We believe there are three key mechanisms through which the conflict between Russia and the Ukraine could impact the eurozone economy:
- Reduced trade (impact minimised due to a long-term decline in exports to Russia)
- Higher energy prices (a potentially significant impact given over-reliance on Russian energy imports)
- Secondary impacts on business investment and consumer confidence resulting from increased uncertainty
Under our core scenario we anticipate higher inflation and slower growth, but if events escalate the impact could be more severe.
At this stage, we continue to believe the European Central Bank (ECB) will keep rates on hold through most of 2022, with the first rate-hike in December.
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- The impact from reduced trade should be extremely limited
- The impact from energy is potentially huge
- Rising energy prices have inflationary implications
- Monetary policy - still on track for now
- Fiscal policy - pandemic responses remain in play
Exports from the eurozone to Russia have been in long-term decline since the 2014 Russia annexation of Crimea. A sharp devaluation in the Ruble, sanctions and a slowdown in the Russian economy have generally suppressed demand for imported goods. As a result, exports from the eurozone to Russia have declined from a high of 2.7% of total eurozone merchandise exports in 2012, but this had declined to just 1.4% by 2021. Amongst the large eurozone countries, Germany is the most exposed; Spain on the other hand exports less than 1% of its GDP to Russia.
Figure 1: Germany is the most exposed to a decline in trade, with other major economies having little exposure1
|Russia (to/from)||Ukraine (to/from)|
|Country||Exports (% GDP)||Imports (% GDP)||Exports (% GDP)||Imports (% GDP)|
Machinery and transport equipment (such as cars) are the main goods exported to Russia, followed by chemicals and manufactured goods such as clothes and footwear, and this pattern holds for all countries. Food only accounts for a small portion of eurozone exports to Russia; never recovering from a Russian embargo on the import of agri-food products which was put in place in 2014.
Unfortunately, given soaring energy prices, the eurozone is heavily reliant on the import of both petroleum products and natural gas (see Figure 2). Although investment has been made in renewable energy, this remains a small part of the overall energy mix.
From an economy-wide perspective, petroleum-based energy is the most consumed, reflecting its use in the transport sector and virtually all of it is imported.
Gas is, by contrast, the primary energy source consumed in the industrial sector and by (non-transport) services and households. Gas also acts as the key marginal energy resource in electricity generation. Gas-fired power plants are flexible and the infrastructure in place (e.g., network interconnections, storage capacity and liquified natural gas terminals) allows gas to flow quickly to respond to fluctuations in electricity demand. More than 90% of the gas consumed is imported.
Figure 2: The eurozone is heavily reliant on imported energy1
Across the European Union (EU), Russia is a significant supplier of energy – accounting for over 40% of EU gas imports and over 20% of EU oil imports. This means that any disruption to the flow of gas or oil from Russia could have dramatic ramifications for energy prices in the EU and more widely across Europe.
|Figure 3: Russia is the EU’s primary partner for imported petroleum products1||Figure 4: The situation is even more stark for imported natural gas1|
Eurozone inflation has surged in recent months, reaching an unprecedented 5.8% year-on-year in February. Energy has been a key driver of this acceleration, accounting for around 300bp of the headline number, tracking significant increases in consumers' utility and fuels bills.
Figure 5: Components of inflation (percentage point contribution to annual changes)2
Examining potential scenarios
To examine the implications of the conflict over 2022 as a whole we examine two different scenarios below:
- Scenario 1 (Core scenario): oil and gas prices average around $110 a barrel and €150 per megawatt-hour respectively
- Scenario 2 (Escalation scenario): oil and gas prices are pushed higher, averaging $150 a barrel and €200 per megawatt-hour respectively
In both scenarios consumer price inflation is pushed higher than pre-conflict forecasts – ending the year at 5.3% year-on-year in scenario 1 and 7% in scenario 2. This doesn’t factor in rising food prices, so the risks to these forecasts are likely skewed to the upside. We would cut our growth forecasts in both scenarios, although accumulated household savings, estimated at €800bn, or 10% of annual disposable income, in Q3 2021 could be tapped by consumers to soften the impact. Under our core scenario, growth will soften to 3% in 2022.
Figure 6: Growth appears likely to slow and inflation accelerate, but to what extent?3
|Assumptions||Pre-conflict||Core scenario||Escalation scenario|
|European gas price||€95||€150||€200|
The ‘stagflationary’ impact of the surge in energy prices aggravates the European Central Bank’s (ECB) trade-off between inflation and growth risks and the central bank’s response is not immediately obvious. Building and persistent inflationary pressure should warrant a tightening of monetary policy, but at the same time, the dampening impact on consumption and investment should warrant more monetary accommodation. At this stage, neither risk appears enough to force the ECB to fully abort its plans to gradually normalise policy, and we maintain our forecast that interest rates will be raised by 25 basis points in December 2022.
We expect fiscal policy to continue to play a key role in the eurozone in the year ahead, and to partly mitigate the impact that higher energy prices will have on inflation and consumers’ disposable income. The General Escape Clause, under which EU fiscal rules are effectively suspended, remains in place until the end of 2022. As such, member states will be able to rapidly respond to the impact of the conflict by increasing deficits, e.g., furlough schemes/income replacement schemes for those sectors most directly affected and the implementation of new policies to shield economies from the burden of higher energy costs.
If events escalate significantly, there is also the potential for a joint fiscal response. The EU could revive the tools it used during the pandemic such as ‘SURE’ financial aid, providing additional resources from the EU budget and European Stability Mechanism credit lines to ensure that financing costs remain low, especially for the member states with the most fragile public finances. It will add further pressure to create a permanent fiscal stabilisation mechanism, deepening integration within the eurozone and potentially putting the differences between the North/South and East/West behind us. Putin’s invasion appears to be pushing the EU to centralise more rapidly than before in its history!