Russia/Ukraine – Observations and Currency Market Implications

The Euro has become increasingly sensitive to developments between Russia and Ukraine. The main channels through which the ongoing crisis impact the Euro are through energy dependency, broader trade flows, banking exposure and sensitivity to financial conditions.

Energy dependency is the most important channel of contagion. At present the EU imports 40% of its gas and 20% of its oil from Russia. There is no indication that these flows will be disrupted, however, over time there will be pressure to source energy from elsewhere and at a potentially higher cost. Also, more immediately the cost of energy imports is significantly higher while EU gas reserves are very low. As such inflation pressures are likely to intensify which will impact domestic consumption and broader GDP. Such a stagflation shock leaves no good policy option for the ECB.

The other channels of contagion are somewhat less severe. EU exports to Russia have been in structural decline and were only 1% of GDP in 2020, with sensitivity largest in the northern and eastern EU states. Similarly, EU banks’ lending to Russia have fallen over the last decade and were as low as 0.7% of total EU bank claims in Q3 2021. That said it is hard to quantify what potential sanctions on Russia’s access to payment messaging systems (SWIFT) may have as these figures may underestimate the interlinkages of complex financial systems.

Other issues to consider are whether a Russian state that is increasingly isolated from global financial systems (and already heavily sanctioned) becomes more disruptive to the EU via cyber-attacks, information warfare and meddling in domestic political systems.

Going forward, the extent and degree to which these trends in Russian/EU interlinkages are exacerbated will depend primarily on two factors:

1. To the extent to which the Russian invasion is a short tactical strike to secure independence for the newly Russian-recognised republics of Donetsk and Luhansk or a full-scale occupation of Ukraine for the longer term.

2. The breadth and depth of the sanctions regime implemented by the West regarding i) limiting Russian energy exports and ii) isolating Russia from the international payments system SWIFT.

As regards to 2.) there is a potential paradox or a conflict between the geopolitical goals and the economic ones. The harsher the response from the Western alliance, the greater scope to exact costs on the Russian regime in geopolitical terms but the more negative it will be for the Western alliance in economic terms and the EU in particular.

Under any scenario, the ripple effects are worse for the broader continental European economy than the US and hence, the initial market reaction of re-pricing the US dollar upwards against almost all trading partners is a rational response. However, the degree to which this persists or has already been discounted in market pricing is largely a function of the depth of the crisis going forward which will depend upon the extent of Russian intentions as summarized in 1.) above.

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