Markets have stabilized after Russia’s invasion of Ukraine on February 24, as if the bombs and missiles weren’t disrupting the global economy. But the economic war running parallel to the gunnery war is heating up and deserves more attention than investors might be paying.
Much of the analysis of the Russian war in Ukraine focuses on brutal land battles over terrain as invasion and defense forces fight village after village in eastern and southern Ukraine. But just as important are multinational efforts to choke off Russia’s economy by cutting the energy revenues that fund Russia’s military and denying foreign technology that Russia needs to maintain and replenish its weapons. Like tank and artillery battles, the economic struggle is a war of attrition in which whoever lasts the longest is likely to win.
The economic war intensifies while the unlikely seems possible: Ukraine could win. The normally taciturn US Secretary of Defense Lloyd Austin has started talking about how the US and NATO are deliberately weakening Russia en route to a Ukrainian victory. Heavy weapons like tanks and artillery, which Western nations were reluctant to hand over to Ukraine at the start of the war, are now flowing more freely.
In response, Russia has now halted natural gas supplies to Poland and Bulgaria, its strongest move yet to punish nations aiding Ukraine and a signal that Russia could shut off taps or shut them down altogether if it feels increasingly threatened. “All three parties to the conflict, NATO, Russia and Ukraine, are escalating,” the Eurasia Group warned in an April 27 analysis. “Further escalation becomes more likely as hostility increases.”
Poland and Bulgaria can probably do without Russian gas. But Russia and its energy customers are now beginning to “arm” oil and gas supplies, in one of the more alarming scenarios analysts painted at the start of the war. If Russia cuts off gas supplies to other European countries or the entire continent, it would lead to skyrocketing prices in Europe and likely a recession, which could erode support for aid to Ukraine by increasing the cost to millions of European voters.
The story goes on
At the same time, European nations are considering a gradual boycott of Russian oil, which they can more easily substitute from sources other than Russian gas. Even so, a broader embargo on Russian oil would raise global prices for everyone and increase inflation in Europe, the United States and elsewhere. Tightening the screws on Russia’s economy is causing collateral damage in many other countries.
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The sanctions against the Russian financial system are having the intended effect. But those sanctions still give Russia room to sell oil and gas, and Russia is benefiting from high energy prices, caused in part by its own invasion of Ukraine. Some analysts believe that Russian President Vladimir Putin timed his invasion of Ukraine to coincide with the departure of former German Chancellor Angela Merkel in December, or even Joe Biden’s ouster from Donald Trump as US President last January. But it’s more likely that high energy prices in the run-up to Russia’s Feb. 24 invasion convinced Putin that even with sanctions inevitable, he would have an energy revenue cushion.
Russian President Vladimir Putin and German Chancellor Angela Merkel enter a hall during a news conference following their talks at the Kremlin in Moscow, Russia, August 20, 2021. Alexander Zemlianichenko/Pool via REUTERS
According to the Institute for International Finance, Russia’s energy revenues reached $76 billion in the fourth quarter of 2021, the highest level in 10 years. The research group believes that higher oil and gas prices could boost Russia’s energy revenues even with sanctions. For this reason, European nations and others that impose sanctions are now considering going further by halting oil purchases altogether or increasing financial sanctions that would effectively prevent the financing of these transactions.
If any of these things happen, a key factor is whether big energy buyers like China and India would buy most or all of the oil that Russia couldn’t sell elsewhere, which they could possibly get at a significant discount to global prices. If they do, it would obviously be a lifeline of sorts for Putin’s military funding. The United States is spearheading efforts to cut off Russia, a pressure campaign that could reshape global relations for years to come. The military struggle in Ukraine is unlikely to spill over into World War III, but the economic struggle could force nations sitting on the fence to choose sides and face the consequences.
An opaque battle over technology
Global energy markets are providing an up-to-the-minute account of how the energy war is likely to affect prices and the global economy. The battle over the technology available to Russia is far more opaque. The United States and many other nations have enacted sweeping bans on the sale of computer equipment and many other items to Russia to inflict pain on Putin and the Russian economy. Some of these technologies have military applications that could directly affect Russia’s offensive in Ukraine.
Russia has vast stocks of Soviet-era military equipment, but its stores of advanced weaponry are more limited. British researchers studying the remains of Russian weapons in Ukraine discovered a heavy reliance on components from the United States and other countries, which are now helping Ukraine fight Russian forces. Russia’s warfare capabilities include US-made circuit boards in the advanced Iskander-K cruise missile, US-made fiber-optic gyroscopes in the 9M949 artillery missile, and a British-made oscillator in the TOR-M2 air defense system.
“Almost all of Russia’s modern military hardware depends on complex electronics imported from the US, UK, Germany, the Netherlands, Japan, Israel, China and elsewhere,” Jack Watling and Nick Reynolds wrote in a recent report for the Research group RUSI.
The Pentagon says Russia is starting to have “stockpile problems” with precision-guided munitions and is relying more on “dumb bombs” that are far less accurate. Building sophisticated weapons is difficult enough, and “here the Russian military industry faces a problem,” according to the RUSI report: “Russia’s latest weapons rely heavily on critical specialty components manufactured abroad.”
Putin and his advisers famously miscalculated by plotting a rapid military campaign that would immediately oust Ukraine’s elected government. That fumbling has left Russia with a shell-shocked army that has lost at least a quarter of its fighting strength and a grueling war that Russia could actually lose.
Another consequence is that Russia is certainly scrambling to find foreign components it needs to rebuild key weapon stocks. Russia does not have to buy this equipment directly from the companies that make it, which in most cases would violate sanctions if they shipped anything to Russia. Instead, Russia is likely to look for components through third party or black market sources, or even through theft. Western governments are likely trying to thwart such takeovers. While troops fight on battlefields, supply chain warriors fight in the shadows.
No end in sight
A popular theme is that Putin wants some sort of victory that he can announce by Russia’s May 9 “Victory Day.” In reality, the two military and economic wars will likely last months, if not longer. Europe is beginning to anticipate a shortage or total shortage of Russian energy for next winter. The point of a phased embargo on Russian oil would be to pressure Putin over a period of weeks and months. For his part, Putin has given signs that he is preparing the Russian public for a stroke that could involve a new draft to help replace soldiers dying and injured in Ukraine. We may know the result by May 9, 2023.
Markets are likely unprepared for a deepening economic war between Russia and much of the rest of the world. Energy prices rose and stocks fell after Russia invaded on February 24, but markets have since stabilized. In the United States, traders are once again paying more attention to inflation data and the Federal Reserve than geopolitical hotspots.
The Institute for International Finance predicts that oil prices could reach $200 a barrel if there is a full and effective embargo on Russian oil. The only time US oil prices, adjusted for inflation, were at this level was in 2008, when a deep recession was looming. Other factors have hurt the economy more than oil prices did then, but we also have other problems now, including non-energy inflation and a rapid shift from monetary easing to tightening. Recessions usually arise from a confluence of factors rather than a single source, and there are still some economic shockwaves likely to come from Russia’s military barbarism.
Rick Newman is the author of four books including Rebounders: How Winners Pivot from Setback to Success. Follow him on Twitter: @rickjnewman. You can also send confidential tips.
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