Opinions - 17.08.2022 - 00:00 

The Russia-Ukraine conflict’s effects on the global financial system

The war has led to difficult circumstances for the global financial system, leaving central banks with a tough choice. Comment by Dr Angelo Ranaldo, professor of finance and systemic risk at the Swiss Institute of Banking and Finance (s/bf-HSG) at the University of St.Gallen.

17 August 2022. One of the consequences materialising from the Russia-Ukraine war is that “stagflation” is arising in several countries. This does not pose a direct threat to global financial stability for now, but the deteriorating global economy will damage the financial system through classic channels such as non-performing loans, losses, and the sovereign-bank evil loop, that is, the deterioration of sovereign credit risk adversely affects the financial health of its banking sector and vice versa. What is more worrisome is that financial players cannot count on the monetary policy support they have become accustomed to over the course of the previous decade.

Indirect effects hurt more than sanctions 

Some factors suggest that the war could be short-lived, with politicians in many Western countries promptly imposing unprecedented sanctions that aim to undermine Russia's ability to finance the war.

This political reaction, along with the disdain aroused among the individuals and private businesses that are boycotting Russia, has led to the country’s isolation from Western capital and intermediate products such as technological components.

Even more destructive for Russia is the increasing outflow of human capital constituted of skilled workers and the middle class from the country, and an acceleration of Europe's energy transition away from Russia. That other nations such as China or India will replace Europe is possible, but they would be certain to do so at a discount.

Russia energy exports to the tune of $1bn a day

Despite the above factors, the war, along with its nefarious effects, could persist for many reasons. One such reason is that Russia is facing war with a solid macroeconomic framework, even if its economy has essentially remained stagnant over the past decade.

Though inflation is now galloping and the worst recession in modern Russian history is taking its toll, Russian government debt is at a relatively low level and thus the downgrade to junk status and defaults of its bonds are not its main concern.

Russia’s foreign exchange reserves are ample and thus its fiscal capacity is not marginal. Its banking sector was recapitalised and as a result became less fragmented. In addition, Russia's central bank demonstrated its skill before the storm by, for example, implementing an inflation-targeting policy. It also did so in the eye of the storm by promptly raising benchmark rates and offering effective liquidity support.

That is not to mention that Russia was already partly prepared for the storm. There were some tools in place that were conceived to counter the 2014 sanctions that were a response of the international community to its annexation of Crimea, for instance the SPFS domestic payment system.

However, what best fuels President Vladimir Putin's ability to finance his war is that Russia is still making $1bn every day from oil and energy exports. And even if Russia exports lower quantities of energy products, their skyrocketing prices mean that Russia is still gaining in this perverse game.

Four unpalatable economic truths

Regardless of whether Mr Putin succeeds in his war or destroys everything, including himself, inflationary and recessionary forces will be felt for some time, of which there are four main elements.

First, the war is inflating energy and commodity prices.

Second, inflation is finding fertile ground in the immense liquidity that resulted from more than a decade of ultra-expensive monetary policies and low unemployment rates.

Third, the war is plaguing trade and international collaboration, which were still recovering from the pandemic. This has led to further deglobalisation and disruption to the “global supply chain”, an effect which by its very nature is inflationary.

Fourth, the phasing in of post-crisis prudential regulations that had worked as a salient deflationary brake is essentially over, as banks have had to set aside capital instead of investing or intermediating. The restrictive monetary policies being adopted by an increasing number of central banks will fight inflation but have a secondary effect as a recessionary brake on economies.

Furthermore, these massive and prolonged unconventional policies have caused a reduction in risk premia, such as the sovereign debt risks of some European countries. The price correction of related financial securities will have a negative wealth effect.

Central banks in a quandary
The good news is that the ongoing war is currently afflicting the Russian but not the global financial system, at least not directly and not to the same magnitude. In addition, post-crisis prudential regulations have made banking systems generally more robust. 

The bad news is that, faced with stagflation, central banks must decide what to fight between a number of conflicting objectives. The main trade-off to be decided is between curbing inflation and supporting the economy. Some central banks, including the US Federal Reserve, have already decided to fight the former.

But this decision has many facets that must be taken into account. For example, this same decision in a country like Switzerland becomes one between lower inflation and a weaker Swiss franc.

In contrast to the 2008 global financial crisis, which was endogenous to the financial system, this crisis is more traditional – it is a deterioration of the economy, affecting the financial sector.  The financial world must expect at least one hand of central banks to be tied and the fiscal capacity of many governments to be reduced.

This article from Prof. Dr. Angelo Ranaldo first appeared in Banker Magazine / Paywall.

(in German: Finanz und Wirtschaft)

Image: Adobe Stock / TexBr

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