Before addressing the topic of this essay, we would like to thank everyone who has generously donated to charities supporting the Ukrainian refugee crisis. As of writing, we have raised $19,374, or 97% of our $20,000 goal. We are touched by the generosity of so many in this time of need.
In this week’s note, we turn our attention to the global economic ramifications of Russia’s war in Ukraine. We examine how surging commodity prices will sap global demand, even as they also boost inflation. We also discuss how countries will find it necessary to reorient their economic and financial security policies due to the war, a process that may take years to sort out.
We begin with the cyclical impacts of war.
Akin to the pandemic, Russia’s invasion of Ukraine has unleashed both supply and demand shocks across the world economy. The supply shocks, in the form of soaring prices for energy, industrial metals and food are easily visible. Surging prices will boost inflation. They may even raise long-term inflation expectations. If so, they will reinforce central bank pivots from policy accommodation to policy tightening, as recently underscored by the ECB’s decision to end its net bond purchases.
But higher prices will also crimp purchasing power as price inflation outstrips wage gains. Uncertainty is also apt to slow consumer and business spending, particularly in Europe. And the timing is far from ideal—recent fiscal stimulus is already flipping to ‘fiscal drag’ and household spending binges following Covid-19 reopening are about to exhaust themselves.
Importantly, higher commodity prices are not a ‘wash’ for global demand—they almost certainly will slow growth. That’s because households with high propensities to spend will see their purchasing power fall. Commodity producers that enjoy windfall profits will not make up for that shortfall, given their lower propensities to spend. In the parlance of economics, the negative multipliers will be larger than the positive ones.
Some observers note that today’s oil price shock is smaller than those of the 1970s. During the 1973 oil embargo, for example, nearly one third of crude supply was withheld from the market. Even if Russia were unable to deliver oil tomorrow, it would ‘only’ account for about an 11% reduction in global supply.
But unlike the oil shocks of the 1970s, Russia’s invasion puts at risk deliveries of other commodities. Russia, Ukraine, and Belarus—as we noted last week—are major source of grain, corn, and fertilizer supplies, as well as of many industrial metals. Unlike the 1970s, today’s supply shock is therefore potentially much broader.
Investors have taken note. Real interest rates, which reflect expectations of future growth, have fallen. Equity markets have suffered setbacks, reflecting falling profit expectations.
The prospect of higher inflation and slower growth puts central banks in an awkward position. Should they fight inflation, they will exacerbate the coming slowdown. Yet they dare not allow already high inflation to become embedded in household and business expectations.
Accordingly, policy uncertainty is rising. Notably, in last week’s ECB decision, 10 of the 25 voting members opposed a tightening of monetary policy. The Federal Reserve is also wavering, with Chairman Powell ruling out a 50bp hike at this month’s Federal Open Market Committee (FOMC) meeting. Global monetary policy is becoming more uncertain.
But the impact of war and sanctions is not merely cyclical. Around the world, governments are rethinking longer-term economic and financial security issues related to the conflict.
At the top of the list is China. President Xi’s ‘Belt and Road’ initiative, which focused on establishing transportation links with global commodity producers, including overland routes across central Asia, is in tatters. China must rethink its reliance on Ukrainian, Russian, and Belarussian supplies of wheat, corn, sunflower oil, and potash, among others. War and sanctions are apt to interrupt those supplies for much longer. Nor can China look inward—its own well-known challenges of water supply preclude a sustainable policy of import substitution for foodstuffs. Meanwhile, as Russia turns to China for economic aid and potentially additional military arms, China may find its massive export-led economy under sanction threat from its largest trading partners. Although it would seem unlikely that President Xi would choose to escalate his ties to Russia at the expense of his economy (and the world’s), this tail risk should not be ignored. The economic and market implications would be vast.
Sanctions will lead to a global rethink of what constitutes financial security. The lesson drawn from the 1998 Asian financial crisis, namely that large war chests of foreign exchange reserves offer a bulwark against financial stress, are now in question, particularly as regards the nexus between finance and foreign policy. As Russia has discovered, ‘bad behavior’ can nullify financial bulwarks instantaneously. The freezing of its foreign exchange reserves and the ejection of its banks from the SWIFT payments system has exposed the security shortcomings associated with global finance.
And yet there is no quick fix. The appeal of a single dominant reserve currency and a single medium of exchange is akin to the appeal of single-platform social media sites or search firms. A single network is best because everyone uses it. Multiple payments systems or variated reserve assets are cumbersome, inefficient, and suboptimal.
Only a few months ago, the world looked forward to a pandemic becoming a livable epidemic. Life could return to normal.
That was nice, while it lasted. War and sanctions have unleashed questions just as great, shattering the post-Covid illusion that all would return to the status quo ante. Growth, inflation, and monetary policy have become significantly more uncertain. So, too, have geopolitics, including in countries far away from the human tragedy of Ukraine.
In this new reality, markets have suffered setbacks, as investors have begun to realize that the ground is once again shifting under their feet. But it is premature to suggest the challenges that lie ahead have been fully discounted.