The Ukraine-Russia war has consequences for Western Europe’s risks

Sanctions on Russia have been swift and more far-reaching than expected, but they come with the risk of retaliatory measures that are adding to the direct effects of the Ukraine invasion in terms of refugees, supply constraints and the need to ramp up defence spending, adding to fiscal problems.

The economic impact is already being felt, with soaring energy prices adding to inflation concerns.

Although this is now being mitigated to some extent by the willingness of Gulf hydrocarbons exporters to step up production, it remains a problem that will only become worse should Russia go through with its threats to restrict supplies of gas to Europe through the Nord Stream 1 pipeline.

Euromoney Country risk survey contributor Norbert Gaillard of NG Consulting notes that between February 18 – the last business day before Putin recognized the Donetsk and Luhansk People's Republics – and March 8, the prices of Brent crude oil and wheat increased by 37% and 55%, respectively.

“This will dramatically affect inflation in Western Europe,” he says, “pushing it up by several percentage points more than expected in 2022 and 2023.”

Gaillard adds that double-digit inflation is possible this year in the eurozone, “especially if the EU bans part or all Russian energy imports (oil and gas), or if Russia cuts natural gas flows to Europe.”

Independent economist Peter Dixon, a former financial economist at Commerzbank AG, says: “UK inflation could top 8% this spring, and remain higher for longer as energy costs lead to further rises in household energy bills.”

Sebastian Bittar, a quantitative risk manager at Quantyx Advisors concurs.

“With respect to oil prices, we reached levels last seen in 2008. Russia is obviously a huge exporter of oil and the world must turn to America and others,” he says.

“Oil prices were already grinding higher with stronger demand due to the economic recovery and a lagging supply. Wheat is at a big risk too, given the size of Ukraine and Russia in global exports.”

Fhaheen Khan, senior economist at the manufacturers’ organization Make UK, is particularly concerned about inflation taking place upstream (affecting inputs) and factory-gate prices increasing.

“This was already a crisis before the invasion, as the pandemic-induced bounce back resulted in a quick return to demand and higher gas prices,” he says.

“One of our recent surveys indicated that around 8% of manufacturers say the rise in input cost increases are so severe their business models are already operationally unviable. Manufacturers across the UK are extremely worried about energy prices as new tariffs are currently being negotiated with energy providers and many businesses have said they will consider shutting down to save cash.”

Khan expects most food products to increase in price, with the ONS basket of 15 standard food items already showing inflation jumping 8% over 12 months.

“So far, we have seen food prices go up across 17,000 items in supermarkets this year. Russia's fifth largest export by value is cereals, so this will result in a rise in prices in staple items that are critical for those in poverty.”

Bigger picture

As for the wider macro-fiscal outlook, much will depend on how the war plays out. There have been no new forecasts issued since the invasion. Euro Zone Barometer, a monthly survey of projections by independent experts, is due out later this month. The IMF’s next World Economic Outlook is expected in April.

What is clear, though, is that economic recovery from the pandemic will be downgraded, inflation expectations higher and deficit and debt trajectories plotting a new course on the back of increased public spending.

“GDP growth in the eurozone could be one or two percentage points lower than expected,” says Gaillard, which will undoubtedly affect macroeconomic risk scores in Euromoney’s crowd-sourcing survey.

There are five economic assessment indicators, along with political and structural indicators, that more than 300 experts are asked to assess. The latest quarterly survey is also under way, and the results are due in early April.

“If the EU bans part, or all, of Russian energy imports, or Russia cuts natural gas flows to Europe, the eurozone GDP growth rate in 2022 could be around 1%, instead of 4% as many forecasters suggested last month,” says Gaillard.

Supply chains and global value chains will be significantly stressed in the next few years, he adds, and as a result Western European governments and firms must secure their energy supplies and rethink how they reorganize and relocate their global value chains.

“This is what I called ‘post-globalization’ in an article in Politique Etrangère, the main French review dealing with international relations,” says Gaillard 

He defines post-globalization as "a logic of high interdependence in economic, commercial, migratory and technological fields between states (and their companies) whose strategic and geopolitical interests are convergent, or at least compatible.”

Western Europe will remain attractive to foreign bondholders, but quite less to foreign exporters 

 - Norbert Gaillard, NG Consulting

In the short-medium term, he says that European demand for consumer goods from abroad will likely stagnate or even decline because European households and firms will spend much more for their energy.

“Western Europe will remain attractive to foreign bondholders, but quite less to foreign exporters.”

Khan, meanwhile, expects UK debt to increase if defence expenditure rises and if the government acts on increasing domestic pressure to support consumers during the cost crisis.

“However, UK tax revenue is also rising sharply as energy prices and fuel costs increase. This will be supplemented by the increase in national insurance contributions in April as well as the corporate tax hike in 2023,” he says, adding that “unless the UK involves itself more directly in the war, sovereign debt should not increase as excessively as it did during the pandemic.”

Dixon believes that fiscal constraints are likely to be a low short-term priority for many governments as they scramble to raise outlays on defence and prioritize efforts to find non-Russian energy sources.

Public deficits in the next few years are thus expected to be higher than previously forecast.

Monetary policy

As for monetary policy, Bittar notes that most experts believe the quantitative easing required to support economies through the pandemic was overdone, resulting in too much liquidity in the financial system, and are questioning whether it is possible to absorb this.

Dixon says that central banks face a dilemma: “On the one hand, the energy shock will depress growth, raising the risk of a technical recession as real incomes are squeezed and uncertainty impacts on investment.

“On the other, they remain mindful of their inflation targets. This will likely result in some modest monetary tightening in 2022, but more aggressive moves are likely if wages follow prices higher.”

Khan believes the Bank of England will raise interest rates further and it will keep doing so until inflation is brought under control.

“This inflation crisis, in our view, is very much supply-driven and therefore raising rates will have little impact. At best, this will allow the bank to maintain some confidence that they are willing to act, even if that action results in minimal effect.”

Gaillard believes, however, that the European Central Bank’s monetary policy will remain accommodative in the short term.

“I do not expect any interest rate hike by the ECB in the next six months,” he says. “In fact, the negative effects of inflation will be fought through proactive fiscal policies and massive bond issuances.”

Gaillard also notes that a source of concern is the exposure of Austrian, French and Italian banks to Russia and Ukraine and as a consequence he says that the ECB should be ready to intervene swiftly to eliminate systemic risk.

As for the exchange rate impact, Gaillard sees the decline of the euro against the US dollar as “pretty logical” for two reasons.

First, the eurozone will be much more affected by the Russo-Ukrainian war than the US. Second, the US dollar is the top safe-haven currency.

A key issue, he says, may be the fall of Eastern European currencies such as the Polish zloty.

“As a result, the ECB should strengthen its central bank swap agreements with Poland, Romania and Czech Republic.”

The impact on Eastern Europe is a topic Euromoney Country Risk is planning to cover in a forthcoming podcast.

Political fallout

Politically there is already a casualty. In Spain, where tensions have been building ahead of regional elections, prime minister Pedro Sanchez’s centre-left Socialist Party government is unsteady over belatedly sending weapons to Ukraine.

This has put the leftist alliance supporting the government in disarray, with Podemos and the communist Izquierda Unida (United Left) at odds with each other over whether to back the government in its attempt to equip Ukraine militarily, or favour diplomacy by amassing a peace movement.

The situation has reached the point at which a general election – not otherwise due until 2023 – is expected early, affecting government stability and policymaking.

Elsewhere, experts do not anticipate any major political fallout in the short term, not least with national parliaments making concerted attempts to stand united against Putin’s aggression.

It may even help Emmanuel Macron’s cause at the presidential elections in France this year.

“Political instability in the west remains a low-risk event,” Dixon states.

“Electorates for the most part support the tough line on Russia, although the UK government appears out of step with popular sentiment due to its tough immigration stance.”

The recent events, he says, are likely to improve Macron's chances of winning the French presidential election due to his efforts to try to mediate with Russia prior to the war and the pro-Putin stance of some of his opponents.

Electorates for the most part support the tough line on Russia 

 - Peter Dixon, independent economist 

Illustrating this, Marine Le Pen’s printing of campaign literature showing her shaking Putin’s hand may not be such a vote winner. But she may well go head-to-head with Macron in a second round, keeping out the centre-right Les Republicains candidate Valérie Pécresse, her far-right rival Éric Zemmour and the far-left’s Jean-Luc Mélenchon.

However, Macron was already the front-runner and his displays of international diplomacy and the fear factor of ousting him at a critical time should see to it that he serves another term.

Gaillard says Putin may seek to help Le Pen win the election, but agrees that Macron most likely will be re-elected.

In the UK, prime minister Boris Johnson is still awaiting the outcome of an investigation into partying during lockdown, although no-one expects a move to oust him during the crisis.

Gaillard does not anticipate any major anti-immigrant demonstrations in Europe either, because a high percentage of Ukrainian migrants will be welcome in Poland, which he describes as “a brother country”.

The political risks will nevertheless reverberate across Europe as the war intensifies. There will be tensions created by a huge influx of refugees, already topping an estimated two million, if more travel further west.

Not all will end up in Western Europe, but border pressures and the cost of absorbing so many people will flare up old animosities between the right and left. The UK’s decision to check all incomers, contrasting with the EU’s more open-door approach, highlights differences created by Brexit which may have some longer-term consequences.

Should any other country be drawn into the crisis – namely Moldova, Poland or one or more of the Baltic states – political problems would easily become much worse.