Opinion – Solange Srour: The economic impacts of the conflict between Russia and Ukraine

While the war in Ukraine remains with no prospect of a short-term ceasefire, the possible economic consequences for the coming years — such as persistent high inflation and a further slowdown in the global economy — tend to be more relevant. In a more long-term perspective, the question arises of the dollar as the dominant currency of the financial system and the role of the Fed as a provider of global liquidity.

The brutal rise in commodity prices, particularly energy and food, was the most immediate effect of the conflict. The world is currently facing the prospect of an inflationary shock as large as that seen in the early 1970s, which should lead to a considerable drop in disposable income and consumption.

Exacerbating the stagflationary effect, we must again face the disruption of global production chains. To cite an example, half of the world’s neon gas is manufactured in Ukraine, and the product is an input for chips and semiconductors. How high inflation will be and how sharp the recessive effect of this new crisis will be depend not only on the extent of the conflict but mainly on the responses of the main economies.

The current complicating factor is the delay in curbing expansionary monetary and fiscal policies that will considerably limit the options available now. With inflation already quite high, the most important central banks will have to choose between intensifying the economic slowdown and de-anchoring inflation expectations.

Before the outbreak of the conflict, US inflation had already reached 7.5%, and the Fed was trying to tame expectations after abandoning the discourse that inflation was transitory. Gradualism in monetary tightening — recommended in an environment of high uncertainty — may not be an alternative when inflation already exceeds acceptable levels and the credibility of the monetary authorities is in jeopardy.

From a fiscal perspective, expansion tends to be more restrictive than it was before the pandemic. In the US, in addition to the significant increase in debt and the prospect of rising interest rates, the political timing for a significant increase in spending has passed. To make matters worse, both the US and Europe can now fall victim to the sanctions imposed on Russia in relation to the financing of its debts.

One of the most relevant sanctions was the Western decision to deny the Russian central bank access to its reserve assets denominated in Western currencies and held in custody in Western institutions. Not that this has not been adopted before, but this is the first time it has happened in a country that has a very significant position in terms of investments abroad.

If central banks can no longer rely on their dollar or euro assets when they need it most, they will begin to question the value of holding those assets.

With the current levels of interest paid by the US and German treasuries, the only reason central banks have for holding bonds from these countries is to guarantee the security of having them available at any time. This could lead to a long-term change in the composition of the reserves of major central banks and the questioning of the dollar as the dominant currency of the international financial system and the euro as an alternative.

For the US, the implications of the loss of the dollar as the world’s most used currency are considerable. In recent decades, the country has been consistently running current account deficits, financed by surplus countries (especially China). If the dollar loses its status as a store of value, the twin deficits become inconceivable, and the result will be currency devaluation and higher interest rates, especially long ones.

For the world, the consequences of this possible financial instability will not be negligible. The Federal Reserve is the ultimate “savior” of the global financial system, ready to pump dollars when needed via swap lines or to inject liquidity into the US economy. This was the case in the crises in Mexico in 1995, in Asia in 1997, in Russia in 1998, in Europe in 2012, in the great financial crisis of 2008 and, more recently, during the pandemic.

The medium and long-term impacts of this war must go far beyond its termination, as it has in all past major wars. Any diagnosis of the global economy in the coming years seems too hasty given the high degree of uncertainty about what will happen in the coming months.