The monetary side of Ukraine War

Two important pillars of neutrality in International Finance have crumbled.

Two things which have happened within 7 days of the Ukrainian war, have occurred so quickly that it is hitting at the very base of international finance, which is built on neutrality.

1.SWIFT has removed many of the Russian Banks from its messaging system. If you look at the website of SWIFT it says : “SWIFT remains a truly global cooperative. Forty years on, the SWIFT community is stronger than ever before. Our global and neutral character is reflected in our increasingly international governance and oversight, including the SWIFT Oversight Forum.”

With the removal of Russian Banks from its system, it is very clear now SWIFT is not neutral any more.

2. The Guardian says " Switzerland, a bastion of neutrality through two world wars, has decided to adopt wholesale singeing EU sanctions against Russia, potentially freezing billions of dollars in assets and further increasing the pressure on the Russian economy. Swiss national bank data showed that Russian companies and individuals held assets worth more than $11bn in Swiss banks in 2020."

Definitely two major neutralities have been breached within one week of Ukraine war. Ukraine must be proud for these supports. But when considered from a third party or third country's point of view these steps are larger than declaring a war on a country. This will definitely shake the confidence of other countries on the international system of financial neutrality.

( It is ,however, quite possible what the secretive country of Switzerland is telling is for the gallery only. Secretly it is shifting the Russian assets to Swiss vaults in bunkers, which are not subject to any strict supervision. Many Indian oligarchic are also presumed to have shifted their ill gotten assets to similar vaults in Switzerland after converting the money of accounts to gold or other precious metals. These vaults are in the alps, not accessible by roads and can be reached only by small planes. )

Stakes are very high on both sides

When Putin recognized the two provinces of Ukraine as separate countries, the sanctions were relatively mild, but now sanctions are coming at full force and at unprecedented level as Ukraine is fully attacked. The stakes are very high on both sides. If Putin is successful in Ukraine, NATO in its current form will not survive, it has to go back to its historical form covering only the core western states, and NATO and EU would be delinked. A cess of 2% of GDP, which NATO used to impose on participating countries, would also be missed from some countries. If Putin fails, he has to resign, may be have to die in a coup, and a new regime in Russia with new reset of relation with the west will start. May be Russia as a country will be divided into parts, which was always on the agenda of some countries. Failure of Putin will be a great danger for China and even for India. The stakes are so high that it is a recipe for World War III.

The War Chest of Russia

The war chest of Russia is 683 billion US dollars of Reserve, which is very close to India's Foreign Exchange Reserve of 632 billion US dollars. But India is a much larger economy than Russia( currently at 2700 billion USD) and on that basis Reserves could have been more for India.

Russia's GDP was 1709 billion USD in 2021. So Russia had about 683/1709 x 12 = 4.8 months of GDP as Foreign Exchange Reserve. 30% of that Reserve is held in China, 20% in Gold and 50% in various currencies including in Euro and US dollars. The Funds at China and reserves in the form of Gold can not obviously be touched by sanctions.

When Putin attacked Ukraine did he not factor in Sanctions?

When Putin attacked Ukraine did he not factor in the sanctions ? Probably yes. But probably he did not anticipate the severity of sanctions. Now because of the sanctions, let us assume that 40% of the reserves of Russia is immobilized, still then he has 60% or about 400 billion dollars in the war chest, which is enough to sustain a long period, because in between Oil dollars and Oil Euros will flow in, as oil and gas exports from Russia has not stopped. In one of the tele conference with Joe Biden, who probably threatened of sanctions, Vladimir Putin says that his country is immune to sanctions and he is not worried about it. Besides Russia has many gold mines, it produces above 330 tones of gold in a year, 89% of which is exported to Europe. When sanctions hold the root the whole gold will be added to the gold reserve of Russia. After China, Russia is the second highest gold producer of the world. ?At current price one ton of gold is 65 million dollars. So 330 tons of gold is worth 21 billion dollars.

How is Russia going to address the fall out of sanctions ?

There are several ways, which we are going to see unfolding. If international assets of Russia are frozen, it can stop payment of both principal and interest of Bonds issued by the Government of Russia. It can also compel resident companies and persons not to honor the loan obligations and stop payment of principal and interest. (Just now there is a news in Bloomberg that Russia has stopped payment of coupons on 29 billion worth of Bonds. ) It can close its stock market in such a way that the foreign holders of stock in Russian companies are not able to sell them back in the stock market even at a discounted price. Ultimately those stocks will be of junk status when the Russian state can buy them and nationalize the companies. The Government of Russia can also stop payment of royalties and stop honoring all contract of services entered into with entities of those countries who have imposed sanctions. May be the western credit rating agencies will downgrade the bonds and other instruments, which may affect Russia's ability to raise future funds, but that will not affect them for the money already raised. The contracts that are being cancelled by western companies in a hurry, are probably losing sight of one more thing. There are non-disclosure clause and intellectual property right related clauses in those contracts. Russia will be able to appropriate those intellectual properties very easily if contracts are cancelled. Russia will also route some of the transactions through China and Chinese currency, which will give China the prominence it was looking for its own currency as a standard of payment for international transactions at par with USD. But even now the Chinese currency is not convertible on capital account, so it has certain limitations. Russia can enter into bilateral trade with some of the stable countries with whom it has good relations, India, Brazil, Mexico, etc.

As recent as December 31, 2021 Russia's monthly import was around 31 billion dollars. The highest ever monthly import in Russia was 33 billion US dollars. The reserve of 683 billion dollars represent 22 months of import bill. Even if you consider the 683 billion dollars is impaired down to 400 billion US dollars because of sanctions etc. then also it can meet import bill of 12 months comfortably at current levels of import.

The impairment of (683-400) = 283 billion dollars of foreign exchange reserve is not permanent perhaps. And even if it is permanent, Russia can just selectively refuse to pay its foreign debts from countries imposing sanctions, because its foreign debts are more than 283 billion dollars, even excluding special drawing rights (SDR) from International Monetary Funds.

In view of the above, sanctions on Russia is futile, except in 3 limited areas :

1. It may prevent Russia getting access to technology. Even that is not a one-way traffic. In certain areas Russia has better technology than the west.
2. It will reduce both future exports and imports, which will hurt citizens of both the sides, Russia and EU, particularly the middle class and upper middle class who are used to super consumption levels of the west. For peasants it does not make any difference.
3. Russia's future growth will suffer because of the disruptions.

Russia is a country which is self sufficient in basic food (wheat), energy (oil and gas ) and defense. I do not think there is any other country with this level of self-sufficiency in the world. Russia has capacity to dig in a war for years, if it is determined, in its national interest. In my view the only weakness of Russia is no growth or de-growth of its population. That is why it wants to secure itself fully as early as possible.

Russia's Foreign Debt level

Russia's Foreign debt level is very low. 378 billion US dollar against a GDP of 1709 billion USD is just 22%. (Of these, government foreign debts are only 78 billion USD, rest are commercial debts by commercial entities) . So commercial defaults may occur, sovereign defaults may not, unless Russia is pushed at the extreme corner of the wall.

Just for comparison, UK's foreign debt level was is 340% of nominal GDP.

The oil and gas sanctions (?)

Russia knows that it is very difficult for the western countries to sanction its oil and gas industry. Russia is the origin of 26% of the EU’s oil imports and 40% of the EU’s gas imports. Russia has never used oil as a tool of reverse sanction, because that is not in its interest. Some times on quality issue import of Russian energy through Belarus was temporarily stopped by EU, but otherwise there were never a blanket sanction. Currently investment in new capacities for both oil and gas globally is very low. So new big capacities are not forth coming. In that situation replacing Russian supply with supply from other countries by EU is very difficult if not impossible.

But with sanctions on Russian Banks, opening of LCs on Russian banks are getting more difficult. Besides there are general averseness to order supply from Russia and export of Russian Oil and Gas to EU will reduce even when there is no sanction on oil and gas. Here so far as EU is concerned, Turkey can be of great help, because Turkey is a member of NATO, but not a full member of EU. How much Turkey is allowed to be a broker in Gas and Oil has to be seen and Turkey also has a pipeline from Russia, already catering to EU demand. There is also an averseness to send ships to Black Sea area to collect crude from other producing countries.

Can Ukraine become a full member of EU ?

Look at Turkey. Its accession request is pending since 1987, when EU was EEC. Negotiations for full membership started in 2005. Out of 35 chapters so far only 16 chapters have been closed in the negotiations. The high threshold of human rights enforcement, budget deficits and inflations are what Turkey is not in a position to navigate for full membership. The basic tenets are these countries have to follow the dictates of Germany and France, whose economic interest the EU represents. So a new bee like Ukraine cannot get the membership of EU so easily.

Russian Trade with EU

In 2020 EU imported 95 billion euro of goods, mostly oil and gas and also gold from Russia and exported 80 billion euro of goods to Russia. If EU does not import Gas and oil from Russia, Russia will also stop importing goods from EU. So that will not create a big difference, it is only a matter of 95-80 = 15 billion Euro. Of course the citizens of the both the sides have to make sacrifice. The stoppage of Russian gas and oil would do a havoc to the prices of oil and gas world over, which will lead to a global depression, not withstanding that some countries including USA will release some oil from their reserves.

Russia's oil production

Russia produces about 11 million barrels of oil per day, about 50% of which is domestically consumed. Russia is a far flung country with lot of fuel consumption for transport. Also now the war is creating more requirement of oil. Out of the balance 50%, about 2.5 million barrels go to Europe and 1.6 million barrels go to China. China is a growing and energy hungry country, and EU has rather very little growth except probably Germany. So even in normal course, export will gradually shift to China. But the price realized from China could be a lot lower because of very long term nature of the contract with China.

Russia's Gas

About 40% of the Gas requirement of EU comes from Russia. Other major suppliers are Norway (24%) and Algeria (11%).Also Russian Gas is the cheapest. The Natural gas production from UK and Netherland is reduced, because of the depletion of north sea gas fields. After the nuclear power plant accident at Japan, EU does not want to put up new atomic plants. Also because of managing carbon emission standard they want to move to solar energy, which is dependent on weather conditions and also it needs higher investment on grid management, which is not yet over. All these have made EU the highest importer of natural gas in the world.

Natural Gas is not as fungible as oil. Russia has the elaborate network to collect and deliver gas through pipelines to Europe (Even not considering Nord 2). US gas has to come in special ships, they have to be liquified and re-gasified, which makes the price higher, besides there are transport costs. West did try to diversify the source of gas through pipeline. And this is why there was Syrian war. West wanted to connect the Qatar gas fields to Mediterranean sea by a pipeline running through Syria, which Syria did not allow. That was a red line for Russia and that's why Russia intervened. Bringing Qatar gas to Europe in that quantity using special ships is not a feasible idea, To me it seems the dependence of EU on Russia for gas is much more serious matter than dependence for oil. In my view by not operationalizing the Nord 2 stream EU has shot itself in the feet. This could also be because Germany is now has a new Chancellor, who is looking for new concessions and new lobbying from Russia. The lobbying done by Russia with the earlier Chancellor has no effect now. Although Putin has not said so explicitly, delaying the commercial operation of Nord 2 in spite of being ready, in one pretext or another, is another grievance of Putin perhaps. And that has sunk 8 billion dollars of investment of Russia and 8 billion dollar investment of other European companies on a 51 : 49 basis.

Who is the loser?

As per Reuter. Russian banks and companies hold $391 billion in outstanding external debt as of October 1, 2021. On the other hand Russian Foreign assets on which US and Europe can lay siege or has laid siege can be 263 billion dollars at maximum. So who is the loser? Russia has to simply deny payment of interests and instalments to those foreign debts and also keep its stock exchange shut so that the foreign investors cannot cash out from the country ?

Chances of sabotage

A large network of Gas pipelines of Russia pass through Ukraine to the EU areas. And the oil from Russia is also pumped through Belarus. If the desperate elements of Ukraine cause any sabotage ( which may also be a desire of Russia), the oil and gas supply to Europe will be affected or stopped. If that happens the oil and gas price will skyrocket bringing depression to many countries because of oil and gas generated inflation.

Ukraine earns $1,2?billion a year from?gas transit from Russia to west Europe, Poland charges only $0.200 billion. Poland's charge is less, besides Poland moves very low quantity of gas from Russia. The survival of the gas pipelines is also for the economic interest of Poland.

The Nuclear Power Plants

20% of the power requirement of Ukraine is met from Nuclear Power Plants. France meets 37% of it power requirement from Nuclear Power Plant and Germany and UK around 5%. The countries have therefore commensurate number of nuclear reactors in their geography. If the war spills over to those nuclear plants, by cyber war or by impact of physical war there could be catastrophic radiations even without the nuclear war. On the other hand Germany has high dependence on on oil and gas for running its power plant, estimated to be around 63% of its total electricity requirement, which cannot be met from non-Russian source.

If the war expands it is a real possibility that most of the nuclear power plants will be shut down in Europe for fear of physical or cyber impact by Russia, when Russia also stops its supply of oil and gas, which it has not done so far. The continent will drown in darkness and their GDP will fall by 15 to 20%.

This is the reason why NATO and EU countries are trading a very cautious path against Russia and do not want to enforce a no fly zone over Ukraine. Ukraine has to fight its own war.

Ukraine economy

GDP of Ukraine is about 600 billion dollars, which is about 1/3rd of the GDP of Russia and its Foreign Exchange Reserve is about 161 billion dollars, about 1/4th of that of Russia. Ukraine economy is already in shambles. It has sought a write off of 67 billion dollars of international loans to date. Another few billion dollars of money will be spent for arms and amination grants by EU countries And then there are the expenses for refugees which in some estimate will cross 3 million people very easily. This will be additional burden on EU areas for a long term, some estimates puts it to about 10 billion USD.

Food

India is the largest producer of wheat in the world. But since it has a very large population to feed, India is not the largest exporter of food grains. Russia and Ukraine are considered to be the bread baskets of the world. Last year Russia exported 39 million metric tonnes of wheat and Ukraine 17 million metric tonnes. This year India could end up exporting 7 million tonnes of wheat. There is no primary sanction on export of food grain because this is a matter of human survival. But sanctions on specific Russian Banks and specific Russian institutions could serve as a dampener, because an importing entity has to move through a maze of financial barriers, as no one wants to be hit by the secondary aspects of the sanction. China is there with open hands to buy Russian food grains and it has recently lifted some quality barriers, which was affecting export of Russian food grains to China. On the other hand Ukraine had a bumper crop this year, but its Black Sea ports being entirely blocked by Russia and internal transportation being highly disoriented because of war, how much of these wheats will reach the world trade is not clear. The farmers of Donsk and Luhansk area may get access through the corridor being established by Russia into Black Sea, but other areas of Ukraine may not be so fortunate if the conflict does not end very quickly.

Apart from wheat, maize is another crop which plays a big role in the export of both Ukraine and Russia. Maize is predominantly used for livestock feed.

Prices of wheat and maize is going to increase by 25% as per the opinion of experts, but how much of this can be capitalized by Russia and Ukraine has to be seen, with Ukraine suffering the most.

Sunflower seed/oil is another item, where India will be affected mostly. Out of an export of 3.4 billion dollar of export of Ukrain, India bought 1.71 billion dollars or say 50% of it. As this export is affected from Ukraine price of edible oil in India will increase substantially.

Corporate earnings

Although Russia's population is small compared to its geographical size, the large corporates had very good earning at Russia. This is a sample:

Japan Tobacco International — 312 billion rubles,

Leroy Merlin — 348 billion rubles,

Philip Morris International — 360 billion rubles,

Auchan — 225 billion rubles,

Renault — 300 billion rubles,

IKEA — 120 billion rubles,

PepsiCo — 250 billion rubles,

Samsung — 250 billion rubles,

Apple — 270 billion rubles,

Huawei — 128 billion rubles.

Total : 2313 billion rubles or about 23 billion dollars a year at current rate of exchange.

The foreign companies will have to ultimately shut shops at Russia, unless the massive sanctions are withdrawn, and all those incomes will evaporate.

Russian Currency Depreciation and Oil Price Hike.

Ruble had fallen to 110 against a US Dollar recently. After taking of corrective measures, it has now come up to 106 rubles against a dollar. ( Indian Rupee is about 75 against a dollar). Ruble fall is around 5% on near month basis and 20% year on year basis. But the price of crude oil has gone up by 35% or so on near month basis. So in terms of price Russia has actually gained. It is another story that Russia mostly supply based on long term price formula and much of the market gain does not come to Russian treasury or Russian companies. These will go mostly to US and European companies who trade in oil and gas and regulate and influence all the oil price indexes, except whatever little is controlled by China.

It is in Russia's interest to keep the oil price as high as possible, even if that means war. At least in spot market Russia can make windfall gains.

In a way this is a funny fight between the customers and supplier of Oil and Gas. The customers want that the supplier remains economically weak so that it is forced to sell energy at a lower price. The supplier wants the price to be higher, so that its economy flourishes. None of them wants the supply to stop.

In between Ukraine becomes the pawn, which Ukraine may not be realizing.

The UN General Assembly voting

The UN general assembly voting shows that majority countries are siding with the west, some consciously and some by default. But there are also 35 countries who have abstained from voting and they include three atomic powers of Asia, India, China and Pakistan. Obviously they do not want the war to continue, and probably they want to leave the room for mediation open. If USA and EU are open to mediation perhaps Pakistan and China, rather than India can play a big role. Other countries that can play a big role are Turkey and Israel.

The west is taking all those stakes, they are hurting Russia and hurting themselves also. We should not take sides, but use all diplomatic means to stop this war immediately and bring a solution at the earliest. This war has been started by USA, NATO, Ukraine and Russia. They must find the solution, not us. We can ask as messengers and mediators, but the main negotiations is between them.

India's position

Over last 10 days there were 4 occasions, 3 at UNO and 1 at UNHRC, where India has stuck to its position of neutrality and India's politico, bureaucracy and defense arms are unanimous in its position. This is a war started by USA, NATO, Ukraine and Russia. They must find the solution together. We can at best be messengers and mediators with their full knowledge and consent.