Russia’s military aggression against Ukraine, which has become Europe’s largest ground war in generations, has impacted millions of people and triggered a large-scale humanitarian crisis as vulnerable Ukrainians take shelter or flee their homes. The intensification and spread of the conflict is deeply troubling and is having a devastating impact on those people caught in the crisis.

This article focuses on potential market and economic implications of the conflict.

Introduction

The events that are unfolding in Ukraine are deeply upsetting and one cannot help but be affected by what we are reading and seeing in the news. Investing in the midst of a conflict can be difficult and bring out heightened emotions. In the context of these heightened emotions, it is helpful to stand back and assess the situation. The escalation of conflict in Russia/Ukraine has led to a spike in risk aversion and large move in risk assets. Recent history suggests that the move in risk assets tend to be highest in the early days, when uncertainty is at its peak, but that the majority of geopolitical crises have not led to long term changes in investing in fixed income. That said, there seems to be a risk of a more significant derailment with the current conflict.  In this note, we look at how Russian assets have performed during previous periods of geopolitical tension and also how differentiation may play out within EM, especially given surging commodity prices.

Impact on Russian assets

In looking at the magnitude of the sell-off in Russian assets, we can compare the current period (year-to-date to 28 February) to four other periods of geopolitical instability in Russia: (1) “Crimea annexation” (Feb – Apr 2014), which covers Russia’s annexation of Crimea and sanctions by the US and Europe from March 2014, (2) “Crimea sanctions” (Jun – Jul 2014), which covers the run-up to the imposition of further US and EU sanctions, (3) “April 2018 sanctions”, which covers US sanctions on Russian oligarchs and their companies and Russian officials, and (4) “August 18 sanctions”, which covers the imposition of US sanctions on Russia in response to murder of an ex spy in the UK.

As can be seen in the chart above, the current sell-off in hard and local currency debt and the exchange rate is significant compared to other periods of geopolitical risk in Russia, unsurprising given the gravity of the situation. 

While Russia’s economic fundamentals are solid (fiscal and current account surpluses, no need to borrow externally, high foreign reserves etc), the developments over the weekend (26/27 Feb) including restricting the access of some Russian banks to SWIFT, are likely to have a major impact on the economy. The SWIFT sanctions will likely prohibit the Russian central bank’s (CBR) ability to sell reserves to stabilise the currency as roughly 50% of the central banks holding are denominated in euros (~30%), US dollars (~15%), and sterling (+~5%)¹. As a result, the CBR is limited in ways to support the currency. This will also have an inflationary impact.  At the time of writing, the currency has weakened around 30% year-to-date (YTD). Using a historical pass-through coefficient of 10%, would imply roughly 300bps of additional inflationary pressure to the central bank’s inflation estimates².  The CBR hiked interest rates by 20% this morning (28 Feb)³ and we could see further rate hikes to slow down dollarization and deposit withdrawals.

While sanctions against Russia only prohibit the secondary trading of new debt, Russia’s counter sanction (banning brokers from selling securities by non-residents) might have an impact on the servicing of debt and Russia may end up excluded from the main indices. Russia’s willingness to service external debt may also change as a “counter sanction”.

Impact on the rest of EM

EM countries will be impacted by the conflict through a number of channels of impact including through commodity prices, direct trade links and market sentiment. 

Russia is the largest exporter of natural gas and the second-largest exporter of crude oil and petroleum products and as a result of the conflict, Brent oil prices have crossed USD100/bbl for the first time since 2014⁴. Both Russia and Ukraine are important food commodity exporters and with Russia and Ukraine accounting for roughly 30% of the world’s wheat exports, wheat prices are at decade high levels⁵. EM countries tend to have a larger share of food in their consumer price index (CPI) baskets and so higher food prices will hurt EM quite broadly, but the impact of higher energy prices will be more uneven. Higher oil prices can exacerbate external funding needs (although EM external balances are quite broadly in a decent position at the moment), while adding to inflation (which may also end up under pressure from weaker exchange rates). The chart below shows that the key beneficiaries of higher oil prices are Russia, Venezuela and Ghana while the largest net oil importers are Ukraine, Hungary, South Africa, India and Poland.

Barclays Research estimates that every USD10/bbl increase in oil prices will add 0.7 percentage points of GDP to Turkey’s and South Africa’s import bills. Meanwhile, they estimate Hungary, Poland and Turkey’s inflation rates to be lifted by 0.7 percentage points for every USD10/bbl increase in oil prices, with Turkey likely to take the worst hit from a GDP growth perspective⁶.

The mix of upside risks to inflation and downside risks to growth may lead to a re-assessment of monetary policy, either to become more hawkish or more dovish, depending on the central bank, but also how long lasting the impact is. There are clear regional differences across EMs – Asia has yet to hike as inflation has stayed benign, CEMEA has delivered hikes though real rates are still negative (both ex post and ex ante) and Latin America has already front loaded the cycle.

Trade with Russia is another route through which EM countries will be impacted, especially with the SWIFT sanctions. According to the Russian Federal Customs Service, Russia‘s top trading partners last year (January-October 2021) were China, Germany, the Netherlands, the US and Turkey. The CIS and central and Eastern European region are also significant and are heavily dependent on commodity exports from Russia. Trade with China may still be able to continue if settled in the Chinese yuan. 

Market sentiment can also be significant. Within FX, Central and Eastern European currencies generally seem to be the most affected given their geographical location and use as regional hedges, along with the higher yielding EMEA countries such as Turkey. Latin American currencies appear relatively resilient and the commodity exporting countries in the region should benefit from an improvement in the terms of trade. 

The uncertainty and risk off environment are likely to be negative for EM FX quite broadly in the near term, but after that, contagion should remain fairly limited given that positioning is quite light within EM as a whole, EM central banks are generally ahead of the curve and EM fundamentals are relatively strong.  Fiscal deficits remain higher compared to previous EM peaks, although public debt levels are still well below developed market levels and remain manageable. Meanwhile, external balances have improved across many EM countries. Pandemic-related restrictions impacted domestic demand more in EM compared to DM as developed markets were able to deploy large scale fiscal stimulus, while undervalued exchange rates also helped EM countries’ competitive positions. EM central banks have been proactive in hiking rates relative to DM central banks – despite weak domestic conditions, helping to keep inflation under control. 

Goldman Sachs compares how a wide range of EM assets have traded YTD in 2022 (the y-axis of the chart) with the average across the historical periods of geopolitical instability. 

Although the YTD returns cannot isolate the current conflict (there was a sharp rise in rates earlier in the year), the data shows that the EM assets that have been resilient YTD have generally tended to be (i) high-carry, (ii) commodity-exporting, and (iii) geographically distant from geopolitical volatility.

Conclusion

The weakness in Russian assets relative to other periods of geopolitical instability in Russia seems to make sense given the seriousness of the current situation. The situation remains fluid, but the new sanctions announced over the weekend will be very damaging for Russia and we see significant downside risks to Russian bonds. On a positive note, contagion to the rest of EM compared to previous risk-off periods should be weaker as positioning is fairly light within EM debt, most EM central banks are ahead of the curve in fighting inflation and EM fundamentals are relatively strong. 

 

1. Source: Central Bank of Russia (which publishes reserve composition to June 2021) and Capital Group estimations. 

2. Source: Capital Group

3.Source: CBR. As at 28 February 2022

4. Source: Bloomberg. As at 28 February 2022

5. Source: Agriculture and Horticulture Development Board. As at 28 February 2022.  

6. Source: Barclays Research