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Russia’s economy depends on ‘what Europe does with its energy policy,’ strategist says

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JPMorgan Head of Emerging Market Economics and Commodities Research Jahangir Aziz joins Yahoo Finance Live to discuss the Russian economy as the Russia-Ukraine war intensifies, oil and gas imports, and the outlook for investments in emerging markets.

Video Transcript

- OK. JP Morgan is out with a major warning on the Russian economy. Strategists say the Russian economy will significantly contract soon and enter a recession. Joining us with more on this call is JP Morgan head of emerging market economics and commodities research Jahangir Aziz. Jahangir, good to see you here this morning. Take us through. All morning long, we've been talking about companies, big multinationals, pulling assets, pulling operations out of Russia. How will that impact the Russian economy this year? Where do you see growth going.

JAHANGIR AZIZ: So look, the first round of sanctions that happened a week back seems like a lifetime back. We had sort of described it as having a modest or moderate impact on the Russian economy. But the ones that came in the weekend will have severe impact. So, essentially, what has happened is that with all of these banks now under sanctions and that-- except for energy that has been carved out, everything is under SWIFT sanctions.

So except for the non-energy part, Russia basically cannot really trade exports or imports. Maybe there is some trade that can happen outside of the hard currency, which is essentially going to be one that is related to China, most likely settled in CNY. But I think the biggest shock, obviously, was that CVR, the central bank of Russia, has $630-odd billion in reserves was virtually brought down to 0. They have some gold, which is not really usable, and some CNY, which will support the China trade.

So all of a sudden, an economy-- even though growth was slowing down, inflation was picking up, rates were rising over the last six to nine months, you still had two very strong pillars to the economy. You had a current account surplus. And you had a central bank with about a $630 billion of reserves. Both were essentially dented very, very sharply by the last set of sanctions.

And so without any real support from CVR-- clearly, you must have seen it already. The ruble is almost in a freefall. Inflation is spiking. The central bank had to double its lending rates to about 20%. And that necessarily will have a very severe impact on the Russian economy. Now, how long it will last, difficult to say. We have about a 20% annualized decline in growth in the second quarter itself. For the year as a whole, about 3 and 1/2%, 4%. But those could easily become worse as the days go by.

- And we were just throwing, Jahangir, the Russian ruble there, which to remind our viewers, that's the dollar versus the ruble. So that's by how much the ruble has fallen. How much of this damage is irreversible?

JAHANGIR AZIZ: That's a difficult question. But it's a great question. I think we need to look towards Europe and to the change in their energy policy that probably will come out in the next few days. And I think that's the big change. So if you look at Russia's exports, Russia's exports, there's pretty much energy plus some other commodities. And we can talk about the impact of those commodities on the supply chain. And I think that can be difficult. But just on the energy side, most of the energy exporters to Europe through different pipelines, including NS2, the nearest pipeline, and to China.

So if Europe decides that it's not going to be dependent on Russian exports-- or imports, rather-- of energy, whether it's natural gas or oil, that really changes the way in which Russia has configured its energy complex. And, therefore, what impact it will have on the economy I think depends not so much on what Russia does at this point in time, but what Europe does with its energy policy.

- That's a significant potential drop here. 20%. Does that essentially make Russia uninvestable for investors?

JAHANGIR AZIZ: I think Russia was made uninvestable for investors by the sanctions already. So I think beyond that, in terms of foreign direct investment, et cetera, as you've already been talking about, I think all of this is going to change. I think at the end of the day, the biggest risk now is a political risk that is being imposed on anyone who is investing in Russia. That risk is not-- you can't hedge against that risk. You can hedge against Fed rates going up. You can hedge about inflation going up, ruble falling. But you really can't hedge against political risk.

And I think that is going to be there for quite a period of time. So I think that the impact on the Russian economy, not just in 2022, but in the medium term, it's going to be very severe. Not just, as I said, what happens to EU policy regarding oil imports and gas imports, but also on foreign direct investment going into Russia.

- We have been looking at this whole situation through the prism of the West, right. What does it mean for European markets? What does it mean for US markets? You focus on not just Russia, of course, but emerging market economies more broadly. In a prior life, you with the IMF. What's the ripple effect there that we need to be thinking about for emerging markets and emerging market economies?

JAHANGIR AZIZ: This will sound very strange to you that in a global risk off, emerging markets are not going to do as badly. Typically, in a global risk off, the first thing you look for is, how do you take your money out of emerging markets? Look at emerging market FX. It's doing pretty well given the circumstances. And the reasons are sort of-- there are two or three reasons behind it. One is that the financial connection of Russia to the rest of the world is limited.

You have about $120 billion of BIS or European banks exposure to Russia. You have some Russian exposure. You have about FX-related derivatives, probably about $100 billion. And in the grand scheme of things, these are not really large numbers. If you look at emerging markets, therefore, the contagion from Russia to emerging markets, therefore, is limited. In addition, and something that we get-- it's sort of got lost in the last couple of months, the scourge of inflation taking over the entire world, and the Fed is going to raise rates, and therefore every emerging central bank will have to raise rates, that really isn't true. There is a scourge of inflation.

If you look at Latin America, if you look at Central Europe, inflation is actually very, very high, including in Russia even before the geopolitical tensions worsened. But if you look at the other part of emerging markets, look at entire Asia, look at South Africa, there hasn't been any pickup in inflation. And, consequently, central banks over there will have a much greater space to raise rates. They do not have to follow the Fed. They can calibrate their moves. So I think that emerging markets was already differentiated.

I think the geopolitics actually differentiates it even more. If you do see commodity prices move up-- and I'm not talking about just about [INAUDIBLE] oil, I'm talking about things like palladium, platinum, wheat, corn, et cetera, then there's a whole host of emerging market countries. South Africa, for one. Huge producer of these PJM platinum group commodities. And the entire Latin American southern corn. All of them are going to benefit from it.

And if that's the case, then they will have better fiscal positions. They will have stronger current account, which means that the central banks do not need to aggressively raise rates just because the Fed is raising rates. So I think there's a lot of differentiation in emerging markets. Sometimes, we sort of don't look at that. But at this point in time, along with China and Japan, probably some of these emerging markets could become safe harbors. I never expected I would ever say this. But I'm saying it.

- Well, incredibly helpful insights here, really. We thank you for your time. Jahangir Aziz, JP Morgan head of emerging market economics and commodities research. Stay safe. We'll talk to you soon.