Macro Bytes: What next in Russia’s invasion of Ukraine?

Luke Bartholomew 00:06
Hello, and welcome to Macro Bytes the economics and politics podcast from abrdn. My name is Luke Bartholomew. And today I'm joined by my colleagues, Edward Glossop, our emerging market economist and Bob Gilhooly, our senior emerging market economist, as we talk through some of the consequences of Russia's invasion of Ukraine. Now, of course, as I say, we are a politics and economics podcast so that will be the main lens through which we think through some of these implications. But first and foremost, I should say that this is ultimately a humanitarian disaster and our thoughts and sympathies are with those that are affected by these terrible events. So, Ed perhaps if I turn to you first. You were on the podcast a couple of weeks ago, on what turned out to be the very eve of the invasion. I think it's fair to say quite a lot has happened since then. We're sitting here on the seventh of March, as we record this. So, can you give us an update on where things stand at the moment?

 

Ed 01:08
Yeah, sure. Thanks, Luke and I just wanted to your sentiments around the crisis, the human tragedy, but Luke, as you say, it does fall on us to assess the macro and political implications. So, at the time of recording on the seventh of March, there are a few developments to highlight. So, first is unfortunately, the conflict shows little signs of abating. It is very difficult to get accurate information about developments on the ground. There are certainly suggestions that Ukraine is putting up a stiff resistance, and that Russia's military progress has perhaps been slower than it may have anticipated. But it's far from clear that Russia's military is running out of steam. So, I think that's where we are to date. You know, with the caveat that we have very little visibility about what's happening on the ground in terms of accurate information. Perhaps the most significant developments since we last spoke a few weeks ago, has been the aggressive round of sanctions imposed by the West on Russia. So, there are a whole host of sanctions that have been imposed ranging from individual asset freezes to bans on secondary trading of Russian government debt to restrictions on Russian imports. There are two measures that are perhaps the most significant and have grabbed the most headlines. The first is SWIFT sanctions, sanctions on SWIFT, the Belgian entity, which is the Society for Worldwide Interbank Financial Telecommunications to give it its full name, the US, EU and allies have agreed now to remove seven major Russian banks from the SWIFT messaging platform, effective from 12th of March. And that includes VTB Bank, which is a very large Russian bank, though not yet Sberbank, and Gazprom, which are two major Russian banks that undertake a large share of energy-related transactions. So, this is where the energy carve out, comes in the people speak of. So how damaging will these be I mean, in theory, any form of messaging such as email, or telephone could be used instead of SWIFT, but it would clearly be far less efficient and reliable, and kind of notwithstanding a general reluctance to engage with Russia, western banks would be unlikely to agree to using such alternatives. So I think that's the key - it's probably going to cut off Russia make it much more difficult for Russia to transact with the rest of the world by trade and investment capital flows. That's the first and the second major sanction is on Russia's central bank. So western powers US, UK, Germany, France, Italy, Canada and Japan have agreed to impose sanctions on Russia's central bank, which is a fairly unprecedented action. I can only think of Afghanistan, where, another central bank that has been sanctioned in the past by the west, but it's fairly unprecedented action. And this limits Russia's central bank's ability to deploy its international reserves. So, Russia's central bank has very large reserves of about 630 billion. But now, a large share of these - estimates around 50% or so will essentially, it'd be difficult for these to be liquidated. And as a result of that the Russian ruble has fallen very sharply by about 30% since those measures have been imposed, and the central bank itself has suggested that it's been unable to intervene in FX markets. So, they are the two major sanctions that we have seen so far.

 

 

Luke Bartholomew 04:53
Great, thanks, Ed. So

Bob, maybe if I bring you in here and perhaps useful to provide a little bit more context about what the central bank reserves are that people are talking about. Because I think Ed's right, this is a pretty unprecedented action that we saw. They were not expected I don't think by many people in terms of the sanctions that the West may put in place, you know, so what is it that's being sanctioned? And why is this so significant?

Bob 05:19
Yeah, thanks. I mean, they're effectively, reserves are sort of effectively an insurance policy to help guard against currency stress and currency crises. So in effect, you know, the west is kind of nullifying that insurance policy. Reserves typically take the form of foreign currency or government bond holdings by the government, especially US dollar holdings, given the liquidity advantages that brings in the global financial system. I mean, large balances are particularly important for countries in fixing exchange rate, but they also help to lean against pressure, even if exchange rates are largely market determined. So, for example, currency depreciation, pushes up on inflation by making important goods more expensive, therefore making the central bank's job harder. So, in some situations, they may want to lean against this and clearly also, the larger the balances you have, the less likely you are to suffer a speculative attack that could you know, in the extreme become potentially self-fulfilling. It is also worth saying, you know, there's a kind of political as well as technocratic dimension to all of this, you know, there is a cost to lending money, say to the US, vis-a vis what you could do with it domestically. Avoiding the need to go cap and hand to the IMF whose lending comes with strings attached is one reason why we've seen reserves rise, notably across emerging markets, since the Asian financial crisis in the late 1990s.

Luke Bartholomew 06:44
Okay, I think that's very useful context. And I like that phrase that it's the insurance policy for a lot of these countries. So Ed if that insurance policy is ripped away through sanctions, and indeed, having been turned off from the SWIFT payment system, can we talk for a little bit about some of the effects of all this on the Russian economy? You mentioned, what was happening to the ruble there, but in terms of sort of what we're expecting from those financial markets and the economy itself? Any observations?

Ed 07:13
Yeah, sure. So I think there already seems to be a very large impact on Russia's economy from the sanctions, for example, the widespread reports of large queues outside ATM machines, that the central bank has imposed various FX restrictions. So capital controls, light capital controls, in order to try to ease the pressure on the ruble in the absence of its ability to deploy FX reserves. And we've seen, you know, lots of stories of people having difficulty using debit credit cards because of the SWIFT restrictions. And so this is likely to result in a very steep contraction in GDP combined with the sharp drop in in trade, too. So we in the research team, have currently penciled in a decline in GDP of around 3.3% this year - and that's roughly in line with the drop seen in the COVID shock, but a little bit more mild than in 1998, in the default in 1998, and the GFC in 2009. But there is a lot of uncertainty about how large that fall will be - and that fall would be very substantially deeper, if we were to see energy-related sanctions, which looks like it may be an increasing possibility.

Luke Bartholomew 08:32
And in terms of that uncertainty, not just around the economy, but also the course of the invasion itself and the geopolitical consequences around that, perhaps some thoughts on how things might develop around there? Maybe I'll start off by asking you what's the best-case scenario from where we are, as you see it?

Ed 08:50
Yeah, I think that probably the best-case scenario, or the least bad outcome from this, maybe at least over a kind of one to two-year period, maybe that Putin comes under, you know, substantial domestic political pressure. And he is eventually ousted, because of kind of miscalculations around the whole conflict. You know, so there are suggestions that there has been a military miscalculation that perhaps Russia had expected to have taken major cities by now. And that hasn't happened because the Ukrainian resistance has been stronger. And so there is a theory out there that Putin could be ousted due to a palace coup, or popular revolt, or perhaps both. And we find this scenario, somewhat unlikely. Because I mean, Putin appears to have purged many of the more moderate figures from his inner circle anyway and become much closer to the military. But of course, widespread repression suggests that any popular revolts may struggle to gain momentum. There are kind of other slightly more positive scenarios like a neutrality deal, which would be better - in the spirit of Finland's position during the Cold War, or kind of a partition - de facto partition - down the middle of the country, if Russian forces are forced to retreat back towards the, towards the east. I think both of these scenarios present challenges. We suspect the Russian military may have more, may have more to go, more gears to go through, and history suggests clearly that Putin is very willing to use these if necessary. You know, with severe western sanctions already imposed, there is arguably little deterring Putin until he has achieved his political goals. In terms of kind of more probable scenarios or scenarios that we find a little bit more likely, the puppet government scenario is our base case. So effectively, this involves, you know, Russia embedding, embedding key personnel into the Ukrainian military in order to establish law and order and perhaps occupying the country for a period of time, in order to install a puppet government similar to similar to how Belarus has evolved. There are of course challenges to this scenario, as well. In particular, it is not guaranteed that Putin would be able to establish law and order with a temporary occupation, and it may turn into a very messy, long term occupation of the country, which clearly is probably not what Putin wants. And then that brings you back to perhaps the partition scenario, which I mentioned earlier. But as things stand, we think this is probably the most likely scenario, even if we have very low conviction on this. It's kind of finally worth noting that the most negative downside scenario we have in our analysis is that Putin attacks NATO members. We still judge this as a very low risk. You know, it's not clear that Putin would risk a major war with the US that Russia could not win. And Putin's inner circle and allies perhaps like China, or you know, more Russian sympathising countries, like China would presumably see this as a major overstep. You know, with Putin become increasingly risk tolerant and radical, we still feel like it is a non-negligible risk.

 

Luke Bartholomew 12:23
Okay, thanks. So,

Bob, maybe if I bring you back in now, and we expand the conversation a little bit. But first, perhaps just to talk about some of the economic consequences outside of Russia, and Ukraine itself. Obviously, we've seen this huge run up in energy prices, further supply chain disruptions in a global economy that's already hit by many imbalances and inflation pressures. I mean, how are we seeing the impact of this on the global economy more generally, and how policymakers might react to it?

Bob 12:56
Yeah, I mean, partly related of course to the fog of war, that Ukraine has created, you know, our uncertainty about how this all plays out to the global economy, is, you know, very high too. The implications of the Ukraine crisis, you know, the sanctions that we've seen to date, but also the reactions of oil, gas, agricultural commodity markets - and think it can kind of be best viewed through the prism of the kind of inflation challenge that was already facing the global economy even before the Ukraine crisis began. And you know, given the Federal Reserve and other central banks are playing catch up, having been kept wrong footed by the strength and persistence of underlying inflation, we're kind of viewing this as the Ukraine crisis effect only making it tougher to kind of look through the increase in energy and commodity prices and inflation is clearly so far above target. Indeed, you know expectations for tightening by the Federal Reserve are kind of little changed since the Ukraine crisis began. You know, we're still penciling in seven 25 basis points hikes by the Fed and withdrawal of policy stimulus being reinforced by quantitative tightening as this balance sheet begins to run down in the second half this year. It's certainly a difficult balancing act for the Fed. Lags between I think the policymaking, currently high inflation combined with sectoral reopening dynamics, as many countries such as the US are kind of shifting towards - this living with COVID strategy, I think kind of potential makes the risks particularly high. So, supply is lagging behind demand potentially as economies reopen. If the Fed's then forced into a braking late, do you think that's going to be amplifying the risk of recession and market turmoil down the road? Indeed, our recession risk models actually now suggest the chance of recession before the end of 2024 currently stands at over 25% - highlighting this kind of precariousness of the outlook and the risk that maybe the Fed inadvertently kills the cycle. It's not of course, the case that everyone faces this kind of same high wire act that the Fed does. I mean war on its borders. It's one reason why we think this kind of tempered tightening by the European Central Bank, not to mention its less acute imbalances than the US, longer history of kind of below inflation target, all suggest the ECB may well be treading cautiously. And then you know China's kind of bookending the other end of the policy spectrum here. Policy easing had actually already begun in China. And you know, if anything, the rhetoric has just shifted, more pro-growth. The most recent example being the 2022 growth target of around five and a half percent which is slightly above consensus expectations. And yes, that may be low by Chinese standards. We do need to see a sequential pickup for them to stand any chance of hitting this.

Luke Bartholomew 15:53
Okay, so that that speaks to the economics. But in terms of maybe a slightly wider lens on geopolitics, I suppose one question that I hear a lot of people asking at the moment is something to the effect of, how does the situation in Ukraine, the invasion of Ukraine, affect some of the political and geopolitical considerations around Taiwan and other hotspots in the world? I mean, is there a connection that can be drawn there in any way?

Bob 16:20
Personally, I think that that connection's a little bit tenuous. So yes, some commentators have speculated risks could be amplified around Taiwan, given kind of US resources and attention is maybe a little bit more stretched across kind of two fronts. And, you know, one can still possibly imagine kind of scenarios where the odds of conflict are maybe increased either intentionally or unintentionally, at the margin. So, for example, if the US spurred on by Ukraine to ramp up sales of advanced weapon systems to Taiwan, maybe China might react adversely to that. But I think what we really would emphasise here is kind of, unlike the Ukraine crisis, where the dynamics particularly the Russian aims, tended towards instability. There are strong kind of bouncing factors and reasons to believe the status quo will largely hold in Taiwan. I mean, most importantly, any sort of forced reunification with Taiwan would put other aims of the Communist Party in jeopardy. So even if a conflict with the US was avoided, the risk of substantial economic sanctions, potential exit of western firms could certainly threaten China's path to becoming a high-income country. And you know, one may will argue that the lesson from Ukraine could be that the west is just much more willing to weaponize its economic and financial system than we may have thought previously.

Luke Bartholomew 17:47
Yeah. So, on this topic of weaponizing the financial system. So, one final question around that. I suppose we talked about reserves earlier, and why various central banks have these large reserve balances as an insurance policy. Now, one country that has extraordinarily high reserves and reserves that are denominated very largely in US dollars is of course China. So, I mean, is China going to observe the way in which the Russian central bank has been treated by the central banks in this crisis and sort of adopt or change its reserve strategy accordingly? I mean, are there more fundamental fault lines about sort of the way in which the PBOC might go about managing its business as a consequence of this?

Bob 18:30
Possibly. It's worth saying that China's FX strategy has been transitioning quite a lot over the last sort of six years, particularly since they did their kind of shock devaluation back in 2015. And so, you know, FX reserves in China, numerically that is large, they've been steady around about sort of 3.1, 3.2 trillion US dollars, and so not to be sniffed at. But that has been falling as a share of GDP also. So, I think there's kind of a question there, but whether they just kind of let this, effectively, this process, maybe continue a little bit faster. It's certainly the case that they don't use these FX reserves nearly to the same extent to prop up the currency. But you're right. I think, you know, this could renew maybe some interest in pushing RMB internationalisation, could potentially see some more steps to encourage use of its own kind of homegrown payment system. So, the cross border interbank payment system rather than the SWIFT network that Ed mentioned earlier. But I think it's also worth considering here, you know, historical lessons suggest that China may well need to become much larger than the US economy before the renminbi has a hope of really displacing the US dollar within the global financial systems. We could still be talking, you know, 15, 20, maybe more years away before that happens.

 

Luke Bartholomew 19:58
Well, looking forward to having that conversation with you in 15 years' time then but in the meantime, I think that is all that we do have time for today. So, thank you very much to Ed and

Bob for their time and insights today. It is as always very appreciated. Thank you for listening. Please do like and subscribe in your preferred podcast platform. And let us once again say you know that we pass on our sympathies to all those affected by the terrible crisis in Ukraine. So thanks so much for listening.

20:40
This podcast is provided for general information only and assumes a certain level of knowledge of financial markets. It is provided for informational purposes only and should not be considered as an offer, investment recommendation or solicitation to deal in any of the investments or products mentioned herein and does not constitute investment research. The views in this podcast are those of the contributors at the time of publication and do not necessarily reflect those of abrdn. The companies discussed in this podcast have been selected for illustrative purposes only, or to demonstrate our investment management style and not as an investment recommendation or indication of their future performance. The value of investments and the income from them can go down as well as up and investors may get back less than the amount invested. Past performance is not a guide to future returns, return projections are estimates and provide no guarantee of future results.