Russia's Asset Swap Gambit Amid West's Ukraine Aid Challenge

Welcome back. Everyone is focused on rate cuts, and while undeniably important and covered here, we wanted to highlight key developments in Eastern Europe and the Caucasus region from the past week. To be more specific, we are breaking down how the war in Ukraine has raised issues regarding frozen assets and reshaped the Armenia-Azerbaijan conflict.

In this publication:

• US inflation rises, won't alter rate cut expectations

• EM bonds heating up!

• Markets are concerned about a tighter oil market, driving prices up

• Russia seeks a swap of the frozen assets with the West

• Armenia is ready to give up more territory to find peace

Let’s dissect

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Markets Snapshot

Bond Markets

• US 10-year Treasury yields surged to 4.31% after a US CPI report indicated ongoing inflationary pressures, with consumer prices climbing to 3.2% and core inflation at 3.8%, slightly above initial expectations. This marks the third consecutive month where the monthly or annual reading has exceeded expectations.

  Nonetheless, economists surveyed by Bloomberg suggest that Fed is unlikely to change their forecasts for three interest-rate cuts this year and four in 2025, with the first rate reduction expected in June after the Federal Open Market Committee will likely keep rates steady within the 5.25% to 5.5% range for a fifth consecutive meeting this week.

• EU: The Euro Area's economic performance remained flat in Q4 2023 according to the latest data, stabilizing after a 0.1% contraction in the preceding quarter amid challenges of high inflation, elevated borrowing costs, and subdued external demand. The annual GDP growth for 2023 was a modest 0.4%, representing a significant slowdown from the 3.4% growth observed in 2022.

• Emerging Markets (EM): The likelihood of government defaults in EM countries, particularly in Africa and Latin America, has significantly decreased this year, leading to a robust rally in previously unstable bonds. This marks the best start for junk-rated sovereign debt since 2019. Countries like Egypt, with a recent $35 bn investment from the UAE (already analysed it here), Pakistan with its new government, and Argentina with its reinvigorated reform agenda (you can read our , have collectively contributed to bolstering market confidence. According to Bloomberg, only 10 countries now show distress signals in the bond market, half as many as in 2022. This positive shift is also attributed to the market expectations of potential rate cuts by major central banks that will help to ease financing costs for the EM economies.

Commodity Markets

• Oil: Global crude oil prices have reached approximately USD 85 per barrel, reflecting a weekly surge of 4.55% following shifts in supply and demand forecasts. The International Energy Agency (IEA) revised its projections for this year, foreseeing a tighter market and increased demand growth compared to earlier estimates, largely attributed to disruptions caused by Houthi attacks on ships in the Red Sea.

  Market caution also lingers amid uncertainty over Chinese demand as the country’s oil imports drop 5.7% in the first two months of the year, raising consumption concerns.

  In its monthly report, OPEC reaffirmed its projection for robust oil demand, anticipating an increase of 2.25 million barrels per day (bpd) in 2024 and 1.85 million bpd in 2025.

In Motion

Global Finance

The Ongoing Dilemma of Frozen Assets

• Russia has outlined terms for a proposed swap of Russian and Western investors' frozen assets, allowing each side to recoup lost value after sanctions were imposed over Russian war in Ukraine. The exchange is aimed at unblocking around $1.1 billion in European securities, mostly owned by Russian retail investors. The Kremlin hopes this will be the first step in a plan to compensate 3.5 million investors holding a total of $16.5 billion in assets in Western countries.

• 'Investitsionnaya Palata,' a broker not under Western sanctions, has been appointed by Finance Ministry to organize the trade. It will collect bids from Russian investors looking to exchange shares held abroad for cash held by non-residents. Russia blocked aproximately $6.6 bn of cash held by non-residents from countries it considered "unfriendly" in so-called C accounts shortly after the start of the war in February 2022 according to Interfax. The cash in these accounts mostly originated from foreign investors purchasing Moscow's sovereign assets, reaching around 35% of all Russian government debt in 2020. Meanwhile, Russian shares held abroad primarily consist of major tech stocks such as Apple, Netflix, and Amazon.

• We have previously discussed the US and EU urging their G7 allies to seize Russian sovereign assets, amounting to approximately $280 billion. These assets were frozen following Russia's invasion of Ukraine in February 2022. Furthermore, sanctions targeting Russian oligarchs have frozen an estimated additional $58 billion in assets, encompassing homes, yachts, and aircrafts.

• There is division among G7 leaders regarding the legal transfer of assets to Ukraine, primarily due to concerns about potential retaliation from Moscow against European assets and worries that depositors from many countries may withdraw funds from Western banks, further complicating the situation. Currently, the EU is gradually advancing separate plans to impose a windfall tax on the profits generated by the immobilized Russian funds. The urgency of the situation has heightened, especially as Ukraine faces critical ammunition shortages, further complicated by Republican lawmakers hindering $60 billion in US aid to Kyiv. Last week, S&P has downgraded Ukraine's sovereign credit rating from CCC to CC with a negative outlook. The downgrade indicates S&P's belief that Ukraine is highly likely to default on its external commercial debts.

Our thoughts

• The proceeds from the windfall tax on the frozen assets will undoubtedly be helpful but won't significantly impact the situation. They amounted to only $4.8 billion in 2023, while Ukraine's reconstruction needs stood at $486 billion as of December 2023, according to the World Bank.

• We believe concerns about the fragmentation of the financial system and potential deposit withdrawals are largely unfounded. The U.S. dollar, Euro, Japanese Yen, and Pound Sterling—all representing G7 members—constitute approximately 80% of global trade, leaving no viable alternatives to these currencies. Those, who might have a reason to reassess their investment strategy in the financial institutions from the G7 coutries, likely did so already in February-March 2022.

• We don't believe it would set a precedent for Western banks to be seen as politically biased or undermine trust in Western institutions. In the US jurisdiction, the implementation of so-called countermeasures provides a legal basis for potential seizures of Russian assets. In essence, it is lawful to impose asset seizures against a state that has violated international laws, aiming to pressure it to cease unlawful behavior and offer compensation. For instance , after the 2003 invasion of Iraq and ousting of its leader Saddam Hussein, President George W. Bush seized $1.7 billion of Iraqi funds in US banks, using some to pay Iraqi government salaries.

• It's also not a legal issue; some skeptics believe that seizing Russian assets would involve preventing international courts from hearing Russian appeal cases, posing a risk of undermining public confidence in the legal system. However, they overlook that not holding an aggressor accountable for violating international law carries a similar risk. In this case, it is challenging to justify that the first risk outweighs the alternative, considering the economic damage the Russian war has caused to Ukraine.

Geopolitics

Armenia is Ready To Cede More Territory To Azerbaijan

• Armenian Prime Minister Nikol Pashinyan signaled his willingness to comply with Azerbaijan's request to vacate four border villages. Azerbaijan reiterated its demands publicly after recent talks between the two countries on border delineation, stemming from Azerbaijan's large-scale military offensive in 2023, which forcibly took control of the Nagorno-Karabakh region. The region was de facto controlled by the self-proclaimed Republic of Artsakh, and de jure part of Azerbaijan. Recent clashes led to Azerbaijan seizing more Armenian territory.

• Situated in Armenia's Tavush province bordering western Azerbaijan, these villages are strategically important as they lie along a key highway to Georgia and a pipeline supplying Russian natural gas to Armenia via Georgia. They were under Azerbaijani control during the Soviet era and later occupied by Armenia in the early 1990s. In exchange, Azerbaijan gained a larger Armenian enclave and agricultural lands.

• On Wednesday, the European Parliament supported a motion advocating for the consideration of Armenia's EU candidacy. The country is currently undergoing a significant shift in its foreign policy, moving away from Russia and towards the West. This shift has been accelerated by the conflict in Ukraine and the Russian government's inability to offer security assurances under the Moscow-led Collective Security Treaty Organization (CSTO) as well as peacekeeping operations in Nagorno-Karabakh region initiated in 2020. Around 10,000 Russian "peacekeeping" troops are stationed in Armenia, with 2,000 Russian soldiers are stil deployed in the Lachin corridor in Nagorno-Karabakh, the sole overland access route to Armenia since 2020.

Our thoughts

• The main obstacle to Armenia's EU aspirations lies not only in Russian stationed troops or ongoing border delineation issues with Azerbaijan, which seeks additional territory from Armenia. After all, Georgia and Moldova, despite Russian-backed conflicts and presence of troops, have been granted EU candidate status. Ukraine, despite being in an active phase of war with Russia, also seeks EU accession talks. And Cyprus, which can serve as a prime example, became an EU member in 2004, despite the northern part of the island being invaded by Turkish forces three decades prior, resulting in a frozen conflict.

• In 2013, Armenia finalized talks on the EU's Deep and Comprehensive Free Trade Area agreement but later pivoted to join the Eurasian Economic Union, an economic union of post-Soviet states lead by Russia, Belarus and Kazakhstan. Now, only amid Russia's failure to intervene during Azerbaijan's takeover of Nagorno-Karabakh, Armenia is reconsidering its stance. However, EU members will demand more than just a mere desire for protection; they will seek Armenia to develop strong institutions and reduce its economic dependence on Russia.

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Our Further Reading Recommendations

• Chinese economic turmoil triggers ripples in global markets, through the lens of concerned investors (Bloomberg)

• Ukraine War Sparks Surge in Oil Refinery Demand Across Europe (FT)