SpecialArticle 2

The Economic Consequences ofRussian Aggression Against Ukraine

By Vesselin Popovski

The beginning of Russia’s aggression against Ukraine on Feb. 24,
2022 triggered great turmoil in the financial markets and drasticallyincreased uncertainty about the recovery of the global economy,
already experiencing serious supply chain disruptions, high inflationand other negative effects since two years earlier due to the Covid-19
pandemic.
In this article I argue, firstly, that China and India are unlikely tosupport the Russian economy in the long-term, and also that China
will not dare to use the shock from Russian aggression to attack
Taiwan. Secondly, I share my expectations that higher commodityand energy prices will increase the threat of long-lasting high global
inflation that could lead to food insecurity, stagflation and even social
unrest in some countries most negatively affected. Certain sectors
such as automotive, transport or chemicals would be the worst tosuffer. European countries will be mostly badly affected, GDP growth
could fall by 1 percentage point, and if they completely cut Russian
natural gas supplies it could cost 4 points of GDP, thereby leading EU
GDP growth close to zero in 2022. Thirdly, my analysis of theRussian economy specifically suggests that it would be massively
affected into the negative, possibly even turning Russia long-term
into an underdeveloped country, where a few multibillionaires exploit
all the natural resources and the population is driven into misery. The
numbers – even at this early stage in 2022 – are indeed staggering.
The decline in GDP may reach 9% and even higher in 2023. The
Russian risk assessment by various ranking agencies will continue tobe downgraded. Interestingly, despite the massive censure andrestrictions on freedom of expression in Russia, senior Russianbankers and analysts also suggest that Russia will need up to a
decade to return to 2021 levels, and this only in case that thesanctions are lifted.
The current numbers might not look excessively bad yet, but thisis entirely because of two factors: (a) many countries continue toimport large amounts of Russian oil, gas, metals, foods and otherresources and commodities; and (b) the prices of these have moved
higher and higher. However, as soon as these countries findalternatives – and there are many – to such imports, and prices in
the markets stabilize (due to balancing the high demand with moresupplies), the Russian economy may be heading for collapse. At thetime of writing there are no signs that the war in Ukraine will end
soon, and even if it does, the economic sanctions against Russia
would most probably continue mid-term and even long-term, as atool to restrict the further militarization of the Russian Federation and26 Japan SPOTLIGHT • September / October 2022

Author Vesselin Popovski

to mitigate the threats to its neighbors in Eastern Europe.
In the first days of the war the Russian currency (ruble) lost
almost half of its value, causing the cost of various essentials to soar
and creating panic amongst Russian citizens, who had to stand inlong ATM queues to pull their money out. Some of the banks had tostop operations, and the whole banking system experienced adramatic shock. As the value of the ruble falls, the external value of
all Russian debt rises and so does the value of all interest payments.
The unstable purchasing power of the ruble, the freezing of credit,
and the higher cost of accessing money with a high central bankinterest rate makes business in and with Russia even more difficult.
All this could dry up private investment which could lead to theWorld Bank’s estimated 8.9% drop in Russia’s GDP, causing a deepand long recession. Financing a war, no matter how strong a nationstate is militarily, stretches significantly its fiscal limits. It also
causes all government debt obligations to the rest of the world toskyrocket – from loans to government bonds.

Will China and India Support Russia?
This question is central and will have a significant impact on theworld economy. It will be interesting to see whether China and India– the world’s most populous nations – choose to support Russia interms of market access, technical assistance and technologicalsupport. Or will they prefer not to rely on Russia anymore, not least
because doing business with Russia will carry very high uncertainty
risks. Will these countries shift their foreign exchange reserves awayfrom US Treasury bonds? Will they reduce their reliance on the dollar
and US banks? Will they curtail their commercial and technologicaldependence on the United States, cutting supply chains andreshoring production? Will the global economy be reconfigured into
rival blocs?
My short answer to all these questions is no. Although we haveseen some movement in these directions, this has not been a
primary result of the Western sanctions on the Russian economy.
Prior to the attack on Ukraine, the US and China, along with othercountries in their orbits, had moved some way in the direction of
decoupling from the previous stable trade relations. Both sides
slapped tariffs on one another’s exports, and both Beijing and theadministration of US President Joe Biden have shown no sign ofthese being reversed. The US has also prohibited sales to China of
high-tech gear potentially useful for surveillance. In addition to that,https://www.jef.or.jp/journal/

Biden issued an Executive Order denying 59 Chinese defense andsurveillance firms access to US investment finance. All these areoccurring against the backdrop of declining US dollar dominance.
The share of the US dollar in foreign exchange reserves has fallenfrom around 70% of the global total at the turn of the century to lessthan 60% today. Most of this movement has been toward thecurrencies of small, open economies with strong policies, such as
the Canadian and Australian dollars, the South Korean won and theSwedish krone.
There is no particular reason to think that the economic sanctions
against Russia will accelerate these trends. Russia has been
sanctioned not just by the US, but by a large coalition of Westernand other countries, including Japan, South Korea, Australia, andNew Zealand. Collectively, these countries are the source of 95% ofidentified global foreign exchange reserves. This means that Russia
and other countries contemplating a scenario in which they findthemselves in the same position cannot hedge against the sanctions
risk by simply shifting from the US dollar into euros or other
Western currencies.
Russia may attempt to shift to gold, as it has done in the past, butgold is in limited supply. Or it may decide to shift towards theChinese renminbi, but this currency comprises less than 3% of
allocated foreign exchange reserves and is not a form in which China
can hold foreign assets. While isolated Russia can shift its reserves
and monetary relations in these directions, these options are notavailable on a large scale to other countries in the rest of the world.
It is not just US banks and clearing houses that have beenprohibited from doing business with various Russian institutions.
Governments, worried about Western countries weaponizing theircurrencies, may seek to make more payments via renminbi. They willclear those payments using the Cross-Border Interbank Payment
System (CIPS), China’s equivalent of the US Clearing HouseInterbank Payment System (CHIPS) or the United Kingdom’s
Clearing House Automated Payments System (CHAPS). But CIPS isstill a small fish in a sea of whales. CHIPS processes 40 times as
many transactions for 10 times as many participating banks
worldwide – including several Chinese banks. CIPS also depends on
SWIFT (the Belgium-based Society for Worldwide Interbank Financial
Telecommunications) for most cross-border messaging. The
continuation of the war in Ukraine and the sanctions on Russia may
encourage additional banks across the world to make cross-border
payments through CIPS. It is revealing that although China has beenbuilding CIPS for seven years, its transactions and membership

remain far behind those of the Western clearing houses.

Will China Invade Taiwan?
My short answer is no. A Chinese incursion into Taiwan mostcertainly would subject China to a similar range of comprehensive
sanctions such as Russia is currently experiencing. Its foreignexchange reserves will be frozen and it will be barred from SWIFT.
China could eventually insist that foreign counterparties makepayments exclusively in renminbi and route their payments throughCIPS. Still, its business with Western countries – major importers ofChinese goods – would be decimated. This would effectively lead toan economic catastrophe for China with very serious negative effects
on the world economy. Chinese officials know this very well.
Regarding Taiwan at least some comfort can be derived from the factthat President Xi Jinping evidently cares more about the health of hiseconomy than does Russian President Vladimir Putin. For China thebest scenario is to maintain global peace and security and to see thatinternational trade is not affected by restrictions, as it economicallybenefits enormously from world peace, international order, anduninterrupted trade relations.
Two signals to look for regarding Chinese intentions are, first, howmuch does China use the US dollar, and second, how much reliancedoes China put on SWIFT. If China trims its US dollar reserves, thismight be an indication that it is preparing to take on Taiwan and facevarious economic, trade and other sanctions. If China insists that
foreign banks with which it does business install digital translators toconvert CIPS’s Chinese language messages into their local language,
this may be another indication that it anticipates being barred fromSWIFT as a result of its potential invasion of Taiwan. So far, no suchsignals are have been noticed. On the other hand, China’s moves
could be innocent. Its reserve managers may simply be seeking toreap the benefits of diversification – a better combination of risk andreturn. Or they may only try to further develop the capacity of ahomegrown payments system. Either way, it is important to keep awatchful eye on all such developments.

Most Vulnerable Sectors Affected by Russian
Aggression
Russia is the world’s third-biggest oil producer, second-biggest
natural gas producer and among the top five producers of steel,nickel and aluminum. It is also the largest wheat exporter in theJapan SPOTLIGHT • September / October 2022

27

world (almost 20% of global trade). On its side, Ukraine is a key
producer of corn (sixth largest), wheat (seventh), sunflowers (first),
and is amongst the top 10 producers of sugar beet, barley, soya andrapeseed.
This explains why the financial markets fell sharply, and the pricesof oil, natural gas, metals and food commodities surged. While highcommodity prices were one of the risks already identified as
potentially disruptive to the global economic recovery, the escalationof the conflict increases the likelihood that commodity prices willremain higher for much longer. This in turn intensifies the threat oflong-lasting high inflation, thereby increasing the risks of stagflationand social unrest in both advanced and emerging countries.
The war in Ukraine is strongly impacting an already strained
automotive sector due to various shortages and high commodity andraw material prices: metals, semiconductors, cobalt, lithium,magnesium. Ukrainian automotive factories supply major carmakers
in Western Europe: some announced the stoppage of factories inEurope, while other plants around the world are already planning
outages due to chip shortages.
Airlines and maritime freight companies will also suffer fromhigher fuel prices, airlines being the most at risk. First, fuel isestimated to account for about a third of their total costs. Second,
European countries, the US and Canada have forbidden access totheir territories to Russian airlines and in turn Russia has banned
European and Canadian aircraft from its airspace. This has resulted
in higher costs since airlines will have to take longer routes.
Eventually, airlines have little room for raising costs, as they continue
to face lower revenues due to the impact of the pandemic.
Rail freight will also be impacted: European companies are
forbidden to do business with Russian Railways which will likely
disrupt freight activity between Asia and Europe, transiting though
Russia.
Another sector expected to suffer is the feedstock forpetrochemicals. This will become much more expensive as thesoaring prices of natural gas begin to impact the fertilizer markets,hence the whole agricultural and food industry.

European Economies at Higher Risk
Because of its dependence on Russian oil and natural gas, Europe
appears to be the region most exposed to the consequences of thisconflict. Replacing all Russian natural gas supplies to Europe isimpossible in the short to medium run and current price levels will28 Japan SPOTLIGHT • September / October 2022

have a significant effect on inflation. At the time of writing, theestimation is for at least 1.5 percentage points of additional inflationin 2022 which would erode household consumption and, together
with the expected fall in business investment and exports, lower GDP
growth by approximately one percentage point.
While Germany, Italy or some countries in the Central and Eastern
European region are more dependent on Russian natural gas, thetrade interdependence of Eurozone countries suggests a generalslowdown. A complete cut of Russian natural gas flows to Europe
would raise the cost to 4 percentage points in 2022, which would
bring annual GDP growth close to zero, and quite possibly into
negative territory.

Effects on Asia & Rest of the WorldIn Asia the economic consequences will be felt mainly through therise in commodity prices, which will fuel already existing inflationarypressures. As always when commodity prices soar, net importers ofenergy and food products will be particularly affected, with thespecter of major supply disruptions in the event of an even greater
escalation of the conflict. The drop in demand from Europe will also
hamper global trade to a large extent.
In the Asia-Pacific region, the impact will be felt almost
immediately through higher import prices, particularly in energy
prices, with many economies being net energy importers, led byChina, Japan, India, South Korea, Taiwan and Thailand.
As North American trade and financial links with Russia andUkraine are fairly limited, the impact of the conflict will mainly be felt
through the price channel and through the slowdown of Europeangrowth. Despite the prospect of slower economic growth and higher
inflation, the recent geopolitical events are not expected to derail
monetary policy in North America at this stage.
According to the World Bank, the US economy will likely expand
2.5% in 2022, 1.2 percentage points below the prior projection due
to higher energy prices, tighter financial conditions, and additional
supply disruptions caused by the invasion of Ukraine. The outlook
for China’s economic expansion is 4.3% in 2022 due to larger-thanexpected damage from Covid-19 and related lockdowns. Eurozone
growth is projected to slow to 2.5%, 1.7 percentage points less thanin January. Ukraine’s economy is set to shrink 45.1%.

The Russian Economy in 2022 & 2023
The Russian economy will be in great difficulty in 2022, falling into
deep recession. The decline in GDP forecast for 2022 by the WorldBank is 8.9%. Sanctions notably target major Russian banks, theRussian central bank, Russian sovereign debt, selected Russian
public officials and oligarchs, and the export control of high-techcomponents to Russia. These measures put considerable downward
pressure on the Russian ruble, which has already plummeted, andwill drive a surge in consumer price inflation.
Russia has built up relatively strong financials: a low level of
public external debt, a recurrent current account surplus, andsubstantial foreign reserves (about US$640 billion). However, thefreeze imposed by Western depositary countries on the latter
prevents the Russian central bank from deploying them and reduces
the effectiveness of the Russian response.
The Russian economy could benefit from higher prices forcommodities, especially for its energy exports. However, EU
countries announced their intention to limit their imports fromRussia. In the industrial sector, restricted access to Westernproduced semiconductors, computers, telecommunications,automation, and information security equipment will be harmful,given the importance of these inputs in the Russian mining andmanufacturing sectors.
Russian government consumption will increase in 2022 as thestate tries to prevent a steeper decline in growth. Government
consumption will be the only component of GDP to make a positive
contribution to headline growth in 2022. Since the invasion, theRussian state has announced plans to spend up to $67.8 billion insocial relief, compared to $42 billion spent on coronavirus support in2020 and 2021. The other component of GDP that will add support
to headline growth is net exports in 2022. In fact, I expect imports tocollapse at a faster pace than exports in 2022 owing to the G7
nations’ goods and technology embargos on Russia anddeteriorating domestic demand.
There may be some recovery in Russian import growth in 2023 asparallel import strategies become more effective. This will turn
Russia’s net export balance negative. As Russian companies run outof current stockpiles of Western-derived component parts, Russia’s
exports will decline in 2023 as industrial production andmanufacturing decelerates. Another factor limiting exports in 2023
will be the reorientation of the industrial sector toward the domestic
market to meet goods shortages. Russian Central Bank Governor

Elvira Nabiullina has urged manufacturers to reduce the goods theyexport in favor of trying to create goods needed at home, stressingthat this will be very important to the economy’s recovery and its
adaption to sanctions.
As a result of a more bearish trade outlook for 2023, Russia’seconomy will possibly suffer another year of contraction at least byanother 1.0% in 2023. The EU’s sixth sanctions package which cuts
90.0% of Russian crude imports from 2023 onward will have serious
negative effects, as Russian crude exports to India or China will not
be sufficient to replace these lost volumes. Crude exports to Europe
have accounted for around 50% of Russia’s total oil exports. At thesame time faster-than-expected disinflation points to very weakdomestic demand. Savings rate data indicate that Russian
households are running down their reserves to compensate forstagnating real wages. Depleted savings will limit spending in 2023,
driving further difficulties for the Russian economy in the mid-tolong term.
To return to the levels of 2021 may take over 10 years, unlessRussia takes reform measures, according to the head of the largest
bank, Sberbank Herman Gref, at the St. Petersburg International
Economic Forum (SPIEF). Under a so-called “inertia” scenario,
Sberbank forecasts Russia’s GDP to fall by 7% in 2022 and 10.3% in
2023 compared with 2021, when it grew by 4.7% to $1.77 trillion.
The decline would slide back into single digits in the following years
and reach -0.1% by 2030.
In sum, the continuing war will have serious negative effects on
the world economy. There are, and cannot be, any winners in thissituation. One may expect that a global recession, and the economic
collapse in Russia specifically, caused by its aggression in Ukraine,
will be a case study in one of the biggest ever political and economic
mismanagements of the 21st century. If this is what Putin would liketo be remembered for in the 22nd century, he will certainly have it.
Vesselin Popovski is a professor and vice dean of the Jindal Global Law
School in India, where he teaches students, undertakes research and writes
books.

Japan SPOTLIGHT • September / October 202229