By Michael Every of Rabobank
Valentine’s Day should be filled with love, but there is very little of that in the air. Neither are there civilian aircraft over Ukraine given it is apparently now impossible for them to get insurance, a huge blow to an already weak economy. In short, markets are belatedly waking up to the geopolitical risks posed by Russian military action against Ukraine. We now even have an alleged potential start date, with all the usual caveats – Wednesday, February 16.
Of course, Russia continues to vociferously deny it has any such intentions, and correctly points to the US not being a good actor when it comes to casus belli. Then again, Moscow just refused to comply with an official Organization for Security and Co-operation in Europe (OSCE) request to transparently explain what its military is doing all around Ukraine’s borders. Said OSCE observers are now being pulled out of eastern Ukraine; a flood of countries are pulling ambassadors or citizens out - including Russia; Ukraine’s army has reportedly had its leave cancelled; and President Zelenskiy has asked President Biden to come to Kyiv as a demonstration that all is well. So, everyone who had been acting pragmatically is now head over heels – but not in love.
What are markets to do should this grim assessment prove accurate? Obviously, risk off, tempering some of the recent surge in bond yields; yet the direct economic impact of a Russian attack is small provided it is not sustained, even if there would be immediate disruption to markets of the kind already seen (i.e., no commercial flights/shipping). An economic history paper (‘The Effect of War Risk on Managerial and Investor Behaviour’) also argues firms cancel IPOs or delist, and become more risk averse.
However, sanctions would have a dramatic impact on energy, food, and key metals prices – even if Russia very undiplomatically claims it “doesn’t give a ****” about whether they are imposed on it or not. Of course, if sanctions aren’t introduced --and Austria says it may block them-- then the West can’t agree on even a financial penalty for invading a neighbor, let alone a military one. So how does a market trade the end of the key principle of global security --that you can’t take what you want by force-- already cracked by past US and Russian actions? It won’t. But that does not mean it is right not to do so!
February 15 marks the 80th anniversary of the fall of “Fortress Singapore” to the Imperial Japanese Army in WW2. I spent yesterday looking at memories of the physical, economic, and psychological shock of that previously inconceivable collapse. I quote from the diary of Captain MacPherson of the Argyll & Sutherland Highlanders lifted from HR Oppenheim, who conveys how/why this transpired:
“A. Lack of co-ordination; Viz B. Complete chaos at Headquarters; C. Lack of leadership and foresight.
Officers spent too much time in clubs and prior to this war refused to leave Singapore or KL and scout round for themselves. None knew the country though they had been stationed in it for a year or more, and few knew the language.
Many officers refused to leave Headquarters and most tried to be posted to cushy jobs.”
Swap British for American/Western, and clubs for think-tanks, and how redolent is that description of our current global architecture, as well as of last year’s fall of Kabul (and its market economy)? Just as pertinent, John Hemmings, Professor of Security Studies, asks: “As the period between WW1 and WW2 was merely an intermission, so the period between the Cold War and this current period of great power competition was an intermission. Discuss.” Indeed, we must - because Ukraine is a global metacrisis over what market architecture will look like ahead.
As a key example, Sam Greene, Professor of politics at Kings College London, stresses: “The inconvenient truth of the present crisis is that behind all the rhetoric about NATO, Moscow's beef is fundamentally with the EU. It's worth remembering that Russia's 2014 invasion of Ukraine was sparked *by a trade treaty*, not by a near- or even mid-term threat of NATO expansion. And no, the EU is not a back door to NATO. If anything, the NATO is a back door to the EU, which is much, much harder to join. Moscow's problem with the EU is geo-economic, which should not be read as being somehow less salient than geo-politics. Put briefly, the continued expansion of the European geo-economic project poses a threat to the current Kremlin's political survival. The expansion of EU influence puts insurmountable pressure on the Russian political economy to move from a rent-based, patronal model of wealth creation and power relations, to a system of institutionalized competition. Having satellite states that are governed in the same patronalist mode as Russia gives Moscow geo-economic breathing space, adding years or decades to the system's viability. Losing those satellites removes those years and decades.”
In short, the soft power of the EU and its markets are clashing with the hard power of Russia and its weaponry. Who wins? Not the market presumption they must win by default, and so war does not happen, “because markets”! Russia’s actions are a *rejection* of said markets! Moreover, as repeatedly stressed here, many global players feel the same way. Iran --NOT thinking about GDP and markets-- continues to haggle over a new nuclear deal; in the background, Saudi Arabia just warned civilians to leave areas of Yemen as it prepares for larger attacks on Iranian-backed Houthis there; and the Israeli press reports a weak nuclear deal could see Israel move against Iran. North Korea --which has no GDP or markets-- continues to fire missiles. And China --with a vast GDP, and markets where Westerners continue to shrug off Common Prosperity as ‘miscommunication’ rather than a fundamental policy shift-- is clearly the focus of the new US Indo-Pacific Strategy. This states the US will pursue key objectives in concert with allies to:
Advance a free and open Indo-Pacific: “through investments in democratic institutions, a free press, and a vibrant civil society. The US will bolster freedom of information and expression and combat foreign interference by supporting investigative journalism, promoting media literacy and pluralistic and independent media, and increasing collaboration to address threats from information manipulation…the US will be a partner in strengthening democratic institutions, the rule of law, and accountable democratic governance.” So, very Cold War!
Build connections within and beyond the region: “deepening our five regional treaty alliances --with Australia, Japan, the ROK, the Philippines, and Thailand-- and strengthening relationships with leading regional partners, including India, Indonesia, Malaysia, Mongolia, New Zealand, Singapore, Taiwan, Vietnam, and the Pacific Islands…. Allies and partners outside of the region are increasingly committing new attention to the Indo-Pacific, particularly the EU and NATO.” So, everyone except Russia, North Korea, and China.
Drive regional prosperity. “The US will put forward an Indo-Pacific economic framework... We will develop new approaches to trade that meet high labour and environmental standards and will govern our digital economies and cross-border data flows according to open principles... We will work with our partners to advance resilient and secure supply chains that are diverse, open, and predictable… We will also redouble our commitment to helping Indo-Pacific partners close the region’s infrastructure gap.” So, rebuilding economic ties on US terms – though how is unclear.
Bolster Indo-Pacific security: “The US will work with allies and partners to deepen our interoperability and develop and deploy advanced warfighting capabilities… We will [find] new opportunities to link our defence industrial bases, integrating our defence supply chains, and co-producing key technologies that will shore up our collective military advantages.” So, US defence as umbrella and umbilical cord - against Russia, North Korea, and China. (There will also be a focus on maritime security, as we predicted back in ‘In Deep Ship’.)
Let’s turn this back to markets. Some research is belatedly realising China has goals of supply-chain and tech strategic autonomy and decoupling from the US dollar. To do so they say China will: maintain a large, mercantilist trade surplus; trade far less with the US; shift import payments to CNY; and shift others to more bilateral trade and holdings of CNY. The argument is therefore that CNY should be a strong currency. Yet how will vast regional US dollar debts be paid back if the US dollar is not being earned? How will China lose US markets and maintain a trade surplus, when everyone wants to take supply chains home? How do others earn CNY if they run trade deficits, apart from borrowing it (we saw how that ended in the Euro crisis)? Apart from government bonds, Chinese assets are not seen as stable right now, as its debt bubble wobbles: indeed, Western capital inflows rest on the whims of MSCI. Most importantly, the Ukraine clash of ‘markets vs. muscles’ has sharpened minds, and the US Indo-Pacific Strategy show the West will resist such geopolitical power-plays. The long-run outlook for currencies and assets therefore changes dramatically depending on who you think has the better odds of prevailing in a global clash of systems, even if peaceful.
What we are talking about here is not ‘an end to globalization’, but a sharp change to it. As another economic history paper on WW1 (‘Globalizing the History of the First World War: Economic Approaches’) notes:
“Deglobalization, if this is taken to mean a significant diminution of interdependence, was not an outcome of the war….far from ushering in an era of autarky, [it] encouraged adaptations of the infrastructures of exchange to meet its demands and reshaped global networks of merchants, shipping companies, and intermediaries, who emerged after 1918 ready to do business with new customers. In the case of shipping, in fact, the war clearly provided a fillip to the forces of integration, as once marginal national fleets expanded into new trading routes after its conclusion.
Wartime disruptions of shipping, moreover, did not make economies and societies that before the war depended on imports --including most of Europe's colonies-- significantly more self-sufficient after its outbreak. Rather, these disruptions made their position of dependency far more painful, particularly for the working people and rural and urban poor forced to bear the costs of these disruptions in the form of rising prices, shortages, and famine. The war's conclusion saw nearly synchronized uprisings in many places that saw steep wartime increases in the costs of living --including Egypt, India, Belize, Trinidad, and Iraq-- which were due, in large part, to disruptions to global supply chains and shipping.”
In short, interconnectivity is here to stay, but its current pattern is not. Today it is Ukraine caught in a maelstrom: but the risks are of a sharper, larger, harder geopolitical and geoeconomic game that will reshape global supply chains and capital flows. It isn’t love in the air on Valentine’s Day. At the very least, it’s change.