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.

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