The human and geopolitical consequences of Russia’s invasion of Ukraine eclipse the economic ones, but it is the latter that is our focus in this note. This week’s briefing starts by examining the linkages between the conflict and the world economy and concludes by considering three lasting changes that could come in the wake of the crisis. The complexity and significance of the issues mean today’s briefing is roughly twice as long as usual.
Russia’s vast land mass and large population (144m) belie its role in the global economy. Russia is the world’s 11th largest economy, somewhat below Italy, while Ukraine is ranked in 55th position with roughly the same level of GDP as Hungary. Unlike China, which is a manufacturing powerhouse at the centre of global supply chains, Russia is a relatively minor player in global trade other than in commodities. Russia’s annexation of Crimea in 2014 accelerating a long-term reduction in Russia’s importance as a trading partner for the EU. Russia accounts for just under 5% of total EU trade, down from over 9% ten years ago.
In terms of military power Russia punches well above its weight, and as Syria, Crimea and now Ukraine demonstrates, is prepared to use it. Peter Robertson, professor of economics at the University of Western Australia, estimates that adjusting for the relative defence costs, Russia gets more from its defence spending than the UK, France and Germany combined.
Russia also plays an outsize role in global commodity markets. Russia and Ukraine jointly account for about a quarter of global exports of wheat, with Middle Eastern countries and Turkey being the main markets. Russia accounts for 40% of the EU’s natural gas imports (about half of German and Italian imports and almost 100% for Eastern European EU members) and 26% of the EU’s oil. About 40% of gas reaches Germany via the Nord Stream 1 pipeline under the Baltic; 30% comes through Ukraine and just under 30% comes via Belarus to Poland and then Germany.
Last week’s decision by the German government to suspend certification of a new Baltic pipeline, Nord Stream 2, represented a U-turn on a 25-year-old German policy of fostering direct shipment of Russian gas to Germany. The new pipeline would reduce Russia’s need to move gas via Ukraine and Poland and had been long opposed by the US and a number of Central European countries on concerns it would increase Russia’s leverage over Europe.
However, Russia’s need for Nord Stream 2 could fade were Mr Putin to succeed in Ukraine, since the Ukrainian route for shipping gas would effectively come under Russian control.
Germany’s decision to stop Nord Stream 2 is likely to be the opening move in a longer-term process of seeking to reduce EU dependence on Russian energy. Last week Boris Johnson said that “we must collectively cease the dependence on Russian oil and gas that for too long has given Putin his grip on Western politics”. That’s probably rather easier for Mr Johnson to say than the leader of, say Germany or Italy, since the UK gets only 5% of its gas from Russia.
But, for now, EU-Russian energy dependence appears to be mutual. Europe needs Russian commodities, and the Russian economy needs Western revenues. Commodities account for 10% of Russian GDP, nearly 70% of total goods exports and over 20% of government revenues.
Countering Western sanctions with an embargo on energy exports, as Arab oil producers did in 1973 in response to the US backing Israel in the Yom Kippur war, would carry serious risks for Russia. Not only would a major source of revenues be severed. As the executive director of the International Energy Agency, Fatih Birol, said last week, failure on Russia’s part to maintain supply “would shatter Russia’s reputation as a reliable partner” in a way that would probably be more damaging for Russia than Europe.
The decision by the EU, US, UK and Canada on Saturday to ban Russia from the global payments system, SWIFT, appears to allow some Russian banks to continue to take payments for energy and other commodity exports. Last night, the Financial Times said such an exemption would be “a major omission” since it would allow Russia to continue to sell its main exports efficiently. It might also be seen as a necessary, if messy, compromise on the EU’s part to keep energy flowing.
At the time of writing, on Sunday evening, it seems probable that commodities will continue to move from Russia to the rest of the world, though subject to possibly major disruptions. That prospect has raised prices of a number of commodities of which Russia and Ukraine are major producers. Oil prices have moved above $105/barrel for the first time in eight years and are 50% higher than a year ago. Natural gas, palladium (used in catalytic converters), titanium (used in the aerospace sector), nickel (mainly used to make stainless steel) and wheat prices have all spiked.
The invasion of Ukraine will spell even higher energy bills for Western consumers, a more severe squeeze on spending power and even higher inflation in the coming months. This poses a dilemma for Western central banks, including those of the US, euro area and UK, which are posed to tighten monetary policy to dampen already high inflation. Now they need to weigh the inflationary shock from higher commodity prices against the deflationary shock to consumers whose spending power will be reduced by higher energy prices. Europe, due to its greater dependence on Russian energy and trade, and its proximity, looks more at risk economically than the US.
As of Friday, financial markets were taking the view that the Ukraine crisis is likely to slow, but not fundamentally change, the trajectory of rising US and UK interest rates this year. Markets see US rates rising from the current 0.25% to roughly 2.0% at the end of this year, only marginally lower than before the invasion. UK rates are expected to rise from the current 0.5% to about 1.25% in a year’s time, about 25bps less than in mid-January. But this could change very quickly, especially if the shock to Western growth from the crisis were to escalate.
Higher, and more disrupted energy supplies represent the most obvious headwind to Western growth. But elevated uncertainty, and the risks of an escalation of sanctions or cyber measures, or a widening of the conflict, are other potential negatives.
Events are moving quickly and unpredictably (the latter illustrated by Russia’s slower than expected military progress in Ukraine). Financial markets offer a real-time gauge of sentiment. Equities rebounded from Thursday’s large losses on Friday partly on the belief that Western sanctions would be less disruptive than initially thought. That response has been overtaken by the forceful Western reaction over the weekend – including reducing Russian access to SWIFT, more funding, including, for the first time, by the EU itself, for weapon sales to Ukraine, and exceptional measures to hamper Russia’s use of its foreign reserves. In a remarkably direct statement, Ursula von der Leyen, president of the European Commission, said, "The EU and its partners are working to cripple Putin's ability to finance his war machine."
In times of uncertainty, higher-risk financial assets tend to underperform and risk premia – the compensation investors require for holding risky assets – rise. Money gravitates to lower-risk assets, such as gold, the dollar, government bonds and so-called value equities (those with higher and more stable dividend streams).
Reducing Russian access to SWIFT, and sanctioning the Bank of Russia, are significant moves. The latter restricts the ability of Russia to access the large reserves of foreign exchange it has built up with mainly Western central banks. This undermines Russia’s ability to support its own economy and the value of the rouble, increasing the risk of a sharp devaluation which would fuel inflation and reduce earnings from exports. The prospect that the Bank of Russia may be unable to access its foreign currency and support the rouble forced the Bank to issue an appeal for calm on Friday and increase the amount supplied to ATMs as demand for cash soared. Russia could offset some of these effects if China were to come to its aid or if it has already drawn down on its European currency reserves. What happens to the value of the rouble and the behaviour of Russian consumers this week will show which way things are going.
If the West faces the prospect of higher inflation and lower growth this is even more true for Russia. The combination of sanctions, disruption to the financial system and uncertainty have created significant new risks for Russian growth. Economists at the Atlantic Council’s Eurasia centre estimate that the milder sanctions imposed on Russia after the annexation of Crimea reduced growth by a hefty average of 2.5%–3.0% a year, reducing Russia’s annual growth rate to just 0.3%.
Recent sanctions are far more stringent than previous rounds but Russia’s leaders have had several years to build its defences against sanctions. Russia has built up the world’s fourth largest foreign currency reserves, reduced reliance on Western loans and markets, cut its budget deficit and started to develop an alternative to the SWIFT payment system. Nonetheless, the scale and severity of sanctions, and the uncertainty the war is likely to cause in Russia, will hit growth. Immediately before the invasion, the average forecast for Russian GDP growth this year among independent economists was 2.6%. I would expect to see that figure reduced significantly, possibly into contractionary territory, in coming months.
We conclude by turning to how the Ukraine crisis could reshape policy in three areas.
First, the crisis is perhaps the final nail in the coffin of the notion, popular 20 years ago, that the world had entered a so-called great moderation, an era of globalisation, integration and stability. The 9/11, then the financial crisis and the pandemic dealt that notion hard blows. Now Russia’s invasion of Ukraine threatens a return to the stand-off between East and West which ended with the collapse of the Soviet Union in 1991. Mr Putin’s ‘fortress Russia’ policies designed to insulate Russia from sanctions represents a conscious decision to reduce inter-dependence. The West in turn, wants to disengage from Russia. This looks a world of more elevated geopolitical risk, rivalry between power blocs and contested globalisation.
Second, the corollary of greater geopolitical risk is rising defence spending. The sharp reduction in NATO defence spending after the end of the Cold war, and the run down in US and UK troop numbers in Germany, is hardly suggestive of the hostile intent that Mr Putin attributes to the West. But it does show the obvious connection between defence spending and risk, and how many Western nations ploughed the peace dividend that came with the end of the Cold War into welfare spending (UK defence spending dropped from around 7.0% of GDP in the 1950s to 4.0% until the late 1980s to 2.0% today). In response to the Russian invasion Germany, Europe’s largest economy and serial under-spender on defence, has committed itself to raising defence spending to the NATO target of 2.0% of GDP. (Adjusting for relative costs Germany’s defence spending is roughly 80% of the UK levels despite the German economy being almost 60% larger.) With Europe heavily reliant on the US for defence at a time when the US itself is trying to focus on countering China, other European countries seem likely to step-up defence spending. Ironically, while Mr Putin seeks to weaken NATO, his actions are likely to increase the attractiveness of membership for the likes of Finland and Sweden.
Third, the crisis underscores the need for resilience and security in energy supply. Renewables such as solar and wind have significantly increased the capacity of many countries to generate their own power. But continuity of supply depends on weather and storage capacity. Large scale battery storage for renewables is in its infancy. Until it matures, Europe may need to build energy resilience through some combination of more ‘green’ energy technologies such as air source heat pumps as well as nuclear power, increased storage capacity for gas, diversification of gas supplies towards producers such as Norway, Qatar and the US and a greater energy efficiency (the oil shocks of the 1973 and 1979 led to a near 20-fold rise in the oil price, fuelling a huge energy efficiency drive in consuming nations). The costs involved come on top of those required to facilitate the shift to net zero. The share of UK household income needed to pay energy bills has been trending down for more than five decades; that is likely to reverse, at least for now.
A widely quoted observation of the nineteenth century Prussian Field Marshall Helmuth von Moltke is often condensed to “no plan survives first contact with the enemy”. Warfare, is unpredictable, and so too are its economic and financial consequences. All of today’s observations should be seen in that light.
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