Rabobank: Escalation Upon Escalation
By Michael Every of Rabobank
Wars can escalate fast. Look where we are today and were we were 14 days ago. Where will we be 14 days from now?
Russia continues to press on into Ukraine. However, it is suffering huge losses, allegedly now 11,000 men, and does not appear able to hold the vast new territory it ‘controls’. So, Russian artillery are making parts of Ukraine look like Grozny in 1999: but what good is this economically to Russia once it holds it? Putin also now states “Today’s (Ukrainian) leadership needs to understand that if they keep doing what they are doing… they will put into question Ukraine’s future as a country.” How is a flattened, embittered land of 44 million to sit in Russia’s belly? Or is there an even darker meaning? Sadly, logic still points towards even greater escalation.
Russia is showing no sign of backing off under Western pressure to date. The Kremlin, via its propaganda, is seemingly rallying much of the country behind its campaign, and we have a new sinister symbol “Z” (for “za”, meaning ‘for’ as well as “zapad”, meaning ‘West’) to publicly show support for the war. On top, Moscow is reportedly looking to hire mercenaries from Syria, matching the apparent 16,000 foreign volunteers who have signed up to fight for Ukraine. Worse, Friday’s shooting at a Ukrainian nuclear power plant was arguably no accident. It didn’t risk repeating Chernobyl, but the message was clear: back off, or we play in this arena. The Russian claim to have now “found plans for a Ukrainian ‘dirty’ bomb”, and that the US has sent plutonium to Kyiv to help build it, are blatant examples of the same. According to some credible voices, these are warnings that if Western arms continue to pour in, and Russia to flail, then the Russian response may be to use a low-yield tactical nuclear weapon against Ukraine.
Some even suspect Putin is looking for a conflict with NATO. Ominously, the Kremlin is demanding the three EU Baltic states guarantee they will allow the safe operation of Russian embassies there, and Putin told landlocked Belarus he believes it should have Baltic access – which means the Baltic states and Poland are in the way. Further, the Russian-backed breakaway Transnistria has declared independence after Moldova applied to join the EU, suggesting another Black Sea front for Russia to attack Ukraine and Moldova from, and dragging in Romania.
Logically, the only way Putin can now achieve anything lasting is via further brinksmanship. Only at the edge of the global cliff might Russia see the West blink and give him his new empire. At least one piece of “Street” research now openly gives armageddon a 10% chance of occurring. Then again, they make the point that if so there is no point in selling risk assets anyway.
Escalation is also inevitable in the economic war. Firm after firm is exiting Russia, now including Visa and MasterCard. Russian stocks have been marked to zero by MSCI, with losses of near $500bn. The Russian stock market remains closed. Most global ocean carriers won’t touch Russian cargo or ports. Even Aeroflot has stopped flying. And Russia is responding: its foreign creditors will now be repaid in roubles, not FX. Bloomberg and other Western media have had to leave Russia for their own safety. And Russia, like China, is talking of cutting off key fertilizer exports.
Putin says Western sanctions are “akin to a declaration of war.” Economic historian Adam Tooze raises an invaluable point in this regard: if so, why is Russia running its economy like an IMF golden child, with tight fiscal and monetary policy? Logically, it should turn to a war economy. That means using MMT to soften the blow from sanctions and build military equipment. Why not run a fiscal deficit of 10% of GDP if GDP is to otherwise shrink 10%? And at least one knowledgeable Russia watcher also insists the country is soon going to fully mobilise its population, supplementing a lack of ethnic Russia youth with those of central Asia, which will make the use of on-ground violence in Ukraine easier given their greater cultural distance.
Notably, Russia meets the prerequisites for MMT –running a trade surplus even if also running a large fiscal deficit– and is prepared for capital controls. But the next step would then have to be one away from European/Western technological supply chains to Chinese ones. The economic adjustment would be brutal –Russian billionaire Oleg Deripaska says: “This is going to be like 1998 crisis, but three times worse and will last 3 years.” –but there is no sign of the Kremlin backing off.
Geostrategic logic says the West will need to escalate as follows, if so:
1) Spend even more. The 2% of GDP NATO defence spending target was for peacetime, not wartime: Poland is to now allocate 3%; the UK is to boost its defence spending by 25% immediately; and Germany and the rest of the EU would have to do even more – Berlin is already considering a debate on reintroducing conscription. Europe would probably also need to subsidise households and business against soaring commodity prices. Altogether this could mean perhaps 5% of GDP in extra spending ahead. The fiscal/debt implications are enormous – unless this is monetised, which is an even more enormous decision.
2) Undermine Russia’s trade surplus, so MMT would push it into a destabilising inflationary spiral. To do so means to stop buying Russian commodities. Last week saw Shell admit to buying Russian crude at a $28.50 discount – and then give a public apology and announce profits from the deal would be donated to war charities. That does not sound like Western firms are prepared to start buying again. Rather, today we see fresh market fears about the US blocking Russian energy after the White House said this is now being discussed: this morning Brent surged to over $136 a barrel on exactly that concern. (And can you see why markets are self-sanctioning Russian goods? Last week this was not on the official cards, when the war’s logic always said it had to be.)
3) Impose secondary sanctions to stop others buying Russian commodities. The US is already warning China not to deal with Russia, as a senior Chinese official stated Friday that it will continue to do. We see questions being asked about why Chinese commodity imports from Russia were shifted from CIF –meaning all the ownership and risk is on the exporter until it reaches China– to FOB –meaning China owns the cargo/risk from the point of origin– three months ago, which is unusual enough a decision to perhaps support US allegations that China knew war was coming. (Although, to be fair, the US was already saying this in public at the time.)
Of course, escalating war and economic war mean deeper hits to economies and markets. After all, the above 1, 2, 3 are what we warned of in ‘Scenario C’ of our (pre-war) Ukraine war report and our “Multipolar world’ reports in 2020 and 2021 – rapid global economic bifurcation. Consider that Russian energy is now taboo – so Brent is $136 and rising, even with a US nuclear deal with Russian-ally Iran perhaps done; and the White House openly talking to fellow Russian ally Venezuela about possibly lowering oil sanctions on it in order to secure supplies(!); and the US considering sending representatives to Saudi Arabia to ask for more oil output. (Who are not pleased with the Iran deal, or the removal of Iran-backed Houthis from US terrorist lists, and White House personal snubs. In short, US energy policy is a total mess, geopolitically.)
Other Russian commodities, even agri, where there may be links to sanctioned oligarchs, are increasingly ‘untouchable’ too. Key Ukrainian exports have collapsed, and its crops may not even be planted this year. As such, almost all major commodities continue to hit new highs, and we are going to find out how industrial supply chains deal without key inputs such as neon and palladium. We are also going to see much more food inflation, when prices were already up 20.7% y/y in February according to the FAO. Energy surging and no Russian (and Belarussian) fertilizer exports are hammer blows, and bad weather is not helping either, as China just warned of their worst winter wheat crop in history. As such, food protectionism is emerging. Hungary, the world’s 12th largest grain exporter, just banned all crop exports. Expect escalating global hunger.
Indeed, with the US dollar soaring alongside commodity prices, markets may even start to revert to state-to-state barter for key agri commodities, and on a geopolitical rather than a neutral price basis – which we already see in US actions re: oil; and/or we may see the imposition of price controls and rationing. China had already spoken of a new national board buying all its iron ore imports. Expect much more of that talk for a far broader range of commodities. Indeed, China also just announced it is aiming for greater self-reliance in technology, supply chains, and *food*. “China can’t rely on international markets to ensure food security,” according to Xi Jinping, and, “should focus on its domestic food markets, while making sure it has an appropriate level of import capacity, “ stressing “farmland protection and technology-led development of the seed industry to help solve food security issues.”
China has additionally declared its GDP growth target for 2022: 5.5%, the lowest for three decades, where the most notable thing other than self-reliance is that defence spending rises 7.1%. All the 5.5% GDP figure really means is that sustainable underlying Chinese trend growth of X will be supplemented with extra unneeded infrastructure spending of Y, to no long-run productive benefit. That is MMT of another sort, as one might say: yet it goes without saying that if this props up commodity demand, it will mean even higher prices – and so more political impetus towards import boards, rationing, or quasi- central planning.
In more traditional financial markets we see EUR/CHF back to parity, which is as risk-off as it gets; the broad DXY dollar index at 98.9, up 3.6% in a month; and US 10-year yields at just 1.70%, down 36bp from their recent peak, despite the fact that we are about to enter a Fed tightening cycle. Bloomberg is mentioning the Hong Kong dollar peg as a potential risk again if the US turns against China. It also says: “Hong Kong feels like it’s on the edge of a nervous breakdown, and it’s tempting to ask how much more people can take.”
You will notice that so far I didn’t mention Friday’s US payrolls report. As the old Jewish joke goes, “Hello, Friday’s US payrolls report.” If you think that datapoint matters much against this backdrop then you must/should work in a central bank, where the food, energy, and military you need magically appears when required. But seriously, the large headline jobs gain will allow the Fed to escalate matters in its own way, with tighter monetary policy… against what could not be a more problematic global backdrop.