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It’s surprising that the business press has not gotten to be apocalyptic about the worst case downside of the economic war on Russia. And by that we are not including nuclear winter. Due to the fact that financial and real economy effects occur in very different time scales, we are in a phase similar to the runup to the global financial crisis, where it was clear Something Bad to Horrible was underway, yet the press and pols were largely sanguine. I gasped out loud in May 2007 when Bernanke declared that subprime was contained.
The reason the blowback from the sanctions could be cataclysmic is that trying to isolate one of the biggest commodity producers in the world, with significant market share in many critical ones, will soon hit Covid-stressed supply chains. And if the economic brinksmanship isn’t dialed down soon, we’ll see tightly-coupled systems start to go critical. Because the hollowed out business press is much more fixated on finance than nitty gritty real economy operations, some bad outcomes will be noticed quickly because they affect visible companies, while others could be just as detrimental but not be picked up until the effects were advanced.
And recall that the defining characteristic of a tightly coupled process is that a shock moves through the system so quickly that it can’t be interrupted (or may not be reversible at all. Mind you, that does not necessarily mean it moves quickly in clock time.
Another characteristic of tightly coupled systems is that moves to reduce risk once the system is spiraling out of control are virtually assured to make matters worse, since participants don’t understand the system well enough to know how to intervene. The only measures that do help are ones that reduce the tight coupling, like trading halts.
Admittedly, the Something Bad to Horrible that is now occupying center stage is the prosecution of the war itself. That plus the West’s desire to punish Russia, combined with its unwillingness to do so militarily, has led to unprecedented economic measures, like preventing Russia’s central bank from using $300 billion of its foreign exchange reserves. Even the Financial Times politely pointed out that that move would focus the minds of other central bankers. As Michael Hudson and other commentators have pointed out, this move alone is a strong impetus of the heretofore slow-moving trend for China and other major non-Western economies to move away from the dollar, which has been a powerful tool of American economic and increasingly foreign policy.
So far, Russia has not imposed much in the way of counter-sanctions, although Russia-friendly websites report that Putin signed a series of measures early this week, to be announced Thursday. Since that shoe has yet to drop, we’ll go over only a few examples of how sanctions aimed at Russia are set to do a great deal of harm outside Russia. (Yes, it is theoretically possible that the US could de-escalate and swallow a peace negotiated by Ukraine, but given the press-induced blood lust and Biden Administration’s ego investment, that seems vanishingly unlikely).
One way Russia has been naughty is in seizing commercial jets under lease. According to Bloomberg, it’s managed to hang on to all but two dozen of over 500 planes. I had assumed Russia would keep them for domestic-only use; they can’t run much of a commercial airline service otherwise. If things ever get back to sort of normal, Russia probably won’t be able to lease planes for a very long time again and might have to make large deposits on service contracts, but count on the profit-minded to find a way.
It doesn’t appear that Russia is even trying to pretend it has no option: “Oh, gee, we understand you want your planes, but we can’t find a safe way to do that given the givens” or “Gee, we’d love to return those jets, but we are entitled to lease termination payments. How about gold for equipment?” From Bloomberg:
Technically, lessors have until March 28 to retrieve the planes under European Union sanctions. But state-owned Aeroflot PJSC and other Russian airlines have already gathered the vast bulk of them back inside the country, out of reach of their owners. The government aided the effort by instructing carriers to stop flying internationally and return the jets to Russia by Tuesday….
In telexes over the weekend, Russian authorities urged the nation’s airlines to restrict flying to domestic routes and friendly Belarus to prevent their jets being grabbed by repossession crews lying in wait, Emily Wicker, a partner with law firm Clifford Chance, told the lessor conference. The Russian government also advised operators to re-register foreign-owned aircraft in Russia from their traditional base of Bermuda, another move that could thwart efforts to revoke an aircraft’s certification — or track its maintenance and upkeep.
Lessors are now weighing their next steps…they’ve hired lawyers to parse insurance and re-insurance policies as they gird for long, costly fights and try to recover their losses….
Russia’s recent actions raise questions about another aviation staple: records documenting every detail of a jet’s upkeep, from maintenance visits to the remaining life for key parts. Without such paperwork, a jet’s value rapidly diminishes, said Chris Sponenberg, a vice president at Wilmington Trust.
However, at this juncture, the vast majority of harm to the non-Russian world is not due to retaliation. For instance, Biden appeared to up the ante by banning Russian oil imports earlier this week. However, Biden may simply have been taking credit for the state of play. It’s not clear how much oil was able to come into the US due to barring Russian ships from ports,1 shipments from Black Sea ports being halted due to war risk, and oil buyers being unable to get letters of credit.
Admittedly, the Reuters Feb 24 story does not parse out how much of the freeze on letters of credit was due to war risk, as in fear of destruction of tankers, versus fear of sanctions, which the US had said it would impose:
At least three major buyers of Russian oil have been unable to open letters of credit from Western banks to cover purchases on Thursday, four trading sources said, citing market uncertainty after the Russian invasion….
Letters of credit from the bank of the buyer are standard practice in commodities trading and guarantee the seller’s bank that payment will be made in full and on time.
Keep in mind that the latest report we have seen says Russia was still sending gas to Europe consistent as stipulated.
Another source of pain we’ve mentioned more than once is fertilizer. Russia and Ukraine provide roughly 40% of global supply. Fertilizer was already expected to be in short supply before the war. It’s hard to ship it given the inability to use the Black Sea and difficulties in getting paid. A lack of fertilizer means greatly reduced output of grains and famine. That will be compounded by reduced wheat exports from Russia and Ukraine.
Similarly, Russia is a critically important supplier of aluminum, necessary for airplanes and other equipment, and metals used in non-electric cars. It was possible to work around chip shortages to a degree. Metals are a much more binding constraint. And car prices were already a big driver of headline inflation.
We are already seeing market upheaval in terms of the massive nickel short squeeze. Matt Levine provided great one-stop shopping, describing how a huge Chinese producer, Tsingshan Holding Group Co., the world’s largest nickel and stainless steel producer, got caught in a short placed by its owner, Xiang Guangda. Levine pointed out how a producer could be net long yet still not having enough ready cash to meet on a margin call on his hedge. Levine described how some people, apparently officials at the LME, decided to intervene on Guangda’s behalf, no doubt arguably to protect market integrity. From Levine:
There is a sense in which this is all a bit unnatural. Yes, nickel prices should go up for geopolitical reasons, but arguably they should not go up that much; arguably the extent of these moves is driven by technical factors (margin calls on short sellers who are “really” long) that, in some sense, shouldn’t count. I mean. You could think that. You don’t have to; you could instead think “no, market structure is part of the real world, and if prices go up because of a short squeeze then prices go up, that’s life.” But some people certainly think that these price moves shouldn’t count, either because they are generically unnatural and unfair, or more specifically because they might blow up some traders and destabilize the market.
One way to reduce this sort of pressure is to suspend some of the margin calls, which happened:….
Another, more drastic way to reduce this sort of pressure is to suspend nickel trading, which also happened:…
A third, even more drastic way to reduce this sort of pressure is to retroactively suspend nickel trading, by canceling trades that already happened. That happened too; from the LME today:
The LME have been monitoring the impact on the LME market of the situation in Russia and the Ukraine, as well as the recent low-stock environment observed in various LME base metals. With immediate effect, and following the suspension of the LME Nickel market announced in Notice 22/052, the LME (acting where required through the Special Committee) has determined that it is appropriate in the circumstances to take the following actions in respect of physically settled Nickel Contracts: (i) cancel all trades executed on or after 00:00 UK time on 8 March 2022 in the inter-office market and on LMEselect until further notice (Affected Contracts); and (ii) defer delivery of all physically settled Nickel Contracts due for delivery on 9 March 2022 and any subsequent Prompt Date in relation to which delivery is not practicable (as determined by the LME and notified to the market) owing to a trading suspension in line with the process in this Notice.
Obviously that’s bad! You don’t want to break trades! The whole point of an exchange is that it is a transparent and predictable place to agree to trades. On the other hand if price moves are too wild, and if they are driven too much by margin calls, you’re going to blow up enough exchange participants to undermine predictability anyway. (If a lot of traders go bankrupt, it is hard to avoid breaking trades. If some of those traders are nickel producers, bankrupting them due to soaring nickel prices is an especially bad idea: You need them to make some more nickel!)
So you shut everything down for a while, including retroactively, and hope that everyone can get their financing in order to make for an orderly reopening. In theory, if the people caught in the short squeeze are in fact largely big nickel producers, this should work. If you’re a nickel producer your nickel should be worth more now, and probably someone will give you some money for it.
On the other hand if you’re a retail investor who was three times short nickel, this was not your week.
Oh, and in a later story, Bloomberg reported that Tsingshan also got emergency bank loans.
What Levine does not say explicitly but strongly implies is if you blow up enough big traders, you could blow up the exchange. If traders fail to meet margin calls and their liquidated position leave a loss, the exchange has to plug the hole from its reserves, or failing that, capital calls to members or other backstops. We’ve repeatedly pointed out that derivatives central counterparties are systemically under-reserved because charging enough to properly reserve would render derivatives economically unattractive. Volatility is certain to continue. How long before we see a CCP or exchange bailout?
Mind you, these are just first order effects. There are going to be plenty of second-order ones due to “for the want of a nail” supply chain problems propagating, as well as businesses failing due to Russia effects, even just exposure to suddenly high energy prices.
The Russia-friendly press has highlighted additional Russian gambits. One sounds potentially very powerful, the other isn’t, as described. The first, from RT, contends that Russia could withhold chip substrates as a quid pro quo for being denied advanced chips. From RT:
The ban on technology exports to Russia, in response to the war in Ukraine, could backfire on global manufacturers of computer processors and semiconductors, as many crucial components for their production are made exclusively in Russia, an industry expert has warned….
While global tech majors are announcing their split from Russia, Izumrudov says potential Russian retaliation moves “would leave almost the entire world without microelectronics.” [Oleg Izumrudov, head of the Consortium of Russian Developers of Data Storage Systems (RosSHD), says.]
According to the expert, Russia accounts for 80% of the market for sapphire substrates – thin plates made of artificial stone, which are used in “every processor in the world,” including those manufactured by AMD and Intel.
“Our position is even stronger in special chip etching chemistry using ultra-pure components. Russia accounts for 100% of the world’s supply of various rare earth elements used for these purposes,” the expert states…
He says the timeframe to ensure the quality of sapphire substrates, required for microchips, for instance, is 30 years of continuous production. Plants at which they can be made have to be located in conditions of almost zero seismic activity, which means the products of enterprises similar to those in Russia in seismically active California or Taiwan “are noticeably inferior in quality and volume to the level required in the industry.”
The key question is whether the second-best sources are workable, and what the cost is in terms of reduced reliability and performance.
Izumrudov also asserts that Russia has work-arounds for the loss of tech imports. He does not mention a large laundry operation through non-banned countries.
Pepe Escobar claims Russia is about to announce a work-around for the banking restrictions. I’m dubious about this one:
Moscow has not even announced a package of what could be defined as “counter-sanctions from hell”. Yet a decree on “foreign exchange obligations to foreign creditors” which allows Russian companies to settle their debts in rubles is already an eye-opener.
Economist Yevgeny Yushchuk defined it as a “nuclear retaliatory landmine”.
It all revolves around a new presidential decree, signed last Saturday: “On Temporary Order of Obligations to Certain Foreign Creditors”.
It works like this: to pay for loans obtained from a sanctioning country exceeding 10 million rubles a month, a Russian company does not have to make a transfer. They ask for a Russian bank to open a correspondent account in rubles under the creditor’s name. Then the company transfers rubles to this account at the current exchange rate, and it’s all perfectly legal.
Payments in foreign currency only go through the Central Bank on a case-by-case basis. They must receive special permission from the Government Commission for the Control of Foreign Investment.
As I discussed with Michael Hudson, what this means in practice is that the bulk of the $478 billion or so in Russian foreign debt may “disappear” from the balance sheets of Western banks. The equivalent in rubles will be deposited somewhere, in Russian banks, but Western banks, as it stands, can’t access it.
Sorry, this is silly, except possibly as a talking point for debt cramdown negotiations: “You know we are prohibited from paying you the usual way. This is much better than nothing, which is what you’d get otherwise.” It cannot be forced on lenders. The question is how many, if any, would bite.
This idea would work only if the debts in question were subject to Russian law. This is almost certainly not the case. The reason Cyprus was a huge center for investment into Russia was that Western companies and investors structured those deals as subject to English law, which could be adjudicated in courts in Cyprus, which used English law.
If not, Russia cannot unilaterally change payment terms. If a Russia borrower agreed to pay as of certain dates in dollars or euros, tendered to a certain account or address, those payments are still due. Depositing a foreign currency in a new account does not cut it.
Due to time constraints, as well as this situation still evolving, I have not begun to adequately articulate how much havoc widespread commodities shortages will inflict in an overly-interdependent manufacturing and trading system. The fact that the harm hasn’t show up much does not mean it won’t become baked in very soon.
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1 I have no idea how much Russian oil is carried by Russian tankers….any informed reader input?
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