At the same time, the picture is complicated by European reliance on Russian oil and gas and by Russian reliance on energy revenues to support its budget. For example, Latvia and Finland rely on Russia for more than 90% of their gas whilst Germany and Italy source about 50% of their gas imports from Russia. In 2021, Russia received USD119 bn in revenues from energy sales, with Europe being its main export destination. This accounted for two-thirds of Russia's export revenues from oil and gas and about half of Russia's budget revenues. So, there is a high degree of mutual dependence: Russia cannot quickly and easily find alternative revenue sources whilst Europe cannot quickly and easily find alternative energy sources.
What about Nord Stream II?
The Nord Stream II gas pipeline from Russia to Germany was built to help secure German and European energy supplies for the future. Historically Russian gas flowed through pipelines that went through Ukraine and this generated a significant amount of foreign revenues for the country, estimated at about USD2.5bn in 2021. Diverting gas pipelines around Ukraine has therefore dealt an economic blow to the country. Consequently, the existence of the Nord Stream II pipeline has created divisions within NATO with European countries keen to see it up and running whilst the US wants to support Ukraine's economic interests, partly as a means of scoring points against Russia.
Possible outcomes and probabilities
(1) Russia invades (30%). With the West having effectively done very little following Russia's annexation of the Crimea in 2014 and with potential divisions and perceived lack of interest in military action from NATO (especially following years of politically unpopular military support in Afghanistan), there is a non-negligible probability that Russia chooses to test NATO's resolve and launch a full-scale invasion. This seems to be a tail risk event, but the risks are rising. It would entail significant risk for Putin if it resulted in meaningful loss of Russian lives or if it turned into another drawn out and ultimately unsuccessful campaign such as in Georgia in 2008.
Furthermore, even if the military campaign were successful, Russia would gain little economic advantage from control of a country that currently depends heavily on IMF funding, which Russia would have then to shoulder - it is not clear that Russia could afford a long drawn-out occupation. Ukraine is bigger than France by landmass and would be a major challenge to govern.
Similarly, there is little appetite from NATO to become embroiled in a war with Russia involving loss of life and associated political unpopularity for a country that is of little strategic, economic or financial importance. This is particularly true in a year in which both the French presidential election and US mid-term elections are scheduled.
(2) The status quo persists (50%) with ongoing shuttle diplomacy, threats of further economic sanctions and an uneasy Mexican standoff that remains unresolved. As there is currently no easy way out for either side, this looks like the most probable outcome. The situation will likely remain uncomfortable and uncertain with threats, counter-threats and political point scoring in an ongoing 21st century resumption of old East-West tensions that remain elevated and unresolved. A challenge is that NATO cannot be seen to interfere in Ukraine's sovereign decision on whether or not to apply for NATO membership although it seems unlikely such an application would be successful as it would require unanimous support from existing NATO members.1
(3) A deal is brokered (20%) that sees both sides walk away with their pride still intact and having won enough politically to claim victory for respective domestic markets. This seems the least likely option in the short term as there is no clear path to a negotiated solution that is amenable to all parties. However, some sort of negotiated solution is likely over the longer term even if relations between Russia and the West remain uneasy. We live in hope.
Investment implications
Per advice already issued, we are of the opinion that Russian and Ukrainian debt continues to face significant risks and for that reason we think that caution is warranted.2 We do not yet think the assets are sufficiently cheap to offset the potential risks, for example if further economic sanctions are imposed on Russia and the country is downgraded. To be clear, Russia has built up a significant financial buffer that suggests it can well afford to continue to service its debt, but the political risks currently offset that.
Final comment
Whilst relations between NATO and Russia are highly charged at the moment, other countries will also be watching developments very closely; there is a risk of spill-over effects. The Baltic states have expressed alarm and concern at Russia's recent actions. No doubt the governments and populations of those countries will feel nervous that, unless there is a very robust response from NATO, there is a risk that Russia will seek to broaden its influence into other former Soviet states.
China will also be watching developments closely. China has never accepted Taiwanese independence and views it as just a matter of time before the island returns under mainland control. If the response from NATO is perceived as weak that could encourage China to extend its influence into Taiwan and Asia more broadly.
1 See “There is a diplomatic route out of the Ukraine crisis”, Financial Times, January 24 2022.
2 See EFG Advisory note “Russian & Ukrainian bonds + equities placed on Watch Status on EFG approved lists”.
