UK Economic Crisis through Trade relations

Our world has undergone a multitude of changes in the last three years. Changes that no expert, researcher, or academician could ever predict. This has caused many inconveniences to people all over the world. Especially to people in certain geographical areas i.e. Europe with the Russia-Ukraine war, Asia with China’s turbulent stance regarding Taiwan, and the US in North America trying to make sense of how it fits in this entire picture and how to proceed further considering their own financial and economic conditions. Trying to make sense of how this smorgasbord of geopolitical events will unveil the future of our world economy is something people all over the world are trying to find the answer to.

But the main concern for this article is how the Queen’s country has fared in all of this. The story begins when a certain country decided to reclaim that which it alleged to be its own. Vladimir Putin, President of Russia attacked Ukraine to take control of Donbas, a Russian-majority colony in Eastern Ukraine. This was an attack that was met by appropriate action at that time. Governments all across the world, especially the US and the UK began placing sanctions on the warring country.

Russia’s quintessential strength is the products that it exports. Crude oil and food grains. Both these products have a large market in the European economies. Almost all of Europe’s crude oil services are rendered by Russia. Due to this inescapable fact, Europe cannot take severe action against Russia as it needs crude oil.

From the above image, we can make an inference about the crude oil and gas situation in European countries.

The Nordstream I is an engineering marvel that cost €8.8 billion. Owned by a Russian conglomerate, Gazprom it transports gas to Germany from where it gets transported to the rest of the continent. The second major producer of oil and gas in Europe is Norway. But comparing Russia’s distribution network and volume of natural resources to Norway’s, it is peanuts.

Let us understand the situation that has happened. When Russia attacked Ukraine, the West along with Europe placed sanctions on the aggressor. MNCs started pulling out of the country in response to this. This caused a financial breakdown leading to a sharp decline in the Ruble.

But Russia was not weakened by this. In response to these sanctions, Russia reduced the gas supply in the pipelines by 75%. This was leverage as now Europe was thrown into a crisis. With lesser gas being pumped from Russia, a supply-demand mismatch had been created. There is a high demand in the market for the goods, but the supply is being underutilized or cannot keep up with demand. Due to this other oil-producing nations like Saudi Arabia, America and OPEC+ have increased the price of oil.

As we can see from the above picture prices in January 2022 were at $79 per barrel, but after the war struck, they hit a high of $110 per barrel. This was damaging to the world economy as now countries that import oil had to do so at that price. Currently, the price sits at $95 per barrel.

Moreover, when this reduction in oil was done Russia forced the European countries to buy oil in Rubles which made it skyrocket in the currency market.

The above figure shows us the gas consumption in Europe. As we can see from the figure that gas consumption starts increasing in the months of September and October. It moves from 30,000 million cubic meters to almost double. Since in those months winter starts setting in. Citizens increase their use of heating devices to survive the winter. But now with decreased supply and increased prices of gas and crude oil, this winter will be the most difficult.

Due to inflated oil and gas prices electricity prices have risen drastically. To offset these prices the Chancellor of the UK government introduced the “mini-budget” on 23^rd September 2022.

In the mini-budget, it was stated that the cap for electricity costs would be increased by a whopping 175%. According to the above graph, the cap before the supply cuts were at £280/MWh since average consumption would be only up to £189/MWh. But after the cuts, the cost is expected to grow to £400/MWh. Hence why the cap is at £520/MWh. This means that even if the cost of electricity were to increase to say £1000/MWh consumers would only have to pay £520. Furthermore, the loss that electricity companies would bear will be borne by the government through bonds.

This is a terrible situation for two reasons:

The above figure shows the energy expenditure of people in the low and high-income percentile. According to NIESR, a poor person who spends about £2750 on energy spends 8% of his income. But a rich person who spends £5000 on energy spends only 3% of his income.

This means that a rich person who can afford to pay £1000/MWh for energy would only have to pay £520/MWh no matter how much energy he consumes. Moreover, unlike India, the UK does not have a variable slab system that could mitigate this problem.

Now comes the second problem that snowballs into the larger issue which encompasses the UK’s entire economic crisis. To begin with, the UK has a debt of $3 trillion that it must pay. So where are they planning to finance these expenses from?

To explain the above figure, imagine a situation of bond issue:

When the government first introduced bonds, the share price was £100 per bond, where the buyers were receiving £3 as interest. But if the government gets no takers then it would reduce the price to £90 per bond. But since the buyer must get the same amount of interest the percentage would increase to 3.33%. So on and so forth. This is a bad situation for any government. Giving lesser prices of bonds at a higher rate of interest is detrimental to the economy of the country.

This is exactly what the above image conveys. Borrowing costs for the government have risen by 300% in a span of 9 months. This is where the problem starts snowballing.

Currency Carry Trade

What is a currency carry trade?

Imagine there is a trader in London. He takes a loan of $1,000,000 from the Bank of America where the interest is 2%. He converts this into Pounds (£) [Exchange Rate =2, Hence £500,00] and then buys government bonds which give an interest of 4%. At maturity, he would get £520,000 which would convert to $1.04 million. Since the interest he would have to pay would be $200,000, the trader would make a profit of $200,000.

Now let’s take the situation of the UK.

As we can see the pound has fallen by almost 21.4% from January. So all traders who engaged in a currency carry trade would make huge amounts of losses.

Thus, we can see that the investors are now quitting the UK market which is further depreciating the Pound value.

This is now devolved into a debt trap. Taking all factors into consideration the energy crisis is not going to rise just because of Russia or the increased consumption in winter but also the falling pound. Therefore, The UK is now in hot waters for the winter.

But India has also been affected by this. But beneficially.

Since Russia has decreased its food grain exports, Indian exports have boomed because of this. Moreover, Russia to offset its decrease in oil and gas supply began selling to India for normal prices. This would in turn just increase prices for the UK.

This is a reason why the world economies have an issue with India since it considers trading with Russia as supporting the war.

When all is said and done UK needs to batten the hatches because it is going to be a rough ride this winter for the Englishmen and women. Alternatives for Britain and most of Europe are quite lacking. One of the alternatives could be a Nordstream II. But the first one itself took six to seven years and a humongous amount of money to build.

In the short term, the UK has a few solutions. Build a trade union with Saudi Arabia, which is taking huge advantage of the oil crisis to sell less oil and gas at higher prices. It could also bow down to Russia’s bullying and give in to its demands.

These are all the options that portray the UK in a weaker light. Yet it’s not without power. The United Kingdom controls nearly 95% of all shipping insurance companies. Shipping companies need insurance to survive as one single oil spill, one terrible storm could ruin and set back entire companies. Russian exports could be severely impacted if the UK were to use this weapon. Moreover, Indian imports of oil could also be affected by this.

The UK must play this game of chess that it has been thrust into along with the rest of Europe against Russia. Right now, the UK is in a bad state and losing. A good leader and an effective government are needed to survive. A government that brings out unconventional policies to bring Europe out of this crisis. Maybe an Indian-origin Finance Minister?

-Denver Roberts
Junior Editor, TJEF