How the Russia-Ukraine conflict has exposed structural malformations in the global economic system
By Prof. Dr. oec. Hanspeter Gondring FRICS, Head of the study program Duale Hochschule
Baden-Württemberg Stuttgart, Founder and Head of the ADI Academy of the Real Estate Industry
Prof. Hanspeter Gondring gave the opening speech at the Immpresseclub conference at the end of June in Frankfurt, giving his take on the current turbulent economic environment and how it will impact on the property market. Here, REFIRE summarises what he had to say.
What we are experiencing now is a "crisis" in the truest sense of the word. Crisis is generally understood to mean an intensification or a turning point at which a situation can improve but also deteriorate. This is true of "Die-Zeitenwende-Rede" (“turn of the tide” speech) by the German Chancellor. In order to be able to take advantage of the opportunities offered by a crisis, it is necessary to make an objective assessment of the respective "course of the crisis". This is precisely where there are unclear, tendentious and false statements in place, at least when it comes to the public perception, as outlined below.
The Russia-Ukraine conflict has exposed structural malformations in the global economic system
This conflict has exposed the structural malformations inherent in the global economic system over the last 30 years. As such, this conflict is not the root cause, but like a "flash", which “flashed” the risks of the globalized economy into the public consciousness. The geopolitical tension has been there since the early 1990s and is only now coming to a head in the Russia-Ukraine conflict. Similarly, the global "system struggle" of the liberal-democratic system against the authoritarian-despotic system is nothing new, it has just become more visible. Ultimately, in the end, two fixed system blocs, each with changing partner countries in Africa, Asia and South America, will face off over energy, raw materials, food and information. Globalization 2.0 has begun.
We have weathered three crises well in the last 20 years – the dotcom crisis, the financial crisis and the Corona crisis. These crises were technical crises with a V progression, meaning that they materialised very quickly and went away again quite quickly.
In contrast, the current crisis is a structural crisis with a U-shape descending slowly into a trough and then rising again just as slowly. We call this a structural crisis because the economic structures of the international division of labour and the trade in raw materials and energy, which have been formed over the last 30 years, were broken up or called into question by the globalization of the countries among themselves. Now, the process of forming new global economic structures - without Russia, among others, and with reservations about China - has begun, which will continue for several years, possibly with minor recovery phases.
Rising energy costs depress economic growth
Energy is a crucial production factor for growth and, therefore, for prosperity. Rising energy costs depress economic growth and lead to a loss of prosperity. In Globalization 1.0, the focus was on the procurement of cheap energy sources, irrespective of the respective ideological and humanitarian circumstances of the producing countries. Nordstream 1 and 2 are prime examples of this. This is not meant to be a criticism of the policy because, firstly, everyone is "smarter" in retrospect and, secondly, there was a confidence in the dogma of being able to effectively convey "ideological values" via long-term economic co-operation.
As a result, Europeans signed up in the past to a "bill of exchange" for growth and prosperity that is now being honoured. In the production of natural gas, the U.S. accounts for 23.3% of world trade, ahead of Russia with 18.1%, Iran (5.9%), Canada (4.5%) and China (4.33%) and Norway (2.9%). In the case of oil, the U.S. also leads with 19.7% of world production, ahead of Saudi Arabia with 11.5%, Russia with 11.1%, Canada with 5.6% and China with 5.2%.
Going forward, brown energy sources and wind power plants do not solve the energy problem and so the conflict arises as to what is more important in sociopolitical terms: growth and prosperity with lignite and nuclear power, or low growth and reduced prosperity with sustainable energy sources and ideologically compliant producing countries. This may sound "black and white," but even a "grey” zone will make energy costs more expensive for years to come.
Food shortage not on the cards in Germany but inflation remains high
There will be no food shortage in Germany because according to the Federal Agency for Agriculture and Food (BLE), the degree of self-sufficiency regarding wheat is 125% and 113% for barley. According to the EU, the surplus producers of wheat such as Germany, France, Romania, Poland and Bulgaria can probably export 40 million tonnes of common wheat in 2022, which equates to 31% of the production. In total, 62% of the world's export of wheat, flour and wheat products comes from the EU, Russia, the U.S. and Canada, with a negligible 1.9% coming from the Ukraine and just 0.1% from Russia.
Subsequently, the sharp rise in food prices in Germany is not due to shortages but, rather, to production costs. For example, between February and March this year, natural gas prices soared by 125%, compared to 66% for electricity and 57% for light heating oil. As a result, food prices jumped by 9.2% in the period, marking the highest level of inflation since 1949.
Growing social and political pressure behind ECB interest rate hike
Purchasing power stability is one of the economic policy objectives of the "Growth Act" Stability Act of 1967. One of the central bank's main tasks was to finance economic growth in an inflation-neutral manner, i.e. to provide as much money supply as necessary to finance economic growth over a three-year target period. Especially after 1974, with the collapse of the Bretton Woods system, the Bundesbank's tight monetary policy made an unprecedented and globally recognized contribution to the monetary stability of the Federal Republic. This neoclassical monetary policy was considered the orientation for the ECB in its early days.
After the financial crisis, this position was largely abandoned and a shift was made to a post-Keynesian monetary policy, which does not target the money supply but the key interest rate as a supportive means of economic policy. The ECB became the main buyer of government bonds - and thereby the financier of weakening EU countries - which is still a "sacrilege" of the predominantly neoclassical economists today. The ECB deliberately and rightly resisted raising the key interest rate for a long time, but was forced to do so "half-heartedly" because of growing social and political pressure.
The following facts justify the ECB's hesitation to raise the key rate or to turn the interest rate screw: rising inflation is not demand inflation as in the 1970s and 1980s but cost inflation. Imported cost inflation – the import of energy, semi-finished products and raw materials - is immune to monetary policy stimulus. The ECB cannot lower energy prices, solve supply chain problems, or produce food. Only 1.5 to 2 percentage points of the current inflation rate are demand-driven and can be influenced by monetary policy: credit-financed house construction, credit-financed vacations, credit-financed cars, home furnishings, home renovations etc.
Risk of a recession looms large
What will remain are the inflation drivers (around 5 - 5.5 percentage points) such as energy, raw materials and also producer prices and now also the rising cost of capital. No key interest rate policy will be able to change this. The longer the Russia-Ukraine conflict lasts, the greater the risk of a recession, which would be accelerated by rising interest rates and prolong the duration of the recession phase. Against such a backdrop, rising key interest rates are very risky from a monetary and economic policy perspective. The ECB's current key rate hikes are seen more as a reaction to the Fed's hefty rate hikes than as an action against inflation per se. The ECB is hanging on the Fed’s "interest rate skirt" because an international interest rate spread can lead to undesirable interest rate arbitrage processes.
Households will clearly be burdened by energy and housing costs for some time to come. Many households will reach or exceed the 40% mark for gross rent in relation to net income. Therefore, the high energy costs this year will not be passed on until 2023, which means that in 2023, many households will struggle financially if they have not made adequate provisions.
Project development is also facing some of the same challenges, not least because it is extremely difficult to make decisions today for future projects down the line. Cost and financing risks are difficult to calculate; adequate risk pricing is de facto no longer possible because the returns would rise from today's 3%-6% (see 5% study by bulwiengesa) to over 10%, which would not be enforceable on the market.
Ultimately, what this means is that project development can no longer generate risk-adequate returns and that a non-negligible share of the risk remains with the project developer, or in abstract economic terms, the uncertainty of the investment increases.
Whether a project development should be carried out now or not depends neither on the "gut feeling" nor on speculative future forecasts, but rationally on the extent to which risks can be shifted. The decision for or against a project development depends on the relationship between expected return and risk and it is to be expected that the equity portion of project financing will increase.
