The economic shock for Europe
The negative impact of the Russian attack on the Russian and Eurozone economies greatly depends on the future stages of the conflict and the resulting actions of the West. We have thus sketched out three war scenarios, which lead to very different economic results. Obviously, the uncertainty around future developments is exceptionally high and we are hesitant to give exact probabilities to each scenario, but note that based on the latest news, the probability of the most pessimistic scenarios has increased.
Significant damage to the Russian economy is inevitable. This is due to the direct hit through the financial system due to the sanctions and the high level of uncertainty that we expect to continue and which will significantly harm investments in domestic and foreign fixed assets, even in an optimistic scenario, where Ukraine and the Russia reach a quick agreement. Even a total collapse of the Russian economy cannot be ruled out.
We expect the negative impact on the Eurozone as a whole to remain limited as long as energy imports from Russia are allowed and fears of an escalation beyond Ukraine remain limited. Ending these would likely cause great uncertainty and lead to a recession in the Eurozone.
The ECB is likely ready for the near-term spike in energy price inflation, but worries about upside inflation risks were real before the Russian attack and central bankers are more likely to delay their policy tightening plans, if necessary, rather than abandon them altogether.
Unfortunately, we cannot rule out the possibility of an even worse outcome than presented in these scenarios.
The uncertainty around the economic impact is enormous
Scenario 1: The current situation will last
In this scenario, we assume that Russia continues to attack Ukraine but the intensity of the war decreases, casualties remain limited, and it looks more like a frozen conflict. The sanctions decided so far will continue to apply but will not have a significant impact on Russian energy exports to Europe.
Risk premiums in the energy market will be there for longer, but as Russian energy exports continue, there will be no more price spikes. Prices will remain around the current high levels throughout the spring and summer, then only gradually recede thereafter.
Russian economy Already suffering a lot from sanctions and we expect uncertainty to continue to prevail, especially around the financial sector and payment systems. The high inflation resulting, for example, from the weakness of the RUB will reduce purchasing power and significantly affect consumption. Fixed investments will be affected by high financial costs, the prevailing uncertainty and the lack of foreign partners. Thus, the Russian economy enters a recession, but does not collapse, as the energy and raw materials sectors continue to provide stability.
Eurozone economy is directly affected by a dramatic drop in exports to Russia. But given their small role (the added value created by exports to Russia represents less than 1% of euro zone GDP), the impact on the economy is limited. High uncertainty and high energy prices should slightly weaken investment growth in the coming months, but in the longer term, European countries should push for an increase in self-sufficiency in the energy sector , which will increase investment and compensate for weak investment in other sectors. Thus, in this scenario, the impact on euro zone GDP is negative but limited.
Eurozone inflation will jump in the short term due to high energy prices. High headline inflation should lead to slightly higher second-round effects, but these are mostly offset by slightly weaker labor markets. This implies that in the medium term, the deviation from our baseline forecast is marginal.
The ECB will need more data to assess the impact of the war on the European economy, but knowing that inflation will rise further in the short term and worrying about the resumption of underlying inflationary pressures seen before the recent escalation in geopolitical risks, it wishes to have more flexibility to act, if necessary. It will decide to accelerate the reduction of its net asset purchases, seeking to end them during the third quarter, but undertakes to continue them for longer or in greater proportions, if necessary to avoid an unwarranted tightening of financing conditions. The central bank will also sever the tie in its forecast which indicates that it will start raising rates soon after net asset purchases end. The first rate hike will be pushed back to early 2023.
Eurozone financing conditions have not tightened since the Russian invasion
Scenario 2: Escalation and restrictions on energy imports
In this scenario, we expect more civilian casualties to take place and the US and EU to respond by adding more sanctions, including severe limits on energy imports from Russia.
Sanctions against Russian energy exports will lead in the short term to a collapse in global energy supply, causing prices to rise sharply (crude oil at around USD 150 per barrel). Even at best, it takes time for Europe to find other sources of supply and for Russia to find other buyers for its energy exports. While the highest energy prices will already be observed in the spring and prices will decline thereafter, they will remain higher than in the other scenarios throughout the forecast horizon.
Russian economy would suffer greatly in this scenario, as in addition to the negative effect seen in Scenario 1, challenges in the financial sector would prove even more devastating and the export sector would see a massive decline. Russia could continue to export energy and raw materials to China and India, for example, but these could not offset Western markets. As a result, the public sector balance would also deteriorate rapidly, limiting the capacity for fiscal easing.
Eurozone economy would be primarily affected by rising energy prices and the resulting uncertainty. Household and business confidence would suffer much more than in scenario 1, penalizing both consumption and investment. The euro zone would find itself in a short recession even if the public sector relieved the pain by increasing compensation for higher energy prices.
Eurozone inflation would increase in the short term due to rising energy prices, but broader price pressures would weaken and the outlook for inflation over the medium term would be weak. The second-round effect of higher energy prices would not materialize due to higher unemployment.
Government support measures to cushion the shock of rising energy prices will lead to higher government deficits and more government bond issuance, which in turn will increase the need for ECB bond purchases. The ECB will buy bonds in size throughout 2022, but will end them in the first half of 2023 as the Governing Council has become more reluctant to continue buying for long periods. Rate increases will not yet be seen in 2023.
Russia could only partially offset the drop in energy exports to the EU by boosting trade with, for example, China and India
Scenario 3: RUS-UKR deal in the next few days
Although it is not necessarily Putin who signs such a contract with Ukraine, such a deal would at least end the heaviest sanctions and bring Russia back into the global economy.
The current risk premia on energy price will pull back and prices will fall from current levels a little faster than current futures prices would suggest.
Russian economy would suffer even then due to the high level of economic uncertainty that would continue to prevail and limit the recovery of investment in fixed assets, both domestic and foreign. However, the stability of public finances would be guaranteed and GDP losses would be limited. The RUB would recover from current levels, but inflation would remain high, allowing the central bank to lower interest rates from current levels, but not to levels seen before the crisis.
Eurozone economy would only be marginally affected in the short term due to reduced business with Russia. In the medium term, increased investments aimed at achieving greater self-sufficiency in the energy sector and a stronger defense capability would contribute positively to growth but would also lead to an increase in public deficits and debt.
Eurozone inflation would remain at elevated levels due to base energy effects for a few more months, but then return to near our base forecast.
The ECB considers the wider economic impact of the war to be short-lived and modest, and maintains its plans for policy normalization amid gradually rising underlying inflationary pressures. Net bond purchases will end in the third quarter and rate hikes will begin in the second half of this year. The ECB deposit rate will move into positive territory in 2023.