Europe Grapples with Russia-Georgia Woes

With energy supplies at risk, the recent conflict in the Caspian region might spur the West to seek other gas and oil sources

by Jack Ewing and Mark Scott

If armed conflict in Georgia proves short-lived, the effect on economic relations between Russia and Europe could be limited. That, in any event, is what European business leaders fervently hope. For companies such as carmakers Daimler (DAI), Renault (RENA.PA), and Fiat (FIA.MI), fast-growing Russia has become an increasingly important market, helping to compensate for slowing sales in Western Europe. "I don't think the conflict will have big consequences, at least if it doesn't escalate," says Martin Hoffmann, a Russia expert for the Federation of German Industries.

But Russia's willingness to use force to pursue its interests will certainly give companies pause about investing there in the future. And it will give impetus to efforts by European countries to become less dependent on Russian energy. "The main problem for Russia is that investor perception, which was already low, will deteriorate even further," says Katinka Barysch, deputy director of the Centre for European Reform, a London think tank.

Denying Any Lasting Effect

Investor nervousness was reflected in the Russian stock market, which plunged Friday then recovered after Russian President Dmitry Medvedev said the conflict was nearing its end. Most affected were energy shares such as Rosneft (ROSN.RTS), Gazprom (GAZP.RTS), Lukoil (LKOH.RTS), and Inter RAO (IRAO.RTS), an electricity generating outfit with plants in Georgia. "The very fact of the conflict is not putting investors in the mood to invest in Russia," says Alexander Petrov, an analyst with Univer investment group.

But it's Georgia, not Russia, that appears to be the biggest economic loser so far. The escalation of the hostilities has already led to a downgrade of Georgia's sovereign debt rating by both Fitch and Standard & Poor's (MHP).

Russia, meanwhile, will have to deal primarily with political damage—and officials in Moscow insisted the fighting would not have a lasting effect on the economy. "The events themselves of course have an influence [on the outflow of capital] but they can't significantly change the fundamentals," Finance Minister Alexei Kudrin told reporters.

Even if the conflict widens, it's unlikely that Western countries will try to impose economic sanctions on Russia—a step that would have major consequences for their own economies. German exports to Russia rose more than 50% in the first half of 2008, to $290 billion, an indication of how important a market Russia has become. "Russia is a very strong country in terms of economic development," says Christian Dreger, an economist at the German Institute for Economic Research in Berlin. "It helps compensate for weaker growth in other regions."

But Russia's integration into the world economy will suffer a setback. "The country is trying to enter the World Trade Organization, and this armed conflict with Georgia will make that process even more difficult," says Carlo Gallo, an analyst with consultant Control Risks Group. "The conflict with Georgia empowers the hardliners [in Russia]. Economic reform in Russia will be delayed."

Alternatives to Russian Gas

The fighting also drives home how dependent Europe is on Russia for energy, particularly gas. As a result, Europe, already a leader in wind and solar energy, is likely to increase its investment in alternative energy.

And the crisis could give new life to other projects designed to weaken Russia's energy grip on Europe. For example, Germany, which has no port to receive liquefied natural gas, might finally push through long-delayed plans to build one. An LNG port would allow Germany to import gas from countries not connected to the region by pipeline. "Russia is an immediate neighbor. You can't wish it doesn't exist," says Friedemann Müller, a senior fellow at the German Institute for International & Security Affairs in Berlin. "I don't think Europeans will say we don't want to have to do anything with this country. But Europeans will think we trusted too much that Russia would become more like a Western country."

Other projects, though, could suffer a setback. A gas pipeline called Nabucco, for instance, is aimed at diversifying Europe's supplies by linking the Caucasus with Austria, Bulgaria, and Turkey. But the conflict highlights the volatility of energy supplies from the Caucasus, which are crucial to making Nabucco a reality. "There's no doubt that what's happening has increased the investment risk within Georgia and the region," says Nick Butler, director of the Centre for Energy Studies at Cambridge University's Judge Business School and former strategy chief at oil giant BP (BP). "This is one more step by the Russians trying to increase their power among their former satellites. That raises questions over further [foreign] investment in Georgia, as well as countries like Azerbaijan and Ukraine."

With Anna Smolchenko in Moscow and Kerry Capell in London.