ews of a Russian military intervention in Crimea and of the Russian parliament granting President Vladimir Putin authorization for an intervention in Ukraine have raised fears of a geopolitical conflict that could extend well beyond its borders.

The situation in the region remains extremely fluid, and several outcomes are possible at this juncture. The outcome will determine to a large extent the systemic nature of the crisis and its impact on global markets, not just Europe.

Three possible outcomes
Best outcome would be a negotiated solution to the conflict that strikes a balance between the territorial integrity of Ukraine and the national interests of Russia. Under that view, Russia's aim in this conflict would be to have its voice heard in the region, particularly when drafting the future political course of Ukraine. Russia feels aggravated by the recent developments in Kiev and sees its interests challenged. Already, prominent figures in the U.S. and Germany have been calling for the "Finlandization" of Ukraine and for Russian interests to be taken into account, which was arguably not the case after the fall of President Viktor Yanukovych last month. Whether the actions in the last 72 hours will help to bolster that view remains to be seen.

In a second possible outcome, the conflict would be confined to Crimea. This could eventually present a buying a opportunity for investors, taking advantage of the overshoot that is likely to hit risk assets when markets first open on Monday, though a lot will depend on how far the West (and Ukraine) are willing to compromise on Crimea to satisfy Russia. In that scenario, the saber rattling on Eastern Ukraine would be a bargaining chip for Russia to achieve its ultimate goal: securing its interests in Crimea. While such an outcome would likely still be negative for Ukraine, a narrowing of the conflict to Crimea would have less systemic impact on global markets.

Finally, a third possible outcome would be military escalation of the conflict, whereby Russia decides to invade Eastern Ukraine. This would trigger flight-to-quality trades, with the potential of creating significant dislocations in certain global markets, including commodities and risk assets, and endangering in the process the fragile recovery in the global economy. The end result would be akin to the shocks experienced during the oil crisis of the early 1970s or the Iranian Revolution in the late 1970s.

An invasion of Eastern Ukraine would also likely provoke a response by the West and might potentially give way to a civil war within Ukraine. In that context, Russia’s relationship with the West would likely be permanently damaged, potentially altering the current geopolitics of Europe.

Much at stake for Russia
It is hard to say which of the three outcomes is most probable, but Russia stands to lose the most if this conflict should escalate into a full-fledged military confrontation, given the country’s financial, economic and reputational stakes.

Russian corporates are among the most active in international debt markets, and Russia has tried hard (and successfully) to open up its local currency debt market to foreign investors while making inroads in improving the investment climate. A confrontation with the West would erode many of these achievements, driving more foreign investors away. The Russian ruble has already been the worst performing currency in emerging markets year-to-date after the Argentinian peso, which has triggered a sell-off in the local fixed income market and raised expectations for interest rate hikes by the central bank at a time when the Russian economy is sharply decelerating.

Rational thinking would thus exclude a worst-case scenario given the interests at stake, but when it comes to geopolitical ambitions, rational thinking can take a back seat, which leaves the range of potential outcomes in Ukraine wide open.

The Author

Francesc Balcells

Portfolio Manager, Emerging Markets

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