Macroeconomic Effects of the Ukraine War

Political and Economic Background

With the Russian invasion of Ukraine that started on 24 February, the global economy faces new disruptions that manifest just when the effects of the COVID-19 pandemic seemed to slowly fade.  Europe is especially impacted, as it relies to a large degree on products from Russia and Ukraine, especially energy carriers and agricultural produce.  For the Baltic states, as well as for Finland, Slovakia, and Slovenia, Russia and Ukraine are also important export markets.

Besides by the direct effects of the fighting, these economic relations are further stressed by different capital market, investment, and trade sanctions that the international community placed on Russia.  Surveys undertaken by the European Commission as well as the increased volatility of stock market indices emphasized also the increased uncertainty burdening the Euro zone.

Economic Projections

With the start of the invasion, existing macroeconomic forecasts were obviously rendered obsolete, motivating efforts to provide updated forecasts.  For Europe and Germany, the European Central Bank (“ECB”), the German Council of Economic Experts, and several Economic Research Institutes provided such analyses, resulting in increased inflation expectations – typically operationalized by the harmonized consumer price index – and reduced growth expectations in the form of lower growth of the gross domestic product (“GDP”).

At the same time, the immediate effects of the conflict became especially visible on the international raw material markets.  Sharp price increases could be observed quickly for energy carriers – crude oil, natural gas, and coal – industrial metals, and foodstuff.  This prompted the German Federal Bank (“GFB”) to further update the economic projections under consideration of the most recent situation.

Models and Assumptions

The analysis of the GFB is mainly based on two macro econometric models: its own model of the German economy and the NiGEM-model that depicts international economic interrelations.  Regarding the political situation, the GFB assumes that the war will continue but fighting remains limited to Ukraine.  Furthermore, an embargo of Russian products, including fossil energy sources, is in force.  Accordingly, exports from the Euro-zone and the G7 to Russia – and the Ukraine – would cease.  Regarding fiscal policy, the analysis considered increased German military spending, compensation by the federal government to households and firms for increased energy cost, and no fiscal changes on international level.

Real GDP Growth

Under the base scenario, the ECB projections from March, the real GDP was expected to grow 3.7%, 2.8%, and 1.6% during the years 2022, ’23, and ’24 respectively.  For 2022, this reflected already a reduction of 0.5 percentage points compared to earlier projections.  Compared to this baseline, the analysis of the Federal Bank resulted in further reductions of the real GDP in Germany of more than 2 percentage points, specifically 2 for 2022 and about 4 for ’23 and ’24 each.

The result would be a real GDP-growth of about 1.7% in 2022 and negative growth of 1.2% and 2.4% in 2023 and ’24 respectively.  This is substantially lower than even the results of the ECB’s most pessimistic scenario, which still expected growth rates of 2.3% in ’22 and ’23 and of 1.9% in ’24.  Most of the negative effects in ’23 and ’24 can be attributed to increased raw material prices (including the effects of these price increases to trading partners).

Inflation Rate

For the three years from 2022 through 2024, the ECB analysis from March projected inflation rates of 5.1%, 2.1%, and 1.9% respectively for the Eurozone.  Here, the Federal Bank’s modelling resulted in increases of the inflation rate of 1.5 p.p., 2 p.p., and 1 p.p., resulting in consumer price inflation rates of 6.6%, 4.1%, and 2.9%.  While this remains below the ECB’s most pessimistic forecast for 2022, which was 7.1%, it does exceed the respective scenario-results for ’23 of 2.7% and for ’24 of 1.9%.  Here, the main price-driver for the first two years are the oil prices, while for 2024 it is expected to be the price for gas.  Increases of food prices are significant, but substantially smaller than the price increases for energy.

Our Perspective

The current political disruptions can obviously be expected to have implications for the transfer pricing of multinationals.  In a first place, the latest growth and inflation forecasts should be considered in analyses for intra-group transfers of businesses and business lines.  However, the changes in growth and inflation expectations should also be considered for more routine-type transactions, such as contract manufacturing and distribution.  One question to be asked here, to which degree which transaction partners should bear losses that can be expected.  A formulaic answer can be that such losses may be borne by the more entrepreneurial entities.

Nevertheless, the recent experience from the COVID-19 pandemic shows that comparable data does not necessarily support such claims. So-called “low-risk” entities will not always earn a “small but stable” profit.  For an ex-post approach, comparable data will typically only be obtained with substantial delay. Therefore, it can typically not be used for true-ups for the annual tax filing.  Accordingly, appropriate economic analyses under an ex-ante approach with the support of experienced valuation analysts are recommended.

The report of the German Federal Bank is available online here: https://www.bundesbank.de/de/aufgaben/themen/krieg-gegen-die-ukraine-energieembargo-koennte-deutsche-wirtschaft-deutlich-schwaechen-889612
The projections of the European Central Bank from March 2022 are available online here: https://www.ecb.europa.eu/pub/projections/html/ecb.projections202203_ecbstaff~44f998dfd7.en.html