In addition to the profound impact on people in Ukraine and around the world, Russia’s military action has wreaked substantial havoc on the financial markets, and will continue to do so in the coming days and weeks. The Russian equity markets have been badly damaged, as has the ruble. The Central Bank of Russia (CBR) more than doubled interest rates to 20% and the government imposed capital controls. As sanctions take hold in the coming days, the full bite of this conflict will begin to work its way through the global economy. Expect uncertainty to remain elevated.
Most global consumers will feel the short-term impacts of this situation in the form of higher heating bills, higher fuel prices and a scarcity of certain goods, like cars and semiconductor chips. Given Ukraine and Russia’s strategic importance for the world’s fuel supplies, it is not surprising that Brent oil prices–and the price at the pump–are up. In the EU, natural gas prices have risen sharply. It is likely that these prices will remain elevated until resolution is reached, with EU residents and businesses suffering disproportionately harder that the rest of the West.
In the absence of further government intervention–which is almost certain–Americans will see even higher prices at the pump and higher costs for home heating oil. And although it may be helpful that a cold winter is drawing to a close in much of the country, the March travel season and the return to work in many states will keep gas prices high, with knock on effects for the transportation and shipping industries.
The Federal Reserve (Fed), European Central Bank (ECB) and Bank of England have all turned markedly more hawkish in recent months but may have to reverse course to avoid pushing their economies into recession. Central bank balance sheets may need to expand again rather than tapering purchases. The Fed will likely have to reopen swap lines with foreign central banks and may have to remove limits from its Standing Repo Facility to ease short-term spikes in the repo market.
Given the high degree of uncertainty, we will watch closely how the imposed (and future) sanctions will influence the course of events. Readers should continue to monitor them in the coming weeks.
Energy: Expect that continued price rises and remedial measures will strain other parts of the global economy, especially sea-based transportation. The “felt” impact of fuel will likely drag on consumption, even in the U.S., which is a net energy exporter.
Natural gas and oil prices have been rising for weeks as Russia amassed troops on the border of Ukraine. Europe is, by far, the most exposed to energy price fluctuations, importing roughly 40% of its natural gas from Russia. Europe was already suffering both from limited inventory and elevated prices for natural gas and oil due to a multitude of factors, including chronic underinvestment in storage and weak wind off the coast of Germany this summer. The U.S. has arranged contingency supplies from the U.S., Canada and Qatar, but Russian supplies cannot be completely replaced. Transactions for energy have been exempted from the sanctions, but this may not remain the case if Russia escalates further. If Russian banks are also excluded from SWIFT for energy sales, natural gas and oil price will climb further. And should it become apparent that there are attempts to evade sanctions through energy sales, western governments will likely impose even more stringent limits.
Higher energy costs will continue to feed through into higher inflation and risks pushing the eurozone into a recession. Having taken a hawkish tilt at its February Governing Council meeting, the ECB will likely have to reverse course and wait longer to normalize policy. A downturn would generate bankruptcy opportunities in the EU and may engender new M&A activity. A contraction in Europe could also drag on external demand for the U.S. as higher oil prices drag on consumption.
Higher energy costs and weak demand risk pushing the EU and the U.S. into stagflation, leaving their central banks stuck choosing between supporting growth or leaning against inflation. The EU in particular has learned its lesson that it must diversify energy sources away from Russia. This will provide a significant boost to ESG assets in Europe.
Other commodities: The automotive industry will suffer, as will industries relying on semiconductors and batteries. Global food production could also be impacted.
Russia and Ukraine supply one-third of the world’s wheat and a significant amount of the world’s fertilizer, both key for global food production. If prices spike or supply is constrained, there could be social and political implications, particularly in the Middle East.
With almost a tenth of global aluminum production and more than a tenth of nickel in play, there may be far-reaching industry impacts for auto manufacturers, semiconductor supplies, and consumer electronics using batteries. Most lithium-ion batteries rely on nickel and Russia accounts for 40% of the world’s mined palladium production, a key input for catalytic converters and chips. With global auto manufacturers already suffering from chip shortages, the conflict will create more pain for industry and consumers.
More risks for chipmakers and advanced technology firms: The most significant U.S. export controls will add risk to companies dealing in advanced technologies that involve U.S. inputs.
The U.S. imposed sweeping export controls on technologies critical to Russian aerospace, defense, quantum computing and artificial intelligence. A blanket ban on the export of American technology to Russia will be incredibly difficult to implement given global supply chains in which each actor has little transparency on the origins of inputs along the way. This introduces new risks to companies, which must be careful to assess that their trading partner is not, in fact, a front for a country with which they are prohibited from dealing. As already highlighted, the global shortage of semiconductor chips and batteries are likely to be exacerbated by the Russia and Ukraine conflict as well, dragging on manufacturing and causing supply chain disruptions.
Financial services: Limited Russian access to SWIFT will persist but Russia’s financial services will be paralyzed and cryptocurrencies will likely become riskier, requiring increased due diligence by counterparties to crypto transactions. Expect a highly dynamic enforcement environment, with western countries taking additional steps as they observe the Russian Central Bank’s activities.
With most of the world’s business done in U.S. dollars, the U.S. sanctions on Russia’s banking system are severe, shutting Russia’s two largest banks out of international dollar clearing. The UK and EU imposed sanctions on Russian banks as well, limiting access to euro and pound funding.
The U.S., EU, UK and Canada agreed to block some Russian banks from using SWIFT, the communications system that facilitates most of the world’s inter-bank transactions. This does not mean that these banks cannot engage in financial transactions, but it does make it more difficult and cumbersome for them. The sanctioned banks could eventually use China’s International Payments System (CIPS) for renminbi transactions, though so far it too has been using SWIFT for communication.
Crucially, energy has been carved out of the sanctions, such that either banks that settle many energy transactions will be exempted or energy-related transactions will be exempted. The exclusion of all Russian financial institutions from SWIFT is unlikely. Doing so would speed development of a SWIFT alternative, and potentially complicate inter-bank transactions in a risky way.
The U.S. and its allies have also announced sanctions on the Central Bank of Russia (CBR), banning any transactions with it. The U.S. has also banned transactions by Americans or U.S. companies with the Russian sovereign wealth fund and finance ministry. The sanctions on CBR should render most of Russia’s USD$630bn in foreign exchange reserves unusable. There will likely be active, regular, and dynamic blocking of new parties as western countries share intelligence on CBR activity. Expect an extremely fluid enforcement environment here for at least several weeks.
It appears that the impact on the Russian financial system and economy will be severe. There are already bank runs underway in Russia, capital controls have been imposed and the equity market did not open the first trading day after the most stringent sanctions were announced. The ruble is likely to continue depreciating significantly, driving up inflation in Russia. Imports (excluding energy) will be extremely difficult to finance. The implications for the global financial system are highly uncertain and will remain so for the foreseeable future.
If Russian banks without access to SWIFT are unable to receive payments, they are also unable to make them, which could cause a series of cascading defaults. Furthermore, a number of the CBR’s foreign exchange reserves may be tied up in USD FX swaps. If Russia cannot sell or redeem those swaps, they could default, creating a market event in the U.S. To alleviate these potential outcomes, the Fed is likely to reopen swap lines with foreign central banks and remove limits on its Standing Repo Facility to address liquidity in money markets.
Market watchers should observe cryptocurrency prices closely in the coming days, and counterparties to cryptocurrency transactions must exercise extreme care, as it is possible that such currencies could be used to attempt to subvert sanctions. If that happens, expect hasty actions by western governments on cryptocurrency regulation. Organizations accepting cryptocurrency from counterparties should prepare to conduct additional diligence on the source and lifecycle of the payments they receive.
Defense Spending: As one would expect, war tends to drive defense spending up. Domestic political support for Ukraine throughout the west may overcome a post Iraq and Afghanistan desire to reduce spending, though, particularly in Europe.
The German government has agreed to establish a 100-billion-euro defense fund and to spend at least 2% of GDP each year on defense by 2024, in line with a NATO target that Germany has consistently missed. Defense spending will rise significantly across Europe, at a time when the EU is currently reviewing its fiscal rules. It is too early to predict how the rules might change, but defense spending and the green transition could push even the fiscal hawks into loosening their purse strings over the next decade. Defensive cybersecurity spending will likely increase significantly as well.
Keep an Eye on the Rest of the World
Until a détente or terminal escalation of the conflict is achieved, disruption will continue to increase and all who engage in transactions that have a counterparty in Russia are at risk.
The West has weaponized finance in response to Russia's war on Ukraine and the financial and economic impact on Russia will be severe. Developments are incredibly fluid and no outcome is certain. With Germany pivoting on its foreign policy and the U.S. and its allies displaying solidarity, the geopolitical system may be shifting. As of this writing, it is clear that western countries have the political support they need to continue a campaign of punishing sanctions. As gas prices rise in the U.S., energy prices rise in Europe, and a frail supply chain gets stressed further, this political support may erode.
With the world’s attention focused on Europe, traditional areas of geopolitical conflict must not escape close scrutiny. China, Taiwan and Japan will continue conducting business delicately in the South China Sea while the U.S. and its allies focus on Europe. Now is the time for business leaders to take a broad, high-level view of the world – not just of Europe and Russia.