Friday, September 16, 2022

Ukraine escalation spells gloom for world economy

 The escalation in sanctions against Russia, including a price cap on oil and a possible cap on gas prices, means more trouble for the world economy and especially for the economies of Europe. On top of that, Ukraine has launched counter-offensives against Russia in the north and the south. The Russians cannot be expected to take that lying down.

So, the outlook for the world has worsened in recent days. But it doesn't look as though the world's leading stock markets have noticed. Do they know something that the world's leading agencies, including IMF and World Bank, have missed.

My article in BS today, Global outlook grows murkier after Russian setback


Global economic outlook grows murkier after Russian setback

As Ukraine escalation raises the risk to global economy, it is time to hunker down for the rough ride ahead

“We are at war”, says French President Emmanuel Macron.” German Chancellor Olaf Scholz sounds only a little less sombre. “We live in serious times… but we are prepared”. After more than six months of relatively low-intensity warfare in Ukraine, there is the prospect now of a substantial escalation on both the economic and military fronts. That bodes ill for the world economy. India’s policymakers need to brace for a rougher ride than thought until recently.

Russia has shut down the Nord Stream 1 gas pipeline that supplies gas to Europe. Last year, the pipeline provided an estimated 35 per cent of Europe’s gas imports from Russia. Russia says that Western sanctions against it make it difficult to ensure effective maintenance of the pipeline. Nord Stream 2, which was due to start supplying gas to Europe in early 2022, faces sanctions from the US and the EU, which make it a punishable offense to utilise the system.  

Russia’s decision to shut down the Nord Stream 1 pipeline came soon after the G-7 countries agreed to impose a cap on Russian oil prices. The G-7 intends to apply the cap to all countries purchasing oil from Russia. How to enforce a price cap in the case of non G-7 economies? The idea is to deny insurance and finance to oil cargoes that are priced at above the price cap that the G-7 will impose.   

. The EU is contemplating a cap on the price of gas imported from Russia as well. The West contends that it has little alternative given the steep rise in gas prices. Speaking at the East European Economic Forum earlier this month, Mr Putin explained that the West had only itself to blame for the spiralling price of gas. 

Mr Putin said that Russia had long tried to persuade the EU and other buyers to enter into long-term contracts for gas— at one point, Russia was negotiating the supply of gas at $100 per 1000 cubic metres. After the Ukraine conflict erupted, Ukraine chose to shut down one of the two gas pipelines passing through it. Poland sanctioned the pipeline passing through Poland. For these and other reasons, gas prices have climbed to $3,000 per 1000 cubic metres. 

The EU now thinks price caps on Russian gas are the answer. Mr Putin has warned that price caps would amount to violation of contractual obligations and Russia would not hesitate to cut off all energy supplies — gas, oil, coal and fuel oil — if that happened.  

As though the escalation in the economic war was not bad enough, there has been a change in the military situation on the ground. Until a few days ago, the general sense was that the war of attrition of the past several months would continue. The Ukrainian counter-offensive in the Kharkiv region in the north and in the south has changed perceptions. Ukrainian claims about territory regained need to be taken with the proverbial pinch of salt —the government in Kyiv is known to make exaggerated claims in order to sustain the flow of arms from the West.

Nevertheless, it is clear that Russian forces have been dealt a blow in the north. This has triggered nationalist outrage in Russia and scathing comment from sections of the Russian media. Russia has responded by pounding the eastern region of Ukraine with missiles, causing power blackouts in several parts.  

Russia has thus far contented itself with launching what it calls a “special military operation”, intended mainly to protect lives in the two provinces in eastern Ukraine that have declared independence. But increased Western military support to Ukraine and setbacks on the ground for Russia have prompted calls for a radical change in  Russia’s approach. Mr Putin is under pressure to deliver a knock-out blow by bringing the full might of Russia to bear on Ukraine. Prospects of a negotiated peace have seem very distant now.

These developments render the global economic outlook murkier. The International Monetary Fund (IMF) had projected global economic growth of 3.2 per cent for 2022, down from 6.1 per cent last year, and at 2.9 per cent in 2023. That was the baseline scenario. 

The IMF had also looked at an alternative scenario in which Russian oil exports fall by 30 per cent relative to baseline, Russian gas exports fall to zero and inflation expectations become more elevated. Global growth in that scenario drops to 2.6 per cent in 2022 and 2 per cent in 2023.  The EU would bear the brunt of the shock with growth in the EU being near zero.

That scenario, which would place global growth in the bottom 10 per cent of outcomes since 1970, does not appear far-fetched now.  The changed outlook will increase uncertainty over the conduct of monetary policy in advanced economies —to hike or not to hike policy rates will be a difficult call (except, perhaps, in the US).

How does India respond to increased uncertainty about  global growth prospects? First, it is unrealistic to expect exports to be a key driver of growth in today’s troubled environment. The decision to walk on two legs — to push exports where possible and also promote indigenous production through modest protection and subsidies — is an experiment worth persisting with.

Secondly, it is not advisable to allow the exchange rate to depreciate too steeply and bear the full impact of the shock in the hope of benefiting from a rise in exports. In a crisis such as the present one, the dollar is the default option for investors. Net foreign institutional investor (FII) flows have turned positive in July and August. Too steep a depreciation in the rupee with respect to the dollar could lead to a swift reversal of this trend. The Reserve Bank of India must continue with careful management of rupee depreciation. 

Thirdly, embarking on “big bang reforms” at this point, as many urge, would be unwise. We do not need political turmoil in the country to add to the grim global outlook. We need instead to hunker down for the rough ride ahead.