The crisis in Ukraine is raising the anxiety level among global investors, with the threat of outright military conflict adding to broader concerns that have roiled emerging markets in recent months.
Though Ukraine has a small economy, with an output smaller than Peru’s, its escalating tensions with Russia have deep implications for neighbouring countries and European banks. Money managers expect the conflict to send investors scurrying into the world’s safest assets, likely resulting in a stronger U.S. dollar and even more pain for emerging market investors.
“If we don’t see any calming in the coming days, we are bound to see more flows into safe havens, which means continued flows into the Swiss franc and U.S. Treasuries,” said Simon Quijano-Evans, head of emerging market research at Commerzbank, in an e-mail.
Investors will be taking a hard look at European banks, which have $23-billion (U.S.) invested in Ukraine, according to the Bank for International Settlements. If the crisis heats up, markets will also start reassessing financial institutions’ investments in Russia, where European banks have a substantially larger $184-billion exposure, Mr. Quijano-Evans said.
Energy prices are poised for volatility, given the important role Ukraine plays in transporting Russian natural gas to the European market. According to Commerzbank, Russia supplies 22 per cent of the European Union’s gas demand, using just three main routes into the region.
Should natural gas supplies through Ukraine be interrupted, Russia won’t be able to make up the shortage using alternative pipelines. “That is, of course, assuming Russia continues to supply gas to the EU,” Mr. Quijano-Evans said.
Observers are already comparing the crisis in Ukraine to the darker days of the Cold War, particularly the 1968 Soviet invasion of Czechoslovakia.
Poland’s prime minister, Donald Tusk, said on Sunday that the “world stands on the brink of conflict.” Tina Fordham, senior political analyst at Citi Global Markets, told CNBC that it marks the “biggest geopolitical risk event in some years.”
“Up till now, the spillover effects to CEE [central and eastern Europe] have been relatively contained, with CEE seen as a relative safe-haven within the emerging markets context,” Mr. Quijano-Evans said. “But that can change quickly, and apparently the only one to recognize this has been Poland’s [Prime Minister] Tusk.”
The Ukraine crisis adds to the clouds that have gathered over emerging markets after a decade of upbeat economic news. In recent years, stronger economic growth and improving economic fundamentals among developing nations drew massive interest from investors.
That interest is now reversing: The MSCI emerging markets index fell 5 per cent last year, even as developed markets rallied. The index has fallen another 3.6 per cent so far this year.
The weak performance follows declining Chinese economic growth and a switch in U.S. monetary policy. With the Federal Reserve tapering its monthly bond purchases, money has been flowing out of emerging markets, sending some currencies into a tailspin and forcing several central banks to respond with interest rate hikes.
Political instability is also rising, with crises in Thailand and Turkey, an apparent separatist attack in China over the weekend and, most notably, the confrontation between Ukraine and Russia.
Although Ukraine isn’t a member of the MSCI emerging markets index – it is considered an even less developed “frontier market” – the distinction between the two has begun to blur for some mutual fund managers.
As well, Russia has a 5.6 per cent weighting in the emerging markets index and is a member of the BRIC nations – Brazil, Russia, India and China – that have been seen as the bedrock of emerging markets investing.
Michael Gregory, deputy chief economist at BMO Nesbitt Burns, believes the latest developments in Ukraine exacerbate an already jittery market. “Russia getting involved takes things to a different level,” he said.
He expects to see a so-called flight to quality, as investors move from riskier investments to the perceived safety of U.S. government bonds, sending prices up and yields down.
The yield on the 10-year U.S. Treasury bond has already fallen below 2.7 per cent from 3 per cent at the start of the year, largely because of disappointing economic news. But Mr. Gregory believes the yield could fall to 2.6 per cent over the next couple of days as markets digest the latest developments in Ukraine.