Ukraine Crisis: Potential Impact of Russian Invasion on Ukrainian, Russian and EU Economies

The significance of Russian aggression for Ukraine, the Russians themselves, and the resulting future relationship between the West and Russia are central to the world we want to live in.

Despite diplomatic efforts and a flurry of visits to Russia and the region, Russia continues to escalate its threat to Ukraine.

With increasingly bellicose rhetoric and the de facto fact of increasingly reinforcing its forces on Ukraine's borders and also in Belarus, Russia continues to build the potential for conflict.

The Kremlin has engaged in multiple attempts and malign activities to undermine Ukraine's democratic institutions and pressure its citizens, has intimidated the Ukrainian leadership, has interfered in Ukraine's politics and elections, has suspended energy supplies and blocked trade, has launched what are believed to be cyberattacks on the country's critical infrastructure, and is attempting to help destabilize Ukraine with a permanent propaganda and disinformation campaign.

Behind the Russian aggression against Ukraine is the question of whether Ukraine has a right to exist as a sovereign state and, subsequently, whether Ukraine has the right to decide whether it wants to be a democracy.

This crisis is not primarily about weapons or military bases. It is about the sovereignty and the right of self-determination of Ukraine and, beyond that, of all states.

And at its core, it is about Russia's rejection and envy of a Europe that is free and democratically elected and, moreover, economically successful.

Therefore, the West cannot allow Russia to violate the priciples and principles that underlie its worldview, developed over centuries.

Allowing it to do so would relegate the entire Western value system to a much more dangerous and unstable time with disastrous consequences.

It would send an additional message to other authoritarian states that these principles are expendable.

Study on the potential economic impacts of a Russian invasion of Ukraine and new sanctions on Russia

The Vienna Institute for International Economic Studies (WIIW) conducted a study on the potential economic impacts of a Russian invasion of Ukraine and new sanctions on Russia.

The authors of the report analyzed two scenarios: a limited military intervention and a full-scale invasion.

The study found that sanctions resulting from any Russian invasion of Ukraine would not only negatively impact Russia but also Ukraine and the EU.

Russian exclusion from SWIFT and US dollar

According to the report’s authors, Russia is most vulnerable to a decrease in its energy exports.

“However, restricting oil and gas trade with the EU is a ‘nuclear’ option, given the huge costs this would inflict on EU members such as Germany, the Baltic states and Central European countries, that are highly dependent on Russian energy supplies,” explained Artem Kochnev, an economist at WIIW specializing in Russia and co-author of the study.

The authors argue that the other “nuclear” option would be cutting Russian banks off from the US dollar and barring them from the SWIFT system.

“That would cause significant financial disruption in Russia, a reduction of lending and investment, and require large-scale state injections of capital into the banking sector,” stated Kochnev.

Although this would severely cripple economic growth in Russia, the study shows that a coordinated policy response by the Russian Central Bank and the government would maintain macro-financial stability for at least one year.

One can see from the study that Russia is not completely protected from the impact of sanctions, but it does have some wiggle room if sanctions are imposed.

Russia has very low levels of external debt (29% of GDP in 2020) and a current account surplus, limiting external exposure.

Excess oil and gas revenues have accumulated in the National Welfare Fund, which accounts for 12% of GDP, and conservative monetary policy has allowed the build-up of substantial foreign reserves, totaling around 640 billion US dollars.

“Putin has worked hard to build ‘Fortress Russia’ to make western threats less of a deterrent, though parts of the economy remain vulnerable to sanctions,” said Olga Pindyuk, an economist at WIIW and one of the authors of the study.

The particularly vulnerable industries are those that rely heavily on high-tech imports from the West, especially semiconductors and machines.

Although an embargo on these products would severely hurt the specific industries, the study found that it would not prove fatal to the Russian economy as a whole.

The authors of the report argue that “given Russia’s substantial fiscal buffers, the real threat to its economy is not in the short term, but rather the effects of significant Western sanctions long into the future.”

They also explain that restrictions on Russian imports of high-tech industrial inputs would amplify the country’s isolation from the most advanced parts of the global economy.

This would hinder economic modernization, particularly a much-needed diversification and improvement in competitiveness.

Additionally, the study shows that Russia will likely be able to partially offset sanctions through closer ties with China, especially in the energy sector.

However, limited access to Western capital and technology would worsen its already weak growth prospects.

EU: Rising inflation looms in case of energy crisis

While the WIIW’s study found that there would be significant impacts on parts of the Russian economy, it also showed that even limited military operations would have “considerable direct and indirect economic consequences for the EU, especially in the energy sector, where dependence on gas and oil supplies from Russia is strong.”

According to the report, the most vulnerable countries are Germany, Austria, and much of Central and Eastern Europe (CEE).

Following Russia's annexation of Crimea in 2014, trade between the EU and Russia dropped considerably.

“Almost all EU and CEE countries export and import proportionately less to and from Russia than in 2013,” noted Richard Grieveson, Deputy Director of WIIW and co-author of the study.

Simultaneously, the share of Russian direct investment has fallen sharply.

Although the Russian and the EU economies have partially decoupled since 2014, the study suggests that the fallout of a military conflict would still be severe for the EU.

Even countries that diversified their energy supplies more than Germany or Austria would be affected.

The current tensions are already contributing to very high energy prices, which has pushed up headline consumer price inflation to multi-year highs across Europe.

The authors of the report assert that any cut in gas supplies to Europe would have an immediate additional impact on world markets.

“Sharp increases in energy prices would further fuel the already high inflation, with negative consequences for the economy in the entire EU,” said Grieveson.

Some European banks could be affected

Grieveson also warned that “financial sanctions against Russia could also hit some major European banks with large Russian holding hard.”

The biggest Western lenders are Austria’s Raiffeisen Bank International (RBI) and France’s Société Générale, both owning Russian assets worth 18 billion euros as well as Italy’s Unicredit with 15 billion euros of exposure in Russia.

Ukraine would require Western support

According to the study, Ukraine's economy would suffer the most from a military conflict.

It has already been affected by the threat of an invasion. The currency has depreciated, and the risk premiums for government and other securities on capital markets have risen. Additionally, the domestic reform process has slowed down.

If Russia does take military action, the report demonstrates that the impact on economic activity will vary between regions. The Western parts of Ukraine, which would be located further away from the conflict, would be less affected.

However, the potential destruction of critical pieces of Ukraine’s infrastructure would have ramifications for the whole economy. Ukraine might lose access to its main ports around Odesa, which handle nearly half of the country’s exports and imports.

If part of the transit pipeline infrastructure is damaged, the report shows it will cause major interruptions of energy supplies to a large part of the country.

Though the economic ties between Ukraine and Russia drastically reduced following the annexation of Crimea in 2014, rising energy prices due to sanctions will strongly affect the economy, as energy bills account for a substantial share of household expenditure and the country has limited fiscal space to shield households from price spikes.

In addition, the conflict is having a significant impact on investment activity and disrupting foreign direct investment inflows.

The authors concluded that, in either scenario, Ukraine would need Western support to ensure macro-financial stability.

The EU and the International Monetary Fund both have promised billions in new aid.

“In the long run, the conflict with Russia could establish a clear demarcation line, with the rest of Ukraine becoming more firmly entrenched in the Western camp receiving significant economic support. However, it is also possible that the current conflict will lead to a further slowdown of reforms,” said Pindyuk.

Vienna Institute for International Economic Studies (WIIW)