Crimeanomics favours the West | FT Alphaville #EuroMaidan

Crimeanomics favours the West | FT Alphaville:

This guest post on the Ukraine crisis is from Jorge Mariscal and Alejo Czerwonko, emerging markets chief investment officer and emerging markets economist, respectively, at UBS Wealth Management.

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Economic skirmishes between Russia and the West over Crimea have gone from mild to moderate – an asset freeze here, a travel ban there. But if tensions get much uglier, when it comes to ‘Crimeanomics’, the West should have the upper hand.

First, Russia’s much-vaunted grip over European energy is smaller than European energy’s grip over Russia. If Russia significantly escalates military tensions in Ukraine, Western leaders should advertise a few simple facts:

• If the EU cut off Russian energy imports, Russia would probably endure a 2009-style recession. True, Russian energy exports account for roughly 30 per cent of the EU’s oil and gas consumption. However, energy exports to the EU also account for 63 per cent of Russia’s oil and gas exports, with an estimated value of $231bn in 2013. Cutting them off would slice roughly 11 per cent off the size of Russia’s economy – literally decimating it overnight.

• A freeze in EU energy trade would cripple Russia’s financial defences.. Oil and gas exports to the EU were three times the size of Russia’s current account surplus in 2012. Total taxes on oil exports represent 50 per cent of Russia’s federal budget. Even with more than $500bn in foreign exchange reserves, the value of the rouble would come under severe pressure. Russia’s cushions against a severe downturn would be lower than during the financial crisis.

• The Russian corporate world would suffer greatly. Energy companies listed in the Russian stock exchange account for 57 per cent of the market. This would hurt the wealthiest players in the Russian economy and undermine a key source of support for the Russian government.

• In its search for energy, the EU would have a number of medium-term alternatives. If the US, its ally in the Crimea dispute, lifted its restrictions on energy exports, the EU would have an important new source of supply which would grow with the US shale energy boom. Canada (and other admittedly less stable nations) could provide a similar boost.

• Although damage from an energy shortage to EU GDP would still be significant, it would partially come initially from inflation, at a time when inflationary pressures in Europe are very low. Moreover, the EU’s starting point is not as bleak as it was 12 months ago. The EU’s economy grew 1.1 per cent in 2013, not far from Russia’s 1.3 per cent growth last year. The West also has wider trade sanctions up its sleeve.

• The EU would win an all-out trade war with Russia hands down. The EU is Russia’s biggest trading partner, while Russia is the third largest trading partner of the EU. Exports to Russia make up 7.3 per cent of the EU’s total, while imports are 12 per cent. On the other hand, the EU buys 50 per cent of Russian exports and sells 42 per cent of what Russia buys from the outside. Also, foreign direct investment from the EU accounted for over 75 per cent of Russia’s total in 2012. FDI from Russia is a small 3 per cent of the EU’s total.

• Russia has even less leverage over the US. Trade with Russia accounts for 1 per cent of the US total. By contrast, exports to the US account for 5.8 per cent of Russia’s total, while imports from the US are 4.9 per cent.

• In response to Iran-style sanctions, Russia could muster one unprecedented measure. It and its allies could stop buying euros, dollars, and Western government debt. However, Western governments should be able to brush this manoeuvre aside.

• In addition to an $87bn oil stabilization fund, Russia has $493 billion in foreign exchange reserves, just over 45 per cent of which were held in dollars as of the middle of last year. Influencing the massive $12.3trn US Treasury market – the obvious target – with such ammunition would be the equivalent of trying to bring down King Kong with a slingshot.

• The only Russian ally that could attempt a meaningful Treasury boycott would be China. But China has refused to take sides during the conflict, and its incentives for intervening in the Treasury market are low. As much as two-thirds of China’s $3.8trn international reserves are held in Treasuries and other government securities, while Treasuries held by China represent 22 per cent of the total outstanding. China could not rapidly dispose of large amounts of US Treasuries without causing severe damage to its own balance sheet.

In sum, when it comes to ‘Crimeanomics,’ it is clear that the US and the EU hold most of the cards. It is in the geopolitical arena where Russia’s leverage is greatest. This, as well as Europe’s reliance on Russian energy in the short term, may ultimately prove to be a limiting factor in the West’s response to the country’s actions in Ukraine and elsewhere. But in this economic “cold war” Russia would be unwise to underestimate the US and the EU’s economic arsenal and underappreciate its own economic vulnerabilities.

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