Get ready for War Aftershocks: Inflation galore

Any disruption in dry bulk trade will spike up global grain, coal, and iron ore prices

By Yaduvendra Mathur 

The unfortunate Russia – Ukraine situation carries huge risks for the world economy already hit by the virus. Two key points of vulnerability – high inflation and jittery financial markets will easily worsen with aftershocks of economic sanctions biting in unknown ways even the distant bystander countries.

The ratcheting up of oil prices beyond US$ 100 per barrel for the first time since 2014, with European natural gas jumping 62 percent, poses a very real threat to global growth. Households all over are under threat – spending an ever-larger chunk of dwindling incomes on fuel and heating costs –  tragically drops in purchasing power for other necessary consumer goods and services – especially health – is going to be felt sharpest in most developing countries. Plunging financial markets would add another drag, hitting wealth creation and confidence, and making it harder for firms to tap funds for investment.

This is going to be harder going forward. Bloomberg Economics has out- lined three scenarios on how this conflict could impact growth, inflation, and monetary policy.

 In the first scenario, a swift end to fighting prevents a further upward spiral in commodity markets, keeping the US and European economic recoveries just about on track. Central Bankers would have to tweak their plans, not scrap them. We are already in the second week of the conflict.

In the second scenario, a prolonged conflict with tougher Western responses and disruptions to Russia’s oil and gas exports would deliver a bigger energy shock and a major blow to global markets. That would likely take European Central Bank (ECB) rate hikes off the table this year while Fed tightening would slow down.

A worst-case outcome would see Europe’s gas supply cut off, triggering a recession, while the US would see significantly tighter financial conditions, a bigger hit to growth, and a markedly more dovish Fed.

Wars are inherently unpredictable and the actual outcome is likely to be messier than any of these stylized versions. Wild swings in financial markets have illustrated this uncertainty. Still, the scenarios should help frame thinking about possible paths ahead.

Energy prices are the main channel through which the Ukraine war has an immediate impact far from the frontlines. This risk is especially acute in Europe because Russia is its main supplier of oil and gas soaring energy costs accounted for more than half the euro area’s record inflation rate in January. European natural gas futures peaked above €140 per megawatt-hour in February and could leave Euro area inflation touching 3 percent by the year-end.

Impact on US Economy

In the US, more expensive gasoline and moderate financial tightening would drag on growth as the US sends out more of its natural gas to Europe, raising prices at home. Headline consumer price inflation is 8 percent in February and by end of the year may close at 5 percent, compared to the 3 percent consensus. Still, the Fed would probably look beyond the temporary price shock and go ahead with its plans to start raising interest rates in March, though not by 50 basis points.

Barring an unexpected turn in the economy, we believe it will be appropriate that the funds’ rate are moved up in March with further increases in the coming months. It is clear that most of the world economies are moving towards normalizing monetary policies, but this may be somewhat delayed.

For the US, the growth shock would be sizeable too and there could be unintended consequences from maximal sanctions that disrupt the global financial system with spillovers for U.S. banks if higher prices led to inflation expectations are entrenched among consumers and businesses. The worst-case scenario for monetary policy is the need to tighten aggressively even in a weak economy.

SWIFT effect

Finding itself cut off from the Swift system for international payments, Russia would certainly retaliate by turning off the gas flow to Europe. This as a scenario wasn’t considered last year by European officials when they ran a simulation of 19 scenarios stress test on European blocks energy security.

Still, the ECB estimates that a 10 percent gas rationing shock could shrink euro area GDP by 0.7 percent. Scaling that figure up to 40percent  rationing, as this is the percentage share of European gas that comes in from Russia, implies an economic hit of at least 3 percent though the actual figure may be significantly higher given the chaos that’s such an unprecedented energy crunch would likely set off.

This would mean recession and no ECB rate hikes in the foreseeable future. The above scenarios of course do not exhaust myriad other possibilities as these are focused on the world’s biggest advanced economies. Yet countries everywhere will feel the impact of commodity price spikes which include food staples like wheat as well as energy.

Supply Chain Disruption

Over the decades, both Russia and Ukraine have emerged as the major exporters of various dry bulk commodities. Russian exports of coal, fertilizers, and grains are in excess of 255 million tons (MT) while Ukraine is exporting 87 MT of iron ore, fertilizer, and grain every year. The segment-wise breakup of Russian exports breakup presented by Marine Analytics’ latest Report on the shipping industry indicates that most of the commodities are traded, largely in super-size dry bulk ships, to South Asian countries the Middle East, and North Africa, is likely to be severely hampered. Russian trades in dry bulk is 18 percent with China, 13 percent with EU, 11 percent with Turkey, 8 percent each with Japan and Brazil, while the other countries constitute the rest.

Russian coal exports are in excess of 49 MT in 2021, up from 25 MT in 2020 while the EU alone imports more than 24 MT in 2021. Russian grain exports to Egypt in 2020-21 were in excess of 6 million tons while countries like Turkey, Iran, Saudi Arabia, even Bangladesh imports 2 MT of grain from Russia along with other South Asian countries. The Middle East and North African trade will also be severely hampered.

Ukraine’s total dry bulk trade is as much as 35 percent with China, 19 percent with EU, Turkey 6 percent, Egypt 5 percent, Indonesia and Russia 3 percent each, while the US is importing around 2 percent of its dry bulk from Ukraine.

Any disruption in this dry bulk trade itself shall certainly spike up global grain, coal, and iron ore prices, just as the natural gas prices increase sharply in European Union will force upward movements to other fossil fuels prices.

There are no data to understand where one goes from here on. These are bizarre scenarios.

With the war situation escalating in these major exporting countries Russia and Ukraine – the sanctions are going to pull out significant commodities, especially dry bulk, from the market spiraling inflation. In the long-run inflation may taper because of a drop in demand but the world economy is in for a very serious shock unless diplomatic and political leadership rises to an unprecedented challenge, never encountered since 1945.

(The writer is a 1986 batch IAS officer. He retired as Special Secretary, NITI Aayog. Mathur is a specialist in development finance and was CMD of Export-Import Bank of India. He had been associated with the BRICS Development Bank, and represented India at the Board level of the African Development Bank.)

Images courtesy of (Image Courtesy: Dry Bulk Report) and .

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