Interview with Albanian Daily News, March 1, 2022

In the first place, Mr. Nemethy did you believe that Russia would invade Ukraine and secondly, do you think that the scenario of a ‘domino effect’ might follow if Kyiv falls with Moldova, Georgia, Western Balkans, and then the Baltic states being the next targets?

It was always an open question whether Putin was bluffing, or truly intended to invade Ukraine. Until recently, perhaps only God and Putin knew the definitive answer to that question.

A few months ago, I visited Georgia. It was quite eerie how the Russians had occupied a good slice of Georgia since over a decade, coming within a stone’s throw of the main highway connecting Tbilisi to the Black Sea. Given that that “first hand feeling” experienced in Georgia, and reading about the subsequent the annexations of Crimea, and large parts of the Donbass and Lugansk regions of Ukraine, to me the idea of a larger Russian incursion into Ukraine was not at all far-fetched. It was common knowledge that the biggest geopolitical disaster to Putin in his lifetime was the disintegration of the Soviet Union.

The Russian invasion of Ukraine is not an isolated event; it is part of an established pattern. Hence, it is a reasonable deduction that if allowed to succeed in Ukraine, Putin could be expected to continue advancing his dream of expanding Russian influence in other parts of the former Soviet Union.

Sanctions after sanctions are being imposed by the West on Russia. How much could they hit Russia economically, financially and its banking system, and incidentally hasn’t the Russian government taken measures to face such expected western blow?

The Russian Government has been bullet-proofing its economy for some time. In other words, they have been taking steps to reduce their vulnerability in case of military conflict or sanctions. For example, they have dramatically reduced their US dollar reserves, and increased gold reserves to some 22% of total reserves, the highest gold percentage of any nation. They have also one of the lowest national debt/GDP ratios in the world. Once again, this is a way of reducing vulnerability.

Western sanctions after Russia mobilized around Ukraine were a first the butt of many a joke. According to one humorist, the harshest sanction the Europeans could apply was the expulsion of Russia from the Eurovision song contest. The mood has changed dramatically in recent weeks.

Current and future sanctions have the potential to hurt the Russian economy more than any sanctions applied as a result of previous Russian foreign incursions. On February 28, the ruble recently fell over 30% vis-à-vis the USD in just a single day. The Central Bank’s key interest rate was raised from 9.5% to 20%, to provide incentive for capital to remain in Russia and stem the devaluation, which will put the brakes on new lending and economic growth. Devaluation and inflation will directly and massively affect the standard of living of the average Russian. Russians are lining up at banks and ATM’s, withdrawing cash and trying to buy US Dollars. Sanctions have put the Russian banking system under enormous stress.

To date, certain Russian banks have been excluded from SWIFT, but if I understand correctly, oil and gas transactions have been exempted. Access to SWIFT may well be further curtailed. It could cut off the Russian economy from most of the world—including the USD 1 billion a day that Russia collects from gas exports to Europe.

In conclusion, current sanctions are already hurting Russia more than any previous sanctions applied, and there is potential to ratchet them further. We are witnessing unprecedented sanctions with unprecedented effect.

In the long-run, however, Russia, just like Iran, is likely to find work-arounds, that will circumvent SWIFT and sanctions, which may diminish American power.

What could be the impact of the devaluation of the ruble, as Russians are still reliant on a multitude of imported goods and the prices for those items are likely to skyrocket?

Russia’s imports amounted to over 20% of GDP in 2020, so the impact of a large devaluation will be substantial. Russia’s has some $630 billion of official reserves, which according to Commerzbank suffices to cover a year’s imports. In my opinion, this offers only a theoretical protection to the Russian standard of living, as it is unknown what percentage of Russian reserves are in frozen foreign accounts, and the Government will likely need the reserves to finance its war effort.

Devaluation leads to higher inflation, and the combination of devaluation and inflation will serve to wipe out savings and diminish the standard of living of the population at large. Unfortunately, it is the man in the street, particularly retirees, or anyone on a fixed income or saver, who will suffer the most.

As a follow up, do these sanctions have any sort of negative repercussions on the countries which impose them in the long run?

There is no question that the countries applying sanctions also bear a cost. For example, Germany stopping the approval of the Northstream pipeline means that Russian gas imported to Europe will likely be limited in supply and higher in price. Years ago, Germany shuttered its nuclear reactors, hence is heavily reliant on imported natural gas for base load power. The rise in energy costs will diminish German economic competitiveness.

The French economy will also be negatively affected. The French have also recently closed a number of nuclear reactors for repairs; hence they are currently more reliant on gas than usual. French-owned companies also employ over 160,000 employees in Russia. Societe Generale, one of the weaker Globally Systemically Important Banks, owns Rosbank, a major Russian private bank targeted by sanctions. The failure of Rosbank would substantially impair the capital of Societe Generale. Many companies in Central Europe have subsidiaries in Russia.

Then there are deals by Central European entities with Russian investors and lenders which will likely be affected, perhaps the largest of which is the $13 billion deal to add two new nuclear reactors to Hungary’s Paks facility. While Prime Minister Orban insists the deal is going forward, the Russian state-owned bank providing financing is under sanctions, putting the whole Paks expansion project under a cloud.

Europe is highly dependent on gas from Russia and cannot quickly find alternative supplies if pipelines are cut. If the crisis continues, how acute could the issue of gas supplies become in the long run and how serious could the energy impact be for the European countries?

The price of natural gas has already approximately quintupled in Europe over the past year. Europe imports approximately 40% of its natural gas from Russia. While some countries import much more than other, the European gas market operates as a unified gas market. So even though a country like the UK only import 5% of gas from Russia, it will also face similar gas price increases.

Gas supply is relatively inelastic—it takes time to build new pipelines, LNG terminals or explore, drill and develop new energy sources. So prices could move potentially much higher than currently already high levels in the mid-term. In the long-term, however, it should be possible to carry out those investments, which would help supply catch up with demand.

By the way, one decision that the Germans could make to alleviate high energy prices in the short- to mid-term would be to restart 14 mothballed German nuclear plants. Chancellor Scholz has already floated the idea.

Let me touch upon Switzerland and its traditional special neutral status. As a seasoned banker do you think that it will take a tougher line with regard to Russia and how much could it affect its credibility worldwide in the future?

The fact that Switzerland has stepped up to bat and joined the European sanctions demonstrates the degree of consensus against the invasion of Ukraine. According to the Swiss National Bank, Russian individuals and companies held some $11 billion in assets in Swiss banks in 2020, which presumably will be frozen. You might say that this violates neutrality; the Swiss claim they are enforcing international law. Swiss President Ignazio Cassis said, “Not since the Second World War have the rights of one country been so violated by another.”

Mr. Nemethy, there are many other countries, powerful ones like China or some in the Middle East, Latin America and other regions that do not follow the line of sanctions. Could Russia reorient its economic and financial connections and how much could such a move bring about an economic relief for that country?

Such a reorientation has already begun. The Russians are building vast pipelines to supply gas to China. I foresee China becoming their dominant export market for hydrocarbons and other products, but the question is whether this reorientation can occur fast enough to help the Russian economy in the short- and medium-term.

It would take years to build infrastructure and logistics, and enormous amounts of capital (which the Russians will lack due to sanctions) to diversify exports. Hence I would not expect too much economic relief in the short- to mid-term.

The United Nations’ refugee agency says it plans to deal with up to four million Ukrainian refugees if the situation worsens. Still, European Commissioner for Crisis Management Janez Lenarčič had said he estimates the figure could reach seven million. How capable is the West to cope with such a situation which adds to the flow of refugees from Afghanistan and Middle East countries?

I am of the view that Europe is facing a demographic crisis, with the population of most countries in ever steepening decline. Even if you had seven million immigrants, that is less than 2% of the population of the European Union. The United States currently has some 13% of its population who are classified as immigrants, compared to 8.3% in Europe.

Of course, this will mean challenges on multiple fronts, from housebuilding to education, but an influx of talented people, in my opinion, represents an opportunity, more than a problem. To the extent that the immigration is more than temporary, it will be Ukraine’s loss.

Mr. Nemethy, is the global economy at risk of a new recession?

In my humble opinion, the global economy had a risk of recession even prior to the Russian invasion of Ukraine. The world simultaneously faces a trifecta of (a) record debt levels; (b) the highest inflation since the early 1980’s; and (c) record asset prices. Like Covid-19, the Russian invasion of Ukraine is yet another risk factor that augments the risk of a recession, at least stagflation.

Most of the world pulled through the Covid crisis without a major or prolonged recession. This was in large part thanks to massive amounts of fiscal stimulus/government spending, accompanied by stimulative monetary policy (Governments buying bonds to keep interest rates low). The US national debt went from $23 trillion to $30 trillion in only two years (and is still rising rapidly).

This combination of fiscal and monetary stimulus, however, helped unleash the biggest increase in inflation in forty years. The Russian invasion of Ukraine, unfortunately disrupts exports of key products such as energy, grain, fertilizer, palladium, etc, adding to inflationary pressure. The cessation of gas flow from Russia to Europe could unleash an energy crisis similar to or worse than that of the late 1970’s.

Many Central Banks, including the US Federal Reserve, have announced their intention to tackle inflation by raising rates and moving from bond purchases to unwinding their balance sheets by selling bonds. Given record levels of personal corporate and government debt (some USD 360 trillion globally), causing unprecedented sensitivity of the world economy to interest rates, this would quickly drive the world into recession. In my opinion, Central Banks are looking for an excuse to “kick the can down the road”—(e.g. not raising rates,) and the Russian invasion of Ukraine may provide just that perfect excuse. If this occurs, be prepared for record levels of inflation—to the point where further down the road there may be a loss of confidence in one or more fiat currencies, which may then trigger something more severe than a recession..

According to Mohammed el Erian, an authority on financial markets, markets are now pricing the probability of a Russian Government default at 50% (up from 34% just a week ago). The Russian Government holds some $478.2 billion of USD denominated foreign debt according to the International Institute of Finance. The European Central Bank has stated that subsidiaries of Russian banks in Central Europe are either failing or likely to fail. Subsidiaries of French, Italian, Austrian and other Western European banks in Russia are also experiencing stress. So there is a distinct possibility of default and contagion in an already fragile European banking system.

To conclude, the Russian invasion of Ukraine has added to the pandemic crisis. The tightening of the isolation of the world’s 11th-largest economy and one of its largest commodity producers has its repercussions worldwide. In face of so many hardships ranging from political to economic and social repercussions in the world do you think that a new global order is needed following the example of the EU, which has launched a year and a half Conference on the Future of Europe?

Putin has done for Europe what the Europeans and Americans could not do for themselves: he has helped foster a sense of unity within Europe, and as bipartisan support for Biden’s State of the Union address demonstrated, also within the US. He has reinvigorated belief in the liberal order, and for better or worse—has helped to dramatically increase German defense spending. Think of how much worse off EU countries would be today if there were 28 separate countries and no union. Perhaps the Conference on the Future of Europe can help better shape that consensus that will be necessary to streamline the institutional reform and heightened integration necessary to achieve that.

Finally, allow me to close on a personal note. I managed a World Bank project from 1993-97 in Kharkiv, Ukraine. As I was sitting here writing this article, watching coverage of the invasion, I witnessed footage of the Russians blowing upthe Kharkiv Regional Government building, a building I visited many times. So I extend my sympathy to the Ukrainian people for their suffering, and commend them for their courage, and hope that at some point when all of this blows over, the Ukrainians can also join the EU.

Perhaps some day Europeans will erect a statue to Vladimir Putin: the person who did more to foster European unity and integration than any other individual.

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