Ukraine is on the brink of economic collapse – but the economic damage is also huge for Russia and Kremlin chief Vladimir Putin.
What is the economic impact of Ukraine’s war on Ukraine, Russia and the rest of Europe? In a new study, the Vienna Institute for International Economic Comparisons (wiiw) examines the immediate consequences, on the one hand, and the medium-term structural changes caused by Europe’s biggest armed conflict since World War II, on the other.
Ukraine is now launching a counterattack against the Russians
In addition to the human suffering caused by thousands of deaths and millions of refugees, the economic damage is devastating, especially for Ukraine. Independent estimates put material damage to infrastructure and buildings in the first three weeks of the war at around $63 billion. The Ukrainian government sees it, including economic losses and damage to the military, at $565 billion. Ukraine’s regions directly affected by the war (including the capital Kiev) have so far generated around 53% of GDP. “Even if you leave out Kiev, a third of industrial and agricultural production and about a quarter of total exports came from the current war zones,” calculates Olga Pindyuk, an economist at wiiw specializing in Ukraine. “Of course the economy collapsed there,” says Pindyuk. With Black Sea ports being attacked by Russia and blocked from the sea, Ukraine has lost more than half of its export capacity. The main export products so far have been grain and steel. Overall, about a third of economic output in 2021 came from exporting goods.
Despite this, Ukraine has so far demonstrated remarkable macroeconomic stability. In mid-March, foreign exchange reserves were US$ 27.5 billion. The banking system has also been stable and liquid so far. “However, the Ukrainian economy will falter massively the more the foreign exchange earnings from exports, which are so important, collapse,” analyzes Pindyuk. Considerable international financial assistance could bring some relief. Including a Ukrainian-issued war bond, they now total about 18.5 billion US dollars.
Reconstruction will require massive financial aid
That doesn’t change the bleak outlook for Ukraine. “If too many companies close and unemployment rises, it will inevitably lead to a massive drop,” Pindyuk said. Banks need to be prepared for massive losses because facilities are damaged and loans can no longer be serviced. “It all depends on the course of the war, so predictions are difficult,” says Pindyuk. Should Ukraine be divided in the long term, the study assumes that the part that will remain independent will experience a strong upswing after the end of the war. Such an unoccupied Ukraine in this scenario would likely motivate many refugees to return, have strong Western ties, receive huge financial support from Europe and the US, and possibly also join the EU. Western investment could drive technological modernization and productivity gains. The opposite development threatens in the event of a division of the areas under Russian control.
Russia: Dissolution of Economic Ties with the West
Aggressor Russia also faces serious consequences. The Russian economy is likely to shrink by 7 to 8 percent at best in 2022, but possibly as much as 15 percent. The inflation rate could rise to 30% by the end of the year, causing real household income and, therefore, private consumption to plummet. “We can already see that sanctions are causing supply chain problems in many areas. This and the departure of many Western companies, for example in the auto industry, is heavily affecting industrial production,” says Vasily Astrov, economist and specialist in Wiiw Russia. The economic stimulus package announced by the government to face the crisis will hardly be able to solve these problems.
Although the Russian central bank was obviously surprised by the freezing of its foreign exchange reserves in the West, it has since managed to stabilize the macroeconomic situation. “Tight capital and exchange controls, regulatory easing for banks and a doubling of interest rates to 20% prevented a financial meltdown. The ruble has recovered to almost pre-war levels,” says Astrov. But investor confidence has been eroded and borrowing costs are rising.
Financing the war without an energy embargo is not at risk
However, the drastic sanctions imposed by the West will only affect Russia’s ability to wage war in Ukraine in the medium term. “The Russian government still has enough fiscal space to finance the war for much longer,” says Astrov. In his opinion, before Russia runs out of money, it is more likely to run out of modern soldiers and weapons.
In the medium term, the outlook for Russia is largely negative. Companies are losing access to Western technology as a result of sanctions and the mass exodus of Western companies, which will solidify Russia’s gap with rich countries. Even wider trade with Asian economies, especially China, can only partially offset this. Real income is likely to stagnate at the lowest level after the current drop. In principle, the attack on Ukraine started the dissolution of the economic network that Russia has built with the West over the past 30 years. “Even if sanctions are loosened, February 2022 will likely go down in history as the turning point where Russia’s integration into the European economy failed for an extended period,” said Richard Grieveson, deputy director of wiiw and co-author of the study.
High inflation due to energy prices and strategic turning point
Elsewhere in Europe, the war and sanctions are pushing up already high inflation, weighing on real incomes and hurting growth prospects. For Germany, it is estimated that each doubling in the price of natural gas reduces economic growth by 1% per year. “Of course, the damage would be much greater if the EU imposed an energy embargo on Russia or if Moscow stopped supplying gas on its own,” Grieveson said. Especially in Germany, Italy, Austria and the Eastern European EU members, which are particularly dependent on Russia for gas. “Of course, a situation could arise – for example, if Russia uses chemical weapons or commits more war crimes – in which Germany, which until now has strictly rejected an energy embargo, would also be forced by great political pressure to support it. it”. argues Grieveson.
In the EU, Russia’s attack on Ukraine will bring about fundamental structural changes at the strategic level. First, member states are likely to massively step up their defense efforts, as the German turnaround in this area shows. Second, the troubled dependence on Russian energy supplies will accelerate the economy’s green transformation. “Replacing Russian oil and gas with renewable energy in the medium term is a deal made in the EU,” Grieveson said. Third, the EU’s economic integration in the Eurasia region with Russia is on the brink of collapse. “The intermediate states will have to decide for one of the two sides, and that decision will mainly go to the EU”, says Grieveson. And fourthly, the prospects for EU membership for the countries of the Western Balkans can and must improve considerably. Ukraine shows how fragile partial Western integration can be. “Putin’s invasion should have made most EU capitals realize that these countries should be admitted more quickly to reduce the risk of instability and armed conflict,” says Grieveson.
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