Russia has officially flown the war flag with Ukraine. Putin's government
has recognized two self-proclaimed separatist republics in Eastern Ukraine
and ordered a full-scale invasion of Ukraine.
The Russo-Ukrainian war will further hit the global economy, which is
currently still struggling to recover from the effects of the Covid-19
pandemic. Global Insight has developed four scenarios as a follow-up impact
of this conflict.
The scenario was compiled by four Global Insight economists namely Scott
Johnson, Jamie Rush, Anna Wong, and Tom Orlik. The scenario is structured by
looking at a limited Russian attack that triggers further targeted sanctions
to a full-blown invasion with comprehensive sanctions and disrupts gas
supplies to Europe.
"We are not international relations experts, but our reading of the latest
information suggests a less extreme scenario as conflict is limited in the
Donbas region and is likely to hit Europe's energy supply," Global Insight
wrote in its research.
For Russia, the war is considered to have the potential to trigger a
recession. While the impact for Europe and the US, higher energy price hikes
could further encourage inflation at an undesirable time although it would
not be catastrophic.
1. The first scenario, Russia's presence in the conflict zone is
getting bigger
The US says the invasion of Ukraine has begun but Russia is sending mixed
signals about its intentions in Ukraine. If Russian troops enter the
conflict zone currently confined to Donetsk and Luhansk which are already
under separatist control, then further sanctions will be limited although
the risk of escalation remains.
The sanctions announced so far will only put light pressure on the Russian
economy. The gas will continue to flow. With oil revenues high, the Ministry
of Finance can ignore sanctions on public debt for now.
In this scenario, the chances of Russia retaliating against European
sanctions will be limited. Gas prices will stabilize around current levels
and be consistent with inflation approaching target later this year, so
pressure on consumers will not trigger a recession and there will be no
pressure on the European Central Bank to advance or delay its monetary
policy tightening schedule.
Meanwhile the impact on the US economy will be limited because its territory
is far from Ukraine. As in Europe, energy prices in the US are expected to
stabilize in line with their inflation target.
2. The second scenario, the attack on Eastern Ukraine begins
Separatists claim wider territory and Putin has deep grievances about
Ukraine's sovereignty. Russia could push further into the eastern Donbas
region, where it could clash with Ukrainian forces. If this happens, Russia
will face more severe sanctions.
Major restrictions on the financial sector would destabilize Russian
markets, forcing the central bank to step in to restore stability. The ruble
will fall and trigger a spike in inflation, forcing further rate hikes on
top of an already aggressive tightening cycle.
Trade sanctions from globally could prolong the pain and increase the risk
of a recession in Russia. Persistent sanctions, high interest rates and a
chaotic supply chain will limit Russia's economic prospects.
While the impact on Europe, gas prices will be higher. If there is a price
spike to 120 euros per megawatt per hour for example, from the current level
of 90 euros, it will lead to 2.6% inflation by the end of the year.
Recession in Russia and some additional supply disruptions due to sanctions
will add to the negative impact on Eastern Europe.
The impact on the US is also the same, namely energy prices will be higher.
As a clean energy exporter, the US could ship more natural gas to Europe,
increasing demand for American consumers.
With the current price spike, the headline CPI could exceed 8% YoY in
February, and end 2022 close to 5%, higher than the current consensus
projection of 3.3%.
3. The third scenario, there is a big invasion
If Russia's limited offensive is countered by Ukraine with resistance then
Putin is likely to respond with great force and go deeper into Ukraine. The
US and Europe could respond with maximum sanctions, including restrictions
on banks' ability to do business with Western countries and stricter trade
bans.
The impact on Russia, asset flight may be more intense, the ruble will fall
further, inflation will rise high and trade disruptions will be greater.
A large amount of gas destined for Europe from Russia flows through Ukraine.
With currents diverted and reserves drawn, Europe will be able to stay on if
the disruption is only temporary.
Even so, the increase in energy prices will have a significant impact. As
prices rise to 180 euros per megawatt-hour it could keep euro area inflation
above 3% by year-end, intensifying real income pressures. Along with
worsening sentiment, a mild recession is likely. Placing more weight on
growth risks than a temporary rise in energy prices, the ECB could delay its
first rate hike in 2023.
For the US, the combined impact of high inflation due to rising energy
prices and weaker growth due to tighter financial conditions and the
negative impact of Europe in a recession will put the Fed in conflict.
In a scenario where oil prices spike further to US$ 120 per barrel, the
headline CPI could touch 9% in March and be around 6% by year-end. Tighter
financial conditions and weaker exports to recession-hit Europe will also
weigh on US economic growth.
"Assuming this scenario holds true, we expect the Fed to focus on risks to
growth. That won't affect plans for a rate hike in March, but could lead to
slower rate hikes in the second half of the year," the economist continued.
Global Insights.
4. Fourth scenario, Russia closes gas lines to Europe
In a full-scale invasion, facing maximum sanctions from the US and Europe,
Russia might be able to retaliate by shutting down gas flows to Europe.
For Russia, a hit to export earnings would add to the surprise of falling
asset prices, a weaker ruble and higher inflation. The recession will likely
be deeper and recovery will be slower than if the energy continued to flow.
Describing a low probability, a complete shutdown of Russian supplies is not
one of the 19 scenarios considered in the European energy security
simulation.
The impact for the US will be much more severe if this scenario occurs. The
Fed will be increasingly confused between concerns about a spike in energy
prices pushing inflation even higher, and worries about downside risks to
growth.
"As in the severe case scenario, we expect Fed Chair Jerome Powell and team
to pay more attention to risks to growth. The nightmare for monetary policy
is if inflation expectations get out of hand, which will necessitate
aggressive tightening," wrote Global Insight.
