A Critical Conflict: Insights into the War in Ukraine and its Regional Consequences
What sparked the War in Ukraine?
Russia invaded Ukraine on February 24, 2022, in an attempt to depose the Ukrainian government, thwart its bid to join the North Atlantic Treaty Organization (NATO), and restore Russia’s international supremacy by reintegrating Ukraine into its territory as it was during the reign of the Soviet Union.
Since the late 1700s, modern-day Ukrainian territory composed part of the Russian Empire until the collapse of the Soviet Union in 1991, when Ukraine declared its independence. In 2008, Ukraine applied to join NATO, and in 2012, Ukraine and the EU agreed to foster closer ties, which Putin ardently denounced. Putin, therefore, instigated the land grab of the most valuable land in Europe: Crimea. Russia’s seizure and annexation of Crimea took place in March 2014, as a result of growing tensions that culminated in the full-scale invasion that continues to devastate the world today.
How did Putin justify this? He claimed it to be a “demilitarization” of Ukraine which would limit its ability to join NATO, an organization Putin believes to oppose Russian interests. The initiation of war, however, has significantly affected the economies of both countries and has disrupted supply chains around the world.
How has the war affected Russia’s Economy?
The Russian government has faced enormous international backlash in response to its actions in Ukraine. Namely, 30 countries – including several key trade partners such as the United States, Canada, and the European Union (EU) – have fixed economic sanctions on Russia. These sanctions have prevented Russia from accessing its foreign currency reserves, allowing it to pay its foreign debt obligations. On June 27, 2022, Russia defaulted on its sovereign bonds. The next day, Russian ten-year bond yields rose by 40 basis points (Russian bonds trading at a discount). Further, Russian ten-year bond yields rose 100 basis points from September 14th to 20th, in response to news of key political leaders in the EU, South Korea, and the US, condemning continued “shelling around nuclear facilities in Ukraine.” Increasing bond yields result in more expensive financing for the Russian government, making it more difficult for them to raise money in the future.
Such increases in bond yields can partially explain the increase in portfolio investment – which grew from 25.3 billion USD in 2020 to 32.09 billion USD in 2021 – in Russian financial instruments. Despite increasing bond yields, Russia has traditionally run a capital account deficit; in 2021, for instance, its capital account balance was -295 million USD. This capital account deficit, however, has traditionally been offset by a current account surplus, which was measured at 122.04 billion USD in 2021.
Economic sanctions, coupled with a need to maintain a large current account surplus, leave Russia at the mercy of its remaining trading partners: China, Germany, Netherlands, Belarus, and South Korea. Importantly, China imported approximately 80 billion USD of Russian goods in 2021, which represented an estimated 65% of their current account balance.
Such a current account surplus, combined with high ten-year bond yields, indicates a relatively cheap currency. Due to high bond yield and low forward rates, Russia may face long-term economic growth challenges in the future as it will be more expensive for them to finance growth investments.
How has the war affected Ukraine’s economy?
For those living in Ukraine, the immediate consequences of Russia’s invasion involved demolished infrastructure, decimated homes, and destroyed lives. Although the country’s gross domestic product (GDP) surpassed $200 billion USD in 2021, the highest in its history, Ukraine’s economy contracted an estimated 30% during the first three quarters of 2022 compared with the same period last year and is expected to decline 35% by year-end.
Such deterioration is largely the result of destroyed productive capacity and human capital. Within just five months of the invasion, Russia inflicted more than $108.3 billion in infrastructural damages in Ukraine, damaging or destroying at least 140,000 residential buildings, 144,700 private homes, 43,700 agricultural machines, and 1,991 shops and stores. More than 7,536,000 Ukrainian refugees have been registered outside of Ukraine while 14,532 civilian casualties – 5,916 deaths and 8,616 injuries – have been recorded since the war erupted in February. Notably, members of the United Nations believe that the official figures are considerably higher. Combined, such destruction of physical and human capital has left Ukraine’s economy in a precarious position, and the costs of postwar reconstruction – which the World Bank currently estimates to be $349 billion – escalate every day that the war continues.
The destruction of production facilities, the forced displacement of millions of people, and Russia’s occupation of the southeast region of Ukraine have significantly reduced supply routes and production capacity within the country. Such a constrained system has caused inflation to accelerate. After inflation increased from 10.7% to 17% from February to May, the National Bank of Ukraine raised its benchmark lending rate from 10% to 25% in June 2022 in what was described as a “resolute step” to restrict rising prices, protect household income and avoid spending foreign reserves to protect its exchange rate. Nevertheless, on July 21 the central bank intervened to increase its exchange rate by 25%, from 29.25 to 36.5686 UAH/USD. These measures were taken to improve the competitiveness of Ukrainian producers, raise inflows of foreign currency revenues, and stabilize exchange rate expectations.
Despite intervention, the balance of payments deficit and inflation in Ukraine have continued to surge. Russia's blockade of key Ukrainian port facilities in the Black Sea and the Sea of Azov is an additional contributing factor to this issue. Although an UN-brokered deal between Ukraine, Russia, and Turkey in July enabled the resumption of Ukrainian grain and agricultural exports – resulting in a total export increase from 5.79 million tons in July 2022 to 9.66 million tons in September 2022, reducing the negative balance of trade from $1.798 billion to $354 million over the same period – Ukraine’s international reserves have continued to decline, falling 5.9% in September alone. Inflation also rose 24.4% year-on-year in the same month.
The National Bank of Ukraine currently possesses USD $23.9 billion worth of international reserves – largely due to steady inflows from international partners – which it reports is sufficient to cover 3.7 months of future imports while financing defense needs. The United States has provided the most support, pledging an additional 12.3 billion euros in September - which brought its total bilateral financial, humanitarian, and military aid to 52.3 billion euros on October 3, 2022. The EU has provided approximately 29 billion euros over the same period. As a proportion of donor country GDP, however, Latvia and Estonia have provided the most financial aid, transferring 0.9% and 0.8% of their respective GDPs.
Despite the determined defiance that civil society in Ukraine has exhibited since Russian forces invaded in February, foreign nations must bolster their aid commitments as the conflict continues. This requirement is especially important for Ukraine, which faces a new wave of missile and drone strikes launched by Russia in early October, in what Vladimir Putin claims are retaliatory measures for the recent destruction of the Crimea Bridge.