After weeks of on-off tensions, Russia has commenced hostilities against smaller neighbour Ukraine, sparking off what has been warned might just lead to Europe’s worst conflict since 1945.
In a move taken from tactical playbooks, the attacks began just before dawn. President Vladimir Putin describes the actions as “a special military operation” with the objective of the “demilitarisation and denazification” of Ukraine. According to Ukraine’s interior ministry, missiles struck and artillery fire rained on various parts of the country.
Just a day before, market commentators were still divided on whether Russia would actually go beyond words and posturing. When news of the attacks broke during Asian market hours, the reaction was certain: Panic.
The S&P500 futures were down by almost 2%, Nasdaq futures lost 2.5% and the DAX and Eurostoxx futures lost some 4%. European natural gas futures, meanwhile, surged by 10% while Brent crude spiked above the US$101 ($136.7) per barrel and US crude near that level too. Gold, the traditional safe haven asset class, reached US$1,950 per ounce and US$2,000 seemed within touch.
Regional markets reacted accordingly. The Straits Times Index closed on Feb 24 at 3,274.62 points, down 3.49% and the Hang Seng Index down 3.21%.
In a fiery speech that referred to Ukraine as “ancient Russian lands”, Putin called on the Russian army to maintain peace in the two provinces. “Ukraine has never had traditions of their own statehood,” Putin proclaimed in the 45-minute address, seemingly pouring cold water on the Biden administration’s attempt to call a summit to de-escalate the situation.
See also: Russia resumes Ukraine grain-export deal in abrupt reversal
Current tensions represent the culmination of Moscow’s dissatisfaction with a perceived growth of Western influence in Eastern Europe. Believing that the West had promised no Eastward expansion into former Soviet territories after the end of the Cold War in 1991, Russia sees the increasing integration of Eastern European states into Nato and the European Union as a violation of this commitment. Previous Russian military action in Georgia and Crimea can be seen as pushback by Moscow against this perceived encroachment into its sphere of influence.
“What the US is doing in Ukraine is at our doorstep ... And they should understand that we have nowhere further to retreat to. Do they think we’ll just watch idly?” Putin told military officials last year according to an ABC report. He warned that his administration would resort to an “adequate military-technical response” and “react harshly to unfriendly steps” should the West continue its “aggressive line” towards Russia.
The Biden administration has so far ruled out deploying troops to Ukraine. Speaking at the Munich Security Conference — the city where the UK and France conceded Czechoslovakia to Nazi Germany back in 1938 — Ukrainian president Volodymyr Zelensky reminded the Western powers to avoid a policy of “appeasement” towards Russia. “The question ‘Why die for Danzig?’ turned into the need to die for Dunkirk and dozens of other cities in Europe and the world. At the cost of tens of millions of lives,” he warned, demanding greater security assurances for his beleaguered nation.
See also: Russian Odesa missile strike tests Ukraine grain export deal
But Sara Meger, lecturer in International Relations at the University of Melbourne, was unconvinced that Moscow will initiate a full-scale conflict. Russia is already achieving its objectives — keeping Ukraine unstable and forcing Washington to take its security concerns seriously. If Russia’s main objective is to defend against an expansion of Western military presence into Eastern Europe, a full invasion would be counterproductive as this would prompt the Western powers to heighten military preparedness.
“If the seizure of Ukrainian territory was significant to Russia’s interests, we would have seen an invasion occur earlier when Russia’s military advantage over Ukraine was much greater. If ever there was a time for Russian troops to sweep through Ukraine, 2014 was it,” Meger contends, referring to the year Russia annexed the Crimean Peninsula from Ukraine.
Tina Fordham, partner and head of global political strategy at advisory firm Avonhurst, takes the opposite view. “Over 2,000 cease-fire violations have now been recorded and shelling is intensifying in Donbas. Russia has announced that it is extending the joint exercises with Belarus it promised would end today. The war has already started,” the 25-year Russia watcher claimed in a LinkedIn post on Feb 20.
Inflationary woes
S&P Global Platts anticipates the conflict to have a downward pull on global credit conditions. With the US and European Union expected to impose sanctions against Russia, Russia’s role in the global economy could be diminished. Strict sanctions and retaliation from Moscow, it argues, could “hinder the operations of exposed borrowers”, while a temporary price shock for oil in Europe is seen to exercise inflationary pressures on the global economy as well.
Wellian Wiranto, economist at OCBC, notes that given Russia’s position as a top exporter of strategic commodities such as oil, wheat and metals, interruptions to Russian exports could prove yet another driver of inflation.
The possibility of exacerbating inflation — already pushed to uncomfortable levels because of supply chain disruptions amid the pandemic — is also flagged by Nicholas Daher, lead energy analyst at the Economist Intelligence Unit (EIU). “While Europe is facing sky-high natural gas and electricity prices, oil prices have reached values not seen since 2014 and a US$100 barrel is just around the corner,” he tells The Edge Singapore in an interview ahead of the hostilities. EIU sees oil prices remaining elevated as long as tensions between Russia and the West persist, with prices likely to further rise if invasion occurs.
Demand for such commodities has tended to surge in times of conflict, potentially adding additional pressure for stretched global supply chains. Net importers of these commodities, says Sue Trinh, head of macro strategy, Asia at Manulife Investment Management, could be worst hit by a stagflationary shock that inflicts lower growth and higher inflation. Asia Pacific is the world’s largest net food and energy importer, though the impact of such a shock on the region could be relatively uneven given the diversity of the region’s economies.
However, Wiranto believes that the direct impact on Asia will be relatively limited. Russia, he observes, is not a big trading partner for most Asian economies, so any disruption to trade flows is unlikely to have a significant impact on exports.
Having said so, Asian markets could suffer if investors believe that the standoff in Ukraine will spill over across the continent for a longer period of time. Many are already wary about a significant hawkish swing in the monetary policy of major central banks.
“The risk of a liquidity shock from a combination of demand shock, supply shock, and a flight to safety would expose those vulnerable economies with high debt levels to either a domestic credit or external funding shock,” warns Trinh.
Policymakers find themselves in a catch-22 where they could raise interest rates at the cost of weaker growth or look through higher headline inflation at the risk of capital outflows. While capital controls remain one option, governments could face sovereign credit rating downgrades, smaller capital inflows and lower long-term potential growth.
Mizuho Bank economist Vishnu Varathan warns that despite the geographical buffer, the impact may be both profound and painful for emerging markets of Asia. Firstly, the surge in oil price will drive up inflation, there is also the potential to affect Russia’s coal exports to China, India and Korea. Next, a wider spill-over of risks beyond just sanctions may set off an adverse financial contagion, might trigger capital outflows from the emerging markets of Asia as well, as jittery investors “shoot first, question later” amid an intense global “risk-off” mood.
“Finally, emerging markets in Asia may face consequential strategic ramifications — from an emboldened and largely unchecked Russia, with whom China appears to have deepening ties [and implied military alliances],” says Varathan.
“[This will cast] doubts on US commitment to its key allies [Japan, Korea and Taiwan], which will inevitably accentuate China-Taiwan risks as well as render North Korea as a flashpoint,” he adds. In short, Ukraine is indeed an imminent economic risk and a longer-term barometer of Asia’s geopolitical stability. “It is just not apparent watching from afar now,” says Varathan.
“At this point, it’s impossible to bet on any scenario. We can only monitor closely the latest developments and stand ready for more volatility,” says Ipek Ozkardeskaya, senior analyst at Swissquote.
On the surface, the combined revenue exposure of the S&P500 to Russia and Ukraine is not much — just 1%. However, there are plenty of policy implications — including, crucially, on the US Federal Reserve, and by extension, on global markets. “The rising energy and commodity prices are a growing threat for the US equities as they will put a further upside pressure on inflation and force the Fed’s hand to act more aggressively to tame the inflation.
“But on the other hand, could the Fed go full blast into an aggressive policy normalisation while a war is taking a severe toll on the global growth and the economic recovery? Not so sure. It will sure give Jerome Powell the best excuse to hold fire and soften the market expectations,” says Ozkardeskaya.
She believes that the Fed should also take into account that there is a war disruption to the global economy and tightening policy too fast may not be a good idea, even with the skyrocketing inflation.
In the face of the market volatility, Kelvin Tay, regional chief investment officer at UBS Wealth Management urges investors to "maintain a calm stance and keep a broad perspective, and to build a portfolio robust enough to navigate the Ukraine crisis and rising US interest rates." His recommendation is for them to continue to favour value and cyclical sectors including energy and financials.
The quest for energy security
In any case, the present conflict will undoubtedly lead to much soul-searching regarding energy security in Europe. Considering that Russia supplies 40% of Europe’s liquified natural gas, which includes half of Germany’s supply, Moscow holds significant leverage over the EU should it turn its ambitions further West. Europe’s ability to present a united front against Russia has been hampered by Germany’s desire to retain the Nord Stream 2 gas pipeline bringing Russian gas supplies to Germany, which Berlin sees as key to German industry.
Photo of the Nordstream 2 gas pipe system / Bloomberg
Thane Gustafson, a political science professor at Georgetown University, tells The Economist that it is no longer unthinkable for Russia to wield the “gas weapon” (i.e. cutting off gas supplies) against Europe to compel their acceptance of its adventurism in Ukraine. Yet, Jaime Concha of Energy Intelligence has also told The Economist that a three-month embargo is predicted to cost Russian oil producer Gazprom US$20 billion in lost sales. This would be a severe blow to Russia’s weak economy.
“Gas supply and its impact on other energy markets dominate fears about the impact of an armed conflict in Ukraine. All industrial activity in Europe will feel the effect of higher power prices,” writes Wood Mackenzie vice-president Robin Griffin. The natural resource consultancy firm observes that the relationship between gas and power prices is already playing out in EU markets. Any further shock to the price of gas will likely push electricity prices higher too.
Such concerns will be top of the mind of German policymakers as chancellor Olof Scholz halted the review process for Nordstream 2. The natural gas pipeline would have pumped more than 50% of Germany’s natural gas consumption from Russia while bypassing Ukraine, saving Berlin more than US$2 billion in transit fees. Still, Kateryna Filippenko, principal analyst, global gas supply, at Wood MacKenzie, says that Europe will still have just enough gas to get through 2022.
But 2023 could pose more serious challenges in the face of declining indigenous gas production and lower gas supply availability for Europe. Filippenko says that the continent could face difficulty refilling its storage to a comfortable level through summer 2023 with an eye towards winter. “Europe would be exposed to weather dynamics throughout next winter ... Only through increased flows from Russia the situation could ease,” she remarks.
Even if the conflict were to end, energy prices are seen to remain high. “A peaceful resolution of the conflict will remove upward pressure on energy prices, but we do not expect a rapid decline of those as the tightness on energy markets, despite being incentivised by the conflict, has roots that are external to the security situation in Europe,” Daher says.
