Russian oil price cap accelerates global economic decoupling

Author: Suryaputra Wijaksana, Bank Central Asia

The oil ‘price cap’ of US$60 per barrel for Russian oil is a controversial move by the European Union and G7. The price cap prohibits Western insurers and shipping companies, which account for more than 90 per cent of the marine insurance industry, from servicing vessels that carry Russian oil above US$60 per barrel.

The intention is lofty — prevent Russia from profiting from high global oil prices, but provide enough incentive for Russia to continue supplying oil, especially to vulnerable countries in Africa and Asia. Yet the price cap can be destabilising and have unforeseen consequences.

Current buyers of Russian oil, namely India and China, can demand even steeper discounts on shipments because they know Russia has limited options. In addition to weakening global demand, this may push global oil prices down in the short run, putting Russia in a tight spot. If its oil prices fall below production costs, estimated at US$35–40 per barrel, Russia may temporarily suspend oil exports or stop production completely. It does not have enough oil storage units left to store excess supply.

Another important player is OPEC, the global oil cartel, which is the main competitor to Russian crude oil. The alliance would push for higher oil prices to maximise profits, cutting supply and increasing global oil prices rapidly.

Restarting Russia’s oil operations after a temporary halt is also difficult and time-consuming, delaying supply of Russian oil into the market. Even if Russian oil reaches global markets, additional sanctions will reduce its effectiveness in lowering prices. Other countries may also seek to further disrupt the oil market, such as Turkey or Azerbaijan — both of which could block Russian oil routes. It is likely that global oil prices will escalate in the mid to long run.

A destabilised oil market could be disastrous for the global economy. It would permanently reduce global oil supplies, pushing energy prices higher and driving up inflation. This would undermine the global fight against inflation and prompt the US Federal Reserve and other global central banks to continue their aggressive monetary stances.

Higher interest rates also increase financing costs for new technologies that decrease reliance on fossil fuels. It is predicted to cost US$3.5 trillion in investment every year for the world to have any chance of reaching net zero carbon emissions by 2050. Yet weaning Europe off Russian gas will cost an estimated US$314 billion by 2030. Worse, higher financing costs also increase the cost of servicing government debt, which is already reaching all-time highs due to the COVID-19 pandemic.

But the most important and worrying impact of the price cap is an accelerated global economic decoupling that could lead to worsening living standards. Other oil-producing countries will be drawn into the US–China rivalry, each weighing in on the advantages of joining the respective blocs and further disrupting global oil supplies.

Meanwhile, Chinese access to Russian crude oil and other energy sources, such as natural gas and uranium, will reduce costs for Chinese manufacturing. The Western drive for more green investment will further increase Chinese dominance in green technologies, as it increases economies of scale. More trade barriers between the West, China and Russia force manufacturers to relocate to multiple or geographically closer countries, increasing production costs.

The price cap may also accelerate decoupling in the financial sphere. The complete embargo on Western insurers and shipping companies in shipments of Russian crude oil will create momentum for an alternative non-US dollar financial ecosystem. This would be in line with Chinese President Xi Jinping’s push for renminbi-denominated settlement of oil and gas trade with Middle Eastern gulf countries in his last visit to Saudi Arabia. Widespread internationalisation of the renminbi would increase its liquidity overseas and produce a more efficient financial system, enabling the growth of expensive maritime insurance and renminbi-denominated cross-border lending.

This accelerated decoupling could push the global economy closer to a ‘tipping point’ of transition from a US dollar-based financial system to a non-US dollar one, likely a multi-currency financial system. If history were to repeat, the transition will not be smooth and will involve higher inflation and a financial crisis. For emerging economies, an accelerated decoupling in the financial sphere can be significantly detrimental, as they still depend on the current system for financing their trade and investment.

Countries can do their best to mitigate looming volatility in global oil prices and accelerated global decoupling. They should diversify the origins of their oil imports and establish future contracts to secure supplies in advance. While biofuels may not be the most environmentally friendly choice, they are one of the most viable. Advanced economies should collaborate with emerging economies on biodiesel programs by utilising excess production of palm oils to reduce dependence on crude oil.

To mitigate economic decoupling, countries should use ongoing manufacturing relocation to integrate new global supply chains and diversify exports to new markets. Countries highly dependent on the US dollar should also start diversifying, preferably with local currencies. Recent efforts by several Southeast Asian nations in integrating a local currency settlement mechanism are a good starting point but more can be done.

Suryaputra Wijaksana is an Economist at Bank Central Asia in Jakarta, Indonesia.

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