Upbeat moods at the beginning of a new year did not last long. It turns out that investors have a number of reasons to worry, and potential Russian invasion on Ukraine is high on the agenda. Are we all going to pay for the Ukraine-Russia conflict?
Struggle lasts for almost decade already
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It should be remembered that conflict around Ukraine has been ongoing for 8 years already. It began with democratic changes in the country after President Victor Yanukovych was overthrown. While Ukraine declared independence in 1991, Russia still sees the country as its area of strategic influence and the most important of the ex-Soviet republics. Situation has led to annexation of the Crimea Peninsula, that Europe and the United States failed to stop, and subsequent Russian military actions in the eastern part of Ukraine. Russia-Ukraine tensions have been absent from news headlines in recent yesterday but Kiev attempts to closer integrate with the West provoked Russia to take actions again.
Problems at your own request?
The truth is that Western Europe is partially to blame for the current situation. Ambitious energy policy combined with a naive approach to Russian foreign policy made Europe more and more dependent on imports of energy commodities from Russia. While as much as 30% of European natural gas imports came from Russia a decade ago, now the share of Russia in European gas imports has risen to almost 47%. This is a strong tender card for Russia to use in its political games. This is especially true now when increasing commodity prices are fueling inflation, making the situation uncomfortable for European leaders.
Markets start to price in risk of war
Markets began to treat the potential for Russia-Ukraine war seriously. Current reaction of the markets have already exceeded one from 2014, when Crimea Peninsula was annexed. Main Russian stock market index RTS50 dropped 30%, even in spite of rising commodity prices that traditionally support Russian equities. Among top laggards on the Russian market one can find financial institutions that risk being targeted by sanctions, (i.e. barring Russian banks from global financial systems) as well as Gazprom, that has so far benefited from the turmoil on the natural gas market.
It should be noted that geopolitical risks are usually highly binary. Market reaction tends to be short-term and the situation quickly returns to normal once investors see that worst-case scenarios have been averted. However, we are not there yet.
Everyone will pay the price of potential conflict
Military conflicts are bad almost every time. It is hard to justify loss of life or damage done to civilians, especially if it is done for the sole sake of leaders' ambitions. Unfortunately, that's how things usually are. However, Russian invasion on Ukraine will also lead to major economic damage. While China is the biggest trading partner to Ukraine, Poland and Germany ranked #2 and #4, respectively, in terms of imports. Exports are also important, especially now when the global economy is struggling with shortages. Poland, Germany, Italy, the Netherlands and Spain all rank high in terms of exports.
Natural gas reserves also play a major role in the conflict. Russia has been limiting natural gas supplies to Europe for months. The United States tries to provide Europe with alternative sources of commodities but a full switch away from Russian gas looks unrealistic. Additional exports of LNG from the US to Europe could help lower sky-high prices but the US cannot fully substitute for Russian gas, especially in the short-term. Firstly, natural gas contracts are usually long-term in nature, especially in Asia, therefore the United States may not have enough commodity to satisfy demand from its current customers and Europe. Even if it did, Europe may not have adequate infrastructure to support increased LNG exports from the US. On the bright side, Russia is highly unlikely to take such radical actions. 75% of Russian exports goes to Europe therefore going all-in will cause significant long-term damage for the Russian economy. More likely scenario is that the parties to the conflict will try to "check" each other, which, however, may mean quite high gas prices in Europe until the situation calms down.