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Economic and Financial Market Update: The Russia story

04 March 2022

Summary:

The biggest impact of the Russia-Ukraine crisis might be the uncertainty of what will happen;
There is a high probability the conflict will lead to higher global inflation. The impact on economic growth is less clear;
The Australian economy ended 2021 on a good note, and there are reasons to think 2022 might be better;
Confidence about the economic outlook and higher inflation means the cash rate might rise even before wages growth touches 3%.

Removing Russia from the global economy will have an impact. The impact would have been bigger one or two decades ago. But Russia has been under sanctions since its invasion of Crimea in 2014 and its interactions with the global economy subsequently declined. Russia is a big player in a number of mining and agricultural products. Prior to the conflict it was its importance as an exporter of energy to European countries (notably Germany and Italy) that was a major concern.

The main impact of the sanctions will be to make it very difficult for the Russians to make payments in the global trading and financial systems. The effectiveness of the sanctions reflects the predominance of the $US in the global payments system. There is a good chance in the short term (1-2 years) the sanctions could be very effective. But the use of the sanctions will encourage countries to examine alternative methods to make international payments (such as the development of digital currencies).

The sanctions will also impact capital flows into and out of Russia. The biggest financial linkages are direct investments. It is likely to be hard for many Russians to access a fair chunk of their international wealth for some time. But it is also likely to be tough for international companies (and fund managers) to sell their Russian assets. There is uncertainty as to how big the impact will be in removing Russia from the global economy. The longer the uncertainty lasts the more likely financing costs rise, a negative for the global economy.

The biggest global impact of the sanctions is likely to be the reduction of Russian supply to global energy and agricultural markets resulting in higher inflation (that in turn could reduce economic growth). Global central banks (most notably the Federal Reserve) might have to provide additional liquidity to financial markets. But the current level of inflation is likely to mean that central banks will continue increase interest rates in coming months.

The broad theme of the Q4 Australian GDP numbers was that domestic economic growth was a lot stronger than analysts (including myself) had anticipated ending 2021. The size of the economy at the end of last year was not only above its pre-2019 level but also back to its pre-pandemic trend growth rate. Growth was strongest in Air Transport in 2021. While a relief this really was just a bounce back from the horrendous 2020. The agricultural sector is benefiting from high commodity prices and favourable weather. The IT sector from the digitisation trend. Rail transport is still doing it tough.

The bottom line is that the Australian economy ended 2021 on a good note. And there are many reasons to expect the music to keep playing this year. As always, there are risks.

As expected the RBA did not change interest rates. And the accompanying commentary was largely as expected. The pace of wages growth is broadly going in line with RBA expectations. The RBA has acknowledged there is a growing chance that inflation might be higher for longer than their current projections. This means that that the cash rate might rise before wages growth hits 3% if inflation is higher than the RBA expects. This makes the Q1 CPI number (released 27th April) a potential dance-floor clearer.