The Ukraine Crisis part2

The Ukrainian crisis continues to remain vivid on investors’ radar as fatalities on both sides regretfully increase. “We are as close to civil war as you can get,” declared Russian Foreign Minister Sergei Lavrov, early this week and in the same breath he urged both sides to find a peaceful solution.

But with both the US and Russia pointing the blame at each other for stirring up the conflict between the Ukrainian government supporters and pro Russian activists there appears to be no respite in sight to this ongoing crisis.  The USA is pushing its EU allies for greater sanctions against Russia but with the EU’s economy having emerged recently from a severe recession and in a fragile state there is no real appetite for this. Europe’s powerhouse, Germany is not keen on any meaningful sanctions, as it is heavily reliant on Russian oil and gas.       

                                                                                       

Meanwhile, the British are calling for a diplomatic solution to the crisis, bearing in mind that at the centre of Russian oligarch wealth lays British tax havens and multimillion pound London properties. So the British too don’t want to slay the goose that lays the golden egg, certainly not in this fragile economic environment.

Russian leader Putin has probably worked out that he is dealing with the weakest western elite in a generation and he might just be testing how far he can push the redline.  First it was Georgia, then Crimea and still no clear redline from the West so Russia may just keep pushing on for more territory.

Moreover, it is not only Russian expansionism that’s ruffling the USA feathers. Since 2007 Russia has been working on a plan, an Independent Ruble system, a financial system based on Russian resources, its own economy and backed by its own gold reserves.   In other words, a Russian economy independent from the US dollar and the whims of speculators.      “Russia, at its present stage of development, should not be dependent on foreign currencies; its internal resources will make its own economy invulnerable to political wheeler dealers,” said a Russian central bank official.

But Putin may be just too ambitious for Russia, a threat to US supremacy and the powers to be in Washington may think it’s time to topple him. So the economic assault on Russia has begun.

Already capital outflows, money leaving Russia has amounted to approximately $50bn since the start of 2014, this full year figure could be as high as $130bn, according to a Goldman Sachs report.  This net capital outflows in the first quarter alone was more than during the whole of 2013, according to a recent report from Alfa Bank.

On the foreign exchange market the repatriation of foreign capital from Russia represents investors selling Rubles and buying either dollar or euro assets, depending on where they reinvest their funds.                                                                      Additionally, in a climate of geopolitical uncertainty the Russian public is also flocking to what they perceive to be safe haven currencies. For example, the demand for USD rose 48% in March compared with the prior month, while interest in buying euros rose 50%.

The resulting outcome of capital outflows from Russia has been the inevitable depreciation of the ruble, due to the fact that there have not been inflow of capital entering Russia equal to, or greater than the amount leaving Russia.  So the negative net inflow of capital has caused the ruble to topple in value against a basket of currencies. The ruble has already depreciated 6.5 per cent against the US dollar this year

Russia’s economy is heavily reliant on the exports of it natural resources namely its oil and gas, which are priced in rubles. Moreover, about 50 percent of the Russian population is sucking on the state’s teat, employed either as civil servants, teachers, public health care worker, pensioners and people on benefits, all of whom rely totally on the state’s income.  A devaluation in the ruble means less income earned to pay for its large public sector.  A crash in the value of the ruble would see Putin’s budget explode. Perhaps Putin’s great danger is that he may have been budgeting for oil at over 150 USD a barrel at a higher ruble exchange rate to finance public spending   

Furthermore, the private sector is relatively underinvested and internationally uncompetitive. The Russian economy is not in a buoyant state. In 2013, Russia’s economic growth slowed to 1.3 percent, its weakest pace since Putin came to power in 2000.

Russia’s Central Bank would not want to raise interest rates in an attempt to support the ruble because this would choke private business investment by making borrowing costs more expensive, which would not be desirable.

Instead, in a desperate attempt to support the currency the Russian Central Bank decided to sell a record $11.3 billion in foreign currency to buy rubles. But it yet remains to be seen if this policy, in the long run, will be enough to halt the tide in the falling ruble. Will the Central Bank throw in the kitchen sink by selling off their gold reserves to support the ruble?  

If so this could result in downward pressure on gold prices.  

As if a depreciating ruble was not enough to worry the Central Bank, the collapse in demand for Russian debt, bonds has result in falling Russian bond prices on the secondary market and simultaneously pushed up bond yields. Secondary market bond volumes have fallen on the Moscow exchange by 43 percent.

Losses are raking up on funds heavily exposed to Russian assets. Moscow-based Prosperity Capital Management which has $3.3 billion in assets under management fund has fallen 16.2% this year.

As one hedge fund manager put it, “It's a very fast world now," said Nicolas Rousselet, head of hedge funds at Swiss-based investment firm Unigestion.  Funds have a position for "one hour, and you take it off."

Darren Winters

Cold War 'The Sequel'

Crisis In Crimea

The Ukraine crisis appears to be anything but a storm in a tea cup. Not only has this crisis in the Baltic reshaped parts of the geographical map that borders with Russia but it is also unnerving smaller sovereign states bordering with Russia.  No doubt some former Soviet States are probably wondering whether they are going to be next in what is now a growing suspicion of Russia’s expansionary intentions.

The rapid increase in NATO troop movements near Russia’s borders underscores the escalating tensions between Russia and her bordering States. On Saturday 150 US troops arrived in Lithuania at the Lithuanian Air Force Aviation Base in Siauliai, according to Reuters. This recent deployment is part of a larger contingent of 600 troops that have already been deployed throughout Eastern Europe to reassure NATO allies. An additional company of soldiers arrived in Poland on Wednesday and in Latvia on Friday and more troops are also expected to arrive in Estonia today.  Equally, there have also been troop movements on the Russian side.  

Last month NATO’s top military commander expressed concerns about the buildup of Russian troops on the Ukrainian border. “Russia is acting more like an adversary than a partner,” stated NATO’s top commander.

The Ukrainian crisis is already reconfiguring NATO’s armies. Prior the crisis in the Baltic, defense officials held the view that large armies weren’t necessary to fight threats from terrorism, that military spending could be scaled down. In the age of austerity public expenditure on defense is a hard sell to a public weary of tax hikes and diminished essential public services.  

So a bloodless war, a cold war, maybe precisely what western defense makers may need to boost their lackluster sales.  If NATO armies are scaled up it means an increase in manpower that translates to the demand for more boots more rifles and more ships to cruise the seas   and planes to patrol the skies to protect us from the Russians. Even if this fear is illusory it becomes apparent that the defense sectors are going to be big gainers from the Ukrainian crisis.  

A conventional war with Russia would be unlikely-it would be MAD (Mutually Assured Destruction.)  MAD was the military doctrine behind cold war where both sides, the US and Russia, have the capabilities to destroy each other completely in a thermo nuclear war. So through terror, total annihilation, paradoxically we have had no major wars in Europe for the last 70 or so years.

The previous cold war between the West and the former Soviet Union was not only a period of heightened tension between the blocks but also a tremendous amount of competition, which had a huge impact on science and technology.  For example, the space race, the two superpowers competition in space exploration drove a lot of advances in aerospace and rocket technology. The humble remote control device that we all use to change TV stations in many ways owes its existence to guided missile technology.  So maybe a new cold war might also give the science and technology sector a new boost?  

However, there are a number of possible negative impacts that the Ukrainian crisis could have on the world economy.  Firstly, perhaps one of the most apparent fears is that the crisis might spark off of a trade war, which would almost certainly damage the global economic recovery.

Already US leader Barack Obama is planning to levy new sanctions on Russia. The US Presidents is also attempting to increase further pressure on Vladimir Putin, said Mr. Obama. There will be new sanctions on Russian individuals and companies in relation to Moscow’s alleged provocations in the Ukraine. The sanctions would include high technology exports to Russia’s defense industry, according to the US President. Over the previous week the US administration has been spearheading support in Europe for sanctions against Russia.             

But it has been a difficult call because Europe’s dependence on Russian gas means that it is not keen on the idea of sanctions that could deteriorate relations between Russia and Europe. Germany, the most dominant member in Europe is in no mood to rock the boat with Moscow, since it has no natural resources, and almost completely reliant on Russian gas for more than a third of its oil and gas needs.   Note, also that Russia is a large trading partner with Europe, exporting automobiles, parts while Europe imports Russian raw materials and commodities.

In view of the above, it would seem unlikely that Europe would willingly pass any sanctions with teeth.  Nevertheless, the Ukrainian situation is fluid and if the situations where to deteriorate further then Europe may have to come on board with more drastic sanctions.  

Assuming, the worst case scenario, that Russian troops walked into Poland, or say another NATO member, then Europe along with its NATO allies would be forced to take more severe measures against Russia.  Based on the NATO members’ agreement that an attack on one member is an attack on all-this could mean military intervention against Russia.

Assuming this unlikely event occurred Russia could retaliate by refusing to sell its oil and gas to Europe and instead sell it to China. This could have implications on energy security for Europe. Energy dependant countries like Germany would be adversely affected, unless they were able to source new supplies and the likely beneficiary here might be the Fraking industry.

Russia could also restrict grain sales to Europe, bearing in mind that the Ukraine is the bread basket of Europe. The reduction in grain supplies would result in a hike in world grain prices, food inflation for essential products like bread could spark off food riots in already severely economically depressed parts of southern Europe.

Indeed, commodities that do well during an economic and political turmoil would do better than other asset classes. 

In the worst case scenario Europe would be adversely affected, the EU may not survive a worse case scenario, resulting in the possible collapse of the euro.

In times of trouble there is normally a flight to the US dollar, gold and sterling.

Darren Winters