COMMENT: What are the contagion risks of the Ukrainian crisis for the rest of CEE?

By bne IntelliNews February 20, 2014

Tim Ash of Standard Bank -

With Ukraine in flames, Tim Ash, head of research at Standard Bank, looks at the risk of the crisis affecting other markets in Central and Eastern Europe.

On the issue of contagion to global EM, the total stock of Ukrainian Eurobonds is only around $30bn or so (half the stock of foreign holdings in the Russian devaluation/default of 1998), or a small part of the EM bond stock, and overall investments in Ukraine are a similarly small part of the EM asset class.

The asset class should hence be able to ride through a Ukrainian devaluation/default, albeit watch for concentrated ownership patterns, which might create some knock on impacts in specific countries.

That said, the worsening situation in Ukraine, adds to the overall perception of heightened risks across EM with political instability now playing out in Ukraine, Turkey, Thailand, Venezuela, et al. It just adds to the negative mood music around EM.

One premise is that there could be a domino effect across other former Soviet states across the region, as Russia pressurizes them to join the CIS Customs Union. I don't really see this panning out. Primarily as most former Soviet states have already made their decision on orientation.

The Baltic Republics are already in the EU now for over a decade, and importantly are NATO members. The five central Asian states are already more closely tied/allied to Moscow - Kazakhstan a signatory of the CIS CU. The Lukashenko regime in Belarus also opted for the CIS CU, as also recently did Armenia - the latter spurning an Association Agreement (AA)/ Deep and Comprehensive Free Trade Area (DCFTA) with the EU as it already relied on Moscow for energy and security.

In Transcaucasia, Georgia seems set to sign the AA/DCFTA by August 2014, but Moscow seems content with the regime change in 2012-2013 which saw the ousting of the uber pro-Western former president Mikheil Saakashvili and his UNM. Georgia appears more willing to normalise the relationship with Moscow and this has brought a boon in trade and investment. Hence, Moscow will probably take/accept its improved ties with Georgia as progress, compared to the dismal relationship with the former Saakashvili regime.

Azerbaijan, meanwhile, seems to have set a much more independent (of Moscow) vent, and is supported by the West and Turkey. Again, Moscow appears much more accepting of this, and perhaps not willing to rock the boat just yet over Nagorno-Karabakh, and with Turkey when big energy deals are in the pipeline.

Moldova could be a potential flashpoint, but it seems determined to push on with its AA/DCFTA, and Moscow appears less interested in it than the big prize, which is Ukraine. Indeed, Ukraine is centre stage for Moscow, given its 1,000-odd year common history, religion and culture with Russia, its Slavic population, and the fact that its 46-million strong populace suggests it will be central to making Putin's vision of a powerful Eurasian Union to rival the EU, politically and economically meaningful.

Two economies which perhaps might be viewed most exposed to instability in Ukraine, through the trade channel are actually Russia and Poland.

Poland: formally only around 3% of its merchandise trade turnover is with Ukraine, but a significant portion of services/suitcase trade is probably undertaken with Ukraine. Note the disruption of border routes through to Poland over the past 24h. Overall though, Poland's balance of payments position is strong, with the current account deficit having shrunk to fit in recent year, and its sources of financing appearing fairly diversified. Poland also does not appear particularly leverage, hence should be able to ride through any fall-out from Ukraine. Depending on how the crisis in Ukraine develops, Poland might be worried over possible refugee flows out of Ukraine, and the potential budget impact. But we still seem some way from that scenario panning out.

Russia: similar to Poland, only around 3% of Russia's trade turnover is with Ukraine, so at face value the impact through the trade channel should be limited. However, of all Ukraine's neighbours Russia could perhaps be most impacted, and for a number of reasons.

First, Russia's banks, and sovereign are thought to have outstanding loans to Ukraine of $30bn or so, and any debt restructuring would likely result in significant haircuts on these liabilities. Admittedly, this is small change when viewed from Russia's strong sovereign balance sheet - and still close to $500bn in gross FX reserves -- while most of the bank debts are to Russian state-owned banks, hence likely to be bailed out ultimately by the Russian state. Still this will be moderately painful - but that said, a $30bn hit when set against Putin's vision for a Greater Russia as per the Eurasian Union is probably seen by the Kremlin as a small investment, worth paying.

Second, around half of Russian gas exports still transit through Ukraine, providing earnings for Russia of around $30-35bn. Much has been made in the past of Russia's ability to cut off gas supplies to Ukraine, to enforce its geopolitical objectives. However, the relationship is symbiotic, and any attempt to cut off these flows would also hurt Russia. Indeed, if civil war ensues in Ukraine, and this leads to a break down in law and order, and security, and disrupts gas transit then this could still be a serious blow to Russia.

Third, Russia is currently suffering from an image problem amongst investors, and foreign investment flows are weak, and domestic capital outflows remain strong. Russia has weak growth drivers, a weak overall investment story, a poor business environment characterised by corruption, red tape and bureaucracy, plus question marks over the rule of law. Perceptions of Russian meddling in Ukraine will hardly help these investor perceptions.

Political unrest in Ukraine may also create concerns over contagion risk to the political scene in Russia itself - which may actually explain Russia's own interventionist strategy in Ukraine itself, and the support for the Yanukovych administration. Already the ruble seems to be being managed weaker by the CBR, given Russia's weak growth outlook, but developments in Ukraine could easily accelerate capital flight out of Russian assets more generally.

Beyond the geo-political/trade contagion channels who else might be vulnerable?

Positioning risk is something to watch out for, and in particular are there concentrated ownership patterns in Ukrainian assets which could easily produce contagion elsewhere - e.g. if the imposition of sanctions forces selling of Ukrainian assets by buy and hold investors? Therein perhaps Hungary would seem most exposed to contagion - and recent weakness in the HUF might be somewhat explained by this tendency, or at least by expectations of that.

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