Ukraine - On Lifeline Support

Despite a tentative agreement on de-escalation in Geneva, Washington, Brussels, Moscow and Kiev disagree on the nature of the Ukraine crisis and measures to defuse it, while extremist groups seek to destabilize the region.

Until recently, the crisis base line scenario was that Russia would not opt for military invasion but de-escalation amid uncertainty. In the second scenario, invasion would be avoided, but destabilization would continue. In the worst scenario, Russia would invade Ukraine but implications would remain regional, or - if crisis management were to fail - spill over internationally.

If Russian invasion would materialize, it could lead to broader and deeper sanctions on Russia, rising risk of energy disruptions for Ukraine and Europe, and deeper contraction in Russia.

In 2014 alone, Kiev's sovereign financing needs will soar to $36 billion, which exceeds its total reserves by 2.4 times. Prime Minister Arseniy Yatsenyuk's government has already halted the pension and other public-sector payments. The government's ability to service its soaring debt is at increasing risk.

For all practical purposes, Ukraine is on lifeline support. Kiev is likely to need a $30 billion IMF package for two years. Without support, Ukraine will default.

Further, if corruption cannot be reduced and structural reforms will be deferred again, a new round of economic turmoil will ensue thereafter.

Russia - Rising Challenges

How would Russia fare in these scenarios? In 2012, Russian GDP growth was still 3.4 percent, but it more than halved to 1.3 percent last year.

In the past, Russia's growth has been penalized by lingering structural reforms, corruption and economic policy that has inadequately supported growth.

In the near-term, the Ukraine crisis will further reduce growth prospects, which will also depend on the degree of sanctions, their impact on investor sentiment and capital outflows. The latter, in turn, are likely to boost inflation and pressure on Russian ruble.

Recently, the IMF still projected Russian growth to be 1.3 percent in 2014 and 2.3 percent in 2015. But these figures seem to ignore the Ukraine risk premium. Even if Russia will not opt for military invasion, growth is more likely to contract in 2014 but could rebound in 2015.

EU - Significant Exposure

In Europe, the risk focuses on Russian energy supplies and Europe's lingering recovery. In the past decade, Brussels has often urged Moscow to diversify its industrial structure, while failing to diversify its reliance on Russian gas.

If the crisis will not last more than two months, Brussels could prevail, thanks to its natural gas reserves. If, however, the crisis will be protracted, the Eurozone could suffer another contraction.

The Eurozone economies that get less than 25% of their gas from Russia would be least vulnerable (e.g., Netherlands, France, and Italy). In turn, those that get 80%-100% of their gas from Russia would face be more exposed (e.g., Finland, Ukraine, Slovakia, Poland, and Hungary).

In Europe, much of the current stability is due to the pledge by Mario Draghi, the chief of the European Central Bank (ECB) to defend the euro "at any cost," new financial instruments to defuse debt, and the nascent banking union. But fiscal adjustment remains unsupportive; unemployment is high in the core economies and continues to soar in Southern Europe.

The ECB is under increasing pressures to move toward US-style large-scale bond purchases, which are likely to take off by the summer, especially if the Ukraine crisis will continue to worsen.

In turn, Brussels is likely to face a major political backlash in the European parliament elections in May. If the elections took place today, the Center-Right EPP and the Social Democratic S&D would take more than 210 seats, each. As the relative share of the left-green socialists and the conservative Euro-skeptics and farright anti-federalists is rising, the political middle is being squeezed.

After the election, Brussels will be more fragmented politically, which tends to slow down decision-making.

US - Relatively Immune

Thanks to its shale gas revolution, the U.S. is relatively immune to the economic risks of the Ukraine crisis. However, the most severe Ukraine scenario would penalize U.S. growth as well.

The current optimistic consensus is that US growth could accelerate to 2.8-3 percent in 2014-15, respectively. But the final figures may be 0.2-0.5 percent less, due to fragility in the housing and labor markets. Further, political risk - the deferred debt debacle - will return by mid-decade, when the deficits will start to deepen anew.
Between 2007 and December 2013, the Fed's balance sheet soared from $0.9 trillion to $4 trillion. As the Fed has tied the duration of its low interest rate to an economic threshold, no hikes are expected until unemployment will decline to 6 percent and inflation expectations remain below 2 percent. If the Fed's tapering will end by late 2014/early 2015, interest rate hikes are expected to ensue few months later, however.

If the Fed raises the rates too soon and too fast, or too late and too slowly, it would destabilize the economy and the financial sector anew. But even a successful balancing act in the West is unlikely to spare the emerging economies from some "collateral damage."

Asia - Escalating Friction

The Ukraine crisis is far from Asia, but the region is coping with geopolitical risks of its own. Since last fall, tension has increased in East and Southeast China Sea; among Japan, China, South Korea, as well as the Philippines, Vietnam and other Southeast Asian nations.

The friction is longstanding, but it has escalated since 2009, when President Obama initiated the U.S. pivot to Asia, which has reinforced Chinese rebalancing in the region.

Recently, Tokyo, Manila and Canberra have intensified military cooperation with Washington, while Defense Secretary Hagel has bolstered partnerships across the region, from Vietnam to Mongolia. In the adverse risk scenarios, Asia could be split into influence spheres.

Right before President Obama's visit in Asia, Tokyo raised stakes significantly as 150 Japanese lawmakers - a third of the total - visited the Yasukuni Shrine, which will further strain regional tension. Any major incident could cause significant damage and a substantial spillover to sovereign creditworthiness in Asia Pacific, as Standard & Poor's has warned.

The approval of the new charter aimed at preventing unintended military conflict at sea can defuse friction. It cannot ensure complete adherence amid territorial disputes, but it does provide a framework of measures for diplomatic venues.

Japan - Debt Stabilization Or Destabilization?

A year ago, the new governor of the Bank of Japan, Haruhiko Kuroda, pledged to do "whatever it takes" to achieve the 2 percent inflation target. That was the first tenet of Prime Minister Shinzo Abe's economic reform agenda. The second was a major fiscal stimulus followed by efforts at structural reforms.

The last tenet, fiscal consolidation, began with a consumption tax hike in early April. It is likely to penalize consumption, however. In that case, Kuroda is likely to increase the BOJ's quantitative easing - in summer or by fall.

Further, Abe?s economic reforms have been weakened by a controversial privacy law and nationalism, coupled with increasing defense expenditures and a hawkish China policy. It may also result in arms exports and the revision of Japan's postwar pacifistic constitution.

The IMF expects Japan's real GDP growth to amount to 1.4-1 percent in 2014-15. But that seems too optimistic in view of recent disappointing data and the huge sovereign debt, which will exceed 250 percent of the GDP by 2015.

China - Increasing Challenges, But Sufficient Growth

In China, the problems of the local government stem from fall 2008, when a large stimulus package of $590 billion was launched to strengthen employment, and infrastructure.

Concurrently, funds were also poured into local governments and state-owned enterprises, which led to overcapacity in several sectors, particularly shipbuilding, metals and mining, building materials, and solar equipment - not to speak of weaker borrowers in the property sectors, especially those with high exposure to trust funding.

In 2014, China's growth target is a "flexible" 7.5% to ensure adequate employment, whereas the 3.5% inflation target is paving way to further liberalization of energy and resource prices. Beijing hopes to demolish the "shadow banking system" with market-driven reforms.

As Premier Li Keqiang has said, China has now arrived at a "critical juncture where our path upward is particularly steep." Beijing seeks to deter threats with a huge reform program, which permeates several industrial sectors and is accelerating financial reforms and the internationalization of the renminbi.

Middle East & Africa - Suppressed Islamism, Spread Of Terror

Only few years ago, there were real concerns about a breakdown in the Middle East. Today, the risks are seen as manageable, receded, or systemically marginal. That perception is a serious mistake. As the Ukraine crisis shows, the challenge of energy as a geopolitical risk has not disappeared.

Further, friction prevails in Israel-Iran relations, while peace talks linger between the Israelis and the Palestinians. In Syria, the civil war has caused a massive humanitarian crisis and potential spread of chemical weapons. During Egypt's 2013 coup d'etat, field marshal El-Sisi overthrew President Morsi, which forced the Muslim Brotherhood underground thus polarizing the society, once again.

As Islamic movements are suppressed across much of the Middle East and North Africa, moderates are radicalizing, while Jihadists use poor or failed states as safe havens. Meanwhile, terror has spread to Sub-Saharan Africa, as evidenced by the bloody al Qaeda-linked insurgency of Boko Haram in Nigeria.

Until recently, financial markets have largely ignored the new geopolitics of risk. Despite increasing and continuing debt-taking, markets are now hovering higher than before the 2008/9 global crisis.

There is a drastic disconnect between the real economy and markets. Investors have not priced the new risks appropriately. Such a status quo is untenable.

Source of documents：EconomyWatch