The top of the list is all about the escalating energy crisis. It’s already starting to get cold here in Berlin and that is focusing everyone on wondering what will happen in the coming months.

The economic war is getting increasingly nasty. If diplomacy is usually an elegant and subtle fencing match, albeit with sharp swords, this fight is turning into just two guys with cudgels taking turns to hit each other in the head. There are actually two crises going on: an energy crisis in the EU and a budget crisis in Russia, as the effects of the sanctions start to bite.

I’ve been trying to work out which one is worse and it’s not easy to say. Judging it has been made more difficult by the obvious bias in the reporting, as obviously we in the West are on Ukraine’s side and want Kyiv to win. Me too. Famous analyst Tim Ash posted a note today saying: “Russia has lost the war!” when that is obviously not true. Despite the stunning success of the Ukrainian President Volodymyr Zelenskiy’s counteroffensive, and encouraging as it is, Russia still occupies most of Donbas, Novorossiya and Crimea and still has a big and powerful army. So it’s a bit soon for declarations of victory.

The reporting on the cost-of-living crisis in the West is continuous but not yet shrill. EUians have not been bitten too hard yet, but with the new power prices coming in in October in the UK (and I get the new bigger bill only at the end of the year here in Germany) it will. Russian President Vladimir Putin is wielding some pretty powerful economic weapons and it is not a given that the good guys always win.

Russia burning cash

Russia’s budget surplus was about RUB1.5 trillion (1% of GDP) at the start of the war but that has almost all gone now. It is down to a few billion in August. This should be no surprise, as Russian Finance Minister Anton Siluanov said at SPIEF in April he was expecting to end the year with a 2% of GDP deficit as all the social spending comes in 4Q22. Plus everyone was anticipating the oil sanctions that will cut further into revenue. Russia's Deputy Prime Minister Alexander Novak said yesterday he expects gas exports to Europe to fall by a third this year to 100bn cubic metres and further in 2023. That’s no surprise either.

Debt is also set to rise as hydrocarbon revenues fall. Elina Ribakova, deputy chief economist at IIF, put out a note saying that it will rise to 17% of GDP from the current 14%. But this again is not a problem. It’s just the Kremlin using the resources it has built up in the last decade to fight its war; 17% is still one of the lowest levels in the world, as low debt is another one of Putin’s monetary weapons.

Much has been made of the Russian 10% budget cuts across the board announced this week, but only for non-protected line items: pensions and public sector wages will not be touched. This is just the Kremlin doing some belt-tightening as it settles in for this winter’s economic war.

But despite these pressures Russia Inc. is a long way from going bust. The economy is still growing, albeit the rate is slowing, and it is on course to experience only a mild recession this year of 3-4%.

The Kremlin is happy to spend all this money because of the billions it is earning from oil exports. Oil exports have not stopped but are actually at an all-time high. The Kremlin feels it can afford to cut gas supplies to Europe because it is earning so much from oil. The current account surplus is still going up – the latest print is an increase from 2Q22 of $166bn to $180bn in 3Q22 – and Putin is not in this fight to make profits for Russia Inc. Money is his most powerful weapon. As we reported in the oil sanctions leakage report Russia will continue to export oil albeit at much lower prices. Will the Western oil price cap scheme make a definitive difference? That is still up in the air.

Gas and power

The question is how long can the two tribes keep this up? Gas prices have fallen much faster than anyone expected. US investment bank Goldman Sachs has predicted that European natural gas prices could more than halve by the end of winter, contrary to most forecasts so far that have predicted prices will remain as elevated as they are now.

Europe has “solved” its natural gas crisis for this year, the bank’s analysts said in a report published on September 13, drawing attention to the increase in storage volumes, now close to 85% of capacity, greater LNG supplies and demand destruction. These factors have more than made up for the steep decline in Russian volumes so far, and the risk that Moscow could cut off gas completely this winter.

Checking the prices this morning (here) and they have come off a lot in the last month but they remain at €202 per MWh, which is still about quadruple what they were when things were normal a year ago.

The Russian budget is not the only one that will come under pressure. The high prices are putting enormous strains on Europe. We have a big feature coming out looking at the number of steel, glass, fertiliser and power companies that have already shut down or are going bankrupt. Germany is now about to follow France by nationalising its biggest power companies, and windfall taxes and some sort of price cap is going to be imposed across Europe. Notably Liz Truss ruled out a windfall tax on her first day as the new PM. As I argued in a deep dive into power, “Can Europe keep the lights on this winter?”, the European power sector was not built to cope with these sorts of shocks.

Costs up, debt growing

The cost is spiralling up. Truss' decision to protect extraordinary energy industry profits means she will borrow some GBP130bn (€148bn) and ignore the reported GBP75bn sitting in energy company accounts. The EU has also just announced it will spend another €140bn on relief that follows on from a new €65bn in Germany and €50bn in Italy. That will almost double the circa €300bn that has already been spent since March and I think it could go as high as €1 trillion by spring.

And governments will have to keep spending until the war is over. Sanctions have caused Russia’s car and aerospace industries to collapse, and the rest will see productivity slashed as they have to go back two generations of technology. But Russia has managed to close down a lot of Europe's energy-intensive industry including metal works, fertilisers, glass and industrial chemicals, which have wide-ranging consequences.

On top of that – and this is Moscow’s most powerful weapon – it has hit the consumer by forcing them to pay thousands of euros extra for heating and power. Indeed, Russia could plunge a lot of Europe into darkness over the winter. The same problems were manifest yesterday in the US inflation print of 8.3% – close to a 40-year high. That also hits the US consumer and will probably cause a recession in America too, just as the US goes into election season. This is a political nightmare for Western governments, and they can’t let it happen. So they will take the cost by borrowing heavily to cap prices to the consumer and stimulate growth.

The EU has a lot more credit power than Russia and so can continue to spend heavily for the foreseeable future. But Russia has a lot more cash than the EU so it can also spend heavily. Moreover, the Western sanctions have not hurt the Russian consumer, who is enjoying life as normal, except food is a bit more expensive (especially cucumbers!) and it's harder to get a new iPhone 14 if you want one, unless you fly to Minsk.

What is going on here is the fiscal equivalent of an artillery duel with both sides bringing out their big guns and pounding the other to see who will crack first.

But neither side can keep this up forever. Debt is already at record highs. The EU had an average government debt of 107% of GDP and the US 122% in 2Q22 – twice the Maastricht recommended maximum. A debt crisis has already started in the EMs, especially Africa, and that could easily spread as balance sheets were already overextended by heavy spending during the coronavirus (COVID19) pandemic.

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