The tit-for-tat sanctions between Russia and the West that heated up last week are only adding to fears that Europe’s economy will fall back into recession or experience “lost decades” comparable to the downturn in Japan that left the Asian giant’s economy drifting, deflated and diminished in global influence.
Europe’s growth came to a standstill in the second quarter, but despite the growing risks, European leaders agreed to go along with the U.S. in imposing a series of sanctions on Russia, culminating late last week in the toughest penalties yet on Russian oil and gas companies, which provide a third of Europe’s energy needs.
The sanctions have, as intended, helped to plunge Russia’s economy into recession. But while they were designed to do as little damage as possible to Europe’s own economy, analysts increasingly question whether they are harming Europe as well, especially since they are hitting hardest on the country that was heretofore Europe’s engine of growth: Germany.
German economic output and business confidence fell in the spring quarter as the conflict in Ukraine broke out and Western leaders prepared their first round of sanctions. France’s economy also took a dip while Italy relapsed into its third recession since 2008. The only major economy in Europe that appeared to be in solid recovery was Spain.
Moreover, the economic brew in Europe has only worsened since the spring. Confidence and output have continued to fall while the U.S. and European Union have ratcheted up their sanctions on Russia’s banks, defense and energy companies, prohibiting crucial financing provided by Western banks or the sale of high-value Western technologies to Russia. Those bans led Russia to retaliate with bans on many European and American food exports.
Now, with winter approaching in the Northern Hemisphere, and no end to Ukraine tensions in sight, Europe faces a major economic test given its dependence on Russia for more than a third of the natural gas needed to heat homes and offices on the continent.
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Analysts say the latest round of sanctions announced Friday tightens the noose around Russia’s energy sector, making it particularly hard to invest in long-term projects to tap into new sources of oil and gas in Russia’s vast Arctic and Siberian regions. Such sanctions might tempt Moscow to play its strongest card and halt the flow of gas and oil, particularly the large share of gas exported through the Gazprom pipeline that crosses through Ukraine.
“The economy would really suffer if Moscow cut back on gas exports,” said Olaf Storbeck, analyst with Reuters Breakingviews. “The German economic minimiracle is on hold,” in any case, he said, and without it, the recovery in Europe is crumbling.
Turning off the gas
Declines in Germany’s stock market show investors fear that Russia could turn off the gas, even though that seems a remote possibility, Mr. Storbeck said. Russia depends on the $80 billion a year it earns from Gazprom sales to Europe and would only disrupt the flow to make a “political point,” he said.
Europe also is heavily dependent on Russian crude oil. Thomson Reuters estimates that a reduction of one-third in Russia’s supply of oil to the euro area could lower growth across the region by between 1 and 1.5 percentage points in the first year.
Thus, Europe is vulnerable should Russia declare an all-out economic war and boycott fuel exports this winter, Mr. Storbeck said. But short of that, Germany and the rest of Europe should be able to get by with only a slowing of growth, he said.
Much has been made of Germany’s extensive trade ties with Russia, with more than 6,000 German companies doing business there. International Monetary Fund Managing Director Christine Lagarde emphasized in a recent interview with Les Echos that the German industrial complex is the most at risk from the standoff with Russia.
“The crisis in Ukraine is having side effects on Russia and on neighboring countries, particularly those that belong to the German value chain and whose trade, energy and financial links are being affected in varying degrees,” she said.
But Mr. Storbeck said the risk for Germany has been overstated. Germany earns more from exports to China and the rest of the world than it does from Russia, he said.
“Exports to Russia are falling quickly, but that makes little difference to the overall economy. Russia is only the 11th largest foreign market for Germany, accounting for 3.3 percent of all exports,” he said.
Moreover, “the EU sanctions have little direct effect on Germany, because the country is not strong in banks and military goods, the most affected sectors,” he said. And while countries like France and Italy may suffer from the block on food imports, that “is also not a big deal for Germany,” he said.
Nevertheless, economists say the timing of the trade war is bad, because it’s now clear Europe has not really shaken off the recession brought on by the European debt crisis in 2012 and 2013. Economies across the EU may still be too fragile to absorb even the modest export losses envisioned under the sanctions regime.
Moreover, they point out that even if the European economy does not fall back into a full-fledged recession, it could face Japan’s fate and succumb to a chronic state of economic drift and decline for years to come.
Joachim Fels, global economist at Morgan Stanley, expects “the escalating conflict between Russia and Ukraine” and tit-for-tat trade retaliation to “depress confidence and activity further” in Europe. And when added to news that consumer inflation there recently fell to a five-year low of only 0.3 percent, he said Europe looks “dangerously close to the deflation threshold.”
Looking like Japan
“The Japanification of the euro area that I dreaded a year ago is no longer a threat; it has become a reality,” Mr. Fels said.
Analysts say Europe’s economy today looks eerily like Japan’s after the collapse of Japan’s stock and real estate bubbles in the 1980s. As with Japan, Europe’s population is aging and starting to shrink, eliminating an important natural source of growth for the economy.
After decades of heavy debt accumulation by governments across Europe, banks on the continent are laden with bad debts and have been unable and unwilling to make new loans to businesses and consumers, stifling credit as a source of economic growth.
And prices in Europe appear perilously close to falling into deflation territory like they did in Japan, prompting consumers to put off purchases in hopes that prices will drop first. The threat of such a deflationary spiral held Japan back for years, and it appears to be what prompted the European Central Bank to take aggressive action earlier this month to lower interest rates close to zero and pump money into the banking system.
In another development mirroring Japan’s experience, falling prices and slowing growth have sent interest rates to their lowest levels on record, with Germany now paying yields of less than 1 percent on its bonds.
“The situation is remarkably similar to that of Japan, with deflationary forces gaining strength,” said a group of Danish retired professors writing for the Seeking Alpha website. “The eurozone is resembling Japan’s lost decades ever closer on a host of metrics, including demographics, growth, inflation, yields and debts. In some respects, the eurozone crisis actually resembles the Great Depression of the 1930s.”
While both the U.S. and Japan have managed to emerge from their economic funks recently through a combination of government spending and aggressively loose monetary policies, European leaders are just starting to consider such measures. The recent setback in Germany’s economy, prompted by fears about escalating tensions with Russia, seems to have been one factor forcing the European Central Bank to get more aggressive, the professors said.
“Now even the German economy, for long the well-performing exception in a pool of economic malaise, is stuttering, and the problems with Russia over Ukraine aren’t making things easy,” they said, predicting that things could get worse in Europe before they get better.
John M. Mason, a former finance professor at the University of Pennsylvania Wharton School of Business, said that looking back, Europe may have been too weak economically to join the sanctions war with Russia.
“The problem I’m concerned about, I believe that all Americans should be concerned about, is that the eurozone might go back into a recession,” he said. “The situation relating to Russia and the events in the Ukraine continue to impact the whole European continent. The rising battles over sanctions have only added to the pessimism that has grown in member countries.”
The European Union is America’s largest trading partner, and a renewed recession in Europe almost certainly would pull down growth in the U.S. economy, he said.