World Economic Update: Inflation, Sanctions, and the Russia-Ukraine War

Tuesday, March 15, 2022

Co-Chief Investment Officer of Sustainability, Bridgewater Associates, LP; CFR Term Member 

Managing Director and Global Head, Official Institutions Group, BlackRock (speaking virtually)

Founder and Chief Executive Officer, Exante Data


Paul A. Volcker Senior Fellow for International Economics, Council on Foreign Relations; Author, The Power Law: Venture Capital and the Making of the New Future@scmallaby

Panelists discuss the economic consequences of the Russian invasion of Ukraine, the use of sanctions by the United States and other countries, and the rates of inflation around the world.

The World Economic Update highlights the quarter’s most important and emerging trends. Discussions cover changes in the global marketplace with special emphasis on current economic events and their implications for U.S. policy.

This series is presented by the Maurice R. Greenberg Center for Geoeconomic Studies and is dedicated to the life and work of the distinguished economist Martin Feldstein.

MALLABY: Great. So welcome to today’s Council on Foreign Relations “World Economic Update: Inflation, Sanctions, and the Russia-Ukraine War.” This series is dedicated to the life and work of the distinguished economist Martin Feldstein. The audience today consists of Council members across the country who are joining us online, as well as a few here in person in New York. COVID is over, as Boris Johnson says, and he never lies. (Laughter.)

So with me to discuss what’s going on I’ve got Karen Karniol-Tambour, co-chief investment officer of sustainability at Bridgewater Associates, and a CFR term member. We know the second affiliation is more important than the first.

Online we’ve got Isabelle Mateos y Lago, managing director and global head of the Official Institutions Group at BlackRock. So she’s speaking virtually.

And over there to the far left of my chair is Jens Nordvig, the founder and chief executive officer of Exante Data.

So I think, you know, we’ll start with Isabelle, because she’s speaking to us from London, and therefore at a disadvantage and needs a special—you know, special preeminence as a result. And I wanted to ask, first of all, you know, obviously the two economies most affected by the war in Ukraine are the Ukraine itself and then Russia. It seems almost beside the point to talk about the economy of Ukraine when the place is being bombed to rubble, unfortunately. But I wanted to talk about the effect on Russia from Western sanctions, as well as the police state crackdown and the consequent outflow of Russian talent.

LAGO: Sure. Hello, everyone. Thank you very much, Sebastian, for the introduction, for giving me the floor first. So, yes, of course, so there’s, first and foremost, a human tragedy taking place in Ukraine and in the countries at the border. But from an economic standpoint, clearly one impact of this war is to destroy two economies at once. The Russian economy has been, frankly, crippled by the sanctions that have been imposed by a host of—by the United States as well as European and a number of Asian allies. And this, despite starting from a fairly strong position. The ruble is down 45 percent, or it changes every day but dramatically. It’s no longer convertible. The Russian debt, which used to be investment grade just a few weeks ago is now on the verge of default. GDP is expected to contract by around 20 percent in the first half of the year. And what happens beyond that, frankly, is anybody’s guess.

But then what’s been really, I think, as unprecedented as some of the sanctions that have been imposed—in particular those on the assets of the central bank—are the voluntary decisions by an increasing number of very large corporates to leave the country, stop their operations in Russia. It started in the energy sector. Then we saw a number of consumer goods companies, then some of the large banks and audit companies. And that, of course, is going to have an impact, you know, beyond, you know, any ceasefire that may or may not be agreed in coming weeks and months. There’s a brain drain associated to that. And really, the impression you get when you listen to Russians either, frankly, still in Russia or in the West, is that Russia is back to 1990, and has gone back to 1990 over the course of the last couple of weeks.

So we’re talking really crippling impact. And this, despite the main part of the Russian economy, namely its energy exports, for the most part not being affected by the sanctions and Russian inflows being extraordinarily boosted by the surging energy prices that we’ve been seeing. So the paradox is Russia’s capital—sorry—Russia’s current accounts are close to the first quarter—sorry—for—yes, for the first quarter, twice as high of that as last year, and the highest in fifteen years. And so this is where we are. You know, I think we’re hearing from a number of governments that they’re planning to intensify the sanctions if there is no ceasefire or cessation of hostilities. So I would say the economic cost is already very large, but it could get larger.

MALLABY: Karen, by all means come in on the Russia impact, but also the channel for the impact on the rest of the world seems to be mostly through commodity prices. So I’m wondering if you could talk a bit about how that’s affecting other economies outside Russia and Ukraine.

KARNIOL-TAMBOUR: Absolutely. You know, we got—the global economy got somewhat unlucky in that this war is hitting with the starting conditions being starting conditions of already the highest inflation we have seen in, you know, forty years or so, and demand outstripping supply across every area you look, ranging from, you know, personnel and the labor market all the way to commodities. And in commodities in particular, an extreme case of very tight markets way before Russia ever invaded the Ukraine. Very low inventories, very, very tight situation. And we know that that vulnerability creates much bigger price moves than a market that is more flexible.

And so if you look, for example, at when the Arab Spring hit, 2011, you know, you get Libya, Gadhafi gets taken out. That’s maybe 1 percent of world oil. You have a huge price move in response to that because you already had a very tight oil market. Now you entered this case where oil prices are at least as tight, probably tighter than they were in 2011—so it doesn’t take a lot of disruption or fear of disruption to get a very big price move. And, very importantly to a lot of the world, you already had very tight, you know, supplies and inventory issues across metals which, you know, starts with the big metals, like nickel and what’s happening in that market, all the way to small inputs to pieces that we just think of as little pieces of a supply chain. We don’t talk a lot about palladium or neon gas, but these are actually important inputs.

And then you get to food where, you basically have, you know, three big crops in the world—wheat, corn, soybeans. There’s a lot of arbitrage between them because you can choose to, you know, feed your animal one or the other, plant one or the other. And before Russia ever invaded Ukraine, all three of them were already very tight, low inventories at the same time. So you’re very susceptible to disruption. So then you get, you know, Russia invading Ukraine into an environment like this, and you’re seeing the ripple through the world basically happening through commodities big and small becoming tighter, getting very big price moves, or even a small supply disruption, and setting up a situation that’s going to take a lot of years to resolve.

You know, if you start all the way with food, you have maybe a third of, you know, wheat in the world is coming Russia plus Ukraine. And you can only plant once a year. And it’s really questionable whether you can imagine the Ukrainians really planting for the next planting season in this environment. There’s a lot of countries—poor countries in the world, if you look at, you know, the Egypts or the Turkeys of the world, who are pretty reliant on getting those imports to feed their people. And when you look even at countries like India, I mean, half their inflation basket, half people’s spending is food.

So these are big, big shifts that are very important for social stability in these countries. And the last time we had anything like this in food, we had big upheavals, things like the Arab Spring that, you know, were kind of exacerbated by this. And then you look at the way to, you know, kind of these small pieces, parts of our supply chain. It was already hard to get furniture, autos ahead of this. All these things are going to get more jammed up because there’s little pieces—we have such a globalized world—that oftentimes are really sourced from Russia. And Russia, I think, is well-aware of its power. It well-aware of what are the commodities that are small deal for its income balance, they don’t make a lot of money from them, but a big deal for the world because they’re a major supplier of a small piece. Then kind of they can jam up a whole supply chain that way.

And then you go to oil markets, which are just very politically sensitive in countries like our own because just having higher oil prices is extremely regressive. So we’ve already been living with the highest inflation we’ve seen in forty years or so. But that inflation was relatively dry. It was created from the fact that we sent every person in the economy a check. And so they could spend it on whatever they wanted, and that money went everywhere. It went to, you know, video games or crypto. It went everywhere. And so you saw very broad inflation, which wasn’t, you know, uniquely painful on certain industries and sectors.

Now that you’re on top of that getting this big supply shock, that creates a very challenging environment. And it’s an inflation that’s a lot more regressive, hurts a lot more at, you know, sort of the bottom of the economy. And I’d be remiss not to mention Europe, which is by far the hardest hit. So the United States benefits from the fact that, you know, we have our own energy sector here. We also will get benefit if we start producing more oil in this country.

Europe is really the hardest hit. It’s the most reliant on Russian energy. And I’d say back of the envelop, if the Europeans really want to replace Russian energy in a relatively rapid way, which they may be forced to do because the Russians will cut them off or they may choose to do because they really want to have their own energy security, they’re not going to replace it all. They’ll probably have to ration energy for at least a third or so of what Russia gives. That’s already a material growth hit, very regressive. And we got a little bit of a preview of what that looks like last year when Russia just kind of slowed its energy imports and you got what you got, which is a lot of governments had to step in in Europe and give money to households to make sure people had heat through the winter.

MALLABY: So, Jens, maybe you can set this in the context specifically of the U.S. economy. How much of a hit do you think this delivers both to U.S. inflation on the one side and growth on the other?

NORDVIG: Yeah. So as Karen said, the U.S. is in a very different position from Europe. Like one very simple statistic you can look at every day is, like, what is the price of natural gas, right? So in Europe the natural gas prices, as a function of this shock, have gone up. Depends on which day you look like. A week ago, it was, like, 200 percent. Now it’s maybe, like, 140 percent, something like that. So just a massive amount of shock to those prices.

And in the U.S., natural gas price is really not any big move, right? That’s a market that is pretty regional, and therefore the U.S. is shielded from that. You can look for, OK, does the U.S. export anything that’s going to be hurt by lower demand in Russia? The U.S. almost has no direct exports with Russia, so very little exposure there. Like, in Europe it’s 1 percent of GDP on average, but for Eastern European countries much more, right? So very, very asymmetric, even on the military side, right?

So Europe has decided now to increase their military spending very significantly. Germany very quickly made that decision that we’ve all read about, but other countries have followed as well, right? So there could be literally 1 percent of GDP, extra military spending, on a multiyear basis in Europe. And a lot of that is going to come from the U.S. So that—even that could be a benefit from the U.S. from an export perspective. So really the channel that can hurt the U.S. is the sort of direct hit to real incomes in the U.S. from the high commodity prices. So that’s what the market is very focused on, and I think rightly so.

I think the other channels are weak. Like we can also go through, you know, the financial contagion channel, right? Russia is not a big global economy that is integrated in the financial system, in the sense that we already had sanctions, right, in place since 2014. A lot of institutions have been very careful with those exposures. Even if you go and look at the most exposed banks in Europe, like Austrian banks, Italian banks. Like, it doesn’t look like it’s systemically important. Certainly not in the U.S. Those exposures are pretty big. So I think the commodity channel is huge. And that’s the one we have to manage in relation to the U.S.

And certainly Karen also mentioned the inflation outlook, right? Normally you would have the central bank saying, oh, we have a supply shock that’s coming from Russia. We’re not going to take it into account at all, right? That’s the kind of stuff we’re absolutely going to see through. But it’s a little bit harder to see through when inflation rate is 7 percent and potentially heading up. And I think that’s exactly the situation you have now, where everybody’s worried that an additional supply shock, even if it is a traditional supply shock that throughout history would be essentially ignored from monetary policy, is it really going to move inflation expectations in a way that is a problem for them? So it’s much, much harder to see through it than it has been in the past.

MALLABY: Isabelle, I wanted to pick up on one thing Jens was saying and ask you about the boost that I think I’m seeing to European federalism. You’ve got Draghi out there saying we’re now expected to, you know, accelerate a transition to a different kind of energy source. We’re expected to spend more on defense. We’re happy to do that, but, you know, given Italy’s budget and debt position that’s going to require deeper solidarity from the rest of Europe. So building on the recovery fund that was put in place during COVID, am I right that this is like an extension of that same pattern?

LAGO: I think yes and no. I mean, certainly Ukraine or the invasion of Ukraine by Russia has been a further wake-up call for Europe, following their—as you said, a surge in federalism in response to COVID. But equally, the old suspicions from certain countries that, you know, it’s not going to be a free-for-all all of a sudden, and we’re not going to go on a—on a rampage of free spending and solidarity overnight. That these suspicions are still there. And so what’s happened is European leaders met in Versailles last week and essentially have agreed to ask the commission to do a bit of extra work along four dimensions.

To, first, try and—four dimensions where certainly every country in Europe is confronted with a similar problem in an asymmetric way, but an agreement that these are shared problems. And ask the commission to quantify, OK, how much is this going to cost? And then depending on that costing, what is the best way of going about it? Should we do it on a national basis or should we do it at the federal level? So I think it’s a bit too early to say. And I believe ultimately there will be a combination of more fiscal spending at the national level thanks to the fiscal rules remaining suspended for at least an extra year. And then almost certainly some additional spending done at federal level, maybe partially by repurposing some of the unspent fund from the Next Generation EU Fund and maybe some new pockets of money.

But just very quickly, these four pillars are, number one, how to offset the shock faced by not only households but also corporates because of the massively increased energy burden. And just as a side point, the energy burden for Europe has spiked to close to 9 percent of GDP, which is more than doubling from last year, and a level not seen since 1981. So as Jens and Karen have said, a much bigger stagflationary shock there for Europe. So there’s an appetite from every government to help both their consumers and corporates to deal with that. You know, how is that going to be paid for? So that’s pillar number one.

Pillar number two, the European Commission has announced fairly ambitious plans to reduce energy dependency from Russia by two-thirds already by the end of this year, and then fully by the end of the decade. This is going to cost money, both to find alternative sources of energy at a time when markets are already very, very tight and prices are elevated. It’s going to require money to accelerate investments in production of renewables. Again, extra spending to improve energy efficiency. And again, some of that can be done at the national level. Some of that can be done at the—at the federal level, as you said.

Third pillar, very important one, refugees. We’re heading towards three million refugees, now the vast majority of whom are in Poland, as well as some in Slovakia, and Hungary, and a handful of other countries. But I think there’s a very clear desire to treat this as a—as a shared burden. Based on previous waves of refugees, the cost is around 10 billion euros per million refugees. So there you go, another hefty price tag there that could be met in a federal way.

And then finally, defense spending. Now, that is at tricky one because on the one hand there’s a lot of political support and momentum towards doing more defense spending. Jens already alluded to in Germany, but I think it goes beyond that. At the same time, the European treaties are very clear that the European budget may not be used to finance defense spending. So in the case of providing weapons to Ukraine, this was handled through a peace facility, but a little bit more difficult to square that circle in the European budget. So this may be something that has to remain at the national level, even though in spirit there is a desire to move as a collective there.

So, you know, long story short, there is an appetite for a bit more fiscal federalism, but exactly at what scale and what form it’s going to take, I think we need to wait a few more months to see how that pans out.

MALLABY: And, Karen, could you extend this conversation to China, Japan? How are their economic challenges affected by Russia-Ukraine?

KARNIOL-TAMBOUR: I think that China and Japan are at the extreme, and Asian conditions, where they’re not facing the same inflationary beginnings that we are here. And so you kind of have this split in the world, and it really points out that most investors are—you know, even though the world economy is, you know, maybe a third in Asia, or half in Asia, depending on how you count it, most of our exposure tends to be very U.S. and Europe heavy. But you have pretty different conditions, where you have a much weaker economy, more of a need to ease, less of an inflationary problem to go tackle. And so for them a supply shock coming from higher prices there is just not the same sort of issue.

Now, in the United States, there’s a little bit of a discussion of highest since 1980. This for us really echoes what 1973 felt like, where you got this geopolitical supply shock into already rising inflation, and so that created a nervousness to tighten into that, and what ended up being a pretty severe set of policy mistakes to let inflation run wild without tightening adequately into that. That’s a very tough set of circumstances for policymakers to be in, looking at stagflation, not knowing how aggressively to tighten into the inflation, worse in Europe and the United States.

If you’re sitting in China, that is not the set of circumstances you’re looking at. You are both much more comfortable, from a geopolitical perspective, to potentially even negotiate cheap access to Russian, you know, commodities, below market prices. And you’re not even as worried about an inflationary shock coming to the same degree. And it’s exacerbating geographic divisions being greater than sort of other divisions in both supply chains and what the economies look like.

The other piece is that if you’re talking then about, you know, Japan, Korea, and that sort of nexus of countries, for them the supply chain issues of what may happen out of Russia are a very big deal. A lot of their, you know, most important companies are, you know, autos, semiconductors, you name it. You see, you know, the equity markets underperforming in places like Japan and Korea. It is highly driven by this sensitivity to the set of supply chains. And one of the biggest questions when you look out at how people will respond to this crisis beyond, you know, it’s only been a couple weeks, is to what degree will this truly accelerate deglobalization.

I think, you know, we went into COVID with people feeling like coming out of Trump years deglobalization must accelerate. But that didn’t really meaningfully happen. Globalization still hit the highest level ever during COVID, the amount of goods that sort of crossed borders. And you still sat in a place—still sit in a place today where every good we use is about as globalized as could possibly be. Meaning, companies have looked around the world and truly found the cheapest way to produce things. There are no goods that aren’t truly globalized. Services are not. And the big question was will services also get globalized?

We don’t know to what extent this crisis will actually change impressions in a deeper, more fundamental way, to say we really want to rebuild supply chains, have more options, not be as reliant. And the same way that COVID pointed out vulnerabilities we don’t think about day-to-day. What’s happening in Russia is pointing out the same—a new set of vulnerabilities. We wouldn’t have said, you know, Russia’s biggest vulnerability is whether Visa operates there. We wouldn’t have said our biggest vulnerability is something like neon. And so just pointing out all of these pressure points. And if you’re sitting in Asia, removed from the inflation problem, removed from as direct of a connection to the conflict as Europe as has these security concerns, are you going to meaningfully rebuild supply chains in different ways? And will that really reshape the world economy in a significant way? We don’t know yet.

MALLABY: Jens, you know, another lesson for some in Asia, particularly China, coming out of all this is, you know, do you double down on attempts to diversify away from the dollar? The Chinese have been trying this really since 2008, when they discovered that they held a lot of U.S. paper and the GSE paper at one point looked like it might not pay back. And so internationalization of the renminbi has been on their agenda for, you know, a good deal over a decade. Not clear it’s got that far, but do you think they double down or do you think that the dollar’s global role is as robust as ever?

NORDVIG: That’s a very complex topic, right? So lots of steps have been taken to make the Chinese currency more international. Very important steps have been taken the last couple of years to essentially allow foreigners to invest in Chinese government bonds, right? And that’s had some success. You know, central banks have some exposure to Chinese bonds in their reserve portfolios, like 3-4 percent if you average globally. And that came from pretty much zero. So they’ve had some success for institutional investors that are benchmarked now to global bond benchmarks that have China in them. And there’s some central banks that have the exposure.

Then there’s the payment systems, right? So, like just mentioned a minute ago, like, OK, Visa and MasterCard that actually have the potential to disrupt what’s going on in Russia. And then China’s offering to come and issue UnionPay credit cards, right? So China has different ways where it’s not that they’re going to solve the problem, but they’re going to perhaps avoid the problem being so extreme because they have ways around it. We also had very interesting news today, right? So there was essentially a story that came out of a meeting between Saudi Arabia and Chinese officials today that Saudi exports to China potentially will be paid in Chinese currency going forward, as opposed to the dollar payments we have been used to. That’s a pretty big shift.

So, like, I’m getting a lot of questions after the Russian reserves were frozen, and essentially the dollars, and the euros, and the yens, and the pounds were not accessible to them anymore. OK, are we going to have some big shift in global reserves away from the traditional reserve currencies? And that’s a tricky thing, right, because if you think about it from China’s perspective, what are they going to buy? Like, they’re not going to buy rubles in their reserves, right? So what are the alternatives they have? OK, they can buy a bit more gold, but it’s very hard to come with an alternative for China where they don’t have the traditional reserve currencies.

But there are other economies around the world, and Saudi is an important one. They have a pretty big pool of reserves. With these oil prices they have a significant amount of foreign currency revenue. How they place that going forward, and if they decide to place it in China’s renminbi, will be a pretty big thing. So it’s not going to change from one day to another, these things. But there are lots of things that are different now than ten years ago.

MALLABY: Isabelle, you, I think, speak to reserve managers for a living. What’s your sense of the desirability of the dollar?

LAGO: So the point where I most agree with Jens is this is a question on everybody’s mind right now. This is very, very prominent because really, you know, there we had seen sanctions on central banks before, but they tended to be small central banks or narrow sanctions. And here we’re talking about, you know, a G-20 member, one of the largest central bank reserve holders in the world. And, you know, the paradox is Russia had already started very significantly diversifying away from the dollar. As far as is known, it didn’t hold any U.S. Treasurys. The total share of its dollar holdings was, you know, around 16 percent, compared to more than half for a lot of central banks.

And yet, you know, it’s finding itself unable to access close to half of its reserves, by its own admission. And discovering that gold and whatever else it holds is not readily available for intervention. So it’s a complicated question. The renminbi, is it a good alternative or not? I mean, certainly the news we saw today coming from Saudi Arabia suggests that some countries may well come to that view. But what I’m hearing from a significant number of central banks is actually, you know, whose to tell us that the renminbi won’t be just as well subject to sanctions, including from the Chinese government itself, right?

I mean, I think—so I think we’re in a new environment where things that were considered unthinkable now we know can happen. And it’s not clear to me that as of today there are meaningfully better alternatives to the existing set of reserve currencies. And by the way, for the world’s largest reserve holders, which is China, the renminbi, of course, is not an option because it’s not an FX reserve. And so that central bank has an even bigger problem on its hands than everybody else in terms of funding new reserve assets.

But I would say the overwhelming point of feedback that I’m hearing right now from reserve monitors is, you know, there’s this old mantra of safety. Liquidity, return is what they’re looking for in FX reserves. Recently there had been a bit more emphasis on the return because, you know, bond yields being so low everywhere. And I think all of a sudden people realized that actually safety and liquidity really matter and are going to look much more carefully at what they’re holding in their balance sheets.

MALLABY: OK, so I’d like to bring in members to the conversation with their questions. Remember the meeting is on the record. We’re going to take some questions from the virtual audience and some from the room. I think the first one—the first one, right here in the front, Tara. Please identify yourself so people on the call know who you are. Mic coming.

Q: Good morning. My name is Tara Hariharan and I work for NWI, a New York-based global macro hedge fund.

I’d love to extend the discussion further to the risks to global growth from a China slowdown. China is clearly in a situation where internal growth is slowing, partly due to self-inflicted, you know, policy tightness. And not just the consequences—the possibility deflationary consequences of a Chinese growth slowdown for things like commodities, but on the flipside an inflationary consequence if the U.S.-China situation gets worse thanks to also the China-Russia nexus. Thank you.

MALLABY: Yeah. Karen, do you want to have a crack at that? And you could throw in the whole issue of the lockdown in Shenzhen. That’s got deflationary consequences too.

KARNIOL-TAMBOUR: I mean, it continues to surprise me that the Chinese are handling COVID as they are but coming weeks will show whether they continue to do that. You know, China is one of the only economies in the world that is truly separate enough—in terms of it has a large enough monetary/fiscal credit system that it is much more self-contained and, you know, its assets look different, and kind of march to the beat of its own drum in a way that others can’t. And we have such an incredibly strongly expansion in the United States that, you know, it’s difficult to really imagine, to me, the situation in China actually derailing the expansion in a material way. How inflationary or deflationary the slowdown in China is will matter, exactly for the reasons you’re saying.

And so the more it is, you know, supply bottlenecks, and you’re adding on top of what’s already happening in Russia, then you create a more difficult inflationary situation, you know, in the world that’s growing quickly, the tougher you’re making those policy tradeoffs and the more I think we’re at a material risk of pretty significant policy mistakes of letting inflation really get way out of control and not being able to tighten into that. On the other hand, if the slowdown is more normal and they ease the COVID policy, they might, in my view, kind of ease the tensions in metals more than create a big deflationary situation because there’s so much demand for metals and it takes so long to bring supply online that, you know, China slowing what it’s doing can matter a lot.

The thing with China is it’s so top-down controlled in many ways that small changes in policy can have very significant implications. And I’ll give a quick example of that, which is last year the way they handled wanting to have fewer emissions caused a very big difference between iron ore and steel prices. And that’s something that we usually think of as more or less one and the same. You know, you take the iron ore, and you use it to make steel. More or less this is the same thing. But what you do is you tell the steel mills, no more making steel. We don’t want more emissions. Actually, demand for iron ore goes down and demand for steel is the one that goes up, and these this massively decouple. And so very slightly changes in their policy stance on COVID, on how they’re going to handle energy security, I mean, what they’re going to buy from Russia and not buy from Russia, and how openly, how scared they are of U.S. sanctions, could really matter to some of these supply chains opening up or closing up. And I think we’ve very early days figuring out what their stance is really going to be.

MALLABY: Let’s go for a virtual question.

OPERATOR: We will take our first virtual question from Megan Greene.

Q: Yeah, hi. Hopefully you guys can hear me. I was wondering if you could comment on counterparty risks, because it seems to be the dog that hasn’t barked, particularly in Europe. And also if you could comment on kind of the dollar funding stress that we’ve seen. It hasn’t been much to write home about, but do you anticipate that getting worse?

MALLABY: Counterparty risk.

NORDVIG: I think there’s a dollar funding thing. (Inaudible)—do that—

MALLABY: Megan, can you explain what you mean by—which kind of counterparty you’ve got in mind?

Q: Well, if we’ve made it so that Russian banks can’t receive payments, they can’t make them either. And so what kind of cascading defaults might result from that. Particularly—as I said, particularly with Europe, given they’re much more exposed to Russia than the U.S. is.

KARNIOL-TAMBOUR: I’ll just—I’ll just answer this. If you look at what’s happened to pricing of European banks in the markets, I think it reflects roughly the right expectation, which is you have losses there. There are real losses there. They’re probably not systemic in size, but there is exposure, and it is real. And if you look at, you know, what’s happening in the metals exchanges, nickel kind of being the most prominent example of counterparty problems and market problems as we get these kinds of shocks, I think you’re seeing—it’s not unpainful, but manageable.

NORDVIG: Yeah, I’ll just add one thing. So, like, we shouldn’t forget that we are still paying for gas, right? So the payments that are happening to Russia at the moment go through Gazprombank, that is not sanctioned, right? So the most important part of Russian exports is also the most important European import. And Russia is still an outflow and those payments are still happening, right? So the real game-changing thing would be if you actually shut down those payments so you couldn’t actually do those transactions anymore. That has not happened, for obvious reasons, right? Europe still relies on that. But that will be the next thing.

Just to go back to your other question about the dollar funding, right? So lots of people look at certain instruments in the market, like FRA-OIS is very popular to look at, and that’s widened a little bit. But dollar funding stress is, like, a very complicated thing, right? So everybody who lived through 2008 have this impression of, OK, now there’s, like, a shortage of dollars. OK, nobody can get the dollar funding at all, people are willing to pay crazy amounts for dollar funding. That’s not what we’re having now. There’s lot of different indicators of stress in the funding market that are not showing anything near what we had in 2008, not even anything near what we had in the spring of 2020. So I think we just have to be careful about how we look at those funding pressures. And it’s not a traditional dollar shortage, like everybody is scared of having again. That’s not what we’re seeing now.

MALLABY: Isabelle, I think I’ve read headlines about BlackRock taking losses in Russia. Do you want to comment on this?

LAGO: Yeah, sure. I mean, first of all, on the sort of counterparty risk issue, you know, the Russian stock market has been shut for two weeks and there’s no indications of when it’s going to reopen. The Russian government has prohibited residents from making dollar-denominated debt payments and they’ve announced that they were minded to not pay interest due on the sovereign debt unless their reserves are unfrozen. And as Jens mentioned, you know, payments for energy exports are still coming in. I mean, I saw somewhere Europe has paid 10 billion euros’ worth of energy bills to Russia only since the start of the invasion. So, you know, at this stage it’s much more a question of willingness to pay than capacity. But unquestionably, the market value of all kinds of traded Russian securities has plummeted. And so, yes, you know, our—the funds we hold on behalf of our clients, you know, reflect the market value of these securities. And that’s fallen dramatically indeed.

MALLABY: Let’s go in the front here. I’ll come to you next.

Q: Hi. Nili Gilbert, the vice chair of Carbon Direct. Thank you for this discussion.

A lot of us have been very focused on the climate transition, and within that, of course, the energy transition, and are concerned in the short term that disruption in the energy markets will lead to higher consumption of high-emitting fuels like coal in Europe, while at the same time hoping also to see a faster transition to renewables. I was wondering if you have any specific opinions about what you expect from changes in the energy mix in Europe right now, as well as in the long term, and how other spending burdens may affect that outlook—such as the increased spending on defense. Thank you.


KARNIOL-TAMBOUR: I think you said that perfectly right, which is, you know, you have—there’s really two broad ways to address climate change. You can raise the prices of the things you don’t want to be doing, and so you can make it expensive to emit carbon, or you can lower the prices of all the green renewables and alternatives. And what’s happening how is a shock that’s forcing prices higher of the bad stuff, but it’s not happening proportionate to climate change. So this isn’t, like, a magical carbon tax that got put on us, right? Coal is a lot less constrained than natural gas, but we should remember that right before this the Europeans actually talked about including natural gas in the green taxonomy as a transitional fuel that was, you know, significantly better for climate change than something like coal.

And so we’re getting a big price shock, but it’s not proportionate and it’s doing exactly as you’re saying. It’s encouraging us to move to, in the short term, actually use more coal. And it’s—the risk of this happening to climate change, in my view, is very significant because political will to impose higher and higher energy costs was already fading ahead of this. I think Europe even last year was kind of looking at the set of outcomes they were living with, the fact that they already had to ration demand, very high-intensity energy businesses were shutting down, when it was much less extreme than what’s happening today. And saying, wait a minute, are we going to keep, you know, raising the price on carbon? Are we going to keep cutting back supply of things like coal? Is this really politically palatable to this?

Now you get this shock, and the big risk is that it really reduces political will to go down that path. Now, the Europeans in the near term don’t have that many choices, is the reality. You can’t, you know, magically will into being massive wind resources. You also can’t do nuclear in a second. You know, if you listen to what Europeans are saying when changing their minds on nuclear, they’re saying let’s not decommission, which makes the hole less big. But actually bringing new nuclear online, these are things that take time. Rejiggering any of the infrastructure around energy takes real time.

So in the near term it wouldn’t be surprising if you see more coal use because you just don’t have so many options. The real question is, how seriously will Europe redouble its efforts and try to get two, three times faster towards increasing renewable energy sources? And we’re hearing a lot of policymakers certainly eyeing that option and trying to take that seriously. Political consensus in Europe about tackling climate change seems to very strong and so far, you know, withstanding in the face of this. But it’s only been a few weeks. The challenges are going to be, you know, some of the federalism issues that Isabelle talked about so well. Like, are they really going to finance this together? Are they really going to do this in a way that works?

And then some of these supply chain issues. Actually you need a lot of these metals out of the ground to build, you know, all of the electric vehicle batteries and solar panels. And so you need to actually get supply chain clear enough that a huge European push will actually materialize. So I think we’re kind of on a—walking a thin line here of whether this makes tackling climate change significantly worse, and we go backwards, or really puts political will behind, instead of raising energy prices, puts real political will behind, you know, subsidizing, using fiscal spending to get renewables online.

MALLABY: We were chatting before we came on stage about the question of whether having watched the world respond so radically to the Russian invasion of Ukraine, whether the same radicalism could be applied to carbon transition, if the demand would be there. If that, why can’t we lose patience with global warming and, you know, sanction global warming as if it was Russia?

KARNIOL-TAMBOUR: Yeah, I think that people are going to look at the private sector response to Russia—how swift it was, how significant it was—and the bar set for what investors can do, what private sector can do, what all really nongovernment entities can do—because a lot of companies are responding to their own employees, they’re responding to customers and, you know, being so significant in their steps on Russia, I think the bar is going to be set much higher to what we can do on different issues, like climate change.

MALLABY: I want to take a question. Esther Dyson, yeah.

Q: Thank you. Esther Dyson. Bittersweet former board member of Yandex, the Russian search engine that can no longer point to the truth.

I have a longer-term question. So everyone knows about the Ukrainian refugees. I think there’s going to be a huge, huge brain drain from Russia. There’s already a lot of Russian techies working from outside the country. What kind of impact is that going to have? I mean, I see it as potentially making the rest of Europe a much more tech-savvy, more entrepreneurial economy than it is now. But there’s going to be a lot of things happening in the middle. So I’d love to hear what you think of that.

MALLABY: Well, I’m going to say one thing, but I don’t know whether Isabelle or somebody else wants to come in. I mean, I observe through family experience, my sister runs a startup in Britain, and the coding team was entirely based in Ukraine. And that was not atypical, that a lot of coding talent in Eastern Europe, in Ukraine, in Estonia, and so on, and Russia, was being integrated into kind of transcontinental startup culture, which in itself is growing exponentially and it’s part of the sort of I think underrecognized stories of the moment, is now exponentially fast European venture capital and startup world is growing. So I guess if the Russian coding talent can leave the country and operate from Istanbul or wherever, that can carry on.

But I don’t know whether Isabelle wants to comment, or anybody else.

LAGO: I mean, maybe just one word on this. I think most people I’ve seen and heard in Europe are really mindful that this is not, you know, the Russian people’s war, and are really careful to not, you know, treat any Russians already residing in Europe or trying to flee Russia as pariahs in the way that the country is being treated. But I think unfortunately the more we see this brain drain happen, the longer lasting the impact on the Russian economy is going to be. If you didn’t have that, in theory you could have a ceasefire tomorrow and a lot of the sanctions that have been put in place in the last few weeks, you know, lifted and things could rebound quickly. But, you know, once people leave the country and restart their lives somewhere else, there’s a long-lasting impact. And so between this and the acceleration of efforts to rid countries of Russian gas and oil and coal, I think what this means is that the long-term damage to the Russian economy is going to be significant, not just the short-term impact.

MALLABY: Let’s take a virtual question. Sorry, Jens, do you want to say something quickly?

NORDVIG: Yeah, just one comment on this. So I think there’s a lot of people who expect, OK, if there’s a ceasefire then something is also going to happen with the sanctions regime. But I think we have to be a little bit careful with that, right? Like, we had the Crimean invasion in 2014, and really almost all the sanctions stayed in place from 2014 until now. And clearly what we’ve seen in the last couple weeks is so many times more dramatic than what happened in 2014, which makes it extremely difficult to roll back the sanctions. So I think most people in Europe would say, as long as Putin is in power in Russia, the sanctions will pretty much stay in place.

So I think that’s relevant to your question about the energy situation in Europe. Like, we’re now on a totally different strategic path. And that’s not going to be altered by any ceasefire. And I think also politically clearly the focus now on helping Ukrainian refugees and so forth, it’s going to be difficult to say, OK, we’re going to have, like, a big spike in asylum applications from Russia that’s going to be accepted. There’s no doubt that there’s a huge demand to get out of Russia. No doubt about it. The question is, OK, is politically this time one where it’s feasible to actually accept those? I think from a—from a sanctions perspective, I think you could argue that it would be the right thing to do. Like, you want to weaken the Russian economy, and you could weaken them by putting those resources into other European economies. But whether that politically could be done I think is a pretty tricky thing.

MALLABY: Let’s have an online, virtual—no? OK. Over here, yeah.

Q: Thanks. Ron Tiersky from Amherst College.

Following on this exactly, and thinking about the influence of what’s going on with the Russian economy and its influence on the war in Ukraine, could you say something about the extent to which you think the Russian economy is going to crash? And how soon will it crash? And what would the effects be in terms of, say, social problems inside Russia? What kind of pressure would that put on Putin’s regime and what he can do in Ukraine?

MALLABY: Karen, do you want to have a crack at that?

KARNIOL-TAMBOUR: Perhaps Isabelle is—

MALLABY: Well, Isabelle sort of talked at the beginning about the impact of sanctions on the Russian economy and the crashing of the economy. What maybe we could add to that is what is the transition mechanism between imposing pain on the economy and achieving a desirable policy outcome in terms of the war? It seems—am I right that that’s just—there’s no evident link that might happen, but it’s a guessing game?

LAGO: I don’t know. I mean, the line of commentary that suggests that via wielding the economic weapon you can get to regime change in Russia, I mean, I’m honestly not sure it’s that kind of regime when, you know, people get arrested for standing up in the street with a white piece of paper. I think it’s going to be difficult to get to that. And so unfortunately, yes, the economy is crumbling but that doesn’t mean, in and of itself, that it accelerates the end of the hostilities. I think as long as, you know, Europe is sending 150 million euros per day to pay for its energy bills, the economy is going to have enough resources to pay for basic needs. And then it’s a large country, it has a large agricultural sector. So, you know, to some extent life is going to be very miserable for anybody who stays in Russia. But it can—it can go on, unfortunately, for probably quite some time. So I don’t think the economic weapon alone can give us a solution there, especially until—as long as Europe doesn’t want to unplug the energy imports.

MALLABY: Do we have a question online? No. Over here.

Q: I’m Victoria Hui from the University of Notre Dame.

I want to actually—so we know that China is learning lessons from the sanctions regime today, and they are trying to figure out if they could get around, you know, this basically overwhelming reactions against Russia. So what are the chances that, you know, next time when Beijing wants to do something, whether it is about Taiwan or something else, that they could get—learn lessons from the current wave of sanctions and get around these?

MALLABY: Yeah, we talked a bit about this before but, Karen, you didn’t talk about it. I mean, maybe just—as I see this question—there’s clearly, as Jens was saying earlier, evidence that the bond market is more open than it used to be, the Saudis may accept payment in renminbi for oil, there are, you know, some growth in renminbi-denominated payments. But fundamentally, as Jens also pointed out, Chinese reserves can’t be held in renminbi. That would be contradictory. So they got to be held in something else, to the extent there’s a limit to gold or crypto. How do they avoid Western currencies? And they can’t avoid Western currencies, are they inevitably always going to vulnerable to the same kind of freezing of foreign currency reserves that the Russians have experienced?

KARNIOL-TAMBOUR: Yeah, I agree with, you know, the basic observation Victoria’s making, which is the Chinese are learning from everything they’re seeing here, as they did prior to this. They’re looking around and realizing they have a lot of vulnerabilities and there are a lot of tools through which the West can cut them off and affect them. And so this is for them I think a continuation of everything they learned from things like Huawei, although here they’re happening to somebody else and so it’s nicer to learn from someone else’s problems and not your own.

And if you step back for a minute and just look at the broad shape of the world economy, the Chinese should—from any, you know, kind of fundamental perspective—have a much more powerful financial system than they do, right? They just created the rules and haven’t let that happen, right? But the U.S. dollar has disproportionate influence relative to the role of the U.S. economy in the world because we’ve just set it up in a way to be able to succeed in that. So over time you would expect that to fade. It would be, like, your kind of starting expectation, I think, just from the shape of how the world economy’s evolved and how significant the Chinese economy within that—you would expect, looking at history, looking at—that these things would converge, that over time the dollar would become less significant than it is today, that the euro would become less significant, that the renminbi and the Chinese financial system would have a more central role.

They’ve struggled to materialize that with all of their other desires to, you know, control their economy in different ways. There’s no doubt they’re learning from all this. You know, as Sebastian said, for their reserves I just don’t think they have that many options. What are you going to put your reserves in? Russia went so much further than China in trying to protect against this outcome, and yet that didn’t help them at all. They still had this outcome. They did so many extreme things. Like, they didn’t hold any U.S. Treasurys. They did so many extreme things that are difficult to pull off, and it didn’t help them very much.

And so I think when it comes to reserves the Chinese aren’t looking at this and seeing great options. The options they can see to just more broadly shield them are around supply chain resilience, where they’re extremely serious about it. They have really made this a big national priority. And because they’re top-down, they can do that in a way that is difficult for the United States to replicate, really mapping out what do we need to do that will make us less vulnerable, how do we diversify our sources, what are we doing there? And the second one is exactly the kind of deal Jens spoke about the Saudis, that is what makes sense for them to pursue. Say why isn’t the renminbi more widely used? What can we do to make that the case so that, you know, the world financial system is less dollarized, as it should be? And perhaps this will accelerate that, like this deal this morning suggests.

MALLABY: I wonder about Belt and Road. Maybe Jens could speak to this. But I mean, the logic of Belt and Road is that you lock up supply inputs, fitting Karen’s model that they’re very serious about thinking about supply chains. But in a proper war, you know, having ownership of some, you know mining assets in Africa ain’t going to help unless you’ve got control of the sea lanes between Africa and China. And so it becomes like a sort of second-order thing. And if—you know, if the U.S. control of supply lanes in the sea is a bit like its control of the dollar, not clear how that turns out.

NORDVIG: Well, I think it’s—like, this is much bigger than—actually, exactly like you said, like some mine in Africa that they have some kind of access to now, right? Like, what we’re talking about right now is—and we’ve seen it in the news over the last two or three days, is China somehow going to support Russia in its military campaign in Ukraine? There’s been talk about supplying food to the Russian army or maybe ammunition, right? All those things are extremely controversial. And it’s been said explicitly by U.S. officials, right, any kind of things that cross that line would potentially expose China to secondary sanctions, like they’ll be sort of caught up in the whole situation here.

Then China is the biggest export economy in the world, right? What they have at risk is totally different from Russia. And if they decided to supply those things that Russia has allegedly asked for, it would really be crossing a line that exposed themselves in a way where we would have the most—like, we would essentially have a bifurcation of the world where China is cut off from all supply chains in a way that is unimaginable right now. So this is, like, a really big thing to watch. I think China is totally aware of what the cost-benefit analysis is and is going to be extremely careful about going that route. But China’s totally integrated in the global economy and really cannot be compared with Russia. It’s just a totally different situation, and the stakes are way, way bigger from a global economic perspective.

MALLABY: Isabelle, last word.

LAGO: Yeah, I mean, I think the space to watch is also all the large, you know, emerging market countries that are not players in this, and are trying to say: Look, don’t ask us to take side with one or the other. But, you know, the Brazils and Saudi Arabia’s of the world. I don’t think, you know, in the next year or so anything they can do would change the course of history, but I think we are potentially looking at the beginning of a remaking of the global financial system. And how they decide to position themselves is going to be important in how this all shapes up.

MALLABY: OK. So thank you to Isabelle, Jens, and Karen. Note that the video of the—and the transcript of today’s discussion will be on the CFR website. And for those of you who are attending in person, hope we can see you at lunch. Thank you. (Applause.)


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