Dr Gerard Lyons is senior researcher at Policy Exchange. He served as Boris Johnson’s chief economic adviser during his second term as mayor of London.
Russia is not an economic superpower. It is the largest country in the world by landmass. Its population is large, at 145 million, but is declining. Before this crisis, it was the eleventh largest economy in the world, while the United Kingdom is fifth. Russia’s per capita income is low. Its military (defense) expenditure is similar in dollar terms to that of the United Kingdom, although higher relative to the size of its economy. In addition to being a military power with nuclear capabilities, Russia is a major producer of raw materials and energy.
According to the International Energy Agency (IEA), Russia produced 10.72 million barrels per day (mbpd) of oil in 2021, second only to the United States at 16.39 mbpd. Russia produces more than Saudi Arabia, but exports less. Russia’s importance in terms of gas is even greater, accounting for 45% of EU gas imports and 40% of its consumption last year.
The most significant economic impact of the war will be contagion through rising energy prices. Before the conflict, gas prices were already high and oil prices tended to rise. War adds a risk premium to the prices of both.
Prices of other raw materials are already higher, especially wheat, given Ukraine’s importance as a wheat producer. In 2019, I gave the keynote speech at the annual Ukrainian Financial Forum in Kyiv, and it was interesting to note at the time how the economy was reforming, with a range of key exports including metals, minerals, agricultural products, a shift to digital exports, and also that about two-thirds of its public debt was owned by foreigners. It is depressing that this move to the open has been stopped dead in its tracks.
For many countries, including the UK, this rise in energy and food prices is occurring in an environment of rising inflation, which has not been helped by the loose monetary policy of the UK. ‘last year. Now UK inflation will peak higher, possibly over 10%, and persist for much longer, highlighting the low Bank of England key rate of 0.5%.
Financial markets are selling strongly. This reflects both uncertainty about the direction the war might take militarily and concern about future growth.
While high energy prices make inflation worse, they also sharply squeeze people’s disposable incomes and raise business costs. Also, while higher interest rates may be needed to rein in inflation, they could dampen the global economy later this year and early next year. Recession is even possible for the UK.
Financial markets have revised the outlook for interest rates: the direction has not changed, but the pace and extent of the expected tightening has changed. Markets are now seeing rates rise less rapidly than expected.
Another impact of the war is through sanctions. The magnitude of the sanctions will lead to a deep recession in Russia. As Russia’s military spending is budget driven, this could reduce its ability to spend more in this area. But there is little historical evidence that economic sanctions halted an aggressor’s military plans.
What impact will these sanctions have on the UK? Russia is the UK’s 19th largest trading partner with total annual two-way trade of £15.9 billion. Russia is our 26th export market and the 15th in the countries from which we import.
Russia as an export market for luxury goods will be closed. Annual exports from the UK are £4.3 billion, with cars being the largest item at £386 million, medicines and pharmaceuticals at £272 million and household goods. equipment at £199 million. Annual imports are £11.6 billion, the main items being: oil £3.6 billion, non-ferrous metals £1.3 billion and gas £559 million, as well as a wide range of other goods.
There will be an impact on financial flows. The UK has invested heavily in Russia and many companies may have to cancel those investments. In 2020, the UK’s direct investment stock in Russia was £11.2 billion. By contrast, total foreign direct investment from Russia into the UK was £681 million. Although this represents only 0.7% of the total stock, this may underestimate the Russian influence. The phrase “Londongradhas been attributed to the City since the introduction of the Golden Visa in 2008 and continued Russian involvement since then.
It’s an association we should seek to abandon – while keeping in mind the importance of differentiating between Russia and Putin’s regime. Being open, transparent, non-discriminatory, non-retrospective and respecting the supremacy of English common law is important to ensure that there are no unintended consequences of the actions we take now. In other words, we should punish Putin’s regime while improving the city’s reputation.
In terms of broader financial flows, the UK financial sector does not appear to be heavily exposed to Russia. The Bank for International Settlements shows total international bank loans to Russia of $121.5 billion, the largest of which was $25.3 billion from Italy, $25.2 billion from France and $17.5 billion from Italy. The UK’s exposure was $3 billion, so relatively low.
Russia’s exclusion from international capital markets is expected to have a profound impact on its economy. London’s role as a global financial center should not be impacted.
A key part of the sanctions was to cut off many Russian banks from the Western global payment system: SWIFT. The impact of this, however, has been diluted slightly due to Western Europe’s reliance on Russian gas and the need to still be able to pay for it; therefore, some Russian banks can still access the system.
However, a key decision was taken to exclude Russia’s central bank and thereby limit its ability to access the large amount of foreign exchange reserves it had accumulated over previous years, most of which is housed in central banks. outside of Russia. This measure, like the crossing of the Rubicon, could have profound longer-term consequences. There is no doubt that this adds to the financial and economic pressure on Russia.
This could accelerate the transition to a non-dollar-dominated global monetary system and a non-Western-dominated payment system. China, in particular, wants an alternative to the dollar-dominated system. Additionally, Russia and China have both developed their own versions of SWIFT in recent years. Moreover, we are already in an environment where, regardless of this war or broader geopolitical issues, a race is underway in all countries to develop new global central bank digital currencies.
Another aspect concerns global defense spending. The war strengthens the case for increased military spending, exemplified most starkly by Germany’s announcement that it will increase defense spending to the NATO target of 2 % expenditure of GDP. The UK is already achieving this target, but could yet decide to further increase defense spending. The war also shows the importance of soft power and control of the narrative, with the BBC being an important tool internationally to counter disinformation from Russia.
Many countries will be affected by the humanitarian fallout. The recent UN World Migration Report noted that there were 281 million international migrants. This represents an increase of six million on average per year worldwide over the past decade. So if, as some fear, there are five million migrants from Ukraine (44 million inhabitants), that would be huge.
War and sanctions will trigger an implosion of the Russian and Ukrainian economies. However, there will also be significant contagion, via higher energy prices. The UK will experience higher inflation now and an economic slowdown – and possible recession – over the next year.