Are the U.S. and Russia Capable of Waging a Financial War?

By: Julian D. W. Phillips | Fri, Apr 4, 2014
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As the Ukrainian crisis unfolded threats of financial war came from Russia and to a lesser extent from the E.U. and the U.S. They were not carried out except a few sanctions targeting key personnel in Russia. These were shrugged off and the crisis appears to have dropped to a series of posturing by both sides. A sigh of relief crossed the developed world and investment life went back to normal. In the past we have had similar events that were defused in a similar way. But history teaches us that that the world can suppurate easily and quickly in tense situation like this. The First World War started because of one shot from a pistol. He Second World War were preceded by trumpeting of 'peace in our time' as mistaken politicians thought they had made peace with Germany.

For the investors, these are signals that should be taken seriously, if his portfolio is not to be taken by surprise. After all, when such situations are ignited, events move too fast to prevent an assault on investments. Most of us tend to feel that if we can't actually see the storm clouds and hear the thunder then the storm isn't coming. It's a certain lemming-like quality where if we see the man in front of us moving forward then we do too. In this case an investor shouldn't do this he should take preventative action even when he doesn't see the storm. To start with, we should ask if both sides are capable of carrying out the threats.


Threats from the U.S. & the E.U.

The overall threat of financial war was accompanied by invidious pressure on global investors to reduce their sizeable holdings in Russia. For more than a decade Russia has sought more trade and investment with and into Russia. Trillions of dollars have flowed into companies controlled by the state. If these were to exit, the economy would be severely damaged. Over the last four years, western investors have sunk $325 billion into stocks and bonds issued by Russian companies and the country's government, according to the research firm Thomson Reuters. Of that, $235 billion has been directed toward corporate borrowings by the likes of Gazprom and state-owned banks like Sberbank. Demand has been so strong that Pimco, the world's largest bond manager, introduced a socially responsible emerging market bond fund in 2010. According to its prospectus, the fund looks to invest in companies that are reducing governance risks. It also reserves the right to steer clear of the bonds of countries that are listed at the bottom of the World Bank's corruption indicator or are subject to sanctions by the United Nations. Now that Russia looks like one of these, can we expect some heavy handed action to disinvest? As of the end of 2013, Russian corporate and government bonds accounted for 31% of the fund's $292 million in assets, nearly three times the weight in its benchmark, a JPMorgan emerging-market bond index.

Pimco has declined to comment.

Gazprom, the Russian energy giant supplies so much gas to Europe it has to be a possible target of the E.U. or a weapon in Russia's hands. It has the American mutual fund giants Pimco and BlackRock among its largest investors and creditors. While the last year has seen the fortunes of the company alongside its share price sag, an attempt to sell the entire U.S. share ownership of theirs would hurt the company and the Russian stock exchange, very badly.

Will the U.S. & the E.U. be allowed to strangle inflows of capital or remove it from Russia without resistance? In the event of the start of a financial war, we believe that Russia would not allow that capital to exit and would take measure to insulate themselves against capital flows from the country. This implies that Exchange Controls would be imposed to encourage inflows and prevent outflows. With China as an alternative investor and on neither sides of the potential conflict, they would likely come in to pick up the pieces cheaply.

This is the most potentially visible of the weapons that would be used. The weapons to be used would extend from the financial to the economic. For instance, Russian companies selling to Europe and the U.S. would switch to buyers in China, the largest consumer of nickel. This was the opinion of eight out of 12 nickel producers, traders and analysts in the Asia-Pacific region. Punitive measures would increase global prices at least in the short-term. This is one aspect of the confrontation.

A second is the sale of gas by Russia to Europe. Europe is heavily dependent on Russian gas and would be badly hurt in the event of either higher prices or a cutback in supplies. In such a war, the weapons such as these extend across a wide spectrum. For sure the investment climate in both Europe and Russia would deteriorate drastically.

The biggest danger would be the attitude in such a confrontation because this justifies punitive actions that hurt the wielder of such weapons as much as it does the victim. What do we mean? The German Finance minister's words that, " The objective is to uphold international law. It is of secondary importance whether there is an economic or financial cost." This is a typical posture that precedes war-like situations.

Investors, after the event, would see the heightened risk and either withhold funds, or demand significant premiums on good investments. Sovereign risks on the E.U. and Russia would elevate borrowing costs and slow the flow of funds where they continue to exist.

It is likely that additional collateral would be required that is outside the pledges of either side. These would be extreme times and so require commensurately non-national assets like gold to be used. We would see gold/currency swaps routed through the B.I.S. to facilitate the continuation of the monetary system as we know it now. Gold would move to a pivotal position internationally in such an event. Nations would scramble to get it, to be able to get international liquidity. Where would they get it from?

The EU agreed on a framework for its first sanctions on Russia since the Cold War. This places the E.U. in step with the U.S.A. The determination we are seeing from the E.U. is more than expected and sets the tone for more action and retaliation. The big question is just how far will the two sides go?

Certainly the dollar and the euro are threatened as are all their 'dependent' currencies'. The damage that Russia could do to Europe is far more direct because they are neighbours.

All global financial markets will feel at least a ripple from the Tsunami that will happen, once matters go too far. The least vulnerable and the bloc most likely to gain whatever advantages may come amongst the rubble of the financial system would go to China.


Threats to 'crash' the monetary system from Russia

A senior adviser to Putin said last week that if the United States were to impose sanctions on Russia over Ukraine, Moscow might be forced to drop the dollar as a reserve currency and refuse to pay off loans to U.S. banks. These remarks were purported to have come from a senior aide to President Vladimir Putin's, Glazyev. While his remarks were later refuted by Russia, the possibility of such action remains. What harm would such moves do?

Glazyev also said that Russia could reduce to zero its economic dependency on the United States if Washington agreed sanctions against Moscow over Ukraine, warning that the American financial system faced a "crash" if this happened.

He said that if Washington froze the accounts of Russian businesses and individuals, Moscow will recommend to all holders of U.S. treasuries to sell their U.S. government debt. Do his remarks have credibility? Apparently, Glazyev is often used by the authorities to stake out a hard line stance. He does not make policy but has the ear of Putin and would be aligned with the more hawkish elements in the Russian government and military. He further threatened that Russia could stop using dollars for international transactions and create its own payment system. Russian firms and banks would also not return loans from American financial institutions. "An attempt to announce sanctions would end in a crash for the financial system of the United States, which would cause the end of the domination of the United States in the global financial system," he added. Glasyev's comments were likely sanctioned by the Kremlin and by Putin himself. They would appear to be a warning to the U.S. regarding isolating Russia politically and imposing economic sanctions. So far they have not been carried out, so will they. Are your investments vulnerable?

Do these threats pose a real and present danger to the West? Should Russian foreign exchange reserves and bank assets be frozen as is being suggested, then Russia would likely respond by wholesale dumping of their dollar reserves and bonds. That will set off a destruction of the financial system that we know now. It takes far less than most expect to cause such damage. Yes, it would border on insanity!

In the state the global financial system is in at the moment such threats followed by any sort of action will produce ripple effects that in themselves will produce turbulence and collateral damage in global financial markets that go far beyond the borders of Europe and the U.S.A.

The hegemony of the dollar will be threatened if not mortally wounded, for sure. Simply the loss of stability in financial markets will rupture many markets. Russia would turn once again to China after trying to sell the dollar. Again, such actions would be cutting of its nose to spite its face. But that's what war is.

The dollar is so entrenched as the globe's reserve currency, that even a small action against it would cause disproportionate damage to its exchange rate. A strong seller of the dollar would hurt it badly. If that seller were known to be a central bank, then the damage would be considerably heavier.

We could go on far more describing the damage that could be done to both sides but we think the point is well made already.


Unlikely - Because of the consequences!

The consequences of even starting down this road are so dramatic that we deem the likelihood of a financial war as most unlikely. The Crimea and the Ukraine were part of the U.S.S.R. Hence we do not believe that either the U.S. or the E.U. will stake so much for so little potential gain. The results would be too horrible to contemplate.

But having said that, prudent investors, as we warned at the beginning of the article, won't wait for these events to happen! They will not only be protecting themselves from the consequences, if these events took place, they would be positioning themselves to benefit from them. And they would do this now, well ahead of such possibilities, or go the way of lemmings.

With gold the clear benefactor in such situations we expect that if markets perceived the bigger danger to be imminent the gold price would surge.

For gold investors, the fact that such rhetoric is taking place is a salutary reminder that gold will rise in extreme times like these and that to buy that gold ahead of the slide down into the abyss is the wise course!

 


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Julian  D. W. Phillips

Author: Julian D. W. Phillips

Julian D. W. Phillips
Gold Forecaster

Julian D. W. Phillips

"Global Watch: The Gold Forecaster" covers the global gold market. It specializes in Central Bank Sales and details, the Indian Bullion market [supported by a leading Indian Bullion professional], the South African markets [+ Gold shares shares] plus the currencies of gold producers [ Euro, U.S. $, Yen, C$, A$, and the South African Rand]. Its aim is to synthesise all the influential gold price factors across the globe, so as to truly understand the global reasons behind the gold price.
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