Global and Baltic outlook

20.04.2022

Spring 2022: Baltic Economic Outlook

Executive summary

We publish this report at a time of multiplying and overlapping challenges for the world economy. Since World War 2, the absence of wars in the affluent parts of the world and a sense of relative security supported the growth of prosperity. Russia’s invasion of Ukraine is the biggest threat to Europe in decades. It will have a profound global effects, - trade patterns will change, prioritizing security considerations and power politics over commercial logic.

The war in Ukraine and related sanctions are contributing to the raising trend in commodity prices that started already last year. In addition to high prices the supplies of other key commodities including metals (nickel, palladium) and food (wheat and corn) are limited. Business and consumer confidence has declined. Zero-covid policies are causing a new wave of lockdowns in China that put supply chains under additional stress. China’s housing market is entering a slow moving, but potentially very serious crisis. There are signs of overheating in the US economy that could require strong monetary policy response. So sub-par growth or even recession in all three main economic centers of the world might occur in our outlook period of 2022 and 2023. Thus external environment for Baltic economies will be difficult during the remainder of 2022 and early 2023. We can hope that during 2023 growth will accelerate as the world will hopefully leave behind the Time of Troubles of the first three years of 2020s.

The structure of this outlook is different from our previous reports. All other factors in the short run pale in importance comparing to the outcome of war in Ukraine and the related issue of sanctions regimes. In the long run, the future of Russia itself is of great importance for the Baltics. Thus these topics cannot be avoided, but due to their complexity and the “non-economic” character of scenario drivers we place them in Annex.

Global macro conditions in general

Global economy was growing at above-trend pace in the beginning of 2022, continuing to fill the pandemic output gap. In 2021 rich countries grew roughly three times faster than in a typical year, in 2022 growth rate was still expected to be roughly double the normal pace, though largely due to carry-over effect. Now prospects look quite different.

There were warning signs already before Russia invaded Ukraine as US economy was showing signs of potential overheating, it was experiencing the highest inflation in 40 years (7.9% in February) and a tight labour market (unemployment rate has dropped to 3.8%). The Federal Reserve started to increase interest rates, reflecting on the possible view that monetary policy is somewhat behind the curve. As long-term dollar rates remain quite low, reflecting moderate future growth prospects. Interest rate curve is briefly inverted at the very beginning of tightening cycle, but might revert back in the coming months. If inflation does not moderate sufficiently in 2022, there will be growing expectations that the Federal Reserve System will need to increase interest rates strongly and potentially cause sharp slowdown or even a recession to maintain policy credibility. Until recently long-term inflationary expectations remained anchored, in other words, US breakeven 10Y rate remained below 3% almost all the time. The latest values indicate that also the future inflation rates may rise.

Policy shift is in the air also in Europe, but here it is much more cautious. In euro area there is still little sign of pervasive wage pressures, the preliminary inflation rate in March, though very high (7.5%) is still of more transitory character than in the USA as Europe is especially vulnerable to energy price hikes. Unlike in the USA where GDP has even exceeded pre-covid trend, in euro area it still lags well behind it. GDP growth rate has been impressive recently (4.7% y/y in Q4, 2021), but that reflects favourable pandemic recovery effects. ECB in its latest (March) forecasts foresees 3.7% growth in 2022 in baseline scenario, but its underlying assumptions are becoming questionable as the economic sanctions widen, commodity prices stay high and supply chains are disrupted. We are writing this report at a time when situation changes very rapidly. Revelations of war crimes in Ukraine make the lifting of sanctions on Russia unlikely even if war ends soon as (probably unfulfilled) demands to hand over war crimes suspects are likely to follow. Thus the loss of Russian market and high energy prices are here to stay and recession in euro area becomes more and more likely.

In contrast to the Atlantic world, the two largest economies of Asia were cooling already at the beginning of the year. Even the extreme global cost pressures moved inflation up to 0.9% in Japan in February. China reported the same number but arrived at it from above. The long-term slowdown of China’s economic expansion is continuing, its policy challenges are getting more complicated. Annual GDP growth rate declined to just 4.0% in Q4, 2021 (it was 8.1% in 2021, but largely due to favourable pandemic baseline effects).

Growth rate in emerging markets (ex-China) had already settled to trend pace at the beginning of 2022. Future outlook for emerging markets is highly contrasting. While rising commodity prices is a positive for emerging markets on balance, rising the US dollar interest rates and the persistent pandemic impact on tourism constitute headwinds. Also the idiosyncratic policy-induced troubles in Turkey where annual inflation reached 61% are worth attention as these could impact euro area, an important trade partner. Commodity importing countries (India, Egypt) will face acute challenges.

Major risks - war in Ukraine

Russia’s attack on Ukraine has probably killed tens of thousands of people at the time of writing and destroyed the sense of security for millions. While nothing compares to that, our report is about economic aspects and these are also important. Trade links have been hammered and supply chains are disrupted or in danger.
Global financial institutions (eg. OECD and the IMF) estimate that because of the invasion the euro area GDP growth in 2022 will be about one percent lower, even after government support programmes. The main channels of influence are the loss of exports to Russia and a disruption to supplies of commodities and intermediate goods. The loss of export markets is relatively minor and manageable as the country in 2021 represented 1.8% of the global economy (3.1% if measured at purchasing power parity, but that is less relevant for evaluating trade impact).

Ongoing and likely disruptions of commodity supplies present much larger potential risks. Russia is one of top 3 oil producers, its exports of oil and oil products represent roughly 8% of global consumption. Dependency of Russian natural gas is a major headache for Europe. There are grave dangers for specific industries, for example, the manufacturing of semiconductors requires neon, 70% of which is supplied by Russia and Ukraine.

While overall energy prices (S&P GSCI sub-index) remained below historic peaks and declined since March 8 that was the peak of war-related stress in financial markets, the prices of internationally trade food commodities are reaching new records. Here challenges are complex – the direct contribution of Russia and Ukraine in wheat markets (1^st and 5^th largest exporters respectively), the role of Ukrainian supplies in animal feed and the high share of Russian and Belorussian enterprises in fertilizer markets among others. Prices of some fertilizers have increased by 40% since February 24 from an already high level. The food inflation provoked by this conflict might set off waves of political instability in the emerging markets that can continue to roll across the world for years.

Unless radical political changes happen in Russia that make it a palatable partner again, the West will work very hard to cut its dependencies even if the war ends soon. There are ongoing efforts to replace potential shortfalls partly through additional supplies from Venezuela, Iran, there is also a chance of extra supplies from Saudi Arabia and US shale oil fields. Development of renewable energy will receive an extra boost that is already reflected in stock markets.

Public policies will partly mitigate the negative effects. While fiscal policy stance was moving towards deficit reduction priority as the pandemic is subsiding, investments in defense and energy transition will take priority over fiscal consolidation.

Major risks - China

While covid is receding in much of the world, it is presenting the most complicated challenge so far in China. It will be very tough to control the omikron variant with social distancing measures as it is exceptionally contagious. On the other hand, letting the virus spread would make a large number of people sick at the same time, as Chinese are immunized with local vaccines and have almost no acquired natural immunity to covid because of the zero-covid policies in place. Currently the government is sticking with its zero-covid approach that is necessitating lockdowns in key manufacturing regions and ports. The insistence on this strategy could cause profound disruptions to global supply chains as there is no viable exit strategy.

There is another crisis brewing that will set in more gradually and will be more manageable but could profoundly affect the global economy. The amount of housing construction in China is unsustainable and needs to be lowered from about 15 to 10 million units annually to avoid further accumulation of excess inventory. Mortgage loan issuance in China is falling for the first time since records begun. The value of bonds issued by high-risk borrowers in real estate sector has declined steadily for over a year, but in March also investment rate issuers started to face rising financing costs. The sector is being shut out of financial markets, this process could become self-sustaining. Systemic financial crisis in China is not expected, but significant growth driver will be lost. This is important as China consumes 50-60% of key metals like steel, copper, aluminum and construction sector is that voracious beast at the heart of the economy. On the positive side, this will reduce demand for energy and certain industrial metals, freeing resources for energy transition that involves an increasing use of electrical equipment.

Baltics - common issues

The last year was more successful the Baltic states than initially expected. Estonia’s growth rate (8.6%) was amazing though largely determined by one-off factors. Lithuania and Latvia expanded at near identical ~ 5% pace. Baltic economies continued their restructuring efforts, increasing the role of high-tech services and goods in their export portfolios. The major bad news was a steady increase of inflation towards the end of the year, but the annual average (3.2% to 4.6%) was still tolerable.
The outlook for 2022 was quite good at the turn of the year, most forecasts clustered around 4% for all three countries (slightly lower for Estonia due to the large role of positive one-offs in 2021), but currently we are looking toward very modest 1-2% growth as economies suffer from direct loss of exports revenue, rising commodity prices, and lower consumer confidence.

It is very difficult to talk about prospects for 2023. If the war in Ukraine ends soon – in summer at the latest, GDP growth rate next year could be a high, above-trend number as economies make up for missed opportunities in 2022 and positive effects of reconstructing Ukraine with European Union funds could lead to extra boost for Lithuania that has more business contacts in place. In the positive scenario Baltics would benefit from recovering consumer and investor confidence, and possibly falling energy prices – most likely because of additional supplies from other sources. Growth of public spending and investments, financed by EU funds is a positive factor that has been largely unaffected by recent events, it will strongly contribute to GDP growth in both 2022 and 2023. However, one can also imagine a scenario of prolonged conflict with deep damage to consumer and business perceptions, rapidly rising burden of military expenditure, possibly also disruptions to energy imports and various supply chain issues. The most recent developments make the relatively optimistic scenario more likely and we will continue to monitor the situation closely.

Unfavourable perception of safety of the region could become a barrier to long term growth. As negative security perception could become one of the main long-term problems for the Baltic development besides demographics, info warfare is becoming an important economic policy tool. The security risk however is not new. Quite on the contrary, it can be argued that the Baltic security has actually improved since February 24, so there is a chance to turn around the views of external observers. Inherent weaknesses of the Russian army have been exposed, it is losing soldiers and equipment at a rapid pace, losing morale. The West has been mobilized politically and militarily, USA is sending more troops to Europe, Germany and other European countries will rearm, Finland and Sweden are moving closer to NATO. There will be extra defense spending in the Baltics. The war in Ukraine shows that there is the biggest relative advantage of defensive vs. offensive weapons in history. If small armies can cause a lot of problems for attackers if well supplied and motivated. Overall the outlook stays positive as the invasion has not been successful and Ukraine has defended itself well.

War scenarios

The outcome of war in Ukraine is important for Baltic economic outlook, as:

Continuation of hostilities would guarantee the maintenance and even strengthening of sanctions, eliminating residual trade links with Russia.
A peace deal or armistice that leaves parts of Ukraine under the control of Russia would not lead to a full or even partial lifting of sanctions.
Long war scenario would negatively impact the perception of Baltic security, harming tourism and leisure sectors.
Near term peace might lead to a partial lifting of sanctions, though evidence of war crimes that will lead to international investigation and perhaps also requests to Russia to hand over suspects (likely rejected) has lessened the prospects of trade normalization. Even in the best scenarios RU/EU trade will not fully recover due to (1) unwillingness to fund Russian military re-building for security reasons (2) understanding of supply chain risks by both governments and businesses.

Immediate Peace

Peace in next few weeks. The most optimistic scenario, but possible. The strategic prospects of Russia are dubious, its forces have withdrawn from most of the North, it looks stuck in the South. The longer the war lasts, the more the balance of power is likely to shift in Ukraine’s favour as it is training a large supply of willing fighters and receives NATO equipment, but Russian losses are mounting. New sanctions measures are being adopted, companies exit, much of that could be irreversible. Russian leadership is reportedly willing to achieve some sort of deal before May 9 parade.

However, we regard this scenario as quite unlikely. Ukraine is unlikely to agree to anything less than a full departure of RU forces (perhaps apart from Crimea and pre-invasion DNR/LNR), but that would be regarded as a humiliation by Russia and would put Putin’s regime under huge pressure from nationalists. Ukraine has time on its side, it can wait.

This is obviously the best scenario from economic point of view, but if in this case there would be lasting consequences as trade relationships with Russia could return to normal only after a long period of time.

Peace in 2022

Fighting continues for several months. Ukraine keeps Russia out from liberated areas in the North (Chernihiv, Sumy, most of Harkiv region), but Russia maintains its position in the South. Eventually Russia agrees to a peace treaty due to its strategic military dead-end situation and willingness to reduce sanction levels. After a stalemate a peace deal is reached. Likely compromise is probably based on postponement of the resolution of Crimea issue, , broad autonomy for Donbass, Ukraine membership of EU, but not NATO etc.

Economic consequences in this scenario would be similar to previous one, just slightly worse.

Frozen conflict

This scenario begins as “Summer Peace”, but doesn’t lead to a peace treaty. Instead, there is an armistice or even just a reduction of fighting intensity as static conflict continues along fortified positions, like in 2014-2021. Existing DNR/LNR “peoples republics” consolidate their control, possibly another one is created in Kherson region. Such situation could conceivably continue for years.

These territorial gains are not recognized by Ukraine and almost any country in the world. The conflict returns to the state similar to 2014-2021 situation, but in a wider area. This situation persists for several years.

This is the second worst scenario from the economic point of view - high-intensity sanctions regime remains in place for years, but Baltic security risk perceptions are moderate.

Reconquista

Ukraine not only drives Russian forces out of the north, but also manages to take back parts of Donbass region occupied since 24.02.2022, in the best case – also territories lost in 2014, apart from Crimea. Though not the most likely scenario, the probability is increasing as Russia is rapidly exhausting its human and technical resources, morale is declining, Ukraine is starting to receive heavy weapons from the West. As forests turn green at the end of April light troops get extra chances to move behind enemy lines. They have a chance to bring a complete disruption of logistics and organization, thus creating openings for Ukrainian main forces.

In this scenario the war can conclude with an armistice (if Russia is unable to recognize its failure) or peace treaty (that would improve its chances of getting rid of sanctions). In hypothetical peace treaty (probably in H2, 2022) Ukraine might agree to minor concessions, for example, accept neutrality, but with security guarantees (“NATO light”) and agree to postpone the resolution Crimea issue, but not recognize it as a legitimate Russian territory.

This is obviously a highly desirable outcome from humanitarian and security point of view, but from economic (sanctions) point of a lot depends on whether Russia agrees to a peace treaty.

Full Z

Russia introduces mass mobilization and maintains efforts to crush Ukraine. It not only conquers all Donbass, but also moves further, taking/retaking most territories east of Dniepr river. Thus high intensity fighting continues beyond the summer of 2022, potentially stretching into 2023. The number of KIA reaches into tens of thousands on both sides. Russia refuses to give up as political leadership and also part of society suffers from the escalation of commitment – it is hard to give up when immense costs are already incurred.

This is obviously the worst scenarios from all points of view – humanitarian, security, economic. The number of civilian victims and refugees continues to increase, that puts growing pressure on Europe, Baltic security perception risks remain high. The level of exhaustion of the Russian army, collapsing morale and growing strength of Ukraine forces makes it quite unlikely, fortunately.

Political future of Russia - scenarios

The future political development of Russia might be more important for Baltic economic future than war outcome in Ukraine. Two main issues at stake:

Continuation of sanctions vs restoration of trade and investment
Perception of Baltic security

The future of the sanctions regime will depend both on war’s outcome and internal political dynamics of Russia. Unless there is a deep political change, Russia will be perceived as a security threat and any sanctions lifting will be partial. After the war crime reports full lifting of sanctions might require not just withdrawal from Ukraine, but also handing over of war criminals that might occur only in the scenario of deep political change that we describe as not very likely in our analysis below.

In case of continued West-Russia confrontation Baltic eastern border will remain semi-closed. The world also might perceive this region to be under risk so reduce our ability to attract investment. So it is obviously in our interests that significant political change occurs in Russia. Optimistic/pessimistic war scenarios are not necessarily linked to optimistic/pessimistic Russia political scenarios though Russian military failure in Ukraine would indeed make favourable political developments in Russia more likely.

Strategic drift - Big Donbass

War in Ukraine does not lead to deep political changes in Russia. Personalities may change, maybe there is even a coup d’etat (though unlikely) by army officers worried about being turned into scapegoats for failure in Ukraine. However, even that may not lead to changes in country’s strategic goals and a deep transformation of society.

The main elements of this scenario are:

Imperial attitudes. Even though Russia fails to keep Ukraine under control, except Crimea and (parts of) Donbass and its military capability is further reduced, the country continues to seek opportunities to extent its control both along its borders and in Third World countries (like in Syria, Mali). Russia continues undermining democracies also in the West, but with little success as resources are limited and any relationships with the country have become too toxic.
Institutional system remains largely the same – stage-managed democracy without genuine division of power. Due to the lack of legitimacy, violence against opposition gradually moves from apparently legal to purely arbitrary procedures, like in DNR/LNR.
Economy remains under tight state control. Government continues to own/control key industries. Entrepreneurial activity in other sector is allowed, but is hindered by weak property rights and other structural problems as well as partial international isolation.

There is some economic progress in this scenario through import substitution strategy, but country’s relative decline continues. This is a strategic dead-end for Russia, but there are no personalities and political movements that both understand this and have sufficient influence to change course.

Long term economic implications for Baltics are mostly neutral. Russia tries to re-integrate back into the global economy, it restores some trade with the West as the sense of acute Russian danger recedes. Also the trade with Baltics is partially restored, but Russia remains a partner of low importance for our economies.

Isolation - Big Bhutan

Russia’s attack on Ukraine fails either through Reconquista or Frozen Conflict scenario. Economic and political isolation of Russia deepens. Country’s leadership understands that Russia has failed to become successful according to “external” or Western criteria and reacts by withdrawing from the world. Often it is described as “North Korean” scenario, but it would be more meaningful to call it a Bhutan scenario. The country and its elite lacks cohesion and discipline to build a rigid totalitarian system, it is capable only of somewhat chaotic authoritarism. Regime builds its legitimacy on paternalism, religious fundamentalism, pan-Slavism, also on militarism, but mostly as a ritual, not an actual intent to conquer anything. Possessing 1-2% of the global economy does not give enough power for external expansion, the impact of Russia on world events is limited and also vice versa. Many educated people leave the country. One can envisage even the restoration of monarchy or even theocracy - giving more institutionalized role and power to the Church.

Economy switches to self-subsistance regime with elements of state capitalism. Living standards are low. Opportunities to import consumer goods are very limited. There are widespread difficulties with industrial capacity as availability of equipment is restricted due to the shortage of resources and residual sanctions. Trade with Baltics is very limited, mostly pharmaceuticals and other humanitarian goods. In this scenario Russia and maybe also Belarus becomes a zone of zero economic energy – neither dangerous nor presenting opportunities, basically irrelevant.

Decentralization / New Kievan Rus

It could also be ironically called “Novgorod Republic’s ultimate revenge on Muscovy”. In other words, Russia’s future is bright, it just needs to recognize that 500 years ago it took the wrong route with sad consequences for itself and its neighbours. The term “Kievan Rus” in this case implies the principle of largely autonomous “principalities”, not Ukraine takeover.

This scenario is most likely if Russia suffers a humiliating defeat in Ukraine that destroys the authority of its central government. This scenario could be accelerated by a conflict between security (siloviki) institutions, signs of which are appearing. To avoid large scale violence Russia’s political elite decides to rebuild the country “from the ground up” through devolving authority to regions and becoming a true federation or even confederation. It is already a federation in name, but in practice it is a unitary state – regional authorities are tightly controlled from Moscow through the repressive system and ruling party (United Russia) structures.

The new arrangement allows to accommodate regional differences and avoid “culture wars”. So relatively liberal and pro-western Moscow & Saint-Petersburg, conservative rural Russia and ethnic regions (Tatarstan, Chechenia) can live together in one country that sticks together as a defense union (“nuclear umbrella”), single market and a distributor of oil rents. Some regions evolve relatively democratic power structures, others are ruled by local strongmen or even warlords. The legitimacy of power is based on ability to solve mundane socio-economic problems, not gain imperial prestige, change world order, spread ideas etc. While this scenario is somewhat messy, a country emerges that can live in peace with itself and the world and is loosely affiliated with the West. Russia becomes quite affluent – the freedom of entrepreneurship in densely inhabited industrial regions is high, economy is freed from excessive military & security cost burden, the country is quite open to the world.

This is the best scenario indeed both for Russia and the world. However, it is difficult as the required decisions would go against centuries of indoctrination. For Baltics in this scenario Russia is both an important export market, perhaps also an energy supplier. Nearby regions (Pskov, Novgorod, Kaliningrad) benefit as manufacturing locations for Baltic companies.

Liberalization - Big Canada

After a failure in Ukraine Russia decides to go back to the decision point of 1999 and tries to become a liberal democracy. This is unlikely but could occur if due to the loss of legitimacy the regime is forced to allow someone who still has some moral authority like Navalny to participate in fair elections. In this case the economic system liberalizes, expansionist rhetoric is cooled down, the country is partly demilitarized, division of powers and pluralism is restored.

It is not certain that the West would be ready to embrace the new regime without limitations due to fear that at some future elections Russia, feeling empowered by reviving economy, switches back to its old, imperial ways. Nevertheless this would be quite desirable scenario for Baltic economies, at least comparing to most others.

Breakdown – Big Congo

The worst scenario. Failure in Ukraine sharpens power struggle in Kremlin. Dissatisfaction in the younger part of the population grows. This leads to an open conflict in power structures, for example secret and security services vs armed forces. In the very worst case - a dispute over the control of nukes. In this scenario Baltics would face a litany of risks including refugee flows.

We regard this scenario as very unlikely. While there is a long-standing competition and suspicion between secret services and the armed forces, they understand the risks and are unlikely to resort to arms. There are no other organized structures in Russian society that have resources or will to initiate large scale violence apart from regional, ethnic separatists, but their possible success would not define the character of Russian state as a whole.

Table. Russia scenarios

	Prob.	Institutional order	Economy	External
Donbass	65%	Managed “democracy”	State capitalism	Confrontation
Bhutan	10%	Managed “democracy” or monarchy / theoracy	State capitalism and subsistence economy	Withdrawal
New Kievan Rus	10%	Decentralized system with both democratic and authoritarian local regimes.	Geographically mixed, but mostly composed of affluent regions with liberal regimes	Cooperation
Canada	10%	Liberal democracy	Market economy	Cooperation or mild confrontation
Congo	5%	Anarchy and/or emergence of independent states	Remains of state capitalism and elements of subsistence economy, emergence of liberal order in places	Regional mix of confrontation, withdrawal, foreign domination