UKRAINE: the Economic Fallout of the War

In the wake of the Russian military intervention in Ukraine, a significant decline in global trade is expected in the coming weeks, amplified by American and European sanctions on Russia.

Given the sharp surge in energy prices resulting from the negative supply shock, the probability of a recession in the euro area is increasing, more strongly than in the United States.

In this context of high macroeconomic risk, economic policies must remain accommodative, at least for a while. In the euro area, the suspension of the Sustainability and Growth Pact could thus be extended.

On the monetary side, the European Central Bank (ECB) is trapped by the energy supply shock that is driving prices up and quantities down. In terms of growth, halting the asset purchase programmes and rapidly raising short-term interest rates could prove costly.

The invasion of Ukraine by Russian armed forces since 24 February 2022 has brought a human and humanitarian disaster, having already caused several thousand deaths and pushed millions of refugees on the road to exile. While the economic consequences of this war on European soil appear to be of secondary concern right now, this article nevertheless seeks to identify some of the possible short-term effects, based on the academic literature currently available.

A World Economy Battered by Two Years of Pandemic

On the back of two gruelling years from an economic standpoint as a result of the COVID-19 crisis, the world economy did not need another negative shock. After a worldwide recession in 2020, global economic activity did rebound sharply in 2021 (global real GDP growth of -3.1% in 2020, then +5.9% in 2021). However, many countries still have a negative output gap and thus remain below their potential. Even though the labour market has enjoyed a steady recovery, economies still bear the scars of the COVID-19 health crisis, particularly when it comes to income and wealth inequalities within countries or the rise in both public and private debt levels (global debt rose to 256% of global GDP in 2020).

Another striking feature of this pandemic is the gap between strong household demand and a supply that cannot keep pace. Two factors in particular are causing this strain: global supply chain disruptions and labour shortages (the so-called Great Resignation). Moreover, the high demand has led to an increase in the price of commodities, notably in the industrial and energy sectors. Consequently, the major advanced economies have seen an inflation spike recently (7.9% in the United States and 5.8% in the euro area in February 2022) and it is difficult today to predict when this will end.

The Crisis Transmission Channels

In this context, through what transmission channels might the war in Europe be influencing the global economic cycle?

First of all, even though this may seem secondary today given the loss of human lives, the economic effects on Ukraine will be dramatic in terms of human and physical capital and they will obviously depend on how long the conflict lasts and the conditions in which it is resolved.

On the Russian side, the economic losses will also be great, although they are difficult to estimate for the time being since they will largely be due to the sanctions imposed by the country’s trade and financial partners – chiefly the United States, Europe and China – and to the substitution effects resulting from them. For now, the depreciation of the rouble by over 40% and the raising of interest rates to 20% by the Bank of Russia suggest a catastrophic scenario even though Russia’s external financial position has improved since 2014. Some economists anticipate a 7% drop in Russia’s GDP in 2022.

As for the international financial markets, stock prices have fallen sharply since the start of the Russian invasion, though the decline had begun in early 2022. For example, the S&P 500 has fallen by around 13% since 31 December 2021, but this does not erase the gains recorded since the COVID-19 crisis (the index has more than doubled in value since March 2020). The Chicago Board Options Exchange’s Volatility Index (CBOE VIX), which measures stock market volatility and is sometimes called Wall Street’s “fear gauge”, rose to levels similar to those observed during the second and third waves of the COVID-19 pandemic, indicating uncertainty among investors. The academic literature teaches us that a rise in uncertainty is generally followed by a significant decline in economic activity.

In this type of uncertain environment, the U.S. dollar generally tends to appreciate against the euro or the pound sterling, as it is considered a safe-haven currency. This is indeed what has happened; the dollar was trading at 1.09 against the euro on 8 March, versus values exceeding 1.20 in early 2021. This appreciation of the U.S. dollar is clearly unfavourable to countries importing commodities denominated in dollars, such as the euro area countries, which are going to see their import prices increase. According to ECB estimates, a 10% depreciation of the euro’s effective exchange rate raises import prices in the euro area by 3% within one year.

As regards of trade in goods, a significant decline in global trade is expected in the coming weeks, amplified by American and European sanctions. A drop in world trade has already been noted over the month of February 2022, down by 5.6% compared to January, according to the Kiel Trade Indicator developed by the Kiel Institute in Germany. The slump in Russian exports is significant (-11.8%), but exports from the European Union and the United States are also on the decline (between 3% and 4%). Even though Russia is not highly integrated in global value chains, a drop in European imports from Russia can also be expected, particularly where industrial, energy and food commodities are concerned.

An Oil Shock on the Horizon?

To date, the most visible transmission channel is the rising energy prices, particularly those of oil and gas. The fear of supply disruptions has sent the prices of energy commodities – already high in the wake of COVID-19 – soaring. The price of Brent crude oil briefly surged past 120 U.S. dollars per barrel and its volatility remains high. In this context, the euro area is the most exposed due to its reliance on Russian exports. Germany, in particular, depends on Russia for about one third of its total energy consumption and is thus highly exposed to the risk of an energy shock.

The economic literature highlights the negative macroeconomic effects of an oil price shock, particularly in the United States and the euro area. Notably, when the price of oil rises, the impact on the profit margins of businesses and on household consumption spending is swift. As an example, in France a 1% hike in the price of imported refined diesel results in a 0.3% increase in the price of diesel fuel at the pump approximately ten days later. However, contrary to a widely-held belief, this effect is symmetrical: the mechanism is the same whether the price of crude oil rises or falls.

The global economic effects depend on the nature of the shock that is behind the fuel price hike. Today, given the Russian invasion of Ukraine, this increase can be seen as caused by a negative supply shock, the economic effects of which are known to be more severe than when the increase is caused by demand shocks. Thus, the optimal point of comparison is not 2008, when fuel prices had surged mainly as a result of demand from emerging countries, and China in particular, but rather the oil shocks of the 1970s, which were pure negative supply shocks (see for example this working paper by the ECB for a historical decomposition of supply and demand during the different shocks). The oil shock due to an embargo on oil sales by some OPEC countries in the wake of the 1973 Arab-Israeli war caused a sharp recession in 1974-1975 in advanced economies, estimated at around 3.6 percentage points of global GDP at the time.

While as a net importer of oil the euro area remains exposed to the risk of recession, this is now a little less true for the United States due to its mass production of shale oil in many states. Since 2020, the United States has become a net exporter of oil products for the first time since 1949.  In this context, since the decline in consumer spending as a result of the oil shock should be offset by a similar rise in corporate investment in the oil sector, ultimately the effect on the American economy will be practically close to zero. That is what Christiane Baumeister and Lutz Kilian demonstrated in their paper on the oil price collapse of 2014-15, which was also a pure demand shock, but a positive one.

What about Economic Policies?

Against this background of uncertainty and high macroeconomic risks, economic policies must remain accommodative, at least for a time. This should be the case for fiscal policy, particularly in the euro area where the suspension of the Sustainability and Growth Pact is likely to be extended to late 2023. Economists have not forgotten the fiscal consolidation measures undertaken too soon after the sovereign debt crisis in the euro area, costing European countries several percentage points of growth.

As far as monetary policy is concerned, the war in Ukraine could slightly delay the interest rate hikes initially planned by the U.S. Federal Reserve for 2022, as often occurs during times of international crisis; but the low expected impact on the American economy should not prevent the raising of interest rates. Indeed, it turns out that Fed decided to increase its benchmark interest rate by 0.25pp after the Federal Open Market Committee (FOMC) meeting that took place in March 15-16 and now expects about six additional hikes by the end of 2022. For the ECB, however, the task may not be so straightforward. The European Central Bank is trapped by the energy supply shock that is driving prices upward and quantities downward. The central banks are ill-equipped to deal with this type of shock, sometimes described as “stagflationary”. The academic literature underscores that a tightening of monetary policy to counteract inflation after an oil price shock tends to amplify the depressing effects substantially. In the current context, halting asset purchase programmes and rapidly raising interest rates could prove costly in terms of growth in the euro area.