Russia/Ukraine War – Collateral Damage

Summary

The Russia/Ukraine war poses additional challenges for European economies, which are now facing higher inflation risks and more growth headwinds.

Russia/Ukraine War, Consequences

Russia continued its military offensive in Ukraine, despite chatter about another round of talks between the two sides. The Russian currency and depositary receipts are doing poorly this morning. Ukraine’s sovereign debt was also under pressure – the fact that Ukraine made a scheduled payment on its 2022 sovereign bond yesterday was noted, but made no market impact due to fat negative tail risks. Concerns about the global fallout are multiplying. However, the U.S. Federal Reserve Chair Jerome Powell said in his yesterday’s testimony to the House that the March rate hike is still on the table. As of this morning, the Fed Funds Futures price in 26-27bps in March, and a total of 5 rate hikes in 2022. 

Europe Growth, Inflation Risks

As regards other major central banks, higher inflation pressures (via food and commodity prices) and more growth headwinds pose additional policy challenges – especially in Europe/Central Europe. Sell-side economists have already started to cut their 2022 growth forecasts for the region. Right now, the revisions are modest – about 1% or so – but if military operations last longer and affect more territory, we should expect sharper growth downgrades. A prospect of wider budget deficits and worsening debt metrics – against the backdrop of large-scale refugee inflows - further complicates the picture. The chart below shows that Central European currencies underperformed emerging markets (EM) peers by a wide margin so far this year, as did local currency debt. Persisting currency weakness can increase pressure on regional central banks to hike more – this scenario is now reflected in the market rate expectations for 6 months. An alternative is to step up interventions on the FX market – this option was used today by Poland’s central bank.

Low-Income Countries Debt Relief

The final point we would like to make today is the potential negative impact on lower-income countries, some of which can be hit by the triple-whammy of higher commodity prices, trade disruptions (wheat importers from Ukraine), and lower foreign direct investments/loans from Russia. Would the debt relief initiative for lower-income countries – which was put in place during the pandemic - have to be revisited in the coming weeks? Stay tuned!

Chart at a Glance: Central European Currencies Under Pressure

Source: Bloomberg LP