Since late last year, Russia has been building up military forces on its border with Ukraine. Moscow insists it has no plans to invade its neighbour and is only conducting troop exercises. But in 2014, Russia annexed the Crimea peninsula from Ukraine and encouraged a separatist rebellion in its eastern Donbas region after Kyiv began to tilt towards the European Union (EU) and away from Moscow’s influence.
Russia is now using its military build-up to demand the North Atlantic Treaty Organisation - the alliance of North American and European nations - will guarantee that it will never offer membership to Ukraine and that it will pull forces out from Eastern European countries that joined NATO after the Cold War ended in 1990-91.
This year, the situation has become more tense. US intelligence has warned that Russia’s military forces are preparing an offensive to start in mid-February. Foreign embassies have evacuated personnel from Ukraine and some airlines have cancelled flights. This week, Moscow claimed it was starting to withdraw some troops but the US, UK, EU members and NATO are warning Russia is still deploying forces on Ukraine’s borders. Though all sides prefer a diplomatic outcome, an early, peaceful resolution is uncertain and the risk of military escalation remains elevated.
A full-fledged invasion of Ukraine by Russia that aims to overthrow the government in Kyiv and occupy the whole country is not our base case.
Source: Bank of Singapore, Bloomberg.
Though Russia has amassed over 130,000 troops on its border with Ukraine and in neighbouring Belarus, there has also been unprecedented levels of diplomatic engagement to avert a conflict. The leaders of the UK, France and Germany have visited Kyiv and Moscow in recent days. US President Biden has been holding conference calls with Russian President Putin and Ukrainian President Zelensky. And Russia’s foreign minister insists Moscow will keep talking to reach an agreement.
But the situation is highly fluid. Even if all parties prefer a diplomatic outcome, it is difficult to see how an agreement could immediately be met. The concessions Russia wants from the US and NATO seem impossible for Washington and Brussels to compromise on. We thus continue to see elevated risk of military escalation, especially in the conflict zone in eastern Ukraine that has been contested since 2014.
If fighting does break out, then financial markets will react strongly.
The chart on the first page shows gold and oil prices have already increased sharply in recent weeks as tensions have mounted.
A prolonged downturn in global markets, however, would depend on whether Russia aims to fully occupy Ukraine - not our base case - and if the US retaliates with harsh sactions that hit Russia’s oil exports.
In the event of military conflict breaking out, the US, UK and EU countries have made it clear they will introduce extensive, broad-based sanctions against Russia.
The US Senate has drafted a bill - ‘Defending Ukrainian Sovereignty Act of 2022’ - which stipulates a wide range of restrictions in case of military escalation. These include:
Such harsh restrictions would likely lead to significant capital outflows from Russia. But Moscow has substantial macroeconomic buffers including USD635 billion of FX reserves. This could help dampen the potential impact on Russia’s economy.
At the same time, we think sanctions limiting energy exports from Russia may be unlikely. Russia supplies one-third of Europe’s energy needs and is the world’s largest gas exporter, and second-largest oil exporter. Limitations on Russian energy exports would lead to significant and sustained spikes in energy prices globally, shifting the costs of western sanctions on Russia to energy consumers in the US and Europe.
Thus, while investors are likely to react strongly to military conflict breaking out between Russian and Ukrainian forces, the prospects of a prolonged downturn in global markets will depend on whether Russia aims for a limited incursion into Ukraine rather than trying to topple the government in Kyiv and whether the US and European countries respond by imposing harsh sanctions not just on Russian banks but also on Russian energy companies that would cause a major rise in oil prices.
If a limited conflict does not lead to sanctions that affect Russia’s energy exports, then financial markets globally may not endure a sustained downturn this year after their initial sharp declines.
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