Ukraine – Global Economic Dislocation has just Started

PK machine gun at Russia-backed rebel position near the division
PK machine gun at Russia-backed rebel position near the division line with Ukrainian army near Dokuchaevsk, eastern Ukraine. (Mstyslav Chernov))
The views and opinions expressed in this article are those of the author John Longhurst, Chairperson, TangentLink.

In conjunction with our colleagues at TangentLink, below is an assessment of the economic impact of Russia’s ongoing invasion of Ukraine. 

Bottom-line: 2022 was meant to be the year the global economy had its ‘covid bounce’. Central Banks were positioned to tighten policy to stop the party getting out of hand. Putin’s Ukraine invasion is instead taking the global economy to 1973/74. Global energy markets have entered a secular re-alignment. As we learned (painfully) with covid, disturbance to globally intertwined supply chains causes havoc for at least two years. The same will now happen to the energy products that underpin every economy. The damage is done, even if a ceasefire was announced tomorrow, let alone if, as many now expect, Putin “escalates to de-escalate”. Energy costs are now 13.8% of global GDP, up from <10% a week ago. Even at this level, it is recessionary for the global economy as a whole. The best case scenario now is that Europe and energy importing Emerging Markets enter recession. Inflation will now enter a period where it is essentially uncontrollable, without dramatic (and costly) intervention globally (eg fuel/fertiliser subsidies). Consumers will bear the brunt of what’s coming, and global debt, already at record levels due to covid, will expand further. For OPEC, and global coal, gas and fertiliser producers, this is a golden period not of their design, same too for ‘war’ beneficiaries like gold and defence equipment suppliers. The Russian economy needs careful analysis – it could be argued that on a 1-2 year view, sanctions damage the West more than Russia on a relative basis (and therefore, sanctions will fail to alter Putin’s course). Russian oil, coal, wheat and fertiliser will find new markets in time, despite Western sanctions, as these are existential imports, and global supply/demand was tight before ‘Ukraine’. The war in Ukraine has not yet spilled over borders, but the collateral damage is only growing. Near term Central Bank/government behaviour is more likely to exacerbate structural inflation, as we saw in the mid/late 1970’s. This didn’t end well.

Geo-political risk+sanctions contagion=global inflation: Fear of war in Ukraine already gave us higher oil prices, but Western sanctions are rapidly dislocating global energy supplies. Russian gas exports are 5% of global consumption, and are an as-yet unused weapon for Putin. Crucially, Russian oil exports are 8.4% of world production. As we know, world oil supply/demand was already very tight, and dislocating Russian oil has fed very quickly into other energy sources. Russia is global No3 coal exporter, and Australian coal has shot up to $400/tonne, equivalent to $111 oil price. The same has happened to gas prices. Earlier concerns around rising energy prices are now dramatically escalated and broadened.

Central Bank quandary: Sharply rising energy costs are destructive to economic activity, yet highly inflationary. From an economic perspective, interest rates should now rise to contain inflation (causing recession), but as with the US in the late-1970’s, and Turkey last year, political realities (expediences) could cause Central Banks to put near term economic stability ahead of controlling inflation. We can expect Western central banks to err on the side of monetary expansion, rather than price control. Either way, governments globally will be forced to ease the burden on societies of higher energy costs via actions that will raise national debt, a factor that will be compounded in Europe/US by commitments to raise defence spending.

Energy – Thinking the unthinkable: The US is proactively seeking to remove Putin’s oil weapon (and punish Russia in the near term); to do so requires potential expediency with Venezuela and Iran, hitherto unthinkable directions. America’s greatest relative strength in the coming Showdown with Putin will need to be its economy – and President Biden is sensibly looking to circle the wagons. Germany might also need to temporarily reconsider its position on nuclear power, so too Japan. ‘Society’ sits precariously on access to cheap energy – this premise is now being tested, and we will continue to see ‘unthinkable’ actions to preserve this.

Europe bears the brunt: The combination of sanctions on Russia and Belarus is dislocating economic activity across Europe, particularly Eastern Europe, which relies heavily on imports of oil, fertilisers and metal/wood products, as well as gas. The weakening of the Euro against the Dollar compounds the impact of rising commodity prices, and is highly inflationary. As Europe is on the ‘front line’ in terms of Putin’s anticipated next steps, and is a major energy importer, it is no wonder that consumer and corporate confidence are weakening rapidly. Major industries that were already weakened by covid (eg airlines), face considerable challenges. The EU has been working hard to find replacements for Russian gas in the event that Putin turns off the tap (as leverage for a Baltic/Polish contingency, for example), but increased supplies from the likes of Azerbaijan and Egypt don’t come soon enough, and are small in comparison to the need.

OPEC economic power is transformed: Until ‘Ukraine’, the ESG movement had called the death-knell of the world’s oil and coal producers. The transition to Green Energy may indeed be accelerated, but that won’t help energy importers in 2022. OPEC nations will need to use some of the windfall to protect their own populations from inflationary effects, and will also be able to support strategic relationships. The same applies to smaller energy exporters like Australia and especially Israel.

Russia – a tough call: As any reader of ‘Putin’s People’ and similar publications will note, the structure of the Russian economy is the same as in Iran and North Korea – a mafia pyramid that is held together by its leader. In such a construct, Putin cannot show weakness. Aside from the bigger questions this raises re his NATO gameplan, from an economic perspective, Russia’s FSB/mafia economy survives as long as ‘everyone gets paid’. Russian citizens have been prepared since 2014 for hardships from Western sanctions. There is little leverage with them. If sanctions are to cause Putin to change direction, they need to sufficiently damage the mafia economy. In the short run, sanctions appear to be inflicting great pain on Russia’s elite, but most of them get their wealth from Russian commodity exports. In Rouble terms, they will make more money in the medium term than before sanctions, in the products where there is tight global supply/demand, and where replacing Russian product simply isn’t politically acceptable (ie Western sanctions won’t work with these nations either). Putin will raise resource taxes to pay refineries, and fund fuel subsidies – all Rouble expenses. When looking at sanctions impact, as with everything related to this situation, it is critical to avoid wishful thinking. For example, China is the one nation that could allow Western sanctions to gain sufficient efficacy. Xi appears to be in no mood right now to yield to this request, preferring China to enjoy the fruits of heavily discounted Russian energy.

by John Longhurst, Chairperson, TangentLink