Asset management

10 March 2014

Economist Insights Unsanctioned

The situation in Ukraine continues to unfold. While not downplaying the seriousness in diplomatic terms, it is interesting to look at the economic implications using game theory. Joshua McCallum Senior Fixed Income Economist UBS Global Asset Management joshua.mccallum@ubs.com

Gianluca Moretti Fixed Income Economist UBS Global Asset Management gianluca.moretti@ubs.com

The situation in Ukraine continues to unfold. While not downplaying the seriousness in diplomatic terms, it is interesting to look at the economic implications using game theory. For investors, the situation was worrying initially because the fear of the conflict widening led to a sell-off of risky assets. Then, as soon as it looked like the crisis would not escalate, the markets calmed down and investors returned their focus to US economic data or the press conference of the European Central Bank. This is just as well for economists, who really should be cautious about taking a view on the likely outcome of such a volatile geopolitical situation Game theory attempts to model decision-making in a situation, and considers potential actions for each player in reaction to what the other players do. Applying this theory to Russia and Ukraine, one potential argument is that the US and Europe should not react to Russias actions because the economic cost to the US and Europe is so low. While this strategy might make sense in a single isolated game, for a game that is repeated, a more appropriate strategy would be to make the outcome painful for Russia to discourage repetition in future. The potential reaction that is most discussed is to impose economic sanctions. Sanctions are most likely to succeed when they are painful for the target country and not so painful for the countries imposing them. Many political analysts have speculated about the relative economic links between Russia and other economies. But just as economists should be cautious about taking views on geopolitical situations, political analysts should be cautious about making use of economic data. It is easy to get over-excited about a number because it sounds big. For example, commentators might note that Italy has strong trade links with Russia because it has a EUR 8 billion trade deficit with Russia. This may sound like a big number, but in the context of Italys GDP of EUR 1.5 trillion it is small amounting

to just half a percent of GDP. In any case, if we are interested in the importance of trade linkages, then the gross exports and imports are what matter, not the net number. At their most extreme, if sanctions are imposed they will limit trade, but will also affect banks that are exposed through cross-country loans. In the case of Russia, energy linkages are important, not least because it is hard to substitute energy imports from one source with other sources. This is particularly true for natural gas, which requires pipelines for transport. To help investors figure out which numbers are significant and which are not, the chart on the next page shows some of the economic links of various countries to Russia in the units that really matter: as a share of GDP, as a share of the banking sector and as a share of total energy demand. There are other linkages that are important, such as cross-border investment of residents in each country. Unfortunately, such data is not readily available. Some economic linkages can be difficult to interpret. For example, consider Russian investments into the European Union. If sanctions are imposed on Russia, then this source of external financing will disappear potentially leaving a shortage of funding for Europe. But from the Russian perspective, these sanctions would be painful because their assets may be frozen. Economic trades are entered into because they bring benefits to both sides, so ending them will always have negative effects in both directions. If extensive sanctions were put in place, it would indeed be painful for both Russia and for the countries imposing the sanctions. But as important as any one country may be to the rest of the world, the rest of the world will always be more important to that country. The question then is how much each country is willing to tolerate the pain.

Uneven importance Trade, energy and banking linkages between Russia and selected other economies Energy dependence on Russia (%)
1.54% 0.86% 0.32% 0.19% 0.07% 0.05%
Energy imports from Russia as % of country GDP Non-energy imports from Russia as % of country GDP Exports to Russia as % of country GDP Energy exports to country as % of Russian GDP Non-energy exports to country as % of Russian GDP Imports from partner as % of Russian GDP Claims on Russia as % of country banking sector assets US Russia EU

Share of Russian energy exports (%)

12.66% 7.07%

1.48% 0.53%

0.35% 0.21% 0.05% 0.54% 0.54% N/A

Japan

12.66% 0.62%

China

2.17% 2.17%

0.58% 0.19% 0.16% 1.48% 1.27% 0.24% 0.56% 0.40% 0.47% 1.18% 0.64% 0.53% 4.65% 1.88% N/A

UK

0.70% 0.24%

Germany

2.50% 2.15%

0.72%
France

0.51%

Italy

1.17% 0.64%

Poland

1.12% 0.45%

1.54% 0.86% N/A

World

26.07% 18.18%

Source: IEA, EIA, Eurostat, IMF, BIS, National sources, UBS Global Asset Management Note: Energy dependence is all energy imports from Russia as % of final energy consumption in tonnes of oil equivalent in 2011. Imports and exports are goods only in 2013 and energy is defined as the mineral fuels category. Banking sector claims on Russia are on an ultimate risk basis in 2013. Energy composition of trade is not available for China and World. The views expressed are as of March 2014 and are a general guide to the views of UBS Global Asset Management. This document does not replace portfolio and fundspecific materials. Commentary is at a macro or strategy level and is not with reference to any registered or other mutual fund. This document is intended for limited distribution to the clients and associates of UBS Global Asset Management. Use or distribution by any other person is prohibited. Copying any part of this publication without the written permission of UBS Global Asset Management is prohibited. Care has been taken to ensure the accuracy of its content but no responsibility is accepted for anyerrors or omissions herein. Please note that past performance is not a guide to the future. Potential for profit is accompanied by the possibility of loss. The value of investments and the income from them may go down as well as up and investors may not get back the original amount invested. This document is a marketing communication. Any market or investment views expressed are not intended to be investment research. The document has not been prepared in line with the requirements of any jurisdiction designed to promote the independence of investment research and is not subject to any prohibition on dealing ahead of the dissemination of investment research. The information contained in this document does not constitute a distribution, nor should it be considered a recommendation to purchase or sell any particular security or fund. Theinformation and opinions contained in this document have been compiled or arrived at based upon information obtained from sources believed to be reliable and in good faith. All such information and opinions are subject to change without notice. A number of the comments in this document are based on current expectations and are considered forward-looking statements. Actual future results, however, may prove to be different from expectations. The opinions expressed are a reflection of UBS Global Asset Managements best judgment at the time this document is compiled and any obligation to update or alter forward-looking statements as a result of new information, future events, or otherwise is disclaimed. Furthermore, these views are not intended to predict or guarantee the future performance of any individual security, asset class, markets generally, nor are they intended to predict the future performance of any UBS Global Asset Management account, portfolio or fund. UBS 2014. The key symbol and UBS are among the registered and unregistered trademarks of UBS. All rights reserved. 23698