The economic shock set off by the Russian invasion of Ukraine will be among the most severe in at least 50 years.
It is igniting high global inflation and will throttle the recovery from the Covid-19 lockdown. Even if a peace treaty of sorts is signed, the economic shock will probably continue due to world tensions.
Globally, this shock has a high risk of setting off social unrest due to increased hardship. The poor tend to spend a large share of their incomes on public transport and food. Oil and food prices are among those that have risen the most. Protests over public transport and food prices can easily risk starting national revolts.
In dealing with this shock, governments have few options and none of them are really desirable. This mammoth economic disruption will be a tipping point for many governments. In South Africa the shock has risks of igniting a repeat of the mass looting of last July. It has already sparked demands for subsidies and price controls to mitigate the effects of price rises. But in most countries, including South Africa, there is little fiscal firepower available from the state to provide subsidies and extra grants. And many central banks have already fully used their balance sheets to support their economies during the Covid lockdowns. Sustained price controls will only lead to shortages, and greater social frustration.
Unlike during the 1973 oil supply shock due to the embargo by Arab producers, the price rises this time round are not confined to just one commodity. Oil and gas, food and metals have all risen in price. That means the secondary effects in pushing up inflation and lowering incomes and thus growth might be all the more severe.
How South African agriculture - and consumers - will feel the war in Ukraine.
Commodity prices have steeply risen over the two years of Covid lockdown, but went almost vertical with the invasion. Oil prices rose by nearly 30 percent and wheat prices by almost 40 percent in the two weeks after the invasion. But last week, on speculation about peace talks and an Iranian nuclear deal, the oil price dropped by about six percent. Then this week oil prices were on the rise again, with signs that European countries may reach an agreement on banning Russian oil and the Saudis saying they would not pump more. There are currently a lot of pressures to keep commodity prices volatile, but on a rising trend.
Europe can’t diversify away from its reliance on Russian oil and gas overnight, but it will make plans to do so and these will be costly to implement. In these circumstances oil and gas prices will remain buoyant if not volatile, as will food and metal prices. Russia and Ukraine account for nearly 30 percent of the world wheat export market. All of this comes on top of continuing supply chain constraints, commodity prices that were already rising, and semiconductor shortages driving up a range of product prices.
With the hit to the growth rate by the Ukraine crisis, the tax take will be lower and the deficit higher. The growth rate projected by the Treasury of 2.1 percent for this year will be lower and the deficit at just below six percent of GDP will be higher.
Central banks have been raising interest rates to deal with inflationary pressures from cost increases. The war, combined with tightening by the US Federal Reserve, means “risk on” towards emerging markets. That means market views on South Africa are hardening, making it more expensive for us to borrow and attract investment.
At 5.7 percent a year, South Africa’s rate of consumer price inflation is already pushing toward the upper end of the Reserve Bank target range. That means the Monetary Policy Committee, which meets later this week, will have little choice about going for a rate hike of up to 50 basis points, and this will continue to tighten through the year.
Higher inflation will reduce real incomes across the world, and this will lower demand, and thus growth. Oil is now well over US$100 a barrel. The petrol price increase for next month will be above R2/litre. If oil prices go to $125/barrel, petrol prices in SA could go to R24/litre from R21.60, and at $150/barrel they would go to R27/litre, says Investec Chief Economist Annabel Bishop in a note to clients. South Africa’s consumer price inflation would then be at 6 percent year on year, and 7 percent in May.
When commodity prices rise, the balance-of-payments impact on South Africa can be almost neutral, as the higher price of imported oil is offset by the rise in prices for gold and platinum. But this time round, at least since January, the price rises of wheat and oil have exceeded the increases in maize, gold and platinum prices.
This is a particularly threatening economic shock for South Africa, given that it has already shot off much of its fiscal and monetary firepower. Scenes of public transport and bread riots in the run-up to the election in 2024 would not be good for the ANC. There are also growing calls for government action, including one recently from Pastor Ray McCauley. Some countries have already changed pricing formulas by lowering the fuel tax take, raising subsidies, and by capping prices.
The Department of Minerals Resources and Energy could cap the price of fuel and use rationing. It has said it also might put pressure on fuel companies to reduce their margins, as well as saving fuel with stricter enforcement of speed limits and encouraging working from home. A “slate fund”, which is used to deal with month-to-month price discrepancy recoveries for fuel companies, was used in 2018 to prevent a petrol price surge. But this fund, used to reimburse the fuel companies if prices were too low in the previous month, or pay out to consumers if they paid too much, is now in deficit.
Although it is food secure, South Africa could suffer potential wheat shortages and will certainly experience higher prices. Fertiliser prices and oil prices have soared, so input costs for our farmers will be higher. Producers and retailers might absorb some of the short-term cost increases of staples, but they cannot do so indefinitely. Government could respond with price caps on bread, but that would be risky.
Using price controls is not the panacea it might seem to populist politicians. When price caps remain in place for too long, shortages ultimately follow. Shortages of basic foods and petrol could be politically more damaging for a government than high priced staples. Prolonged price caps mean there is no incentive for production or for retailers to stock the item. Shortages often result, and rationing has to be introduced to restrict demand. Producers often respond to price caps by lowering the quality of ingredients. Another result is the creation of black markets.
Price controls and rationing create a minefield of problems and are best avoided. Another problem of price controls and subsidies is that they are politically very difficult to lift.
