Market’s Plumbing Bends But Doesn’t Break – Yet

(Bloomberg Opinion) -- Russia's invasion of Ukraine has kicked off perhaps the worst geopolitical crisis since World War II, with President Vladimir Putin making a veiled threat of using nuclear arms if the West intercedes. Western leaders responded with a wave of economic sanctions, including their own monetary “nuclear option”: cutting some of Russia's largest banks off from the international financial system by excluding them from SWIFT, the messaging service that facilitates the vast majority of money transfers globally.

Scary times, indeed, but there's at least one bit of good news, if there is any in this human tragedy: The plumbing of the financial markets looks as if it's functioning just fine — for now. One critical gauge of stress in the financial system — overnight funding costs for banks — naturally jumped on Monday, but nowhere near as much as might be expected. This measure rose 10.7 basis points to as high as 23.8 basis points before easing back to 18.5 basis points, or 0.185 percentage point, late in the day. Although that level is still the highest since September 2020, it reached 80.6 basis points during the early days of the pandemic in March 2020, when economies were being locked down. It's also below the average of about 22 basis points over the past five and 10 years.

This is encouraging because the last thing anybody wants to see now is concern from banks about doing business with one another. Such a scenario would quickly escalate the current geopolitical crisis into a global financial one. Of course, it's still early days, but the takeaway is that the financial markets are suggesting that Russia's economy, which accounts for about 1.7% of the world's gross domestic product, can be effectively ring-fenced without too much damaging financial fallout.

Sanctions announced on Russia's central bank along with the decision to exclude Russian banks from SWIFT would knock only about 0.2 percentage point off global GDP this year, Jennifer McKeown, the head of global economics service at Capital Economics in London, wrote in a research note to clients Monday. The International Monetary Fund said in late January that it expected the global economy to expand 4.4% this year. Here's how McKeown summed it up:

The escalation of the conflict in Ukraine has increased the risks posed to the global economy, but we still expect the broader effects to be relatively contained given limited trade and financial exposures to Russia. If more severe adverse consequences were to materialise, we think that they would be more likely to relate to trade and supply shortages than to financial market disruption.

Such views are also echoed in the foreign-exchange market, where the cost to convert foreign cash flows into dollars with cross-currency basis swaps rose to the highest since March 20 but then eased back to more normal levels. At the same time, volatility in the $6.6 trillion-a-day currency market was little changed, holding at about 20% below the average in data going back to the start of 2021 as measured by JPMorgan Chase & Co.

Perhaps this is due to a bit of complacency in markets, but it's not as if some sense of security is unwarranted. The financial system has become much safer since the financial crisis in 2008 and 2009, thanks to reforms such as the Volcker Rule, the Dodd-Frank Act and Basel III. Also, central banks have flooded the financial system with cash over the years. The combined money supply of the U.S., China, euro zone, Japan and eight other developed economies surged by $20 trillion over 2020 and 2021 to a record $102.5 trillion, according to data compiled by Bloomberg. The amount totaled less than $35 trillion in 2008.

It's too soon to sound the all-clear signal. If we've learned anything from past crises is that there's always something that comes up that almost nobody considered. Putin on Monday banned all Russian residents from transferring hard currency abroad, including for servicing foreign loan contracts, which, according to Bloomberg News, potentially puts much of the country's $478 billion of external debt at risk of default. Then consider that Russia has about $300 billion of foreign currency held offshore, enough to disrupt money markets, according to Credit Suisse Group AG strategist Zoltan Pozsar, who drew comparisons with the 2008 collapse of Lehman Brothers Holdings Inc. and the pandemic-related market seizures of March 2020.

Exclusions from SWIFT will lead to missed payments and giant overdrafts similar to the missed payments and giant overdrafts that we saw in March 2020, banks' inability to make payments due to their exclusion from SWIFT is the same as Lehman's inability to make payments due to its clearing bank's unwillingness to send payments on its behalf. History does not repeat itself, but it rhymes.

Here, again, the financial system is more equipped to handle such a disruption. The Federal Reserve in the wake of the financial crisis set up currency swap lines with other central banks to become a sort of lender of last resort of dollars to ease any crunch. The Fed in 2021 also established a repurchase agreement facility for foreign and international monetary authorities, known as FIMA, to help alleviate pressures in global dollar funding markets, according to Bloomberg News.

No one can say for sure how the severe economic sanctions on Russia will ultimately stress the financial system, but the initial reaction of money markets is encouraging.

More From Other Writers at Bloomberg Opinion:

Competing Narratives in Ukraine — Which Will Win?: John Authers
Pariah Status Will Exact a Toll on Russia: Ashworth & Gilbert
West Uses Russia's Central Bank Against Putin: Timothy O'Brien

This column does not necessarily reflect the opinion of the editorial board or Bloomberg LP and its owners.

Robert Burgess is the executive editor for Bloomberg Opinion. He is the former global executive editor in charge of financial markets for Bloomberg News. As managing editor, he led the company's news coverage of credit markets during the global financial crisis.