Viewpoint on the Russia-Ukraine Conflict

The upshot is that Russia would lose too much from a full-scale conflict in the short term, and Europe can’t afford a tough stance on Russia.

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Russia’s occupation of the Ukrainian region of Crimea has resulted in minor sanctions by the West, but no military action. While NATO intervention is a remote possibility, I believe a stalemate is most likely. Both countries will pile up troops along the border, but Russia will not take another bite off Ukraine.

A war with Russia would be a blow to Europe’s economy. One third of Europe’s energy is generated from natural gas; another 30% comes from oil. The European Union receives 29% of its net natural gas imports from Russia, according to the International Energy Agency, and 36% of its crude oil.

Alternatives to Russian energy are either scarce or impractical. Norway’s spare capacity cannot replace Russian sales, and shale gas fields in Poland and the U.K. cannot fill the gap, either. Coal will not replace gas overnight.

Liquefied natural gas could be the answer. Europe’s terminals are underused. But imported LNG from Qatar, the Asia-Pacific region, and Nigeria is much more expensive than Russian gas.

In the short term, the EU is stuck with Russia. Russia needs Europe too. Eighty-four percent of its oil exports go to Europe, as does 76% of its gas, according to EIA data.

European banks account for 75% of external loans to Russia. For Europe, however, I believe the direct financial risk is small. France, Russia’s largest lender, has an exposure of $54 billion, and Italy’s is just $30 billion, according to the Bank for International Settlements. The fallout for European banks, then, would most likely be modest if the EU imposed lending restrictions, or if Russian borrowers defaulted. A war might trouble Russia more than Europe.

Financial markets back this interpretation. European equities barely flinched when Russia annexed Crimea, but the Micex index of 50 Russian stocks dropped, along with the JP Morgan EMBI indexes of bonds and the ruble. Credit default swap rates likewise jumped. Capital outflows seemed to accelerate in early March.

Unstable financial and political conditions come at a bad time for Russia. Its economy was stagnating in the first half of 2013, well before Crimea popped up on CNN. Things were picking up toward the end of 2013, but PMIs from the first quarter of 2014 suggest that GDP shrunk. That would be a first since the 2008-09 recession. Higher inflation is likely, because a depreciating ruble raises the cost of imports. A recession would not be surprising.

Beyond the next quarter or two, though, the Ukrainian crisis might not make a difference. In my opinion, a European ban on Russian oil, the country’s bread and butter, is unlikely. In addition, it seems that Russia will be able to withstand capital withdrawals in the short term. As of January, foreign exchange reserves stood at $500 billion, or two years’ worth of imports.

The upshot is that Russia would lose too much from a full-scale conflict in the short term, and Europe can’t afford a tough stance on Russia.

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About Author

Francisco Torralba, Ph.D., CFA  Francisco Torralba, Ph.D., CFA, is an economist with Ibbotson Associates.

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