By Justyna Pawlak and Adrian Croft
BRUSSELS (Reuters) - The European Union would target state-owned Russian banks vital to financing Moscow's faltering economy in the most serious sanctions so far over the Ukraine crisis under proposals considered by EU governments on Thursday.
Ambassadors of the 28-nation bloc discussed options to curb Russian access to capital markets, arms and energy technology in response to the downing of a Malaysian airliner in an area of eastern Ukraine held by Russian-backed separatists on July 17.
Talks on the options for stepped-up action drafted by the European Commission will continue on Friday morning, an EU official said, and diplomats said decisions on wider sanctions were likely at the earliest next week.
However, the ambassadors did agree to add more people and entities to the EU's asset freeze list, using expanded criteria including Russian companies that help to undermine Ukraine's sovereignty.
The names will not be published until late Friday but diplomats said it concerned 15 individuals and 18 entities, half of which were companies.
Ambassadors also agreed to further expand the scope of sanctions to include companies and people who support Russian decision-makers responsible for the annexation of Ukraine's Crimea region or for destabilising eastern Ukraine.
Under one key proposal, European investors would be banned from buying new debt or shares of banks owned 50 percent or more by the state. These banks raised almost half their 15.8 billion euro ($21.29 billion) capital needs on EU markets last year.
"If implemented such sanctions would be a serious blow to the Russian economy, exacerbating an already very likely recession this year and sustaining an economic depression for longer," said analyst Michal Dybula of BNP Paribas.
The proposals included an arms embargo, although diplomats said it would apply to future deals and would not bar delivery of a French warship built for Russia under a 2011 contract.
The EU was also weighing restricting exports of technology for deep-sea drilling, shale and Arctic energy exploration and so-called civilian-military "dual use" items, diplomats said.
After months of hesitation, powerful EU states including Germany, Moscow's biggest trade partner, are pushing for quick action as they believe Russia has consistently failed to meet international demands to end violence in Ukraine. The crash of Malaysian Airlines flight MH17, which U.S. intelligence officials believe was shot down in error by the rebels with a Russian-supplied missile, has stiffened Europe's resolve, officials said. Most of the victims were Dutch. The moves to restrict access to EU capital markets and defence and energy technology would mark the first time the Europeans have gone beyond asset freezes and visa bans to target sensitive sectors of the Russian economy.
The Commission did not propose a ban on buying Russian government bonds. However, the cost of insuring Russian sovereign debt against default rose on the news.
The largest banks with state ownership of over 50 pct are Sberbank, VTB, Russian Agriculture Bank (Rosselkhozbank) and VEB.
"Restricting access to capital markets for Russian state-owned financial institutions would increase their cost of raising funds and constrain their ability to finance the Russian economy," the Commission's options paper said.
"It would also foster a climate of market uncertainty that is likely to affect the business environment in Russia and accelerate capital outflows," it said.
Russia's state-controlled banks would have to turn to the state, domestic savers or new regions such as Asia if EU sanctions shut off investment.
On the energy front, the EU's proposed sanctions targeting sensitive technology would take aim at Gazprom's huge South Stream gas pipeline project to Europe and Novatek's Arctic Yamal liquefied natural gas (LNG) facility by restricting Russian access to specialised pipes.
Russia's ambassador to Britain, Alexander Yakovenko, said Western sanctions against Russia were illegal, counter-productive and could hurt the global economy.
"In my view the sectoral sanctions against Russia may well trigger a long anticipated end-game of the present global crisis," Yakovenko told a news conference in London.
"We welcome reports that the EU ... is likely adding additional names to its sanctions list today,"
White House spokesman Eric Schultz welcomed reports that the EU was set to add more names to its sanctions list.
"We also understand they're continuing discussions to impose further more significant measures ... We anticipate some of their names will overlap with those ... that we have already sanctioned," he told reporters in Los Angeles.
MERKEL WANTS ACTION
A spokesman for German Chancellor Angela Merkel said on Wednesday she wanted to see quick decisions, adding that EU leaders had expressed their readiness last week to hold a special summit if necessary to approve the measures.
European Commission spokesman Jonathan Todd said once member states had decided what they wanted to do, the EU executive would draw up formal legislative proposals which he expected to be adopted by governments next week.
They must also decide how long the EU will give Russia to comply with its demands before imposing the sanctions.
The options were designed to spread the burden among the main EU powers, affecting German technology, Britain's financial centre and French defence sales. Trade data show Germany and Italy have most to lose if the EU steps up sanctions. Austria and the Baltic states are also heavily dependent on Russian gas.
German officials told a closed-door Brussels briefing for industry representatives that Berlin favours a time limit on the new sanctions to provide an opportunity for relations to return to normal, an EU source said.
EU foreign ministers said this week that to avoid tougher sanctions, Moscow must stop the flow of weapons across the border to Ukraine and use its influence with pro-Russian rebels in Ukraine to allow an independent investigation into the downing of flight MH17 with the loss of 298 people.
Despite threatening tough action since Russia's annexation of Crimea in March, the EU has been divided over imposing economic sanctions on its main gas supplier.
Britain and France have clashed openly over Paris's plan to deliver the first of two Mistral helicopter carriers to Moscow.
It remains uncertain whether EU leaders would hold an extraordinary summit to approve sanctions or whether governments could approve the decision in writing.
Experts said capital market sanctions could strain Russia's foreign exchange reserves over time and spark more selling.
"If the corporates and banks lose access you will have to keep an eye on the hard currency reserves because they would have to rely on the Russian central bank to provide the dollars to fund their external debt," said Viktor Szabo, portfolio manager at Aberdeen Asset Management in London. It was not a short-term problem, but more of an issue on a two to three-year horizon, he said. Michel Danechi, portfolio manager at Swiss fund manager EI Sturdza, said he was staying away from sanctioned companies. "(Sanctions are) an ongoing process but we can't say still that share prices of companies such as Novatek and Rosneft have fallen to bombed-out levels. People are underweight Russia but that doesn't mean more selling cannot happen because investor confidence is quite fragile," he said.
(Additional reporting by Barbara Lewis, Jan Strupczewski, Tom Koerkemeier, Martin Santa and Robert-Jan Bartunek in Brussels, Stephen Brown in Berlin, Katya Golubkova in Moscow, Andrew Osborn, Sujata Rao, Carolyn Cohn and Marc Jones in London, Jeff Mason in Los Angeles; Writing by Adrian Croft; Editing by Paul Taylor, Giles Elgood and Sonya Hepinstall)