In February the economic outlook and financial markets were dominated by talks of war, actual war, increasing consumer price inflation (CPI) and the outlook for interest rates.
A short background on the cause of the war between Russia and the Ukraine is appropriate as it creates perspective and impacts the international economic environment. A war was predicted some seven years ago by well-respected international political analysts. They stated the main cause of a war (when it eventually happens) would be the continued drive of the “West” (dominated by the USA) to expand the North Atlantic Treaty Organsation (NATO) – which would have put the USA and Europe on the Russian border – if the Ukraine were to become part of NATO. The USA (NATO) would then be free to establish a military presence in Ukraine. Russia (and China) continued to oppose this “power play”. However, for Russia it would become a a lose-lose situation. If it accepted Ukraine’s inclusion in NATO, the USA and Europe would have been on its border. If it went to war with Ukraine, most of the world would turn against them (imposing sanctions and reducing its international credibility). Russia chose to go to war! Although some talks about ending the war is ongoing, talk of a nuclear war is also increasing.
The war added fuel to the surge in some commodity prices. It has already contributed to higher international CPI, and “war-inflated” commodity prices are due to continue for at least as long as the war lasts. Energy prices, such as natural gas and oil, surged as Russia and the Ukraine are prominent players in these markets. Brent oil increased to more than $100 per barrel. Analysts estimate the price of oil could be less than $70 per barrel if the Russian-Ukraine conflict and some others in the Middle East can be resolved. However, chances are for oil to rather rise towards $110-$120 per barrel in the second quarter of the year, which, if it happens and stay at these levels ($120 per barrel) in the medium-term, may according to Capital Economics temporarily add two percentage points to world CPI.
As high oil and natural gas prices will increase CPI across the world, it puts central bankers in a difficult position. In the USA the CPI-rate has already risen to 7.5% in January, with energy and semi-conductor shortages still the main drivers. Although CPI may now increase more than expected (before the war), the Fed would most likely look past the effect of the war. It was amid strong demand already on a path to increase rates in March and will continue to do so. If the war doesn’t escalate, six interest rate increases of 25 basis points each, is possible this year (150 basis points), which, for one, will add pressure on emerging market currencies to depreciate (as the hiking cycle progresses).
In Europe and the UK, Purchasing Managers Indices increased sharply in February, reflecting a strong recovery from the dampening effect caused by the Omicron variant (of COVID-19). However, a cut of 10% in energy supply (as estimated by Capital economics) could reduce quarterly economic growth by 0.5%. In addition, input costs also recovered, putting more pressure on CPI. The Bank of England will continue to raise interest rates, but a more fragile Europe might still delay monetary tightening.
In South Africa, in his budget speech the minister of finance announced downward adjustments in personal income tax (PIT) by erasing bracket creep. This equates to a drop of approximately 40 basis points in interest rates. The fiscal deficit was also adjusted lower due to a revenue overrun, caused mainly by higher company tax collections stemming from profits accruing from high commodity prices. At this stage it seems the revenue overrun may continue for another year or so, reducing the fiscal deficit faster than budgeted. Also, the national treasury estimates that the number of PIT-payers to increase by about 500 000 this year, which may further contribute to revenue overruns in coming years.
Multivest Economic Division
The effects of sanctions on Russia – an easy to read explanation by Deloitte
It is difficult to write about the war in Ukraine without the text quickly becoming obsolete. Last week, first after Russia placed troops in eastern provinces of Ukraine, and then after Russia invaded Ukraine, Western countries announced a series of sanctions on Russia. Initially, the United States, the United Kingdom, the European Union, and Canada imposed such sanctions as banning secondary trade in Russian government bonds, banning interaction with key Russian banks, banning exports of critical technology to Russia, and freezing the assets and banning travel for elite Russians. In addition, Germany halted the Nord Stream 2 gas pipeline.
Russia’s defense against sanctions was the revenue it continues to obtain through the sale of oil, gas, and other commodities; and massive foreign currency reserves worth US$630 billion held by its central bank.
Given uncertainty as to how the war would unfold and what counter-sanctions Russia might initiate, financial markets reacted harshly to the invasion. Global equity prices fell sharply, especially prices on European exchanges. Bond yields fell, safe currencies (such as the US dollar and Japanese yen) rose in value, and the prices of oil and natural gas increased. The prices of other commodities that Russia and Ukraine export increased as well, including wheat and corn. Moreover, the Russian ruble and Russian equities fell sharply.
Then, over the weekend, the Western powers imposed more severe sanctions. Specifically, they sanctioned the Central Bank of Russia (CBR), thereby making it far more difficult for Russia’s central bank to obtain access to much of its foreign reserves. This was done by the United States, the United Kingdom, Germany, France, Italy, the European Commission, and Canada. Russia holds a sizable share of its foreign currency reserves in other countries. Much of its reserves are held in euros, pounds, and dollars, but some are held in gold and Chinese renminbi. If Russia cannot sell much of its reserves, it cannot defend against attacks on the ruble, thereby making the ruble vulnerable to collapse. Indeed, knowledge of this fact could generate a run on Russian banks.
Following the weekend decision by Western powers to sanction the CBR, the Russian ruble fell precipitously, dropping as much as 40% against the US dollar before bouncing back to a loss of about 28%. In response, the CBR increased its benchmark interest rate from 9.5% to 20%. CBR governor Elvira Nabiullina said that “the central bank today increased its key rate to 20% as new sanctions triggered a significant deviation of the ruble rate and limited the central bank’s options to use its gold and foreign exchange reserves. We had to increase rates to compensate citizens for increased inflationary risks.”
In addition, the CBR suspended equities trading on the Moscow Exchange. The Russian government imposed capital controls, meaning that Russians may not send money abroad and cannot service foreign currency debts. Also, the government ordered Russian exporters to sell 80% of the foreign currency they have earned this year in order to help support the ruble. This might help to offset the shortage of foreign currency driven by the sanctioning of the central bank. S&P Global cut Russian sovereign debt to junk status.
The restrictions placed on the CBR are the most important. US Treasury secretary Yellen said that “the unprecedented action we are taking today will significantly limit Russia’s ability to use assets to finance its destabilizing activities and target the funds Putin and his inner circle depend on to enable his invasion of Ukraine.” Prior to these sanctions, there was a widespread view that the CBR’s massive pool of foreign reserves (US$630 billion) would protect Russia’s economy from other sanctions and enable it to fund the war as well as compensate for any loss of export revenue. This is now in doubt given that Russia will lack access to a sizable share of its reserves. Moreover, the act of sanctioning the CBR led Russians to attempt to liquidate bank deposits, thereby putting the entire banking system under stress. On the other hand, the sanctions include a “carve-out” that enables energy-related transactions with the CBR. This is meant to avoid sharp swings in energy prices and allow oil and gas to keep flowing from Russia to the rest of the world.
The other major action this past weekend was to limit the ability of several Russian banks to utilize SWIFT, a financial messaging system at the core of international trade and cross-border currency movements. CBR governor Nabiullina said that Russia has a system to replace SWIFT and that all obligations of Russian banks will be fulfilled.