Russia - Ukraine: Implications for Australia

The tragic developments in Ukraine are dominating the attention of the world and markets.

Russia formally invaded Ukraine over a week ago, with President Putin ordering a ‘special military operation’ in the country. Missile strikes have been carried out across the country. It is not clear how far Russia will go. Some have raised the concern that Russia’s invasion could result in a broader conflict.

Western nations responded by implementing a range of new sanctions, including measures that restrict Russia’s access to international payments. Russia’s energy exports – a critical driver of the Russian economy – have notably been excluded from the sanctions list. The Biden administration has advised it will not sanction Russian crude oil because it would cause prices to spike. One senior White House adviser said sanctioning oil flows may mean President Putin could “sell only half of his product, but for double the price”. In other words, “the United States and our allies would suffer”.

Russia is the world’s largest exporter of natural gas and the third-largest exporter of crude oil and petroleum products (behind Saudi Arabia). Between Russia and Ukraine also lies a large share of global production of wheat, base metals and precious metals.

Russia’s military actions in Ukraine and the sanctions on Russia by the West have raised economic and geopolitical uncertainty for markets. One of the immediate reactions has been for investors to pare back risk, which has resulted in lower global bond yields, wider credit spreads and higher oil prices. There has also been heightened volatility in financial markets. However, movements have been relatively modest since the invasion began.

Europe stands as the most exposed to the conflict. It is highly reliant on Russian gas and possesses significant trade and investment links with Ukraine and Russia.

This conflict comes at a time when major central banks around the world, including our own Reserve Bank, are grappling with mounting inflationary pressures while their respective economies recover from the pandemic. This conflict adds to the challenges of an already difficult inflation backdrop. It raises the risk of higher inflation, especially via higher energy prices. It also poses downside risks to consumer sentiment and world economic growth; the extent of downside risk to world growth depends on how this conflict evolves. In particular, if it draws the world into a wider conflict, there would be more severe economic ramifications. It means stagflation risks have grown, which is the scenario of low growth and high inflation.

At this point, a clean resolution looks unlikely. While current market risk premiums will fall away, there will be a significant strategic shift in the West. This is likely to see a significant rise in defence spending, an acceleration of the move to renewables, substantial investment in gas storage and the need for reinvestment in strategic commodities.  In combination, this means substantially more investment spending and less optimised supply chains.

But what does it mean for the Australian economy specifically?

One of the main transmission mechanisms from the conflict to Australia is higher commodity prices, which in turn could add to inflationary pressures. Further disruptions to global supply chains could also add to inflationary pressures. Australians have already been hit by higher prices at the petrol pump – unleaded petrol price averaged 180 cents per litre nationally by month-end.

Australia has limited ‘direct’ trade ties with Russia and Ukraine, altogether accounting for just 0.2% of both Australian merchandise exports and imports in 2021. There is also negligible trade in services. However, there is also a possibility that the developments could weigh on global economic growth, which in turn would flow through to weaker demand for Australian exports more broadly.

There could be some short-term upsides for some Australian wheat and natural gas exporters via higher prices. Russia is the world’s biggest wheat exporter and Ukraine is the fifth largest – collectively they account for more than 25% of the world’s exports of wheat. So, disruption to these supplies would likely drive an increase in the price of wheat. Similarly, a hit to gas supply will push up global prices and benefit Australian gas exporters. However, in aggregate, these benefits could be outweighed by other disruptions to the global economy.

Russia produces about 8% of the global LNG supply (roughly 30 million tonnes per year). This may become hard to replace.  In addition, Russia relies on Western technology and companies for infrastructure servicing and repairs. This could lead to further decreases in supply if withheld for an extended period of time.  Another 20 million tonnes of capacity are under construction in partnership with western firms. The latter’s withdrawal could see these projects delayed substantially.  In the medium term, Australian gas projects potentially become more attractive given the security of supply and Europe’s desire to reduce reliance on Russian volumes.

Like oil and natural gas, coal prices are surging on tighter markets.  Russia provides 17% of the world’s thermal coal and 9% of metallurgical coal. This may drive more interest in Australian coal as a reliable alternative, though in the near term it means coal prices are likely to rise to the point where it chokes off demand.

Russia and Ukraine together supply 25% of the world’s wheat, 24% of its barley, 14% of corn and 58% of sunflower oils.  History suggests agricultural supplies are not disrupted during wars. But clearly, there is risk given reliance on the region.  Planting season is from late March into April. The question is whether there will be access to seeds and fertiliser to allow proper planting. The wheat price rising 50% in 10 days reflects the risk here.  There are also potential second-order effects. A surge in food prices has historically been the catalyst for civil unrest in some countries.  China will also be mindful of their exposure, especially since issues with swine flu are affecting pork supply. Beijing has apparently moved to withhold fertiliser exports to ensure domestic supply to support their crop yields.

Another consideration is the implications for Australia’s already tense relationship with China. China has not condemned the Russian invasion and, in fact, has lifted restrictions on Russian wheat and barley in recent days. The move prompted criticism from Prime Minister Morrison that China is subverting Western sanctions on Russia. An escalation in Australia-China tensions risks resulting in further punitive measures from China on Australian exports.

The market’s saving grace has been the strength of the economy and corporate earnings. But this degree of uncertainty and risk is likely to drive markets lower in the near term.  European markets are bearing the brunt at the moment, but the consequences could spread.

Australia is proving to be the most defensive of markets, largely due to the combination of commodity exposure, geographic distance, less need to tighten policy and strong economic growth.

Reserve Bank

The Reserve Bank (RBA) met last Tuesday, unsurprising there was no change in policy setting but speculation is heating up over when the RBA will lift the cash rate.  At this stage developments in Ukraine is unlikely to deviate the RBA from its path for now, but Putin’s plans remain uncertain and unpredictable.

Many commentators expect that the first-rate hike will come in August this year, with a 15 basis point move, although an earlier hike cannot be ruled out. Expectations of a further  25 basis point hike later in 2022.

With the unemployment rate at 4.2%, and likely to head lower, the RBA can comfortably tick off its goal of full employment, meaning the timing of the first hike will depend on consumer price inflation and wages. Last week’s annual wages print rose to 2.3% in the December quarter. It reflects a pick up in growth and a tightening of the jobs market but isn’t shooting the lights out. Wages growth may pick up more materially as we move through 2022. Retention payments, bonus payments and job-hopping are already rising, as are wage expectations. This supports the expectation of an August move.

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