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Russia–Ukraine War: How Could It Affect The UK Economy?

Posted: 29th March 2022 09:35

The UK has few direct economic links to Russia. Trade between the two is small relative to the size of either economy and Russia is not closely integrated in the global financial system. However, Russia’s invasion of Ukraine – and sanctions imposed as a response by the UK and its allies – could still have a significant impact on the UK economy.

This explainer looks at the direct trade links that do exist between the UK and Russia, and two key areas of the UK economy most likely to be exposed to continued disruption: energy and other commodity markets, and financial markets. It then assesses the possible impact to the global economy.

What Are The Direct Trade Links Between The UK And Russia?

Russia accounts for just 0.7% of UK goods and services exports, and 1.5% of imports. The UK’s biggest exports to Russia are vehicles and their parts, machinery and appliances. Imports from Russia to the UK were almost entirely comprised of oil & petroleum products and precious metals in 2019, the latest year for which data is both available and unaffected by the pandemic.  ­­­­­

How Could These Links Be Disrupted?

Trade is likely to be disrupted as a result of the conflict for four reasons:

  1. Firms will face logistical issues in getting goods to and from Russia. Shipping giants Maersk and MSC, for example, have already announced a stoppage on all cargo bookings to/from the country, covering all points of entry including in the Baltic and Black Sea ports and in Far East Russia, with some exemptions for essential goods such as food, medical equipment and humanitarian goods.
  2. Sanctions include a ban on the export of ‘dual-use’ goods and technology to Russia (that is, those that have a military as well as civilian use) and may be extended further. Financial sanctions, including locking some Russian banks out of the SWIFT money messaging system, also make payments for international transactions difficult.
  3. International businesses are already withdrawing from Russia due to reputational concerns, as well as the difficulties imposed by current and future sanctions. Large firms already doing this include Apple, General Motors and Volvo.
  4. The steep devaluation of the ruble means that imports will become significantly more expensive for Russian households and firms, ultimately reducing their total demand for those goods and services.

The combination of these is likely to substantially reduce Russia’s trade volumes, particularly imports. Given that direct links between the UK and Russia are very small, however, the spillover effect on the UK economy is likely to be minimal. A far bigger problem for the UK will be the indirect effects from price rises and volatility in commodity markets – particularly energy.

How Is The UK Indirectly Exposed To Russia Through Energy/commodity Markets And Global Supply Chains?

Energy

Russia is a prominent exporter of energy, producing 17% of the world’s natural gas supply and 12% of its oil. It was the largest external supplier of gas to Europe (defined here as the EU and UK) in 2021, with pipeline deliveries accounting for 31% of total European supply. Russian liquified natural gas (LNG – natural gas that is liquified for transport without pipelines, for instance on ships) accounted for a further 4%, meaning more than a third of Europe’s gas comes from Russia.

These total import figures hide some important variations. Some sectors, such as ammonia and fertilizer production, are wholly dependent on gas to operate.This can create problems down the line as these sectors produce CO2 as a byproduct used widely in other sectors themselves recently struck by shortages.There are also large differences across countries: generally speaking, EU member states closest geographically to Russia are most heavily dependent on its gas, while those furthest west the least.

The UK imported around 13% of its total fuel (oil, gas, LNG, electricity) from Russia in 2019. Relative to central and eastern European countries this means the UK is less reliant on Russia for its direct energy supply – Germany, for example, imported around 30% of its total fuel from Russia in 2019, and its dependence is even greater for natural gas imports.

However, any disruption to the supply of energy to Europe will affect wholesale prices in the UK to a greater extent than implied by direct trade links. UK and European gas prices have moved in tandem in 2022.This is because traders buy gas in the UK to avoid higher prices in Europe then export it to the continent, both reducing UK supply and causing prices to rise in Europe, until the prices equalise. Disruption to Russian gas exports to other European countries would also push up prices in other markets the UK uses, such as Norway, as demand would rise across Europe.

Other Commodities

While much commentary is focused on Russia’s energy there are several other commodities whose supply could be substantially affected by the Russia–Ukraine war, from wheat to palladium.

Ukraine and Russia are both major agricultural exporters. Ukraine is the world’s second biggest exporter of grains and Russia often tops the ranking for wheat exports. Together they also account for about 80% of sunflower oil trade. Any disruption to flows would quickly ripple through to buyers globally, raising costs for bread and meat. Though Russia and Ukraine predominantly export these agricultural products to Africa, Asia and the Middle East, the scale of the impact on global supplies could result in increasing demand from the Americas or Europe as well, feeding through to higher prices there. And while commodity prices tend to be only a small proportion of the price of final food products, UK consumers would be likely to see higher prices on supermarket shelves – this could manifest later this year at a time of already high inflation.

Russia also produces other commodities, notably metals, that are essential for a range of supply chains. For example, in 2020 the country produced 43% of the world’s palladium, an essential component of catalytic converters in cars. Trade disruption may therefore exacerbate existing supply chain problems and lead to further price rises in specific sectors such as aerospace, smartphones, and automotive.

What Impact Could This Disruption Have?

The economic impact of the war will depend on the extent to which the conflict, and therefore the severity of sanctions and economic disruption, escalates and how long it lasts. Below is an outline of how disruption to the trade of energy and commodities could affect the UK and other European economies under three broad scenarios. All three lead to higher consumer prices, which will mean a reduction in households’ ‘real’ incomes (that is, adjusted for inflation) and therefore consumption, limiting their economic output (GDP).

Limited Disruption Scenario

In a scenario where there is relatively little disruption to energy supplies, the main impact on the UK and other European economies is comes from uncertainty on gas prices. So far gas has continued to flow from Russia to Europe (including via Ukraine) during the conflict, though wholesale prices have increased significantly.

If gas prices evolve as market pricing currently implies, and assuming there is no disruption to actual supply, the impact on the UK economy will be minimised but is likely to still be noticeable. Modelling a scenario of this sort, Oxford Economics predict that higher energy prices will push CPI inflation to an average of 6.5% in 2022, up from a previous forecast of 6.2%, with the peak in April exceeding 8%. The impact on GDP is forecast to be muted in 2022 (nominal growth of 3.7%, revised down from 3.8%), but will become more stark in 2023 as households are further exposed to higher wholesale energy prices after the next rise in the price cap in October 2022 (GDP growth for 2022 as a whole has been revised down to 2.1% from 2.6%).

Substantial Disruption Scenario

In the most disruptive scenario Russia could turn off its supply of natural gas to Europe. This has the potential to push the Europe and possibly the UK into recession.

Analysis from Brussels-based economic think tank Bruegel suggests the EU would be able to survive large-scale disruptions to Russian gas supplies until summer 2022, by increasing LNG imports from elsewhere (to the limited extent this is technically possible) and by taking steps to reduce demand for gas. Higher market prices for gas would on their own be expected to reduce demand. But European governments could go further and force non-critical industries to shut down or mandate a reduction in use of gas in commercial/office buildings and homes.

However, like large-scale LNG imports these solutions are subject to high uncertainty over technical limitations and costly, and any kind of energy rationing – mandated or voluntary – would have a significant impact on European GDP growth. Due to the links between UK and EU energy markets described above, UK GDP would be likely to take a severe hit too. The National Institute for Economic and Social Research has published analysis on the economic impact of the war, which assumes that energy prices rise by more than in Oxford Economics’ ‘limited disruption scenario’, and stay higher for longer. In this scenario, UK GDP growth would be close to zero in 2023, with significant risk of a recession.

Intermediate Scenarios

There are many possible scenarios between these two extremes, where energy supply from Russia to Europe is reduced but not eliminated. This could happen due to:

A strengthening of financial restrictions (discussed further below). Many of the sanctions imposed on Russia’s financial system so far exclude transactions related to energy and agriculture. If sanctions were to go further, for example by including Gazprombank (a key bank for Russian energy conglomerates) in the SWIFT ban, European countries may have difficulty paying Russian firms for gas, which could result in a reduction in supply.

Damage to physical infrastructure. This is most likely to affect the two major pipelines that cross Ukraine to bring Russian gas to Europe. An event such as this would imply localised disruption to the flow of Russian gas via Ukraine.  

Partial sanctions on energy trade by Russia or Europe. Either side could choose to impose partial or targeted sanctions on energy trade, rather than a full cut off of supply.

How Exposed Is The UK To Russia Through Financial Markets?

On 22 and 24 February, the UK and its allies announced an initial set of sanctions on Russia, some of which targeted Russian banks and businesses. These included powers to exclude Russian banks from the financial system, including access to sterling and clearing payments through the UK, and powers to ban Russian state and private companies from raising funds in the UK and trading debt. These measures, along with more general economic uncertainty, caused the ruble to drop to record lows against the dollar. However, the Russian Central Bank – its equivalent of the Bank of England – was able to use at least $1bn of its foreign exchange reserves to support the currency.

More severe sanctions were announced on 26 February. The UK, along with the US and EU, announced that some Russian banks would be excluded from SWIFT, the widely used global inter-bank messaging network that enables cross-border transactions. The UK, US and EU also announced sanctions against the Russian Central Bank, which involve freezing its assets held in sterling, dollars and euros. By restricting Russia’s access to much of its $600–700bn in foreign exchange reserves, this move significantly limits the central bank’s ability to stabilise the rouble as it had done in response to the initial sanctions.

So far, however, the UK, US and EU have refrained from imposing financial sanctions that would directly disrupt gas and oil trade, although there is evidence that some traders are reluctant to deal with Russian suppliers. Gazprombank, which is part owned by Russian energy giant Gazprom and acts as a key bank for Russia’s energy conglomerates, has so far been excluded from the SWIFT ban.

The UK has few direct financial links to Russia – but any financial sanctions on energy trade could cause more harm

Despite these sanctions creating disruption to businesses and livelihoods within Russia, the risk of direct financial contagion from a Russian financial crisis to the UK and other advanced economies is relatively small because the rest of the world has relatively little direct exposure to the Russian financial system. Data from the Bank for International Settlements shows that liabilities owed by banks in Russia to institutions abroad account for only 0.4% of the global total, while around 80% of the country’s bonds are held domestically.

However, as indicated above, if financial sanctions are extended such that they disrupt energy trade, this could lead to more profound economic impacts for the UK and other European countries. Including Gazprombank and Sberbank, another majority state-owned bank, in the SWIFT ban could further disrupt the energy trade.

Some companies – and their shareholders – could make large losses

Many companies are now making the decision to leave Russia, due to the difficulties inherent in operating under sanctions, deep uncertainty about Russia’s economic future, and reputational concerns.

BP Plc, Russia’s largest foreign investor, led the way on 27 February by announcing that it would exit its 20% stake in Rosneft, a state-controlled company. This could result in a $25bn write-off and a large reduction in its global fuel production.

Other companies have also announced their intention to end joint ventures and partnerships with businesses associated with the Russian state, including Shell, Norway’s Equinor ESA and France’s TotalEnergies SE. Manufacturers have also announced that they are stopping shipments to Russia, and many law firms (particularly those in London) are severing ties with Russian clients.

These actions are likely to be felt by individual firms and investors, and potentially some sectors, but their wider impact will not be large relative to, for example, those relating to energy supply.

Heightened geopolitical uncertainty will also hold back the UK economy

A conflict of this scale brings with it severe geopolitical risk, which on its own can hold back economic performance.Increases in geopolitical risk have been found to induce persistent falls in industrial production, employment and international trade. One measure – the Geopolitical Risk Index developed by the US Federal Reserve – rose sharply as Russia began its invasion of Ukraine to levels not seen since 9/11.

Geopolitical risk feeds through into real economic activity because uncertainty over future economic conditions, particularly when caused by a large-scale war, causes firms and consumers to adopt a ‘wait and see’ approach, cutting back on investment and consumption plans. It also causes investors to move their money out of emerging economies and towards advanced economies as they look for safer, less volatile assets.

The strong recovery from Covid in the UK and other advanced economies last year and early this year was driven by a bounce back in household consumption, which until recently had been expected to continue to drive economic growth. However, the rise in geopolitical risk caused by Russia’s war with Ukraine could contribute to renewed economic disruption. This would be amplified by falling UK consumer confidence, which had weakened even before the invasion because of the cost of living crisis and impact of the Omicron variant.

Whatever the medium- or long-term effects of the war it is likely that firms and households around the world, but also in the UK – fearful of the worst-case scenario – will delay investment and consumption decisions, holding back the wider pandemic recovery.


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