* Ukraine crisis casts cloud of uncertainty over euro zone
* Economists say jolt to confidence poses biggest threat
* Consensus grows among industry and politicians for action
By Annika Breidthardt and John O'Donnell
BERLIN/FRANKFURT, July 29 The knock to
confidence from harsher European sanctions on Russia could spoil
the euro zone's budding economic recovery even if it shrugs off
the fallout on trade.
Following months of hesitation, the European Union will seek
on Tuesday to seal the first broad economic sanctions on Russia
- its third-biggest trading partner - following the downing of a
Malaysian airliner over territory controlled by pro-Moscow
rebels in eastern Ukraine.
If endorsed by ambassadors from 28 European Union countries,
Europe could limit access to capital markets by Russian state
banks, impose an embargo on arms sales and restrict trade of
high-tech energy technologies and "dual use" technology that has
both civilian and defence applications.
Even if these measures are diluted, they will mark a
fundamental change in how Europe deals with Russia, one which
carries risks not just for Moscow but for Europe itself.
"The impact on trade is relatively small. The far bigger
risk is a knock to overall economic confidence," said Gregor
Eder, an economist with Allianz, one of the world's largest fund
"A spiral of sanctions together with the loss of overall
confidence could be enough to bring the already fragile economic
recovery in Europe to a halt," Eder said.
Previously, EU leaders were reluctant to impose sweeping
sanctions on Russia, and with good economic reason. Not only
does Moscow supply about a third of the EU's gas needs, trade
ties in other areas between Russia and Europe run deep.
German energy giant E.ON has invested 6 billion
euros since 2007 in Russia while chemicals firm BASF
has a joint venture with Gazprom.
In France, defence group Thales owns a stake in a company
that sells warships to Moscow, while Franco-German aerospace
group Airbus and its suppliers depend on Russia for titanium to
make heavy-duty plane parts such as landing gears.
The trade ties help explain why German business confidence
fell to its lowest level in nine months in July, with
respondents blaming the Ukraine crisis.
The EU has already imposed narrow sanctions since Russia
backed rebels fighting Kiev's forces in east Ukraine. A list of
people, including allies of Russian President Vladimir Putin,
are subject to asset freezes and travel bans.
These limited measures have already discouraged business -
euro zone exports to Russia were down 13 percent between January
and April and foreign investment in Russia has dropped sharply.
Exports from the euro zone to Russia account for less than 5
percent of the bloc's total and economists believe Europe could
cope with lower Russia trade. But the blow to confidence and
knock-on effect on investment could be more serious.
"The German and European economies are already experiencing
negative effects from the conflict with Russia. The biggest risk
to Europe, however, stems from the enormous uncertainty that the
conflict has caused," said Marcel Fratzscher, head of
Berlin-based DIW economic research institute.
"Companies do not know if they can still sell their products
to Russia in three months' time or a year. Banks are uncertain
whether loans will be paid back. It is unclear for energy users
and consumers what will happen with oil and gas prices."
The uncertainty comes at a bad time for the 18 countries in
the euro zone, whose economy is already in the doldrums.
The currency area is expected to have eked out barely any
economic growth in the second quarter of the year with the
Bundesbank forecasting that even the mighty German economy
Policymakers' biggest hypothetical concern is about the
potential for gas supplies to be interrupted, requiring
countries to seek more expensive supplies from elsewhere - which
could depress spending in other areas even further.
Given the financial cost to Russia of turning off the taps,
industry experts say that may be unlikely. U.S. and EU sanctions
so far have avoided targeting Russian gas export monopoly
Gazprom. But there are other ways Russia could fight
back, short of switching off the gas.
"Russia will retaliate," said David Gordon of Eurasia
research group, predicting that Moscow could erect informal
barriers such as stricter health and safety rules to make it
harder for foreigners to do business in Russia.
Eder of Allianz fears worse. "How would Russia react if
European banks were not allowed to grant credit to Russian
companies?" he said.
"There could even be the threat of confiscation of
productions sites in Russia from European companies."
Any counterstrike from Moscow to sanctions would fall
heaviest on European countries with the deepest trading ties.
The Netherlands, which bore roughly two thirds of the
casualties when the Malaysia Airlines flight was downed over
Ukraine, is among those that could lose most.
The Dutch economy, which shrank 1.4 percent in the first
quarter of 2014, depends on its port of Rotterdam, the single
largest destination for Russian exports last year, receiving
shipments of oil that is then dispatched across the EU.
The Netherlands also needs to safeguard its own energy
supply from countries including Russia after earthquakes forced
it to cut output from one of its most important gas fields.
Other euro zone countries depend on Russia to buy certain
goods and services, even if in most cases it is not a top
overall export market. Italy exported 12.7 billion euros to
Russia last year, while France, at more than 10 billion euros,
was not far behind. Austria, which has long had close energy and
financial ties to Moscow, exported 4.6 billion euros.
The largest repercussions may be felt from potential
restrictions on Russian banks' freedom to refinance themselves
in Europe. This would hit Russia's two biggest banks, Sberbank
and VTB Bank, whose Austrian arms were recently taken under the
watch of the European Central Bank.
Any retaliation by Moscow could affect European banks active
in Russia, such as Italy's UniCredit, Austria's Raiffeisen or
France's Societe Generale.
For some small European countries that offer off shore
financial services, flows of funds from Russia have been
disproportionately large. Russian individuals moved more than
$33 billion into tiny Cyprus, Ireland and Luxembourg last year,
according to data from the Bank of Russia.
European banks, meanwhile have lent tens of billions to
Russian industry and would suffer if they were not repaid.
Russian companies, individuals and banks have borrowed more than
$650 billion, according to the Bank of Russia, much of which
analysts believe is owed to European banks.
For now, however, it appears that European politicians
believe that sending a political signal to the Kremlin is worth
the economic cost.
"These sanctions are harder than anything we have ever had
before," said James Nixey of British think tank Chatham House.
"It will hurt a little bit but it's a down payment on the future
security of Europe. It's a question of Western credibility."
(Additional reporting Martin Santa in Brussels, Anthony Deutsch
in Amsterdam, Sabine Wollrab in Frankfurt, Alexander Winning in
Moscow and Gernot Heller in Berlin; Writing by Annika
Breidthardt; Editing by Peter Graff)