Dr. Ronald Johannes, PhD. is the Global Economic Strategist at Farr, Miller & Washington, LLC. Formerly, he held the position of Head of the Bank of England’s international markets team, and concurrently served as Chairman of a European Central Bank working group. In December 2010, while working for the World Bank, Dr. Johannes visited the Ukraine and met with the Ukrainian Central Bank. We are delighted to share his unique insight and expertise with our clients.
In recent weeks, the stock market has moved markedly up and down on news, alternately positive and negative, of tensions on the border between Russia and Ukraine. Western trade sanctions on Russia have been met with counter-sanctions. Cold war memories have been revived by the annexation of Crimea, the downing of the Malaysian airliner, the massing of Russian troops on the Ukrainian border (numbering 45,000 according to Ukrainian authorities), a NATO warning of possible Russian military intervention and, at the time of writing, a convoy of 280 Russian trucks headed for Eastern Ukraine, purportedly on a humanitarian mission.
Yet a dispassionate assessment of the direct economic linkages between the United States and Russia shows that Russia accounts for just a tiny portion of US exports: less than 1% (just $11 billion) in 2013. Of course, a serious military engagement by western powers would be disastrous for markets, but that eventuality seems highly unlikely. So the question arises: Why does the market care about Russia and Ukraine?
The short answer is that it is the indirect economic linkage through the European Union (EU) that matters: the EU accounted for nearly 17% of US exports ($262 billion out of $1.6 trillion) in 2013 (chart nearby). It is the disruption to that trade-not to mention the potential further disruption in the event of military escalation-that is worrying the market. In contrast, the outbreak of Ebola in Africa, the default on Argentinian debt, and even the conflicts in the Middle East do not yet rise to that level of concern. To understand the current risks, we need to look a little closer at how the Ukraine and the EU got to where they are today.
Since the Orange Revolution of 2004-05, the Ukrainian economy-small by European standards but populous-has resembled nothing so much as the Wild West. Unshackled from the former Soviet Union, it plunged into entrepreneurial capitalism, with institution-building and the rule-of-law playing catch up. That led to a fast growing economy until the 2008 financial crisis hit. Ukraine suffered a severe banking crisis and was forced to devalue the hyrvnia, its currency.
Ukrainians looked for help in 2008, both to the West and to the East, reflecting their history and geography. Successive Ukrainian presidents favored closer ties, first to the West, then to the East. Membership of NATO was off-the-table for the foreseeable future (for fear of provoking Russia), but the EU was willing to offer Ukraine some trade preferences and financial aid. It did so, however, in a ham-fisted way that opened the door to the rise of President Yanukovych, who was favored by the Russians. His ouster seems to have precipitated the crisis.
EU imports from Russia are dominated by oil and gas, and Ukraine has been the conduit for most of these energy supplies through a network of pipelines. Moreover, the value of these imports is very large: some $264 billion in 2013, about the same as EU imports from the United States (again, chart nearby). Additionally, EU countries export machinery, chemicals, medicines, agricultural products and so on to Russia, and hold big direct investments in Russia. That is why the EU economies have suffered and stand to lose a lot more if the crisis worsens. And that could feed back to a significant loss of US exports to the EU and slowing US growth.
In better times, the EU might be able to weather an adverse economic shock from Russia. But the European economies are unusually vulnerable at present for two reasons. First, the eurozone economies (those countries that use the euro, including Germany, France, Italy and Spain, though not the UK) are still recovering from the effects of a feared break-up of the euro a few years back. Even before the Ukrainian upheaval there were some signs of a slowdown in growth.
Second, remarkably, the euro-zone is in danger of slipping into deflation. Euro-zone consumer price inflation is currently running at 0.4% and heading towards a zero or negative rate. Today, the specter of falling prices and attendant economic dislocations haunts the euro-zone-a phenomenon not seen in the US since the 1930s, but until recently afflicting Japan for some two decades. Any growth slowdown in the euro-zone could tip it into deflation.
For these reasons, we expect that the market will continue to watch the Russian-Ukrainian border closely.
Today’s global economy is characterized by an interconnectedness that has never existed before. For the US, this is a double-edge sword. Just as the US economy has enjoyed the benefits of exporting to high-growth emerging markets, we must accept that our trading partners in developed markets will act as somewhat of a headwind for a period of time. As such, the situation in Ukraine is and will continue to be eminently relevant to the investment landscape for as long as the crisis persists.
– Ronald Johannes, PhD.