There are clear signs off growth in many corners of the world but the risk of conflict is both real and perhaps not fully discounted by markets. Keith Wade, Schroders highly respected Chief Economist, shares his views on the world economy and examines possible outcomes from the current standoff with Russia.
Signs that the weather is turning bring increased optimism that the world economy will rebound in the spring. This is certainly the case in the US where readings on retail sales, employment and industrial production indicate that the economy is shrugging off the impact of a harsh winter. Our growth indicators for Europe and Japan also remain positive, however the emerging economies led by China continue to struggle to gain traction. However, whilst growth is tracking our baseline view, on the policy front there is a sense that central banks are becoming less supportive.
Although the Federal Reserve continued to taper as expected in March, markets were surprised at forecasts which indicated tighter than expected policy by end 2015. Concerns were also increased by new Federal Reserve (Fed) chair Janet Yellen’s press conference where she implied rates could be raised in the second quarter of 2015 having said that 6 months could be the lag between the end of tapering (likely to be October) and the first rate rise. She went on to emphasise that rates were likely to remain in their current range until the economy was closer to full employment and inflation significantly higher than today. Nonetheless, the impression is that this was a hawkish Federal Open Market Committee (FOMC) with the Fed preparing the markets for a normalisation of policy.
Elsewhere, the Bank of Japan seems content with current policy settings and relatively relaxed about the economy’s ability to withstand the increase in consumption tax. In the Eurozone, markets were disappointed with the lack of action from the European Central Bank (ECB) in the face of sub 1% CPI inflation. Only the Bank of England appears to be talking of looser policy than markets are currently expecting by playing down the prospect of rate rises.
Economic recovery would always mean that central banks would have to withdraw support, however markets seem concerned at the speed with which this is occurring. Concerns are particularly acute in the Eurozone where there are fears that the ECB is heading for a major policy error. As our analysis highlights, the risk of deflation is increasing, bringing comparisons with Japan in the 1990’s.
The Eurozone is recovering and deflationary pressures should ebb and in the near term low inflation is helping the recovery by boosting real income. However one of the lessons of Japan’s experience was that policy should focus more on the tail risks when deflation is a threat. This would suggest that the ECB should be easing more. Alongside the situation in the Ukraine, which has the potential to derail the upturn (see below), we would see recent developments as moving the ECB nearer to quantitative easing.
The Russia- Ukraine crisis: the threat to activity
Tensions between Russia and the West have increased significantly following the annexation of Crimea from the Ukraine. At the time of writing, the US and EU have agreed to impose sanctions in the form of travel bans and asset freezes on key Russian officials. These are modest (to say the least), but the message is that they will be ramped up should the situation deteriorate. If so then the outcome would be damaging for both Russia and the West with the former at risk of losing foreign investment and trade, whilst Europe is primarily exposed through its dependence on Russian energy supplies.
At this stage, investors in European equities seem unfazed with the DJ Eurostoxx holding firm, but the ruble (RUB) has weakened substantially, continuing a trend which has been in place since the beginning of the year.
For Europe, the situation in the Ukraine, and the response from the West to Russia’s actions could have serious economic consequences. Russia is currently the top crude producing nation in the world and the second largest gas producer. In the event of trade sanctions that extend to trade in energy, Europe would face a significant shortage in the supply of oil and natural gas.
Russia supplies 29% of total European natural gas needs which amounts to about 7% of the region’s total energy consumption. Unsurprisingly, the Ukraine, Hungary and Turkey are particularly exposed. However, the most exposed major European economy is power-house Germany which receives about 40% of its gas from Russia. According to the IEA, Europe receives 36% of its total net crude oil imports from Russia and about 69% of all gasoil product imports. Neither energy source would be easily replaced. In the event of a disruption to Russian supplies we would still expect a significant rise in energy prices in Europe.
Long term this might be addressed through alternative sources such as shale and, or exports from the US, but in the near term Europe and the rest of the world economy face the prospect of a stagflationary shock.
The pressure on crude oil prices would also be significant if there was a disruption to Russian oil supply. There is virtually no spare capacity in the oil market at present and inventories are hovering around 10 year-lows outside the US with Saudi producing at around 96% of peak capacity. Furthermore, we are heading into peak demand season in the Northern Hemisphere, the so-called driving season, together with peak air-conditioning season in the Middle East. Europe and the US have strategic reserves, but any major supply disruption from the Russian side could be very damaging in terms of higher oil prices. On the natural gas side, Norway has spare capacity so could help counter a loss of Russian supply, for the right price. Storage levels are also fairly plentiful given such a mild winter. But according to our energy team any major disruption would definitely see prices adjust higher from current spot levels of around 60p/ therm in the UK closer to 90p/ therm in order to attract LNG cargoes. In a world of relatively low US natural gas prices, the competitive impact of even higher energy supply costs on Europe should not be under-estimated. Efforts by the UK chancellor to reduce energy costs for UK manufacturers and improve competitiveness in the recent budget would be blown away by this.
Beyond trade in energy, Russia is not a major trading partner with Europe. Russia has far more to lose, and actually runs a small trade deficit with Germany.
Financial sanctions could be problematic for some European banking system. According to BIS figures, European lenders account for nearly three quarters of global exposure to Russia with France having the highest at $54bn. The second most exposed European country is Italy at $30bn. In the scheme of things these figures are not that significant for the European banking system, amounting to around 0.5% of total assets and so should not pose a systemic threat. However, this does not take account of potential second round effects from weaker activity, and the exposure of individual countries, such as Austria which has 1.3% of bank assets (possibly more) exposed to Russia.
From crisis to conflict?
In thinking about how the situation will evolve we would consider three scenarios:
The first would be that Russia stops with the Crimea and does not intervene further in the Ukraine;
The second, would be one of continued unrest in the south and east of Ukraine such that there are persistent fears that Russia will intervene to protect the pro-Russian population (i.e. a stand-off)
Third, that those fears are realised in the form of an invasion by Russian forces and war with Ukraine.
In terms of impact, the first scenario is clearly the most benign as it allows energy exports from Russia to continue uninterrupted as sanctions are unlikely to be significantly extended, despite western discomfort over Crimea. There would probably be scope for the political risk premium on Russian assets to decline, supporting equities and the RUB.
The second “stand-off” scenario would be more damaging as persistent uncertainty would hit business and consumer confidence in Europe. Decisions to invest in Eastern Europe and even core Eurozone countries in close proximity, such as Germany and Finland, may be put on hold. Energy prices in Europe for gas are likely to edge higher on fears of supply disruption as discussed above, acting as a drag on activity – a stagflationary shock. The nascent Eurozone recovery would be threatened and the ECB are likely to loosen and, or keep policy looser for longer in such a scenario. Meanwhile, the risk premium on Russian assets would remain, and possibly increase as western investment in Russia stalls.
The conflict scenario would see a major impact with Russia likely to cut gas and energy supplies to Europe as a trade war breaks out alongside the fighting. Even if NATO forces remain on the side-lines, there is likely to be significant disruption to energy supplies as pipelines through Ukraine are damaged and we enter a new Cold War. Expect greater damage to household and business confidence, on both sides, which is likely to send the region into recession. Eastern Europe would be hit hardest with regards to an economic downturn, given the region’s ties with Russia, and the close proximity of fighting. The ECB are likely to respond with emergency measures, which would include QE.
At this stage, it seems that Europe and Russia have too much to lose to allow the situation to escalate further and President Putin has said he does not wish to intervene further in the Ukraine. However, the annexation of Crimea has made him very popular at home and there will be pressure to go further to “protect” the pro-Russian population in east and southern Ukraine.
From this perspective the most probable outcome would be the stand-off scenario whereby Russia continues to threaten Ukraine and sanctions are gradually escalated. Ironically, business may already be doing the politicians work for them by withdrawing activity from Russia. There would need to be a major rapprochement to turn the situation around at this stage and prevent long term damage to the Russian economy.
Impact on Russia and the wider emerging markets
Looking more specifically at Russia, questions have been raised over her debt, and the possibility of a repeat of the 1998 crisis. For example, Standard & Poor’s have revised their outlook to negative. At 12% of GDP, total external debt issuance is similar to the levels seen in 1998, though the vulnerability now lies more in the private than public sector. Meanwhile, slowing growth – our forecast was 1.8% for this year, before recent events unfolded – and a weaker currency will increase debt service costs. However, if we look at short term financing requirements, using our preferred gross external financing requirement (GEFR) metric (short term debt – current account), it stands at a mere 0.4% of GDP and 1.5% of reserves, which is far more manageable. The fall in the currency will also have boosted RUB revenues from energy sales, helping Kremlin finances.
Concerns will be justified if Russia faces a prolonged political and economic isolation. The full extent of capital flight will not be revealed until the first quarter’s balance of payments data comes out in April, but an attempt at estimating the net outflows to date can be made by looking at central bank intervention in the foreign exchange markets and its current account position. Capital Economics estimates that, to date, $50bn, or 2.5% of GDP, has left Russia this year, and project that the first quarter will see $70bn of outflows in total. With foreign reserves of $444.1bn currently, the central bank seems in a resilient position for now. However, credit conditions will be tightening in the Russian economy and hurting already anaemic growth.
Within emerging markets, India and China could be quite exposed on the energy front. Commodity markets should, broadly speaking, see price increases. Ukraine’s role as a wheat exporter will push up agricultural prices, while uncertainty over oil and gas supply will push up the energy matrix. This could all be supportive in the short-term for some commodity exporters, particularly if they are energy-independent. However, we should not neglect the role of politics. It seems unlikely that China would join Western sanctions on Russia, and the end result could be that sanctions result in cheaper energy prices for Asia, as Russia pumps gas and oil previously destined for Europe towards less hostile nations at a significant discount.
Keith Wade is Schroders Chief Economist.
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