Europe fears chill of new Cold War

Few could have predicted the political and economic turmoil which Ukraine’s refusal to sign a promised trade co-operation agreement with the European Union would unleash almost one year ago. 

The U-turn led to a popular revolt in the capital of Kyiv and many regions of Ukraine, Europe’s largest country by landmass. More than 100 protestors were slaughtered in the subsequent clampdown, the thuggish President Victor Yanukovych fled across the border and Russia quickly seized the militarily strategic Crimean peninsula.

As if things could not get any worse, Russia funded and encouraged a revolt against Ukraine’s new government in the industrialised Donbass region, which kicked off a new Cold War-style stand-off with Western powers.

Tensions rose further after a Malaysian passenger aircraft was blown up by a missile, apparently fired from Russian-backed rebel-held territory, killing all 283 passengers and 15 crew. As sanctions against President Vladimir Putin’s inner circle and key state-owned companies are gradually ratcheted up, asset managers and private banks are modelling their own risk scenarios and advising clients accordingly on how to re-allocate portfolios.

Analysis from James Bevan, head of investments at charity and family money manager CCLA, suggested EU members were intitially slow to act. UK banks, for instance, which act as counterparties for 28 per cent of Russian interbank loans and deposits, could be severely hit in terms of fees, feared the British government.

Similarly, German and French industry may suffer. France has suspended delivery of two helicopter carriers in a Ä2bn deal  with Russia until a lasting peace deal is struck in Eastern Ukraine. Exports to Russia are also likely to decline, believes Mr Bevan.

“History suggests it would require a significant shock to the Russian economy to undermine domestic support for Vladimir Putin’s government,” he says.

“To achieve that would require such severe sanctions that they would likely impose significant costs on the EU’s own economy and this at a time when the European economy is already weak.”

The conclusion is that while co-ordinated and meaningful sanctions that could seriously “move the dial” on Russia would be tricky to get agreed in Europe, the price of doing nothing is much higher. There could potentially be much greater risks from inaction, damaging both Europe’s economy and the shares quoted on its financial markets.

Among companies singled out by CCLA were brewer Heineken and energy giant Shell, which could suffer from significant direct business exposure to Russia.

While studies from US investment banks suggest European economies are not particularly vulnerable to the crisis in Ukraine, they highlight international firms such as Swedish household goods producer Oriflame, Finland’s Nokia Tyres, Danish brewer Carlsberg and French food giant Danone as deriving significant revenue streams from Russia.

Similarly, Austrian and Greek telecoms and Spanish energy and industrial players could be hit, should the crisis spread to Russia’s former Eastern bloc neighbours.

There has been a reluctance to hold Ukrainian assets by many managers and private banks due to problems understanding the whole debt arena and wrestling with unpredictable coupon payments, coupled with volatility and due diligence issues.

London & Capital for instance, was keen on Ukrainian banks and resource-related companies, both in Russia and Ukraine, explains the wealth manager’s fixed income boss Sanjay Joshi, but they are hindered by custodians’ new restrictions in trading those markets.

Among the scenarios modelled by Mr Joshi’s team, the best case involves Mr Putin being satisfied with having snatched Crimea and stepping away from Ukraine, with IMF aid to follow.

The worst case would involve the annexation of East Ukraine, followed by a Russian military offensive to secure a corridor from Donetsk to Crimea. Recently L&C ascribed a “more than 50 per cent probability” to the latter, but this is now falling.

In the light of these calculations, L&C has recalibrated allocations to French and German banks with Russian interests, now pronouncing itself “comfortable” with positions in SocGen, BNP Paribas and Crédit Agricole. All of these banks have taken steps to reduce Russian exposure.

But the Ukraine crisis has “raised the level of general anxiety” among institutions and clients already concerned about looming recession, unpredictability of central bank policies and geopolitical risk from the Middle East, believes Didier Duret, chief investment officer at ABN Amro.

In Kyiv, where life appears to be almost back to normal, after newly elected Mayor and former heavyweight boxing champion Vitali Klitschko led a clean-up of pavements and buildings damaged during disturbances, anxiety persists.

Nearly 50 per cent of once-busy stores in the flagship Globus centre in Independence Square have moved out, due to the plummeting Hryvnia currency and an economy tanking from the cost of defending Eastern provinces under Russian attack.

“We are not strong enough for bilateral talks with Russia. They will outplay us,” said prime minister Arseniy Yatseniuk at the recent Yalta European Strategy summit in Kyiv, where many Western leaders joined the debate to show their solidarity with Ukrainians. “Putin wants another frozen conflict and to get his hands on our belly fat.”

While the beleaguered country is likely to receive some Western weapons in a new Cold War scenario, coupled with IMF aid, some more radical voices in parliament are even calling for Ukraine to re-activate its nuclear deterrent.

But most agree President Putin still holds the key cards. News of the eventual signing of Ukraine’s EU association agreement in mid-September was used to mask a shadier deal struck on the same day to grant limited autonomy – for a three year period – to rebel-held territory in Donetsk and Luhansk.

This gives President Putin a continued military stake in mainland Ukraine, without any official political or financial responsibility.

For institutional investors, all of this is part of a long-developing pattern says, Create-Research CEO Amin Rajan, whose latest survey on emerging markets investing gave Russia a very low score on the report card.

“What Russia has been doing is a clear example of political ‘overstretch’, by annexing Crimea and trying to create a Eurasian bloc through deals with neighbours,” says Mr Rajan. “You need strong institutions for this. But Russia does not have institutional strength in any sector. It is run by a dictator with a parliament which rubber-stamps every decision he makes.”