Wednesday, 24 August 2022 — Albert Park

By Callum Newman Editor, The Daily Reckoning Australia

[7 min read]

• Biden raises the ante on sanctions
• The Russian response

Dear Reader,

The invasion of Ukraine by Russia sent shock waves through markets. Today, Jim Rickards begins his deep dive into the impact of the war on the economy.

Before you look at the aftereffects of a big geoeconomic event like this, it’s important to have a clear understanding of what exactly is going on. So, in this edition, Jim takes us back to the beginning of the war and analyses the short-term responses to the crisis.

With this background, you can be better positioned to see how we got where we are now…

Regards,

Callum Newman,
Editor, The Daily Reckoning Australia

By Jim Rickards Editor, The Daily Reckoning Australia

Dear Reader,

The war in Ukraine began on 24 February 2022, when Russian forces — aided by Ukrainian separatists and militias — commenced a full-scale assault on Ukraine from the south (Crimea), the north (Belarus), and the east (Russia and Donbas).

The apparent goals were to encircle and subdue major Ukrainian cities (Kyiv, Kharkiv, Odessa, Mariupol), create a land bridge from Donbas to Crimea, replace the existing government with a kind of puppet government, and announce a ceasefire and treaty that would cement a new status quo that serves Russia’s interests.

That status quo is likely to include de facto Russian sovereignty over all Ukrainian territory east of the Dnieper River (either through annexation or the creation of subordinate regional authorities) and commitments from the newly reduced Ukraine not to join NATO or the EU and to maintain strict neutrality between Russia and Western Europe (on the model of Finland or Austria during the Cold War).

There’s no assurance that these goals will be accomplished. The outcome of the war is highly uncertain. It may take massive destruction and loss of life, including high civilian casualties, for Russia to achieve its aims. Russia has used these blunt force tactics before in Aleppo, Syria, and Grozny in the Caucasus.

Those cities were peripheral to US and EU interests and were not places the West was inclined to intervene in. Ukraine is different in that it’s geographically the heart of Eastern Europe, and it forms a critical link in East–West natural gas supply chains that keep the lights on in Western Europe.

Kyiv has devoted considerable efforts to building financial and political links to Western elites. In particular, Ukraine has been a huge source of cash for democratic politicians and foundations, as illustrated by the millions of dollars paid to Hunter Biden to cultivate influence with Joe Biden. These, and other factors, make Ukraine far from a walkover.

Biden raises the ante on sanctions

Western financial sanctions against Russia were swift and relatively strong. After announcing a weak set of sanctions on 24 February, Biden raised the ante by announcing much stronger sanctions on 27 February and in the days following. These sanctions ejected 10 major Russian banks (with about 80% of all Russian bank assets) from the SWIFT messaging system.

It’s important to understand that SWIFT (the Society for Worldwide Interbank Financial Telecommunications) isn’t a financial institution or a payments system. It’s a message system where major member banks can confirm financial transfers. The confirmations are irrevocable and legally binding, but the actual transfers don’t occur via SWIFT. Instead, they occur through other payment channels, such as the international CHIPS system and Fedwire.

So it’s still possible for Russian banks to complete transactions without SWIFT, although the process is slower and more cumbersome, and it may involve old-school message traffic using telex and telephone. The Biden administration also left payment channels open for dollar payments for oil and natural gas to not deprive Western Europe of badly needed energy supplies. In short, the SWIFT ban is meaningful, but there’s much less there than meets the eye.

A separate sanction, which is both impactful and unprecedented (at least, since the end of the Cold War), is a freeze on the assets of the Central Bank of Russia (CBR). The CBR saw the confrontation coming and gradually divested itself of US treasury securities over the past year. Still, it has huge holdings of government bonds denominated in euros and Swiss francs, and it has about US$150 billion in physical gold (about 2,300 metric tonnes) that can’t be frozen.

The sanctions effectively freeze the bonds and cash equivalents in place. They aren’t confiscated, but they can’t be sold or transferred. Russian gold is safe in its physical form inside Russia, but if it needs to be converted to dollars or euros, those currency transactions will be blocked. In effect, the CBR is offline, except for internal transactions and some transactions with nations outside the Western sanctions, such as China. Other Western sanctions include prohibitions on selling certain high-tech equipment to Russia.

The Russian response

It didn’t take Russia long to respond. The CBR imposed capital controls that prevented foreign owners of Russian companies from selling those shares. The amounts covered by this ban are enormous, including minority interests of BP, ExxonMobil, and Shell in major energy development projects in Russia, especially in Siberia and Sakhalin Island.

The CBR also banned payments by Russian borrowers to Western creditors in ruble (RUB) and hard currency-denominated bonds. This default may trigger cross-default clauses in other agreements and lead to a cascade of financial failure and a broader global liquidity crisis.

Something like this happened in 1998, in the Russian Long-Term Capital Management (LTCM) financial crisis. Russia defaulted on its bonds and currency on 17 August 1998. By 28 September 1998, markets were just hours away from a shutdown of every major stock and bond exchange in the world. Only the US$4 billion rescue of LTCM orchestrated by the Fed that day saved the world from collapse. We’re not there yet, but we may be headed down the same path.

Assessing the economic consequences of the war

The war news changes daily, and our purpose isn’t to give a dense chronology of causes, events, and prospects in this war. Readers have plenty of sources on the progress of the war and will form their own views on how it’s going. Our purpose is to consider the economic consequences of the war, regardless of military success or failure by one side or the other.

These consequences will be with us long after the war is over, independent of whether Russia subdues Ukraine or not. In some ways, the damage has already been done. What remains is to understand the positions of Ukraine and Russia as commodity suppliers and key links in global supply chains and to assess the impact on the global economy now that these links in the chain have been broken.

In future editions, we’ll look at this topic through the specific areas of energy, agriculture, semiconductors, and strategic metals. So, make sure you stay tuned, because unprecedented times bring unprecedented opportunities to profit and preserve wealth, despite the geopolitical turmoil.

Regards,

Jim Rickards,
Strategist, The Daily Reckoning Australia

This content was originally published by Jim Rickards’ Strategic Intelligence Australia, a financial advisory newsletter designed to help you protect your wealth and potentially profit from unseen world events. Learn more here.

By Bill Bonner Editor, The Daily Reckoning Australia

Dear Reader,

‘The problem in a nutshell is that between the post-dotcom crash and subsequent moneyprinting spree and flood of central bank credit in 2020, global central bank balance sheets soared from $4.7T to nearly $42 trillion. That 9X increase in money supply brought only a 2X growth in GDP. The rest went into the pockets of the elites and created asset bubbles now at risk of popping.’

John Dienner

Mr Dienner is describing classic ‘inflation’. More money leads to higher prices. But wait…where’s the inflation?

CNN announced last week: ‘Housing market has entered a recession’.

House sales are down 20%, July 2021 to July 2022, it tells us.

Moneywise this morning: ‘Homebuyers are backing out of deals at the fastest rate since the pandemic’.

Bloomberg adds: ‘US Mortgage Lenders Are Starting to Go Broke’:

‘The US mortgage industry is seeing its first lenders go out of business after a sudden spike in lending rates, and the wave of failures that’s coming could be the worst since the housing bubble burst about 15 years ago. 

‘…market watchers nonetheless expect a string of bankruptcies broad enough to trigger a spike in layoffs in an industry that employs hundreds of thousands of workers, and potentially an increase in some lending rates. More of the business is now controlled by independent lenders, and with mortgage volumes plunging this year, many are struggling to stay afloat.’

It sounds more like deflation than inflation. And many people are confused by this. Those who aren’t confused aren’t thinking hard enough.  

As John Dienner highlights above, central banks ‘printed’ plenty of money. It’s no coincidence, he insinuates, that prices are generally rising. European ‘inflation’ is at 8.9%. German consumer prices are going up at the fastest rate in 70 years. Argentina is struggling with a 90% inflation rate.

But if ‘money printing’ by central banks causes price increases, why would anything — housing, stocks, instant pudding — go down?

Danger ahead!

Oh dear…oh dear…if it were only simpler! In the first half of this year, stocks and bonds had one of their worst six months ever. Brent crude was still US$122 a barrel in June; now it’s US$88. And now houses are going down too. What happened to all that printing press money?

Many economists and market analysts think the threat is over. They see the ‘inflation peak’ behind us…and give the ‘all clear’. Now, the Fed can ease up, they say…the band can tune up…and assets can go back up.

According to the official tally, prices since 2009 are up about 40%. But if the supply of money went up four-times faster than GDP, shouldn’t prices have gone up four times too? Instead of 40%, shouldn’t they be up 400%?

And isn’t the Fed still lending money at a rate far below consumer price inflation? The CPI is 8.5%. But the Fed lends at 2.5%. A borrower scores a 6% gain simply by taking the Fed’s money. Since this encourages borrowing, it also encourages banks to create money they can lend. More money should bring forth even higher prices. 

And yet, there are many economists and politicians (such as Elizabeth Warren) who argue that the whole hypothesis is wrong — that ‘printing press money’ has little to do with rising consumer prices and that by raising interest rates the Fed is doing more harm than good. In their analysis, if you can call it that, the Fed should never have bothered to try to head off inflation. Price increases would take care of themselves, they thought, as bottlenecks and supply chain disruptions were resolved.

What gives? Are prices going up or down? Are we out of danger?

Hmmm…let’s see.

Mo’ money, mo’ problems

First, the generally accepted view of inflation is probably mostly correct: Add more ‘money’ and prices will rise. There’s a lot more to the story, of course, but if you get too deep into the details, you’re likely to miss the main point.  

Most of the Fed’s money printing goes to Wall Street (because the Fed uses its new money to buy bonds); there, it boosts asset prices. Assets are different from consumer items. If you have a stock worth $100, you have a claim on $100 worth of goods and services. If the stock goes to $200, you can buy twice as many goods and services. The trouble is, as Mr Dienner informs us, the output of goods and services didn’t come close to matching the increase in dollars. So as asset prices rose, a lot of people had claims on goods and services that didn’t exist.

The resolution of this imbalance is deflation…and/or inflation. One way or another, asset prices have to get back in line with available goods and services. Falling asset prices (deflation) reduce investors’ claims on real output (GDP).

Meanwhile, the rise in consumer items also helps to correct the imbalance. A 100% inflation rate, for example, cuts the value of asset prices in half every year. 

Rising consumer prices on one side. Falling asset prices, on the other. And American households, investors, and businesses crushed between them.  

But for how long? And how bad?  

To be continued...

Regards,

Bill Bonner,
For The Daily Reckoning Australia