Could the invasion of Ukraine trigger a global financial crisis?

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The Russian assault on Kyiv and other Ukrainian cities has heightened uncertainty in the global economy. To condemn Putin’s war, Western leaders announcement certain restrictive economic measures targeting Russian financial institutions and individuals.

Sanctions include: removal of some Russian banks from the Swift messaging system for international payments; freezing the assets of Russian companies and oligarchs in Western countries; and prevent Russia’s central bank from using its US$630bn (£473bn) in foreign exchange reserves to undermine sanctions.

In response to these movements, several rating agencies either downgraded Russia’s credit rating to unwanted status or signaled that they might do so soon. In other words, they think the prospect of Russia defaulting on its debts is higher than before. According to a group of global banks, a default is “extremely likely”.

The threat to banks

With more than $100 billion in Russian debt in foreign banks, it raises questions about the risks for banks outside Russia – and the possibility that a default could trigger a 2008 style liquidity crisiswhere banks panic over the solvency of other banks and stop lending to each other.

European banks are the the most exposed financial institutions to new sanctions from Russia, in particular those from Austria, France and Italy. Figures from the Bank for International Settlements (BIS) show French and Italian banks each have outstanding claims of around $25 billion on Russian debt, while Austrian banks had $17.5 billion.

Relatively, American banks have decreased their exposure to the Russian economy since the Crimean sanctions in 2014. Nonetheless, Citigroup has a US$10 billion exposurealthough this is a relatively small portion of the US$2.3 trillion in assets held by the bank.

There is also the question of exposure to a possible default by Ukraine on its debts. Ukraine about 60 billion US dollars of bond debt has also downgraded to undesirable status, raising the risk of a default from low probability to real danger.

In addition to debt exposure, many banks are going to be affected because they offer banking services in Ukraine or Russia. According to Rating agency Fitch, French banks BNP Paribas and Crédit Agricole have the most exposure to Ukraine due to their local subsidiaries in the country. Société Générale and UniCredit are the most active European banks in Russia, and both are also among the most exposed to Russian debt.

SocGen is one of the banks considered to be the most exposed.
Hadrian

In other bad news for European banks, there has been a sharp rise in the cost of raising US dollar funds in the euro swap market. Banks use this market to raise the dollars that are essential to most international trade, so higher rates will put additional pressure on their margins.

So how serious are the overall risks of bank failure? American investment research firm Morning Star believes that the exposure of European banks, not to mention American banks, to Russia is ultimately “insignificant” with regard to their solvency. Nevertheless he has been reported European, US and Japanese banks could suffer heavy losses, potentially in the order of US$150 billion.

Banks will also likely be affected in other ways. For exampleSwitzerland, Cyprus and the UK are top destinations for Russian oligarchs looking to store their money overseas. Cyprus also attracts Russian wealth with golden passports. Financial institutions in these countries are all at risk of losing business because of the sanctions. For example, the share prices of British banks Lloyds and NatWest have fallen more than 10% since the start of the invasion.

Beyond the banks

Besides the banks, the war will cause substantial losses for many companies with interests in Russia. Any companies that Russian companies owe money will struggle to get reimbursed, given that the ruble has fallen by 30% and the Swift restrictions will make payments very difficult. For example, Reuters reported that US companies have approximately US$15 billion of exposure to Russia. Many of these debts will potentially be end up being written off, causing heavy losses.

Some oil companies like Shell and BP have said they will get rid of assets they hold in Russia. Others, such as the trading and mining group Glencore, which has significant stakes in two Russian-linked companies, Rosneft and En+ Group, said he put them to study. But if the value of these assets evaporates because there are no buyers at reasonable prices, companies like these could face substantial write-downs.

A danger is that this will lead to a panic selling of the shares of these companies which creates a domino effect in the market similar to what happened with the banks in 2007-08.

BP poster in Moscow as someone fills up their car
Companies like BP offload Russian interests, but at what cost?
Reuters

Pension funds are also in the line of fire. For example, the Universities Superannuation Scheme (USS) team wants to sell its Russian assets. The USS is the UK’s largest independent pension scheme with around 500,000 customers and £90bn in funds. His Russian assets are worth more than £450m. The fall in value of these toxic assets is potentially going to be a bad blow. More generally, many investment funds also have money in Russian sovereign debt and also shares of Russian companies. They too are looking at potentially serious losses.

In short, the ripple effects of this war are potentially huge, and many more are likely to emerge in the days and weeks to come. While the global economy is still recovering from the pandemic and is already dealing with significant inflation, markets have been very volatile. Russia’s invasion of Ukraine has intensified this situation, and finance will be on high alert to see how things unfold.

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