Russian Risk Rising

Sanctions' Effects on Russian Markets. Source: WSJ

Sanctions’ Effects on Russian Markets. Source: WSJ

There are between 25,000 and 35,000 Russian troops amassed on the border with Ukraine, just a few hours’ unhindered drive from Kyiv, Ukraine’s capital. Last week, Putin sent a very strong signal about his intentions to invade the rest of Ukraine, but only to those who could hear it. There are two ways to say ‘Russian’ in their language: one way, “Rossisskii,” is used to describe any citizen of Russia regardless of their ethnicity. Mongols, Chechnyans, Russians and Ukrainians can all be “Rossisskii” if they carry a Russian passport.  And that’s how Putin always referred to citizens of his country, until last week. He suddenly switched to using “Russki,” the form that means ethnic Russian. He called Crimea primordial ‘Russki’ land and its main seaport, Sevastopol, a ‘Russki’ city. Most telling, he actually said Ukraine’s capital, Kyiv, is “the mother of Russki cities.” As this Washington Post article points out, this must have grated on the ears of any Ukrainian listening, as it was a revisionist reference to Kyiv’s role as the capital of the ancient Rus’ civilization. Peter the Great, the ruler of what was then the country of Muskovy, wanted to improve his country’s reputation by bolstering its historic credentials. He decided to rename his country by starting with Ukraine’s ancient name of Rus’ and adding a few letters. It caused an uproar among Muskovites at the time, but Peter prevailed and claimed his neighboring country’s richer and far more ancient heritage for his own. This Identify Theft would prove decisive in helping Peter establish his newly renamed country on the European stage. Peter stole Ukraine’s history and name; Putin now aims to take her cities.

Just a few days ago, NATO’s Supreme Allied Commander Europe said “the (Russian) force that is at the Ukrainian border now to the east is very, very sizable and very, very ready.” For their part, Ukrainian troops have begun digging anti-tank ditches and have placed giant jax-like concrete tank-blockers near the border. Today, the Ukrainian government started broadcasting messages preparing people for the likelihood of a massive invasion in the coming days.

The US and the EU have already levied sanctions for Russia’s actions in Crimea, and have threatened more if Russia pushes further. So far, the sanctions target those in Putin’s inner circle and include visa bans and asset freezes that have even impacted credit card transactions. Because significant equity in Bank Rossiya and Sobinbank is owned by those on the US sanctions list, MasterCard and Visa have stopped authorizing transactions for credit cards issued by those banks. In Brussels today President Obama said that Moscow must consider “the potential for additional, deeper sanctions” if it pushes further into Ukraine. He went on to say “we recognize that in order for Russia to feel the impact of these sanctions, it will have some impact on the global economy as well as on all the countries represented here today.” Just a few days ago US Energy Department said it would permit exports of liquefied natural gas from Oregon to help European nations struggling with supporting further sanctions because of their reliance on Russian energy.

The market has not been kind to Russia in the past few weeks, as this Twitter post from the Wall Street Journal shows: equity markets down 13%, interest rates up about 150 bps across the curves, and the Ruble continuing to fall. In addition, Russia has admitted that it expects between $65B and $70B of foreign capital to leave Russia before the end of March!

If Russia does indeed invade more of Ukraine, we expect significantly more in terms of sanctions and capital flight. As I pointed out in an earlier post, it’s easy to be fooled into thinking that since a portfolio has no direct exposure to Russia that it won’t be affected by these events. In reality, many countries, including Germany, are significant trading partners of Russia’s and their equity and fixed income markets would certainly suffer from contagion.

Stress Testing is a good way to simulate possible market effects of materially increased sanctions or even open warfare. As I pointed out in the last post, modeling would include spikes in energy prices and agriculture products. I think moves of 10% to as high as 50% are not out of the realm of possibility, depending on how the political and military situation plays out. Also be sure to stress correlations quite high between Russia and its main trading partners – Germany, Italy, and France to a lesser extent. Contagion to the interest rates and bond prices in Russia’s largest trading partners should not come as a surprise to anyone. “Flight to Safety” of capital out of Russia in excess of the $70B already expected in the coming weeks would also be reasonable. In a full military escalation to open warfare coupled with seriously increased sanctions, prudent managers would also simulate a collapse of the Ruble, hyper-inflation and a modern Russian default.

Late on March 26, CNN reported that US Intelligence analyst say there’s a greater likelihood of a Russian invasion than previously believed. The House Armed Service Committee, when it learned of the report, sent a classified letter to the White House expressing concern. An unclassified version of this report said members feel ‘urgency and alarm’ about the information now in their possession.



Russian Ruble Risk Redux

Ukraine Pipeline

Gas pipelines from Russia through Ukraine

Putin’s Ukraine Gambit is reverberating through the markets: Monday, the first trading day after Russia’s invasion of Crimea, the Russian Micex stock index was down 11% representing a drop of about 80B USD. The commodities in play are Oil, Natural Gas (both of which Russia exports), Corn and Wheat (both which Ukraine exports). The Ruble, the Euro and the German Bund are also at risk. It’s not just the supply of the commodities that may lead to a rise in their prices – there’s also a real chance of economic sanctions being imposed on Russia by both the EU and the US, which expressed the possibility of economically “isolating Russia”.

According to the Telegraph, Monday’s emergency meeting of EU foreign ministers shows important divisions in countries’ willingness to impose sanctions on Russia: eastern European countries led by Poland and Lithuania called for strong sanctions but Germany and Italy, both of which import a lot of Russian gas, wanted to soften the message. The EU delayed any decisions about expelling Russia from the G8 until Thursday. They gave Russia until then to return all of their forces back to their base in Crimea or face sanctions like visa restrictions, arms embargoes and asset freezes. Should Russian troops still be occupying Crimea come Thursday, we should expect to learn from the strength of the EU’s sanctions just how important Russian gas really is to Germany and Italy. But US Secretary of State John Kerry said on the Sunday morning talk shows that the US is prepared to sell Europe Natural Gas to make up for any diminished supply due to any sanctions that are imposed. The US finds itself energy rich, and wants to use that leverage in its foreign affairs efforts.

Ukrainian Flag

The bottom half of Ukraine’s flag represents the country’s wheat fields

According to the NY Times, Germany imports 24% of Russia’s Natural Gas exports and Italy imports 11%. It points out that Germany has a 6% trade surplus with Russia but that it gets about 75% of its gas and oil from Russia. Current European stockpiles of gas is high – about 2 months’ worth, enough to take them through the remainder of the winter. Ukraine’s agriculture exports are significant: it is the fifth largest wheat exporter and the world’s third largest corn exporter. Archer Daniels Midland and Bunge having large operations in Ukraine. Ukraine’s flag pays homage to its nickname “The Breadbasket of Europe” – the yellow bottom half of the flag represents the flowing wheat fields found throughout the country. Any war in Ukraine would seriously disrupt that distribution, as most of the farmland is in the Eastern part of the country, near Russia.

Back in 1998 before the Ruble collapsed, many investors believed themselves to be insulated from Russian risk by investing in German stocks, only to find a high correlation of the Ruble with the DAX, which suffered at 37% drop in 1998 from which it too over a year to recover. Other markets, like the US and Japan, has losses of about 20% and took only a few months to recover. Today, Germany is still highly dependent on Russian exports, so we should look for any impact on Russia – whether through sanctions or because they decide to attack – to reverberate through the German markets.

Stress testing this situation includes modeling spikes in energy prices and agriculture products. I think moves of 10% to as high as 50% are not out of the realm of possibility, depending on how the political and military situation plays out. Also be sure to stress correlations quite high between Russia and its main trading partners – Germany, Italy, and France to a lesser extent. Contagion to the interest rates and bond prices in Russia’s largest trading partners should not come as a surprise to anyone.

On the upside, if Russia does back down and withdraws its military threat, look for a new more democratic and European leaning trading partner to emerge in the coming years. The EU announced a $15B loan and grant program today and is eager to sign the previously stalled EU Association Agreement with Ukraine, whose new government is equally eager to sign. As the largest country by area in Europe (yes, Ukraine is slightly bigger than France) with a highly-educated population of 46 million people, if Ukraine is able to adopt real democratic reforms and European business practices, the business landscape on the Continent could look quite different a decade from now.