Why The Latest Russia Crisis Might Be Worse For Berlin Than Moscow And Kyiv

When oil prices rise, the value of Russian stocks rise with it. Not this time. They are going in opposing directions, and emerging market investors might not want to buy the dip this time around as rumors of war return in Ukraine.

Washington’s concerns over a supposed Russian invasion of Ukraine has opened up a can of worms. It’s bad for Russia’s economy. It’s bad for Ukraine, still reeling from the pains of the Euromaidan that never healed and it’s bad for Europe.

Germany is wedded to Russian oil and gas. If things got hot, what would Russia do? It is an investment risk few are considering as Europe stocks are moving in line with U.S. stocks, rather than underperforming as they should. They’re in the crosshairs, not the U.S.

“In the hypothetical event of a full-blown conflict between Russia and Ukraine, we would expect the main impact on the eurozone economy to stem from higher gas prices,” says Amarjot Sidhu, an economist for the U.K and Europe at BNP Paribas. “We would expect gas prices to more than double. Eurozone inflation would hit over 6% by the spring and remain elevated longer than in our base case.

The United States is bolstering its military presence is central and eastern Europe, the Pentagon announced on February 2, in response to fears of a Russian invasion of Ukraine.

Led by Washington, the Western countries have been part of an ugly divorce between Moscow and Kyiv since 2014. If this were a marriage, Washington is akin to the “other woman”. Even Ukrainian president Volodymyr Zelensky warned that the Biden administration was stirring things up above and beyond the real threat from Russia.

With Biden’s presidential approval now looking worse than Trump’s, Ukraine is looking more like a distraction. This is why the market thinks it won’t be much different previous sanctions and war rumors.

Assuming more sanctions, what economic impacts can be expected this time around?

Russian Sanctions: Bad Timing

The IMF came out with its global growth forecast two weeks ago and global GDP is trending downward over the next 12 months. The Euro zone will be the weakest, with growth of 2.5%, but not much different than the U.S. or Latin America.

For this year, the IMF raised Russia’s growth forecast by 0.1 point to 2.8%, citing a weak harvest and worse-than-expected third pandemic wave. Next year, the IMF thinks Russian GDP falls to around 2.1%. Close Russia watchers know this is within the wheelhouse of Russian growth anyway.

Sanctions will make it worse.

“It’s very challenging to sanction-proof your operations (in Russia), especially when you don’t know what kind of actions (from the U.S. government) that would be,” Adam Smith, a partner at law firm Gibson, Dunn & Crutcher LLP, told the WSJ on January 31.

The current sanctions target:

• Financial sector (ban on Russian bond buying)

• Oil and gas (technology sharing and finance embargoes)

The new sanctions are supposedly after:

• High tech, quantum computers, electronics (tech embargo)

• Aerospace

Nobody knows what these last two will look like.

The Commerce Department’s Entity List bans on Chinese tech companies like Huawei serve as one example. American companies are banned from selling to Entity List companies unless granted government permission.

Existing sanctions target Russia’s most import sectors.

Russia’s biggest exports in the month of September were all commodities – oil, coal, gold, and wheat. Its top imports were smartphones, automotive parts, pharmaceuticals, computers and cars.

In September, the most recent month for free public data, China was the main destination for Russia’s exports, accounting for $5.92 billion.

It is the energy sector that poses the biggest risk to Europe in a worst case scenario. Will Russia tolerate continually be painted as the black sheep of the European family? Will they roll back their military from the Eastern Ukraine border to placate the West? This is highly unlikely barring assurances that Ukraine and NATO never wed.

And so Europe has a Russia risk problem and the market doesn’t seem to care.

Europe’s Russia Problem

The political battles around the North Stream II gas pipeline connecting Russia to Germany began around 2015. There is already Nord Stream I, but Russia went ahead with its German partners Wintershall and others to build Nord Stream II right alongside it. It was designed to be an alternative route away from Ukraine. The Germans and Austrians, (OMV is a Nord Stream II owner-investor) have always been against sanctions against that pipeline. Trump approved Congressional sanctions on Nord Stream II. Biden removed them.

The latest imbroglio over Ukraine has generated deep splits inside Germany. Most recently, the commander of the German Navy Vice Admiral Kay-Achim Schönbach was forced to resign for saying Russian leader Vladimir Putin deserved respect.

Although the Green Party in Germany opposes fossil fuels, their leaders have said natural gas is necessary in the transition period to “green energy”. Russian accounts for 32% of Germany’s natural gas supply as of December 2021, followed by Norway (20%), Denmark (12%) and storage (22%), which could have also come from Russia at one point.

It will take years to unwind German (and European) demand for Russian gas. This makes any severe outcomes against Russia a risk for Europe. It depends on how Moscow chooses to retaliate with its own economic leverage.

During a recent visit to Russia, Germany’s new Foreign Minister, Analena Berbock, threatened the Kremlin with abandoning Nord Stream II if Russia took over the Donbas region of Ukraine. Considering her ruling coalition of the Social Democratic Party of Deutschland (SPD) and the Green Party are shutting down the three remaining nuclear reactors, imported gas will remain a necessity.

Europe is forced to deal with the possibility of Gazprom, the major Russian gas supplier in Europe, to go against its own contractual obligations. It’s never done that before in Europe. But there is a first time for everything. This becomes more likely the more forcefully the Russian government is pushed against a wall over Ukraine.

Energy prices in Germany in December were up 69% compared with December 2020.

In the worst-case scenario of Gazprom abandoning its contractual obligations for gas delivery, European homeowners and businesses become hostage to Ukraine-Russia border politics.

The U.S. said it will shore up any supply shortfalls if Russia did that. But they would need to sell a lot of LNG to make up for Gazprom’s absence.

Moreover, most of the U.S. LNG goes to Asia with orders booked years in advance. The U.S. cannot just flick a switch and reroute supplies. Given inflation of energy prices at home, it would be politically unviable to drain supply domestically to save the Germans.

“Germany is between a rock and a hard place,” Marcel Dirsus, Non-Resident Fellow at the Institute for Security Policy at Kiel University, was quoted saying by Reuters last month. “The SPD wants to keep the Americans happy because they are Germany’s most important allies outside of Europe. But they don’t want to annoy the Russians either. That’s tough to do.”

The current mood in Germany is more somber than in the United States.

Berlin, together with Paris, will refrain from sending weapons to Ukraine. Germany supposedly banned Estonia from selling German-made weapons to Ukraine.

Back in 2019, Germany and France agreed that Ukraine, within the framework of the Normandy peace negotiations format, would commit to the implementation of the so-called “Steinmeier formula”, named after former German foreign minister Frank Walter Steinmeier.

Ukraine watchers knew it once as the Minsk Agreements. This was a more simplified road map that envisioned, like Minsk, voting to be held in the separatist territories of east Ukraine under Ukrainian legislation and the supervision by the Organization for Security and Cooperation in Europe. If the voting was deemed free and fair by OSCE, then a special self-governing status will be given to the region. In turn, Russia would leave its easternmost border with Ukraine and give border control back to Kyiv.

The Zelensky government never moved forward with this plan.

In theory, Brussels could work with Washington to find a compromise to diffuse the situation in the Donbas.

Russian Market Talk

The real mystery for the markets is what will become of Russia’s relationship with Europe. That will depend on the White House…and the Kremlin.

The huge dichotomy between oil prices and Russia’s main equity index (RSX) seems to indicate that the Russia political risk is overpriced, while the German and EU one is underpriced.

Russian equities have actually lost more ground in the face of present sanctions threats than the closest comparable episode which took place in 2018, notes Charles Henry Monchau, CIO at Bank Syz from Switzerland.

Profitable exporters and profitable banks have been hit massively this year, with the Moscow financial index down 30% since last August.

“This could indeed create opportunities,” Monchau says, adding that he sees the potential for the four scenarios unfolding:

1.  A de-escalation of tensions as an agreement between Russia and U.S. on a new security accord is found. he ruble would strengthen against the dollar and Russian assets would rebound aggressively. (Medium probability)
2. Tensions to stay elevated. The two parts continue to talk but no agreement is reached. Risk premium on the ruble and Russian assets stay elevated for some time. (High probability)
3. Escalation of the conflict in Donbas. Russia gets involved in Eastern Ukraine either directly or indirectly and the West retaliates with sanctions. (Medium probability)

The worst case is a full-scale conflict with the invasion of Ukraine by Russian troops leading to massive sanctions by the West.

“The ruble collapses and the risk premium on Russian assets will go through the roof,” Monchau says.

Denis Rodionov, Head of Research at Halcyon Portfolio Management in Moscow said no one is selling their positions in the Halcyon Russia hedge fund.

“This is probably because most of our investors have had exposure to Russia for a long time. They’re accustomed to the political noise,” he says.

Meanwhile, Ukraine is struggling. Outsider Zelensky always faced an uphill battle.

Russia tensions, fomented by the U.S., as Zelensky believes, are bad for Ukraine, a country in crisis. The constant panic takes the country off the radar of big corporate investors. It keeps foreign portfolio investors at bay even after the EU has spent more than 15 billion euros on the Ukrainian economy and reforms, and the IMF: $15 billion, its second biggest bailout after Argentina.

The hotter the conflict, the more difficult it will be to strengthen the call to turn Ukraine into a Western-style capitalist democracy.

This inability for Russia, Ukraine, and “the Other Woman” – the U.S. — to call a truce means the base case for Ukraine is more of the same: a hot mess.

A truce might look like this, at a bare minimum: No NATO membership and Russia recognizes Ukraine’s right to exist as she sees fit: an independent and sovereign country.

Ukraine would revert to its old foreign policy doctrine, originally proclaimed in the Declaration of State Sovereignty on July 16, 1990, just before the break-up of the USSR. It stated that the country should become a neutral state and not participate in military blocs.

A diffusion would also mean Kyiv demonstrates progress in the implementation of the Steinmeier formula. It will not be easy. Zelensky doesn’t want to Ukraine to lose territorial control like it did in 2014-15 over Crimea. But if there was a re-up of the old Minsk agreement, and who says it can’t happen, then all sides can declare victory and the Russia risk subsides, if only for a little while.

“Those who came to the market recently are finding political risks too much to bear,” says Rodionov about Russia. “If you’re a long-term investor and have the stamina to sit through political volatility, then investing in Russia at these levels is probably the right thing to do.”