Ripples from Rising Tensions with Russia Impact on the Middle East

Conflicts Forum's Weekly Comment, 14-21 November 2014

The ratchetting of Anglo-sphere tensions with Russia needs no real rehearsal -- after the G20 they are evident enough. The US may want a ‘frozen conflict’ in Ukraine – one which places an obstacle in the face of the Germany’s (and therefore the EU’s) tentative attempt at ‘ostpolitik’ with Russia -- that is, to the EU gaining some autonomy in foreign policy -- and which at the same time smacks-down President Putin’s “defiant” foreign policy. But the Ukraine is pit of vipers; it has its own dynamics, and events are likely to take a turn for the worse – not least because the Ukrainian economy is crashing.

The promise of economic strangulation on Donbas uttered by Poroshenko, and Lavrov’s comments this Wednesday at the Duma (which seem to be aimed at preparing the ground for a possible Russian riposte to any new military thrust by Kiev to the east), are but just the latest portents. Cameron (and Merkel – though less stridently) 'warned' Putin at the G20 that he was at a "crossroads", and that his present path would lead directly towards further sanctions and escalation.

If so, we certainly will witness Russia’s pushback. Putin -- and Russians generally -- are not noted for their faintheartedness. In fact, Russia’s responses are already becoming apparent in the Middle East and, as tension escalates, so most probably will the impact of these responses – geo-political and geo-financial – reverberate throughout the region.

The bitterness created at Brisbane in Russia’s relations with the West will, in different ways, permeate the climate of Middle Eastern politics as a whole. It will jaundice the Russian perspectives in respect to future western motives in the region.  Russia’s policy in the Middle East will remain cool and level-headed, but its vision henceforth will be bathed in a darker wash of scepticism towards western intentions – particularly if they be perceived to have weakening Russia as a subsidiary objective.

Syria is an obvious example of this heightened suspicion, where even now, Russia is ensuring that Damascus has the capability to defend itself with sophisticated SAM missiles, were US warplanes suddenly to begin to make the Syrian state a target in addition to ISIS (as Turkey and Saudi Arabia and some in America are urging). In short, Russia and Iran have now taken a position on Syria from which it would be difficult to step back. A US attack on the Syrian state now would bring us to a new ‘missile crisis’ – albeit conventional, rather than nuclear.

Less noticed perhaps, is the matter of ISIS, and how Cold War tensions are shifting the calculus of several states in respect to how they will deal with ISIS.

ISIS matters, and matters hugely to Russia (and China). Both know their societies to be vulnerable to external disruption via the wedge of Wahhabism intentionally hammered deep into their societies.  Both already are feeling its effects domestically. Indeed, Prince Bandar made this vulnerability very explicit, according to leaked diplomatic reports of his July 2013 meeting with Putin (in which Bandar (unsuccessfully) had sought Russia’s cooperation on several Saudi concerns, particularly Syria and Iran).  Bandar said: “I can give you [Putin] a guarantee to protect the Winter Olympics in the city of Sochi on the Black Sea next year. The Chechen groups that threaten the security of the games are controlled by us.”.  He went on to say that Chechens operating in Syria were a pressure tool that could be switched on and off, as quoted in the Telegraph: “These groups do not scare us. We use them in the face of the Syrian regime, but they will have no role in Syria’s political future”.

Robert Parry was subsequently told by his Russian sources that Putin barely had managed to keep his anger in check: “Putin viewed Bandar’s offer to protect the Sochi Olympics as something akin to a Mafia don shaking down a shopkeeper for protection money”.

Russia therefore views the radical Wahhabism of ISIS as simply another (Saudi-western) tool that equally can be ‘switched on’ in order to undermine Russia’s security, just as the Chechens were such a tool - according to Bandar. It is against this background and perception of events that Russia and its allies in Iran, Iraq and Syria have come to look askance at America’s proclamation of ‘war on ISIS’.

It is not just that US prosecution of the war against ISIS has seemed somehow half-hearted and barely effective; it is not just that American boots on the ground have not been proffered; or that the mooted Sunni Arab ‘boots’ have not materialized -- all this was fully expected. Rather, the doubts go deeper.

The history of the last fifty years of American (and British) involvement in the Middle East has been one of a primordial western dependence on Saudi Arabia as an ally – and a reliance on the Saudi ability to fire-up Sunni radicalism in order to meet western and Saudi common interests and perceived threats (such that of the Soviet Union in Afghanistan).

All these four states (Russia, Iran, Syria and Iraq) understand that this latest firing-up of radical jihadism initially was aimed at Syria – Syria having been perceived in Washington and Riyadh (in the wake of the 2006 war in Lebanon) - as the weakest link in the axis connecting Hizbullah, Syria and Iran -- the so-called 'resistance states'.  ISIS (and its predecessors) was conceived, by some in the western ambit, as one (particularly militarily effective) component to the taking-down of this ‘axis’ which America has regarded as a major threat to its interests.  The West ‘looked aside’ at best, or quietly colluded with Saudi Arabia in this project at worst.  It was to be a repeat of Afghanistan in the 1980s with radical mujihadin ‘bringing down’ the USSR (and - now – ISIS & An-Nusrah being used to bring down the Syrian government).

Whilst clearly the American and European public is (rightly) incensed by ISIS beheadings – it is also the case that ISIS has been, as it were, a western 'asset' in the joint project with Saudi Arabia to overthrow President Assad. The question standing before Russia and its allies therefore is: Does the US truly want to ‘degrade and destroy’ ISIS?

Or is Washington caught in a dilemma of public outrage, on the one hand, that demands to be assuaged, and, on the other, a feeling (promoted by Gulf states) that despite its disagreeable outward aspects, the founding of a Sunni state (IS) right plumb centre in the middle of the ‘axis of resistance’, is not wholly a bad thing. It provides regional 'balance' -- of a kind.

Furthermore these states can see that the US can only deal with ISIS in two ways: Either it can definitively try to destroy ISIS by putting boots-on-the-ground (which it does not want to do, and Arab or Turkish ‘boots’ plainly are not going to be forthcoming), or it is obliged to resort to ‘old habits’ – in which case the ‘war on ISIS’ may become little more than (necessary) public theatre, as it were.

The ‘old habits’ were to have Saudi Arabia somehow assimilate and re-absorb the incendiary movements back into wider Sunni Islam, or at least, to switch radicalised Sunnism into ‘stand-by mode’, for the time being. The Awakening Councils were one such example of this approach: I recall one prominent Iraqi tribal leader making his plea to me (pre-Awakening Councils) that America should arm his, and other, Sunni tribes to fight the Shi’i and Iran, whom he detested unequivocally: “We (the Sunnis) can defeat and destroy them. Give us the money and the weapons and we’ll do it”, he said.  This tribal leader (like most) had feet in both camps: members of his tribe were both in the resistance (al-Qae’da), as well as in the Iraqi official armed forces.

At that time, the US said ‘no’. But later, General David Petraeus suggested a better idea to them: fight against al-Qae’da and America will give you money (implicitly with which to buy weapons).  The tribal leaders, such as the one with whom I spoke, simply switched his tribal youth in the resistance onto ‘stand-by’ – i.e. he ‘absorbed’ the insurgency, made a show of killing some foreign jihadi fighters, whom all Iraqis disliked, and grabbed the money.  The Tribes were desperate to have weapons  - so that they could more effectively defend the Sunni community in the ethnic cleansing that was then taking place in Baghdad, and other towns.

This is what Paul Pillar calls ‘the myth of the Surge’ -- (Iraqi) Sunni jihadists were not ‘degraded and destroyed’, but simply metamorphosed back into the tribal structure. These latter used the money provided, and the Awakening Council structures, to lay down a framework that would subsequently emerge as Iraqi ISIS – a framework that subsequently could take a big city such as Mosul without any fighting. Mosul could never have happened without having laid down these Awakening network of connections. In short, Sunni insurgents had agreed with Petraeus to postpone their war with the Shi’i, but not to end it.  The new phase is currently underway.

Iran and Russia do not want another pièce de theatre. So, amidst all the ‘war’ hullabaloo in America, what we have is passing almost unnoticed: A coalition is taking shape to genuinely fight ISIS, but it is not the American-led one. It is a coalition whose core is Russia, Iran, the Iraqi government and Syria, all of whom co-ordinate closely on the details of the war.  This coalition has a second layer to it, which includes China, Egypt, Hizbullah, the Houthis and even (quietly) some GCC states in a supportive role.

This coalition intends to fight the war on its own, and in its own way.  Iraqi PM Al-Abadi has made it clear that he does not want US boots-on-the-ground. In fact, he does not want any boots. He says that Iraqis will fight the war themselves (though clearly with support and in co-ordination with Russia, Iran and Syria) - and with limited western technical help.

It would be a mistake therefore to understand the photos circulating of Iranian General Qassem Soliemani leading Iraqis into battle as Iran signalling its strategic significance to America, but rather the initiative is designed to demonstrate to Iraqis (rather than Americans) that they, with the help of allies, can prevail against ISIS.

The point here is that because of increasing geo-strategic tensions, Russia’s policy-makers fear that America will be tempted to hold on to its ‘assets’ and historic alliances. The Administration may listen to the Siren voices singing in America and the Gulf (and possibly from the Ba’athist and former army officers collaborating with ISIS) that only if Assad is ousted, and the Sunnis restored to substantive positions of power in Baghdad, will ISIS melt away, as Saudis work their ‘magic’. Just as Prince Bandar promised Putin that the jihadists were indeed a useful tool in Syria, somehow they would be ‘melted away’, never to form any part of the subsequent Syrian political dispensation, so too, some of ISIS’ Ba’athist collaborators may hope for (or even be betting on) a similar prospect in Iraq.

Russia and Iran simply do not believe in Saudi’s ability to massage away ISIS. Putin did not believe Bandar when he made his bold claims, and the two leaderships believe it even less in light of the subsequent rise of ISIS as the new 'Caliphate'. And even if they did believe it, they would not accept it: they have watched, over more than a quarter of a century, as this Wahhabist jihadi orientation has become more extreme, more dangerous and more murderous. They key fact here is that ISIS has as its aim the overthrow of the Al-Saud itself. Russia and Iran are determined to make sure that ousting Assad is not an option, and that a real ‘war’ against ISIS is launched.

Given the possibility that America may revert to old habits, there is a possibility that the Cold War could spill over into a hot Middle East war – were American leaders to allow the Siren voices to sway them into accepting that removing Assad somehow would disempower ISIS.  Fortunately, there are also powerful voices in the US – including Hagel and Dempsey – saying that this is nonsense: with Assad ousted, ISIS simply would take over.

In short, escalating tensions with Russia are already reconfiguring the Middle Eastern system of alliances. But aside from these, other components to Russia’s riposte to the West are beginning to impact on the region.  Firstly, there is Russia’s joint initiative with China to create a non-dollar denominated trading system and an inter-bank financial clearing system that will be an analogue to SWIFT (the Russians say that their alternative, worked jointly with China, should be operational in May 2015).

Here we might note – even if this is to be a slow incremental process - non-dollar trading, whether in Yuan or Roubles, which bypasses US claims to legal jurisdiction – if achieved – will transform the prospects facing Iran, Iraq and Syria, particularly in the field of energy reserves – lifting the threat of sanctions.  For Iran, this prospect is already impacting on its cost-benefit calculus in respect to the P5+1 nuclear negotiations (i.e. in the Supreme Leaders’ injunctions to the Iranian negotiating team to include it in their strategic approach).

But directly connected to non-dollar trading arrangements is the question of how Russia – in the face of sanctions – will set about reducing its economic dependence on the West.  This is already in evidence, with Putin having signed major deals in the energy and defense industries with China and India, among other countries, and by re-orienting the economy toward import substitution.  All of this will be to the benefit of Iran too.

President Putin has also said (in the context of reducing Russia’s economic vulnerabilities) that he views the dollar monopoly in energy trade as damaging to the Russian economy.  Since hydrocarbon revenues form the most substantive part of Russia’s revenues, Putin's desire to take action in this area is not surprising. He is not alone in his concerns either: they are widely shared by other energy producers.

The dollar’s role as the world’s reserve currency was first established in 1944 with the Bretton Woods agreement. The US then held the largest gold reserves in the world, and the dollar was pegged at $35 an ounce – and freely exchangeable into gold at that rate. But by 1971, convertibility into gold was no longer viable (as America’s gold drained away), and the dollar became a pure fiat currency (decoupled from any physical store of value), until the petrodollar agreement was concluded during the immediately following years.

As a result of this agreement with Saudi Arabia, the dollar then became the only medium in which energy exchange could be transacted. This underpinned its reserve currency status through the need for foreign governments to hold dollars; re-circulated the dollar costs of oil back into the US financial system – and - crucially - made the dollar effectively convertible into barrels of oil.  The dollar was moved from a gold standard onto a crude oil standard.

US interest rates were then managed so that oil exporters (who formerly looked to gold as the basis of their reserves) would be indifferent to whether they stored their currency reserves, earned from oil exports, in US Treasuries, or in gold -- their value was equivalent.  The Fed consistently managed the Fed Funds rates to keep oil price/USD exchange rate pair steady, even when it required mid-teen percentage interest rates and back-to-back recessions in 1980-1982. Since US Fed Funds rates were managed to preserve US creditors’ and oil exporters’ purchasing power in oil terms, the system proved acceptable to most nations.

While the Petrodollar arrangement worked well for nearly thirty years, the arrangement began to start to wobble around 2002-04. Oil prices began steadily rising in 2002 and 2003, but rather than focus on maintaining exporters’ purchasing power, Fed Funds rates remained low, to mitigate the fallout from the 2001 US recession/Tech Bubble. As a result, the number of barrels of oil that could be purchased for a face-value US Treasury bond declined sharply.  After maintaining a range of 55-60 barrels of oil per US Treasury from 1986-1999, a $1,000 face value US Treasury went from buying 60 barrels of oil in 1999, to fewer than 30 by early 2004.  It has more recently fallen as low as 10 barrels per $1000 Treasury.

But what may ultimately be seen to have proved fateful to the petrodollar system has been the policy of zero interest-rate policy (ZIRP) and QE pursued so unrestrainedly since 2008.  Effectively, energy producers saw that the US economy had now become so dependent on low interest rates that it could never again manage its interest rates to keep oil prices steady relative to US Treasuries without blowing up the global financial system.  The US economy had now become too ‘financialised’ to withstand anything more than a token interest rate hike.

The Petrodollar system, which had allowed the US dollar to supplant gold as the backing for the oil trade from 1973-2002, was broken. Energy producers began to accumulate real assets, and returned to purchasing physical gold in lieu of US Treasuries.  Finally this year, the long established re-circulation of petrodollars back into the US financial system came to an end - according to BNP:  "The oil producers will effectively import capital amounting to $7.6 billion. By comparison, they exported $60 billion in 2013 and $248 billion in 2012. This will be the first year in a long time that energy exporters will be sucking capital [and liquidity] out”, noted David Spegel at BNP.

This then, is the backdrop to Putin remarks about the dollar monopoly and against which he is likely to craft his response to Saudi Arabia’s decision to message the market into accepting that the Kingdom would not defend $100 oil, but will be content to see the price drop 30%.  (And whatever the market circumstances – and other Saudi objectives - that may have contributed to the fall in price, there is little doubt that ‘oil price war’ is the interpretation that President Putin will place on it).

This new oil price drop simply is crushing producers’ currencies in foreign exchange markets. The combination of the petrodollar loosing its ability to act as a store of value, combined now with exchange rate blues, may be the straw that breaks the producer ‘camel’s back' in respect to OPEC and dollar-denomination.

Such a moment would seem ripe for Russia and Iran to begin a gradual challenge to Saudi’s leadership of the OPEC cartel and to the dollar-denominated energy system: if enough OPEC members and other producers are prepared to rebel.  Iran has been lobbying hard in this direction ahead of next week’s OPEC meeting.  Little may change next week, but in the longer-term Russia might take up Prince Bandar’s suggestion that Russia become a key determiner of oil prices and output – but rather in a cartel of its own making, rather than in the manner Bandar had proposed in July 2013: “Let us examine how to put together a unified Russian-Saudi strategy on the subject of oil. The aim is to agree on the price of oil and production quantities that keep the price stable in global oil markets,” according to the diplomatic account.

And why should producers opt for Roubles or Yuan?  Well, both China and Russia have recently been big buyers of physical gold. Russia’s present gold reserves would back 27% of the narrow Rouble money supply. That is a high ratio -- far in excess of any other major country, and also in excess of the US Fed’s original stipulated gold coverage minimum. Moreover, Russia is a large net exporter of goods and energy, notwithstanding sanctions. So Russia’s gold reserves, by implication, are likely to continue to grow, rather than decline. In the longer term, holding Roubles or Yuan may allow producers to escape the damaging inflationary effects of a dollar system now dependent for its stability on low interest rates and monetary expansion.

These prospective changes are still speculative, but are potentially highly significant. The petrodollar has lasted for over 41 years, and has been the driving force behind America's economic, political, and military power. It would be ironic indeed, were the tensions with Russia inadvertently to become the driver of America finally losing its petrodollar card.