Ukraine crisis scenarios. The Ukraine crisis has most likely pushed the Russian economy into recession, while there are mild contagion effects to other countries in the region. In addition, investors have become more risk averse and we have seen a severe correction in several markets. Still, the effects on the broader global economy – so far – have remained modest. However, there are risks that the conflict may deepen further. Although the outlook of the conflict is very difficult to forecast, in this Macro Focus, we present four scenarios, a base and three stress scenarios, and their impact on the world economy.
Base case is relatively benign. While there might be no imminent solution to the crisis, in our base case, we think that leaders will ultimately recognise that an ongoing escalation is to nobody’s advantage. As a result, tensions should gradually ease in the course of the year. Although the Russian economy seems to have fallen into recession, and the EU has strong energy ties with Russia, direct trade links in general between Russia and the EU/US are relatively modest. In addition, while both the EU/US and Russia have imposed economic sanctions, these seem to only have a limited impact on economic activity. Moreover, sanctions that target Russia’s energy sector only focus on investments, and will not have an effect on Russia’s energy supply in the short-run. The impact of the world economy should therefore remain small.
Three risk scenarios. The impact on global demand is also moderate in the first alternative scenario, in which both sides step up their economic sanctions, though the conflict remains relatively contained. In the second alternative scenario, in which there is a military escalation, there will be more serious effects on the global economy, as investors turn more risk averse, and global consumer and business confidence is likely to be more seriously affected. In addition, the longer the conflict lasts, the more severe the economic effects will be. In the final – and least probable – alternative scenario, Russia’s energy exports would be affected. Of all four scenarios, this scenario will have the biggest impact on the world economy, as it would most likely involve sharply higher energy costs. Indeed, in the more extreme case, the world economy could experience a sharp slowdown, also taking negative confidence effects into account.
The Ukraine crisis has most likely pushed the Russian economy into recession, while there are mild contagion effects to other countries in the region. In addition, investors have become more risk averse and we have seen a severe correction in several markets. Still, the effects on the broader global economy so far seem to have remained modest. There are, however, risks that the conflict may deepen further. For instance, both the EU/US and Russia may step up their economic sanctions, or there could be a military escalation. In a more remote risk scenario, Russia stops its gas exports to Europe, or the EU no longer imports oil from Russia. Although the outlook of the conflict remains very difficult to assess, and developments remain highly in flux, in this Macro Focus, we will present four different scenarios, a base and three risk scenarios, and their impact on the global economy. We also present probabilities, but these should be seen as merely indicative and treated with more than a pinch of salt.
Base case: Tensions gradually ease
(Likelihood 50%; economic impact: small)
In our central scenario tensions between Russia, Ukraine and EU/US stop escalating and ease gradually in the course of the year. While there might be no imminent solution to the crisis, we think that leaders will ultimately recognise that an ongoing escalation is to nobody’s advantage. In terms of economic effects, the Russian economy – due to negative confidence effects and the outflows of capital – seems to have fallen into recession, while there are some contagion effects to other countries. That said, the direct trade links between Russia and the EU/US are relatively modest. In addition, although both the EU/US and Russia have imposed economic sanctions, these seem to only have a limited impact on economic activity, albeit that specific sectors and companies are hit hard. Moreover, sanctions that target Russia’s energy sector only focus on investments into Russia’s energy sector. While likely to affect Russia’s energy supply in the longer-run, these will not have an effect in the short-run. Finally, the starting point for the global economy is favourable, with global demand growth accelerating, the supply of oil and many other commodities plentiful, and financial conditions easy. The eurozone economy’s position is clearly worse than that of the US as the recovery is weaker and more vulnerable. In addition, Europe’s economic links with Russia are more significant than those of the US, making Europe more vulnerable to Russian sanctions.
Alternative scenario 1: Stepping up of sanctions and conflict drags on for longer
(Likelihood 30%; economic impact modest)
In the first alternative scenario, both sides step up their economic sanctions, while the conflict would drag on for longer. Although there would probably be more export restrictions to target investments into Russia’s energy sector, these are unlikely to affect Russia’s energy supply in the short-run. Moreover, while Russia’s recession would be deeper and contagion effects to neighbouring countries larger, the effects on the global economy would remain modest, for the reasons described above. In terms of risk/economic cost analysis, this scenario could probably thought of as a scenario with a relatively high probability but with a modest global economic impact, reflecting the factors discussed in the base case above.
Alternative scenario 2: Military escalation hits sentiment
(Likelihood 15% – 20%; economic impact: more serious, could be painful)
In this scenario, the conflict escalates, possibly because Russian forces enter the east of Ukraine. The most likely cause for such a course of events is that president Putin decides to ‘call the West’s bluff’. We consider this scenario less likely than the first alternative scenario, as it implies serious risks for the Russian leadership, but it can certainly not be dismissed as an option. Again, we think that this would not affect Russia’s energy supply, but there will be more serious effects on the global economy, as investors would turn more risk averse, and global consumer and business confidence is likely to be more seriously affected. Business confidence in Europe might be particularly hit, while second round effects due to the economic spill-over to other economies in Emerging Europe could be larger. How this scenario would ultimately evolve also depends on the response by the EU/US, but there would be a significant softening in global growth. Moreover, the longer the conflict lasts, the more severe the economic effects will be.
Alternative scenario 3: Energy supply shock hurts global economy
(Likelihood <5%; economic impact: severe)
In the final alternative scenario, Russia’s energy exports would be affected. This scenario would have the biggest impact on the world economy, but also has the lowest probability. In fact, it should be seen as a tail risk. This is because both Europe and Russia have large mutual interests in keeping energy flowing. Indeed, the Russian economy remains highly dependent on energy, which accounts for 25% of GDP, 70% of export revenues and half of fiscal revenues. Meanwhile, Europe imports more than 30% of its oil, and even almost 40% of its gas out of Russia. Especially for gas there are hardly any alternatives in the coming decade. The ‘energy weapon’ will therefore only be used as a last resort.
There are various ways in which such an energy scenario could take shape. In the first, Russia stops exporting gas towards Europe. While this could lead to shortages of gas in countries that tend to import a lot (e.g. Germany and Ukraine), gas inventories are at very high levels. So the impact for the coming winter looks manageable. However, there are issues for the next winter season, as there are few alternatives for Europe’s gas imports. While this is likely to drive gas prices higher during the course of the conflict, probably by as much as 40 to 50 percent, European gas prices have recently tumbled due to the favourable inventory situation, which will mitigate the economic costs of a gas crisis. That said, there would be costs to the Russian economy, as it would be impossible to find alternative buyers due to lack of a proper infrastructure. The eurozone economy would suffer, at first due to the confidence effects and gas price hikes/and later on due to the direct supply restrictions. The eurozone economy will likely fall back into recession in such a scenario. The ECB would respond by putting full-scale QE into place. Another possibility is that Russia may decide to raise its prices for European gas and oil, but would leave its current supply in place. This would naturally affect the European economy as energy costs rise, though would not have big consequences to the Russian economy. Although Europe will probably seek alternatives, which will lower Russia’s gas sales, this will be compensated for by higher prices.
Another way an energy shock could materialise is that the European Commission will impose energy related sanctions against Russia. If Europe wants to hurt Russia’s economy, it is likely to ban oil imports from Russia. Importantly, the effects on oil prices would depend on whether Russia is able to find alternative buyers. For instance, emerging Asian countries (India, China) could start importing Russian oil. Indeed, the EU/US sanctions against Iran taught us that these countries were willing to buy Iranian oil at a discount. In this case, as the total oil supply remains constant, oil prices are not likely to be affected much, except for a rise in the risk premium (of say $5 – $10 per barrel). Disruptions to the oil market would be more severe if Russia were not able to sell its oil elsewhere. Although OPEC countries will most likely step up their oil production, this would still reduce the oil reserve capacity and therefore lead to a price increase in the range of $20 – $40 per barrel. In this case, the Russian economy would be hard hit, though it is important to note that Europe – at least for a significant part – could replace its oil demand from Saudi-Arabia, Iran, or even the US (though this is not yet officially allowed).
We estimate that a $10 rise in oil prices reduces global GDP by around 0.3%. So in the more extreme case, the global economy could experience a sharp slowdown, also taking the confidence effects into account. The US economy would likely slow to weak growth rates, the eurozone would likely dip back into recession. Policymakers around the world would move to easier macro policy settings. The Fed and BoJ could potentially extend asset purchases, while the ECB would likely set up a QE programme of its own. The Chinese authorities would also step up their stimulus efforts.