Zeitenwende

Key Points

• The stepped-up sanctions will trigger a very significant macro-financial crisis in Russia.
• The EU – and particularly Germany – have made a time-defining strategic choice on defense. The natural and necessary complement to this new assertiveness on foreign policy and defense is more fiscal mutualization.
• The partnership between Russia and China will be asymmetric. Moscow is in a position of weakness.

The EU has very significantly stepped up its reaction to the war in Ukraine. The restriction on the Russian central bank access to its own assets combined with a selected ban on SWIFT has the potential to trigger a far-reaching macro-financial crisis in Russia. In the economic realm, beyond the immediate market reaction which may force Western central banks to stand ready to extend liquidity, the next crucial issue is to see how Moscow responds on gas and oil supply. The wholesale energy market is unlikely to wait anyway and we need to brace ourselves for another steep rise in energy prices, which would visibly affect the EU’s growth trajectory.

Sanctions were only one aspect of the EU’s tougher stance. Germany has jettisoned its traditional attitude towards Russia, defense, and military implication in Europe, and accepted the financial cost of such a shift, which Christian Lindner, a fiscal hawk, explicitly said would be covered by debt. This is likely to be a signal for a general move towards more military spending in the EU. Together with the cost of the energy transition – made even more urgent by the new geopolitical configuration – the fiscal burden continues to rise from the already elevated level left by the pandemic crisis. For now, we think the ECB will choose prudence and is likely to be flexible on the fate of the APP, which would help keep sovereign funding cost low. However, in the medium run, this can’t be a sustainable set-up. The solution probably lies in another step ahead on fiscal mutualization, extending the scope and size of the Next Generation framework. Now that the EU is taking the first steps towards “federalizing” its defense, pooling its resources to fund a share of military aid to Ukraine, the logical next move is in the fiscal realm to mutualize the transitory macroeconomic cost of this new strategic assertiveness.

An even tighter partnership between Russia and China is likely to be a consequence of the current crisis. Financial and trade links have already intensified these last few years. It is likely to be a very asymmetric partnership though. Russia is running out of alternatives, and its economic prospects are poor. China can diversify its energy supply with Russian gas and oil without providing unambiguous support to Moscow.