Will sanctioning Russia fuel financial contagion?
THE UNPRECEDENTED sanctions imposed on Russia, which some have dubbed economic weapons of mass destruction, have globalised the Ukraine crisis, exacerbating market uncertainty, and potentially derailing the post-pandemic recovery. Across Europe and elsewhere, growth forecasts for 2022 have been revised down sharply.
Beyond dampening output and causing already-high inflation to spike further, these sanctions are heightening the risk of a financial crisis. Today’s increasingly complex global financial system amplifies this danger, because the magnitude of derivatives markets and the codependency of supply chains and payment chains make contagion more likely.
Stagflation was already a looming global threat, and the war in Ukraine has further increased the danger. The world, still grappling with the fallout from the US-China trade war and the COVID19 pandemic, now faces its third policy-induced economic crisis in quick succession.
The pandemic-related downturn, which disrupted supply chains and exacerbated inflationary pressures, was a crisis of necessity, because containment measures were the price paid to stem the spread of COVID-19 as best we could. But the impending growth slowdown and potential stagflation triggered by sanctioning Russia would, like the Sino-American trade war, be a policy-induced economic crisis of choice.
One lesson from the US-China trade war is that increased interdependence in the era of globalisation makes it extremely difficult to implement targeted economic sanctions – from trade barriers and tariffs to restrictions on financial transactions – without causing unintended consequences for countries not directly involved in the dispute. Two such effects are especially relevant to the Russia-Ukraine conflict: indirect ‘collateral damage’ affecting thirdparty countries, and ‘boomerang’ effects on the states imposing the penalties.
Collateral damage usually results from trade destruction or diversion and increasing disruptions to just-in-time global supply chains. For example, the International Monetary Fund estimates that supply chain problems triggered by the US-China tariff war, and exacerbated by the pandemic, slashed world output by half a percentage point and raised inflation by around a full percentage point in 2021.
The larger the economies imposing sanctions are, the greater the collateral damage is likely to be. Low- and middle-income countries, which depend heavily on trade for growth, invariably suffer the most, because they lack the economic infrastructure or capacity to capitalise on the distortionary effects of sanctions or on the opportunities arising from the short-term reordering of supply chains. Most entered the pandemic with limited fiscal space, reflecting the sharp reduction of global demand caused by the US-China trade war.
In some ways, the imposition of sanctions on Russia is affecting poorer countries more severely than either the trade war or COVID-19 containment measures did. In particular, sharply reduced access to essential products is raising the spectre of a global food crisis and pushing the prices of most commodities, including oil, to their highest levels in a decade, thereby also raising long-term inflation expectations.
While higher commodity prices may herald a fiscal bonanza for oil exporters, they create serious macroeconomic management challenges for low- and middleincome countries in particular. Most are net importers of oil and must also contend with the growing risks of social unrest from rising food insecurity and, in some cases, hyperinflation.
The boomerang effects of economic sanctions can be just as significant. Again, an evaluation of the US-China trade war is instructive. In addition to the steep decline in US exports to China (and a similar decline in US imports from China), research by the Federal Reserve Bank of New York and Columbia University found that US firms lost at least US$1.7 trillion in stock value because of the imposition of US tariffs on Chinese imports. US households also were affected, as prices and exchange rates did not adjust automatically to shield consumers.
For China, the boomerang effects of the trade conflict accelerated the economy’s slowdown, raising the possibility of a hard landing. Chinese officials are targeting GDP growth of about 5.5 per cent this year, the slowest pace in decades, with the exception of the pandemic-related deceleration in 2020. This could have significant negative spillover effects for the rest of the world, and especially for developing countries, most of which count China as their largest trading partner.
In the Ukraine crisis, European economies that depend heavily on Russian energy have sought to mitigate the boomerang effects of sanctions by not extending the measures to Russia’s hydrocarbon exports or Russian banks involved in the energy trade. But several European firms in other key industries with direct exposure to Russia will be significantly affected. In the transport and logistics sectors, several financially sound companies could face bankruptcy if the stringent and wide-ranging sanctions remain in place for a prolonged period.
Even in the short term, the sanctions against Russia have caused substantial collateral damage, with mounting price pressures increasing many economies’ internal and external vulnerability. Concurrently, and ironically, the commodity market rally that the sanctions have fuelled is sustaining the flow of cash to Russia from Europe to cover the continent’s essential energy imports.
A new bout of supply chain disruption is already stirring inflationary pressures, further weakening the post-pandemic recovery and raising the risk of stagflation in Europe. Simultaneously, sanctioning Russia threatens to worsen the debt crisis and could set the stage for a longerlasting financial crisis. The risk of contagion will be exacerbated greatly if credit default swaps are not settled seamlessly in the event of Russian bond defaults, or if the sanctions herald a largescale reallocation of public assets to hedge against the globalisation of political risks.
The ongoing struggle for geopolitical supremacy means that powerful states will increasingly be tempted to use economic sanctions to advance their strategic goals. In an economically and financially interdependent world, such measures will make policy-induced economic crises more frequent, and all countries will suffer the consequences.
One of the main challenges facing the world in the coming decade will be to ensure that no country’s geopolitical interests supersede the quest for global prosperity. Unless we succeed, the risks of globalisation may come to outweigh the benefits. Diplomacy, undoubtedly, remains a better alternative to economic weapons of mass destruction.