Markets & Economy
Russia’s invasion of Ukraine shocked the world in February, sending markets into disarray and pressuring commodity prices higher. The upheaval came at a delicate time, as central banks were trying to strike a balance between taming persistent inflation and supporting economies still recovering from the COVID-19 pandemic.
Europe, with its extensive trade ties and geographical proximity to Russia, is particularly exposed to the economic impact. New forecasts by the European Central Bank reflect subdued expectations, with consumer prices expected to keep rising while growth softens.
Foremost among those concerns is the European Union’s reliance on Russian energy. Many EU members, including Germany and Italy, receive a significant portion of their oil and natural gas from Russia. That’s put the bloc in an awkward position of grappling with an energy supply shock while juggling inflation and the pandemic.
Europe’s reliance on Russian energy has influenced its approach to the war in Ukraine. The EU has joined the U.S. in imposing punishing sanctions but has been reluctant to target Russia’s energy exports; additionally, EU leaders have sought to maintain diplomatic contact with Moscow.
“A significant reduction in gas supply would have substantial negative effects on the eurozone’s GDP, especially in Germany and Italy,” Capital Group economist Robert Lind explains.
However, there are glimmers amid the storm clouds. European leaders proved themselves to be flexible and forward-thinking in their pandemic response, Lind says — essential qualities when responding to the Ukraine war. Additionally, the eurozone had been benefiting from a generally well-executed stimulus effort that helped limit inflation and job dislocation.
“In hindsight, the European fiscal stimulus in response to the pandemic looks well targeted,” Lind adds. “Before the Ukraine crisis, there wasn’t a sense that the eurozone needed to go through the kind of monetary contraction that the U.S. might need. And it produced fewer issues with labor supply, nothing like the Great Resignation the U.S. experienced.”
Perhaps most immediately pressing for the Continent is its outsize exposure to Russian energy, which accounts for nearly 40% of eurozone natural gas imports and 25% of oil imports.
“Germany really can’t afford right now to turn off Russian gas, because it’s such an important power supply,” observes Capital Group equity portfolio manager Carl Kawaja. “Many European countries depend on Russia for stable energy supplies.”
That has made the EU hesitant to aim sanctions directly at Russian energy, Lind explains.
“The ECB estimates a 10% reduction in energy supply would reduce eurozone GDP by around three quarters of a percentage point,” he says. “A full energy embargo could depress GDP by 3% to 4% relative to the pre-war baseline.”
Such a headwind would be a serious threat to any economic recovery. Some states are already taking steps to diminish their dependence on Russia: Germany suspended certification of Nord Stream 2, a pipeline that would have substantially increased the amount of natural gas that Russia could export, while the Group of Seven economic bloc — which includes Germany, France and Italy — agreed to refuse a Russian request in late March to pay for natural gas with rubles.
Domestically, Lind says some European governments are focusing their budgets on defraying energy costs for consumers. Meanwhile, another round of EU fiscal spending could help countries permanently step away from Russian energy.
In the short term, EU countries will likely search for alternative sources of energy, such as liquefied natural gas (LNG). However, the suddenness and timing of the invasion could undermine efforts to pivot. With prices suddenly rising across the board and countries eager to bulk up energy stockpiles ahead of winter’s higher demand, it’s likely that energy costs will become a drag on European economies for the foreseeable future.
“I think we’ve seen the beginnings of a reordering of the global energy complex,” Kawaja says. “There are going to be a lot of implications for energy and infrastructure companies. Anyone that doesn’t have a domestic energy supply is now looking at building facilities to import LNG.”
While the EU remains a diverse set of countries, Lind says national leaders have already shown a strong capacity to work together and implement far-reaching plans — valuable assets during a fraught period.
Early in the pandemic, there had been fears that the EU was not prepared for any sort of crisis. The UK had just left the bloc, and Germany’s Chancellor Angela Merkel — the de facto leader of the union — was close to the end of her term. That was compounded by memories of the Greek debt meltdown, a largely self-inflicted wound fueled by punitive politics after the 2008 global financial crisis.
However, European leaders overcame those worries, Lind says. Their carefully targeted stimulus plan encouraged employers to keep workers on payrolls during the depths of the lockdowns and limited how much excess cash was added to the system. The resulting post-pandemic recovery hasn’t been as explosive as its U.S. counterpart, but it’s been marked by less inflation and labor disjunction. In addition, the EU’s Recovery Fund has deployed common borrowing to promote public investment in the climate transition, which is supporting growth in countries such as Italy and Spain.
In its response to the pandemic, the EU showed a remarkable willingness to learn from its past mistakes and provide a forceful policy package to contain the damage, Lind adds.
Now, the war in Ukraine presents another crisis that requires strategic thinking and a willingness among policymakers to be flexible and pragmatic. With parliamentary elections in France and a new government in Berlin trying to reconstruct Germany’s diplomatic, military, energy and economic policies, the next few months could be critical to the stability of the EU.