Another Short History Lesson On Russia and Ukraine

By WIn Thin

Parallels have already been drawn between current events in Ukraine and the Russian-Georgian conflict of 2008. These parallels are unmistakable, yet the one big difference so far is that Ukraine has taken care not to give Russia any excuse to engage in a full-scale invasion to other parts of eastern Ukraine. Another brief history lesson is in order, and may also help explain why things may be slightly different this time around. The underlying themes for us are that quick resolution is unlikely, and that a prolonged period of uncertainty, market turmoil, and sanctions will take a greater and greater toll not only on Ukraine, but on Russia too.

POLITICAL OUTLOOK

As Mark Twain reportedly quipped, “History does not repeat, but it does rhyme.” The Georgian and Ukrainian conflicts both took place around the time of the Olympic Games. Both involve potential breakaway republics, and both brought on widespread international condemnation of Russia. Yet the international response 2008 conflict clearly did not prevent Russia from taking similar actions in 2014.

As in the case of Ukraine, the problems in Georgia started with the breakup of the USSR in 1991. When the USSR broke up, Georgia (like Ukraine) became an independent country. With the entire region in flux, two small regions of Georgia (Abkhazia and South Ossetia) gained de facto independence (under the Soviet system, they had a fair degree of local autonomy). Russian peacekeepers were installed, and an uneasy truce held for over a decade. These tensions never went away, and were then exacerbated by Georgian attempts to forge greater ties with Western Europe.

The election of President Mikheil Saakashvili in 2004 was the watershed moment. As he pressed for stronger relations with the West (including entry into NATO) and became the poster boy for democracy in Eastern Europe, frictions with Russia rose sharply. Russia established formal ties with the two breakaway provinces in April 2008, basically recognizing them as sovereign nations. Meanwhile, Saakasvili was re-elected that year, promising to bring the two territories back under Georgian control. Both Russia and Georgia have accused the other of escalating the tensions, as many incursions, troop buildups, and clashes were seen in the following months. Eventually, Saakashvili took the bait and on August 8, he ordered a full-scale military operation to retake control of South Ossetia.

This gave Russia the cover it needed to launch a full-scale invasion into Georgia. That same day, Russia quickly responded as its tanks rolled into Georgia. The short, five-day war led to hundreds of deaths and thousands of casualties. Following a six-point ceasefire plan brokered in part by France, there has yet to be closure. The US and most other nations have not yet recognized the two as sovereign nations. Over two dozen rounds of talks have taken place since 2008, with little substantive progress to be reported. Georgia said it would still like to join NATO, but no timetable is in place now. Meanwhile, Russian forces remain in both breakaway provinces.

ECONOMIC OUTLOOK

How will Russia/Ukraine impact the US economy? We see four potential channels: 1. Gasoline prices, and energy prices more generally, may rise. We don’t think this is a very significant risk. US energy is cheaper than Europe and this, if anything will only increase the gap; 2. Grain prices may rise. Ukraine is an important exporter of wheat and corn. This, coupled with the weather, may lead to a bit more food inflation; 3. US bond yields may fall, lending support to the broader economy; and 4. US companies with direct Russia/Ukraine presence may be affected by embargoes and trade restrictions. These potentially include Pepsi, Alcoa, Abbott Labs, Dupont, and General Dynamics.

Ukraine’s economic outlook was already poor going into this situation. There are certainly more headwinds and risk ahead, but at least Ukraine can count on some sort of aid package from the IMF or Western Europe. Russia has decided to go it alone, and so it has no backstop.

The economic costs to Russia of all these factors won’t be known for some time, but they are not insignificant. Rate hikes, capital outflows, and a potential freeze on foreign investment would have a serious impact on Russia’s short-term and long-term growth potential. But as we pointed out in last week’s piece on Ukraine and Crimea, there does not appear to be a quick resolution to tensions and so the costs for Russia will only mount over time. We believe the ruble and Russian stocks are likely to continue underperforming for the foreseeable future.

INVESTMENT OUTLOOK

What happened to global markets during this period in 2008? It is hard to say exactly what the precise driving forces were, as the Georgian conflict came just before the Lehman failure in September 2008. For what it’s worth, the euro had just posted its all-time high near $1.6040 on July 15, 2008, just weeks before. On August 8, the day the Russians invaded, the euro dropped nearly 4 cents from above $1.53 to just below $1.50. The euro continued to weaken, moving below $1.40 by September 11 and below $1.25 by October. The low near $1.2330 was the trough, however, as the euro recovered to end that year near $1.40. Movement in JPY that same day was negligible, while USD/CHF jumped over two big figures.

The S&P 500 peaked near 1440 on May 19, and then eased to trade near 1300 as Russia invaded in early August. Equities held up for much of August, but then went into free-fall in September and October as the financial crisis deepened. Similarly, 10-year UST yields peaked around 4.25% in mid-June, and then plunged to near 2% by the end of the year as the crisis hit.

So far, Ukraine has resisted the temptation to respond with force, perhaps sensing the potential for “inviting” even greater Russian involvement in eastern Ukraine. That is really the big question. Crimea appears to be a foregone conclusion now, but what if other regions in eastern Ukraine try to break away too?

It’s worth pointing out that Russia faced no serious reprisals or penalties from its invasion of Georgia. This time, the US and Europe has threatened sanctions and other measures. Surely, President Putin was fully aware of the potential consequences, but the cost-benefit analysis still swung in favor of annexing Crimea.

Yet the costs to Russia have yet to be fully determined. Russian equities tumbled nearly 11% today, while the ruble weakened sharply. It has been the second worst EM performer YTD (down over 10% and second only to the Argentine peso). The Russian central bank earlier this year pledged unlimited FX intervention if outside the band. Press reports suggest $10 bln was spent on Monday alone. Even with reserves still close to $500 bln, this is not a pace of reserve loss that they can or will want to sustain. Nor will the central bank want to get drawn into a protracted interest rate defense. We suspect that if these FX pressures continue, they will simply move the ruble corridor to a much weaker range rather than try to sustain the current range.