I wrote an article last fall, warning that long-term stability of the world is being threatened by geopolitical trends in a region stretching from Afghanistan in the East, to the strait of Gibraltar in the West and from Yemen in the South to Russia in the North. It is an area comprising over a billion people, trillions of dollars in global GDP, trillions of dollars in sovereign, corporate and consumer debts as well as about 40% of current global oil production. It comprises East and Central European states as well as mainly Muslim states in the Middle East, Asia and North Africa. We are looking at not only defaults but potentially failed states, where money will never be recovered and there will not be enough stability in place to allow for continued production of crucial global commodities such as oil and gas in places like the Middle East, or soft commodities produced in places like Ukraine, Romania and Hungary. Sadly, it seems no one is paying attention to the fact that there is a massive area of instability developing, thus we get irresponsible power games being played out between Russia and the West in places such as Ukraine, helping further destabilize this wide swath of territory.
Thanks to the meddling of the global power players we now have Ukraine joining an already long list of countries that are either failing, on life support, or a combination of the two. In this category we now have Greece, Ukraine, Yemen, Iraq, Syria, Libya, Egypt and Afghanistan. These are all countries where there is no longer much of a chance of redressing the situation. In places such as Greece, where the debt/GDP ratio will always be too elevated to prevent eventual sovereign debt default, money will always have to be poured in. Ukraine joins that category due to the fact that from this point on, it will be a country in perpetual revolution. Russia offered them $15 billion in order to stay afloat, now the EU has stepped in with an offer of $27 billion over seven years together with the IMF in order to prevent default (link).
We also have a number of countries that are on the brink, which is the category Ukraine was in before it was pushed over the edge by internal divisions combining with irresponsible external pressures. In this category we have Turkey, Serbia, Pakistan and Bosnia-Herzegovina. Serbia is ready to make a deal with the Emirates in order to prevent it from defaulting (link). Pakistan already gets aid from the United States in order to prevent it from becoming a failed state due to pressure from tribal warlords and the poor economic situation. Turkey is not yet at the point of having to be bailed out, but there is a chance of the IMF having to intervene soon given the drop in its currency value so far this year. As for Bosnia-Herzegovina, it is a state that should have been allowed to disintegrate in the 1990s with the Bosniak Muslims becoming an independent entity and the Serbs and Croats joining the states of Serbia and Croatia respectively. As things stand right now, it remains a powder keg created in the aftermath of the last Balkan war, which is always ready to explode and plunge the region into turmoil. Recent street protests, which are currently not ethnic confrontation driven, can easily morph into another civil war.
The majority of the rest of the countries in Eastern-Central Europe as well as in the Muslim world in the Middle East, Asia and North Africa are either just a step or two from the brink, or in danger of being taken down with the rest through proximity exposure.
How the Ukraine situation threatens the entire region to the west
The EU offer of aid comes with an IMF partnership, and there are already some preconditions being set. The most important of these preconditions is a phasing out of natural gas subsidies, which are absolutely necessary in order to make heating affordable for ordinary Ukrainians. In the absence of those subsidies, average Ukrainians with a GDP per capita of less than $4,000 simply cannot afford to pay the European market price of natural gas. This means Ukraine will inevitably unleash another standoff with Russia over gas, most likely by not paying for the imports they will consume. Russia will once again have no choice but to end shipments through pipelines towards the EU that transit through Ukraine, and this time they may take further steps. Russia may perhaps even start the process of diverting the resource by either finding alternative domestic use for it, or alternative export markets, thus deciding to keep the pipeline closed permanently.
A large number of countries in Europe could be affected by this, including large economies such as France and Italy. By far the most devastating effect would be felt by countries in Central Europe and the Balkans. These countries include Austria, Hungary, Croatia, Slovakia, Poland, Serbia, Romania, Macedonia, Bosnia-Herzegovina and Slovenia. A prolonged Russian shutdown may throw the entire region into economic turmoil, not only because of the need for gas in winter for heating but because industrial output in the region depends to a large extent on natural gas consumption either directly or indirectly. We could already see this situation play out as soon as next winter, in which case we will find out just how contagious the current pockets of instability in the region can be. Europe could find itself thrown into another recession due to this situation, which is the last thing it needs after six years of economic crisis, which left some countries such as Spain with an unemployment rate of 25%.
The Drain Effect (A global state welfare system developing)
Aside from the contagion effect caused by instability, there is also the drain effect on countries pouring in resources in order to prevent an implosion. Greece is perhaps the most famous recipient of funds meant to stabilize it and the most costly by far. So far about $330 billion were committed to this bailout (link). I don't believe this money will ever be recovered. The debt holders may change in time, but eventually Greece will default. Egypt recently made it on to Arab oil welfare, so far receiving about $20 billion in aid and loans (link). I already mentioned the $27 billion pledge to Ukraine. The United States has spent and will be spending a lot of money to keep Afghanistan stable. The money poured in to spots of instability is starting to run at a steady rate of tens of billions of dollars per year, if we are to include the recipients of smaller volumes such as Pakistan. There are also states such as Syria that are simply imploding, so there is far less money spent on aid there, but humanitarian aid is increasingly needed in order to allow for the majority of the people in that failed state to survive. States such as Syria are also causing contagion elsewhere as seen in Iraq, where fighters from Syria's civil war are pouring in, so the direct price exacted on global finance may be modest, but the indirect price of further instability elsewhere can be huge.
Private sector threat
Franklin Templeton (NYSE:BEN) owns $3.8 billion in Ukrainian sovereign debt (link). It added to its position recently even as the turmoil was unfolding, with the conviction that one way or another Ukraine has money coming its way. It used to be Russian money, now as it turns out it will be EU-IMF money. Ukraine has about $63 billion in total government debt as of the end of 2012, which is not much given its $170 billion economy, but it is a lot to deal with when people are already so poor that any little cut in spending will affect the population tremendously.
The domino effect of a potential default will be disastrous for global finance. As the example of Templeton shows, some funds can take a very significant hit. Current bets on Ukraine debt may be influenced by the belief in an IMF backed deal, which makes the debt safe. However, no one is accounting for the multiple threats to having that deal nullified.
Ukraine caught in perpetual revolution
The IMF loan will now be in place to prevent Ukraine default, but only as long as current government stays in power. I don't believe Ukrainians will be able to digest the IMF recipe that comes with the $27 billion EU-IMF loan. It will lead to a rise in the price of heating in the winter, and to a large portion of Ukraine's non-viable industrial base being shut down. A devaluation of the country's currency was also mentioned as being part of the deal, cutting even further into the population's buying power. It is still unknown when these reforms will start to bite, but when it happens, it will be very painful.
Some may argue that it is no different than what happened in the 1990s all over the region. All these reforms were implemented elsewhere yet many countries came out of it all right. There is one very significant difference, however, and that is the EU and global economic context. In the 1990-2008 period, the former communist region experienced a significant influx of western capital looking to take advantage of lower wages and what was then robust consumer demand in the West. That trend is pretty much gone now. The EU has been in economic stagnation mode since 2008 and will continue to be, while low-wage products are increasingly manufactured in Asia, making it harder for East European countries to compete, especially given that consumer demand growth is also increasing in Asia, while struggling in Europe. Nokia's (NYSE:NOK) decision to liquidate production facilities in countries like Romania in favor of concentrating production in Asia is a reflection of the trend (link). Chances of economic recovery in Ukraine are now almost zero, therefore someone will have to be left holding the bag eventually.
Threat of civil war
A little-covered aspect of the current revolution against Yanukovic is the hardliner nationalistic aspect of the pro-western movement. The first reform implemented by the current parliament was to revoke the minority language rights enjoyed regionally by the Russian, Hungarian, Romanian, Polish, Tatar and other historical minorities that make up a significant portion of Ukrainian society (link). Most minority groups such as the Hungarians, Polish and Romanians will likely simply capitulate. They are relatively few in numbers and will likely depend on Hungary, Romania and Poland speaking up for them. Russians, however, make up about 17% of the population and will most likely have the backing of Russia in case hostilities were to break out. The threat of civil war is real and it is a threat to Ukrainian debt holders.
Need for a new way of thinking
If the deterioration of the geopolitical and economic situation of the large high-threat region I identified in this and previous articles continues, it will lead to a domino effect. Numerous defaults on sovereign debt will eventually affect the solvency of all nations. With developed world debt levels now considered by many to be a threat already, developing world defaults may at first bolster developed world bond buying as a safe haven play, but the economic fallout from the developing world will make that safe haven play short-lived. Given the lack of appreciation of policy makers from various major powers involved in pulling strings in the high-threat region, I cannot help but compare the current elite involved in foreign policy to bulls let loose in a china shop. We will all inherit the pieces unless major policy changes are introduced as soon as possible.
Disclosure: I have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.