Russia’s invasion of Ukraine dismantles economic forecasts. The new war crisis, unforeseen by all the analysis houses until a week ago, creates a new situation in Europe that brings the continent’s economy closer to stagflation: a scenario of low growth and rising prices. The conflict will have an almost immediate impact on European prices and Gross Domestic Product (GDP). Inflation will thus grow twice as fast as GDP.
Specifically, the situation will lead the average rate of the CPI to rise, moving away from the foreseeable path of decline that the forecasts marked. Inflation is thus doomed to close 2022 at a record average rate -both for Spain and for the eurozone- of 6.5%, well above the 3.5% average registered last year. In addition, the escalation of war and the massive sanctions approved by the European Union against Russia could lead to a cut of more than 1% of GDP in the midst of the western economic recovery after the coronavirus crisis. In this way, 2022 could close the year with growth of around 3%.
“The crisis has increased the risks of stagflation”, confirms the analysis team of Generali Investments Partners. “We had already reduced our risk-on bias in the face of high inflation and the upcoming monetary policy tightening. While geopolitical tensions often create buying opportunities, we don’t think there is a need to rush into dips. For the time being, we further reduce cyclicality portfolios, waiting for greater stability in both the complex geopolitical and energy scenarios”, they explain in their latest paper.
For their part, specialists at the fund manager Loomis Sayles, of the Natixis Investment Managers group, believe that, in the long term, “the conflict will probably create a more complex monetary policy decision environment, as central banks face the risks of a possible stagflation”. In his opinion, in this scenario, central banks may have to adapt their strategies accordingly.
The impact of the crisis
The Russian invasion and Western sanctions will be mainly a supply shock, rather than a demand shock, according to Capital Economics. “There is the risk of further supply chain disruptions. After starting to recover from the chip shortage, the global auto industry could struggle to source catalysts if supplies of palladium, of which Russia is the world’s largest exporter, are tightened,” said Simon MacAdam, senior global economist at Capital Economics. In 2018, sanctions on Rusal were enough to send aluminum prices up 10% on supply concerns.
For its part, Oxford Economics sent a note to its subscribers this Friday warning of new risks for the European economy. “Even if the war means higher inflation, its negative impact on growth and financial conditions may prompt the ECB to take action,” he notes. “Current conditions may lead the European Central Bank (ECB) to reconsider its current plan to raise interest rates later this year and end asset purchases at a rapid pace, instead adopting a more flexible and data-driven approach, based in the evolution of the crisis”.
The situation amplifies the tensions that have existed since the Crimean crisis. Western banks have reduced their exposure to Russian banks by 80% since Russia’s annexation of Crimea in early 2014, and its claims on the rest of the Russian private sector have been cut in half. At the same time, Russia has pursued import substitution policies for almost a decade.
Each of the parties now has a renewed drive to take the process further, reducing technological linkages and finding ways to reduce the exposure of the two-sided supply chain. This is likely to manifest itself most clearly in relation to the mutual energy dependency of Russia and the European Union.
In either case, prices will skyrocket. This new front in the east opens a new brake on the recovery of the Eurozone, which has been losing traction for months. The latest inflation data exceeded expectations in all indicators. The market expected the headline CPI to slow down to 4.7% (vs. 5%), while they also expected a slight drop in core to 2.5% (vs. 2.6%). On the other hand, the monthly rate (what prices have risen from one month to another) has been 0.4%. Energy is the biggest contributor to this price boom, with a record rise of 26% year-on-year. However, this rise in prices is already being transferred to consumption. More and more goods and services in the shopping basket are beginning to make stronger contributions to the CPI, meaning price increases are already everywhere.
The EU, the most affected
Russia is generally poorly integrated into the world economy. It joined the World Trade Organization (WTO) in 2012 and has signed just ten trade agreements covering 11% of Russian exports, mostly with former Soviet states.
Meanwhile, the EU takes half of Russian exports. Its second trading partner, China, represents only 14% of exports. However, Russia accounts for only 5% of the Union’s trade. “In that sense, Russia is much more exposed to trade disturbances with the EU than the EU is with Russia,” analysts at the European Bruegel Institute point out.
In any case, there are substantial differences between the trade exposures from EU countries to Russia. Eastern European countries are more dependent on Russian oil and gas. Russia is an important trading partner for Lithuania and Latvia. At 17%, Lithuania had the highest share among EU countries of exports to Russia in 2019. More than 14% of Finland’s and 10% of Bulgaria’s exports also go to Russia. Latvia imports more from Russia in relative terms, and the value of its imports is about 8% of total imports.
In turn, Russia depends in some sectors on imports from the West. The EU’s share of Russia’s imports of high-tech and pharmaceutical products is about 45%, while the US share is 6%. Approximately 70% of Russian imports of chemical products and 60% of imports of instruments and apparatus came from the EU in 2019.
Economists believe that sanctions may repeat the scenario of the Crimea crisis. In part because of these sanctions, the Russian economy has experienced a lost decade. The Russian economy is still heavily dependent on fossil fuel exports, with the European Union being by far its most important trading partner. Despite Russian efforts to build resilience against further financial sanctions, the unprecedented measures currently being discussed would have a substantial impact on the Russian economy if implemented by European leaders.
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