“Never, never, never believe any war will be smooth and easy or that anyone who embarks on the strange voyage can measure the tides and hurricanes he will encounter; the statesman who yields to war fever must realise that once the signal is given, he is no longer the master of policy but the slave of unforeseeable and uncontrollable events.”- Winston Churchill.
Winston Churchill was appointed the Prime Minister of the UK in May 1940 amid the German Invasion of France. In anticipation of a war that could severely damage London, the UK built “Cabinet War Rooms”, which were ready by 1939. Churchill, after his appointment, visited the Cabinet War Room and declared that:
“This is the room from which I will direct the war.”
The UK financed the WW2 war machine by raising taxes, selling assets and borrowing from the US. Even the US massively raised taxes for the middle class and the wealthy. The strong public opinion towards the war enabled the Allies to mobilise the resources required to sustain and eventually win the war.
The WW2 knowledge demonstrates that wars can be prolonged and costly. The most significant problem that our world faces today is that the financial world is more interconnected than ever due to globalisation.
Thus, an extended economic war can be too expensive for the global economy.
Today, we will discuss the recent proposals by the G7 countries to limit the resources for the Russian war machine. We will also understand the consequences of the “proposals” by Europe to bail out the consumers and utilities from the electricity price shock.
The Oil Price Cap!
The G7 has recently proposed a price cap on “Russian Oil”. The big push transpired from the US, which has advocated for the price cap since March. According to the G7 statement:
“The G7 would ban the provision of services which enable maritime transportation of Russian-origin crude oil and petroleum products globally above the price cap”.
In layman’s terms, the insurance cover is mandatory when the oil is exported via ships (maritime transport) due to the risk of oil spills and shipping flammable material on the high seas.
The G7 wants to block the insurance cover so that oil export beyond a specific limit doesn’t take place. This is designed in such a way that the export revenues of Russia drop, and they are constrained to finance the war. Assistant Secretary for Economic Policy at US Treasury, Ben Harris, explained the modalities of price cap in the below thread.
The oil price cap looks great on paper, as 90% of the maritime insurance is dominated by the US and UK insurers.
However, it’s doubtful that it will be enforceable (just like Russia has successfully circumvented the sanctions). Let us understand why:
Post-war, the Russian oil is mostly flowing to India and China on Sovcomflot tankers. India has accredited Ingosstrakh as an insurance company for shipping oil. Ingosstrakh is the fourth largest Russian insurance company, and most probably, Russia has given sovereign guarantees on behalf of Ingosstrakh.
Furthermore, IRclass( Indian Register of Shipping) is offering safety certification for more than 80 ships managed by Dubai-based SCF Management Services, a subsidiary of Sovcomflot.
India has officially stated that it will not join the price cap coalition. Undoubtedly, China will also continue to trade with its all weather-ally Russia.
While the G7 announced the price cap, Russia has hit back and “threatened” to ban oil exports to countries implementing the price cap. The numbers indicate that the Russian oil finds its way back to the US and Europe after its refined by Indian and Chinese refiners.
The consequences will be disastrous if Russia retaliates by stopping or reducing oil exports. Just to recap, Russia currently produces roughly 10–12% of the world’s oil even after the harshest sanctions were imposed. Post-war, Russian oil production is down by only 2–3%.
Even the EU is importing 3 mbpd of Russian Oil.
Note that the EU has already approved the Russian Oil Embargo, which comes into place on 5th December.
Any disruption in oil markets will lead to a massive jump in prices. We have already seen that OPEC+ decided on a symbolic production cut in their last meeting, and the physical market is still tight.
There is also a disconnect between the paper and physical markets, as lately, the paper markets have become very illiquid.
As the electricity and gas prices rip apart, the consumers, utilities and, businesses, governments across Europe have come out with some big bang “stimulus packages”. But, as I earlier wrote, wars can be costly, and we are seeing the enormous, real-time cost of war.
Some economists estimate that the stimulus announced will total 5%+ of GDP. However, if the situation worsens (harsh winter), it could reach as high as 10% of GDP.
Data compiled by Reuters and Bruegel indicates that governments across Europe (ex-UK) have already committed €282 billion to provide relief across the spectrum.
In the UK, the incoming PM, Liz Truss, has announced a price cap of £2500 (annual electricity bills) for all the citizens for the next two years.
The price freeze will cost the UK government a whooping £ 130 billion. Furthermore, the UK government will also give the businesses relief of £ 40 billion. The current estimate is that the UK’s subsidy bill will equal 6.5% of the GDP.
If we include the UK, the European subsidy bill has crossed €500 billion.
The UK subsidy is an “energy” stimulus which is “unlimited” as the liability will increase with the increase in energy prices!
In fact, it can be viewed as a big short position by the UK government against gas prices.
The biggest question is how Europe will fund the massive war bill, which will most probably breach even 10% of the GDP if Russia retaliates against the imposition of the oil price cap by the G7.
The colossal bailouts will be financed by additional borrowings. The bond markets are already anxious post the announcements of stimulus. As a result, Europe is witnessing a massive sell-off in the bond markets. The gilt futures are now in free fall and at multi-decade lows.
The fiscal deficits, which were already projected to increase massively before the stimulus announcements due to higher interest costs, will skyrocket further.
Undoubtedly, higher fiscal deficits and capital outflows will tremendously pressure the Sterling and the Euro.
The sharp currency depreciation will lead to a further increase in energy import costs as Europe imports the majority of its energy needs.
As a result, Europe might enter into a vicious circle.
Depreciation → Increase in energy imports → More stimulus → Higher Fiscal Deficits → Further depreciation.
We have also seen that the manufacturing powerhouse of Europe, Germany, which over the years has been able to scale up its exports massively (majorly due to cheap Russian gas) and thus reported trade surpluses, has shockingly reported its first monthly trade deficit in the last 30 years!
On the other hand, ECB, which has no control over the energy prices and the supply, is raising interest rates (to counter the Euro depreciation and control monstrous inflation, which has skyrocketed to 9.1%) which will further lead to the hardening of bond yields.
Thus, the cost of servicing debt for governments, businesses and consumers will see an astronomical rise.
Hence, elevated stress for households, government and consumers.
As the governments across Europe subsidise the energy, there’s a high probability that the demand destruction will not happen as desired to lower the prices.
There are high chances that this may keep inflation at elevated levels (around 8–10%) for a long time (H2 2023).
To win a war, as experience from WW2 demonstrates, nations battling together must unite against the enemy. However, unfortunately, Europe today is not united, specifically on the energy policies, which is the need of the hour. The diverse views on nuclear power in Germany, the renewable policies in the whole of Europe and the divergent views on the gas price cap in the EU indicate that a lot needs to be accomplished on the ground by the European leaders if they want to avert a catastrophe.
As Russia has weaponised energy, the current war can potentially induce enormous pain across the global economies, especially in Europe, vulnerable Emerging Markets and even in Russia itself.