The Russian invasion of Ukraine in February 2022 had many important effects on the global economy. It came just after the global recession caused by the CoVid pandemic, when Western governments were still flooding their economies with stimulus packages and extraordinary spending measures. The supply shock and uncertainty triggered by the invasion and Western sanctions that followed generated a massive upshot in energy prices and triggered a dramatic readjustment of the import portfolio of most European countries, leading them away from Russian pipeline-imported gas towards other existing pipelines (Algeria, Azerbaijan) or the LPG market, both through increase import (for example from the USA) and investments in import capacity.
The war had a further ripple effect. The energy crisis quickly transferred itself into prices, fueling an upsurge in inflation. Prices had started to rise already in autumn 2021: by that time spending had increased substantially as COVID restrictions were lifted (and as COVID payouts lingered, also because of the upcoming presidential elections in the US). The energy crisis fueled further a price surge.
The monetary policy response to the inflation uptake has been strong on both sides of the Atlantic, with Fed and ECB interest rates going from practically zero to almost 5%. The inflation flare seems now mostly absorbed. The European Central Bank already operated its first rate cut rates in June and there are reasonable expectations of rate cuts by both the ECB and the Fed before the end of 2024.
All in all, the more general geopolitical uncertainty, with China’s tensions with Taiwan and the ongoing conflicts in the Middle East, has contributed to a new awareness by the government of the need to diversify the supply of vital components such as micro-conductors. More generally, to “de-couple” the Western economic system from China through what goes under the name of “re-shoring” or “friend-shoring”.
There has been a lively policy debate on whether sanctions are indeed working in limiting Russia’s economic stability and its capacity to fund the ongoing war. Detractors highlight how sanctions have just re-directed Russia towards China, allowing the Asian superpower to increase its geopolitical weight, supplying Russia with vital industrial components, and increasing the share of international transactions settled in Renminbi.
Critics of the efficacy of sanctions also highlight that sanctions are costly also to those who impose them: exporters to Russia in Western Europe mostly had to give up their Russian operations, trying to find alternative markets for their goods. Sanctions on energy product import have then put a toll on all manufacturing sectors which has contributed (among other factors) to the poor performance of the German economy.
It is well known effective punishments are costly also to those who punish: disciplining your kids, monitoring employees, and chasing a debtor are all costly activities.
With import and export restrictions it is even more evident: a sanction will be more effective the stronger the trade relationship between two countries is, imposing costs on both sides. Moreover, the less the traded goods are substitutable, the more the sanctioned country will be hit. At the same also the more difficult it will be to find alternative customers for one’s good.
According to a recent paper by researcher based at NYU – Abu Dhabi (Imbs and Pauwels, “An empirical estimation effect of trade sanctions with an application to Russia”) trade sanctions are 15 times more costly for Russia than for its trading partners. However, this effect is very unevenly distributed. This effect is skewed against Eastern European countries, who bear the brunt of the cost of these sanctions, as their historical ties and geographic proximities make them more interdependent with the Russian economy and less able to diversify their energy sources.
Russian reliance on physical infrastructure such as pipelines for its exports (mainly gas) makes it very vulnerable as it is nearly impossible for the Kremlin to find alternative markets for its gas. On the other hand, European exporters to Russia, who mainly export manufactured goods, are more likely to be able to find alternative markets for their products.
CoVid pandemics also taught us how firms that see their value chain disrupted are able (not without time and costs) to adapt their supply patterns and find a way around problems.
The sectoral composition of these shocks is also highly relevant: firms technologically closer to the energy sector or more energy-intensive, such as electricity production or steel plants, are likely to be hit hardest by sanctions. Also, the construction sector in Eastern Europe and the Baltics, which is heavily reliant on Russian energy and supplies, has been hit particularly hard.
Analyzing data on Italian imports and exports can be particularly interesting: comparing the last quarters of 2021 and 2022 gives us a good picture of how trade patterns have been affected by the war and sanctions against Russia.
Italy is an interesting case as it is a major manufacturing country, and is part of the Western European (German-led) global value chain. It is also a country that relied strongly on Russian energy products, having decided to close its (small) nuclear program in the Eighties in the aftermath of the Chornobyl disaster.
The first thing to notice is that the value of exports between 2021q4 and 2022q4 rose by 17% while exports to Russia dropped 28% – from just over 2bn Euros to 1.45bn Euros. The picture on imports is quite different, as the increase in energy prices implies that imports from Russia grew in value from 2.45bn to 2.6bn. If we look at non-energy imports from Russia, though, these dropped by 30%.
It can also be noticed that while Italian exports to Russia dropped, several neighboring countries saw their imports from Italy increase. Kirghizstan saw a +525% increase in imports from Italy, Armenia a +116%, Kazakhstan +90%, and Azerbaijan +60%. It is of course impossible to know whether this reflects companies using third countries as a way to bypass sanctions (“trade diversion”) or if it is companies finding new legitimate markets for their products. The increase in trade to neighboring countries in absolute values is anyway substantially smaller than the drop in exports to Russia, and a large percentage reflects the fact that Italy trades relatively little with them. The most extreme case is Kirghizstan, which received only half a million imports from Italy in 2021q4, which increased six-fold one year later (see graphs below).
Trade data is very detailed, as it is broken down province-by-sector. Looking at sectors, we can see that most (2-digit ATECO classification, analogous to the American NACE) sectors dropped their exports. In particular, sectors such as Gas, Oil, and Logging saw a 100% drop in imports from Russia. Some sectors had a small increase in their exports to Russia, such as the beverage (mostly wine) industry (+22%): Russian sanctions forbade exports of high-value alcoholic beverages priced over 300 Euros per bottle, leaving most European wine producers untouched by sanctions.
A sectoral analysis is particularly interesting for its potential internal political consequences: regions where hit sectors are more prevalent are also more likely to show political grievance against sanctions and be more prone to populist pro-Russian rhetoric (and propaganda).
There is a recent streak of economic literature that analyzes the so-called China shock. When China was admitted into the WTO in the late Nineties, the Chinese import into the US and Europe grew dramatically. One of the consequences of this was downward pressure on the general level of prices, which contributed to many years of low inflation in the US and Europe. Another major effect was a negative shock on many traditional manufacturing sectors particularly exposed to Chinese imports (the textile sector being the most obvious example).
A large economic and political science literature (David Autor, David Dorn, and Gordon Hanson being its most prominent authors) explored the social and political effect of this “China shock” and found strong evidence that the increased job and political polarization and the uptake of so-called populist candidates in the US or Western Europe can be attributed directly to it. Research shows that those geographical locations suffering more because of the China shock have been more likely to vote for Donald Trump, in favor of Brexit, in favor of populist parties in continental Europe.
It would not be absurd to think that Russian sanctions may have a similar social and political backlash in those communities (countries or regions) most hit by them, making them more prone to be lured by Russian propaganda or populist parties. In this sense, firstly, Western governments must be willing to compensate those parts of their electorate hit the most by the sanctions. Secondly, transparently explain to their citizens both the necessity and costliness of their opposition to Russia’s actions.
The article is based on the author’s opinions based on research and analysis.
Prof. Emanuele Bracco
Associate Professor of Economics
Dipartimento di Scienze Economiche
Università di Verona, Italy