Why has the EU been much quieter on the Ukraine question versus the US? Ashmore’s Dehn responds

Jan Dehn, head of Research at Ashmore discusses the sanctions against Russia and why the EU has adopted a low profile on the Ukraine question versus the US.

Despite supporting sanctions against Russia, it is notable how the EU has been relatively quiet on the Ukraine question compared to the US. At first sight, the EU’s low profile is curious when you consider that the EU’s stake in the conflict is far, far greater than that of the US. Why is the US so vocal, while the EU is so silent?

1. We are still in the escalation phase of this conflict. During this phase it makes sense to let the US take the lead. The US has much less to lose from a serious deterioration in relations with Russia. After all, the two countries have relatively few mutual interests, and on the question of gas the US could stand to gain from further escalation, at least over the medium term.

2. Mutual interests between EU and Russia are enormous. They include not just energy, but also broader economic ties, financial flows, and the simple fact that Russia and EU are right next to each other geographically. Neither side can afford to seriously damage ties. This makes the EU’s low profile approach entirely understandable and deliberate, but also tactical and significant as a pointer to the eventual resolution to the Ukraine situation.

3. The Ukraine conflict will ultimately be resolved through an agreement between the EU and Russia. The EU is deliberately not matching the aggressive rhetoric from the US in order to leave a window open for a diplomatic solution, which, we think, the EU will lead and shape. As long as this window is open it is likely that the conflict will be resolved diplomatically.

In our view, the main question is not whether a solution will be found, but when. There is still scope for further escalation near-term before things get better. Both Russia and the US are still publicly adopting very aggressive positions vis-à-vis each other.

This encourages extremist elements on the ground within Ukraine to step up their actions, but we believe that these elements can be reined in very quickly should a breakthrough appear possible at a higher level. Also, the Ukrainian elections are still some time away and Russia will want to ensure that question marks are raised about the legitimacy of the election outcome ahead of the fact.

On the other hand, further escalation is already having economic costs, especially for Russia. S&P’s downgrade of the credit this past week is an example. Further sanctions would be another cost. The Russian central bank’s decision to raise rates by 50bps to 7.5% is a third example. Business confidence will also be hurt by the lingering uncertainty.

On the issue of sanctions
More Russian companies are at risk of being targeted by US OFAC (Office of Foreign Assets Control) sanctions, following the inclusion of Bank Rossiya and Chernomornaftogaz on this list. But who would get hurt by such a move, Russia or Western interests? OFAC sanctions could bar some investors from holding the Russian names in question, forcing them to sell positions at low levels and thus crystalizing mark to market losses. Others could be afflicted if the names are removed from fixed income benchmark indices. In equities, questions of country and company inclusion in benchmarks tends to be determined by users. In fixed income, index inclusion tends to be more rules- based.

For example, ‘Index replicability’ is the main principle used by JP Morgan as the basis for including names in their indices. Whether index providers believe that the ‘loss’ of investors subject to foreign imposed sanctions constitutes enough of a challenge to ‘index replicability’ to justify dropping the names from the market’s benchmark indices remains to be seen; after all there are many investors and market makers in Russian assets outside of the US that would not be subject to, say, OFAC sanctions.

This poses an interesting question to index providers in the event of new sanctions on index names: Can the index providers continue to be neutral or are they likely to be swayed in the interests of one particular stakeholder group, such as the US government or non-US clients? Of course, whether or not a name appears in an index does not, in itself, impact that name’s ability or willingness to pay.

In general, we think investors should be prepared to expose themselves to off-benchmark securities in Emerging Markets, not least because 89% of all fixed income securities are off-benchmark anyway.

While the Ukraine situation is likely to inflict economic pain on Russia – which will ultimately hurt President Putin – it is also clear that Russia’s credit fundamentals are extremely strong. Net of official fiscal reserves, Russia’s total public debt to GDP ratio at the end of 2013 was just 1.5%. As of 18 April, Russia’s foreign exchange and gold reserves amounted to USD 482bn, surpassed only by China, Japan, Saudi Arabia, and Switzerland (Source: Ashmore/Bloomberg).

Moreover, a change in macroeconomic policy adopted after 2008/2009 away from fixed towards a more flexible exchange, means that a weaker Ruble actually improves the public finances, thus improving the government’s ability to pay. Besides, Putin is popular. In other words, Russia can stomach a lot of pain, both economically and politically.

We think investors should bear these factors in mind and not base their decisions on the headlines emanating from the heated public spat between the US and Russia, or questions of index eligibility. Investors should focus on value. Tensions may escalate further in the near-term, but this crisis looks likely to be resolved diplomatically. Given Russia’s ability and willingness to pay, we think the right strategy is to add at weak levels, not to sell at or near the bottom.

We note in passing that the IMF looks set to approve a USD 17bn support package for Ukraine, possibly at a meeting on 30 April.

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