investment insights
Borders, brinkmanship and the Ukrainian stand-off
Lombard Odier Private Bank
Key takeaways
- Tensions between the West and Russia over Ukraine are monopolising headlines
- Diplomatic channels to resolve the issue remain open
- We believe that the confrontation will eventually be diffused with an economic solution, rather than through military means
- Rising uncertainties are already visible in Russian asset prices; any conflict would create a global oil supply shock, driving inflation further and complicating monetary policies.
The US and Russia continue to seek a diplomatic solution to the stand-off along Ukraine’s border. The danger is that any failure to de-escalate leads to an accident triggering a conflict that no-one wants. The confrontation is more likely to play out economically than militarily, with implications across markets.
Last week Russian and US diplomats met in Geneva for a second time this year to discuss tensions over Ukraine. As expected, the meeting did not result in a breakthrough. For now, both sides continue to engage in a dialogue, and exchange rhetoric. Another meeting is scheduled this month, pending a written response from the US. In the meantime, the US has called on the families of diplomats and embassy staff to leave Kyiv.
Russia has built up armed forces close to Ukraine’s northern and eastern borders in recent weeks and denies that it was responsible for a cyber-attack in Ukraine, or plans to overthrow the pro-Western government in the capital, Kyiv. Germany’s new foreign minister Annalena Baerbock, on a visit to Moscow last week said that the Russian troops were there “for no understandable reason,” adding that “it’s hard not to see this as a threat.”
“We will take appropriate retaliatory military-technical measures and react harshly to unfriendly steps,” Russian President Vladimir Putin said on 21 December.
Russia wants commitments from the US and EU ruling out any further eastern expansion. In 2007, then US President George W. Bush said talks should begin on the eastward expansion of the North Atlantic Treaty Organization (NATO) to include former Soviet republics Ukraine and Georgia. Germany and France, both NATO members, have consistently opposed those aspirations.
Russia would prefer a geographic and political buffer free from western influence on its western border. In addition to promises of NATO expansion, the EU has offered increasingly deep economic ties to Ukraine. In 2012, an EU-Ukraine association agreement came into force, designed to improve trade relations. Since Russia imposed sanctions on Ukraine in 2013, exports from Ukraine to Russia have collapsed from nearly USD 18 billion in 2012 to USD 2.7 billion in 2020. Commerce with the EU recovered in 2020 to 23.1 billion euros in goods imports and 16.5 billion of merchandise exports.
‘Minor incursion’
We see three possible scenarios at this stage. First, the continued status-quo thanks to a diplomatic stand-off, second, a limited Russian incursion along the Black Sea coast to build a bridge between the Russian-held Donbas region and Crimean peninsula and thirdly, a wider invasion of Ukraine.
The difficulties of making a coordinated response to Russia were underlined last week when President Joe Biden hinted at the disagreements between the US and its European allies, even on the question of what would constitute an incursion into Ukraine.
After claims that Russia has carried out cyber-attacks on Ukrainian sites, and accusations that Russia is prepared to de-stabilise the government in Kyiv, President Biden told reporters last week that the US expects Russia to invade the Ukraine, adding that “a minor incursion” would split the US and the western allies. “It's one thing if it's a minor incursion and we end up having to fight about what to do and not do,” said Mr Biden. The White House quickly clarified that any incursion would be met with a “swift, severe, and united response,” but the self-evident complications of a joint response were plain.
The stakes for the US are clouded by the polarised nature of politics during a year of mid-term elections. The US looks unusually divided and especially opposed domestically to foreign policing roles after its 20-year intervention and highly public departure from Afghanistan in August 2021. That also means that Russia is wary of commitments that may be overturned by any future change in the US administration.
This is why the Russians have insisted on “ironclad, waterproof, bulletproof, legally binding guarantees,” said Russian deputy foreign minister Sergei Ryabkov after the first Geneva meeting on 10 January.
Is a broad Russian invasion of Ukraine likely? It seems unlikely as it would look like a failure of Russian diplomacy: there is nothing to gain by seizing the Ukraine, an economy that by most measures, is one of the poorest in Europe. Russia already seized the Crimean peninsula in 2014, securing its access to the Black Sea and warm-water ports, after Ukrainians overthrew their pro-Russian government. Since then, military clashes have killed more than 14,000 people.
Sanctions and gas
On 20 January, the US Treasury targeted four Russian-government or Russian-security linked individuals, in addition to sanctions already in place. To date, the Western allies have not cut off Russia’s access to Swift, the international system that facilitates money transfers between banks, including international energy markets. Russia has had time to prepare for such an eventuality.
In the meantime, Russian troops intervened in early January – on invitation - to quell protests in Kazakhstan against rising fuel prices. That resulted in the deaths of 225 people, officially, and around 10,000 detentions.
The stakes for European governments, beyond the threat of armed conflict, are immediate and economic, thanks to Russia’s role as the main supplier of gas to the EU.
The EU response to the crisis looks uncoordinated. Where French President Emmanuel Macron has called for the European Union to renew a separate dialogue with Russia, Germany’s coalition government is divided over whether to open up gas supplies through the new Nord Steam 2 pipeline. Price spikes such as the one witnessed in December are still likely given the record low level of inventories. For now, a relatively mild European winter has meant that gas reserves have proven adequate to meet demand.
The continent is divided over whether to turn on the 1,200 kilometre long Nord Stream 2 pipeline, completed last September. While it would double the pipeline capacity through the Baltic Sea to 110 billion cubic metres (bcm), it would increase the continent’s strategic dependence on Russian energy. The timing is tricky as the EU is struggling with an energy crisis that is estimated to be costing households hundreds of euros extra this year. While each European country will be impacted differently, depending on the mix in its energy supply, in Germany for example, household energy bills are expected to rise by around 50% on average this year.
Russia supplied 43% or 166 bcm of Europe’s total gas imports in 2019, according to Eurostat, the EU’s statistical agency. In comparison, the EU’s second-biggest gas supplier, Norway, provided 23% of the bloc’s needs the same year. In theory, the US could supply more gas to Europe, but that comes from fracking, which has been severely criticized in Western Europe for environmental reasons.
Russia is becoming less dependent on western European buyers for its gas, as China has stepped up purchases in recent years. China, already the world’s biggest gas consumer at 331 bcm, is expected to need 526 bcm this decade as the country scales back its coal dependence. Under a 2014 agreement, Russia will supply gas to China for three decades through the ‘Power of Siberia’ pipeline, opened in 2019. This is expected to carry 38 bcm annually. A second pipeline, to deliver another 50 bcm, is under discussion.
Blueprint and market impacts
If there were a conflict, emerging markets would be the first to feel the impact, as oil prices would immediately rise, potentially benefiting net exporters and damaging the economies of net importers. This could also inflict a global supply shock, driving inflation from already high levels, and complicating central banks’ monetary policy decisions.
While Russia is the world’s third-largest oil supplier, after the US and Saudi Arabia, any confrontation may push foreign investors out of all Russian assets, and create substantial pressure on the rouble.
Market uncertainty about possible additional sanctions, or conflict, is already visible in the value of Russian assets. Since the start of 2022, Brent crude oil has gained 10% to more than USD 88 per barrel and natural gas is little changed at USD 3.92 / mmBtu or metric million British Thermal Units. Despite the oil and gas sector representing almost half of Russia’s stock market capitalization, the Moscow stock exchange has fallen more than 12% year to date, and by almost one quarter from an October 2021 high. In addition, the rouble has declined by almost the same amount against the US dollar and the euro this year, -3% and -2.5% respectively.
Our expectation is that the Ukraine situation will eventually be diffused. There is seven-year old blueprint for diffusing the face-off. Signed in February 2015, the Minsk 2 agreement between France, Germany, Ukraine and Russia, set out a ceasefire, withdrawal of weapons to create a security zone, exchange of prisoners, and then a series of national and local elections within Ukraine to allow some political autonomy in the Donbas region. In return, Russia would withdraw troops from the Ukraine border, and Western powers commit to no further eastern expansion. However, since 2015, Russia has increased its demands to include the withdrawal of any troops deployed to eastern Europe since 1997.
Nevertheless, the conflict is more likely to play out economically than militarily, with Russia absorbing the threat of further limited financial sanctions in return for consolidating its existing 2014 position.
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