Together with many business and economic leaders around the globe, we at the Kenan Institute of Private Enterprise support the harshest feasible sanctions against Vladimir Putin in the immediate interest of Ukraine and its people. More broadly, we view such measures as vital to the long-term survival of democratic values. But as the Russian invasion continues, seemingly unabated by unprecedented economic and financial sanctions, we must ask: what more is feasible? And for how long can such restrictions be sustained?
To answer those questions, we must first acknowledge that Russian sanctions cannot be contained. Restrictions will increasingly impact the global economy and supply chain, putting advanced economies – those responsible for the toughest and most meaningful sanctions – under pressure. Whether that pressure will be enough to prompt policy changes, though, is uncertain. To that end, we set out to better understand the forces at play through analysis of sanctions’ effects on western economies.
We examined the impact of economic sanctions as related to three important factors: divestment, inflation and economic growth.
First, large investment pools – especially in the U.S. and Europe – have pledged to abandon or liquidate investments tied to Russia. Similarly, many multinational companies have announced a suspension of business in Russia. Are these pledges credible and sustainable? We believe they are. From our discussions with investors and business people, Russia represents a small share of investment and income, and these assets are already likely to be impaired. While there was no legal obligation — and perhaps the opposite — to divest, institutional values dictated the response and important stakeholders appear very supportive.
Most institutions have very little direct investment exposure to Russia and Ukraine; by our estimates, less than 2% of total portfolios. Much of this is via emerging market equity indices and emerging market debt (EMD). While EMD is probably most at risk and will see some form of default, total risk is on par with risk-budget expectations for the asset class. Likewise, there have been quite modest effects to date on broad equity and fixed income market indices. The concern is that increased costs of capital (higher risk premia) and declines in wealth from falling equity prices. Yet, most equity markets are down just a few percent from pre-invasion levels, and interest rate spreads between high yield and risk-free bonds have risen by less than 1% since news of a possible invasion first surfaced. In short, the pure financial impact of sanctions, while potentially devastating for Russia, will be small for most other countries.
The economic effects of sanctions on advanced economies is a bigger threat. Here, we need to be careful to differentiate between Europe and the rest of the world. Beginning with non-European advanced economies, the conflict in Ukraine raises two main concerns: higher inflation driven largely by energy prices and falling consumer spending. If the current jump in energy prices holds, it is likely to increase headline inflation by roughly one-to-two percentage points in March. Will this cause the monetary authorities (e.g., the Fed) to accelerate the tightening of monetary policy and increase the risk of a hard landing? We believe not. The lessons learned from previous energy price spikes is that they act as a tax on consumers which slow the economy, and so central banks are likely to look past energy price increases that are driven by geopolitical conflict.1
But will the “energy tax” depress consumption significantly on its own? We estimate the current increase in energy prices will cost consumers roughly one-quarter of a percent of GDP, though some of this will be offset by increased income and investment in the energy sector (particularly in the U.S. which, because of increased energy independence, will have a much larger offset than 20 years ago). Effects from declining wealth on consumption are also likely to be very small. For example, a change in equity value of $100 has historically induced just a $3 change in annual household spending.2 Historical macroeconomic models suggest that even a sustained 10% decline in the equity market lowers overall GDP growth by only about two-thirds of a percent of GDP over the next year.3
Another direct channel is the impact on international trade. For example, U.S. exports to Russia total about $11 billion per year, while Ukraine is less than half of that. If exports completely stop to both countries, that would cut less than 0.1% from U.S. GDP growth. Most non-European countries have similarly low export exposures, suggesting modest effects to economic growth.
Taken together, current conditions imply a total drag of less than 1% on GDP growth over the next year for advanced economies outside of Europe. While this is undesirable, it is unlikely by itself to substantially alter the sentiments around sanctions.
The real economic risk lies in Europe. Effects on both inflation and the real economy will be much greater. However, the saliency of Russia’s hostility there is also greater. On net, these appear to tip in favor of continued support for severe sanctions, but the rest of the world should not take this for granted. Direct assistance from non-European countries, such as the U.S., should soften the blow being felt by Europe. While some of the challenges Europe faces over the next year may be extreme, coordinated economic responses could be effective. Imagine a “Marshall Plan” that goes full-bore over the next nine months to help replace Russian natural gas with LNG and Russian wheat with North American and Asia-Pacific wheat by rapidly expanding production and transport capacity. This could also support developing economies which could be hit hard as they tend to have greater energy and food dependency.
The unified and strong reaction to Russia’s aggression is encouraging, but we believe it is also most likely to succeed if policy coordination can work quickly and deliberately to diminish the impact to the economies at greatest risk.