Russia’s war against Ukraine and the West’s response will have structural long-term economic consequences. A month after the beginning of the war, we take stock of some of the big questions around the macroeconomic impact and the global financial system.
Russia and Europe will pay a heavy price
A global recession is unlikely. The IMF has said it will downgrade growth projections for this year, while the OECD expects an average of more than 1% to be shaved off GDP growth (1,2% in the EU). Goldman Sachs analysts expect Russia’s GDP to shrink by 7% this year. Inflation is now well above 6% in much of the West and is likely to continue to climb, fuelled by soaring energy prices.
So far, financial markets have largely held up – except for commodities. This is consistent with historical trends: markets tend to dip at the outbreak of war but quickly recover. Volatility is high, but not excessive and fear indices have declined. The US dollar is seen as relatively safe and is appreciating against the Euro and Sterling. Significant escalation by Russia could see markets fall, with much shakier prospects for recovery.
Financial stability at risk
The global financial system entered the Ukraine crisis in a position of strength. Banks are far better capitalised than before the 2008 financial crisis and the supervisory environment is more sophisticated and stringent.
However, uncertainties on the ground and the possibility of further financial and trade sanctions create the possibility of a financial crisis. Some EU and US banks have heavy exposures in Russia – Unicredit, Société Générale, Raffeisen, Citi. Closing out transactions with sanctioned Russian banks has not been resolved, leaving open exposures on the books of Western counterparties. Rising inflation will lead central banks to raise interest rates, with potential impact on the property sector – which historically has the highest propensity to cause financial distress. There may also be surprises and stress particularly in non-bank financing channels which contain 50% of all global financial assets but are far less regulated.
In the medium term, higher interest rates will affect the sustainability of public debts, particularly in the EU. Member States will take further measures to mitigate soaring energy prices. This will put further pressure on public finances and exacerbate North-South tensions within the EU. Debt rescheduling in the EU is well spaced out into the medium term, reducing the risk of short-term debt pressures. However, when euro base rates increase, some pressure can be expected on Italian-bond spreads – especially given high Italian energy dependency on Russia.
Towards a more fragmented international monetary system
Sanctions against individuals and banks were expected and priced in. The sanctioning of the Central Bank of Russia (CBR) and its ability to access and manage foreign exchange was not. The consequences are likely to be far-reaching and hard to predict. A major source of foreign exchange has been frozen, leaving the CBR with limited recourse to defend the Ruble. Only inbound forex for oil and gas and measures forcing Russian exporters to sell some of their foreign income has prevented its total collapse – this combined with the short-term fillip of Putin insisting in payment in rubles on even existing euro or USD contracts.
Perhaps more significant are the long-term political consequences for the global monetary system. Until the CBR sanctions, it had been assumed that such action against foreign exchange reserves held across the global banking system were off limits. Any further de-integration of the global financial system could lead to a realignment of political relationships, with the emergence of loose blocs, with one clustered around the US dollar trading system. While US currency hegemony is likely to continue in some form, it may not have the same global reach it has enjoyed since the end of the Cold War.
China could benefit the most. It may look to reduce USD exposure in its forex reserves to reduce the impact of future secondary sanctions in the current crisis, or future ones over Taiwan. More significantly, other nations may consider holding yuan at the People’s Bank of China (PBOC), knowing that China will always provide access. On means of payment however, the Yuan is not ready to take on the dollar. Talk from Saudi Arabia of pricing some oil contracts in yuan is a familiar trope used to send warning to the US on the state of the relationship. The PBOC still have serious decisions to make if they are going to take on the dollar.
While Russian dependence on China will increase, global bifurcation and greater dependence on China for other nations is still a way off. But history shows that empires fall when reserve currency status is lost to a credible global rival. The US should take note that some others at least view this as the beginning of the end.
On crypto-currencies, investors are watching to see if this is the moment when they enter the mainstream. Competing against the dollar as a store of value and means of exchange is one thing. But competing in a landscape where the value of foreign exchange reserves and the status and longevity of fiat currencies is less certain is another. In various ways, the US, China, EU and others will try to incorporate the growth of digital assets into their monetary systems. But in a more fragmented global landscape, digital assets will gain importance and it is only a matter of time before the IMF and others seriously incorporate them into their activities.
Before the Ukraine crisis, globalisation was already under strain. Trade wars, the pandemic and technology meant that governments around the world were considering how to reduce strategic dependencies. Western governments were looking more to likeminded countries for investment, and many had started to prioritise diversification of their trading supply chains. Russia’s invasion of Ukraine and its consequences are likely to accelerate and reinforce this trend.
The poorest people will suffer the most. There will be greater risk of political instability in Africa and the Middle East. In Europe, high energy prices have led in the past to serious social and political instability, including in France and Spain. Managing this will be a challenge for democratic governments, who will face populist pressures linked to the cost of living. Net zero policies will be set back.
Democratic Europe’s military and economic dependence on the US has been underlined. The EU will need US support to ensure alternative energy sources, increase trade and maintain financial stability. EU integration in some areas will continue but it will be more difficult for the EU to assert its independence and autonomy. There are currently no substantive signs of EU banking and capital market acceleration.
Simon Horner is a Director at Flint and advises financial services clients on climate, ESG issues and technology, he wrote this piece with Flint Directors Francois-Joseph Schichan and Katie Whitting and Flint Specialist Adviser David Wright.
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