In addition to a critical humanitarian crisis, Russia’s continued invasion of Ukraine has caused an economic shock, with many repercussions now and in the future. From IESE’s Economics Department, Nuria Mas and Javier Diaz Gimenez offered their analyzes of the fallout from the war.
“Permanent” inflation sets in
Food and energy prices are important components of inflation. For Europe, Russia and Ukraine are the main suppliers. That prices are rising is clear. “The question was: is the inflation we are currently experiencing temporary or permanent?” said Javier Diaz Gimenez. “Well, now we know.” It will be more “permanent”, that is, it will have a lasting impact. Nuria Mas agreed that the war completely changed the economic outlook. Instead of inflation that was meant to be temporary – and coupled with impressive growth – we have a different scenario to deal with, but it also highlighted the possibility that stagflation could end up being deflationary in the medium term.
As inflation sets in, “we will be poorer,” warned Diaz Gimenez. Businesses should plan for this possibility.
A supply shock is hard to fix
“In economics, to put it simply, we tend to think of two types of shocks: demand shocks and supply shocks,” Mas explained. Of the two, demand shocks are easier to manage with the policy tools at hand, as governments can spend more to stimulate demand. What is happening now, however, is clearly a supply shock, as high commodity prices are hitting producers very hard. In this situation, there will probably be less growth but higher prices. So what should policy makers do? To stimulate the economy, governments may not want to risk pushing prices even higher.
To examine the current shock, Mas recommends taking a closer look at four transmission channels: commodity prices, international trade, supply chain and confidence. Looking at these four channels for the United States, Germany, France, Italy and Spain, “all have clearly been negatively impacted,” she said. And Germany and Italy are the most exposed. The supply shock is clear. How long that might last is another question.
Although we don’t know what will happen next, suggesting possible scenarios helps with business planning. Here are four possibilities:
1. A long and interminable war would have a lasting impact on food and energy prices, meaning that inflation rates could remain high. This is the scenario that seems most likely, with Ukraine’s fierce resistance to the occupation.
2. A diplomatic agreement is the best-case scenario, with a limited impact on the economy. But would peace come in time to plant crops and ease other price pressures? Spring is here and it’s time to plant.
3. an escalation, with the entry of NATO, is a frightening possibility. But we have to think about it to prepare ourselves, the two professors said.
4. A de-escalation, with the sanctions and human costs of war weakening Putin over time, will likely be faster than Option 1, but still slower than Option 2. Russia’s GDP is expected to fall 11% this year . Yet Putin seems determined to stay the course.
In any case, “we have learned that Europe is vulnerable with its energy dependence”, declared Diaz Gimenez. “Europe must become energy self-sufficient.” With Russian gas accounting for 40% of Europe’s gas imports, this point becomes clear. Digging into the details, it’s not easy to find replacements, Mas explained. “Maybe the UK and Norway could provide a bit more,” but not enough, she said.
As with the COVID crisis, Europe’s response so far is unified and promising. The financial sanctions against Russia are a clear example of this. The time seems ripe to finally propose a unified energy plan. Already, the European Commission has proposed the outline of a plan to reduce Europe’s dependence on Russian gas by 60% by December 2022, while boosting renewable energies at the same time.
Global GDP Outlook: More Volatility Ahead
“2022 was supposed to be an amazing year,” Mas explained. As the COVID crisis waned last year, the International Monetary Fund (IMF) predicted robust global growth of 4.9% for the year ahead. In January 2022, with the Omicron wave, the IMF’s 2022 estimate was reduced to 4.4% growth. And very soon, in mid-April, we will hear the latest forecasts from the IMF. “Everyone is now guessing less than 4.4%,” said Javier Diaz Gimenez. “The great mystery is how much less? Will it be 3.9%, 3.4%, 3%?
In short, “while the world is still recovering from a pandemic, Russia’s invasion of Ukraine is a brutal shock that impacts the entire global economy“, according to Diaz Gimenez. “The Bank of England and the US Federal Reserve have already raised rates and of course that has an impact on the whole global economy,” he said. “Volatility and uncertainty will be massive,” Mas agreed.