The year of economic warfare

| December 22, 2022

The world has witnessed the outbreak of economic warfare this year, quite unlike anything seen since the end of World War II.

The machinery of economic sanctions, which has been honed over decades against minor dictatorships, has been turned by the West on Russia with a ferocity never before applied to a major economy.

Russia has been using its role as the world’s largest energy exporter to strike back, curbing supplies to Europe as the northern winter approaches in the hope that freezing its citizens will persuade their governments to cut support for the Ukraine.

At the same time, Washington has choked the flow of US technology to China and is trying to enlist allies to do the same, with the objective of maximising the West’s technological lead and, implicitly, retarding China’s economic development.

China has not yet found ways to retaliate against the US but is continuing its campaign of economic intimidation against smaller nations, including Australia and Latvia, by closing its markets to selected exports.

After decades during which the rapid growth in international commerce was seen as a desirable goal in itself, the outbreak of economic hostility among major powers marks a structural break.

One lesson from the economic warfare of 2022 is that it doesn’t bring quick results. Another is that stopping a country from importing can be more disruptive than stopping it from exporting. That’s because imports find their way into so many nooks and crannies across a nation, whereas export industries tend to be fairly concentrated. And perhaps a third is that commodities are less effective as economic weapons than high-end technology.

While most economists, including those at the International Monetary Fund, expected that the loss of around 40% of Europe’s pre-Ukraine-war gas supply would result in a recession, the latest figures show that manufacturing production across the European Union is at record levels, with nearly all EU countries producing more in September 2022 than they did a year earlier.

A Financial Times newsletter reports that an astonishing 75% of German industrial companies using gas for their primary energy source have been able to reduce their gas use without having to cut production. Nearly 40% say they could cut their usage further without sacrificing production. Similarly, in Italy, industrial gas consumption has dropped 24% below the 2019–2021 average, but industrial output has increased.

There’s a widespread view in Europe that the gas shortages are encouraging a faster shift away from fossil fuels and towards renewables. There’s also confidence that Europe has accumulated sufficient gas reserves to see it through the winter, although the International Energy Agency warns that it may be harder for Europe to replenish those reserves ahead of the 2023–2024 winter if the supply cuts continue.

Europe and the West have been targeting Russia’s energy exports. Russian coal, which used to supply around 18% of the global thermal coal trade, has come under sanctions, meaning ships carrying it can’t get insurance or trade finance from European or US institutions. The West is also imposing a cap on the price of Russian oil and is planning to do the same on Russian gas.

The oil price cap of US$60 a barrel, intended to stop Russia from profiteering from the war, has so far had no effect because the price for Russian oil has fallen below that. A softening world economy means that the loss of Russian supplies is no longer squeezing the oil price. Gas and coal prices have also eased, although they remain elevated.

From Moscow’s perspective, the West’s economic sanctions haven’t brought the Russian economy ‘to its knees’ as some expected. The IMF’s latest forecast is a 3.4% contraction this year and another 2.3% in 2023. Both Russian businesses and consumers are making do without supplies from the West. As an excellent Financial Times report shows, smuggling is occurring on a large scale through former Soviet states like Kazakhstan and Armenia, and manufacturers are being innovative in replacing Western supplies.

A forklift manufacturer now uses motors made in Belarus rather than Japan. The microchips that used to control tractors have been replaced by simpler chips from Asia. It’s harder to improvise with servers and other high-end electronics, and smuggled goods don’t carry warranties or after-sales service.

In the longer term, consumers and businesses will adjust to the more limited choice of goods and poor product quality, as was the case in the Soviet Union. The FT report cites a Russian oligarch saying, ‘There will be more paper in the sausage.’ Russia’s imports are down by about a quarter. It is estimated that most Russian industry relies on imports for at least half its inputs. Russia will also probably never regain access to European markets for its piped gas and it will take many years to divert it to Asia.

The impact of US efforts to sever China’s access to Western technology will also take time to emerge. There has been a profound shift in Washington’s attitude towards global business. Open trade served US strategic interests during the great expansion of US multinationals from the 1950s to the 1980s, helping cement the US’s place as a global power.

The US is now less convinced that, for example, the operations of Apple or Tesla in China are fundamental to its interests. Businesses will always have an influential voice in Washington, but the US is more concerned with the advantages, both economic and strategic, from technological leadership than with the benefits that flow from offshore investment by US multinationals, which was the logic underpinning Pax Americana in the decades after World War II.

As US National Security Advisor Jake Sullivan explained in September, the US had always sought to stay a step ahead of rivals on technology, but that was no longer enough. ‘Given the foundational nature of certain technologies, such as advanced logic and memory chips, we must maintain as large of a lead as possible.’ The US national security statement released the following month set an objective for the US of ‘outcompeting [China] in the technological, economic, political, military, intelligence, and global governance domains’.

The export controls imposed in October prevent US companies from selling advanced microchips or chipmaking equipment to China, while a growing number of Chinese technology companies have been placed on the US ‘entity list’, which prohibits any US sales at all. The new US CHIPS and Science Act prevents any tax credits from going to companies that build or expand fabrication operations in China.

The effectiveness of this strategy will turn on how successful China is at developing its own indigenous capacity and on the success of the US in gathering the support of key allies like South Korea, Japan, the Netherlands and Taiwan. The Netherlands is home to ASML Holding, the most important manufacturer of high-end chip-making equipment, and is under pressure to strengthen its controls on exports to China. At the G20 meeting in Bali last month, Chinese President Xi Jinping sought out Dutch Prime Minister Mark Rutte.

Xi’s G20 meeting with Prime Minister Anthony Albanese is yet to be followed by any relaxation of Chinese import barriers, although the end-of-year visit to China by Foreign Minister Penny Wong has raised hopes.  China would in particular like to resume access to Australian coal. Although the barriers have caused some pain in the wine and lobster industries, other exporters have largely diversified away from China.

Much like the Ukraine war, it’s hard to see what would bring a return to the days of economic peace.

This article was published by The Strategist.