How Russia's invasion of Ukraine disrupts the world economy

Russia started its war on Ukraine with the invasion of Crimea eight years ago, but the large-scale escalation this winter triggered a very profound global impact. It has turned Ukraine into a war economy, Russia into a scarcity economy, and the rest of the world into a disruption economy.

Economists expect Ukraine’s GDP to drop between thirty and forty-five percent. Infrastructure has been destroyed on a massive scale (damage estimates vary but $100 billion seems a minimum); about half of the country’s private companies have shut their operations at least temporarily; a quarter of the population is displaced (ten percent have left the country, another fifteen have sought shelter away from the war zones); tax collection is in freefall.

Electricity consumption, a good proxy, is down 40%. This is much worse than in 2014-15, when GDP had dropped around 20% over two years. Despite the admirable resilience of banks that continue to open whenever they can, a war economy, much more cash based, is developing.

Exports have stalled, with agriculture a particularly acute concern. Farmers have behaved admirably, managing to plant despite the invasion: 70 to 80% of the fields have been seeded and the harvest is now coming in.

Anecdotal evidence reports farmers driving their tractors with body armour and helmets. But it has been tough to maintain and nurture the fields: fuel, fertiliser and manpower have been more sparse than necessary, and some farmers have been targeted by the invader. There will not be a bumper harvest. Exporting remains close to impossible: silos (when they have not been bombed) are mostly full.

Rail exports are limited and complicated due to different gauges between Ukraine and central Europe; some flows are now diverted towards Danube ports, but overall exports are at 20% of the pre-war five million tons a month. As long as the Black sea remains closed, it will be almost useless to harvest and impossible to evacuate the cereals and oils that finance Ukraine’s trade balance and feed the world.

The recent agreement to re-start exports is a step in the right direction, but its implementation remains a question mark. Exports of steel and iron ore have also stopped. Mariupol alone processed 15% of Ukraine’s exports, not least thanks to the famous – and now destroyed – Azovstal plant.

Finally, Ukraine’s finances are under pressure. Its pre-war GDP ($180 billion) was a tenth of Russia’s. Financing the war is thus a monumental challenge. Ukraine’s budget deficit amounts to $5 billion each month. According to the Finance Ministry’s numbers (as of 21 July), Ukraine had raised $24.6 billion: around half (12.7) from foreign support (3 from international financial institutions and the rest from the US, the EU, EU countries and Canada).

Internal sources made up the other half, through war bonds (4.2 billion) and the central bank (7.7 billion). Such a level of monetary creation is not sustainable without triggering inflation and devaluation.

The Central Bank maintains high interest rates (currently 25%); it has just devalued the Hryvnia’s by around 20%. This is bound to continue. If the allies do not want to see Ukraine lose the war through lack of funding, they must finance the country’s budget deficit as long as the war rages.

Russia is also expected to see a recession, currently estimated at around 10-15%; this wipes out a decade of per capita income growth. But it relies on an economy ten times larger, and was well prepared financially.

Its exchange reserves, which had fallen from $500 to 350 billion between the invasion of Crimea in 2014 and early 2015, have since continuously grown, to reach 650 billion by February 2022. That impressive war chest was also highly diversified: US dollar holdings only made up 11%, far behind the Euro (34%), gold (21%), and the Chinese Renminbi (17%).

From this picture, one can draw two conclusions: first, the share of USD is very low, unnaturally so given the structure of the country’s trade flows. This is an indication that the risk of US sanctions was deemed more material than from the EU. Second, it takes years to achieve this sort of reserve allocation: one does not buy 2,300 tonnes of gold (the fifth largest reserves in the world, just behind France and Italy) in a few days. Russia’s gold reserves were just around a thousand tonnes ten years ago.

Moreover, Russia keep raking money in, mainly through oil and gas. Oil is sold at a discount: Urals oil sells for 25% less than Brent, around 30 dollars less per barrel. Such a price divergence is unprecedented. However, even at around 80 dollars, oil remains a boon for Russia’s budget. Experts reckon that the country’s budget break-even price (admittedly, before the war) is around 53 dollars per barrel.

Russia’s balance of payments is further improved by the collapse of imports, resulting from lower consumption and the reluctance of western suppliers to ship to Russia. But despite the financial wealth, a scarcity economy, reminiscent of the USSR, is coming back. This is largely due to sanctions, in particular on advanced technology: Russia’s efforts at substituting these critical imports with domestic sources have been at best a mixed success. And the exports of capital have continued, reflecting the continued pillaging of the country by its elites.

One should not place too much hope in sanctions as a short-term game changer. Even if they were completely tight, they would not force a different political choice. However, they significantly erode the country’s innovation and growth capacity; together with the large human capital losses, they point to a bleak future indeed.

Beyond these two countries, the war’s shockwave hits the rest of the world in a number of ways.

The first is of course the large energy and commodity price shock. It threatens to push millions of people back into poverty, and contributes to accelerate global inflation, which was already under way before the February invasion (independently of the pre-war European gas shortages that very likely were part of a plan to soften the resolve of the EU countries).

Utility and food bills generally represent less than a fifth of household consumption in rich countries: the impact there is very real, however limited to the less well off. But they amount to more than 40% of household budgets in emerging markets like Georgia, Moldova and Armenia, neighbours of the warring countries whose bills will soar along with their anxiety at the risk of being sucked into the conflict.

This will hit the poorest hardest. Many countries depend on Russian and Ukrainian cereals: for example, Egypt imports 59 per cent of the wheat it consumes, of which 73 percent comes from Russia and Ukraine.

In Turkey, the figures are 35 and 75 per cent. This reverberates along the global food supply chains: global hunger is a very real threat, and with it the destabilisation of the entire Mediterranean and Africa region. Soon the situation will be worsened by the much more dreadful prospect on an availability shock. A company that uses gas in its production process can much more easily withstand a doubling of gas price than a delivery interruption that can leave it unable to operate.

Refugee flows, the drop of tourism spending and remittances also play a role in transmitting the shock.

The refugee situation is complex. Beyond the innumerable individual human tragedies, solidarity has been extraordinary across much of Europe. However, tensions appear on social services (hospital and school capacity) and on housing. It is less visible for now on employment markets as the countries with the most refugees also had a very low unemployment rate. In any event, the shock is severe.

Tourism is in decline in Turkey and Georgia for example. In countries like Kirghizstan, Takjikistan and Moldova, remittances, often from Russia, represent between ten and twenty percent of GDP. Currently these flows hold especially given the Russian ruble’s appreciation, but they are fragile. A recession or travel restrictions could worsen the situation.

Capital markets have been hit, too: debt is much more expensive, including in central Europe. We see healthy, prosperous companies struggle to close debt issuance that would have been a walk in the park six months earlier.

Shocks arise from unexpected quarters. It can be hunger riots, export controls, the destabilisation of a banking group, the disruption of a complex supply chain… all these factors push the world economy towards disorder and unpredictability.

Against Russia, a much larger aggressor that can choose to escalate or keep pushing for attrition, and that clearly expects the resolve of Western powers to wane, Ukraine impresses the world with its courage, its resilience and its military talent. We, too, must hold the line, for Ukraine’s freedom and for our own.

Francis Malige is a Managing Director at the European Bank for Reconstruction and Development; he writes in his personal capacity.

A French version of this article was published in Revue Esprit in July 2022.

Francis Malige