Russia's Invasion of Ukraine on Global Economy

AFP/WOJTEK RADWANSKI

TOPSHOT - Helena (R) and her brother Bodia (L) from Lviv are seen at the Medyka pedestrian border crossing, in eastern Poland on February 26, 2022, following the Russian invasion of Ukraine. - Ignoring warnings from the West, Russian President Vladimir Putin unleashed a full-scale invasion of Ukraine that the UN refugee agency said has forced almost 116,000 people to flee to neighbouring countries.

A young woman looked very sad. A red winter hat covered part of her flowing blonde hair.

She spoke in broken English as she was interviewed by CBS TV. "The situation is very sad, only blood, debris and all the bad things from war that are there,” she said. With their suitcases dragging behind them, women and children walked for hours to save themselves.

Some of them were carrying bags containing babies. Families must be separated. Children and women fled, while men had to stay. I can hardly imagine how they feel.

The writer Albert Camus once wrote bitterly in his novel, Sampar, “When war broke out, people said: "This is too stupid; it won't last long." The war may be a "too stupid" act, but stupidity has the talent to find its way; something we should know if we weren't too busy with ourselves."

War and the global economy

Last week, we sadly witnessed Russia invade Ukraine. Victims began to fall, the economy was in turmoil. War is a human tragedy. What is the impact of the war on the world economy and also Indonesia? To answer the question, there are several things that are important to note.

First, in reaction to the Russian invasion of Ukraine, European countries and the United States have decided to impose sanctions. Is this effective? George Tsebelis, a political scientist from the University of Michigan once wrote an interesting paper “Are Sanctions Effective: A Game-Theoretic Analysis?” (1990).

By using game theory, he showed that although sanctions are often applied in conflicts between countries, they are not effective. Huffbauer et al (2009) showed that sanctions have a low level of effectiveness if the targeted country is strong, as well as politically and economically stable, and autocratic and hostile. This criterion is similar to Russia. If Huffbauer et al's hypothesis is correct, then the sanctions may not stop Russia.

Also read:

> ‘Quo Vadis’ Russia-Ukraine War

> Russia, Ukraine Seek Common Ground

We know, conceptually, that the optimal solution can be made if both sides are cooperative and amicable. However, like the prisoner's dilemma in game theory, each country tends to put its own interests first, even though it gives worse results, rather than if they are cooperative.

For Western countries—especially Europe that imposes these sanctions— it is not an easy decision. There is a dilemma here: if sanctions are too harsh, European countries will also suffer the consequences. European countries rely heavily on gas from Russia.

Perhaps that is why European countries were hesitant to exclude Russia from the global banking system SWIFT, the platform used in global financial transactions for commodities and energy, including gas, which is an important commodity of Russia.

European countries are certainly aware that if they use SWIFT to sanction Russia, the gas supply will be disrupted and, if Huffbauer et al’s hypothesis is correct, sanctions may not be effective. In fact, it is not impossible that Russia will retaliate, for example by stopping the supply of gas and oil to Europe.

In addition, Russia and Ukraine account for about 13 percent of global wheat production. This conflict will disrupt this supply. Prices of gas, oil and wheat will soar. We noted that when the Russian attack was launched, the price of West Texas Intermediate (WTI) oil surged to US$100 per barrel.

However, according to Jason Furman of Harvard University in 2022, the economic impact may not be as dramatic as imagined. Furman pointed out that although oil prices initially rose, they were still below 2011-2014 prices. A heavy blow may hit European countries: inflation will rise sharply, and this will disrupt their economic recovery. Oil importing countries will also be affected.

Also read:

> Russian Invasion Marks another Dark Chapter in Europe

Second, in the US, the increase in energy and food prices will exacerbate the current inflation. The US economic recovery will be disrupted. If global and US economic conditions weaken, the US Federal Reserve's rate hike may not be as aggressive as the initial plan.

Here, the Fed is in a dilemma. If interest rates are not raised, inflation will increase further.

On the other hand, if the interest rate is aggressively increased, it will disrupt the US and global economy. It is a difficult choice. In Russia, we see the ruble has dropped and inflation has begun to increase.

But do not forget, as Furman said, Russia has sufficient foreign exchange reserves thanks to its large current account surplus.

With this situation, the impact of sanctions on the Russian economy will not be felt immediately. The risks that may arise are soaring inflation and a slowdown in the global economy, especially in Europe.

Impact on Indonesia

Third, what is the impact on the Indonesian economy? We have to look at two factors, namely the financial and trade channels.

From a financial perspective, Russia's links with the financial sector in Asia, including Indonesia, are very limited. That is why we see the financial market, including the rupiah exchange rate, remain relatively stable.

In fact, due to its potential risks to the US and global economy, the Fed may be less aggressive in raising interest rates, thus financial markets in emerging markets, including Indonesia, are relatively stable.

From a trade point of view, rising oil prices will encourage people to look for oil substitutes. Demand for coal as well as palm oil will increase. The price will go up. The price has even begun to increase in the last few days. The increase in coal and palm oil prices will have a positive impact on Indonesia's exports as well as purchasing power outside Java.

State revenues will also increase. However, in the medium term, the risk of a global economic recession will have an impact on Indonesian exports. If global economic growth slows down, the economic growth of China and India will also be affected.

This will result in a decline in the demand for coal and palm oil. I estimate that in the short term, we will see an increase in Indonesia's exports, but in the medium term, if the war continues and a recession occurs, then Indonesia will also feel the impact of the global recession.

What needs to be anticipated is that rise in the energy and wheat prices will also push up inflation in Indonesia. Here, Bank Indonesia—like the Fed—will be in a dilemma. Inflation will increase due to a combination of the supply shock (due to rising food and energy prices) and the demand side.

We can see that even before Russia's invasion of Ukraine, producer-side inflation or the wholesale price index (WPI) had already exceeded the consumer prices index (CPI). It means that production costs have begun to increase but entrepreneurs have not passed them on to consumers.

The reason may be that demand is still weak. The business world chooses to reduce profit margins rather than increase the price. But this cannot be continued. One day, the entrepreneur will have to raise the price. I estimate the inflation will increase in the second or third quarter of this year. Under such conditions, Bank Indonesia will likely tighten liquidity and raise interest rates, perhaps next year.

In the medium term, the risk of a global economic recession will have an impact on Indonesian exports.

From the fiscal side, contingent liabilities will also increase. The increase in energy prices will also put pressure on the balance sheets of state oil company Pertamina and state electricity company PLN. If the government does not allow an increase in the prices of electricity and fuel, there is a risk that PLN and Pertamina will be in trouble. I can imagine that the Finance Ministry will have to bear the financial burden.

Fourth, we know that the Covid-19 pandemic has increased the risk of non-performing loans (NPLs). Currently, the Financial Services Authority (OJK) is implementing credit relaxation so that the NPLs looks low. However, look at the ratio of loans at risk (LaR), which is relatively high. So if the normalization is carried out by the OJK, the NPLs will increase.

In addition, if Bank Indonesia starts to raise interest rates, the risk of NPLs will increase further and also disrupt the economic recovery. Based on Indonesian interests, we hope that the Fed will not be too aggressive in raising the interest rate—for the reasons I mentioned above. We will have to wait and see how the Fed responds to developments in Ukraine.

An increase in interest rates in the US will also increase the risk for companies that have high loan exposure (highly leveraged). In the case of Indonesia, the combination of the impact of Covid-19, the increase in interest rates from the Fed and Bank Indonesia, the increase in energy prices and the weakening of the rupiah exchange rate will disrupt the ability of companies. Several companies, including Indonesia’s state-owned enterprises (SOEs), will also be potentially under pressure.

As a result: the risk of contingent liabilities to the State Budget (APBN) also increases. This will be a burden on the government.

Fifth, 2023 will be a difficult year for us. The global economic recession may potentially occur simultaneously with the government's plan to carry out fiscal and monetary consolidation and the increased risk of inflation.

In this context, the exit strategy must be prepared properly and carefully. We know that currently many government bonds are held by banks, Bank Indonesia and Pension Funds. If in 2023, the Pension Funds and banks release their bonds—because they anticipate an increase in interest rates or to expand their credit—the bond supply will increase.

The bond price will go down, the yield will increase. Government interest costs will become increasingly expensive and burden the state budget. On the other hand, if bond prices fall, banks will be reluctant to sell their bonds and credit expansion will be hampered due to limited liquidity.

Here, the role of Bank Indonesia in maintaining the bond market and repurchase agreement (repo) instruments will be very important to maintain financial market stability.

We are entering a difficult year. Coordination of fiscal and monetary authorities must be carried out properly to avoid economic turmoil. The increase in energy and commodity prices on the one hand will have a positive impact on Indonesia, as well as if the Fed does not raise interest rates as aggressively as initially expected.

However, on the other hand, we see the potential risk of inflation, global economic recession and contingent liabilities.

That is why an exit policy must be created carefully. The monetary and fiscal tightening measures should be implemented together; they can cause multiple impacts. The impact of the rising food prices on vulnerable populations also needs to be considered. The price increase may lead them into poverty.

The fiscal policy priority should be helping the vulnerable. In budget priorities, the government must carefully distinguish between what it should do and what it wants.

Where did the children go?

It is too early to draw conclusions about the impact of Russia's invasion of Ukraine. We really have to wait, to understand the extent of the impact on the global economy. However, there is a big question that cannot wait: where will the children go?

Where will the suitcases dragged by the women and children, or the bags containing the babies be taken? Imagine the young woman in the red hat talking sadly: "Only blood, debris and all the bad things from war that are there". War is indeed a tragedy for humanity.

I remember what the French thinker Voltaire wrote. He may be cynical and sharp-tongued, but I'm afraid what he said is true: “It is forbidden to kill; therefore all murderers are punished unless they kill in large numbers and to the sound of trumpets. ”

KOMPAS/RADITYA HELABUMI

Muhamad Chatib Basri

Muhamad Chatib Basri, Lecturer at the School of Economics and Business, University of Indonesia.

(This article was translated by Hendarsyah Tarmizi)