Robert Kahn

Macro and Markets

Robert Kahn analyzes economic policies for an integrated world.

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Russian Contagion, Geopolitical Risk, and Markets

by Robert Kahn
May 8, 2014


Yesterday, I published my Global Economics Monthly. I argue that further economic sanctions against Russia would have significant global economic effects because of the Russia’s connectedness to energy and financial markets. Why then, are markets apparently so sanguine? Is it because investors, by and large, expect de-escalation? Is it a view that Russia does not matter for the global economy? Could it be a search for yield? Or is it the inherent difficultly that markets face in pricing in hard-to-quantify, large geopolitical dislocations? Probably a little bit of all of the above.

A poll of investors by Citigroup’s Matthew Dabrowski and Tina Fordham illustrates the problem even if it doesn’t answer these questions. The survey of over 1000 investors reported significant concern about political and security risks in Russia, China, and Europe this year. In addition to sanctions, these risks included a breakdown in Iran nuclear talks, victories by fringe parties in European elections, snap elections in Greece, and Sino-Japanese military tensions sanctions. Russian trade sanctions and China tensions were seen as having the most negative impact (see their chart below), but markets remain constructive at the same time, “raising the question of whether market participants have fully considered these geopolitical risks.”

Citi Matrix

Source: Citigroup

David Gordon at Eurasia Group also sees a disconnect between the two worlds: the political and the markets-based. He contrasts rising geopolitical concerns with the generally constructive mood among investors at the recent IMF-World Bank spring meetings as well as strong (and not-terribly volatile) markets. He is more comfortable than I am that markets  have it right: “geopolitics is not quite the nightmare some seem to think. Markets don’t always have it right, but their current perspective on the big picture remains pretty close to the mark.” He does agree, though, that on Russia in particular, markets do seem too sanguine.

What does this mean for our sanctions policy towards Russia? Up till now, it does appear that vulnerability of Western companies to sanctions and possible retaliation has been a brake on the Obama administration’s willingness to move aggressively ahead with financial sector (“sectoral”) sanctions. But that may be changing. There is a growing recognition that the chill of potential sanctions has not been an effective constraint on Russia’s aggression against Ukraine, and perhaps frustration that markets have not reacted more. (Though my market friends emphasize it is hard to derisk in this environment, particularly for large emerging market portfolio investors facing shrinking liquidity.) There is a sense now in Washington, D.C. that markets have been warned and have had time to adjust.

Financial sector sanctions are not a zero-one decision, as they could in principal be targeted at certain transactions and relationships to try and manage the fallout for the West. But sectoral sanctions seem to me the most likely scenario. The continuing disconnect between D.C. and New York suggests markets could correct sharply if conditions on the ground in Ukraine worsen.


Post a Comment 2 Comments

  • Posted by Tyler P. Harwell

    Thank you. Allow me to attempt to complete what I see as a partial explanation of the disconnect observed. To do so, one must look at the whole picture, and not get lost in the woods.

    My thesis is as follows.

    Russian behavior towards Ukraine is irrational from the standpoint of economic advantage. There are other motives for this behavior. In fact, economic considerations are a countervailing factor.

    To put it simply, the Russians are nuts about European courtship of Ukraine, and are ruled by passions. One would think they would be thrilled to have the European Union bail out Ukraine , so that it could pay its bills to Russia with European money, rather than with money lent to it by Russia. As for invasion fears: would Ontario want Detroit? It is much the same question.

    Therefore, the biggest cost, or “sanction” Russia faces if it continues down the road it is on is the inevitable damage it will do to its own economic interest by reason of market reactions alone. The fact that Russian natural gas to Europe flows through piplelines that pass through the Ukraine is a Russian liability, not an asset. Does anyone think that gas supply will continue uninterrupted if Russia seizes eastern Ukraine?? It will not. The damage to the Russian economy will be massive.

    World financial and commodities markets, if they are rationally related to events, can not be insensitive to the prospect for such a debacle. And in fact they are not. They have already reacted to it; and I would suggest the “disconnect” supposedly observed does not really exist. Rather, I would submit, the reaction has already occurred on the two markets where one would most reasonably expect to see it: the Russian stock market, and the currency exchange market, with respect to the Ruble, which both have lost great value. If western markets have so far not followed suit, that is not a cause for explanation. Rather, it makes perfect sense, for “tis an ill wind that blows no man good”. Other concerns stand to gain from Russian mistakes.

    Whatever punitive actions western powers or multi-national companies have so far taken, or might take in the future in response to such a misadventure are of little consequence, as they can in no way add to the damage that Russia would inflict upon itself, and has, to date.

    Investors everywhere can do nothing but hold their breaths and wait at this point. In a negative way, Vladimir Putin has cornered the market.

  • Posted by fabio

    I tend to disagree.
    Russian are not “nuts” about Ukraine. They are rational and with big memory.
    For them Ukraine is Real Red Line (not like President Obama with Syria). Ukraine on the “West” is too dangerous.
    We, in the West, tend to think…who wants to invade Russia?
    In Russia they remember that in 1932 Nazi Germany was a poor and depressed country and just after not even 10 years they declared war on the world.
    And Kiev is 853km from Moscow…of just easy to cross plains.
    And yes they are passionate about the region as their offensive against the nazis left just 1 million Russian dead soldiers (estimates, wiki).

    And the sanctions, till now, avoid careful to hit where it hurts (Gazprom) in fear or Russian retaliation.

    A subtle and dangerous game

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