn’t be filled with fear” that sanctions could provoke retaliation, Merkel said in Berlin on April 5.
Behind the scenes, Berlin is making plans for the next phase of sanctions, says a high-ranking German official who declined to be identified in keeping with government policy. The measures under consideration would be wider-ranging and more harmful to Russian business than the limited asset freezes and visa bans already in place, this official says. A possible next step: targeted measures such as curbs on critical high-technology and military exports to Russia. In one of the most extreme scenarios being discussed in Europe and the U.S., Russia could be locked out of Swift, the Belgium-based international money-transfer system, as happened to Iran in 2012. That would cripple Russia’s banking system.
With Merkel on board, the odds that the European Union will launch a tough package of sanctions increase considerably. Europe’s most powerful politician, she has a record of getting balky neighbors to follow her lead. Germany, as Russia’s biggest European trading partner, would bear an outsize share of the risk if Moscow retaliated against European business interests in Russia.
The Europeans could tie the Russian economy into knots very quickly—and more effectively than the U.S., whose trade with Russia is only about one-tenth that of the EU. Hammering out a sanctions package will be tricky, though. The most obvious risk is that Moscow could curb the flow of Russian oil and gas, which accounts for about one-third of Europe’s supply. Germany is particularly vulnerable, because its gas imports have risen since Merkel ordered a shutdown of the country’s nuclear plants. German industrial giants such as chemical group BASF (BAS:GR) also depend heavily on Russian fuel.
Other EU states have different vulnerabilities. Britain has become a financial hub for Russian companies, which raised about $8.2 billion through London stock market listings over the past five years. Prime Minister David Cameron has joined Merkel in calling for accelerated talks on sanctions and could back them up by barring a couple of big Russian banks from doing business in London, says John Herbst, a former U.S. ambassador to Ukraine who is now at the National Defense University in Washington. “A discrete sanction or two from the City or London may be enough to keep Putin from doing something really nasty in Ukraine,” he says. But Herbst says he doubts Britain would take such action, because it’s hooked on Russian money.
Likewise, France isn’t eager to give up deals such as a $1.7 billion contract to sell two Mistral helicopter carriers to Russia’s navy. Foreign Minister Laurent Fabius said on April 15 that the EU should impose stiffer sanctions on Russia if scheduled talks under way in Geneva fail to produce an agreement on Ukraine. But while Fabius said earlier that France “could envisage” blocking the Mistral sale as part of a sanctions plan, he said France wouldn’t make a decision on that before October.
Merkel could face a rebellion at home. Some 6,000 German companies do business in Russia, while the jobs of 350,000 German workers depend on Russian trade, according to the Committee on Eastern European Economic Relations, an organization representing Germany’s main business lobbies. Until now, Germany Inc. has kept quiet. “There was an unspoken deal struck in which the business community grew silent in return for Merkel agreeing to work very hard to prevent economic sanctions,” says Carsten Nickel, senior vice president of Teneo Intelligence in Berlin.
That agreement now seems to be unraveling. Joe Kaeser, Siemens’s (SI) chief executive officer, traveled to Moscow in March for a meeting with Putin that, he told Germany’s ZDF television, was intended to show his company “won’t be overly influenced by short-term turbulences.” The trip drew a rebuke from Vice Chancellor Sigmar Gabriel, who said German companies should show that Germany can’t accept Putin’s “imperial policy.”
The chief executives of steel giant ThyssenKrupp (TKA:GR), Adidas (ADS:GR), and Deutsche Post (DPW:GR) questioned the need for sanctions in a roundtable discussion with the newspaper Die Welt in late March. Asked if Putin should be stopped, Adidas CEO Herbert Hainer said, “I’d turn the question around. I wonder if one shouldn’t have included Putin in the process much earlier, rather than starting talks when it’s too late.” That echoes arguments from Moscow. “If you have more sanctions, it makes it much harder to conduct a diplomatic process,” says Fyodor Lukyanov, chairman of the Council of Foreign and Defense Policy, a leading Russian think tank that’s close to the Kremlin.
Since early March, Merkel and Putin have averaged more than one phone call a week. Until recently, Merkel thought she had a basic understanding of Putin, according to the high-ranking German official, who’s familiar with their discussions. However, this official says Merkel was shocked by the move into Crimea and by her discovery that Putin had lied to her during some conversations—for example, by denying that Russian soldiers had entered Crimea. Merkel doesn’t allow herself to be distracted by “personal emotions” in such situations, Teneo’s Nickel says. “But trust and reliability play a big role. It turns into a question of credibility.”
