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Ukraine Conflict and Deteriorating Investment Climate Hit Russia's Economy

In addition to souring relations between Russia, Europe and the United States, further escalation of Russia's engagement in Ukraine could cost Russia more than 3 percent in GDP in real terms or USD115 billion in current dollar terms on average in 2015. The conflict could also exacerbate recessionary pressures, and lead to a reduction in European real GDP of about 0.15 percent overall, according to a scenario developed by economists at IHS Inc., (NYSE: IHS), the leading global source of critical information and insight. Details of the scenario will be presented at the IHS Forum in Berlin May 13.

Russia’s economy, already likely in recession, will dampen further in the face of a deteriorating political situation; tougher sanctions; falling investor confidence; and a business climate worsened by fears of retaliation against western companies that produce in or sell to Russia, according to the IHS scenario.

A severe slowdown of Russia’s economy in the second half of 2014 and continuing into 2015 would lead to a reduction in European real GDP growth by about 0.15 percent overall, but with large variations between countries, the IHS study says. Most affected would be traditional machinery and equipment and chemical products’ exporters such as the Netherlands, Belgium and Germany. Also impacted would be Italy and Spain, as would countries highly dependent on Russian imports, such as Finland.

Additionally, non-European economies stand to suffer from the slowdown. Among these are Argentina, Australia and Brazil, who would suffer from lower world demand for their commodity and manufactured exports, triggering spill-over effects on their own trading partners in Asia and Latin America.

IHS economists developed the scenario in response to heightened tensions brought about by Russia’s annexation of Crimea and its ongoing dispute with Ukraine following the ouster of Ukraine’s president and scheduling of new elections in May.

The scenario was developed by a team headed by Elisabeth Waelbroeck-Rocha, IHS Chief International Economist, and IHS Chief Economist Nariman Behravesh using a new, state-of-the-art IHS Global Link Model. The model enables IHS to quantify the impacts of further degradation of the economic situation in Russia on other countries in Europe and globally.

“While Russia could end up paying a very heavy economic price for its annexation of Crimea and its ongoing conflict with Ukraine, the negative impacts on other parts of the world, notably Europe, will also be hard to avoid,” says Behravesh.

The scenario assumes:

    1.   An erosion of business confidence in Russia, leading to the postponement or outright cancellation of investment projects.
2. Increased outflows of capital from Russia, exerting severe downward pressure on the rouble and forcing monetary authorities to raise interest rates to stem the outflows:
--   Russians shift part of their savings abroad, or into foreign-currency denominated accounts;
-- Inbound foreign direct investment into Russia falls by as much as 50 percent in 2014-15;
-- Higher FDI outflows occur, further worsening the capital balance;
-- The balance of portfolio flows also deteriorates: although not much is expected on the inflow side (portfolio investments into Russia being fairly limited in any case), capital outflows increase as residents move out of rouble assets in anticipation of a depreciation of the rouble;
-- Trade credits and bank lending to Russia are also hard hit: this is the lion’s share of foreign investment in Russia at this time, with 84.0 percent of total foreign investment in the non-financial sector in 2013, according to RosStat, at $143 billion;
-- The “Other Liabilities” account also shrinks, leading to a total impact on the capital account of the balance of payment by USD83 billion in 2014 and USD108 billion in 2015.
3. These capital outflows prompt a depreciation of the rouble by up to 15 percent by end-2014, and trigger a 175-basis-points increase in the Russian Central Bank’s key intervention rate to slow the depreciation; in 2015-16, interest rates remain higher than in the baseline scenario, and only come back to the level in the reference scenario by the end of 2016.

As a consequence, credit conditions tighten significantly and credit costs rise. Private and public sector investments are negatively affected – state-owned enterprises suffer cuts in earnings and find it harder to borrow abroad, defense spending slows because of reduced revenues and projects are either slowed or stretched out, and private sector investors cancel or postpone projects because of higher financing costs and tighter credit conditions.

The scenario also foresees a temporary spike in natural gas prices – 20 percent in Europe and 10 percent in Asia – because of the standoff between Russia, Europe and the U.S. The price shock is short-lived, however, because end-users shift to other sources and types of fuel: increased power generation from coal-fired plants, higher gas imports from Algeria, greater share of renewables, and higher energy conservation. In addition, the scenario foresees a limited diversion of some exports of Russian crude and products to Asia.

The impact of Russia’s slowdown of imports from the rest of the world is one of the main spill-over effects on other countries’ growth. Most impacted are Finland and Romania where real GDP growth is cut by 0.2 percent in 2015. Belgium, the Netherlands, Poland and Slovakia also feel a slowdown in GDP growth.

Least affected in the group is Germany. Machinery and equipment accounted for a large portion of the 48.6 percent of Russia’s total imports in 2013, much of it coming from Germany. However, the impact on German GDP, just 0.10 percent in 2015, reflects Russia’s status as a relatively small trading partner for Germany.

China and Korea’s growth is less affected, by only 0.05 percent. In Asia, the negative impact of Russia’s slowdown is attenuated by the relative improvement in energy price trends compared to Europe. Real GDP in India will be reduced by 0.2 percent; Indonesia by 0.6 percent; and Malaysia by 0.6 percent. There is virtually no effect on Japan’s economy.

Asia also benefits from the trade diversion that occurs. The effects of the slowdown on world commodity prices are expected to remain muted. So, while Russia is a major exporter of steel, there are excess production capacities for steel in China, enabling China’s exports to fill the gap in the market.

Complimentary Media Pass – IHS Forum Berlin

Members of the press can register for a complimentary pass to the IHS Forum in Berlin, held at the InterContinental Hotel Berlin, May 12-14. Please send an email with your name, title and outlet details to [email protected].

Further information and delegate registration is available at http://ihsglobalevents.com/forum/berlin2014

About IHS (www.ihs.com)

IHS (NYSE: IHS) is the leading source of information, insight and analytics in critical areas that shape today’s business landscape. Businesses and governments in more than 165 countries around the globe rely on the comprehensive content, expert independent analysis and flexible delivery methods of IHS to make high-impact decisions and develop strategies with speed and confidence. IHS has been in business since 1959 and became a publicly traded company on the New York Stock Exchange in 2005. Headquartered in Englewood, Colorado, USA, IHS is committed to sustainable, profitable growth and employs more than 8,000 people in 31 countries around the world.

IHS is a registered trademark of IHS Inc. All other company and product names may be trademarks of their respective owners. © 2014 IHS Inc. All rights reserved.

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