Russia’s invasion of Ukraine has claimed countless lives and set off a refugee crisis, prompting Ukrainians to flee to neighboring Poland, Hungary, and Slovakia (among others). In addition to its humanitarian toll, the war is expected to have a range of consequences for businesses and the global economy. In this article, we explore how the conflict could affect the global financial system in the medium to longer term.
The trade disputes between the US and China have clearly demonstrated the disruptions that can occur when the links of global trade are shaken by geopolitics. Now, the war in Ukraine is demonstrating the potential disruptions that can occur when the links of global finance are shaken. In a widely circulated note, Zoltan Pozsar, an analyst at Credit Suisse and arguably the world’s preeminent expert on repo markets and financial plumbing, noted:
Banks’ inability to make payments due to their exclusion from SWIFT is the same as Lehman’s inability to make payments due to its clearing bank’s unwillingness to send payments on its behalf. History does not repeat itself, but it rhymes …
Credit Suisse estimates that between the Bank of Russia and the private sector, Russia contributes roughly $1 trillion to liquid global wealth, of which about $300 billion is deployed in money markets. The many nuances and implications of severing Russia’s relationship with the global financial system are beyond the scope of this piece, but such an action would be somewhat comparable to the failure of a $1 trillion balance sheet.
One immediate tactical policy response would be to enlist the Federal Reserve to plug the gap (Pozsar suggests some specific likely measures in his note). But this would have the concerning implication of requiring the Fed to expand its balance sheet again before it has even slowed the pace of expansion from the “last crisis”—all against the backdrop of an already inflationary economy facing the threat of an additional energy supply shock. We have written recently about how the Federal Reserve is trapped between its two official mandates (low unemployment, stable inflation) and its unofficial third mandate: stable financial asset prices. The unfolding Ukraine conflict is the type of problem that could nudge the Fed into an effectively unwinnable situation: It could potentially pose both a liquidity shock due to the effects of sanctions and an inflation shock due to interrupted energy/commodity supplies.
In the longer term, the weaponization of financial systems is likely to hasten the balkanization of the US dollar–based global financial system. The breach of a long-standing precedent—that of not using the plumbing of the financial system in service of geopolitical aims—ushers in a new era of potential risks to the global financial system. As we have written in the past, we believe that one of China’s key geopolitical goals is to be able to buy what it needs in a currency that it controls (e.g., the renminbi). (We wish to note here that Louis Gave and our friends at Gavekal have been asserting this point consistently for a number of years.) Recent events are likely to serve as a big flashing signpost to China to redouble its efforts in this area. We expect to see tangible consequences of that redoubling in the months and years to come, likely to the detriment of the global dollar system and the capital superabundance it helped facilitate.
That said, we are frequently asked if we believe that the Chinese renminbi could displace the US dollar at the apex of the global financial system. Putting aside the vast gap in the US dollar’s current preeminence with respect to its use in international trade and as a reserve currency (it accounts for 59% of global foreign exchange reserves), our working hypothesis is that the position of universal apex currency is likely to ultimately become vacant (“sede vacante” or “the vacant seat”). The existence of globally preeminent reserve currencies—like the British pound sterling and French livre before that—has a long historical precedent, but the emergence of one national currency at the apex of a globalized fiat currency system is a fairly recent anomaly. This state is likely more than coincident with the rise of global capital superabundance, and the conclusion of this anomaly could hasten the ending of this era. The world doesn’t need a universal apex currency to facilitate normal and relatively balanced trade, but it is difficult to generate large, persistent capital surpluses (and corresponding large debts) without a dominant and frictionless reserve currency.
For businesses and investors, the pace of events in the Russia-Ukraine war will only permit tactical reactions as information becomes known. As we have said since the middle of last year, the global economy has been riding the consensus “middle path” of recovery along a knife’s edge, buffeted by strong winds, so we neither recommended conviction around the middle path nor offered an alternate scenario as the single most probable one. The invasion of Ukraine prompts us to further expand our range of possible scenarios; an inflation-induced recession continues to be our favored alternate scenario for planning purposes.
In the longer term, there is more room for strategic realignment. If there was any doubt about the reality of post-globalization, recent events should confirm three things:
- the globalized order is in slow but terminal decline;
- post-globalization is not just about trade and China; and
- geopolitical fracture lines build slowly over time, making it tempting to delay tough strategic realignments, but once those lines fracture, it is often too late to do anything but react.
On this last point, BP’s recent decision to divest of its Rosneft stake should serve as a warning of how suddenly geopolitical motion can accelerate. Businesses should consider their risk exposures carefully, and not just in Russia. The fault line between China and the West remains unstable, and the risk of any type of “financial disconnect” across any border has increased now that the precedent discussed above has been broached. These recent events should raise the premium for home market strength and increase the discount for far-afield holdings.
This article was originally published on the Bain Macro Strategy Platform as part of our ongoing coverage of the geopolitical forces that will reshape the world in the coming decade; it has been modified slightly for publication on Bain.com. You can request more information about the Macro Strategy Platform here.