Russia’s invasion of Ukraine has put Europe on the brink of the biggest armed conflict since World War II, and is posing a threat to the recovery of the international economy after two years of the Covid-19 pandemic. The attack launched by Russia on Thursday will further shake energy markets and fuel the current wave of inflation. The increases will mainly affect the countries most dependent on gas imports within the EU, and buyers of grain grown in the region. Beyond Russia itself, the European Union is the market most exposed to a retaliatory war.
The market reaction so far is a taste of what may be to come: oil and gas prices soaring, the cost of grains rising, stock markets sharply down and the economic recovery in doubt. All this comes in a context already complicated by uncertainty over the impact of a new round of sanctions from the West. The magnitude of the blow to the world economy will depend on the duration and intensity of the conflict. “The main way this will be felt in the European economy will be energy prices,” predicted Lorenzo Codogno, professor at the London School of Economics and former Italian Treasury Secretary.
The economy faces rising inflation in the short term. “We are going to see inflation persist and probably see a tightening of monetary policy,” said Juan Carlos Martínez Lázaro, economist and professor at Spain’s IE University. “It’s a complicated scenario for central banks,” he added. Isabel Schnabel, a member of the European Central Bank’s (ECB) Executive Board, recalled on Thursday that the attacks came just as Europe was beginning to recover and the ECB was thinking of tightening its fiscal policy to curb inflation. “The impact of the war looming over Europe has clouded the global outlook,” Schnabel said.
Inflation climbed to 7.5% in the United States in January, the fastest pace in four decades, and 5% in the eurozone, the highest since 1997. Pressure to raise interest rates is set to intensify, but there are also doubts about whether to do this, and by how much, without slowing the recovery.
“The attack and sanctions response will have far-reaching impacts on the global economy,” political risk consulting firm Eurasia Group said in a report. “Oil and gas prices will rise significantly, reinforcing inflationary pressures and weighing on financial markets and global growth.” Their analysts estimate that growth in the developed world could be reduced by one percentage point, while supply chain problems worsen and governments take more protectionist measures.
We are going to see inflation persist and probably see a tightening of monetary policyJuan Carlos Martínez Lázaro, economist and professor at Spain’s IE University
One of the biggest problems for European economies is gas. Russia and Ukraine together account for a modest share of the world economy, but the EU is highly dependent on Russian energy. Europe buys almost half of its gas and almost a quarter of its oil from Russia. Prices have been rising for months and official gross domestic product (GDP) growth forecasts are increasingly being questioned. Investment bank JP Morgan, for example, has just lowered its first-quarter forecast for the eurozone from 1.5% to 1%.
Experts consider it unlikely that Western sanctions will severely penalize Russian gas, at least until alternative sources of supply are sought. Taking such action is highly complicated given the volume that Moscow provides to Europe. Nor is there any indication that the Kremlin will cut off the supply and forgo these important revenues. Even if Moscow increases gas sales to Beijing, as has been happening in recent months, pipelines to China do not currently have the capacity to compensate for what would be lost in Europe.
Professor of Economics José Manuel Corrales at Spain’s European University highlights the importance of Germany’s freeze on the rollout of the Nord-Stream 2 gas pipeline, the announcement of which caused energy prices to spike as one of the most concrete and harshest retaliations undertaken so far against Moscow. “It all depends on the scale of the intervention, but there will be huge economic repercussions, because the inflationary dynamics can affect the recovery process. It will be a major setback, and it will be felt immediately in people’s pockets,” Corrales explained.
Dependence on Russian gas places Europe as one of the markets most exposed to an escalation of the conflict and to the fallout of sanctions, according to experts. The details of these punitive measures have yet to be detailed, so it is as yet unknown whether they will affect Western companies and investors working with Russia.
The EU has said that sanctions will be imposed in a gradual manner, in a nod to its trade relations and dependence on Russian gas. The EU buys almost 40% of Russia’s exports of goods, but almost 70% of this total is gas, oil and coal. “Germany and Italy are the most exposed countries, because of gas and oil,” added Codogno. Energy aside, the volume of manufacturing exports to the EU is insignificant at around €25 billion. The sale of goods is another €10 billion. There are important exceptions: Russia’s MC Norilsk Nickel is the world’s largest producer of palladium, an important metal for the automotive industry, which is already suffering from a shortage of semiconductors. Western sanctions are unlikely to target this sector.
The attack and sanctions response will have far-reaching impacts on the global economyPolitical risk consulting firm Eurasia Group
In contrast, EU exports to Russia do carry some added value, and are important for industry in the east of the continent. In this sector, manufactured goods account for 88% of exports – half of which are vehicles and machinery – and bring in €78 billion a year. Sanctions are unlikely to target these areas either, but Moscow could turn its back on these imports and look to China.
Grains are also important, as Russia and Ukraine are responsible for 30% of global wheat exports. The Black Sea is one of the major distribution channels and Ukraine is also a major producer of corn and barley. This Thursday, grain prices reached their highest levels since July 2012. Economists believe that Western countries can cope with the price rise, even if it increases inflation, but the impact could be devastating for more fragile economies. “An increase in prices or shortages could trigger a crisis in North Africa or the Middle East,” warned Corrales.
The caution in imposing sanctions so far makes it unlikely that Russia will be banned for now from accessing the SWIFT global payment system, which is used by more than 11,000 financial institutions in over 200 countries. Such a move would hit Russian banks hard, but the consequences could be more complex. A SWIFT ban would make it difficult for European creditors to get their borrowed money back, although Russia has been setting up an alternative payment system. European banks – particularly those in Austria, Italy and France – are the most exposed to Russia.