By Gregory L. White in Moscow and Anton Troianovski in Berlin
As Western governments seethed last spring over Russia's
takeover of the Crimea region in Ukraine, Vladimir Putin told
advisers that the world eventually would accept the audacious move.
The Kremlin was confident the economic costs of Western sanctions,
though substantial, would be tolerable for the world's
ninth-largest economy.
For much of the year, the Russian president's gamble seemed to
pay off. "His forecasts have come true," Alexei Kudrin, a former
finance minister and longtime Putin adviser, said in May. "A lot of
people have come to terms with Crimea now, at least
informally."
Mr. Putin also seemed confident, according to people who spoke
to him at the time, that the deep ties he had nurtured for years
with major trade partners like Germany would limit the fallout.
Those calculations turned out to be dead wrong. Broader
sanctions choked off Russia's access to Western capital and
technology, tipping the economy toward recession. Then came a
second blow that neither Western governments nor Russia could have
anticipated: The price of oil--the lifeblood of Russia's
economy--plunged 40% since midsummer, magnifying the effect of
sanctions and sending the ruble into a tailspin. The slide turned
into a full-on currency crisis on Tuesday as the ruble dropped as
much as 20% against the dollar.
As the problems intensify, Mr. Putin's miscalculations have
restricted his options. After largely ignoring the economic costs
of the conflict for most of the year, freezing out liberal aides
who tried to warn of the impact, he has begun trying recently to
win back the confidence of business and revive the economy, people
close to the process say. Mr. Putin is expected to be questioned
about the ruble crisis during his annual news conference on
Thursday.
The Ukraine conflict has produced the deepest breach between
Moscow and the West since the Cold War. A notable casualty has been
Mr. Putin's relationship with Angela Merkel, who emerged as
Europe's most powerful leader in large part because of Germany's
relative economic strength.
As recently as a year ago, the German chancellor was one of Mr.
Putin's most reliable Western partners, offsetting more anti-Moscow
voices such as the U.S. and Poland. Now, she is keeping the rest of
Europe in line behind sanctions and warning of the danger she says
Mr. Putin poses to security across the continent.
"We are suddenly confronted with a conflict that goes, so to
speak, to the core of our values," Ms. Merkel said in Sydney,
Australia, in November. "Old thinking in terms of spheres of
influence, in which international law is trampled upon, cannot be
allowed to assert itself."
Mr. Putin's rhetoric on Ukraine seems to have softened in recent
weeks as state-run pollsters in Russia report growing alarm over
the falling ruble and rising prices. "Whenever they start to feel
danger in their bones--we saw it in [the financial crisis of]
2008--they start looking for the liberals to help," a senior
Russian legislator said of the hard-liners in Mr. Putin's inner
circle.
The Kremlin declined to comment for this article.
With Mr. Putin's government warning that significant relief from
sanctions could be more than a year away, there is little chance of
avoiding surging inflation and further declines in the ruble. This
week's currency crisis has increased the urgency, making a steep
recession next year all but inevitable.
The Kremlin appears to have written off hope of rapprochement
with the Obama administration, which has pressed the European Union
to back strong sanctions. And patching things up with Ms. Merkel
doesn't look any easier.
"Russia has become unpredictable, which is the biggest threat to
partnership," said Gernot Erler, the German government's
coordinator for Eastern European affairs. "We don't know at all
what Russia's goals are."
A year ago, it looked as though German relations with Moscow
were warming. The revelations of National Security Agency leaker
Edward Snowden helped turn public opinion against Washington in
privacy-sensitive Germany. Last December, Ms. Merkel formed a new
government with the Social Democrats, historically a party friendly
to Russia. Foreign Minister Frank-Walter Steinmeier said the EU may
have underestimated Ukraine's economic and "historic emotional"
ties to Russia.
Russia annexed the Crimea Peninsula in March. In the early weeks
of the crisis, Ms. Merkel remained cautious about tough sanctions,
fearing they might prevent a way out for Moscow.
The first round of sanctions mainly affected officials and
businessmen with ties to Mr. Putin. Opening a meeting with aides
after they were announced, Mr. Putin didn't even mention the
possible economic impact, calling instead for faster growth. But
after state-television cameras were ushered out, officials
expressed concern.
Mr. Kudrin, the former finance minister and longtime Putin ally
who attended, said that even if the sanctions were limited just to
individuals, they still would hit growth hard. Wider sanctions on
state banks--they would come in the summer--would be much more
painful, he warned, fueling capital flight, sapping investment and
bruising the ruble.
At the time, the government was expecting the economy to grow
and inflation to remain under control. Mr. Kudrin estimated at the
time that the Ukraine crisis cut about one percentage point off GDP
growth--about what the government spent on the Sochi Olympics. Over
two to three years, the bill might rise to $200 billion--"not
catastrophic," as he put it later.
His warning didn't dissuade Mr. Putin and the rest of the
leadership from confronting the West. "They all understood
everything," Mr. Kudrin recalled later. "They're ready to pay that
price."
When additional sanctions came during the spring, some
government officials began to recognize that the informal
effect--chilling business activity--was more painful than expected.
But their appeals to Mr. Putin were largely ignored, according to
people close to the discussions.
"There was a sense that foreign policy was the priority and that
it could be conducted without doing much harm to the economy," said
one Kremlin adviser.
As the ground fighting in Ukraine worsened over the summer,
Germany's resolve to take on the Kremlin stiffened. The U.S. had
been pressing the Europeans to do so for months. Some German
officials were concerned that earlier sanctions hadn't been tough
enough.
Ms. Merkel and Mr. Putin held lengthy, often combative phone
calls, according to German officials familiar with the
conversations.
Western intelligence suggested Russia was supplying the
separatists with weapons and appeared to be coordinating their
operations. Mr. Putin said he had nothing to do with it, and told
Ms. Merkel that Ukraine was the kind of place where abandoned tanks
could be found on farms, according to one official familiar with
the discussions.
Ms. Merkel's office had the German spy agency, the BND, draw up
biographies of rebel leaders, most of whom hailed from Russia. Over
the phone, Ms. Merkel repeatedly confronted Mr. Putin with evidence
that the rebel leaders had ties to Russian intelligence, according
to German officials. Mr. Putin, who rarely raised his voice during
the discussions, denied he had any influence over the rebels. At
important points, he would shift from Russian--which Ms. Merkel
learned growing up in Communist East Germany--to German, which Mr.
Putin speaks well.
German diplomats thought the downing of Malaysia Airlines Flight
17 on July 17, killing all 298 people aboard, might open a path to
calming the conflict. But Mr. Putin publicly denied the rebels had
shot down the plane, repeating theories broadcast by Russian
television that the Ukrainians were responsible.
He told Ms. Merkel over the phone that his own plane was in the
air over Europe at the time and that the shootdown may have been an
assassination attempt. "I could have been a victim, too," he said,
according to one person knowledgeable about the call.
German officials analyzed Mr. Putin's flight path and didn't buy
the contention, according to one person familiar with the
effort.
Convinced that Mr. Putin wasn't pushing the rebels to stop
fighting, Ms. Merkel corralled the other 27 European Union member
states to follow the U.S. and back the first sanctions against
sectors of the Russian economy. They amounted to a body blow to
Russia, whose largest banks and companies depended on Western
financing and technology.
The Kremlin responded with sanctions of its own against food
imports from the West, hitting some European farmers hard.
Inside Russia, pro-market advisers who had warned about too much
confrontation with the West, including Mr. Kudrin, found themselves
largely frozen out, according to people close to them. Mr. Kudrin
lamented publicly that he rarely was consulted by the Kremlin
anymore and that business was alarmed by Moscow's anti-Western
turn.
A tight circle of mostly hard-line advisers, including Defense
Minister Sergei Shoigu and Federal Security Service head Alexander
Bortnikov, had become Mr. Putin's closest confidantes, according to
Kremlin insiders and diplomats.
In early September, even though pro-Russian rebels had just
signed a cease-fire agreement with Ukraine, Ms. Merkel pushed for a
second round of economic sanctions. Ms. Merkel and other Western
leaders said Russia was doing little to carry out the terms of the
cease-fire agreement, including preventing weapons and fighters
from crossing the Russian border into eastern Ukraine.
In early October, German Gref, chief executive of Russia's
state-run Sberbank and the pro-market author of Mr. Putin's
economic programs, lashed out in public at an October conference
where the president was to speak.
Warning that defying "the laws of economic development" would
bring Russia to collapse as it did the Soviet Union, Mr. Gref
ridiculed government policies for replacing sanctioned products
with domestic ones. "You cannot motivate people through the Gulag,
like in the Soviet Union," he said to nervous applause.
Mr. Putin shrugged off the comments when asked about them later.
The government still was expecting Europe to lift sanctions by the
middle of 2015 and for oil prices to recover to $100 a barrel,
Russian officials said at the time.
Within weeks, an additional plunge in oil prices forced the
Kremlin to reassess its plans.
After spending $30 billion in October in an unsuccessful effort
to slow the ruble's slide, the central bank announced in early
November it would let the Russian currency float freely to save its
reserves. Hard-line advisers in the Kremlin, including economic
aide Sergei Glaziev, had called for fixing the rate and restricting
access to foreign currency. But Mr. Putin rejected that advice as
risking even more economic disruption. The central bank's move
triggered a slide in the currency.
"In late November and early December, the authorities realized
there would be a crisis," said one Kremlin adviser. Just before Mr.
Putin's state-of-the-nation address on Dec. 4, the Economy Ministry
revised its forecast. Russia would get no relief from low oil
prices or sanctions in 2015, the new forecast said, which would
drive the country into recession.
After other officials criticized the outlook as too gloomy, it
quickly disappeared from the ministry's website.
In his speech, Mr. Putin announced steps to improve the business
climate. But he also warned that the Kremlin knew who the
"speculators" were who were selling the ruble, which did little to
reassure investors or offset market fears.
Tensions exploded this week. The currency plunge left Russians
racing to convert their savings out of rubles. An emergency rate
hike by the central bank did little to stop the selling.
Frictions surfaced between liberals and hard-liners. Mr. Kudrin
took to Twitter to say the market plunge was the result not just of
sanctions and low oil prices but "also a lack of confidence in the
government's economic measures." He criticized a bailout deal for
the state oil company, prompting the company's CEO to denounce him
as a "provocateur."
Amid the deepening crisis, Western diplomats have reported hints
of softening in the Kremlin's position on Ukraine, though they say
it is too early to declare a shift. Late Tuesday, Mr. Putin joined
a conference call with Ms. Merkel, French President François
Hollande and Ukrainian President Petro Poroshenko to discuss new
talks to stabilize the cease-fire in eastern Ukraine.
But after a year of diplomatic wrangling, German officials say
they have little reason to believe the Kremlin's policies will
change quickly.
The Germans say that continuing to talk to the Kremlin is
important for affording Mr. Putin a way out of the crisis. Some
German diplomats worry that with the Russian economy deteriorating,
Mr. Putin may be tempted to escalate the conflict in Ukraine to
distract his countrymen from problems at home.
In November, Ms. Merkel met with Mr. Putin at the Hilton hotel
in Brisbane, Australia, talking and sipping wine for more than
three hours as their aides waited outside the room. Ms. Merkel
hoped that confronting him in a more relaxed format could lead to
progress. It didn't.
Just over a day later, Ms. Merkel delivered some of her angriest
remarks of the crisis.
"We can no longer simply hold speeches at memorial events," Ms.
Merkel said, referring to the many commemorations of World War I,
World War II and the Cold War held in Europe this year. "Now we
have to somehow show what we have learned from all this."
Alexander Kolyandr and Philip Shishkin contributed to this
article.