As of this morning, Russia’s recent overtures to ease tensions over the Ukraine crisis seem to be receiving a mixed reception at best in Kiev and the West. And as early as next week, another round of Western-imposed sanctions will loom if Washington and its European Union allies conclude Moscow is seeking to subvert the May 25 Ukrainian Presidential elections that the US and Europe hope will cement an aura of legitimacy on a new government in Kiev.
The geopolitical risks in the confrontation over the fate of the Ukraine have drawn our close attention these last few months (most recently 5/7/14, “Ukraine: Russia Indicating Military Option off the Table,” and SGH 4/30/14 “Ukraine: Threatening the Elections,” among others), and we will continue to utilize our contacts to report on the developments on Europe’s eastern edge.
We nevertheless wanted to step back a bit at this point to also look more broadly and across a longer time horizon than we traditionally do. Picking up on a range of comments and observations made to us in recent weeks by an assortment of policy makers and investment managers, we are wondering to what extent the underlying assumptions to cross border capital flows and investments since the end of the Cold War are beginning to seriously fray due to these recent events.
The irony is that much of the damage being done is not ideological or a questioning of the merits and benefits in the free movement of capital, capital, labor, goods and services or technology. Rather it is in the utilization of the international financial infrastructure as instruments of power to further foreign policy objectives.
Countries that bought into the Anglo-Saxon model of legal protection and an assumed “rules of the road” have already or are scrambling to build alternative financial infrastructure such as payment and clearance systems to defend against their vulnerabilities to the US-dominated financial infrastructure. In effect, new barriers or obstacles are being erected, more fundamental than even capital controls as a defense against the dislocations of hot money flows (the outflows anyway).
That such national or regional structures are going back up could become a lasting legacy of the crisis in Ukraine, a tipping point to an ongoing reversal in the assumptions of globalization and economic liberalization that have come to underpin trading and investment strategies ever since the Berlin Wall came down and China opened itself to the global economy nearly 25 years ago.
The cornerstone to the post-Cold War financial architecture was the so-called “Washington Consensus” that was given its intellectual and institutional heft by the International Monetary Fund, the World Bank, and the US Treasury in the 1990s after the Berlin Wall came down and China started opening up to the global economy.
The Consensus came under as much stress in its early years in the Mexican and Asian crises, much in the same way the post-war Bretton Woods system was pock-marked by the shortage of dollars and the Triffin Dilemma, numerous current account crises, and currency devaluations. But a particular turn in this fraying of the Washington Consensus came unexpectedly and in an entirely unforeseen way in the wake of 9/11 and the Bush Administration’s turn to the international financial infrastructure as an instrument to pursue its national security objectives to prevent another terrorist attack on the US or its allies.
Since widely reported but secret at the time, within weeks of 9/11 the Central Intelligence Agency worked with US Treasury to track down the financing of terrorist networks by accessing the massive databases of the Society for Worldwide Interbank Financial Transactions, or SWIFT, as well as thee transactional records of Visa and MasterCard. The Brussels-based SWIFT is, of course, the glue to the global banking system, these days processing some $6 trillion a day in payments by its 8,000 member banks, while the two US credit card companies control some 85% of the world’s credit card payments and processing.
Initially, the Americans were focused on transactions of suspected individuals out of Saudi Arabia and the United Arab Emirates, since most of the 9/11 hijackers were from those two countries. Both countries cooperated extensively, and the intelligence gleaned is said to have helped lead to the capture of several wanted al-Qaeda figures.
But what was initially assumed to be a temporary but urgent measure to deal with imminent terrorist threats came to have an extended shelf life, with the access broadening out in ways unforeseen. Several countries began to take notice, quietly complaining to Washington or meeting to discuss banding together to form alternatives to the US-controlled financial systems. By the end of 2003, SWIFT officials also began to object and safeguards were introduced. In 2010, the US and the European Union signed an agreement on the terms for access to the financial transactions data.
But the precedent was set in using the global financial infrastructure as a foreign policy tool. In 2012 again, under pressure from the US, this time the Obama Administration, SWIFT agreed to disconnect the Iranian Central Bank and 30 other Iranian banks from its network as part of the expanded financial sanctions imposed on Iran to deter its nuclear weapons program. Far more than the oil sanctions, the financial sanctions and the SWIFT action in particular were devastating to the Iranian economy. More than anything, it is what brought Iran to the negotiating table last year on its nuclear program under its new president Hassan Rouhani.
Again, however justified the intent, the unintended consequences swiftly — if that is the right word — followed: it raised alarm bells across scores of countries. It is in everyone’s interests to fight terrorists, and it could even be argued there are likewise reasons to pressure Iran from pursuing nuclear weapons; but if the Americans can go after al-Qaeda individuals and now Iranian institutions through the financial payments systems, who was next?
The answer came earlier this year in the crisis over Ukraine and the Russian annexation of Crimea. Rather than pay the potentially high political and financial costs of broader economic sanctions or much less a military confrontation, the Obama Administration instead sought to maximize leverage over Moscow by going after individual Russians deemed to be in the inner circle of power around Russian President Vladimir Putin. Administration and National Security officials also are said to have met with a handful of international asset managers to less than subtly remind them of their responsibilities in assessing the risks in investing in Russia.
Soon after the first round of sanctions were announced in March, perhaps the biggest shock to Moscow was the announcement by Visa that it would have to curtail its services to SMP Bank, since it was controlled by two of the oligarchs on the Obama Administration’s sanctions list. Other oligarch-controlled Russian banks beat Visa to the punch and announced they would no longer work with Visa and MasterCard.
But the entire Russian banking system is dependent on Visa for its ATM cards as it lacks its own nationally controlled payment system, and the Kremlin realized the economy could be made cashless overnight if these threats escalated.
The Russian parliament, Duma, is now scrambling to pass emergency legislation to require providers of domestic payment services to put their processing and settlement center in-country, and in effect to be controlled if not owned outright by the Russian central bank. It looks like the new law will also require collateral be put up for foreign payments and for fines to be imposed on foreign payment system providers if not an outright expropriation of assets.
Russia’s biggest bank, Sberbank is also reviving previously derailed plans working with other Russian banks to establish a locally controlled system to link the different banks’ payment systems, and a working group of Russian banks is working with the Russian Central Bank to create an entirely domestically-controlled national payment system. The Russians are likewise looking into a potential link-up to China’s UnionPay, a rival credit and debit payment processing firm to Mastercard and Visa, now the third largest payment service provider and itself a creation after several years of joint venture with Visa.
Russian assets have obviously taken a nosedive in the wake of the crisis over the Ukraine, and while the Russian markets may bounce back up on the barest of positive news about an easing of tensions, it remains questionable whether the Russian borrowers will have such an easy access to the international capital markets any time soon. Perhaps the Russian central bank can cough up the dollars to help these companies roll over their existing debts, make their coupon and dividend payments, or expand their operations.
But maybe not. And again, the question mark hangs over Russia, for now, but where next, as geopolitical tensions ripple across to other parts of the world?
Foreign investors seem to have so far taken the crisis in stride, often shifting their higher yielding trades to the relative safety inside the Euro area by pouring into the bonds of the European peripheral countries, or as far away from Russia and the Ukraine as possible, such as to Latin American plays, or of course, into the ultimate safe asset of US treasuries.
In theory, risk premiums for the investments in the lower credits or emerging markets should be rising, not falling. Instead, the sheer weight of momentum and the grasp for yield have been driving the risk adjusted assessments of most asset managers.
But what exactly are assumptions are being made in the legal protections or what currency clearing and settlement will be done, and what are the fiduciary responsibilities in the grasp for yield? Or what do these new barriers, if they do indeed expand from here as scores of countries seek to protect themselves, mean for the assumptions about lower costing global manufacturing supply chains?
Previously seen as neutral infrastructure, domestically-controlled payment systems are becoming matters of national security, however costly or long it will take to build. An international financial system, built on the foundation of a single seamless payment and clearing system and layered with legal protections for a lubricated and easy flow of capital and investment seems to be giving way to new national barriers or regional trading systems.
Maybe this is a good thing, or at least an inevitable development in the larger scheme of things – after all, the world trading blocs are becoming more multi-polar. But that wasn’t the vision at the end of the Cold War, and again, more to the point, it is not what has been the assumption underpinning most of the financial trading and investment strategies of the last few decades.
For now, the great tide of liquidity being provided by the big three central banks, all essentially at the zero lower bound, is dampening volatility and washing over these more fundamental concerns over medium to longer term risks. But that, of course, is eventually going to change, however lower for longer or gradual the trajectory of the inevitable tightening is expected to be.