Written by 3:35 am Europe Economy

The ballooning costs of the Ukraine war

The Ukraine conflict is exposing the massive costs that accompany a relatively small and contained war—one in which the military action is entirely confined to one of the poorest nations in Europe.

Although Ukraine has a population of 45 million, the annual output of its economy before the war was just a little larger than that of New South Wales, and that’s after accounting for differences in purchasing power of the two currencies. Pre-war Ukrainian incomes were on a par with those of Paraguay or Fiji.

The OECD estimates that the world economy in 2023 will be US$2.8 trillion smaller than was estimated in December 2021, before Russian troops and tanks swarmed into neighbouring Ukraine. It is a cost estimate that’s about five times the entire size of the Ukraine’s pre-war economy.

The costs—both financial and human—are obviously monumental for Ukraine itself. The US military estimates that 40,000 Ukrainian civilians have been killed in addition to perhaps 100,000 Ukrainian military casualties. About 6.8 million Ukrainians have left the country, while around 6.6 million are internally displaced.

An analysis of the economic costs conducted jointly by the Ukraine government, the World Bank and the European Commission estimated that the direct damage was just under US$100 billion. Damage to housing accounted for US$39 billion, to transport infrastructure, US$30 billion, to commerce and industry, US$10 billion and to energy, US$3 billion. The analysis was released in August, before the intense Russian bombardment of Ukraine’s energy infrastructure that began last month.

In addition to the direct damage, there are indirect losses stemming from lost agricultural production, land contamination and dislocation of the population. The total losses reach just over US$250 billion. The cost of rebuilding and decontamination reach US$350 billion, with the most urgent needs costing an estimated US$105 billion.

There has been significant Western budgetary support for Ukraine, in addition to the flow of military equipment. Analysis by the German Kiel Institute estimates that bilateral financial support reached US$37 billion between January and October, while humanitarian aid totalled US$15 billion. Military aid was US$40 billion. The US has provided 44% of the budget support, 66% of the humanitarian aid and 71% of the military aid. President Joe Biden’s administration asked Congress this month for a further US$37 billion in emergency aid.

The aid still leaves a massive budgetary gap. Ukraine’s tax revenue has fallen by 27%, yet its spending, including on the military, has risen by 40%. The government has been issuing war bonds to help finance its military, but it has also sought direct funding from the Ukraine National Bank. By the end of June, central bank support of the government had reached US$7.7 billion. Direct funding is contributing to inflation of 30%, which makes it harder to sell the bonds.

The cost of the war to Russia is minor by comparison—indeed the Russian government has sought to project a business-as-usual picture of life for the average Russian citizen. The International Monetary Fund has upgraded its estimate of Russia’s economy, and now predicts a fall of GDP this year of only 3.4%, compared with an estimated drop of 8.5% in April this year. (The IMF has made no forecast for Ukraine, but private estimates are for a 30% to 40% fall this year.)

However, the cost of the war to Russia is growing and will eventually have a major impact on Russian living standards. In the short term, there’s the direct budgetary burden of supporting a major military operation, and Western sanctions are squeezing both exports and imports.

The Russian government last week raised the equivalent of US$13.6 billion in bonds to help fund the military effort. UK Defence Intelligence updates note that Russia’s declared ‘national defence’ spending for 2023 has increased by more than 40% to the equivalent of US$84 billion from estimates made in 2021, before the war.

The impact of sanctions is showing in unexpected ways. The lack of heavy-duty ball bearings, all of which were imported from Sweden and the US, has forced Russian railways to withdraw 10,000 rail freight wagons from service. Russia’s National Transport Company has warned that the national fleet of 200,000 wagons is at risk. Rail freight is a pivotal economic service in such a vast country.

Russian motor vehicle production, which was just under three million units in 2021, dropped to just 281,000 units in the first half of this year. Mobile phones, computers and whitegoods are all in short supply. The cancellation of aircraft leases and maintenance contracts has resulted in the collapse of domestic aviation. Other signs of economic pressure include a 33% increase in bankruptcies and a 40% fall in consumer borrowing.

The loss of access to Western technology will have long-term effects. At the consumer level, Russians have lost access to Spotify, Airbnb, eBay, PayPal and a host of games providers. South Korea’s Samsung and Taiwan’s Taiwan Semiconductor Manufacturing Company have both stopped supplying Russia. More fundamentally, Russia has lost access to Western software critical for a vast range of business operations. Research collaborations with Western counterparties have also stopped. China will fill some of this gap—Huawei can provide smartphones and communications infrastructure.

The energy crisis precipitated by the Ukraine invasion has enabled Russia to maintain export revenue in the face of declining export volumes. Russia’s energy exports were not initially covered by Western sanctions. Russia attempted to use Europe’s dependence on its gas as leverage, unilaterally cutting gas flows ahead of the northern winter in the hope of undermining public support for Ukraine. Russian gas supplies to Europe have dropped to 20% of pre-war levels.

The major European nations appear to have this winter’s needs covered. Germany this month opened its first import terminal for liquefied natural gas, and a further expansion in its ability to use US LNG is scheduled over the next year. The G7 nations will impose sanctions on Russian oil from 5 December, banning the supply of insurance and trade finance to ships carrying Russian oil, unless it has been loaded at below a G7-specified price cap. There have been warnings that the plan could backfire if Russia refuses to sell oil on these terms.

The biggest long-term cost to Russia will come from the loss of its European Union market which, before the war, accounted for 37.9% of its exports and 36.5% of its imports. Having used its gas exports as a form of economic warfare, it is hard to imagine Russia gaining the trust of European customers again. Despite spanning half the globe, Russia is overwhelmingly oriented, both economically and population-wise, towards Europe, not Asia.

For the world at large, the biggest costs from the Ukraine conflict come from rising energy and grain costs, particularly the US$2 trillion transfer of wealth from consumers and business energy users to fossil-fuel producers. The shifts have added to already intense inflationary pressure and contributed to the rapid rises in official interest rates that are squeezing the global economy.

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