Unusually, this week’s #MacroMemo focuses on a single topic: the Russia—Ukraine conflict and its economic implications. These are set to be significant.
Elsewhere, the COVID-19 numbers are mostly improving, with the new BA.2 sub-variant failing to trigger a major new wave yet. Recent real-time economic data argues that activity is rebounding nicely as earlier restrictions are lifted. In Canada, anti-government protests are largely over and the economic damage was likely fairly small. A lack of action in Canada’s currency and sovereign bond market argue the country suffered little reputational damage.
I had previously stated that the probability of a Russian invasion into Ukraine was, while significant and potentially greater than 50%, less than what was priced into the market. In reality, it has proven to be not just higher, but 100%.
I had thought that Russian President Putin could win in non-military ways. His popularity could surge at home as he made threats. He could sow additional discord into NATO and dissuade other border states from joining NATO. He might even put sufficient non-military pressure on Ukraine to force regime change.
Further, a war wasn’t obviously in Russia’s best interests. It would be expensive. It wouldn’t guarantee that Russia had the final say on Ukraine. It would set the world against Russia for years to come – both in the form of sizeable sanctions and also a long-term pivot away from Russian energy sources.
Nevertheless, a war is what we have gotten. Let us work through the developments and implications.
The conflict escalated rapidly over the past week. Initially, Russia simply formally recognized Ukraine’s Donetsk and Luhansk provinces as new, independent states. This was undesirable but didn’t functionally change the situation on the ground. These areas have been partially under the control of separatists since Russia’s last foray into Ukraine in 2014.
Then, Russia officially sent troops in to reinforce those claims of independence. Again, this wasn’t necessarily a huge departure from the status quo to the extent that Russia has provided considerable military support to the breakaway territories in the past. Indeed, a conservative estimate is that 13,000 lives have been lost in the simmering conflict between 2014 and 2019.
However, Russia then clarified its stance, declaring that it would defend the sovereignty of the entire two provinces, not just the 30% held by pro-Russian rebels. This was the first indication that Russia intended to claim territory actively held by Ukraine. In turn, it was clear that there would be serious bloodshed.
Parenthetically, more than 90% of the Ukrainian population voted for independence from Russia in 1991 as the Soviet Union fell. Support approached those levels even in the eastern provinces. Even Crimea voted to join Ukraine (with admittedly lukewarm 54% support).
Most recently, the Russian military simultaneously invaded from the north, the east and the west, demonstrating Russia has its sights on the whole country rather than just the disputed territory. This can’t quite be called the worst-case scenario since there are scenarios that would result in far greater loss of life and/or even the use of nuclear weapons. But it is certainly a bad scenario.
At the time of writing, Russia has made significant advances, but is nevertheless not faring as well as expected. It failed to capture and hold a key airport near the capital, and Ukrainian opposition has been fierce, especially in urban environments. While Ukraine’s military is both smaller and more poorly funded than Russia’s, defending is usually easier than attacking. In addition, Ukraine’s population is highly motivated and well-armed, its allies are furnishing it with weapons and its military has accumulated eight years of experience skirmishing with Russian-supported rebels. Conversely, one might imagine that Russian troops are less motivated as they invade a historically allied neighbor.
Russian forces have now captured a number of minor Ukrainian cities, but progress has been slow against the country’s larger cities, including the capital Kyiv. Recent reports suggest Russian ally Belarus may be preparing to send its own troops into battle against Ukraine. It is unclear whether this should be viewed as a positive for Russia – the offensive broadens – or instead as a negative if it means Russia is finding it cannot easily handle Ukraine by itself.
Interestingly, cyberattacks have not been as intense as feared. Neither have drones featured as centrally as one might imagine for a 21st-century war. Instead, this war is mainly being fought on 20th-century principles.
NATO nations have responded to Russia’s attack with the provision of weapons (and, presumably, intelligence) to Ukraine. But the main tools have been wide-ranging and intensifying economic sanctions:
- The West will no longer provide key technological exports to Russia, limiting the country’s industrial development.
- Russia’s financial institutions have either been blocked from interacting with their western counterparts, or greatly restricted. This has been strengthened by new restrictions against Russian access to the SWIFT global payments system.
- Major state-owned companies are blocked from raising money across much of the West.
- Russian government bonds issued after March 1 cannot be bought by the inhabitants of several western nations.
- The Russian central bank is not able to access its foreign reserves or conduct international transactions.
- Russian elites have had their western assets frozen.
- Russian planes can no longer land at many western airports.
For its part, Russia has imposed capital controls in an effort to prevent too much capital flight. This reduces the withdrawal of money in the short run, but surely casts a chill on anyone considering investing in Russia in the future.
Some of this damage will be offset by greater economic and financial activity flowing in other directions, such as between Russia and China, but this provides only a small reprieve.
Where does the conflict go from here?
Recent negotiations at the Belarus border have seemingly not advanced far. Russia demands western recognition of its Crimea claims and the demilitarization of Ukraine, while Ukraine demands an immediate ceasefire and the withdrawal of Russian forces. Russia sent only low level negotiators, and the country’s repeated deceptions over the past few weeks would make any agreement suspect. Another round of negotiations are scheduled.
Despite Russia’s slow progress, it seems likely that it will ultimately gain control of Ukraine’s cities. However, this is not entirely certain as the amount of military equipment from Ukrainian allies grows. Recently, Europe has committed to sending more fighter jets for Ukraine to use.
What may prove harder for Russia is holding those cities if/once it captures them. The opportunity for guerrilla warfare will be high, especially with an occupying force of perhaps 100,000 troops against 44 million Ukrainians. That stage of the conflict could be quite lengthy and challenging for Russia.
What end game does Russia aspire to? It would presumably seek to demilitarize Ukraine, appoint a pro-Russian government and formalize its control over (or, technically, the independence of) Donetsk and Luhansk. It isn’t clear that all of this will prove possible. The Ukrainian population seems especially unlikely to tolerate pro-Russian leadership for long after Russian troops eventually exit. Demands that NATO membership and weaponry retreat further away from Russian borders seem quite unlikely to be complied with.
As such, Russian forces will likely remain in Ukraine for a lengthy period of time.
Russia probably doesn’t seek to fully absorb Ukraine. Supporting this idea, after invading Georgia in 2008, Russia simply recognized the independence of two Georgian territories rather than claiming them. It acted similarly with the two eastern provinces in Ukraine (though not Crimea, which has a special place in the hearts of Russians).
There are several risks to this view.
Putin’s declaration that Ukraine is not a real country, paired with his apparent focus on recreating the territory of “Historical Russia”, argues he could well aspire to fully absorb Ukraine, and perhaps even seek to add Belarus, the Baltics, Poland, Finland and little Transnistria (a breakaway region of Moldova). Most of this is unlikely – especially since many enjoy NATO support and given that Ukraine has likely proven pricklier than expected – but it cannot quite be completely ruled out.
Another risk is that Russia – having been bloodied by Ukraine’s formidable defense and angered by economic sanctions – opts to become even more aggressive.
This could involve more forceful Russian military tactics, perhaps including more 21st-century technologies. In a worst-case scenario, Russia could even escalate to nuclear weapons. While this last scenario seems exceedingly unlikely and even counter-productive for a country that is downwind of its foes, Putin recently put Russia on a high level of nuclear alert.
Alternately, there are scenarios involving radioactive emissions in a different context: Russia has taken control of the Chernobyl nuclear power plant, site of the world’s worst nuclear accident and still a fragile situation. In addition, Russia has bombed two radioactive waste-disposal sites in Ukraine.
Russia could instead become more aggressive from an economic standpoint. In addition to the capital controls it is already imposing, it could opt to withhold some of its key commodity exports. This is the biggest risk from an economic standpoint.
Another risk revolves less around what Russia does next, but instead what happens to financial institutions. As the connections between financial institutions are severed by sanctions, problems may arise. Italian and French banks are each estimated to hold around $25 billion in Russian government bonds, as an example. Were Russia to default on its debts – S&P recently downgraded the country’s sovereign debt to “junk” status – there would be rippling consequences.
The financial market hit within Russia has naturally been enormous. The country’s currency is down by around 50% since October. Its stock market is down by over 40%, even before factoring in further losses likely sustained this week. Additional sanctions were applied over the weekend but markets remained closed on Monday at the time this was written. The situation is quite bad for Russian companies on any number of fronts – they lose access to foreign markets, lose access to key inputs and cannot as easily fund themselves.
Western companies will also suffer some losses as they lose ready access to the Russian market. Some companies must divest themselves of Russian investments or partnerships.
Commodity prices are naturally higher given Russia’s status as a key commodity producer and exporter. Oil is at nearly $100 per barrel.
Despite, or perhaps because of all of this, we are now inclined to take incrementally more investment risk as opposed to less. While the conflict is hardly good news for economies or companies, let alone the participants in the war, financial markets have already substantially adjusted. Historically, the stock market fully prices in acts of war with remarkable haste, bottoming within a few days to at most a few weeks of the onset of the conflict, and then recovering to prior levels within a few weeks to a few months. No two conflicts are ever the same and this one appears bigger than many, but it is not without precedent.
That brings us to the economic implications. Curiously, while the economic outlook is no less certain than the military outlook, it doesn’t actually depend much on the military outlook. This is because most of the theoretical economic damage at the global level comes from sanctions, and those sanctions are unlikely to be lifted quickly even if the military conflict is somehow resolved rapidly. Instead, the uncertainty about the economic outlook revolves mainly around whether energy and food exports will be restricted from Russia.
The Ukrainian economy is small – just 0.14% of global output – but has likely been devastated by the war in the short run. It should be significantly undermined over the medium run.
Short-term damage – that suffered during the conflict itself – comes from power outages and damage to other infrastructure, stay-at-home orders, severe transportation limitations, the conscription of Ukrainian men and the flight of some women across the border.
Most of these problems will abate whenever the conflict ends, but the infrastructure damage won’t. Further, especially if the conflict lasts for a lengthy period of time, Ukraine’s international trading relationships will have eroded. Its financial sector will be significantly weakened and so less capable of furnishing credit to the economy. Its public debt will be significantly higher and foreign investors may be reluctant to invest into the chaos of a recently war-torn country.
In brief, the Ukrainian economy will likely suffer the most of all parties.
The Russian economy is also set to weaken, but for different reasons: mainly due to sanctions on the international stage.
It must be conceded that Russia prepared its economy well for this war. The country’s current account surplus was built up to a large 7% of GDP – meaning that Russia relies less on foreign imports than the rest of the world relies on Russian exports, and further, that Russia has been actively acquiring foreign assets (rather than the rest of the world acquiring a stake in Russia).
Consistent with this, Russian foreign corporate debt has fallen by a third over the past eight years. The central bank has built up $630 billion of reserves (about 37% of GDP). The country’s sovereign wealth fund has accumulated further liquid wealth equal to 7% of GDP.
In addition, with oil prices not just high but rising, Russian energy giant Gazprom is projected to make in the realm of $90 billion in operating profits this year. That’s up from just $20 billion in 2019. Those profits will feel even larger when converted to now-diminished rubles.
All of this is to say that Russia timed its invasion well.
However, Russia may not have anticipated such ferocious sanctions from NATO members. As the ruble has plummeted, the Russian central bank has had to double its policy rate from 9.5% to 20%, literally overnight. That’s a lot of economic drag that has suddenly been delivered.
The central bank cannot easily sell its foreign reserves to support the ruble because such reserves are now hidden behind sanctions. The government will find it somewhat more difficult and much more expensive to roll its maturing debt over. Banks will have only a limited ability to lend. By extension, companies will have limited access to funding. At the same time, import controls will limit the acquisition of technology needed to support Russia’s highest value industries.
So far, forecasters haven’t been willing to project figures worse than about a 1% decline in Russian GDP in 2022. Even that is an outlier forecast. Most of the private-sector forecasts submitted to Bloomberg over the past four days continue to anticipate 2%-plus growth for the year. This seems hard to fathom. In fairness, most of these forecasts predated the sharp increase in sanctions over the weekend. We flag a rather considerable downside risk to this. We imagine that Russian GDP will likely shrink in 2022 unless a rapid and improbably tidy solution is found to the conflict.
Lastly, and arguably of greatest relevance to most investors, is the economic impact on the global economy. Russia’s share of global GDP is just 1.7%, making its economic pain visible but not overwhelmingly influential for global growth.
What about the rest of the world?
The direct economic damage from exporting fewer products to Russia is likely to be fairly small. Russia just isn’t a big driver of global demand.
Financial conditions should be somewhat tighter. Risk assets such as the stock market are down and credit spreads are wider, but this could be partially offset by slightly less hawkish (non-Russian) central banks in the short run. More on that shortly.
Finally, and of the greatest relevance by far, commodity prices are substantially higher as a result of the war. This is the main economic channel that must be considered. It is also the most uncertain. Prices are already elevated but would spike further if Russian exports of energy and/or food were suddenly restricted.
Russia is a large exporter of oil, natural gas, wheat, potash (even more so when Belarus is included), aluminum and copper. Indeed, it is the world’s largest exporter of natural gas and the second-largest exporter of oil. This is of particular relevance to Europe, which imported 47% of its natural gas from Russia in the first half of 2021. Russia also supplies nearly 10% of the world’s aluminum and copper, and a huge 43% of palladium (a component in motor vehicles). Russia and Ukraine combined produce 29% of the world’s wheat exports.
Europe is clearly the most vulnerable region economically, despite several positives:
- Germany has some capacity to pivot to coal and perhaps nuclear.
- The continent has sizeable energy stores.
- Europe has some access to international liquid natural gas shipments.
- Energy imports are set to drop as the weather warms.
A scenario of moderately elevated commodity prices in the relevant resources would subtract on the order of 0.2% to 0.5% from global growth, with Europe at the more impacted end.
However, should Russian commodity exports be seriously pinched – so far, this is mostly a fear rather than a reality – commodity prices could rise significantly further. The name of the game so far has been escalation by both sides. Germany has indefinitely paused the activation of a major new gas pipeline from Russia. Should Russian energy exports be seriously halted, the damage to European GDP might be as much as four times greater – approaching a drop of 1 percentage point (ppt) from the rate of global economic growth and 2 ppt from the rate of European economic growth.
It seems prudent to land somewhere between these two extremes. With the caveat that these forecasts are all written in pencil as opposed to pen, we are inclined to subtract 0.7ppt from our 2022 Eurozone growth forecast (taking it to +3.0%). We subtract 0.3ppt from the U.S. (down to +3.1%) and 0.2ppt from Canada (also down to +3.1%). It should be noted that our forecasts were already below the consensus before this shock.
At a more granular level, it is quite possible that the Eurozone could suffer a negative quarter of growth somewhere in the mix, though a recession is unlikely barring an extreme stop in the supply of energy.
The risk of recession is obviously higher as a result of the new conflict. Whereas traditional models argue the risk of a U.S. recession over the coming year is no higher than 10%, we have been inclined to think it is more like 25% when one factors in geopolitical issues, the risks surrounding monetary tightening, plus a generally aging recovery.
It must be conceded that the commodity shock is not a negative for everyone. Oil-exporting regions of the world are set to do quite nicely. Canada’s oil-rich Alberta, for instance, now appears to be on track for its first balanced budget since 2014 – the last time oil was in the realm of triple digits.
Inflation and monetary policy
Despite the anticipated economic damage, this is an inflationary shock. Commodity prices have risen. They could rise further, depending on the supply of energy and other commodities from Russia. A conservative estimate would be an additional 0.5ppt to the rate of inflation over the next few months. An aggressive estimate – assuming significant supply restrictions – might add several percentage points.
Tentatively, we add a percentage point to our peak inflation forecasts. For instance, we are turning our U.S. Consumer Price Index (CPI) outlook from a peak reading of around +7.5% to a peak of +8.5%.
We continue to believe that the present period of high inflation is ultimately different and less worrying than the equivalent experience in the 1970s. However, it must be admitted that this war diminishes our resolve slightly. Why?
- It will result in inflation remaining high for at least a few months longer – providing another opportunity for inflation expectations to become stuck at a high level.
- One of the distinctions between the inflation of the 1970s and today has been eroded a little. We have tended to view this experience as primarily a positive demand shock versus the 1970s as a negative supply shock when OPEC withdrew its supply of oil. The Russia-Ukraine conflict might also become a negative supply shock, in part, if the supply of resources is constricted from Russia. To be clear, there are still other important differences – the end of the gold standard in the 1970s, much slower population growth today etc.
Central banks have a dilemma. Do they raise rates more because inflation is set to be higher, or less because growth will be weaker and risk assets have tumbled? It seems more likely that central banks will tighten more cautiously. Case in point, U.S. market expectations were for nearly 50 basis points (bps) of tightening as of just a few weeks ago, whereas they have now retreated to a single 25bps rate increase. This seems about right. If needed, central banks can catch up later.
In all of this, we emphasize it is still early days: a significant change in the path of the war, or a significant change in sanctions or the supply of commodities could radically alter the trajectory relative to this discussion.
At the risk of overstating the significance of this war, there are a range of potential long-term repercussions.
The Cold War appears to be back as Russia again pits itself against the West. This comes on top of what might be characterized as a “Cool War” between China and the West. In such an environment, not only is the risk of war greater than normal, but cliques of countries form and international institutions weaken. This is all to the detriment of global trade and global growth. The recent decision to limit Russian access to the SWIFT payment system could well backfire as both Russia and China have versions of their own that will now gain greater currency. This could further fracture the world and also reduce the impact of future SWIFT sanctions.
It is entirely possible to imagine Russia and China – both presently on the outs with the developed world – significantly strengthening their bonds. This has already been happening in subtle ways over the past decade, with energy deals and other initiatives. Not so subtly, China criticized recent western sanctions against Russia. China is now in a position to purchase more Russian commodities and to support Russia financially via lending. There are parallels to the 1950s and 1960s.
Having observed a lack of military opposition from western nations to Russia’s attack, China may also be more inclined to seek to reclaim Taiwan, which broke away from China in 1949 during the communist revolution. The economic consequences would be far greater than the present conflict. Sanctions on China would be highly problematic for the global economy and Taiwan is a key global producer of high-end chips and electronics.
That said, we should not assign too high a probability to this scenario: the U.S. is thought likely to defend Taiwan in such a scenario, yielding an undesirable confrontation between China and the U.S. Further, China now sees how forcefully the rest of the world might sanction the aggressor. A betting market assigns just a 10% chance that China would land military personnel on the disputed Pratas Islands in 2022 – a far more modest step than engaging all of Taiwan.
North Korea may also be taking notes.
India declined to criticize Russia at the United Nations. This can best be understood as a reflection of the fact that India receives weapons from Russia, buys energy from Russia and receives voting support from Russia in the United Nations when the matter of the disputed Kashmir territory arises. We are still inclined to think India is more in the U.S. than the Russian orbit, but perhaps this is not quite as assured as widely thought.
On the opposite side of the table, NATO has surely been strengthened by this experience. That is diametrically opposite to one of Putin’s key objectives in initiating this conflict. NATO members are re-connecting with one another and increasing their support for their most exposed eastern European partners. Pundits speculate Finland and Sweden may be keener to join NATO than in the past.
Military spending / fiscal
As NATO engages, military budgets will only grow. Having finally abandoned the long held notion that Russia can be tamed into friendship, Germany announced plans to increase its defense spending from 1.2% of GDP to 2.0% of GDP, with an additional 100 billion euros committed to modernizing and strengthening its long waning military.
While the effect is not enormous, one might imagine NATO countries running fiscal deficits that are in the realm of 0.25% to 1.5% of GDP larger than otherwise as they bolster their militaries.
The U.S. is now thought to be more likely to strike a deal with long-time foe Iran, lifting sanctions and ushering in additional Iranian oil production at a time when Russian production is at risk. This would be good for the supply of oil, but perhaps negative later in terms of nuclear proliferation.
Belarus – Russia’s ally – is now musing about acquiring its own nuclear weapons. Ukraine surely regrets negotiating away its weapons as the USSR crumbled, especially since it did so in exchange for assurances that Russia, the U.S. and the U.K. would never attack Ukraine, and (seemingly non-binding) promises of assistance in the event that Ukraine’s sovereignty were challenged. Other countries will also take note that they are not just vulnerable to attack when lacking nuclear weapons, but free to engage in misdeeds if they have them (as per Russia).
Europe’s reliance on Russian energy requires a great pivot, with a variety of global energy implications to consider.
In the short run, the implications are more bad than good from a climate change / green energy perspective:
- Europe is incented to revive its coal production (and nuclear, which some view as polluting and others do not).
- S. green initiatives, having already struggled unsuccessfully for passage in the Senate, will be an even lower legislative priority as the White House seeks to reduce fuel costs for Americans leading up to the mid-term elections. Carbon taxes and restrictions on shale oil production will be the last thing on anyone’s mind.
In the long run, one can argue that the reverse is true:
- Europe is strongly incented to diversify away from Russian energy, with a particular focus on renewable energy. In fact, Germany just announced that it has accelerated its plans for 100% renewable energy from 2040 to 2035.
- High energy costs in the short run will encourage green innovation and green spending over the long run.
The bottom line is that this war between Russia and Ukraine is extremely serious. In addition to the lives and livelihoods at risk, there are real global economic consequences. These consequences will be expressed mainly through the channel of high commodity prices and the supply of commodities.
The situation is still quite fluid. The big economic question is centered more on whether energy and food exports will be restricted rather than the precise duration or scale of the war itself.
As indicated, we tend to view this as an opportunity for incrementally more investment risk-taking, as opposed to less.
Finally, there are a variety of potentially major long-term implications, including the return of the Cold War, the re-invigoration of NATO and a revival of military spending, and a myriad of new energy trends.
-With contributions from Vivien Lee, Andrew Maleki and Aaron Ma