The United States and its allies moved quickly to weaponise finance when Russia invaded Ukraine, imposing significant pain on its economy and markets. The ruble sank like a stone, there was a run on the banks and Russian equity markets still haven’t reopened since the sanctions were announced. But Moscow was left with one way to amass US dollars and continue transacting with the international community—there was a carve out in the sanctions for Russian energy exports. This window of opportunity for Russia is now closing, but whether it remains wedged open depends largely on the European Union.
Earlier this week, the US announced a blanket import ban on Russian fossil fuels effective immediately, while the UK vowed to completely embargo Russian oil by the end of the year. Oil prices jumped as soon as the embargoes were announced, and higher energy costs will drag on growth in the US and UK. As the US mulled these additional sanctions, it sent a senior delegation to Venezuela for the first time in years, signalling that it might be open to alternative sources of oil. That said, only 10 per cent of US and 8 per cent of UK energy comes from Russia; import bans will not on their own be a game-changing development for either economy.
The primary impact of the US and UK announcements may be increased pressure on the EU to sanction Russian energy, which would have far more significant implications for both the Russian and EU economies. Europe is Russia’s largest market for natural gas. The EU is reliant on Russia for roughly 40 per cent of its natural gas, 30 per cent of its oil and 50 per cent of its coal.
For this reason, some EU leaders are reticent to join in the energy embargo, particularly German chancellor Olaf Scholz. A recent academic study showed that a sudden halt of energy imports from Russia would reduce German GDP by between 0.5 and 3 percentage points. The high end of that estimate comes mainly from banning Russian gas and failing to find suitable alternatives. This is not a pie-in-the-sky worst case scenario—it would be difficult to find enough liquefied natural gas to compensate for losing Russian gas supply.
As a result, an immediate EU ban on Russian natural gas would hurt the Russian economy but could hurt the EU’s even more. European gas futures (in which a buyer agrees to purchase a particular quantity of natural gas at a future date and price) prices have already soared 13 times higher than their level a year ago. A gas embargo would send prices skyrocketing even higher and would almost certainly push the EU into stagnant growth and soaring inflation—so-called stagflation.
A more likely scenario is an EU oil embargo, as the bloc works to reduce its dependence on Russian gas over time. In 2021, Russia generated almost three times more revenues from oil exports than from gas. A more global ban on Russian oil would impact the Russian economy significantly.
The EU recently announced plans to cut Russian gas imports by two-thirds over the next year. The proposal still has to be adopted by member states, and even if it is, it is incredibly ambitious. The International Energy Agency also put together a plan to reduce EU reliance on Russian gas and determined the EU could reasonably reduce demand by 30 per cent this year. This scenario is less aggressive, and yet still presses a number of assumptions to their limits.
If the EU imposes an oil embargo and pivots away from Russian gas over the next year, it will drive energy prices up further and drag on growth. In the short term, demand across the EU could fall significantly. But over the medium to long term, the EU is on track to significantly boost investment on both the green transition and defence. The big question is how to fund it.
One option is for the European Central Bank (ECB) to keep monetary accommodation in place longer than it had planned before Russia invaded. If eurozone countries are to spend big on greening their economies and on beefing up defence, the ECB can help by keeping borrowing costs suppressed via continued asset purchases under its Quantitative Easing programme.
Even better, the EU could expand the Recovery and Resilience Facility (RRF). The RRF was a package funded by joint EU debt issuance that provided loans and grants for EU member states to address the asymmetric shocks from Covid-19. The conflict between Russia and Ukraine also creates asymmetric shocks for member states; Germany is far more reliant on Russian gas than Spain, for example, and will have to undergo a bigger transition to diversify its energy supply. Currently, 37 per cent of the RRF funds must be earmarked for the green transition and they must be absorbed by the end of 2026. Additional debt could be issued at the EU level to frontload the green transition.
There is a nascent proposal to issue EU debt and use the proceeds to make loans to member states to finance new initiatives. There will be opposition to this proposal among the so-called frugal EU countries—led by Germany—and it would probably take months to work out the details. But if implemented, this could boost EU member state fiscal spending significantly and could accelerate the green transition.
Wherever the financing is found, the immediate energy crisis in Europe could prompt significant investment, boosting growth in the medium to long term. Even more importantly, debt mutualisation could become a regular tool for fighting asymmetric shocks in the eurozone, turning the bloc into a more optimal currency area. With war on the continent, Europe may ultimately emerge much more resilient.
