UBS: The danger for the Eurozone from the invasion of Ukraine – Experience from the eight shocks of the last 20 years

Her Eleftherias Kourtali

Predictions of how the situation with the Ukrainian issue will develop after the invasion of Russia are very early at the moment, as UBS points out, however – trying to answer the big question of the markets, that is, how one can influence the Eurozone – examines eight episodes of negative geopolitical and economic shocks that have hit the region in the last 20 years.

These are the following:

1) September 11, 2001

2) War in Iraq in 2003

3) The collapse of Lehman which triggered the global financial crisis in September 2008

4) The first rescue program of Greece, May 2010

5) Widening of the Eurozone crisis in the second quarter of 2011 (second rescue program of Greece, followed by the rescue program of Portugal in mid-2011)

6) Rescue program of Cyprus in March 2013.

7) Russian annexation of Crimea, February / March 2014.

8) Brexit Referendum, June 2016

The nature, size, and global / regional context of each of these eight shocks were very different, making them imperfect benchmarks for simulating a Russia / Ukraine shock, UBS notes. He also added that he decided not to include the Covid crisis, as its characteristics were very specific and informal that would have unjustifiably falsified the results of the analysis. In addition, he says it is often difficult to isolate the impact of individual vibrations.

However, looking at a variety of shocks, covering both geopolitical and economic fronts, UBS hopes to capture some of the features that may be relevant in the current context. In any case, these episodes are instructive as they can help answer questions related to the magnitude of the vibrations, their duration and -mostly- the transmission mechanisms.

Methodology: For each shock, it calculates how the quarterly GDP growth (and its components) evolved on average in the four quarters after the event, compared to the four quarters before the event (acceleration / deceleration).

Comments on previous shocks

1. Not every shock is necessarily followed by a sharp slowdown in GDP growth at the Eurozone level. Some shocks (war in Iraq 2003, first bailout of Greece 2010, Cyprus 2013, Crimea 2014, referendum on Brexit 2016) were followed by acceleration of GDP growth compared to the period before the shock. This could be due to the fact that the economic shock may have been small at the Eurozone level (although probably much larger for individual countries, such as Greece or Cyprus) or its impact was too small to negatively affect its average four quarters. Probably more important, as UBS points out, is that the negative impact may have been overcompensated by other factors related to the underlying economic dynamics. It is difficult to identify the situation that would have developed if the shock had not occurred. This means that even when growth accelerated after a shock, the acceleration could have been even more pronounced if the shock had not occurred.

On average, quarterly GDP growth slowed by 0.2% in each of the four quarters that followed, compared to the four quarters before the shock, an annual loss of about 0.8%. However, the global financial crisis and the Eurozone crisis were clear extremes, which significantly increased the average of the eight crises. Excluding these two shocks, Eurozone GDP growth accelerated by an average of 0.15% in each of the four quarters following a shock. The impact of 9/11, the financial crisis and the Eurozone crisis were severely negative, but the Greek bailout, the bailout of Cyprus, the annexation of Crimea and the Brexit referendum were followed by accelerated GDP growth. This is not because these events were positive, but probably because their negative impact was over-offset by other (positive) factors, such as a strong global economic environment.

2. Most of the damage tends to occur during the first quarter – or three quarters, if you include the financial crisis and the crisis in the Eurozone, which were extremely long in duration.

3. Fixed investments tend to do more damage during adverse growth crises.

4. Household consumption tends to react less sensitively than corporate investments. However, if and when household consumption suffers (Lehman, eurozone crisis), the negative impact on GDP tends to be high. After all, household consumption accounts for about 55% of GDP, while fixed investment accounts for “only” 20%. Underlying labor market trends are very important: Where labor markets are flexible and / or in an underlying recovery trend, household confidence tends to suffer less. This, UBS points out, explains why during the Eurozone crisis, household consumption in Germany (where employment remained stable) was relatively resilient, while consumption collapsed in Italy and Spain, where unemployment rose sharply. In contrast, uncertainty shocks not followed by deteriorating labor markets tend not to significantly affect consumption. In the case of the current tensions around Russia / Ukraine, the outlook for household consumption in the Eurozone appears to be at risk, as rising (or persistently high) energy prices could affect household purchasing power.

As a general rule, UBS estimates that any 10% increase in fuel, electricity and gas prices deducts about 0.4% from household consumption and 0.2% from GDP growth. If this is applied to the rise in energy prices from January 2021, it is estimated that the potential loss to GDP growth in the Eurozone is 0.4-1.3% due to weaker consumption. 50% of this blow to GDP (ie 0.2-0.7%) occurred already in 2021, with the rest (0.2-0.6%) likely to occur in 2022, mainly in the first half.

5. Consumption of governments tends to be resilient, as they offset the negative growth shocks through counter-cyclical fiscal policy. However, the conditions of public funding of individual governments are of great importance. For example, during the Eurozone crisis, some governments had fiscal room for counter-cyclical policies, while others were forced to tighten budgets aggressively, given the harsh conditions of bailouts or market pressures.

6. Exports and imports tend to react with great sensitivity, but often move in parallel, with the result that commercial shocks are often relatively moderate. The Eurozone’s export exposure to Russia is quite limited and has decreased over the last decade, but the Eurozone’s dependence on Russian energy is very high.

In the context of the current tensions around Russia / Ukraine, the exposure of individual countries will depend not only on their export exposure (mainly to Russia), but also on their dependence on energy imports (from Russia) and their consumer sensitivity to prices (and hence household purchasing power) to fluctuations in energy prices. The fiscal policy response, including the adjustment of regulated prices (amid rising wholesale energy prices), will also be crucial in this regard, UBS concludes.