More on the Ukraine conflict

Today’s links carry a widely-diverging set of opinions about the moral issues surrounding the situation in Ukraine. But since this is a finance site, I want to discuss the economic issues. I continue to believe the Ukrainian situation will have only a modest impact on the global economy unless war breaks out. Moreover, Europe’s trade linkages to Russia make sanctions a trickier subject for Europe than the US. Expect to see diverging views within NATO and no meaningful economic penalty as a result.

According to the Guardian yesterday, the crisis in Ukraine sent the prices of wheat and corn up substantially as Ukraine is one of the world’s largest exporters of both grains. Oil prices have also increased. And European natural gas prices are very tied to Russia as natural gas is not a global market. When Ukraine and Russia had a natural gas conflict a few years ago and Russia stopped delivery, prices in Europe rose 20%. This highlights the touchy economic situation developing around Ukraine, especially for Europe. From a food and energy perspective, the Ukraine conflict is a big deal for Europe.

Let’s remember that the eurozone is in a nascent recovery. It is still touch and go. But, in the last round of manufacturing data, the four largest economies in the eurozone, Germany, France, Spain and Italy, all saw manufacturing output rise. Spain, for example, is seeing its manufacturing numbers at the highest levels since the sovereign debt crisis began. Greece is also moving up. So, for the first time in a long while, there is a hope that Europe will see sustained growth.

The positive momentum in Europe all goes away if the Ukraine situation turns ugly because grain, oil, and natural gas prices would rise and send Europe back into recession. A European recession would mean lower output, rising government debt to GDP in the periphery, rising bond yields, and worsening bank balance sheets. Europe would return to a debt crisis very, very quickly. Moreover, Ukraine would not have any way of getting finance except via Russia in that circumstance. The risk, therefore, is a default that sends shudders through the emerging markets. And where we have been concerned with Latin America and the fragile five, eastern European countries would come under pressure. Slovenia, for example, is seeing growth after 8 quarters of decline. That goes away immediately, and the need for a banking system bailout returns. The risk for contagion to emerging markets at large would also increase greatly.

The bottom line here is that sanctions against Russia would lead to tit-for-tat sanctions against the EU and the US. And this would greatly harm Europe because of Europe’s trade linkages to Russia. The US is in a completely different situation. Putin knows this and is betting that any sanctions would be ceremonial and symbolic: paralympics boycott, G-8 conferences ban, diplomatic rows, visa freezes, etc. These are all powerful political symbols but they have no real economic impact. Moreover, these sanctions have to be worked out in bodies like NATO because Russia has a veto at the United Nations. So nothing will come from that route.

Within NATO then, we have the US and Canada and the other countries are European. The closest ally to the US is Britain. And the British are saying behind closed doors that they don’t want any real sanctions i.e. no trade curbs: “the UK should not support for now trade sanctions or close London’s financial centre to Russians”. Now I could be wrong and Europe could move to sanctions anyway. But that would be cutting its own throat, especially in the eurozone. The question then is what could Putin now do to provoke sanctions i.e. act so aggressively that the Europeans have no choice but to take a stand on trade as well as symbolic issues. I don’t know what that is, but we are a long way from it.

For now, the impact of the Ukrainian conflict is muted. I expect no meaningful sanctions to occur because it would be greatly harmful to the eurozone. Instead, I expect to hear a lot of non-specific words of condemnation that lead to minor and less onerous non-economic penalties for Russia. The ball is now in Putin’s court. The situation depends on how far he is willing to go to assert his control over Russia’s sphere of influence. Only if we see military action or if Putin pushes beyond Crimea into the rest of Ukraine will economic penalties be on the table.

In the meantime, safe haven assets will continue to see some support. That is bullish for the Yen, the US dollar, Treasuries and gold. I expect emerging markets investors to be more jittery and to react negatively on any bad news. So the contagion in sentiment will manifest itself this way.