Mind Games

Last week’s dataflow has confirmed that the economic fallout from the war in Ukraine is already tangible in the Euro area, especially in Germany where the IFO survey’s forward-looking components in manufacturing are now below the levels seen during the “mini recession” of 2012-2013. Awareness of the magnitude of the shock is clearly high in policy circles in Berlin, and a top-up to the fiscal package supporting consumers has been swiftly announced. On the European front however, the Council meeting concluded on Friday without producing any breakthrough. Key decisions – on defense spending an energy in particular – won’t come before the Commission provides detailed propositions first “by the end of May”.

There is one area though where some progress has been made: joint purchases of gas across member states to secure better prices will be possible, and gas storage will be better supervised to improve the EU’s energy security. The elephant in the room however is that to secure large enough gas inventories for next winter, the EU will have to accelerate imports significantly, and for now this means accepting significant Russian supply.  President Biden’s offer lift exports of US LNG to the EU would cover only the equivalent of 10% of Russian natural gas. Still, the message to Moscow is that at the latest by 2030 the EU wants to wean itself entirely off Russian gas. Russia is incentivized to maximize its profits “while it can”, i.e. as long as the EU does not have a clear alternative supply sources. So, it’s in Moscow’s interest to try to lift gas prices as much as possible without switching supply off. This may be what is behind V. Putin’s demand last week that EU gas imports from Russia are paid in rubles. Drawing attention again on the gas supply issue pushed prices up at the end of last week.

Still, the cost to Russia of the war in Ukraine is piling up rapidly even beyond the economic realm. Support from China may be more hesitant, as Sinopec’s reported decision to suspend an investment project in Russia suggests. Militarily, although Russia seems to be scaling down its ambitions in Ukraine to focus on Donbass, the need to divert troops to this war may already be reducing the influence of Russia in other key areas on its borders. Last Friday Russia has accused Azerbaijan of having sent troops to an area of Nagorno-Karabakh controlled by the Russian army. While the market may react positively to this weakening of Russia, we continue to think that we need to brace ourselves for more flare-ups ahead.