Recent elections in Germany and Italy have demonstrated a shift away from the nationalist, anti-EU sentiment that was popular only a few years ago. In France, Russia’s invasion has strengthened President Macron’s position ahead of presidential elections in April, at the expense of candidates seen to be friendly towards President Putin. As a result, the European Union has a much stronger centre of gravity now, compared to its situation before the pandemic.
A worst-case scenario: long-term disruption to gas supplies
Further escalation of the war and long-term disruption to gas supplies are plausible risks to our base case scenario. They could materialise due to a further tightening of sanctions, physical damage to pipelines, payment system problems or the wilful interruption of supply by Russia. Russia supplies around one-third of Europe’s energy imports, a gap that would be difficult to plug in short order. Such a shortfall could meaningfully affect energy-dependent, industry-heavy economies that rely on Russian gas, like Germany and Italy.
Provisional calculations based on ECB research suggest that a 10% reduction in gas supplies to the euro area would reduce gross value added by 0.7%, not including amplification effects on economic confidence and supply chains. Back-of-the-envelope calculations suggest that a total shutdown of Russian gas supplies to Europe might reduce euro area GDP by as much as 5 percentage points (the red line in Figure 1) – an effect 10 times larger than our base case.
Even these conservative estimates of the effect of long-term disruption on European growth are large, in line with the Global Financial Crisis (2008). Should our worst-case scenario materialise, we expect that GDP growth would fall to –1% in 2022, similar to what happened during the euro sovereign debt crisis (2012).
Asymmetric risks to the euro area
Disrupted Russian gas supplies would have an asymmetric impact across the eurozone. Austria, Slovakia and Italy would feel the effects of a stoppage first, because they rely on Ukraine as their main transit corridor for Russian gas. Later on, Germany and Italy’s industry-oriented, energy-intensive economies would be hardest hit, due to their greater reliance on Russian energy than, for example, France. The Netherlands and Germany export significant volumes of high-tech manufacturing equipment to Russia, which export bans would reduce.
An asymmetric shock may disproportionately weigh on growth in economies such as Italy and make their debt unsustainable. That danger may make the ECB more cautious in normalising monetary policy, to prevent peripheral sovereign bond spreads from widening. But traditional monetary hawks such as Austria, the Netherlands and Germany are relatively susceptible to the supply shock we described as well. Their acquiescence could remove a further obstacle for the ECB to adopt a dovish stance for longer.
If the situation were to deteriorate, we could see the continuation of open-ended asset purchases, a so-called “lower for ever” scenario for interest rates and active interventions by the ECB to stop a widening in the bond spreads of peripheral eurozone members. Even the creation of a permanent central fiscal authority for the Euro area could conceivably be an option.
Conclusion
In our base case scenario, the crisis in Ukraine will reduce euro area growth from 4.2% to 3.7% in 2022, delaying but not definitively derailing the recovery. Euro area budget deficits will widen further, possibly by 1 to 3 percentage points as a share of GDP, and monetary policy is expected to remain lower for longer, with no rate hike in 2022.
In our worst-case scenario, long-term disruption of Russian gas supplies could reduce the euro area’s GDP growth by as much as 5 pp in 2022, to -1% for 2022. The conflict in Ukraine will affect some euro members, such as Italy, more than others. Such fragmentation could lead to an even more dovish stance by the ECB and greater fiscal integration across the euro area.
