(click to enlarge)
One has to be impressed by the market’s apparent sangfroid in the face of recent Ukrainian political and economic developments. For the market has effectively treated the Ukrainian crisis as a one-day event and has seemingly chosen not to price in any risk of a Ukrainian tail-event on the European economic outlook. It has done so despite every indication that Ukraine now faces a prolonged period of economic and political turbulence that has the potential to disrupt Russian energy supply to the rest Europe. It has also done so despite the extremely high dependence of the Baltic countries, Hungary, Poland, and Turkey on Russian natural gas imports.
One might have thought that the market would be paying attention to the clearest of indications that the Russians are now stirring up trouble in Ukraine’s all-important Russian-speaking Eastern provinces. More importantly yet, one would have thought that the markets would be taking notice of the fact that the Russians are cynically making full use of their energy supply lever over Ukraine. Last week, Russia chose to increase the price on its natural gas exports to Ukraine by around 80%, knowing full well how crippling such an act would be on the Ukrainian economy.
Russian natural gas imports account for around 40% of Ukraine’s overall energy needs and they cost the country around US$7.5 billion, or around 5% of GDP, in 2013. An 80% hike in natural gas prices would constitute a major economic shock to a Ukrainian economy that is already deep in recession and that is being required by the IMF to undertake major public spending reductions and domestic energy price increases. It would also have the effect of increasing Ukraine’s external financing needs by around as much as 4 percentage points of GDP. Presumably such an additional weakening in Ukraine’s external financing would require even more painful economic adjustment than has been contemplated to date.
What is most surprising about the market’s apparent calm in the face of growing indications that Russia is engaging in economic warfare with Ukraine, which could very well destabilize the country, is that the market is overlooking the fact that a major part of Russia’s natural gas and oil exports to Europe pass through Ukraine. Indeed, it is estimated that 40% of Russian gas exports to Europe pass through Ukraine and those exports account for some 15% of Europe’s overall natural gas needs. The market also seems to be oblivious to the particularly destabilizing effect that a deepening in the Ukrainian crisis could have on the Baltics and other East European countries that are extremely dependent on Russian natural gas imports for meeting their energy needs.
All of this is not to say that it is a certainty that the Ukrainian risks will fully materialize. However, it is to say that minimally one might have expected the markets to price in at least some probability of those risks materializing.