The big news in the markets today is the standoff in eastern Ukraine between pro-Russian armed rebels and the Ukrainian military. This has European markets selling off. The potential for problems in eastern Ukraine is something we should have seen as a possibility given the motives in the Texas annexation I outlined as a comparative case. Given that analysis, I still believe the question now is more about how Ukraine responds in eastern Ukraine than how Russia, Europe, NATO, or the US respond. It looks like we will get a military response. And as such, the potential for dramatically increasing tension with Russia is high. The European periphery will be especially vulnerable because of this. In addition, Russia is already moving away from the West as a hedge. Thoughts below
Last week I wrote some thoughts on Ukraine in two parts. The first piece focused on a decision tree view of why Ukraine matters. And here I would say the key assumption is that incumbent politicians are naturally risk-averse, making political governance problems under corrupt or inept incumbents intractable but politics relatively more stable. In Ukraine, western influence was crucial in bringing about the ouster of Yanukovych, making Ukraine a country destabilized by regime change and increasing the risk of military confrontation. And that necessarily means punitive economic sanctions and economic crisis, something about which markets were complacent until today.
The second piece focused on a historical analogue in German – French tensions post Franco-Prussian War that led to wars in the 20th century. I believe that if one looks at US – Russian animosity as analogous, the bitterness over past Russian economic and territorial losses and continued American mistrust of Russia, confrontation is more likely over Ukraine. De-escalation is going to be very tricky, in particular because the US is using Ukraine as a proxy for dealing with Russia without any direct control over events on the ground to help stabilize the situation after regime change.
And so that brings me to the outline of the Ukrainian crisis I presented in mid-March using the Texas annexation example. Here we could see Vladimir Putin as akin to US President John Tyler who used the Texas secession from Mexico to create tensions with Mexico that ended with the annexation of Texas and war. Mexico lost the Mexican-American War in 1848, leaving it open to full annexation by the US. But ultimately a deal was established which hived off the northern part of Mexico, all of which was annexed by the US in what later became the western US states of present-day California, Nevada, Utah, New Mexico, most of Arizona and Colorado, as well as parts of Texas, Oklahoma, Kansas, and Wyoming. An analogue for today would be the annexation of eastern Ukraine by Russia.
Judging from the Texas situation, getting from here to there is not about the EU, NATO or the US. Crucially I wrote, “that Ukraine’s reaction to the annexation of Crimea is more important than what the EU and US do. It’s Ukraine as Mexico that is going to matter, more than the US and 1845’s Great Britain.”
So what we are seeing now is exactly what one would expect – unrest in eastern Ukraine and a potential bloody, military confrontation as Ukraine reacts to stabilize the situation. Ukraine has threatened a military operation to dislodge the rebels they call terrorists who have taken over government buildings in eastern Ukraine. The US and Ukraine both blame Russia for fomenting this unrest behind the scenes. The EU is discussing more Russia sanctions and police support. I would love to make some comparisons to the breakup of Yugoslavia here on the military front. But I will save that for another day. Suffice it to say, it could get worse. Russia has called an emergency UN meeting. What this can achieve is unclear given the previous political positions staked out and the growing level of mutual distrust.
Russia is making contingency plans. Here are three interesting developments on this front:
- Turn toward Asia for gas and oil customers. Because of potential sanctions in Europe, OAO Gazprom, the world’s largest natural-gas producer, is turning to Asia for gas contracts. Bloomberg reports that the crisis in Ukraine has increased the chances that Russia will sign a 30-year deal next month to supply gas to China via pipeline after over ten years of wrangling. China needs the gas and Russia now needs the gas customer. The CEO of Rosneft, Russia’s biggest oil producer, Igor Sechin, conducted an Asian tour last month to boost cooperation with Asia. Russia plans to double oil flow to Asia over the next 20 years to 32% of total oil exports via the East Siberia-Pacific Ocean pipeline which spurs into China.
- Turn toward Chinese yuan for all currency transactions. On the same front, Gazprom is considering issuing yuan-denominated debt. China is making a push to get the yuan more international usage as it liberalizes its financial system. This would be a move in that direction. Other moves in the last month include PBOC currency band widening, direct trading with the New Zealand dollar, and yuan transactions at banks in Ireland. If the West imposes sanctions onto Russia, this could drive the Russians away from the dollar and toward the yuan.
- Move away from dollar for oil and gas contracts. Russia has also broached the subject with its customers of selling oil for payment in euros instead of dollars. While European sanctions are the ones which will hurt Russia the most, moving away from dollars in contracts would be a move to hurt the US economically by reducing demand for the US dollar as a reserve currency.
Interestingly, at the same time Iran is offering itself up as an alternative to Russia for natural gas in Europe. According to Handelsblatt, a German newspaper, Iranian Economic Minister Mohammed Resa Nemazadeh said in an Interview with the paper that “Iran can be a trustworthy, safe and long-term partner for Europe”. He also said “we want to play a big roll in the international gas market in the future.” So everybody is marking their position.
What will this mean economically? Everyone knows that sanctions will boomerang back onto Europe most heavily given trade relations with Russia. But the situation in the periphery is where we should look for the greatest problems.
I noted last week that Greece still has 176% debt to GDP despite the ever declining yield on its sovereign debt. Legitimately, there will be a restructuring down the line. The question is how Greece restructures and when. Bond market participants are taking the risk that the bonds they buy will not be restructured. But the risk of an unfavourable restructuring increases in a situation in which Greece re-enters recession. Bond yields would rise and crisis would begin anew in the European periphery. Remember that despite Greece’s primary fiscal surplus, the huge debt burden means the country runs an enormous deficit even so. Today Greek figures for 2013 were released showing a deficit in 2013 of 12.7% of GDP. With state debt of 318.7 billion euros at the end of 2013 and climbing, the debt to GDP ratio will automatically increase regardless of how fast Greece grows. And for this reason, Wolfgang Munchau says this could be the moment for Greece to default.
Greece is not the only place where there are problems in the periphery. Even in Ireland, the best positioned country in the periphery, the government debt problem is large. While the Irish government beat its deficit target last year, the deficit was still 7.2% of GDP, again largely because of the huge debt burden the state has. Government debt at the end of 2013 was 123.7% of GDP. That’s up from 117.4% of GDP in 2012. That figure will continue to rise in a recession scenario. And even Ireland will decouple from the core as a result. So bond convergence in the eurozone is a play that is only successful in a recovery scenario. A recession means huge losses for investors of periphery sovereign debt.
And let’s not forget about the bank – sovereign nexus because Europe’s undercapitalized banks are still cutting staff, still restricting credit and still raising capital to shore up their balance sheets. According to Reuters, Europe’s largest banks cut their staff by another 3.5% in 2013. That’s 80,000 jobs lost. If sovereign yields in the periphery climb, bank capital impairment would be huge and it would send Europe back into a crisis due to the sovereign – bank entanglement whereby recession weakens the sovereigns revenue and fiscal profile, increases sovereign debt and deficits, increases sovereign bond yields and weakens bank balance sheets. Bail-ins are no panacea here. Just because the sovereign is not formally on the hook for topping up bank capital doesn’t mean that this isn;t a debt deflationary scenario.
I imagine the ECB understands the severity of the situation and in the back of their minds, the talk about deflation and QE is a back door way to forestall this from happening because it means they have an excuse to buy sovereign bonds.
he bottom line here is that the Ukraine crisis is a potentially large economic shock now that it has the potential of becoming bloody. While I have only focused on the eurozone periphery here, the effect will be global.