Ukraine Repercussions Include Heightened Geopolitical Risk, Widespread Uncertainty

Across financial markets, the confrontation over Ukraine generated that least welcome of investment factors: uncertainty. Volatility ran high as investors pondered various military-intervention scenarios.

Would Russian President Vladimir Putin ever relent and give diplomacy a chance? To what extent would the U.S. or NATO allies engage militarily? What would be the role and efficacy of financial and trade sanctions, and the fallout in terms of economic impact, energy costs and inflation, stock and currency values, cyberattacks and supply chain disruptions?

Win Thin, Brown Brothers Harriman global head of currency strategy, said serious repercussions would mainly be “localized to Ukraine and Russia, perhaps other neighboring countries like Poland or the Baltic States” – though that would still represent a shock of significant proportions. “There is potential for a spillover into Western Europe if Russia decides to retaliate against sanctions by cutting off gas supplies,” Thin added.

Stagflation Warning

Geopolitical risk was a priority during a February 17-18 meeting in Indonesia of G-20 finance ministers and central bankers. Allianz chief economic adviser Mohamed El-Arian stated that markets had not fully priced in the possibility of full-scale combat, and stagflation could result (see Russian Invasion of Ukraine Could Trigger 'Stagflationary Wind’).

The European Securities and Markets Authority, in its Trends, Risks and Vulnerabilities Report released on February 15, was wary of “high risks to institutional and retail investors of further – possibly significant – market corrections.” ESMA saw scope for risk reduction “if past improvements in the economic environment and the relatively low volatility in the market prove to be resilient. This resilience will critically depend, in particular, on the ability of markets to deal with geopolitical tensions building up in eastern Europe and to withstand a reduction in public policy support on the monetary or fiscal sides without material disruptions.”

Detail from European Securities and Markets Authority Risk Dashboard, February 2022

Meanwhile, the International Monetary Fund was at the ready, with $700 billion in lending capacity, to help member countries deal with crisis effects. Sanctions would inevitably interrupt some financial transactions and financial system functioning, especially if Russian access to the SWIFT financial communications network were restricted, IMF Managing Director Kristalina Georgieva said at a Washington Post event, as reported by Reuters.

Peter Atanasov, senior vice president and sovereign analyst with Gramercy Funds Management, said that with the U.S. holding out the threat of “significant economic sanctions . . . the scale and nature of Russian action will determine how punitive those sanctions would be.” He added that “general market sentiment on Russian assets would take a hit in such a scenario on investors’ anticipating the measures.”  

Focus on Debt

Some observers’ financial market concerns centered on Russian debt. The first tranche of sanctions announced by President Joe Biden on February 22, subsequently tightened by governments on both sides of the Atlantic, included “full blocking” of two banks and “comprehensive sanctions” on Russian debt, effectively cutting off Russia’s government from Western finance.

“If Putin directly invades Ukraine, Russia will at the least face a ban on U.S. persons trading in the secondary market for new Russian sovereign debt, and NATO forces will move their forward positions closer to Russia’s border, raising tensions to a degree not seen since the collapse of the Soviet Union,” Eurasia Group had projected in its Top Risks 2022 report.

“Any holders of debt face the risks of forced selling,” BBH’s Thin explained. “Russia’s foreign reserves have risen to around $635 billion, and so it has a pretty big cushion to service its external debt and pay off any maturing debt if foreigners cannot roll over existing holdings due to sanctions.” 

As an indication of global geopolitical risk exposure, Russian bonds make up about 7% of the JPMorgan Emerging-Market Debt Index. Matthew Zimmer, head of international governance research, Newday Impact Investing, believes that large-scale fighting would cause difficulties far beyond the conflict zone. “Many emerging market countries took on higher debt loads to deal with the fallout from the pandemic, so they could be vulnerable if there is a sudden stop in investors’ willingness to finance profligate borrowers,” he said.

More Costly Financing

In a Peterson Institute for International Economics analysis, senior fellow Jeffrey J. Schott weighed possible financial sanctions and raised some doubts about their deterrent effects. Amid such questioning, the U.S. Senate stopped short of legislating a comprehensive sanctions package before an outright invasion took place.

Several banks, PIIE’s Schott said, “could be blacklisted by the U.S. Treasury, transactions involving new Russian sovereign debt issuances prohibited, and some entities blocked from access to SWIFT. These restrictions would make financing in Russia more costly and cumbersome for both domestic and international transactions.

“Sanctions to decouple major Russian banks from international markets will hurt affected customers and shareholders, but the systemic impact would be small compared to taking similar action against China’s top banks, the largest in the world. And important Russian firms will surely still have access to finance from the Russian government.”

PIIE’s Jeffrey Schott

Schott noted that sanctions imposed after the 2014 annexation of Crimea “had only a minor economic impact on the Russian economy, did little to dislodge Russia from Crimea and eastern Ukraine, and – as now seems evident – only temporarily deterred Putin's territorial ambitions.”

Subsequent actions resulted in “deepening Europe’s dependence on Russian gas, opening new gas export markets in China, and developing a new financial messaging platform, the System for Transfer of Financial Messages, to compensate for the potential expulsion from SWIFT.”

Dutch central banker and Financial Stability Board chair Klaas Knot, in the Financial Times, called for caution on sanctions, saying “severe measures” could disrupt global payment flows.

“Fortress Russia”

The military buildup around Ukraine “is a crisis Russia has chosen to instigate, and going into it they have made plans, often called ‘Fortress Russia,’ that they hope will allow them to weather any sanctions,” Newday Impact’s Zimmer said.

The New York Times assessed Russia’s defensive actions in Putin, Facing Sanction Threats, Has Been Saving for This Day and Will Biden’s Sanctions Hold Him Back in Ukraine? Russia also could use cryptocurrency to work around hard-currency restrictions.

Zimmer pointed out that central bank reserves are at a record high and surpass the country’s external debt, and a sovereign wealth fund, which was not tapped for pandemic relief, is worth about $190 billion, equivalent to 12% of GDP. The fund has announced a shift out of dollars, providing further insulation from external economic pressure. Russia currently has a current account surplus and balanced budget, and government debt is at about 20% of GDP.

“Their conservative policy stance probably gives them the wherewithal to withstand the initial shock of punishing sanctions, but those measures are likely to cause significant damage to Russia’s economy over the longer run,” Zimmer added.

Newday Impact’s Matthew Zimmer

Russia’s external debt is running at around 30% of GDP, and foreign currency-denominated debt is around 14% of total government debt. To Gramercy’s Atanasov, “these are low and very manageable numbers.”

The country is not where it was in 2014 with "low international reserves, a relatively undiversified trade structure, and a large amount of U.S. debt," which made it "particularly vulnerable to any disruption to its foreign exchange inflows," American Enterprise Institute senior fellow Desmond Lachman wrote in Barron's.

“Russia’s authorities have worked hard to make their economy as sanctions-proof as possible,” Atanasov said. “It is definitely not immune to the impact of new sanctions, but even draconian ones would tend to be incrementally less damaging.” 

“It is difficult to hedge against the worst-case scenarios," Zimmer said. "Consequently, my advice is if you’ve been brave enough to hold onto Russian debt this long, then probably it's best to hold tight and hope for some form of de-escalation."