Russian troops are massing at the Ukrainian border. Western leaders and intelligence officials are issuing warnings and threatening sanctions. The Ukrainian public, politicians and the media are alarmed, while the army prepares to defend the country.
This is the picture we’ve been seeing over the last few months, as Russia has started its most recent military buildup at Ukraine’s back door.
War is a terrible thing and of course we all hope that it will be avoided and this period of tensions will end the same way as the previous ones did – with Russian troops returning back to barracks and the danger fading away (at least, temporarily). Nevertheless, we need to understand the consequences of possible Russian invasion, and not just the military ones. The impact on the economy, a backbone of any country, is no less important.
So what would happen to Ukrainian economy if the Russians do indeed invade?
While instinct tells us that the effects would be devastating, the reality is actually more nuanced.
Arguably, the Russians are not planning to get stuck in some kind of prolonged war of attrition (they’ve already created one in Donbas). The scenario we’re discussing is a relatively short conflict, which would impact the economy in several ways.
First, the financial impact. Ukraine is dependent on foreign financing and foreign investment to keep its public finances and economy afloat. Any kind of open military conflict would keep the investors away, which is a danger to financial stability and a risk for the local currency, the hryvnia.
However, thanks to the prudent macroeconomic policies – both monetary and fiscal – adopted after the Maidan revolution, the country is in relatively good shape. The reserves of the National Bank have recently exceeded $30 bn, and they would be used in this kind of crisis to keep the hryvnia afloat and to provide support to the financial system. The projected fiscal deficit of 3.5% of GDP is relatively low and there is no doubt that, in case of open conflict with Russia, the Western partners and IFIs would provide financial support to the Ukrainian state, as they did back in 2014. If the conflict is short, these resources should be enough to soften the financial impact of war.
Second, the impact on the real sector of the economy. Undoubtedly, many industries would have to temporarily shift to the military mobilization mode – e.g. the railroad transport would mainly serve military needs, while the energy sector would have to concentrate on ensuring secure and stable supplies to support the military effort. Other sectors would temporarily freeze – fewer people going to cafes and entertainment venues, new investment projects ceasing until the conflict is resolved etc.
In a way, this is similar to the COVID-induced lockdowns, the most recent of which peaked in the country just a month ago. They are quite disruptive, but neither are they deadly to the economy, nor do they lead to any kind of prolonged economic slump. The moment normal economic life can resume, it does.
So is economic doom and gloom on Ukraine entirely unwarranted in case of open war with Russia? Unfortunately, no.
We can only speculate what the Russian military aims would be in such a conflict. Yet it is clear that among the potential scenarios are those that imply the occupation of large areas of Ukraine. In particular, one much talked about scenario is the occupation of Ukraine’s southern coastal areas, which would cut the country from the sea and allow Russia to create a land bridge to the already occupied Crimea.
This kind of territorial loss would create a massive negative economic impact. It would directly take away the GDP produced by the newly occupied territories. Indirectly, it would sever the existing production chains and create a further drop in production in the non-occupied areas. Being cut away from the sea would be particularly devastating, as Ukraine’s economy is dependent on commodity exports which are mostly done through the ports.
Ukraine’s economic resilience in face of Russian invasion directly depends on the ability of the army and territorial defense units to protect the country’s territory from occupation. If they can deny Russia the ability to take and hold major areas of Ukraine, the country can weather the storm. If the Russians take some major territories (the South in particular), then the losses would be much bigger.
This kind of analysis is predicated on the “as is” global situation. Ukraine is classified as a small open economy that is dependent on exports (which constitute 40% of the country’s GDP) and foreign investment flows. Such an economy is impacted severely by negative outside events. If the world sneezes, Ukraine falls sick.
Eurasia is already beset by the energy crisis. Rising inflation has by now hit the whole world. China’s huge construction sector companies’ defaults have created fears in major financial markets. In short, there is potential for a major economic or financial crisis in the world, though we can never be sure in advance when exactly it will hit.
Such a crisis would automatically make Ukraine’s economic position much more vulnerable. The NBU reserves and foreign aid would have to be spent on keeping the economy afloat. The real sector, dependent on exports, would be in a much worse shape simply due to the global situation. In these conditions, it might be enough for the Russians to create a military disturbance – without occupying any major areas – for Ukraine to suffer a significant economic crisis.
Perhaps that’s the kind of opportunity the Russians are going to be looking for. It’s important for Ukrainian and Western leaders to understand this strategy and to counter it by strengthening the country’s economic resilience. Intensifying reforms and improving the investment climate in Ukraine is a good way to achieve this.
