Russia-Ukraine conflict will lead to oil price-led inflation

The Russian invasion of Ukraine’s sovereign territory is very bad news for Europeans. It has the potential of unravelling belief in what is known as the post World War II 'Europe project'.

This project has been an experiment for more than fifty years, and a belief that dissimilar countries separated by language and ethnicity who have had bloody conflicts can live peacefully as neighbours. For over 60 years it seemed to be working. There have been occasional spurts of violence.

The peace of six decades has been punctuated by the ethnic cleansing in Bosnia, and the subsequent intensive bombing of Kosovo by NATO forces, which was not approved by the United Nations. But until recently the belief was that the very existence of Europe – a salad mix of two dozen plus nations – was proof that peaceful coexistence was possible. The peaceful unification of East and West Germany in three decades after the Berlin wall was built.

The introduction of a common currency – the Euro, embraced by 19 countries – is a testimony to the desire to live together in harmony. The Schengen treaty signed by 26 countries meant no border controls. Signed in Schengen, Luxembourg, the treaty too has survived, fostering the free movement of people. The Maastricht treaty introduced voluntary fiscal discipline and free movement of capital between member states and was signed by 12 major EU economies. The exit of the United Kingdom from the European Union was a severe jolt, an unthinkable act of a major nation breaking away.

But even that did not shatter the belief in the endurance of the European project. War-weary Europe wanted no conflicts which could not be resolved by dialogue and diplomacy. The Europe project is also like a beacon of hope for troubled neighborhoods around the world, showing them that peaceful coexistence is possible and that disagreements can be resolved without war.

In 2014, Russia annexed the autonomous Republic of Crimea, situated along the Black Sea coast. While Russia and many UN member states recognise Crimea as part of the Russian Federation, Ukraine claims Crimea as part of its territory – a wound in the belief structure that has not healed. The current intrusion into Ukraine has the potential to provide a fatal crack in that belief structure.

The crack may get repaired over time, but scars will remain and will show. Europe seems helpless and cannot stop Russia. It is bound by trade links, but cannot condone an attack on the sovereignty of Ukraine. And who knows how long-drawn this violent conflict will be. The Russians have indicated that they are ready for talks and negotiations just one day after the bombing. But they might change their stand the next week.

The United Nations is trying to get the world community to stand as one and impose sanctions against Russia, but the permanent members of the Security Council will use their veto power to scuttle any resolution. Obviously, Russia will not vote against itself, and China is likely to remain non-committal about condemning the Russian action. India faces a double challenge – one diplomatic and the other economic. Both challenges are formidable.

On the diplomatic side, it is under pressure from the United States and allies to strongly condemn the Russian action. But India has historic, military and diplomatic ties with Russia, which to this day provides reliable military support in terms of armament supplies, maintenance, other hardware and training. The S400 missile system which India is thinking of buying from the Russians is state of the art. But this too has displeased the United States, which can threaten punitive actions against India for proceeding with the purchase.

When it comes to military supplies and technology, what the US offers India is not top-of-line, but atleast one or two generations older, and runs the risk of obsolescence. So that is a sore point for India. On the other hand, it was the US that brought India out of nuclear apartheid, by signing the Indo-US civil nuclear deal in 2006. Since then, the India-US bonhomie has blossomed into high levels of strategic dialogue, and more recently, the formation of QUAD or the Quadrilateral Security Dialogue between the US, Japan, India and Australia.

Bilateral trade is also robust and rising. The US is one of the very few countries with which India enjoys a large trade surplus, thanks to the export of software services. But bear in mind that a lot of that software export is from American companies which are based in India, such as IBM, Ernst & Young, Accenture or Google.

Indians, of course, have a cultural affinity with America and now many Indian Americans are visible not just as corporate leaders but also as political leaders in that country. So, India will have to do a tightrope balancing act in the way it deals with the Russian aggression in Ukraine.It cannot be prescriptive, nor can it condemn, but can articulate its principles of why such action is unacceptable.

For the Americans, it needs to show support but without being seen to tilt too much. Incidentally,the Americans and other allies have not exactly gone overboard in supporting India in the face of Chinese aggression at Galwan. The other formidable challenge for India is economic. If oil prices spike up and stay above 100 dollars a barrel, it would have four adverse effects.

Firstly, the current account deficit will worsen; secondly, the exchange rate will be under pressure; thirdly, the domestic inflation might flare up; and lastly, the fiscal deficit will take a hit, since a lot of subsidies like fertiliser and cooking gas depend on oil prices. To add to this, are investor anxiety and nervousness, the pullout by foreign portfolio investors, the consequent tremors in the stock market and overall business sentiment. Ukraine can indeed cast a long shadow onthe economy andmarkets.TheLIC IPO too looks vulnerable. All this cannot be countered easily by economic policy.

As a developing country dependent on global oil prices and foreign inflows (to plug the trade deficit), India will have to grin and bear it (or rather the right metaphor may be that it will have to “clench its teeth”). There has been considerable domestic heft to the economic momentum, and the country’s post-pandemic recovery is well underway. The Union Budget gave a capex boost signal.

However, the Ukraine conflict can undermine India’s economic momentum.

(Dr Ajit Ranade is a noted economist)