The economic fallout of Russia-Ukraine conflict

March 24, 2022 0 admin

Sanctions are the new weapons of modern warfare. They can act as a potent non-violent alternative to hinder the sanctioned country. While sanctions may not lead to war causalities, the effects are war-like with unintended long-term consequences. As the Russian-Ukraine conflict knocks on week 5, we ascertain the fallout of the US-led sanctions so far.

Summary of the West’s toughest sanctions imposed on Russia so far

Russia 2022 sanctions timeline

Western countries began imposing limited sanctions on Russia when it recognized the independence of Donbas during its major military build-up near the Russo-Ukrainian border that fuelled the crisis between the two neighboring nations. The US, EU, and the UK announced the initial sanctions on several Russian institutions and individuals, while Germany froze its upcoming gas pipeline deal.

When the West’s initial round of sections failed to deter Russia’s aggression after the latter announced the military operation in Ukraine, it imposed harsher sanctions aimed at intensifying global isolation of Russia’s economy.

Two of the key new measures that target the heart of Russia’s financial system are: freezing the central bank assets and cutting off some Russian banks from SWIFT (an international payment system). Sanctions on the Central Bank of Russia would make its more than $600 billion of forex reserves (the world’s 4th largest) inaccessible to the Russian government, and harm the nation’s ability to keep the rouble from depreciating. Excluding certain Russian banks from SWIFT is aimed at delaying the payments Russia receives from its energy exports, while at the same time taking into consideration Europe’s energy needs, considerably dependent on Russia.

Subsequently, the US imposed export controls that prevent Russia from importing advanced US technology critical to its defense, aerospace, and shipping industries, among others. Following the sanctions and criticism for their businesses in Russia, a boycott movement began and many companies – including Visa and Mastercard, two of the world’s largest payment processors – exited Russia voluntarily.

Previously neutral countries, such as Switzerland and Singapore, also imposed unilateral sanctions on Russia, including the introduction of export controls and asset freezes.

As of March 1, the total amount of Russian assets being frozen by sanctions was $1 trillion, indicating some of the toughest sanctions imposed on any nation in modern times.

Impact of sanctions on the Russian financial market and Russia’s reaction

MOEX Russia

After registering its 5-year peak level in October 2021, Russia’s stock market (MOEX Russia) started falling since the start of the crisis. It crashed by 33% on Feb 24 this year, the first day of its military operation in Ukraine, in response to the initial round of sanctions announced. After recovering 20% the next day, trading was suspended till March 18, making it the longest stock market closure since October 1998. The London-listed stocks of Russian companies have also plummeted – with key stocks such as Sberbank, Gazprom, Lukoil, Polyus, and Rosneft down over 90% YTD – forcing London Stock Exchange to suspend trading of 27 Russian securities. Russian benchmark crude Urals oil was also trading at a huge discount to Brent as it was struggling to find buyers when Europe turned to the Middle East to replace it.

Economic sanctions forced S&P Global Ratings to downgrade Russia’s credit rating to “junk”, causing funds that need investment-grade bonds to dump Russian debt, making further borrowing very difficult for Russia.

Excluding selected Russian banks from SWIFT impedes them from executing financial transactions and payments with foreigners, which would paralyze all sectors of the economy engaged in international trade.

The West’s move to freeze Russia’s central bank assets assumes significance as the latter’s massive build-up of forex reserves was seen as the buffer against sanctions and loss of export revenue. Freezing of Russian assets also added to the volatility of the rouble as it depreciated over 40% against the US dollar since the start of the year, with losses sharply accelerating after sanctions were imposed. This also caused a bank run as Russians lined up at banks to try to get their rouble deposits and convert them into the safer US dollar – something that would cause a drain on the central bank’s reserves. The sanctions put Russia’s sovereign wealth fund at risk of disappearing.

This forced Russia’s central bank, in its first market interventions since 2014, to more than double its key interest rate from 9.5% to 20% to stabilize the market. It introduced some capital controls to limit the capital outflow. The country also paused dividend or interest payments to foreign investors who hold stocks or government bonds, and also stopped them from selling those assets.

Importance of Russia’s exports to Europe and the world

Russia’s $1.6 trillion economy is the world’s 11th largest and Europe’s 5th largest. Due to its vast geography, the country is known to have enormous natural resources – estimated to be the world’s 30% – making it an important determinant of economic activity.

Russia is the world’s most widely described energy superpower, reflecting its position in the global supply of crude oil and natural gas. It is the second-largest petroleum exporter (only after Saudi Arabia) and the largest natural gas exporter in the world.

EU imports of crude oil

Russia is the second-largest oil producer in the world, second only to the US, although Russia’s position fluctuates with that of Saudi Arabia at times. It produces around 11 million barrels of crude oil per day, of which, it consumes roughly half of the output and exports the other half mostly to Europe and China. Europe sources about a quarter of its crude oil requirement from Russia, making it their largest source of energy.

Due to its vast gas reserves and an extensive existing pipeline network in Europe, Russia is the dominant source for the EU’s gas markets supplying 41% of its gas requirement.

Europe has more flexibility to switch suppliers when it comes to oil but not gas since gas supply requires complex infrastructure to store and transport. While Russia holds more leverage over natural gas, it earns far more from selling oil. Its 2021 oil exports revenue ($110 billion) was two times that of natural gas exports.

Russia is also the world’s largest exporter of grains, fertilizers and among the world’s largest suppliers of metals including palladium, platinum, gold, cobalt, nickel, and aluminum. It is also the world’s largest exporter of wheat.

The global impact of the crisis

Energy supply uncertainty over the Russia-Ukraine conflict fuelled massive shock waves across the European energy markets. Energy prices skyrocketed with Brent Oil crossing the $100 mark for the first time since 2014 while natural gas prices in Europe reached all-time highs.

Acknowledging the importance of Russian energy supply to Europe, the western sanctions have largely bypassed Russia’s energy sector. However, the possibility of Russia cutting off supplies in retaliation for sanctions cannot be ruled out.

The economic impact of the crisis is not confined to energy. The effects of shipping disruptions through the Black and Azov Seas, plus some Russian banks being cut off from SWIFT, also extend to the global agricultural commodities and fertilizers market.

Ukraine is the fourth-largest exporter of wheat and corn and the world’s largest exporter of sunflower oil. Russia and Ukraine together export 29% of the world’s wheat supply and 75% of the world’s sunflower oil exports. The shutting down of ports in the Black Sea fuelled wheat prices trading at the highest level since March 2008, with the prices of corn and soybean also spiking.

The ongoing crisis severely limits Ukraine’s ability to plant crops in spring 2022 before losing an agricultural year, while an embargo on Russian crops would add more inflation to the food prices. Recovering the crop production capabilities may take a long time even after the end of the crisis. The Food and Agriculture Organization (FAO) reported an all-time high Food Price Index in February, a 24% YoY increase.

An increase in inflation would push the interest rates higher in many countries, making borrowing costlier. The IMF projected lower growth for advanced economies at 3.5% this year, compared to 4.4% last year.

How global commodity prices moved…
March 2 Year ago Month ago Price in
Brent crude 112.9 62.7 89.5 USD/barrel
Coal 440.0 87.5 220.1 USD/tonne
Wheat 1058.5 663.2 755.0 Cents/bushel
Corn 739.0 560.7 622.5
Soyabean 1677.5 1414.0 1545.2
Skim milk powder 4481.0 3302.0 4051.0 USD/tonne
Cotton 138.7 94.2 141.5 Cents/pound
Crude palm oil 6660.0 3735.0 5523.0 Ringgit/tonne
Sugar 18.6 16.4 17.9 Cents/pound
Urea 900.0 390.0 596.0 USD/tonne
MOP 587.0 247.0 447.0
DAP 950.0 504.0 900.0
Phosphoric acid 1530.0 795.0 1330.0

Is there a better alternative for Russian oil and gas for Europe?

Not really. More than 60% of the EU’s energy needs were met by net imports.

Russian natural gas supply to Europe has remained largely consistent in the last decade while domestic production has dwindled significantly owing to a number of factors such as resource depletion and production limits applied to encourage renewable energy transition.

The direct energy transition from coal to renewables was never that easy. So, countries turned towards an intermediate solution – natural gas – a reliable and efficient source of energy to fill the gap. This led to an increase in consumption of natural gas in the last 50 years in Europe to offset decreasing reliance on coal.

During the ongoing crisis, the EU tried to reduce its energy reliance on Russia and substitute it with more imports of LNG from other sources. However, the key issues with LNG are its infrastructural requirements which makes it 40% costlier than gas, alongside an acute shortage of its supply.

Can cryptocurrencies offset the impact of sanctions?

The West-imposed sanctions on Russia rely heavily on banks for its enforcement, making it easier to verify the identity of sanctioned entities and individuals. On the other hand, cryptocurrencies are operated by a decentralized system outside the realm of standard banking, making it difficult to track individuals. New cryptocurrencies can be created and sold without involving the banks and regulators – something that would make it more attractive to entities under sanctions.

Russia is already developing its own central bank digital currency (Digital Rouble) that would make it less dependent on the US and help evade sanctions. It would let Russians conduct transactions outside the international banking system with any country willing to trade in digital currency.

China, Russia’s largest trading partner, has already launched its own central bank digital currency. Iran, North Korea, and Venezuela are some of the countries, hit by US sanctions, assumed to be trading in digital currencies to evade sanctions.

The West also targeted Russian billionaires perceived to be in President Vladimir Putin’s inner circle. Interestingly, cryptocurrency research firm Kaiko discovered a spike in crypto trades involving the rouble, suggesting oligarchs might be trying to use digital currencies to evade sanctions.

Binance, the world’s largest cryptocurrency exchange, announced that it would block Russian sanctioned individuals but rebuffed calls to freeze the assets of all Russian users.

Russia’s prolonged efforts to make a sanction-proof economy

This is not the first time that Russia had to face western economic sanctions for its involvement in a major conflict. In fact, the country faced various sanctions since the start of Russo-Ukrainian War in 2014, although not as harsh as it is for now.

For the last 8 years, Russia is said to be setting up defenses, reducing reliance on the dollar, and trying to sanction-proof its economy.

For instance, only 16% of Russia’s foreign exchange is now held in dollars, down from 40% five years ago, while 13% is held in the Chinese renminbi. Russia has also reduced its reliance on the West for investments while seeking new trade opportunities in China. More so, it developed its own system of international payments (SPFS) equivalent to the SWIFT. These moves were meant to shield the economy from external shocks like the current economic sanctions imposed.

Who are the beneficiaries from this crisis?

On March 8, the US and the UK announced a ban on Russian oil while EU members discussed gradually weaning itself off its dependence on Russian fossil fuels. The West has hit Russia with energy curbs after calculating the cost at home. This would force these large consumers to turn to the OPEC cartel to fill the Russian energy supplies gap – which would increase OPEC’s market share. Countries like Iran and Venezuela already expressed their interests to replace the Russian barrels. Energy exporting countries are also benefiting from skyrocketing energy prices.

China, the world’s largest oil consumer, may benefit from cheaper oil imports from Russia at a time when the latter will be finding buyers to support its economy. Recently, China also lifted all import restrictions on Russian wheat. India, with its more than 80% energy need fulfilled by imports, may also continue to take a neutral stance and use this as an opportunity to negotiate better terms with Russia.