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Theme: The war in Ukraine

The economic effects of a lengthy war

In the long term, the big loser of the war in Ukraine will be Russia and the Russian economy, which will stagnate under Western sanctions. In the short term, however, the biggest cost will be borne by Ukraine – both in human lives and economically – and to a lesser extent by the EU, which faces an energy crisis and the threat of recession. Support for Ukraine by the US, the EU and others will be challenged by high costs. Yet this support will probably be sufficient to enable Ukraine, potentially for several years, to defend itself and prevent a Russian-dictated peace.

Russia's invasion of Ukraine has turned into a war of attrition, with neither side seeming capable of resolving the war in its favour within the foreseeable future. A more accurate assessment of events is difficult to make, since there is great uncertainty about the reliability of information from the war. Our main scenario is that the war will continue at least until the end of 2022 and probably into the first half of next year, but there is a major risk that it will continue for several years. The intensity of fighting will vary but will probably continue much as before. Russia, which has an advantage in terms of weapons, ammunition and troops, will probably make small, slow advances in eastern Ukraine, causing widespread destruction. Ukraine has launched a counteroffensive in the south but does not appear to have enough powerful weapons or troops to make major gains. Quickly supplying Ukraine with all the weapons it needs to drive out Russian troops carries two main risks: If Ukraine were to turn the tide of the war in a short period, there is an increased risk that Russia would escalate the conflict in desperation, potentially by threatening nuclear war. On the other hand, if Ukraine failed to turn the war around despite increased support, the domestic and international political cost to donor governments would be high. believe that the external military support for Ukraine will gradually increase, forcing Ukraine to conduct a war of attrition without a major counteroffensive but with constant attacks aimed at breaking down Russian combat will and capability.   

A war of attrition to break down resistance 

We believe that external military support for Ukraine will gradually increase, forcing Ukraine to conduct a war of attrition without a major counteroffensive but by using constant attacks aimed at breaking down Russia’s fighting spirit and capability.  

One alternative to this attrition scenario is a major escalation of the war. The Kremlin has been reluctant to declare a general mobilisation (which would probably be politically very unpopular) but by all accounts, President Vladimir Putin is keeping this option open. Talk or implied threats of nuclear or chemical weapons have been more muted recently but these threats might become a reality if the Kremlin perceived that it was rapidly losing the war. An escalation could also draw other countries into the conflict. Russia could attack Poland or one of the Baltic states (which have been the most critical of Russia and have contributed arms and other assistance to Ukraine) if support from or via these countries were to become decisive in the war. This in turn would force NATO to act. However, a Russian escalation would pose an increased risk to the survival of the Putin regime, making that scenario less likely. 

A third possible scenario is that both Russia and Ukraine reach a point of exhaustion and seek a negotiated solution. But the probability of this occurring in the near future is almost negligible, despite the agreement allowing exports of Ukrainian agricultural products through the Black Sea. First of all, there is nothing to negotiate. Dmitry Medvedev has said peace will be on Russia's terms, which means that Russia would only accept an unconditional surrender. Beyond a doubt, the Kremlin wants to annex parts of Ukraine, but which parts is unknown. At present, it would also be quite unthinkable for Kjiv to give up the areas occupied since the February 24 invasion. Russia still has a military advantage, but Ukraine may have time on its side thanks to Western support, including increasingly sophisticated weaponry, and an expected gradual deterioration in the Russian economy as a result of the sanctions. 

The effects of the war are being felt globally 

Ukraine's economy has been hit hard. Its GDP will probably shrink by a third this year due to territorial losses in the war as well as destroyed production capacity and infrastructure. As long as Ukraine manages to halt further Russian advances, the economy should grow next year as some production is moved from the occupied territories and reconstruction begins. The July 22 agreement allowing Ukraine to export agricultural products through the Black Sea offers a glimmer of hope and could generate up to US 1 billion a month in export earnings for Ukraine. We expect the deal to hold but believe Russia will disrupt these deliveries (in order to reduce Ukraine’s revenues) on grounds that they are being used, for example, for military purposes. Ukraine’s government finances are unsustainable. Kyiv was forced to suspend all payments on its euro bonds in July and devalue the hryvnia by 25 per cent. To meet its budget deficit of around USD 5 billion a month, the government needs greater international assistance. But the war has strengthened the EU’s political will to welcome Ukraine, which must mean increased technological and monetary support in the future. 

Sanctions against Russia can be divided into three broad categories: 1) restrictions on individuals; 2) economic sanctions, including bans on trade in certain goods and services and on financing of Russian companies and banks; and 3) diplomatic actions. In addition to these sanctions, a number of international companies have decided to greatly reduce their activities in Russia or leave the country altogether. Economic sanctions have been especially harmful to those industries that depend on imported input goods. Auto production, which has almost come to a standstill in Russia, is the clearest example. But industries – including the energy sector – that need imported parts and services will also be hit hard. Unconfirmed reports indicate that tank production has also ceased.   

No collapse but low growth awaits Russia 

The aim of sanctions is to reduce the ability of the Russian economy to bear the costs of the war. An expected 3-6 per cent decline in GDP is a sign that the sanctions have had such an effect, albeit less than expected. We believe the EU will gradually reduce its imports of Russian energy and that the Kremlin will be unable to fully redirect exports, especially of gas, to other markets. Nor will Russian industry be able to fully replace Western input goods and technology. Compared to the decline in GDP during the COVID-19 pandemic, this downturn will be shallower but far more protracted. Overall, we expect GDP to fall again in 2023 and growth to stagnate at a low level of around 1 per cent after that. According to IMF forecasts, Russia’s per capita GDP growth (adjusted for inflation and purchasing power parities) will average 1.6 per cent a year in 2021- 2027, compared to about 4 per cent a year in the rest of the world. If this forecast proves correct, Russian GDP per capita will increase by about 12 per cent over this period, compared to 32 per cent in the rest of the world and 44 per cent in emerging economies. The Russian economy will not collapse but will probably be increasingly reminiscent of the final years of the Soviet Union. 

The war and sanctions have had a significant impact on global commodity prices, especially for energy. Attempts to limit Russia's revenues from energy exports – the Kremlin's main source of income – have not been as effective as restrictions on exports of input goods to Russian industry. Together with pandemic-related factors, weather effects and Kremlin countermeasures, actions targeting Russian energy exports have contributed to sharply rising prices, especially for natural gas in Europe. The EU, the single largest importer of Russian energy, faces a difficult balancing act. It wants to limit the Kremlin's export earnings while keeping these exports going in order to avoid further price increases and a global recession. 

One problem, however, is that global energy prices are being driven up as the EU replaces its Russian energy purchases with alternatives such as liquefied natural gas (LNG), for example from Qatar and the US, and oil from the Middle East, Africa and the US. Sanctions have increased the discount on Russian oil compared to Brent from around USD 2/barrel to more than USD 30/barrel. Despite the discount, the average price of Russian oil (Urals) has been higher in 2022 than before. Combined with continued strong Russian production and exports, this has allowed Russia to boost its oil revenue this year. The countries that have increased their imports of Russian oil the most are India, China and Turkey. Russia is the world's second largest exporter after Saudi Arabia and the world's third largest producer of oil, accounting for over 10 per cent of global production. If sanctions were to halt Russian oil exports, this would lead to a global recession and completely undermine international support or acceptance of the sanctions against Russia. An agreement with Iran on its nuclear programme that might allow Iran to resume sales of its oil in the world market would mitigate these effects but would not be enough.   

The Kremlin, with the help of state-controlled Gazprom, has reduced the flow of natural gas through the important Nord Stream 1 pipeline to about 20 per cent of capacity in response to EU plans to stop importing Russian oil and reduce dependence on Russian natural gas. We believe Russia will not completely choke off the gas supply but will keep its threats alive. The aim is to drive up prices as much as possible, both to increase revenue and to cause the highest possible costs to the EU, the US and their allies. In the long run, the war is likely to accelerate the green energy transition, but new sustainable alternatives cannot be built fast enough to avoid an energy crisis this winter, especially if Russia totally cuts off the flow of natural gas to Germany and other major EU countries.   

No major sanctions packages expected 

No major sanctions packages are expected any time soon. In May the EU decided to stop buying Russian oil imported by ship starting 5 December 2022 and petroleum products starting 5 February 2023. A ban on insuring shipments of Russian oil above a certain value to countries outside the EU and the UK has been postponed due to implementation difficulties and the risk that the ban would create a shortage of oil in the world market and drive prices up further. Given the difficulties in agreeing on the details behind already approved sanctions, we do not expect any major new sanctions packages in the near future. Some US senators are pushing to define Russia as a terrorist state, but the Biden administration opposes this step since it risks forcing the US to punish allies that operate in, or have other relations with, Russia. But further restrictions on individuals and organisations are likely in response to Russian atrocities in Ukraine. Western political efforts in the next year will focus on ensuring sanctions enforcement and closing potential loopholes. 

The course of the Ukraine war will depend on economic developments in Russia. The hope that sanctions would prompt the Kremlin to end the war quickly and withdraw its troops was never realistic. It will take time before sanctions affect the Kremlin's current approach to Ukraine, potentially several years.