1 March 2022

The military situation on the ground following Russia’s unprovoked invasion of Ukraine remains fluid, and many outcomes are still feasible (including a few catastophic scenarios). In order to begin assessing the economic fallout of the invasion, I must make some assumptions. Even now, what seems apparent is Russian President Putin has made numerous tactical and strategic miscalculations. In particular, he believed Ukraine would be easily defeated, and Russian forces would be given a hero’s welcome. Likewise, he assumed he could take advantage of divisions with NATO. However, Ukraine has defended itself valiantly, and the western response has been strong and united. In addition, Russia’s slower-than expected military advance suggests even the deployment of 150,000 soldiers has been insufficient, especially given the decison to attack simultaneously on three fronts.

Strategically, President Putin wrongly convinced himself that countering NATO enlargement by invading Ukraine would enhance Russian security. Of course, Russian aggression will only encourage Ukraine and other nations to seek EU and NATO membership. On a psychological level, many experts have noted President Putin has become more isolated in recent years, especially during the Covid pandemic, and has relied less on his advisors. Even I have observed that his speeches have become angrier, more emotional, more xenophobic, and more irrational. Indeed, his public dressing down of his chief security advisor was a throwback to the Soviet era. Such volatility adds to the possible range of outcomes and financial market risks.

These considerations may have an important bearing on the economic outlook. If President Putin believes his own preposturous rhetoric that a western-oriented Ukraine poses an existential risk for Russia, military failure is not an option. Indeed, failure may even cast doubt on President Putin’s own political future. Therefore, rather than cutting his losses, I expect President Putin to add additional military resources. He may focus on overtaking key strategic areas in northern and/or southeast Ukraine (preventing Ukrainian access to the Black Sea). More likely, however, Russian forces may encircle and lay siege to key urban areas, including Kiev. In Syria and Chechnya, such violent campaigns involved heavy bombardment and substantial civilian casualties.

Tragically, therefore, I am expecting the conflict will be protracted, and may become even more violent in coming weeks, especially as Ukraine resists both the invasion and the potential Russian occupation. This will occur in full view of the world’s media, and will further damage Russia’s and President Putin’s global credibility. So much for “making Russia great again”.

As a result, I am reducing Europe’s 2022 GDP growth forecast by 1% (to 3.5%), and I will make important distinctions in the outlook for individual EU nations. While the economic consequences are more limited in both the USA and UK, I trim 2022 GDP expectations by 0.5%: to 3.5% and 4% respectively. Further reductions may become necessary, if energy prices rise substantially further. The current sanctions regime is far tougher than following the annexation of Crimea, especially the decision to curb the Russia’s access to SWIFT and to sanction the central bank’s assets. Therefore, I project the Russian economy will contract 6-7% during the year ahead.

Rising Energy Prices: Everyone Feels the Pain

Which countries will be most adversely effected by the recent 50% rise in energy prices (as measured from the average of the past three years)? The efficiency of energy usage (the amount of energy required to produce GDP) will play a key role. While all oil-importing nations have made considerable progress in recent decades, the Chart above illustrates that European nations are far more energy-efficient than the USA. Within Europe, however, wide disparities exist. For example, the more industrialised Eastern European nations are far less efficient than their more prosperous neighbours to the west.

However, Europe’s Achilles heel is its dependence on foreign energy sources. Unlike the energy-independent USA, the Chart above indicates that 60% of Europe’s energy needs are imported. And, Europe’s dependency ratio has risen in recent decades. Again, there’s wide variation within Europe (for reasons we will soon discover). Scandinavia and much of Eastern Europe are better positioned. Italy, Benelux, Spain, Hungary, Lithuania, and Germany are more vulnerable.

In the context of the current crisis, the sources of energy imports will determine Europe’s ability to mitigate this risk in the near term. While natural gas gathers the headlines, oil represents two-thirds of the region’s energy imports. The sources are quite diverse, but Russia supplies nearly 30% of Europe’s petroleum needs (Chart above). Further diversification will be required in the future. And, fortunately, many possible options exist.

On the other hand, natural gas accounts for nearly 30% of the region’s energy imports. Importantly, the sources are less diversified, and Russia accounts for nearly half of the region’s needs. Liquid natural gas could help widen Europe’s options over the medium term. However, despite the recent surge in American LNG exports to Europe (the USA is now Europe’s top supplier followed by Qatar and Russia), LNG is unlikely to meaningfully reduce Europe’s short-term vulnerability.

Europe’s superior energy efficiency limits economic risks from rising oil prices relative to the USA. But, this advantage is more than offset by the much sharper rise in natural gas prices in Europe (and far higher price level), reflecting the region’s heavy reliance on Russian NG imports. Further, Europe confronts the additional risk that Russia may reduce energy supplies. Fortunately, I do not believe this is likely, for now at least (to be discussed later).

Who’s Economically Most Vulnerable to Russia in Europe

The Table above details the reliance of individual EU members to Russian energy imports (for confidentiality reasons only ranges are provided). Eastern Europe (especially Hungary and Slovakia), Finland, and the Baltic nations appear most at risk. Of the larger countries, Germany and Italy are most exposed. Scandinavia is far less reliant on its powerful neighbour. In contrast, the USA imports only 5% of its oil and no natural gas from Russia. Likewise, the UK sources only 10% and 5% of its oil and NG from Russia.

Each EU member’s energy mix influences its reliance on Russia also. Indeed, even if a large share of oil and gas comes from Russia, vulnerability is lower if fossil fuels are not a major energy source. The Chart above provides additional evidence of vulnerability in Italy, Germany, Hungary, and the Benelux countries — all prolific consumers of oil and natural gas. Spain meets its fossil fuel needs largely from non-Russian sources. Again, in contrast, the Nordic countries’ (including Finland) risks are mitigated by extensive use of renewable energy sources (Latvia also). France’s reliance on nuclear power lowers its Russian exposure. And, while undesirable from an environmental perspective, extensive coal use in Poland and much of Eastern Europe curbs their vulnerability to their powerful neighbour.

The imposition of sanctions and the inevitable slump in the Russian economy will harm European export prospects to its large neighbour. The most exposed to this risk are the Baltic nations — 30% of Latvian and Lithuania exports (excluding intra-EU sales) are destined to Russia. Likewise, Finland and Eastern Europe have meaningful trade ties with Russia (Chart above). The UK, France, Spain, Scandinavia, along with the USA are less exposed to this risk.

Russia: Deep Recession Seems Inevitable

To be sure, Europe’s reliance on Russian energy imports creates economic risks. But, the vulnerability runs in both directions. Despite burgeoning energy trade with China, Europe accounts for 50% and 72% of Russian oil and natural gas exports respectively. For this reason, while Russia may try to sow divisions among NATO allies by threatening to cut off energy supplies, I doubt they will take this step in the near term. Indeed, Russia’s public finances and external trade are highly reliant upon energy revenues: accounting for 50% of overall exports and 25% of government tax revenues. Without these inflows, Russia would run very large current account and budget deficits (Chart below). (My earlier blog “Russia: Not Rushin’ In” details how the failure to address underlying structural economic problems during the Putin era will impede Russia’s long-term growth prospects).

Given its reliance on the energy sector, higher oil and gas prices will be a near-term tailwind for Russia’s economy. And, given the nation’s low government and foreign debt (20% and 28% of GDP respectively) and enormous stockpile of international reserves (US$ 630 billion), Russia probably could have coped with the imposition of sanctions for several years.

However, the NATO allies’ ability to sanction the central bank’s assets and to exclude Russia from SWIFT will dramatically limit Russia’s ability to trade internationally and to access its foreign exchange reserves held abroad. In addition to the energy sector, Russia’s substantial agricultural exports will suffer also (next Chart). Furthermore, Russian corporations will have great difficulty rolling over their $100 billion in short term foreign liabilities in coming months.

Therefore, the impact of sanctions is likely to be sharp and swift. Following the imposition of sanctions after the Crimean annexation, Russian GDP declined 2% in 2015. By contrast, Iran’s GDP shrank 12% after the introduction of US sanctions. To be sure, Russia will take advantage of its low level of government debt to cushion the impact of sanctions and rising inflation on the general population. Nevertheless, I expect Russian GDP to shrink up to 7% in the coming year.

Strategic Considerations:

• Despite its superior energy efficiency, the European Union is more vulnerable to rising energy prices than the USA and United Kingdom, largely reflecting its heavy reliance on Russian natural gas.
• In the future, Europe must diversify its energy suppliers to reduce its vulnerability to Russian energy imports. Oil options are plentiful, while natural gas alternatives are more limited. Therefore, LNG imports, especially from the USA (and Qatar), will play an important role in the short/medium term. Longer term, Europe must redouble its already successful efforts to expand renewable energy sources, which will also help achieve the region’s ambitious CO2 reduction goals. In this environment, Nord Stream 2’s future seems in doubt.
• Within Europe, the Baltic nations, Finland, and Eastern Europe (especially Hungary) are most vulnerable to the risks posed by Russia at present. Scandinavia is best positioned. In western Europe, Italy, the Benelux countries, along with Germany are most vulnerable.
• The economic impact of the Ukraine invasion is not sufficient to change the US Federal Reserve’s plan to tighten monetary policy. Interest rate hikes will commence this month, and will likely continue at each of this year’s meetings. The Fed may limit the March hike to 25bp, rather than the 50bp rise markets were expecting. Given the more uncertain economic outlook, the ECB may delay higher interest rates until late this year or into early 2023. I will provide more detail in my next blog.
• The US dollar and UK sterling will strenghten further, as the Ukrainian crisis intensifies in coming weeks.