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Moody's Talks - Inside Economics

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February 15, 2022

Bonus Episode: Russia-Ukraine Conflict

Gaurav Ganguly, Senior Director of Economic Research at Moody's Analytics, joins the podcast to focus on the Russia-Ukraine conflict and what it means for the global economy.

Full episode transcript.

Mark Zandi:                       Welcome to Inside Economics. I'm Mark Zandi, the chief economist of Moody's Analytics. This is a special bonus edition of Inside Economics. We are going to be tackling the question of Russia, Ukraine, and what it all means for the global economy. I'm joined, well, we're missing one of our co-hosts, Ryan Sweet, who's struggling to get in. I'm sure he'll figure it out at some point, and also Cris deRitis. Hi, Cris, deputy chief economist. Welcome.

Cris deRitis:                        Hi Mark, thanks.

Mark Zandi:                       Good to have you. The man of the hour, Gaurav Ganguly. Gaurav is our colleague in Europe and he is the head of EMEA Economics, European Middle East and Africa. Welcome, Gaurav.

Gaurav Ganguly:              Thank you, Mark. Hi, Cris. Good to be on the show.

Mark Zandi:                       We have a lot to talk about. As I said, we are focused on the Russia Ukraine conflict. I thought about using the word kerfuffle, but that doesn't feel significant enough, right?

Cris deRitis:                        No.

Gaurav Ganguly:              It doesn't.

Mark Zandi:                       I should say conflict. Yeah, conflict.

Cris deRitis:                        Incursion? [crosstalk 00:01:18]

Mark Zandi:                       Incursion, [crosstalk 00:01:19].

Cris deRitis:                        I think Biden said incursion.

Mark Zandi:                       He used the word incursion? Okay.

Cris deRitis:                        Yeah. That might be a little strong.

Mark Zandi:                       How do you [crosstalk 00:01:23] Gaurav, what are you...

Gaurav Ganguly:              I sort of flip between saying incursion and invasion, depending on how I feel about the whole thing.

Mark Zandi:                       Oh, well yeah. Good point. Okay, well [crosstalk 00:01:31].

Gaurav Ganguly:              There is a dark view in Europe. Robert Habeck, Vice-Chancellor of Germany said that we are facing prospect of war on Europe soil for the first time in 70 years. Certainly on this side of Atlantic, some of the views around this conflict and the escalation of this conflict are quite somber.

Mark Zandi:                       Appropriately so. Hey, one other nomenclature issue. Do you call the capital of Ukraine, Kiev? I believe that's the way the Ukrainians pronounce it or Kiev. I believe that's the way the Russians pronounce it. How do you pronounce the capital?

Gaurav Ganguly:              Well, I should probably indicate my sympathy and say Kiev.

Mark Zandi:                       Yeah, okay. That's my instinct here. I think most major media outlets, at least here in the U.S. are now saying Kiev, because it's the way the Ukrainians pronounce the capital's name. We set the ground rules here. It's an incursion until it becomes an invasion, and the capital is Kiev. Oh, I should say MIA, I said European Middle East and Africa and Gaurav, you joined us now, wow, almost about five, six months ago now, I think.

Gaurav Ganguly:              Five months ago, I think. Five or six months ago.

Mark Zandi:                       Well we've got you on the hot seat here, so thanks for doing all this work. We've got a lot planned with regard to our efforts to analyze this incursion. This is the first thing that we're doing this podcast, so we'll give you a sense of how we're thinking about things. We do have a webinar. Gaurav is going to lead the way. That comes next week, I think February 24th. Invitations are going out for that.

                                                We are running a number of different scenarios. Obviously a lot of uncertainty here. Who knows how this is going to play out, so we are considering different scenarios. We're running that through our global model and producing forecasts based on those different assumptions around what happens in Ukraine, in Russia, and putting that into databases for people to use. That'll be available sometime next week, as well. Finally, Gaurav, I think you said you're writing a white paper to kind of explain all this.

Gaurav Ganguly:              That's right. You got the timeline exactly right.

Mark Zandi:                       By the end of next week, we'll pretty much have all our analysis available for clients to use and for people to take a look at. Here we are. How are things going there? Can you, Gaurav, just give us a lay of the land politically? I mean I know it's very difficult because it's very fluid, a lot of things changing this morning.

                                                Here we are talking the morning of Eastern time of Tuesday, February 15th, and already a lot of news today. How are you thinking about things? What's the lay of the land with regard to this issue?

Gaurav Ganguly:              Well as I said a moment earlier, at least in some quarters in Europe, the mood is quite somber, and it is a fairly worrying situation. Some say that this is fairly par for the course, that about every year this time for several years, Putin sent troops close to the Ukrainian board, but what's happened this year I think sort of make some of the events of previous years pale in comparison.

                                                We've seen significant troop buildup for the last couple of months. We worried about troops in the eastern part of the country first, but now we are increasingly also worried about troop buildup in the northern part of the country, fairly close to Kiev. Now Putin says that that's all been planned and signaled in advance. These are joint troop movements that the Belarus typically conducted around this time of year, but the timing is curious. The troop movements have been quite alarming, at least from a NATO perspective.

                                                Now when you look at some of the demands Putin has made, it seems like they are quite extreme. He issued a set of demands to NATO, as you're aware. I think everybody's aware now, everybody's following this quite closely, asking for NATO to pull back their troop movements and basically revert to their 1997 position. Now that's unacceptable to NATO, I think. That sets the bar below which he's not willing to negotiate, and that's a bar that's just impossible to meet.

                                                NATO's advanced in successive stages since the fall of the Soviet Union, and it had actually planned to include the Ukraine as part of NATO, which I think is completely unacceptable to Putin, but equally to roll back to 1997 would be absolutely impossible. Then that means that if that's the bar that he's set and that's not a bar that's ever going to be met, then where do we from here? I think that's the key, that's the key question.

                                                A couple of possibilities that would still avoid conflict. I think that is what's keeping up hope in Europe, that we don't have to necessarily go down the route of an incursion, far less a full-blown invasion, that there are diplomatic possibilities available to Europe and to Russia. It probably might even be reflective of the comments made by foreign minister Lavrov yesterday when he said that it would be possible to find a diplomatic solution to which Putin then gave his assent. That probably focuses on what's been happening in the eastern part of the country ever since 2014, when...

Mark Zandi:                       Can I ask one what, so there's been a couple pieces of I guess good news. I mean markets this morning are responding positively. You mentioned Lavrov, the foreign minister, saying something publicly to Putin about perhaps there's a diplomatic path forward. I'm obviously paraphrasing, but that's kind of roughly what he said, which seems somewhat encouraging.

                                                Then we hear that the Russians have announced that they're pulling back some of the troops on the border. I don't know if they are or not, but they were announced that's what their intention is. Markets are interpreting that positively. Stock prices are up, oil prices are back down. How do you handicap all of that, I mean what do you think is going on? Is this as positive as people seem to think or obviously we don't know, but what's your sense of that?

Gaurav Ganguly:              As you said, we don't know. It's really hard to get a line of sight into what's going on in Putin's head at the moment. It probably requires somebody with considerably greater strategic acumen than I have. If I look through some of the noise that's been going on over the last few days, the kind of noise that you outlined very clearly Mark, then I'd say that the general tone of the discussion has turned a bit darker in the last weeks.

                                                I guess maybe a week ago I would've said there's a 50-50 chance of some sort of incursion into Ukraine versus troops actually pulling back in some kind of negotiated settlement. I get the feeling now it's a bit worse than that, there's still a significant path to no incursion, which might be somewhere closer to 40, 45%, but it's probably, balance of probability has probably shifted over to some kind of incursion, 55%.

Mark Zandi:                       Interesting. What you're saying is the improvement in market sentiment is misplaced, in your view. I mean you're thinking has gone in the other direction, here?

Gaurav Ganguly:              Yeah, and actually maybe what we look at is not just the recent, the today's pull back in markets, but the fact that there's been a bit of extra volatility in the market just because we've seen in the last few days, because we're seeing pronouncements go in either direction.

Cris deRitis:                        I guess it's a question of degree, as well, right?

Gaurav Ganguly:              Exactly.

Cris deRitis:                        Not just invade, don't invade, there are different levels of invasion and it could be that markets [crosstalk 00:09:06] are interpreting this as perhaps a bit of a concession, but that certainly doesn't rule out an invasion of the Donbas region, for example. Maybe the probability of a full takeover is lower.

Gaurav Ganguly:              I think that's right.

Cris deRitis:                        Do we agree, or are you still pessimistic?

Mark Zandi:                       That's interesting. You're saying the markets are focused on the-

Cris deRitis:                        The tail.

Mark Zandi:                       ... the tail risk, and they're saying, "Oh, that looks less likely," but it doesn't mean the probability that they might actually invade the Donbas region, which we'll come back, maybe we'll let Gaurav explain all that, but that's a less aggressive incursion or invasion, that that feels more likely, then. That's kind of what you're saying?

Cris deRitis:                        I think. I guess is the question to Gaurav. Is that what you're interpreting or when you say you're a little bit more pessimistic, is it tail or is it in the middle?

Gaurav Ganguly:              I think that's right. I'm probably even a little bit more pessimistic than what you've just outlined, Cris. I kind of feel that that tail kind of scenario is probably roughly the same, maybe it's gone down a bit. There are some bits within the tail that are very remote, and I'll come back to those later. In fact, one of our scenarios touches on some of the really remote things that could happen in the deal.

                                                I think you're right in that markets are probably thinking that some kind of incursion maybe to the Donbas region is possibly slightly more likely but that's palatable. [crosstalk 00:10:29] Those economic outcomes, those would be palatable.

Mark Zandi:                       We're going to go down these different scenario paths shortly and make that very explicit and clear in people's minds in terms of how we're framing this, in terms of scenarios and probabilities. Before we do that, and again, these questions are obviously, who knows, but I'm just curious what you think, and Cris as well.

                                                What is the end game here? What do you think is going to, really? Why is Putin doing this? What does he hope to accomplish at the end of the day here? Do you have a sense of that, or do you have any view on that?

Gaurav Ganguly:              I've been thinking about this long and hard and trying to figure out what exactly Putin once. I gave up on economics at this point and started reading history. Discovered the really long, rich history that the Ukrainian people have and their long connection with different parts of Europe, from Poland and Lithuania through to Russia. Then I kind of fast forwarded all of that to 2010, 2011 when Ukraine first expressed an interest, and started to express a serious interest in getting closer to the E.U.

                                                There was talk of trade association with the E.U., which ultimately led to Russia interfering in Ukrainian politics and having the Ukrainian Premier removed, which led to people's protests and subsequently then, incursion into Donbas and Luhansk and the Crimean takeover, or supporting the separatists in Donbas and Luhansk in the eastern part of the country and the Crimean takeover.

                                                That was very clear that Putin was very unhappy with the state of affair with Ukraine getting closer and closer to Europe, not just NATO's proposal to actually extend its front further eastward and envelope the Ukraine. All of that gets somehow Ukraine, having performed as an independent state in 1971 after the fall of the Soviet Union, now actually being absorbed into Europe, absorbed into NATO seems to be completely against Putin's thinking.

                                                I think he feels that he needs to leave his legacy and in his legacy it's got to be that Ukraine or the Russian favored part of Ukraine actually returns to the fold, which does make me think that there's still a significant possibility that he will be content with an outcome where that happens without necessarily having to send his troops in. There are different ways, we can get onto that later, there are different ways in which that can actually happen. That's what I think his motivation is.

                                                I think that by setting the bar so high with NATO, he may have miscalculated, but he may not, to be honest it's really hard to tell, but I don't think that's what he's after. He's not after NATO actually going back to its 1997 border because I'm sure he must surely recognize that that's completely impossible.

Mark Zandi:                       It's really not about NATO per se, it's just really about the eastern part of the Ukraine, which is in his view historically that's been Russia. II mean that's part of Russia and therefore I want that back.

Gaurav Ganguly:              I think that's right. I think it's about more than just the eastern part of Ukraine. It's about getting back the Russian speaking part of Ukraine back into Russia, and making sure that Ukraine... I guess if that means that he's got to play a fairly destructive game to make sure that the Ukraine doesn't move towards the E.U. or towards NATO, then he'll do that.

Mark Zandi:                       I suppose also this may be just a test. I mean maybe he didn't really expect to gain anything with regard to NATO but hey, why not probe here a little bit? I mean just see how they react and maybe there will be some... It would create some fissures between NATO allies, between the Germans who are tied very closely to Russia via the natural gas that flows to Germany and the rest of NATO. Maybe that's part of what he's thinking, too.

Gaurav Ganguly:              That could well be. That could well be. He played his hand very well in terms of restricting oil and gas and restricting, sorry, gas supplies to Europe. Taking advantage of the winter season to do that. He also restricted Russian wheat exports in December, ostensibly to preserve domestic consumption but actually that's not something that great for wheat prices, either.

                                                Certainly he's gained a lot of really good publicity if you imagine that Putin has all he's had to do is put 100,000 troops near the border with Ukraine and every single major world leader has flown over to meet him as a result. Do you recall that meeting with Macron and the big white table, that's just, I guess that's just [crosstalk 00:15:18].

Mark Zandi:                       What a picture, right?

Gaurav Ganguly:              What a picture, exactly.

Mark Zandi:                       The table was a football field, it looked like. Putin was on one end and Macron was on the other. It was pretty bizarre, yeah.

Gaurav Ganguly:              He's managed to show the world that he's prepared to align himself with China, and that China is willing to have that, and that they're willing to deepen their economic relationship. I don't know what that really means, how meaningful that is in the long run, but at least it's a sign.

Cris deRitis:                        I think at a minimum he's now solidified Ukraine as a buffer state, right? The West is not going to embrace NATO or bring Ukraine into NATO anytime soon, right, because of these tensions, so that alone might be enough, right? I just want to make sure or he just wants to make sure that Ukraine is in the middle there as a buffer, doesn't want any troops on his borders.

Mark Zandi:                       Good point, because they were thinking they were flirting with becoming part of NATO, I guess.

Cris deRitis:                        It's gone back and forth over the years. I think that is really off the table now. Maybe not exclusively, but implicitly for the foreseeable future.

Mark Zandi:                       Hey let's talk about the scenarios, then. I guess this is kind of a, if you think about it, a tree of possibilities in the kind of the first branches, invasion, no invasion, right? How do you think about that, Gaurav? How do you handicap that part of the probability tree?

Gaurav Ganguly:              I think as I was saying earlier, I think I'm a bit more pessimistic about the prospects of some kind of incursion into the Ukraine over the last week. Whereas a week ago I was much more even about it, thinking it's about 50-50-, I now think it may be more like 45, 55, or even 30-60 on a dark day.

Mark Zandi:                       40-60.

Gaurav Ganguly:              Oh, sorry, 40-60. Getting all these probabilities in my head. I kind of veer between this sort of a boundary right now, so a bit more negative around the possibility of no incursion. Let's be clear that even not sending troops in doesn't mean that Putin's not going to interfere with the Ukraine.

                                                I think the possibility that actually Putin takes his troops back from where they are now, that he completely leaves Donbas and Luhansk alone and doesn't try to interfere with Ukrainian domestic politics and acquiesces to NATO's wishes to unfold Ukraine, virtually zero. There's no way that's going to happen.

Mark Zandi:                       Right.

Gaurav Ganguly:              Which means that when we talk about no incursion, what we mean, and this speaks to Cris' point that he's going to continue to interfere with the Ukraine for some time to come. He's going to continue to want to weaken the Ukraine's sovereign structure, the relationship with provinces, with the central government, weaken them, make sure that these provinces become more federalized, that they have greater freedom to align themselves with Russia if they wish. He'll be willing to fight proxy wars or even encourage regime change in order to get it. That's the new invasion scenario, which is not really that great an outlook for the Ukraine.

Mark Zandi:                       Let's stop there for just a second. One question is okay, I guess that's the most positive possible outcome here that Russia does not actually invade, but certainly they're going to interfere and they're going to create havoc, but they're not going to invade. If that's the case, what does that means in terms of, I think kind of the benchmark we're using to assess the economic consequences of what's going on there is oil prices.

                                                Oil prices, if you look at Brent, which is kind of the globally traded price, that's close to, well lasts I looked was close to 95 bucks a barrel. That feels like that's up 10, $15 a barrel on the Russian news. I mean it was up anyway because of demand supply dynamics coming out of the pandemic.

                                                Demand picked up faster than supply. There was a lot of things going on with OPEC and North American fracking and therefore prices were up. The problems in Russia, Ukraine have added 10 to 15 bucks a barrel. My question to you does that sound about right, and does that come out of price, do you think if we go down this more positive scenario of no invasion?

Gaurav Ganguly:              I don't see that it comes down a whole lot if he simply backs his troops away because there will always be the fear of some renewed threats. Maybe some of it comes back down, as there'll be some relief in the market, I guess, if he does this. I could see some of it coming back down.

                                                Overall, he's still going to be very connected with the Ukraine. He's still going to be very interested, but it's less oil that I worry about to be honest, Mark. It's more European gas that I worry about. Here I think I struggle to see does the stress go away at all, even if he steps back, because Russia has such a strange relationship with Ukraine when it comes to the supply of gas through the Ukraine into Europe. It's going to do whatever it can I feel simply reduce that supply and deny the Ukraine transit fees from gas. They've very keen to have Nord Stream come online.

                                                Now Nord Stream will carry about 55 billion cubic matters a year. That's Nord Stream, that'll double the entire Nord Stream capacity. Nord Stream 1 has the same capacity so that'll be entire 10 billion cubic meters of gas that can flow outside of the Ukraine directly under the North Sea into Germany. Ukrainian gas, its capacity is currently about 45 billion cubic meters. It carries much less because gas crop simply refuses to supply the gas via the Ukraine.

                                                I can't see that that pressure goes away, that suddenly we'll have full flow of gas through the Ukraine, Europe gets what it needs, and maybe even Nord Stream comes on because Europe feels comfortable with Nord Stream operating. I think those pressures remain. Maybe it takes Nord Stream some time to come online, it might be out to the end of the year to get various regulatory approval, et cetera.

                                                At that point, maybe we start to see gas prices starting to come down, but then we're also going into winter at that point. If you go through a stressful summer, Europe simply will be going into the next winter in a fairly vulnerable position without enough gas in storage, so I can see pressure on gas remaining for some time. That's pretty bad from a Europe perspective and inflation in Europe.

Mark Zandi:                       That's a good point. Kind of a parochial U.S. perspective, I'm focused on oil, but because natural gas markets are generally local markets. With the price here of natural gas, it's elevated a little bit because of what's going on in Europe through liquified natural gas demand, that kind of thing, but it's pretty much on the margin.

                                                Here and in much of the rest of the world, the economic fallout from what's going on in Russia, Ukraine, is through oil prices, but in Europe, you're right. It's mostly about natural gas because correct me if I'm wrong, I think about a third of European gas comes from Russia, and just to level set for the listener. The main way of getting natural gas from Russia to Europe is through the Nord Stream... I'm sorry, I did this-

Gaurav Ganguly:              There are four pipelines, Mark.

Mark Zandi:                       Four pipelines.

Gaurav Ganguly:              There are four principle pipelines that carry gas from Russia into Europe. You're right, it's about a third of Europe's gas requirement. The rest comes from places like Norway, Algeria, some from LNG terminals and a declining part of it from domestic production in the Netherlands. Now that's actually a bit of a problem. The domestic production of the Netherlands, because the Dutch shut down on production and it's on a steeply declining trend over the past few years because they've been experiencing earthquakes in the north of the country where these gas fields are. That's meant that reliance on Russian gas has actually sort of increased over that period of time.

                                                Yes, there are four pipelines that bring gas into Europe. The one that I was talking about, the one through the Ukraine supplies a bunch of central European countries, and that's the one that's of course had a fair bit of spare capacity. Again, as we were saying [crosstalk 00:23:36].-

Mark Zandi:                       The Russians want to shut that down basically and move it up to Nord Stream 2, which is the second pipeline that goes through the kind of the North Sea into Europe, which is directly from Russia into Europe. They want to use that instead of going through Ukraine.

Gaurav Ganguly:              That's my sense of it. Of course Russia hasn't said that. It's important to note that. That's not Russia's stated intention, but it would clearly be another lever, another bit of pressure to bring to bear on the Ukraine if Nord Stream 2 were to operate, because that's 55 billion cubic meters of gas right there, bypassing the Ukraine.

                                                If you take the second pipeline that the second north European or the third north European pipeline, if you take Nord Stream 1, Nord Stream 2, and then the third pipeline that runs from Belarus into Poland and Germany, then you would get in total about 160 billion cubic meters. That's almost sort of half of what Europe gets, or more than half of what Europe gets from Russia in a year. At that point, Russia is in a hugely strong position when it comes to negotiating with the Ukraine.

                                                The other point to make is that the gas [inaudible 00:24:40] agreement with the Ukrainian pipeline distributor, after gas, runs out in 2024, so right now there's a long term contract and a long term commitment to supply a certain volume of gas through the Ukraine, but that's all up for grabs in 20204. If you get Nord Stream 2 up and running before then, then I think going back to that scenario of continue interference in the Ukraine, that's a very powerful viva.

Mark Zandi:                       40% probability of no invasion, but regardless, there's still, it may be global oil prices come in a bit, but gas prices, natural gas prices going into Europe remain elevated. Of course the uncertainty around the supplies will remain very, very high going forward.

                                                One other question about that before we move on to the other scenarios. It seems from a European perspective that this is a bad arrangement, that they need to be working, regardless of what happens, even if Russia pulled 130,000 troops off the border and went back to their barracks, after all this wouldn't you really be working pretty hard to get off of Russian gas? I mean LNG seems the most likely way you would go.

                                                By the way, I just saw a statistic. I think if you look at the share of natural gas comping into Europe, LNG is now the highest share. It's higher than Russian, it's more than a third.

Gaurav Ganguly:              [crosstalk 00:26:04]

Mark Zandi:                       It's rising very quickly, but it feels like you would just go into hyper drive on LNG, Local Financial Gas, and try to get from Middle East, maybe from the U.S., I don't know, that kind of thing. Is that part of the discussion? It must be. You would think it would be.

Gaurav Ganguly:              It is. It certainly is. You're right, LNG supplies and since the start of this year really ramped up and there have been many stories of vessels just queuing to get into deep sea ports in France and in southern Europe to offload their stocks. There's of course a capacity constraint there. You can only offload so much and then you've got a capacity constraint and re-gasification plants because the liquified natural gas has to be gasified again and then sent up through a pipeline.

                                                On that broader story of why on earth is Europe not doing more to actually diversify away from Russia, I think this is also a typically European problem once again. Europe has taken a bunch of measures over the last 10 years to improve its gas security and its gas efficiency, in payment.

                                                It all started out with having gas pipes flowing through Europe, carrying gas from Russia, across European countries, but they only went in one direction or they largely went in one direction, which was to their destination. You couldn't do effective demand management, as a result.

                                                Then gas inter connectors were improved to allow gas to flow back, and that improved energy efficiency. At the same tie, deep sea ports started to be built to increase capacity for LNG. All of that takes time, and also I guess it occurs at a typically European pace because there are 27 member nations to deal with, an agreement has to be, you know you've got to get agreement from all sides before you can do something big.

                                                Now I guess what this shows is that energy security simply is really top of the agenda, and having a unified energy storage solution, for instance, is quite important, so there are gas storage facilities across Europe, but each country does its own thing, that's so not an optimal arrangement. You actually need Europe to be acting as one in buying and storing gas and agreeing to distribute it across countries.

                                                You've got to have greater ability to source LNG. That's not an overnight solution, in addition to having to build ports, lots of energy is supplied on long term commitments, so actually diverting LNG is not that straightforward. You've got to scale up renewables. That's got to be part of the solution, so it is possible for instance to double base of installation of solar PD. You've got to do more effective demand supply management and energy conservation measures, so a whole bunch of measures have to come together. Problem is that none of that's of course overnight.

                                                Russian gas dependency doesn't really go away that soon. It's all really interesting, one more thing I'll say about it, which is Russia's old perspective on this. In 2020, Putin brought in a Russia energy security act which sees Russian plans to diversify away from Europe out to 2035. Putin really wants to sell more gas to Asia, but if he's going to do that, then Europe had better sit up and pay attention and work a lot hard to diversify away from Putin.

Mark Zandi:                       That makes sense.

Gaurav Ganguly:              [crosstalk 00:29:17]

Mark Zandi:                       I guess just as a quick sidebar, exacerbating all of this course was Germany's decision back under Angela Merkel to mothball all the nuclear facilities for electricity, so they became very reliant on natural gas to power their electric utilities. That's why almost half of the gas they consume comes from Russia, because they're so dependent on it. Just something to keep in mind.

Gaurav Ganguly:              Absolutely. That was a big energy policy mistake if ever I saw one. That was just such a knee-jerk reaction to Fukushima.

Mark Zandi:                       Right, which was the Japanese facility that [crosstalk 00:29:53] got nailed by the earthquake and tsunami. Let's move on, so 40% probability, no invasion. We kind of talked about that. Now let's go down the other part of the probability tree and that is invasion. Kind of lay that out, because there's different versions of this scenario. Give us a sense of that.

Gaurav Ganguly:              We've talked a little bit about it already and we've mentioned the Donbas region and the possibility of invading there. I mentioned that [inaudible 00:30:24]. This again takes us back to 2014, so a little bit of history again, I guess.

                                                When Russia essentially supported separatists in two eastern provinces and these eastern provinces declared themselves as [inaudible 00:30:39] autonomous states, and they've been basically fighting ever since with the Ukraine, Russia claims not to be supporting them, but of course it is. A protocol was actually signed in 2015 called the Minsk Protocol that sought to bring all of this to an end, so to have a ceasefire there, to have these provinces actually federalized and set their own foreign policy. That protocol never came about.

                                                My feeling is that a big win for Putin would be to actually get that protocol revived and to see eastern these two provinces in eastern Ukraine be firmly in his hands, just as much as Crimea is in his hands right now. I guess one of the parts down to invasion would be to say that actually Putin is not going to achieve that through diplomatic means and therefore simply has to send troops into that part of Ukraine, and actually into the wider eastern part of Ukraine, which is called the Donbas region.

                                                That's actually a fairly big region and it could be quite difficult for him to even hold onto that region for a long period of time, but it's certainly doable. He may even then to send a message to the West and to the Ukrainian regime, go beyond the Donbas region, so to sort of extend a little bit further west, and that would be one scenario.

Mark Zandi:                       Now we're down the incursion, invasion probability part of the tree, and that has a 60% probability all in. What percent of the total possible range of outcomes would be this okay, I'm going to invade the eastern provinces, the Donbas region of Ukraine and top there, or go a little bit further into the western put, but that scenario. What kind of probability would you attach to that?

Gaurav Ganguly:              That's my main incursion scenario. Everything else I see is in the tail, so I'd be putting upwards of 50% on that one.

Mark Zandi:                       That's 50% of any possibility?

Gaurav Ganguly:              [crosstalk 00:32:42]. I'd be putting somewhere between 50 to 53, 54% probability on that occurring. If I put 40% on new invasion and I'm putting up to 50 to 53% on this particular [crostsalk 00:32:58].

Mark Zandi:                       Oh I see.

Gaurav Ganguly:              [crosstalk 00:32:58]

Mark Zandi:                       This is the most, in your view, likely scenario?

Gaurav Ganguly:              Yes. That's what I would see is the most likely.

Mark Zandi:                       This would be your baseline, then?

Gaurav Ganguly:              It kind of is in terms of, yeah, in terms of his actions, yes.

Mark Zandi:                       Interesting. Very interesting. Let's think about that for a second in terms of the economic implications. First of all, it sounds like if he does that, there's going to be some reaction from the West, from Europe and the U.S. In that scenario, what kind of response do you think you'd see here/

Gaurav Ganguly:              I think there's got to be some reaction and from the U.S., I think there's got to be a fairly clear reaction. I'm less convinced about what Europe might do and how Europe might play along to anything that the U.S. does.

                                                For so many reasons, it's important for the U.S. to stand up to any incursion into Donbas, including wanting to send the Chinese a clear message about international politics, so that's clear. It's less clear that the Europeans would at this point be completely unified in their response because we'd have to look at what exactly it is that the U.S. does.

                                                Now a number of options have been outlined. It might be worth just stepping through some of these. These include sanctioning individuals in the Russian government and, or in Russian companies and extending that out potentially to include even Putin himself. There could be sanctions levied on banks. Now don't forget that these sanctions, to some extent, already exist. Russian banks, et cetera have been sanctioned since 2014 in the Crimea crisis. Now we're talking about ramping up those sanctions.

                                                There is the possibility of actually killing the Nord Stream 2 project. Now we can talk about how that could be done and whether it would be feasible to do that, but there's certainly the possibility that exists of actually sanctioning Nord Stream 2 itself. I guess what else could America do? What else could the U.S. do? Those kind of become pretty big sanctions, right?

                                                You could, as a big, potentially a fairly big measure, exclude Russia from the international payment system known as SWIFT so that Russian companies seeking to do business and make payments, at least abroad, would not have access to a payment facilitation system. They'd have to really resort to fairly old-fashioned methods like sending faxes in order to get payments done, which would be very, very costly for them. Actually, it would be a big blow for [Gastron 00:35:37] because [Back Gastron 00:35:37] of course wants European revenues and it wouldn't be able to clear its payments very easily.

                                                Again, we can talk about how feasible all of that is. That's where I struggle, because a lot of these measures involve getting the Europeans to buy into these sanctions. SWIFT is headquartered in Belgium. It's a cooperative, it's a neutral company, so to get the Europeans to agree to actually bar Russia from SWIFT, that's a big step. Nord Stream 2 is a big step. You'd likely see a certain amount of European discontent in terms of agreeing to sanction Nord Stream itself.

                                                Don't forget that some Nord Stream activities have been under U.S. sanctions for several years, particularly the laying of pipelines, but I think we're talking about something bigger now. We're talking about actually blocking Nord Stream and ever allowing it to become operational. I think that would meet a fair amount of resistance.

                                                I suppose if you come to sanctioning Russian banking system en masse, completely blocking them out of international system, that's going to hurt the Russian people a lot. You could argue that that's not the desire at its sanctions, but you could equally argue that this time it has to be because of the nature of Putin's actions. There are lots of challenges with these sanctions, but those are basically the types of sanctions that could be levied.

                                                I think that some of the harsher sanctions probably won't be levied in this particular scenario, not because perhaps... I don't know again, I don't really have a clear line of sight into the U.S. administration, but even if the U.S. administration wants to levy every single one of these sanctions, I'm not sure the Europeans would buy into it.

Mark Zandi:                       Right, so there would be... Cris, did you want to say something? Go ahead.

Cris deRitis:                        I was just going to ask, this scenario excludes any type of military response, at least not a direct one from the U.S. or Europe, is that correct? Is that in your tail?

Gaurav Ganguly:              That's a good question. I think we've constructed all our invasion scenarios, incursion stroke, invasion scenarios to exclude a military response from NATO. That I think would be really very much a complete game changer. This is already a game changer, particularly a tail scenario where we do see a broader invasion of the Ukraine. That's already a game changer. For NATO to take the step forward and send its own things, it's own things and infantry and cavalry, I think that's something that would spark a lot of international sort of ruptures.

Cris deRitis:                        Again, [crosstalk 00:38:05], oh sorry, there could be a range, but it could be certainly just assistance to Ukrainian forces. Is that part of your scenario at all, or is a military...

Gaurav Ganguly:              I think that that's [crosstalk 00:38:23] scenario. That's already happening, so it's actually sending [crosstalk 00:38:23]. In fact, you can build that out further if you like, because Russia has of course got so many frozen conflicts around the region in Georgia, Chechnya, et cetera. You could easily see in a scenario like this that over a longer period of time, Western allies actually starts to fight proxy wars with Russia in those regions.

                                                I think it's very destabilizing for the geopolitics of the region as a whole, and the scenario is not just limited to Putin sending troops in and then facing sanctions. There is a slow burn, which is very geopolitically negative for the region.

Mark Zandi:                       In this scenario where Russia invades the Donbas region, there will be some sanctions. Obviously, hard to know how far the U.S. and the West will go, the Europeans will go. My read on what you're saying is they can't go all the way because there just won't be that kind of support from Europe to do that.

                                                Maybe Nord Stream 2 will be put on ice for a little bit of time, at least some period of time. I'd be surprised if that wasn't the case. President Biden said that was going to happen, so if that doesn't happen, I'd be surprised. The German Chancellor didn't deny or say yes or no to that, but sounds like that would happen.

                                                There would be sanctions on individuals, no doubt about that. There would possibly be some restrictions on the use of International payment system, the SWIFT system, but that feels like a bridge that might be a little bit too far under the scenario. If that's kind of sort of the... Did I miss anything, Cris?

Cris deRitis:                        Sorry, it's complex. Any other trade restriction? My understanding is Russia is a large exporter of aluminum, palladium, other things that are critical for the auto industry. Do you see those as being sanctions or some type of trade restrictions, as well?

Gaurav Ganguly:              Let's take that one separately because that's another very complex political discussion. I think there could be other trade sanctions, in payment the restrictions on imports and machinery, cars, and that kind of thing, to really to hurt Russia. Telecoms equipment, mobile phones, TV sets, cars, et cetera. These could all face sanctions entering Russian, which would then lead to [crosstalk 00:40:54]. You can imagine what would happen to Russia. You'd have a collapse of the ruble, you'd have inflation, you'd have a massive contraction of consumption and so on and so forth. [crosstalk 00:41:03].

Mark Zandi:                       I don't think they want to do sanctions that are going to be net detrimental to Western economies, to the European economy. They don't want to do that.

Gaurav Ganguly:              That would be very difficult.

Mark Zandi:                       I suspect they won't want to go down that, in this scenario. I'd be surprised if they did that because it's like shooting you, what's that phrase?

Gaurav Ganguly:              Shooting yourself in the foot.

Mark Zandi:                       Cutting off your nose to spite your face, kind of thing. I don't know, is that a European phrase?

Gaurav Ganguly:              That's definitely a English phrase.

Mark Zandi:                       Yeah, English phrase.

Gaurav Ganguly:              There' something similar in one or two other European language, [crosstalk 00:41:43].

Mark Zandi:                       Let me ask on that scenario, what is the economic implications of that? I mean it doesn't feel like that's going to result in significant turmoil in financial markets. Maybe briefly when it's all happening, because there's the fog of what's happening and you don't know where it's going to all land, but not a prolonged period of financial turmoil, not a big impact on oil or gas prices. They'll remain elevated because there's going to be a risk premium in there, kind of like what you talked about under the no-invasion scenario, but doesn't feel like this has big global, macroeconomic implications.

Gaurav Ganguly:              Of its own, its impact is very largely limited to Russia. I think what matters is what Putin does next. AS you said, maybe Nord Stream 2 doesn't even have to be officially sanctioned. Europeans can simply drag their heels for a couple of years and that's enough to do that while they try and figure out whether they should or shouldn't impose sanctions on Nord Stream 2 and kill the project.

                                                You impose sanctions on some Russian companies, maybe even stop a few companies from using SWIFT, but let other companies continue to operate, put some sanctions on exports of manufacturers into Russia. This is largely a Russian problem. I think the question then becomes what does Putin do next? 

                                                In order for Putin to put pressure on the world, he's going to have to rely on the two leaders, the only two leaders he has, which are oil and gas, and particularly gas into Europe. I guess she would want to foster a sense of divisiveness in Europe and a clear way to do that would be to show who's in charge when it comes to gas supplies coming into Europe. You could see that he would use that lever a bit, maybe not a whole lot because that's fairly detrimental to him as well, but you could see some innovation, some reduction in oil supply into Europe, some reduction in gas supply into Europe.

                                                Maybe not a whole lot, you saw some reduction of gas supply in January, for instance, and then a pickup in recent days, but if you go back to that kind of level coming out of winter through the summer, that puts a fair bit of pressure on Europe when it comes to filling up its reserves and boosting its storage ahead of next winter. You could see that you'd have a bit more pressure on European gas prices in this scenario for a few quarters at least until the situation normalizes, potentially even a bit of elevated tension in Brent for a few quarters, but nothing serious. Nothing that's going to cause financial markets to melt down.

Mark Zandi:                       Just to summarize, the 50, 55% probability goes to this Russia invades Donbas region. There's some sanctions put on by the U.S. and Europe. Russia responds, but this is kind of a temporary dislocation to energy markets and financial markets. Life goes on and tensions remain high but they don't boil over.

                                                The 40% probability is no invasion, so you were kind of at 90, 95%. Now the remaining part of the distribution of possible outcomes is kind of out there in the tail, on the dark side, maybe 5 to 10% kind of probabilities. How would you characterize that dark scenario?

Gaurav Ganguly:              I'd say that 5% in that tail, that's again, it's a range of different things that could happen there. The full 5%, if I look at it just coming up to that 5%, that dark scenario is invasion on the eastern and northern front, so that true buildup in the north, the border with Belarus on the east. There's a simultaneous incursion, Putin marches into Kiev, topples the regime, you've got tanks rolling down Kiev. I think at this point that's a very, very [crosstalk 00:45:23].

Mark Zandi:                       We agreed on Kiev.

Gaurav Ganguly:              Sorry?

Mark Zandi:                       We agreed on Kiev.

Gaurav Ganguly:              I beg your pardon, thank you.

Mark Zandi:                       There you go, okay.

Gaurav Ganguly:              At this point it's incredibly negative for Europe. We go back to those comments about Europe facing prospects of a war for the first time in 70 years, and the reemergence of those Cold War divisions. I think Europe is in emergency mode at this point. That of its own is a very negative scenario. I think it really opens the way to inviting a United European and American response in terms of sanctions against Russia.

                                                This is much more national security over energy security, but I guess that first scenario was more Europe. Europe puts its energy security first over national security, so I think as you get very, very significant sanctions against Putin at this point, including shutting gas from out of SWIFT, shutting the entire system out of SWIFT, sanctioning, completely sanctioning the Russian financial system, possibly even sanctioning Putting himself, and Russia just becomes a complete pariah state, which I guess, given how the FX reserves that Putin has and the fact that he's been building what they call Fortress Russia for the past few years, he may even be willing to countenance, but it's not going to be pleasant for Russia.

                                                I think what then matters is what Putin does next. Again, it comes back to those two levers. I put very low probability on that, that he would actually then go out and really, really, really shoot himself in the foot by turning off the oil and gas taps so significantly reducing the oil and gas taps. That's the scenario we've chosen to model as our dark scenario, where Putin actually does that.

                                                Not only does he invade Ukraine, both from the north and the east, not only is he then subject to very significant sanctions from the West, but he then takes that additional step of wanting to hurt Europe in particular by significantly restricting oil and gas supply. That I think is quite negative because at this point we're facing one, a geopolitical paradigm shift, be a loss of gas supply but actually you can't replace that easily, a significant reduction in oil that can't be rerouted that easily. This is all just very, very risk of, it's a very risk of environment.

Mark Zandi:                       Right, so that feels like that scenario, which broadly defines the tail of the distribution, it sounds like you're saying more like 5% than 10%, has lots of different shades of darkness, obviously. The shade that we decided to actually quantify through our modeling is way out on the tail. I mean just kind of at the end of the distribution of possible outcomes in your mind. Is that a fair characterization?

Gaurav Ganguly:              That's a fair characterization. I think for Putin to restrict oil and gas to that degree, that it results in a huge pickup in European inflation, for instance. That would be very, very damaging for Putin as much as [crosstalk 00:48:23] damaging for the world.

Cris deRitis:                        You kind of, I saw your face, so you know I'm always in the tail. We're not talking World War III, we're not talking about, right?

Gaurav Ganguly:              No, we're not.

Cris deRitis:                        Actual conflict, right? I could certainly paint a much darker scenario for you, if you'd like. You're stopping there. Just to quantify, right, because I think clients are talking about well what if there is more of an armed conflict, right? We're talking comparisons to World War II, Sudetenland, et cetera, et cetera.

Gaurav Ganguly:              I think that's [crosstalk 00:48:53].

Cris deRitis:                        We're not going to that degree.

Gaurav Ganguly:              No, we're not.

Cris deRitis:                        I mean we're seeing at worst in this very dark scenario, the Russians do take over Ukraine, but then the border stops there. There's no additional incursion. Certainly troops are massing along that border and it's hostile, but we're not going beyond that in terms of an armed conflict.

Gaurav Ganguly:              That's right. I think going back to some of your earlier comments Cris, we'll still see proxy wars being fought, we'll still see arms being supplied to Albanian troops and it's not going to be easy for Putin to go to the Ukraine for a long period of time, so plenty of potential for conflict in that region.

                                                Of course, it's an incredibly dark geopolitical narrative for Eastern Europe and for Russia, but I think if we handicap that at about 3% probability, that's out in the tail, but not way out in the tail, I think you could go much further out into the tail with having full blown conflicts and need for sending troops in, et cetera, et cetera, but honestly to me that fells like that's incredibly remote.

Cris deRitis:                        Sure, sure. No, I think it's important to quantify.

Gaurav Ganguly:              It's important to lay them out, yes, I agree.

Cris deRitis:                        Even under this scenario then, trade is not restricted. It's not voluntarily restricted per se, right? They were still saying that gas, the Europeans would still be willing to purchase gas, other goods?

Gaurav Ganguly:              Well I base that on the entire history of the Soviet Union when even at the darkest hour or relations between the West and during the Cold War between the West and the Soviet Union, gas continued to flow into Europe. I'd much rather characterize that scenario via Putin doing something negative in oil and gas rather than the West-

Cris deRitis:                        Correct.

Gaurav Ganguly:              ... tamping down on Russian oil and gas.

Mark Zandi:                       What does that mean, this scenario now, kind of on the tail, we've kind of I think nicely put into relief. What does it mean for the economy? For the Russian economy, for the European economy, for the global economy?

Gaurav Ganguly:              So the Russian economy is hit so badly in the first scenario, and it gets hit much worse in the second, of course. It's the same levers. The ruble plummets, inflation spikes, consumption slows down, consumer disposable incomes are really badly hit. Then similar sorts of things would happen in the Ukraine as well, so we mustn't just think of Russia, but spare a thought for Ukraine and what happens there with war [crosstalk 00:51:16].

                                                When we come to Europe, this is much worse for Europe because we'd actually see a significant pickup in inflation. We modeled gas prices, European gas prices at about close to 280 Euros per megawatt hour. That's roughly what we saw back in December when one of the big pipelines actually completely reduced supply for a few days and European gas price futures spiked immediately to that kind of level.

                                                If you see those sorts of prices coming back, maybe it won't stabilize at 180, maybe it comes down to 150 after a brief spike, but nonetheless, if it stays there for a few quarters because Putin deliberately restricts gas supply considerably, that's very, very negative for European inflation and European growth. I mean there's going to be a huge squeeze on disposable incomes.

                                                We'd be worried about corporate investment, we'd be worried about corporate profits and revenues, so it would be a very dark picture for Europe for some time to come. That's also going to spill over to the global economy because we'd see elevated oil prices for a while. We're actually modeling rent at $150 a battle for several quarters. That's going to have a knock-on effect on U.S. and Asian inflation.

                                                Then we've got to think about a competitive response because this is clearly an emergency situation. In Europe, you can see that fiscal policy and monetary policy will have to work together, but then it's a bit unclear as to how each will operate. Would fiscal policy choose to help households, help corporates, or one and not the other? Would monetary policy adopt a wait and see approach because it's such a negative emergency situation, but then that may have some negative consequences for inflation expectations. Would the fed do something different because it's less of a problem? Inflation will be, it'll be less of an emergency problem in the U.S.

Mark Zandi:                       All right. That's a pretty dark scenario. All righty. Well a lot to think about and I'm sure between now and next week when we have the webinar, there'll be a lot of changes in the moving parts that are changing pretty rapidly here. We'll follow this very carefully and report back and make any changes to our forecasting scenarios that we think are important to do. Any last comments, anything we missed in the conversation? I thought it was a very thorough kind of discussion of possible outcomes here. Did we miss anything?

Cris deRitis:                        One quick question.

Mark Zandi:                       Yeah sure, fire away.

Cris deRitis:                        Around timing, I heard this statement from some military commanders if there was to be an invasion of any type, it would occur within the next few weeks while the ground is still hard and that because once you get into the spring and it becomes very muddy, troop movements become very difficult. Give any credence to that or any weight to that type of argument that if something's going to happen, it's going to happen soon otherwise we'll be in a stalemate for a while.

Gaurav Ganguly:              I mean I've heard yet another date put out there, which was the 20th of this month after the closure of the Beijing Olympics, the Winter Olympics, that it would wait until then to make sure that you know, the world was at peace and people could enjoy the Winter Olympics before invading, so it may be very, very, very, very soon.

                                                There's certainly a case to be made for doing it sooner rather than later, but I guess he's also got to think about optimal European response. The more time he has to play with, the more chance he has of driving a wedge between the U.S. and Europe, so and I get the feeling that he's just an incredibly strategic player who weighs all these things up very carefully.

Mark Zandi:                       All right. Well thanks, Gaurav, that was very helpful and making it very clear how we're thinking about this. Again, we'll update our listeners and clients as we go along here. Thank you so much and with that, I think we're going to call it a podcast. Thanks everyone for listening in, and we'll talk to you soon.