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Summary

  • Before the Malaysian flight tragedy, I argued that a mutually destructive economic confrontation between the West and Russia is not likely to happen. This is a game changer.
  • The effects of such a confrontation (it is going to spiral out of control) can lead to global economic chaos for the rest of the decade and perhaps beyond.
  • Given past months of rhetoric on this issue, it is now hard for the West to formulate a responsible policy in this situation, therefore Russian capitulation only way out.

I started writing about the Ukrainian crisis months ago, because I felt the turmoil there will have a big impact on markets and the economy. One source of danger I identified as being the more likely to happen is already unfolding in the form of the natural gas disruption to Ukraine, which occurred a month ago. This is likely to endanger supplies to over a dozen EU members if Ukraine decides to siphon off gas transiting towards EU customers from Russia, which is almost certain to happen if the coming winter will be cold. A prolonged disruption to EU gas imports will plunge the continent back into recession and will expose the feeble state of many EU economies, many of which are vulnerable and could be pushed towards default.

With the tragedy of the Malaysian airline, which was shot down in Ukraine close to the border with Russia, comes a situation I hoped would not arise. Due to this event we now find ourselves at a junction which depending on what the actors involved will do, can either lead to a de-escalation or take us on the road towards the mutually destructive economic confrontation with Russia I previously thought we will never be in danger of engaging in. Personally, I hope that the responsible course will be taken and this opportunity will be used to call for an immediate cease fire and call on both warring sides to begin negotiations meant to end hostilities. Given the tragedy this conflict inflicted on a third party, which had nothing to do with the conflict, it would be hard for any side to refuse such a demand coming from the international community.

Since the beginning of this crisis, all sides involved neglected to weigh the dangers of destabilizing a country already suffering from many divisions. The EU asking Ukraine to choose between its relationship with Russia and its own offer of the association agreement seems like a un-calculated, uninformed or simply careless move to say the least. More divisive actors appeared on the scene in Ukraine as the EU and the US lent unconditional support to any groups in Ukraine willing to move against former president Yanukovic as a response to his refusal of the EU offer, including extremist far-right movements. It should have come as no surprise then that the first act of the interim Ukrainian government which was installed after the ouster of Yanukovic and included many of these elements was to repeal minority language rights, which then unleashed the backlash from the ethnic Russian minority, which led to the current situation. The overly hawkish position taken by the US and to a lesser extent the EU since hostilities began, which only blames the Ukrainian separatists and Russia for the violence and exempts Ukraine authorities from any responsibilities served to lessen the willingness of the Ukrainian government to compromise.

The Russian government's efforts to exploit the ethnic Russian backlash and use the opportunity to protect its strategic position in Crimea by incorporating it into the Russian federation did not help either. The effort to foment separatist sentiments along its border where millions of ethnic Russians live in Ukraine in order to destabilize the new pro-western Ukraine government is Russia's undeniable contribution that led to the current situation. The irony is that in my view it was not even necessary. The move to turn off the gas and demand payment for money owed as well as a gradual disengagement from Ukrainian imports into Russia would have been enough given the already dire situation Ukraine finds itself economically. The situation is also worsened by the IMF demands for reform which will lead to more pain and suffering for a society which is already among the poorest in Europe.

Bottom line is that for many months now Ukrainian and outside actors interfering in its affairs have been acting irresponsibly, and as a result of it, we are now on the edge of the cliff and staring down towards the fall. Based on the experience we had so far, we can expect a continuation of irresponsible acts, I therefore doubt that a push to use this tragedy in the interests of peace will materialize. It is more likely that given the likelihood of the plane having been shot down not by Ukrainian military, but by either Russian or rebel fighters, the West will try to press for a complete victory.

Danger of a severe economic confrontation:

In the many articles I wrote on this subject, I pointed out that we should not expect a severe economic confrontation because most actors should in theory be aware that it would lead to worldwide economic consequences given Russia's role as a provider of oil for the international market. Russia is in fact exporting the equivalent of about 8% of the world's total liquid fuel needs. As i pointed out already in other articles, the cessation of these exports for the duration of one year would lead to an initial drop in global economic output of as much as 10%. My assumption is based on a rough estimate of productivity gains in past decades of about 1.5% and an assumption that in addition to the productivity gains every 1% gain in yearly GDP requires an average yearly increase in liquid fuel supplies of about 0.5%. Needless to say that such a drop in economic activity would have ripple effects, including massive defaults on a sovereign, consumer and corporate level, which would likely lead to many years of global economic chaos. Russia therefore has the means to retaliate by bringing everyone down with it, in the event that Western sanctions become too aggressive and end up substantially harming its economy.

I have to say that the current tragedy which led to the death of 295 people is the game changer which is likely to harden the position of the West and the Ukrainian government. It is therefore up to the ethnic Russian rebels in Ukraine and the Russian government to decide whether they accept total surrender or stand their ground and push back. It is this decision which the health of the global economy will now depend on.

Likely shape of confrontation:

The West may press Russia by introducing more severe sanctions on firms or entire sectors. It is unfortunate that the media and politicians failed to explain to the public the magnitude of the potential pain we could suffer due to possible Russian reprisals. Russia's most likely immediate response will be to hit companies operating in Russia. It could suspend the operation of oil companies such as BP (NYSE:BP), hitting not only BP's bottom line but also global growth prospects if the 1 mb/d of Russian production attributable to BP will be missing from the global market. Other foreign producers will be hit as well. Exxon Mobil (NYSE:XOM) may end up losing its investments it was hoping would stem the slide in production which it and most other major oil producers have experienced in the past few years as I pointed out before (link).

The European Union's ties with Russia were discussed within the context of its gas dependence for the past few months. Little notice was paid to EU exports to Russia which come mainly in the form of manufactured goods and services and amounted last year to $150 billion.

Source

There are already signs that major EU exporters such as Germany are starting to suffer a significant drop in exports volume to Russia and it is directly linked to job losses. It is the last thing the EU needs with an unemployment rate over 10%. A complete halt to finished goods and service imports on Russia's behalf could cost the EU a few million jobs and I believe it would be enough to push the struggling union over the edge with severe global consequences.

In a worst-case scenario, with its back to the wall, Russia could go all-out and halt oil exports which as I often pointed out in previous articles would amount to mutually assured economic destruction if it were to be sustained for a prolonged period. For Russia it would likely mean wiping out the gains in living standards achieved in the past decade and a half or so and reverting back to the misery of the 1990's. Bad news is that Western living standards would most likely reach a similarly miserable level, given that the shock to the system would wipe out our financial system due to massive defaults in all debtor categories ranging from consumers to sovereign states.

The public really has been done a great injustice by not being informed of the ability of Russia to inflict this kind of damage on the global economy. All the talk and active encouragement of sanctions without discussing what can happen if Russia retaliates for months and months has left the Western political elite with little choice but to follow an aggressive path, because I believe it is now too late to try to explain the potential consequences. If one wants to understand just how impossible it is to formulate a more prudent response, it is enough to go back and forth between a right-leaning and left-leaning news television channel for a few minutes and observe just how eagerly both sides are embracing the idea of an aggressive and punitive response towards Russia.

If one reads my previous articles on the topic of Western sanctions against Russia tied to the Ukraine crisis, the reader can see that I consistently argued that we will not reach this dangerous point. Now I sadly have to admit that I was probably wrong and investors need to brace themselves for a mutually destructive economic confrontation, which can now only be avoided by Russian capitulation. I'm uncertain how likely that is to happen, but I think we have little reason to be optimistic.

Disclosure: The author has no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours. The author wrote this article themselves, and it expresses their own opinions. The author is not receiving compensation for it (other than from Seeking Alpha). The author has no business relationship with any company whose stock is mentioned in this article.

Source: Crisis In Ukraine: Path To Peace Or Disastrous Economic Confrontation...