The prices of both Brent Crude and West Texas Intermediate spiked this morning on the news that Russia had sent troops into two provinces of Ukraine, as did the wholesale price of gas. With Russia as an energy superpower, the energy market was always going to be the first to react to increased tensions with the West. But it is worth reflecting on how increased tensions with Russia and the likely response Western response will affect the world economy more generally.
If sanctions are to be effective they will have to force Western countries to reduce their dependence on Russian products and business. While sanctions are likely to extend to non-energy sectors, the aggregate effect on the global economy of this will be small. More importantly for global growth, an effective set of sanctions must eventually include not buying Russian oil and gas for Continental Europe and not allowing the UK legal system or the City of London to be used by Russian companies amongst other measures. In line with the above, Germany announced this morning that it would halt the certification of the Nord Stream 2 gas pipeline in reaction to the Russian military action.
An accelerated transition away from fossil fuels would be costly, while a hit to the City of London (currently about 7 to 8% of UK GDP) would reduce not only the incomes of bankers and lawyers but many others dependent on their incomes. There would also be an impact on the UK property market if the government decides to make a fire sale of Russians’ property or, worse, have their assets frozen or confiscated.
A US-led rearmament boom would normally boost the world economy but much less so at present when economies are limited by supply shortages and inflation. The impact, unless financed by higher taxes, would be to increase both these supply shortages and inflation.
Russia is a key supplier not just of energy but also many metals including aluminium, cobalt and copper. It is also well provided with international reserves and can probably sit out a boycott that lasted less than two to three years.
So any international action will likely not only add to the current inflationary binge, possibly bringing inflation close to 10% in the main Western economies, but also should slow down growth quite rapidly.
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World GDP growth in 2022 had been forecast to be about 4% at the turn of the year. Rising inflation has been edging this down and it might fall as low as 2% with the inflationary spur from the conflict with Russia if severe sanctions cause a much more serious spike in energy prices, pushing oil towards $130 and gas to 300p a therm with corresponding moves in metal prices. This would mean no growth at all for the rest of the year, possibly with some quarters of contraction, which would mean getting close to a recession (on the technical definition of two consecutive quarters with negative growth).
Perhaps the biggest issue that will determine how severely the West is affected by the issues with Russia is whether there is the cohesion and willpower to put up with sanctions on the scale that might eventually affect Russia. The analysis above suggests that action could be costly, particularly for living standards that are already under pressure.
Will voters be willing to accept an enhanced squeeze? The answer to that question will determine the scale of the hit to the world economy.
Douglas McWilliams is Deputy Chairman of Cebr.