Although Russia has 146 million people1 and the largest land mass in the world, its economy is relatively modest in size, with GDP roughly comparable to that of South Korea.2 The principal reason that Russia plays above its weight is that it is a major exporter of some of the world’s most important commodities. Thus, the Russian invasion of Ukraine and the consequent sanctions imposed by various Western countries create a risk that trade in commodities could become disrupted, especially exports of oil and gas commodities to Europe. This risk is manifested in a sizable increase in the prices of key commodities,3 potentially leading to even higher global inflation and weaker global growth. In addition, sanctions have led some companies to become averse to trade with Russia, thereby potentially disrupting key supply chains. The magnitude of the economic impact will depend on how the war progresses and how that affects global trade in key commodities. In this brief report, we look at the most impactful sanctions, their impact on Russia, and the potential impact on the global economy.
Following the Russian invasion of Ukraine, which commenced on February 24, major Western countries including the United States, the European Union, the United Kingdom, Canada, and Japan imposed4 a range of sanctions on Russia. These included banning secondary trade in Russian government bonds, banning interaction with key Russian banks, banning exports of critical technology to Russia, and freezing the assets and banning travel for elite Russians. In addition, Germany halted certification of the Nord Stream 2 gas pipeline.
Russia’s defense against sanctions was the revenue it continues to obtain through the sale of oil, gas, and other commodities; and the US$630 billion pool of foreign reserves held by its central bank.5 Indeed, there was concern in the West that Russia might impose counter-sanctions such as limiting or halting exports of oil and/or gas as well as other key commodities. The idea was that, by sanctioning the European Union, Russia might undermine the unity of the NATO alliance as well as undermine European resolve to sanction Russia for the invasion. Moreover, it was understood that, with its massive pool of foreign currency reserves, Russia could afford to absorb a big decline in revenues—at least temporarily.
Given uncertainty as to how the war would unfold and what counter-sanctions Russia might initiate, financial markets initially reacted harshly to the invasion.6 Global equity prices fell sharply, especially prices on European exchanges. Bond yields in the United States and Europe fell, safe currencies (such as the US dollar and Japanese yen) rose in value, and the prices of oil and natural gas increased. The prices of other commodities that Russia and Ukraine export, such as wheat and corn, increased as well. Moreover, the Russian ruble and Russian equities witnessed a sharp fall (figure 1).
Sanctioning the central bank
On February 26, the Western powers—namely, the United States, the United Kingdom, Germany, Italy, the European Commission, and Canada—sanctioned the Central Bank of Russia (CBR), thereby making it more difficult for the CBR to obtain access to much of its foreign reserves.7 Russia holds a sizable share of its foreign currency reserves in other countries, mainly in the West. A significant share is held in euros, pounds, and dollars, but a fair amount is in Chinese renminbi as well as gold. If Russia fails to sell much of its reserves, it cannot defend against attacks on the ruble, thereby making the ruble vulnerable to collapse. In addition to the sanctions on the CBR, the Western powers banned some Russian banks from access to the SWIFT financial messaging system.
Following the sanctioning of the CBR, the Russian ruble fell precipitously, dropping as much as 40% against the US dollar on the first day before bouncing back to a loss of about 28%.8 In response, the CBR increased its benchmark interest rate from 9.5% to 20% (figure 2). CBR governor Elvira Nabiullina said that “the central bank today increased its key rate to 20% as new sanctions triggered a significant deviation of the rouble rate and limited the central bank’s options to use its gold and foreign exchange reserves. We had to increase rates to compensate citizens for increased inflationary risks.”9
In addition, the CBR suspended equities trading on the Moscow Exchange. The Russian government imposed capital controls, meaning that Russians may not send money abroad and cannot service foreign currency debts. Also, the government ordered Russian exporters to sell 80% of the foreign currency they have earned this year to help support the ruble.10 This might help to offset the shortage of foreign currency driven by the sanctioning of the central bank. S&P Global, meanwhile, cut Russian sovereign debt to junk status.
Prior to these sanctions, there was a widespread view that the CBR’s US$630 billion pool of reserves would help protect Russia’s economy from other sanctions and enable it to fund the war as well as compensate for any loss of export revenue. This is now in doubt given that Russia will lack access to a sizable share of its reserves. Moreover, the act of sanctioning the CBR led Russians to attempt to liquidate bank deposits, thereby putting the entire banking system under stress. On the other hand, the sanctions include a “carve-out” that enables most energy-related transactions with the CBR.11 This is meant to avoid sharp swings in energy prices and allow oil and gas to keep flowing from Russia to the rest of the world.
Commodities account for 10% of Russian GDP, nearly 70% of goods exports, and more than 20% of government revenue. Thus, although Russia will benefit from higher commodity prices, its economy is likely to suffer due to financial sanctions. Much higher interest rates will have a negative impact on credit market activity. Consumer efforts to liquidate bank deposits and convert cash to foreign currencies will undermine the ability of banks to provide strong financial intermediary services to the economy. Sanctions on Russian banks are causing some global companies to become averse to transacting with Russian companies for fear of running afoul of complex sanctions implemented by multiple regimes. Although there have been no direct restrictions on trade in oil, it is reported that refineries, banks, and shipping companies are shunning the Russian oil market, possibly to avoid the legal and reputational risk associated with doing business in Russia.12 Rising costs of insuring shipping have also contributed to higher costs of doing business in Russia. Some major shipping companies have halted shipments to and from Russia. Other companies are either divesting their Russian operations or ending trade with Russia irrespective of the sanctions implemented.13 If many global companies avert Russian trade, this could lead to shortages of consumer goods as well as key inputs used in Russian production. Most importantly, reductions in exports of Russian commodities will likely lead to even higher global commodity prices, thereby affecting the global economy.
Meanwhile, it is likely that Russia will be affected by recent events in two important ways. First, the sharp decline in the value of the ruble (figure 3) and, second, a potential shortage of imported goods will likely cause a substantial acceleration in Russian inflation. Moreover, a weaker currency, by raising prices of imported goods, will lessen the real purchasing power of Russian consumers. That, in turn, will likely lead to a sharp decline in real GDP.
In addition, if the war and/or occupation of Ukraine continues for a prolonged period, the direct cost to the Russian government could be substantial. Given that the secondary market for Russian government debt has been sanctioned, Russia’s borrowing costs have risen sharply. Although Russia starts from a strong fiscal position with relatively modest debt, future expenditures might be difficult to finance under new financial conditions, thereby placing stress on the economy and the financial system.
There are two principal channels by which the current crisis is likely to affect the global economy—changes in commodity prices and disruption of supply chains for commodities. In the week following the start of the war, the global prices of oil and natural gas rose sharply, especially gas in Europe. In addition, the prices of key mineral and food commodities increased, including nickel, palladium, neon, wheat, and corn (figure 4). To some extent, these increases reflected fear and risk rather than actual sanctioning or disruption of trade. Investors likely worry that there could be new events that would disrupt trade in commodities, including European reductions in purchases of Russian oil and/or gas, or possibly a Russian decision to limit or curtail exports of key commodities.
Higher global commodity prices, if sustained or exacerbated, will likely cause accelerated and prolonged high inflation in many countries, especially in Europe. Higher commodity prices can also weaken economic growth. Prior to the invasion, some of the world’s leading central banks were already on a course toward tighter monetary policy,14 a reaction to the sharp increase in inflation in many countries. While the war could exacerbate inflation, it could also weaken growth. Thus, central banks will have to choose which of the two scenarios is more important. Futures markets indicate that many investors expect a continued tightening of monetary policy but at a slightly slower pace.15 Based on those interest rates, investors evidently think that the crisis will have a negative impact on economic growth in the West, thereby implying less inflationary pressure. On the other hand, higher energy prices and more disruption to supply chains would imply higher inflation. Thus, for central banks, it will be a challenging balancing act.
Meanwhile, immediately following the imposition of severe sanctions, bond yields in the United States, the United Kingdom, Germany, Japan, and other countries fell sharply due to a flight to safety (figure 5). Yet interestingly, the inflation-expectations component of bond yields increased, as evidenced by higher breakeven rates (which are an excellent measure of bond investor expectations of long-term inflation).16 This reflects investor fear that recent and potential events could lead to an acceleration in inflation. This fact will likely influence the decisions made by central banks.
Another important risk to the global economy comes from how the crisis will affect supply chains for key commodities. So far, several events have taken place that raise the possibility of supply chain disruption. Major container shippers, including the world’s two largest, concerned about running afoul of sanctions imposed by Western governments, are halting all cargo bookings to and from Russia, with shipments of food and medicine exempted.17 This comes in addition to a UK decision to ban all Russian ships from British ports. Meanwhile, European and Russian aircraft are banned from each other’s air space.18 The result is that planes traveling between Europe and Asia must take longer and more expensive routes. Not only is this disruptive to passenger travel, it also increases the cost and reduces the efficiency of transporting high-value merchandise. Plus, Russian cargo aircraft will be disrupted, reducing global capacity. Notably, about 14% of sailors on freight ships19 are either Russian or Ukrainian, potentially creating a labor problem for the shipping industry should those workers need to be replaced.
The cost of insuring freight shipping has increased sharply. In addition, the prices of industrial metals, such as aluminum, as well as food have increased on fears of potential shortages or disruption. The cost of transporting oil tankers has increased on fears that Russian and Ukrainian pipelines might be disrupted, thereby increasing demand for Middle-Eastern and West African oil.
One way to measure disruption, or at least the threat of disruption, is to look at the behavior of the prices of traded goods. As of this writing, there has been a sizable increase not only in the prices of oil and gas, but also wheat, corn, coal, steel, aluminum, and palladium to name a few. The disruption of Russian-Ukrainian supply chains, or the risk of such disruption, comes at the same time that global supply chains are already under stress because of the past year’s surge in demand for goods combined with pandemic-induced constraints on production and transportation.
The Russia-Ukraine conflict comes amid already tight global natural gas markets. A number of supply and demand factors have been in play in recent months: supply disruptions, increased demand from pro-gas policies in Asia, and a historically severe drought in Brazil.20 Even with increased liquid natural gas (LNG) export capacity from the United States this winter and relatively mild weather, European natural gas storage levels are still at five-year lows.21 Russia supplies about 40% of Europe’s gas demand via pipeline and LNG. A temporary or partial disruption in natural gas deliveries from Russia to Europe (about 10% of Europe’s natural gas demand transits Ukraine) could potentially be managed through increased LNG imports or increased domestic production. However, a longer-term disruption or complete cut-off, while highly unlikely, would have more serious consequences. Additionally, prior to the conflict, Europe expected that the Nord Stream 2 pipeline would carry additional volumes from Russia into Europe to help refill storage this summer. However, Germany has halted the pipeline’s certification indefinitely.
The escalation in the Russia-Ukraine conflict has also driven Brent and WTI crude oil prices to their highest levels since 2014 (figure 6). Oil prices were already higher than usual as demand returns post-omicron, but US producers have followed an unusually slow production increase in response to higher prices. In 2021, oil prices increased by over 75% while O&G capex increased by only 17%. Significantly, oil prices and investment decisions of O&G companies have somewhat decoupled as O&G companies have prioritized capital discipline. Adding to the tightness globally, OPEC output has fallen short of targets, with Angola and Nigeria suffering from outages.22
Russia only accounts for 4.8% of EU trade,23 which is down from 9.3% in 2012, and 2.3% of German trade. Ukraine only accounts for 1% of EU trade. Russia’s annexation of Crimea in 2014 accelerated a long-term reduction in Russia’s importance as a trading partner for Europe.24 However, EU trade with Russia is strongly concentrated in energy. Russia accounts for 40% of EU gas imports, 25% of oil imports, and 47% of imported solid fuels.25 If there were to be a complete shutdown of Russian gas, there would likely be bottlenecks in several European countries, including Germany, stemming from difficulties in distributing alternative sources of energy.
With the help of its well-developed gas infrastructure, Europe will initially be protected from supply shortfalls. How long it can avoid serious disruption depends on available LNG imports, storage levels, and the development of alternative sources. Any shortfall of supply would lead to higher prices and, consequently, higher inflation in Europe. Moreover, prolonged disruption of supply could have a negative impact on growth. Plus, uncertainty could weigh on consumer and business sentiment in Europe. Private households, meanwhile, have built up significant excess savings during the pandemic,26 thereby providing a buffer against declining economic activity.
Trade between the United States and Russia or Ukraine is relatively insignificant compared to the size of either economy. The principal channel through which this crisis might affect the United States is the impact on the price of oil and the prices of some key commodities. In addition, if the crisis has a significant negative impact on the European economy, that could spill over into the United States because of the extensive trade between the United States and Europe. Moreover, Russia and Ukraine are major producers of commodities that are important in the production of semiconductors and batteries. If Russian and/or Ukrainian exports of these commodities were to be curtailed, the global price would rise and shortages could ensue, thereby hurting some US industries, adding to inflation, and reducing potential output.
Trade between Asia and Russia is modest, with Russia providing some oil and gas to China and Russia importing electronic and information technology products. This trade is not likely to be severely disrupted, but it could be affected by the need for trading companies to stay clear of sanctions. Plus, as a net importer of energy, Asia is vulnerable to sharp rises in the prices of energy and other commodities.
Uncertainty about how the war will transpire, whether more sanctions will be imposed, and how Russia might respond to existing or potential sanctions will play a role in determining the economic impact of the war. Uncertainty elevates commodity prices and risk premia. It also increases the cost of doing business and likely delays important business investment decisions. In the days, weeks, and months to come, the direction of commodity prices and the prices of financial assets will evolve in ways that, hopefully, will enable businesses to make informed decision.
Beyond the economic impact of this war, it appears likely that the geopolitical framework of Western Europe is rapidly evolving. There could be a sizable increase in government spending on defense, raising questions about taxes and spending priorities. In addition, the fact that energy is at the root of the potential economic impact suggests that a larger debate about energy policy is likely to ensue. This could mean investments in diversifying sources of carbon-based fuels, as well as intensifying investments in clean energy. Finally, as of this writing, we are witnessing a disruption of supply chains for some commodities and increased stress in global financial markets. The war raises questions about the continuation of globalization and about the ability of any country to act against the wishes of the international community with impunity. These are issues that will be vigorously debated in the months and years to come.
Still, one cannot help but feel that we have entered a new era. Analysts have offered numerous historical analogies, many of which involve heightened tension and weakened global trade and cross-border investment patterns.27
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