On the Ukrainian conflict
The conflict in Ukraine is first and foremost about the violent overthrow of a corrupt regime that was not increasing living standards. But now that Ukraine has appealed to the west, it has become much more about Russia’s sphere of influence and the encroachment of the US, the EU, and NATO on former eastern Bloc and soviet areas. The contagion to Russia has begun. However, unless we see armed conflict, the implications for other emerging markets remains muted.
The conflict in Ukraine is first and foremost about the violent overthrow of a corrupt regime that was not increasing living standards. But now that Ukraine has appealed to the West, it has become much more about Russia’s sphere of influence and the encroachment of the US, the EU, and NATO on former Eastern Bloc and Soviet areas. The contagion to Russia has begun. However, unless we see armed conflict, the implications for other emerging markets remains muted.
As a former diplomat, I feel as comfortable analyzing the geopolitical world as I do the financial or tech world. So let me give you my take here. What is happening in the Ukraine has overtones similar to what happened in Georgia six years ago. Former Soviet leader Mikhail Gorbachev gave his view of the Georgian conflict in August 2008:
Russia has continued to recognize Georgia’s territorial integrity. Clearly, the only way to solve the South Ossetian problem on that basis is through peaceful means. Indeed, in a civilized world, there is no other way.
The Georgian leadership flouted this key principle.
What happened on the night of Aug. 7 is beyond comprehension. The Georgian military attacked the South Ossetian capital of Tskhinvali with multiple rocket launchers designed to devastate large areas. Russia had to respond. To accuse it of aggression against “small, defenseless Georgia” is not just hypocritical but shows a lack of humanity.
Mounting a military assault against innocents was a reckless decision whose tragic consequences, for thousands of people of different nationalities, are now clear. The Georgian leadership could do this only with the perceived support and encouragement of a much more powerful force. Georgian armed forces were trained by hundreds of U.S. instructors, and its sophisticated military equipment was bought in a number of countries. This, coupled with the promise of NATO membership, emboldened Georgian leaders into thinking that they could get away with a “blitzkrieg” in South Ossetia.
In other words, Georgian President Mikheil Saakashvili was expecting unconditional support from the West, and the West had given him reason to think he would have it. Now that the Georgian military assault has been routed, both the Georgian government and its supporters should rethink their position.
At that time, I also wrote a piece on the Georgian conflict highlighting the fact that, “Russia sees the U.S. as a global hegemon, looking to expand its sphere of influence eastward into the Caucasus, and Central Asia, two oil rich regions.
“Since the fall of the Soviet Union, Russia has seen its economic and political power shredded. It has witnessed the exiting of Eastern Europe, the Baltics and arguably the former Yugoslavia from its sphere of influence. It has lost oil-rich areas in the Caucasus and Central Asia. It has seen important bilateral nuclear agreements with the U.S. unilaterally disregarded. And it has seen rich Western companies trying to snap up access to vital oil reserves within Russia. With a number of Eastern European countries having entered NATO and/or the EU, Russia has drawn the line at Georgia.
“The U.S. looked to bring Georgia into NATO, effectively putting NATO right on Russia’s doorstep. While Bush et al. see no harm in this, Russia sees NATO behavior as a direct military and economic threat and used this opportunity to end this threat.”
The same is true here yet again; the forces now vying for power are in part backed by western money as the US has been trying to foment regime change in Ukraine for some time. The US, the EU and NATO are seeking to advance right up onto the Russian border in a way that the Russians have to see as a geopolitical provocation. Whereas one must legitimately ask what strategic interests the US has in Ukraine, it is clear that Russia has very vital strategic interests at stake. See here for a short history on Ukraine and Crimea.
The best analogy I can come up with is an incursion into Canada or Mexico by the Russians or the Chinese. But even there, neither of these countries was once a part of the United States. Nonetheless, it bears asking what the US response would be if the Canadian or Mexican government fell and then wanted to join a permanent Russian military alliance. Here’s a scenario: There’s chaos in the streets of Montreal with scores dead due to a brutal response by the Canadian Prime Minister. Stephen Harper is then overthrown. Jean Chretien, the new premier, decides to join a new Chinese global military alliance. What would the US response be? The Bay of Pigs/Cuban missile crisis was over 50 years ago, but I think the threat to Canada or Mexico would invite a similar response or a more aggressive one. Tactically speaking, the US would want to support the overthrown Mexican/Canadian government before a new government could legitimatize itself. But the Chinese or Russians would not risk military confrontation in the American sphere of influence.
Thus, in Ukraine, the response was always likely to be disproportionately aggressive on the Russian side versus the NATO side given there is no military solution available to the United States. The first Russian imperative is to prevent any government in Ukraine that wants to join NATO from taking power and legitimizing itself internationally. That is why they have been forced to intervene as quickly as possible. Having done this, another Russian imperative then is to drive a wedge between NATO members via Germany to prevent NATO having a united front. Greece is another option here. But I believe Germany is the obvious and more significant counter to the US within NATO. And the Germans are especially dependent on Russian gas now that they are trying to de-nuclearize themselves. That’s why talks with Merkel are happening.
Where this goes from here is anyone’s guess. But, the Russians want some event to legitimize their incursion into Crimea the way the Georgian move into South Ossetia legitimized the Russian response there. It probably won’t happen. Therefore, Putin is stuck in diplomatic negotiations both with the west and with the Ukrainians. What Russia wants is to prevent Ukraine from ever joining NATO or becoming a NATO or EU beachhead on Russia’s borders. Any compromise agreement must solve this basic problem. Now clearly, if you were Ukrainian, the appeal of the EU would be the same as it was in Poland or Latvia or Bulgaria. But I don’t see Russia allowing Ukraine to join the EU. Let’s see.
For now, the contagion has been to Russia, where the Rouble fell to a record low, forcing the central bank to hike rates from 5.5% to 7.0%. The Russian market was down about 10% today as well. Markets everywhere are declining, with Europe off about 2%. Treasuries were trading at 2.61%. I expect the yield to go lower.
What long-term impact will this have? I think the impact will be limited because Ukraine is not well connected to any other Emerging countries except Russia. And I believe Russia can handle the shock of a Ukrainian default and depression. There could be a negative impact on the Russian economy. But Russia is not dependent on capital flows the way Brazil, Indonesia or India are. Only if this confrontation turns into an armed conflict will we see more contagion. In the meantime, this will just serve to lower sentiment toward emerging markets such that when negative macro surprises, hit they will be met with selling and capital outflows, back to the US or Europe.
Overall, the Ukrainian conflict is supportive of safe haven assets like Treasuries, the US Dollar and gold, all of which have been rising.