With The White House proclaiming Russian stocks a “sell” today (and in the meantime Russian stocks and the Ruble strengthening), it is clear, as Citi’s Steven Englander notes, that the Russia/Ukraine crisis may be the first major political conflict that is played out in international financial markets. The difference, Englander points out, between this and standard imposition of sanctions is that both sides have some options that can inflict damage on the other side.
International finance as a continuation of war by other means (via Citi’s Steven Englander)
Normally sanctions involve a big group of countries on one side and a vulnerable target on the other so the vulnerability is very asymmetric. Small countries can occasionally expropriate big country assets but in most cases that ostracizes the small country from the international financial community.
The US/EU are hoping that they can make the crisis sufficiently painful to Russia that it backs off from the Ukraine. The Russians may suspect that the willingness in the West to pay a financial/economic price is limited and that public opinion will swing quickly if volatility emerges.
So far we have:
1. Formal sanctions by the US and Europe on a small set of Russian/Crimean officials, plus the threat that the sanctions will be extended
2. Possible release of oil from the Strategic Petroleum Reserve (denied by the White House as an effort to push oil prices down)
3. Pressures on Russian asset markets
4. Probable move of Russian reserves out of Fed to non-US custodians
5. Russia destabilizing Ukrainian gas and debt markets
There are even reports that there were efforts by Russia in 2008 to exacerbate the US financial crisis, although the reports do not have firsthand documentation. Other countries may be watching this as a template for how events would play out in case Asian political issues over conflicting territorial claims or other issues escalate.
These developments may give a different meaning to the term ‘currency wars’ that became so popular in recent years.
One advantage using finance as a weapon is that it can be scaled up or down as needed, and is much more reversible than military actions. It is also quicker than traditional trade sanctions to have an impact, and arguably is more likely to hit decision-makers and those who have access to them than trade sanctions, which often hit the poor and almost always create profit-making opportunities for the well-connected in sanctions-running.
How far can this go and what are the implications?
So far the steps taken are baby steps – sanctions applied to a handful of Russians and Crimeans by the US and EU, but no real screws being applied (Russian President Putin not named, for example). Probably there are huge holes through which transactions can continue to occur and the sanctions can be evaded. However, if the crisis intensifies, the US/EU may be tempted to apply broader sanctions on Russian assets on the view that this is the quickest way to apply pressure and that Russians will be unable or unwilling to move their assets into friendly jurisdictions quickly enough.
For the Russians, the temptation may be to try and sell USD assets in order to disrupt US asset markets, but the leverage may be temporary. Their reserves are almost USD470bn but they have been actively diversifying away from USD for years. Relative to the size of any market they might be tempted to disrupt, the USD holdings are small. Moreover the sense that the price was being driven down by politically-motivated selling would likely attract buyers on the view that the effects would be limited. Were they do convince other countries to join them, the impact would be more longer lasting and more disruptive, but it is a little bit like letting your own home run down because it will lower the property value of a neighbor you dislike. The damage you do to yourself is more than you can expect to do to your neighbor.
The Russian holdings of USD are probably enough to give the USD a big whack, were they to go into the market selling, especially as since there may be selling pressures already from other reserve managers, and given the trend-loving nature of currency investors. Once you get past hurt feelings, it is not clear that USD weakness would be a US economic or financial market negative. A strong dollar is hardly a US policy priority, to the extent that USD weakness would crowd in both exports and imported inflation, it would probably be viewed as going in the direction preferred by Fed policymakers. Were it not for the unfriendly motivation, it is unlikely that US policymakers would object.
If the use of financial market warfare intensifies, the risks are:
1) More home bias in investing,
2) Official investors gravitating to jurisdictions and custody arrangements that insulate their assets from seizure
3) Premium on gold, physical commodities and other unattachable assets
This would unwind many years of international capital market liberalization. Moreover, it would have the greatest impact in discouraging long-term, illiquid investments, as these would be most vulnerable to seizure. It is much easier to cut positions in short term liquid assets if there is trouble brewing.
External deficit EM economies would probably suffer the most since creditors would see an extra force majeure risk premium added. Apolitical safe havens would probably benefit the most. Where there is an interaction with the traditional currency war discussion is that the damage to EM borrowers would probably be greater than to G10 borrowers. When EM countries depreciate, they often get hit by higher bond yields as well. G10 countries, even when they depreciate sharply, often do not face big pressures on their bond markets. Moreover, higher food prices from depreciation are not nearly the same social issue in G10 that they are in EM.