Russia’s invasion of Ukraine on February 24th caused a tremendous amount of misery and death (both military and civilian). Though largely anticipated by western governments, the invasion has both profound geopolitical effects and resulted in real economic and financial costs for the global economy.
Wars are expensive to finance by the countries involved, while also leading to rippling effects outside of the conflict zone. To understand these effects and the consequences of this ongoing conflict is to understand the financial implications it brings and could bring in the future to all nations — not just Russia and Ukraine. This includes the costs and ongoing risks for multinational companies, many of which are based outside of the conflict zone.
Looking at Geopolitical Conflict as an Investor
The risks of war offer real financial risks. Some of these risks are easily identifiable and can be quantified within reason, while others can be more difficult (if not impossible) to identify and quantify.
- For companies with publicly-listed equity and debt securities, there is often sufficient information in the public disclosure documents to broadly assess the additional costs or foregone revenues that these companies might suffer because of the war.
- For private companies, it is up to equity investors, debt investors, and bank lenders to ask the right questions to management about war-related consequences for their business.
To understand the risks investors face, one must take a deeper look at the potential negative effects of Russia’s invasion of Ukraine on companies as a whole.
Commercial Business Disruptions
Commercial disruptions have occurred in the conflict zone for two reasons: sanctions on Russian (and Belarusian) companies and disarray in Ukraine, the country under siege.
Customer/Client-Facing Disruptions: Extensive and comprehensive sanctions on Russia, or simply moral pressure to “do the right thing,” mean that many foreign multinational companies with storefronts or client-facing operations/ or facilities in Russia have reduced (or halted completely) their businesses in the country.
- Pulling up stakes in Russia obviously reduces or eliminates sales in the country, the world’s 11th largest economy (GDP in 2021 of $1.7 trillion equivalent) with a population of 144 million.
- Many multinational companies operated in Russia prior to the war, some for many years, only to curtail or close their local business completely.
- Some well-known multinationals that ceased operations within Russia include McDonald’s, Starbucks, Heineken, Este Lauder, Siemens, Nestlé, Visa, Bloomberg, Netflix, Apple, Renault, Boeing and Caterpillar, among many others.
- The effect of the Russian invasion on international oil companies has also been in the headlines. Companies like BP, ExxonMobil and Shell ceased joint ventures and other arrangements with Russian partners like Gazprom and Rosneft.
- Most commercial and investment banks, along with consultancy firms, have also stopped business in Russia or are winding down activities in the country.
Although not the target of sanctions, commercial business activities in Ukraine were also disrupted as the war is fought there, in many cases leaving multinational companies little choice but to reduce their production of goods or provisions of services in the country.
- Even if companies continue to operate in Ukraine in a more limited capacity, sales within Ukraine are hampered by the vastly weaker economy. Ukrainian finance minister Sergii Marchenko said in a meeting at the European Council in mid-April that about 30% of companies have completely stopped their activities in the country, while 45% have reduced production (as per Investment Monitor).
- The World Bank projects the Ukraine GDP will decline by 45% this year, and the collateral damage to the European economy will cause GDP growth to decline to 3.0% in the EU this year compared to the pre-war expectation of 4.1%.
Service Business Disruptions: A number of foreign companies, ranging in size from early stage/start-ups to large multinationals, have outsourced certain job functions to teams based in Ukraine and perhaps, to a lesser extent, to teams in Russia.
- According to a Wall Street Journal article. Ukraine’s information technology sector was booming prior to Russia’s invasion. The article goes on to say that there are an estimated “85,000 to 100,000 export service workers in Ukraine, employed predominantly in software engineering and other IT services.”
- Clearly, the war disrupted this important nucleus of high-tech outsourced workers both in terms of ongoing Russian attacks in the country and periodic disruptions in internet services.
- Foreign companies that relied before on Ukraine’s high quality expertise in IT and tech support have in many cases turned elsewhere, leading not only to an inconvenience, but also to potentially higher costs and a degradation in services (or both).
Supply Chain Disruptions
The extensive sanctions applied by the U.S., Europe, and other western countries on Russia are severely affecting global supply-chains. Goods and components manufactured in Russia and Ukraine, along with natural resources and agricultural products produced by both countries, are heavily impacted.
- Both countries supply final goods and components needed to manufacture finished goods abroad.
Energy: The most discussed and clearest effects have been on oil, gas, and other extractive minerals and on agricultural products, all of which are exported to countries around the world.
- Prior to the invasion, Russia – an important member of OPEC+ – was the second largest producer of oil globally, just behind the U.S., accounting for around 13% of global oil production.
- The cost of oil rose nearly 20% since the day before the invasion, and 46% since the end of 2021, when the possibility of an invasion was already being discussed.
- Perhaps more importantly, at least for Europe, Russia is the second-largest producer of natural gas (behind the U.S.), and the largest exporter of natural gas in the world. According to the EIA, Russia accounted for 45% of total EU imports and 40% of natural gas imports in 2021, illustrating the EU’s reliance on Russian natural gas.
- Since the invasion, the cost of natural gas has been highly volatile, initially tripling within weeks following the invasion but now settling to a level that is around 34% higher than the year-end price.
Energy might be the most obvious issue as far as supply-chain disruptions, but there are a fair number of other products and components produced on-shore in Russia and Ukraine meant for export to complete finished goods abroad.
Agriculture: Both Ukraine and Russia were significant exporters of agricultural products prior to the war.
- Ukraine’s top three exports were seed oils, corn and wheat, which, according to the OEC, collectively accounted for 28.2% of the country’s $52.7 billion of exports in 2020.
- Though Russia is a much larger exporter of oil, gas, minerals, and metals, wheat accounted for 3.05% of Russia’s total exports in 2020 of $330 billion. According to the Financial Times, Russia and Ukraine collectively account for 30% of the world’s exports of wheat, which explains why the price of wheat has soared since the invasion.
There are fears that the disruption in agricultural products might be setting the stage for further price increases and shortages of food in select (importing) countries around the world.
Banks and the Transfer of Money
Severe restrictions were put on the transfer of U.S. Dollars to and from Russian banks by U.S., Europe, and other western powers, and Russia’s foreign reserves were frozen by the U.S.
- The U.S. and global banking system is heavily policed by the U.S. government and transactions involving Russian companies, subsidiaries, affiliates and, in some cases, shareholders are heavily scrutinized in order to eliminate the flow of U.S. Dollars to sanctioned Russian banks and companies.
- As a result, banks and multinational companies inevitably face higher costs associated with compliance, internal monitoring, and due diligence to ensure they do not run afoul of these restrictions.
The burden might fall most heavily on financial institutions, but the heavy cost of a mistake almost certainly means that even non-financial companies have had to increase the manpower and sharpen their focus on anti-money laundering and general financial compliance.
Higher Transportation Costs
Multinational companies that previously transported their goods via shipping routes or air transport over or through Ukraine or Russia as the most direct and least expensive route were forced to find alternative routes that likely take longer and are more expensive.
- Being forced to transport goods over less efficient routes raises transportation costs and squeezes operating margins for companies that have had to alter their shipping routes.
Global Financial Risk Premia
Broader geopolitical risk raises risk premium across global markets, which, ceteris paribus, raises the discount rate used to discount future cash flows and reduces the present value of companies.
- Since the onset of the Russia-Ukraine war on February 24th, the S&P declined 5%, and sentiment has progressively declined across risk markets.
- Greater geopolitical uncertainty also drives investors to safe-haven currencies like the U.S. Dollar, which some analysts believe is overvalued but firm.
- A strong U.S. Dollar raises the costs of goods exported by U.S. companies, diminishing demand for these products in the global marketplace. These sorts of distortions led to less-than-perfect allocation of capital, and this can have negative economic consequences over the long-term.
What questions should alternative investors ask?
Equities investors have the benefit of mandatory disclosures companies must make as public companies to learn about any impacts the war may have on their holdings. Investors in private companies and assets like alternative investments do not have the luxury of extensive SEC filings to comb through to assess risk.
Though some companies offer transparency into their due diligence on a per-asset basis, the only way to really assess, understand, and quantify risks surrounding the current war is to question the investment platforms themselves. Understanding these risks and potential costs are important whether you are an equity investor or a debt investor, and you should thoroughly investigate platforms and their managers to get the applicable information:
- Ask about customers in the conflict zone and the likely impact of revenues from these customers related to the war.
- See if access to raw materials, finished goods, or component parts that might be affected by sanctions on Russia or war disruptions in Ukraine impact any investments.
- Inquire about reliance/use of outsourced services in Ukraine (or Russia), and the alternative if these services are/were disputed.
- Find the percent and magnitude of effect on the operating cost base because of higher oil and gas prices, and/or increases in transportation costs.
- See if commercial or other business-related transactions with companies that are subject to U.S. sanctions.
- Find if shareholders and/or creditors might be subject to U.S. sanctions, and how this might affect other (non-Russian) investors in the company.
The Toll of War
Wars are expensive to finance and have real collateral effects on countries and companies located outside of the conflict zone. Russia’s unprovoked invasion of Ukraine led to a cascade of actions by countries (sanctions) and companies (exiting the country, supply-chain disruptions, higher costs of transport and compliance), all of which have severe negative consequences on global economic growth. Some companies and sectors have benefitted, including energy and defense companies, yet they are few and far between. The damage is felt by innumerable large and small companies alike located in all corners of the world.
When analyzing the creditworthiness of companies, halting business in and exports from Russia (due to sanctions) and Ukraine (due to war) can cause a negative revenue variance (i.e. due to lost sales), a negative operating cost variance due to delays in ascertaining critical components needed in the manufacture of finished goods, and/or significantly higher prices of end products due to scarcity of components.
Simply put, this war has and will continue to have far-reaching consequences for businesses well beyond the borders of the conflict zone.