How Russian gas became Europe’s most divisive commodity

Nord Stream 2 will pipe energy to Germany but critics warn of political tensions

Tobias Buck in Lubmin

© Getty

Lubmin is a picturesque resort on Germany’s Baltic Sea coast that boasts a long stretch of sandy beach bordered by soft dunes and a lush pine forest. Located a few hours north of Berlin, the town offers tourists a postcard version of seaside tranquility. Or it would, were it not for the fleet of excavator barges that sails out from the local port every day, and the large building site hiding behind the pines.

Both are part of a fiercely contentious project that has split Europe down the middle, and set Germany on a collision course with some of its closest allies. Out in the sea, the excavator barges are digging a massive underwater trench that runs in a straight line towards the building site on land. If all goes to plan, that trench will soon hold a pipeline filled with the most explosive commodity in European politics today: Russian gas.

The Nord Stream 2 pipeline has been in planning since 2015, and is due for completion in late 2019. Its defenders argue the project makes perfect commercial sense: the pipeline will connect the world’s biggest exporter of natural gas with the largest economy in Europe, doubling the capacity of the existing trans-Baltic link, Nord Stream 1, which has been operational since 2011. Together, the two pipelines will eventually be able to carry 110bn cubic metres a year of natural gas, enough to meet almost a quarter of total demand across the EU.

The Nord Stream landfall facilities in Lubmin, northeastern Germany © Alamy

Critics regard the pipeline — and Germany’s role in it — as an act of betrayal and a geopolitical folly of the first order. Countries such as Poland and Ukraine have denounced it as a blatant attempt to marginalise their own gas pipelines — and a reckless move that will leave them and the rest of Europe at the mercy of Moscow. The European Commission is another opponent of Nord Stream, arguing the project undermines its push for greater energy independence and more diversified supplies.

The most formidable adversary, however, sits in Washington. President Donald Trump has made clear repeatedly that he wants to stop the €9.5bn project — and that he is ready to impose tough sanctions to achieve that goal. Last week, Mr Trump launched a blistering attack on the new pipeline at the Nato summit in Brussels, warning that Germany had become “captive to Russia, because it’s getting so much of its energy from Russia”.

Kirsten Westphal, an energy analyst at the German Institute for International and Security Affairs, likens Nord Stream 2 to an “onion” — you peel away layer after layer of controversy only to discover that the next one is more contentious still. At its core, however, the pipeline poses a simple but crucial question: should the west trust Russia or not?

“Russia’s annexation of Crimea in 2014 and the war in Ukraine have changed everything,” says Ms Westphal. “For many people in the west, the idea that Russia is a dependable partner has gone. There is doubt: given all the geopolitical tensions, should we further expand our energy relationship with Russia? Should we make a bet, despite it all, to keep the channel open?”

Russia is the largest supplier of natural gas to the EU

For reasons of history as well as naked economic self-interest, that question tends to find a different answer in Germany than in other European countries and the US. It is summed up neatly by Axel Vogt, the mayor of Lubmin and — like most locals — an enthusiastic backer of Nord Stream. “For us, Russia has always been a reliable business partner. And we don’t see any sign that this is changing despite all that is happening on the big political stage,” he says. “For Lubmin, Nord Stream means jobs, it means contracts for local businesses and it means more business taxes,” the mayor says.

He adds that this affection for Russia goes beyond economic gain, and reflects ties forged in the time when Lubmin was part of communist East Germany. “Before reunification there was a very close relationship with Russia . . . and they want it to stay that way.”

For now the project enjoys the official support of the German government (as well as the unconditional backing of the Kremlin). But the chorus of critics in Berlin, including inside the government, is growing ever louder.

Officials at the 2011 opening ceremony of Nord Stream 1 in Lubmin, including chancellor Angela Merkel, former chancellor Gerhard Schröder and Russian president Dmitry Medvedev © Getty

“Nord Stream 2 has divided the EU, and that cannot be in Germany’s national interest,” says Norbert Röttgen, a senior member of parliament for the ruling Christian Democratic Union. “The most important role that Germany has is to bring Europe together, not to divide it. But without Germany, this division would not exist.”

Earlier this year, German chancellor Angela Merkel signalled a subtle but important shift in official rhetoric. Nord Stream 2, she said, was “not just an economic project”. Political factors also had to be considered, she added, not least the need to preserve Ukraine’s status as a transit country for Russian gas. Kiev earns as much as $3bn in transit fees a year, according to Naftogaz, Ukraine’s state gas company, money the embattled government badly needs. The gas link also acts as motivation for the two countries to keep their military and political conflict from spinning out of control. When the gas stops flowing — as it did, briefly, in 2006 and 2009 — both sides stand to lose.

After meeting his US counterpart on Monday Vladimir Putin, Russia’s president said Moscow was willing to “extend this transit contract if the dispute between [Gazprom and Naftogaz] is settled”.

Russian imports to Europe have risen in recent years

Yet circumventing the Ukrainian network is precisely what Nord Stream is about, as Russian officials have made clear. The new pipeline will allow Russia to cut out the middleman for much of its westbound gas shipments — and to avoid the kind of disputes over payments and conditions with Kiev that have flared up in recent years. The fact that Ukraine’s pipelines are in urgent need of repair and investment provides an additional incentive.

For the Russian-European consortium that is bearing the cost of the project, Nord Stream 2 is, above all, a promising investment. Unlike Nord Stream 1, which was a genuine Russian-European joint venture, the new pipeline will be owned entirely by Gazprom, the Russian gas group that controls Russia’s pipeline exports. Half the financing, however, is provided by five European companies: Uniper and Wintershall of Germany, Austria’s OMV, Engie of France and Royal Dutch Shell.

Nord Stream’s backers are making a simple bet with potentially huge rewards. They know the pipeline will come on stream in 2019 just as supplies of European gas from the North Sea are starting to dwindle. The consortium estimates that even if overall gas demand is stable or declines slightly over the coming two decades, Europe will have to find an additional 120bn cubic metres a year of natural gas by 2035. That gap will be filled by shipping large volumes of liquefied natural gas from countries such as Qatar and the US, or through pipelines from Russia.

US liquefied natural gas ready for export from Texas © Bloomberg

The looming gas shortfall has sparked a rush to build infrastructure, as suppliers jostle for position. Not far from Lubmin, on the other side of the Polish border, stands one of several new LNG terminals that have popped up on Europe’s coastline in recent years. Most are working well below capacity, reflecting the fact that pipeline gas is as much as 25 per cent cheaper than LNG.

Some German business leaders and officials suspect that this is one of the core reasons for the opposition to Nord Stream 2. The US, they say, is simply trying to boost the commercial prospects of LNG. That was the central complaint in an open letter signed by a cross-party alliance of senior German lawmakers earlier this year.

“It is not the job of the EU to keep potential competitors off the backs of US companies that want to market their . . . natural gas in Europe,” it said. “American liquid gas is welcome on the European gas market, but it has to face the competition just like others.”

Nord Stream 2 gas pipeline map

Why should German and European consumers and companies pay a premium for non-Russian gas? The obvious answer, say critics, is politics. Moscow, they argue, is engaged in a broad campaign to split the western alliance, destabilise European democracies and reassert Moscow’s influence in eastern Europe and the Baltics. One of the most potent weapons in that campaign is Russia’s control over energy resources — and Europe’s dependency on them. Concern over what might happen if Russia turns off the taps has weighed heavily on European minds for years. Nord Stream 2 will make those concerns even more acute.

“Last year, Germany received slightly more than 40 per cent of its gas supplies from Gazprom. If we now double the capacity by way of Nord Stream 2, we will see another significant increase in supplies from Russia,” says Mr Röttgen. “I believe this pushes us into a danger zone, both in terms of energy policy and foreign policy. We will lose some of our independence.”

Leading importers have increased their dependency on Russia

There is, he adds, another consideration: “The whole Putin system rests on two pillars: the military and the export of energy resources. By stabilising that second pillar, Germany is also stabilising the Putin regime.”

Gazprom says that given that its newer gasfields are in Russia’s north-west, Nord Stream 2 will save 2,100km of transit compared with the Ukrainian route, and cut emissions by 61 per cent.

A natural gas pipeline in Donetsk, eastern Ukraine © Getty

Russia has also warned that US threats against it are illegal. “We believe that any sanctions against companies involved in an international project would not be legal,” Mr Putin’s spokesman Dmitry Peskov said this month. “This is an exclusively international, commercial project devoid of any political motives, based on the principles of commercial gain for the countries that participate in it.”

The geopolitical case against Nord Stream 2 is made with particular intensity in eastern European capitals such as Warsaw, where fears over a Russian-German carve-up have a strong historical resonance. That sentiment was expressed in blunt terms by Radoslav Sikorski, the former Polish foreign minister, who likened the Nord Stream project to the 1939 deal between Hitler and Stalin to divide eastern Europe.

In Berlin, however, officials prefer to point to a different historical antecedent: the Ostpolitik of Willy Brandt, the German chancellor who pushed for rapprochement with the Soviet bloc in the late 1960s and early 1970s. In economic terms, the policy gave rise to a “gas-for-pipes” deal between West Germany and the Soviet Union. Against fierce US opposition, the Germans agreed to ship steel and pipes to the USSR, in exchange for natural gas imports.

The first Russian gas arrived in Germany in 1973, and imports rose steadily in the decades that followed, undisturbed by the cold war. For supporters of Nord Stream 2, that experience holds a crucial lesson. They see the gas relationship not as one of western dependence on Russia, but of mutual dependence between buyer and seller. Moscow needs western payments as much as the west needs Russian gas.

“I see Nord Stream as a stabilising factor for the relationship between Russia and the West,” says Matthias Platzeck, a former leader of Germany’s Social Democratic party and now the president of the German-Russian Forum, a Berlin-based association designed to foster bilateral ties. “Even at the high point of the cold war the Russians always delivered their gas. Why should that change now? After all, they need the money.”

Excavators work on a discharge channel of the new Nord Stream 2 Baltic Sea pipeline in the Bay of Greifswald © Alamy

As the political argument continues to rage, the project itself is making steady progress. Over the past two years, the consortium has amassed vast stockpiles of concrete-coated steel tubes, and deposited them at various points on the Baltic Sea. A few weeks from now, workers will begin welding the 12-metre-long pieces together at sea and lowering them into the water. With much of the investment already made, and all but one regulatory permit for the project granted, even critics admit that it will be hard to stop it now.

As long as the project does not hit fresh political and technical turbulence, Gazprom is planning to open the taps at the Russian end of the 1,200km long pipeline in late 2019. The impact at the other end, however, is already being felt.

“In commercial terms, there is a case to be made for Nord Stream 2,” says Ms Westphal. “In political terms, however, it is clear that Germany will pay a heavy price.”

Additional reporting by Henry Foy in Moscow and Helsinki

World Economic Outlook Update, July 2018

Less Even Expansion, Rising Trade Tensions

  • Global growth is projected to reach 3.9 percent in 2018 and 2019, in line with the forecast of the April 2018 World Economic Outlook (WEO), but the expansion is becoming less even, and risks to the outlook are mounting. The rate of expansion appears to have peaked in some major economies and growth has become less synchronized. In the United States, near-term momentum is strengthening in line with the April WEO forecast, and the US dollar has appreciated by around 5 percent in recent weeks. Growth projections have been revised down for the euro area, Japan, and the United Kingdom, reflecting negative surprises to activity in early 2018. Among emerging market and developing economies, growth prospects are also becoming more uneven, amid rising oil prices, higher yields in the United States, escalating trade tensions, and market pressures on the currencies of some economies with weaker fundamentals. Growth projections have been revised down for Argentina, Brazil, and India, while the outlook for some oil exporters has strengthened.

  • The balance of risks has shifted further to the downside, including in the short term. The recently announced and anticipated tariff increases by the United States and retaliatory measures by trading partners have increased the likelihood of escalating and sustained trade actions. These could derail the recovery and depress medium-term growth prospects, both through their direct impact on resource allocation and productivity and by raising uncertainty and taking a toll on investment. Financial market conditions remain accommodative for advanced economies—with compressed spreads, stretched valuations in some markets, and low volatility—but this could change rapidly. Possible triggers include rising trade tensions and conflicts, geopolitical concerns, and mounting political uncertainty. Higher inflation readings in the United States, where unemployment is below 4 percent but markets are pricing in a much shallower path of interest rate increases than the one in the projections of the Federal Open Market Committee, could also lead to a sudden reassessment of fundamentals and risks by investors. Tighter financial conditions could potentially cause disruptive portfolio adjustments, sharp exchange rate movements, and further reductions in capital inflows to emerging markets, particularly those with weaker fundamentals or higher political risks.

  • Avoiding protectionist measures and finding a cooperative solution that promotes continued growth in goods and services trade remain essential to preserve the global expansion. Policies and reforms should aim at sustaining activity, raising medium-term growth, and enhancing its inclusiveness. But with reduced slack and downside risks mounting, many countries need to rebuild fiscal buffers to create policy space for the next downturn and strengthen financial resilience to an environment of possibly higher market volatility.

Expansion Continues at a Less Even Pace 

As the global cyclical upswing approaches its two‑year mark, the pace of expansion in some economies appears to have peaked and growth has become less synchronized across countries.

Among advanced economies, growth divergences between the United States on one side, and Europe and Japan on the other, are widening. Growth is also becoming more uneven among emerging market and developing economies, reflecting the combined influences of rising oil prices, higher yields in the United States, sentiment shifts following escalating trade tensions, and domestic political and policy uncertainty. While financial conditions remain generally benign, these factors have resulted in capital inflow reductions, higher financing costs, and exchange rate pressures, more acute in countries with weaker fundamentals or higher political risks. High-frequency data present a mixed picture of near-term global activity. Retail sales volumes appear to have picked up in the second quarter, and survey data of purchasing managers for the service sector remain generally strong. Industrial production, however, appears to have softened, and survey data of purchasing managers in manufacturing indicate a weakening of new export orders.

Commodity prices and inflation. Largely reflecting supply shortfalls, global oil prices increased 16 percent between February 2018 (the reference period for the April 2018 WEO) and early June 2018 (the reference period for the July 2018 WEO Update). In June, the Organization of Petroleum Exporting Countries (OPEC) and non-OPEC oil producers agreed to raise oil production by about 1 million barrels per day from current levels, correcting the recent undershooting of the November 2016 group target. Market expectations suggest that declining capacity in Venezuela and US sanctions on Iran may pose difficulties for the group to deliver the agreed upon production increase consistently. Futures markets, however, indicate prices are likely to decline over the next 4–5 years (in part due to increased US shale production)—as of end‑June, medium-term futures prices are about $59 per barrel (20 percent below current levels). The increase in fuel prices has lifted headline inflation in advanced and emerging market economies. Core inflation has strengthened in the United States as the labor market has tightened further, and inched up in the euro area. Core inflation in emerging markets has also increased, reflecting pass-through effects from currency depreciation in some cases and second-round effects of higher fuel prices in others. Prices of agricultural commodities have increased marginally, reflecting diminishing excess supply.

Financial conditions in advanced economies. With firmer readings on inflation and strong job creation, the US Federal Reserve continued the course of gradual policy normalization. It raised the target range for the Federal Funds rate by 25 basis points in June, while signaling two additional rate hikes in 2018 and three in 2019—a steeper schedule than indicated in March. The ECB announced that it will taper its monthly asset purchases from the current €30 billion to €15 billion in October, with an anticipated end to the program on December 31. It also indicated it will maintain policy rates at their current levels at least through the summer of 2019, a somewhat more accommodative forward guidance than anticipated by markets. US Treasury 10-year yields, at around 2.85 percent as of early July, have risen modestly since February, while yields on German 10-year bunds, at around 30 basis points, have declined over the same period. Among other advanced economies, in late May Italian sovereign spreads widened by their largest amount since 2012, following difficulties around the formation of a new government. They have since declined but remain around 240 basis points as of early July on concerns about future policies. Spillovers to other advanced economies’ bond markets were mostly contained, with other euro area spreads remaining compressed. Equity prices in advanced economies are generally higher than their February-March levels. After the February spike, volatility has subsided and risk appetite has been strong. Consequently, financial conditions in advanced economies remain generally accommodative.

Financial conditions in emerging markets. Central banks in key emerging market economies —including Argentina, India, Indonesia, Mexico, and Turkey—have raised policy rates, responding to inflation and exchange rate pressures (coupled with capital flow reversals in some cases). Long-term yields have also increased in recent months, and spreads have generally widened. Most emerging market equity indices have declined modestly, reflecting, in some cases, concerns about imbalances (e.g., Argentina and Turkey), and, more generally, rising downside risks to the outlook.

Exchange rates and capital flows. As of early July 2018, the US dollar has strengthened by over 5 percent in real effective terms since February (the reference period for the April 2018 WEO), while the euro, Japanese yen, and British pound sterling are broadly unchanged. In contrast, some emerging market currencies have depreciated sharply. The Argentine peso has weakened by over 20 percent and the Turkish lira by around 10 percent, due to concerns about financial and macroeconomic imbalances. The Brazilian real has depreciated by over 10 percent on a weaker-than-expected recovery and political uncertainty. Weaker-than-anticipated macroeconomic data for South Africa contributed to the 7 percent depreciation of the South African rand, unwinding part of the sharp appreciation that had occurred in late 2017 and early 2018. The currencies of the largest emerging market economies in Asia have remained broadly in line with their levels in February, with the Chinese renminbi depreciating modestly. Reflecting signs of financial stress in some more vulnerable countries and growing trade tensions, capital flows to emerging economies weakened in the second quarter (through May) after a strong start to the year, with a pickup in non-resident sales of portfolio debt securities.

Global Growth Forecast

Global growth for 2018 and 2019 is projected at 3.9 percent, as forecast in the April 2018 WEO. While headline numbers suggest a broadly unchanged global outlook relative to the April WEO, underlying revisions point to differing prospects across economies. The baseline forecast assumes gradually tightening but still favorable financial conditions, with localized pressures based on differences in fundamentals. Monetary policy normalization in advanced economies is assumed to proceed in a well-communicated, steady manner. Domestic demand growth (notably investment, which has been an important part of the global recovery) is expected to continue at a strong pace, even as overall output growth slows in some cases where it has been above trend for several quarters.

In the baseline forecast, the direct contractionary effects of recently announced and anticipated trade measures[1] are expected to be small, as these measures affect only a very small share of global trade so far. The baseline forecast also assumes limited spillovers to market sentiment, even if escalating trade tensions are an important downside risk.

Advanced economy growth is expected to remain above trend at 2.4 percent in 2018—similar to 2017—before easing to 2.2 percent in 2019. The forecast for 2018 is lower by 0.1 percentage point compared to the April WEO, largely reflecting greater-than-expected growth moderations in the euro area and Japan after several quarters of above-potential growth.  

  • In the United States, near-term momentum in the economy is expected to strengthen temporarily in line with the April WEO forecast, with growth projected at 2.9 percent in 2018 and 2.7 percent in 2019. Substantial fiscal stimulus together with already-robust private final demand will lift output further above potential and lower the unemployment rate below levels last registered 50 years ago, creating additional inflationary pressures. Imports are set to pick up with stronger domestic demand, increasing the US current account deficit and widening excess global imbalances.

  • Growth in the euro area economy is projected to slow gradually from 2.4 percent in 2017 to 2.2 percent in 2018 and to 1.9 percent in 2019 (a downward revision of 0.2 percentage point for 2018 and 0.1 percentage point for 2019 compared with the April WEO). Forecasts for 2018 growth have been revised down for Germany and France after activity softened more than expected in the first quarter, and in Italy, where wider sovereign spreads and tighter financial conditions in the wake of recent political uncertainty are expected to weigh on domestic demand.

  • The growth forecast for Japan has been marked down to 1.0 percent for 2018 (0.2 percentage point below the April WEO projection) following a contraction in the first quarter, owing to weak private consumption and investment. The economy is expected to strengthen over the remainder of the year and into 2019, aided by stronger private consumption, external demand, and investment.

Emerging market and developing economies have experienced powerful crosswinds in recent months: rising oil prices, higher yields in the United States, dollar appreciation, trade tensions, and geopolitical conflict. The outlook for regions and individual economies thus varies depending on how these global forces interact with domestic idiosyncratic factors. Financial conditions remain generally supportive of growth, though there has been differentiation across countries based on economic fundamentals and political uncertainty. With the updraft on oil exporters from higher oil prices largely offset by the combined drag on other economies from the forces described above, the group’s overall 2018 and 2019 growth forecasts remain unchanged from the April WEO at 4.9 and 5.1 percent, respectively.
  • Emerging and Developing Asia is expected to maintain its robust performance, growing at 6.5 percent in 2018–19. Growth in China is projected to moderate from 6.9 percent in 2017 to 6.6 percent in 2018 and 6.4 percent in 2019, as regulatory tightening of the financial sector takes hold and external demand softens. India’s growth rate is expected to rise from 6.7 percent in 2017 to 7.3 percent in 2018 and 7.5 percent in 2019, as drags from the currency exchange initiative and the introduction of the goods and services tax fade. The projection is 0.1 and 0.3 percentage point lower for 2018 and 2019, respectively, than in the April WEO, reflecting negative effects of higher oil prices on domestic demand and faster-than-anticipated monetary policy tightening due to higher expected inflation. Growth in the ASEAN-5 group of economies is expected to stabilize at around 5.3 percent as domestic demand remains healthy and exports continue to recover.

  • In Emerging and Developing Europe, growth is projected to moderate from 5.9 percent in 2017 to 4.3 percent in 2018 and further to 3.6 percent in 2019 (0.1 percentage point lower than in the April WEO for 2019). Financial conditions have tightened for some economies with large external deficits— notably Turkey, where growth is set to soften from 7.4 percent in 2017 to 4.2 percent this year.

  • Growth in Latin America is projected to increase modestly from 1.3 percent in 2017 to 1.6 percent in 2018, and further to 2.6 percent in 2019 (0.4 and 0.2 percentage point lower than projected in the April WEO). While higher commodity prices continue to provide support for commodity exporters in the region, the subdued outlook compared with April reflects more difficult prospects for key economies, owing to tighter financial conditions and needed policy adjustment (Argentina); lingering effects of strikes and political uncertainty (Brazil); and trade tensions and prolonged uncertainty surrounding the NAFTA renegotiation and the policy agenda of the new government (Mexico). The outlook for Venezuela, which is experiencing a dramatic collapse in activity and a humanitarian crisis, was revised down further, despite the pickup in oil prices, as oil production has declined sharply.

  • Oil exporters in the Middle East, North Africa, Afghanistan, and Pakistan region have benefited from the improved outlook for oil prices, but the outlook for oil importing countries remains fragile. Several economies still face large fiscal consolidation needs and the threat of intensifying geopolitical conflict continues to weigh on growth in the region. Growth is projected to strengthen from 2.2 percent in 2017 to 3.5 percent in 2018 and further to 3.9 percent in 2019—0.2 percentage point higher than in the April WEO for 2019.

  • The recovery in Sub-Saharan Africa is set to continue, supported by the rise in commodity prices. For the region, growth is expected to increase from 2.8 percent in 2017 to 3.4 percent this year, rising further to 3.8 percent in 2019 (0.1 percentage point higher for 2019 than forecast in the April WEO). The upgraded forecast reflects improved prospects for Nigeria’s Its growth is set to increase from 0.8 percent in 2017 to 2.1 percent in 2018 and 2.3 percent in 2019 (0.4 percentage point higher than in the April WEO for 2019) on the back of an improved outlook for oil prices. Despite the weaker‑than-expected first quarter outturn in South Africa (in part due to temporary factors), the economy is expected to recover somewhat over the remainder of 2018 and into 2019 as confidence improvements associated with the new leadership are gradually reflected in strengthening private investment.

  • Growth in the Commonwealth of Independent States is projected to stabilize at around 2.3 percent in 2018–19, with an upward revision of 0.1 percentage point for each year compared with the April WEO. The outlook for the Russian economy is similar to the April projection, with the positive effects of higher oil prices counterbalanced by the impact of sanctions, while the outlook for Kazakhstan has improved on stronger oil prices.

Risks Tilted to the Downside

While the baseline forecast for global growth is roughly unchanged, the balance of risks has shifted to the downside in the near term and, as in the April 2018 WEO, remains skewed to the downside in the medium term. The possibility for more buoyant growth than forecast has faded somewhat in light of the weak outturns in the first quarter in several large economies, the moderation in high-frequency economic indicators, and tighter financial conditions in some vulnerable economies. Downside risks, on the other hand, have become more salient, most notably the possibilities of escalating and sustained trade actions, and of tighter global financial conditions.
  • Financial tensions. Recent bouts of volatility highlight the possibility of abrupt shifts in global financial conditions due to markets’ reassessment of fundamentals and risks, including changing expectations about monetary policy or the effects of rising trade tensions, sudden increases in risk- or term premia, and increasing political uncertainty. As discussed in the April 2018 WEO and Global Financial Stability Report, signs of firmer‑than-expected inflation in the United States could lead to a shift in market expectations of US interest rate hikes, which are currently well below those in the WEO baseline forecast. A sudden deterioration of risk appetite could trigger disruptive portfolio adjustments, accelerate and broaden the reversal of capital flows from emerging markets, and lead to further US dollar appreciation, straining economies with high leverage, fixed exchange rates or balance sheet mismatches. In some euro area countries, policy inaction and political shocks at the national level could lead to sovereign spread decompression, worsening public debt dynamics and weakening bank balance sheets. In China, where the authorities are taking welcome steps to slow credit growth, uncoordinated financial and local government regulatory action could have unintended consequences that trigger disorderly repricing of financial assets, increase rollover risks, and lead to stronger-than-forecast negative effects on activity.

  • Trade tensions. The outlook is also clouded by ongoing trade tensions and waning support for global economic integration in some advanced economies. In the past few months, the United States has imposed tariffs on a variety of imports, prompting retaliatory measures from trading partners. At the same time, NAFTA and the economic arrangements between the United Kingdom and the rest of the European Union are under renegotiation. An escalation of trade tensions could undermine business and financial market sentiment, denting investment and trade. Beyond its immediate toll on market sentiment, the proliferation of trade measures could increase the uncertainty about the potential breadth of trade actions, thus hindering investment, while higher trade barriers would make tradable goods less affordable, disrupt global supply chains, and slow the spread of new technologies, thus lowering productivity.

  • Noneconomic factors. By raising the possibility of slower reform implementation or significant changes in policy objectives, political uncertainty, including in the context of upcoming elections or their immediate aftermaths in several countries, could deter private investment and weaken economic activity. In Europe, the late May sell-off in Italian bonds has once again turned the spotlight on deep structural challenges and thin buffers at the national level, posing significant risks to the outlook. Geopolitical risks and domestic strife are weighing on the outlook in several economies, especially in the Middle East and sub-Saharan Africa. Furthermore, many countries remain vulnerable to the economic and humanitarian costs of extreme weather events and other natural disasters, with potentially significant cross‑border ramifications through migration flows.
Policy Priorities

While the baseline forecast for the global economy points to continued, if less even expansion in 2018–19, the potential for disappointments has increased. Against this backdrop, there is an even greater urgency to advance policies and reforms that extend the current expansion and strengthen resilience to reduce the possibility of a disruptive unwinding. Moreover, medium-term per capita growth projections remain below past averages in many economies. Without comprehensive measures to raise potential output and ensure the benefits are shared by all, disenchantment with existing economic arrangements could well fuel further support for growth-detracting inward-looking policies. Multilateral cooperation within an open, rule-based trade system has a vital role to play in preserving the global expansion and strengthening medium-term prospects. Given the diversity of cyclical positions, structural constraints, and available policy space, policy priorities differ across countries.
  • In advanced economies, the macroeconomic stance should be tailored to the maturing cyclical position. Where inflation is converging to targets, a gradual, well-communicated, data‑dependent monetary normalization can ensure a smooth adjustment. With debt levels near record highs in many countries, fiscal policies should start rebuilding buffers where needed. The pace should be calibrated to avoid sharp drags on growth, with appropriate measures to enhance economic inclusion. Procyclical fiscal stimulus should be avoided and rolled back (e.g., United States), while further steps should be taken by countries with fiscal space and excess external surpluses to boost domestic growth potential and address global imbalances (e.g., Germany). To strengthen medium term prospects, countries should prioritize supply‑side measures that raise potential output and productivity, including investing in physical and digital infrastructure, boosting labor force participation where aging threatens future labor supply, and enhancing workforce skills. Repairing remaining pockets of vulnerability in the financial sector is essential in some advanced economies in the euro area, including through continued balance sheet cleanup, promoting consolidation in overbanked jurisdictions, and boosting bank profitability. More broadly, avoiding an indiscriminate rollback of postcrisis regulatory reforms would help maintain resilience in a potentially more volatile financial environment.

  • Many emerging market and developing economies need to enhance resilience through an appropriate mix of fiscal, monetary, exchange rate, and prudential policies to reduce vulnerability to tightening global financial conditions, sharp currency movements, and capital flow reversals. Long‑standing advice on the importance of reining in excess credit growth where needed, supporting healthy bank balance sheets, containing maturity and currency mismatches, and maintaining orderly market conditions has become even more relevant in the face of renewed market volatility. In general, allowing for exchange rate flexibility will be an important means for cushioning the impact of adverse external shocks, although the effects of exchange rate depreciations on private and public sector balance sheets and on domestic inflation expectations need to be closely monitored. With debt levels rising rapidly in both emerging and low-income economies over the past decade, fiscal policy should focus on preserving and rebuilding buffers where needed, through growth-friendly measures that protect the most vulnerable. To raise potential growth and enhance its inclusiveness, structural reforms remain essential to alleviate infrastructure bottlenecks, strengthen the business environment, upgrade human capital, and ensure access to opportunities for all segments of society.

  • Multilateral cooperation remains vital to address challenges that transcend countries’ borders. Global economic integration under an open, rule‑based multilateral trade system has raised living standards, helped lift productivity, and spread innovation throughout the world. To preserve and broaden these gains, countries should work together to reduce trade costs further and resolve disagreements without raising tariff and non-tariff barriers. Cooperative global efforts are essential across a range of other areas, such as completing the financial regulatory reform agenda, preventing further buildup of excess global imbalances, strengthening international taxation, and mitigating and coping with climate change.

[1] These include the increase in US tariffs on imported solar panels, washing machines, steel, aluminum, and a range of Chinese products, and the announced retaliatory measures by trading partners as of July 6. The effect of the broader trade actions announced by the United States on July 10 is not incorporated in the baseline.

Table 1. Overview of the World Economic Outlook Projections
(Percent change unless noted otherwise)
 Year over Year    
Q4 over Q4 2/      
 EstimateProjections April 2018 WEO Projections 1/ EstimateProjections
 2016201720182019 20182019 201720182019
World Output 0.00.0
Advanced Economies1. –0.10.0
United States1. 0.00.0
Euro Area1. –0.2–0.1
Germany1. –0.30.1
France1. –0.3–0.3
Italy0. –0.3–0.1
Spain3. 0.00.0
Japan1. –0.20.0 2.01.0–0.6
United Kingdom1. –0.20.0
Canada1. 0.00.0
Other Advanced Economies 3/ 0.10.1
Emerging Market and Developing Economies4. 0.00.0
Commonwealth of Independent States0. 0.10.1
Russia– 0.00.0
Excluding Russia1. 0.10.1 . . .. . .. . .
Emerging and Developing Asia6. 0.0–0.1
China6. 0.00.0
India 4/ –0.1–0.3
ASEAN-5 5/ 0.0–0.1
Emerging and Developing Europe3. 0.0–0.1
Latin America and the Caribbean– –0.4–0.2
Brazil– –0.50.0
Mexico2. 0.0–0.3
Middle East, North Africa, Afghanistan, and Pakistan5. 0.10.2 . . .. . .. . .
Saudi Arabia1.7– 0.20.0 –
Sub-Saharan Africa1. 0.00.1 . . .. . .. . .
Nigeria– 0.00.4 . . .. . .. . .
South Africa0. 0.00.0
Low-Income Developing Countries3. 0.00.0 . . .. . .. . .
World Growth Based on Market Exchange Rates2. –0.10.0
World Trade Volume (goods and services) 6/ –0.3–0.2 . . .. . .. . .
Advanced Economies2. –0.5–0.2 . . .. . .. . .
Emerging Market and Developing Economies2. 0.20.0 . . .. . .. . .
Commodity Prices (U.S. dollars)           
Oil 7/–15.723.333.0–1.8 15.04.7 19.622.5–6.4
Nonfuel (average based on world commodity export weights)– 0.40.0 1.97.6–0.3
Consumer Prices           
Advanced Economies0. 0.20.3
Emerging Market and Developing Economies 8/ –0.20.1
London Interbank Offered Rate (percent)            
On U.S. Dollar Deposits (six month) 0.20.1 . . .. . .. . .
On Euro Deposits (three month)–0.3–0.3–0.3–0.1 0.0–0.1 . . .. . .. . .
On Japanese Yen Deposits (six month) 0.00.0 . . .. . .. . .

Note: Real effective exchange rates are assumed to remain constant at the levels prevailing during May 3-31, 2018. Economies are listed on the basis of economic size. The aggregated quarterly data are seasonally adjusted. 1/ Difference based on rounded figures for both the current and April 2018 World Economic Outlook forecasts. Countries whose forecasts have been updated relative to April 2018 World Economic Outlook forecasts account for 94 percent of world GDP measured at purchasing-power-parity weights.

            2/ For World Output, the quarterly estimates and projections account for approximately 90 percent of annual world GDP measured at purchasing-power-parity weights. For Emerging Market and Developing Economies, the quarterly estimates and projections account for approximately 80 percent of annual emerging market and developing economies' GDP measured at purchasing-power-parity weights.

            3/ Excludes the Group of Seven (Canada, France, Germany, Italy, Japan, United Kingdom, United States) and euro area countries.

            4/ For India, data and forecasts are presented on a fiscal year basis and GDP from 2011 onward is based on GDP at market prices with FY2011/12 as a base year.

            5/ Indonesia, Malaysia, Philippines, Thailand, Vietnam.

            6/ Simple average of growth rates for export and import volumes (goods and services).

            7/ Simple average of prices of UK Brent, Dubai Fateh, and West Texas Intermediate crude oil. The average price of oil in US dollars a barrel was $52.81 in 2017; the assumed price based on futures markets (as of June 1, 2018) is $70.23 in 2018 and $68.99 in 2019.

            8/ Excludes Argentina and Venezuela.

A Wake-Up Call From Japan

Central banks are withdrawing from ultra-loose monetary policy as gradually as possible, but volatility is still inevitable

By Richard Barley

What happens when you wake a market from deep slumber? Japan is the latest place investors should watch.

For a long time, central banks have helped to tamp down swings in markets via ultraloose monetary policy, boosting risk appetite. But things are changing, even in the spiritual home of low interest rates.

The Japanese 10-year bond yield jumped to 0.13% on Wednesday, a day after the Bank of Japan’s latest policy decision. That’s the highest since January 2016, when the BoJ introduced negative interest rates. The one-day jump in yields of 0.08 percentage point, which followed a decline of 0.05 percentage point Tuesday, is huge in a market where bond prices have moved only fractionally for months, thanks to the BoJ’s policy of pinning yields close to zero. This could mark a regime change for markets, argue strategists at Mizuho.

Two clashing policy tweaks are at work. The BoJ Tuesday introduced forward guidance that monetary policy would stay loose. Central banks have come increasingly to rely on this tool for smoothing market expectations and hence reducing volatility. But the BoJ also said it would allow 10-year yields to move in a wider range—up to 0.2%, said Governor Haruhiko Kuroda. Markets are starting to test that new range. 
What happens when you wake a market from deep slumber?

What happens when you wake a market from deep slumber? PHOTO: DAVID BECKER/GETTY IMAGES

The potential for bigger moves in yields is a risk for investors and a boon for traders. Investors will require a higher risk premium to hold bonds, contributing to somewhat higher yields. That could spill over into other markets where Japanese investors have flocked to put cash to work in the face of zero yields at home.

The BoJ isn’t going anywhere fast. But the big picture is one where central banks globally are pulling back gradually from years of deep involvement in markets. Snoozing through that process isn’t an option.

In Iraq, Local Protests Could Have Wider Implications

The demonstrations in an oil-rich region could exacerbate the problem of declining spare oil capacity.

By Xander Snyder

Over the past week, protests have erupted in Iraq’s oil-rich Basra province. They have now spread throughout southern Iraq and beyond, reaching Najaf, Karbala, Dhi Qar, Maysan, Muthanna and even Baghdad. Protesters are angry over the lack of jobs and poor public services. Basra accounts for about 80 percent of Iraqi’s oil reserves and roughly 3.2 million barrels per day in oil exports. Iraqi police have reportedly killed as many as four protesters, and Iraqi Security Forces have been placed on high alert. Local government offices, as well as Dawa Party offices, have been attacked, and airports have been stormed, forcing several airlines to temporarily suspend operations. On Friday, Prime Minister Haider al-Abadi flew to Basra from Brussels, where he attended the NATO summit, to begin talks with regional leaders.
The threat to Basra’s oil production has much broader implications due to a new report by the International Energy Agency that spare oil capacity is being tapped out. As OPEC countries boost oil production in response to lower supplies from Venezuela and in anticipation of declining exports from Iran, spare capacity is being stretched thin. This shouldn’t be a surprise – as production increases, spare capacity is bound to fall. But as the ability of oil producers to increase supply declines, prices can become volatile, especially if supplies can no longer meet demand. And since global demand isn’t expected to decrease anytime soon, unexpected supply shortages during a period of unusually low spare capacity may have a significant impact. If a substantial portion of Basra’s oil production is brought offline – which hasn’t happened so far – then it could exacerbate the problem of declining spare oil capacity.

So far, it appears as if the uprisings in Basra have been driven by local residents rather than external forces. But there have been some reports that pro-Iran Popular Mobilization Forces militias were deployed to support the protesters. (There were also reports of protesters attacking the offices of the Badr Organization, the largest pro-Iran PMF group in Iraq – possibly a sign that, although Iran has links to the protests, it isn’t really controlling them.) Tehran may be doing this as a way to threaten global oil supplies at a time of lower-than-normal capacity just as U.S. sanctions are set to kick in. This would certainly be a dangerous game for Iran – shutting off Iraq’s major source of revenue could create instability that Sunni insurgents could take advantage of, at a time when Iran itself faces significant challenges at home. But Iran may want to demonstrate that it has the power to inflict pain on the global economy.
Supply Disruptions
The challenge with supply shortages is that they are often unpredictable and can come from myriad events. For example, production at Canada’s Syncrude oil sands facility, which produces 360,000 bpd, was shut down in June after a tripped transformer caused a power outage. It’s expected to remain offline at least through the rest of July and possibly into September. Other short-term outages have occurred in Norway, Libya and Nigeria, and hurricane season could disrupt production at U.S. facilities.

Supply disruptions are even more worrisome because global demand is expected to continue to rise. The IEA expects demand to increase by 1.3 million bpd in the second half of this year and by 1.2 million to 1.6 million bpd in 2019. At the same time, new pipelines in the U.S. are expected to increase transport capacity by over 2 million bpd, making it easier to bring inland oil to the global market. In the long term, greater supply from U.S. shale producers still appears to be enough to offset the losses that are expected from Iran and Venezuela.

In the short term, production levels are far more difficult to predict. Nevertheless, the combination of strained transport infrastructure in the U.S. and decreasing production in Iran and Venezuela may cause prices to stay elevated through 2019, when new pipelines in the U.S. are expected to come online.
Spare Capacity
Spare production capacity is also hard to measure. Though both the U.S. Energy Information Administration and the International Energy Agency report figures on spare capacity, there’s a lot of skepticism about the accuracy of these figures. Saudi Arabia, which has the greatest spare capacity of any oil producer, claims that it can produce 12.5 million bpd but has never produced more than 10.7 million bpd. Even if it can produce more than it is currently, doing so may require additional drilling. And even at sites that do not require additional drilling, maintaining the operability of offline machinery is costly. Increasing production isn’t as easy as flipping a switch; it could take months even at sites with well-maintained equipment.

The EIA estimates that OPEC currently has about 2 million bpd in excess capacity, with Saudi Arabia accounting for the largest portion by far. Though the EIA claims that Saudi Arabia usually maintains about 1.5 million to 2 million bpd in excess capacity, it’s currently producing at higher-than-normal levels, so its excess capacity is believed to be closer to the lower end of this estimate. If OPEC’s total spare capacity is 2 million bpd and Russia’s is roughly 500,000 bpd, the total global spare capacity is about 2.5 million bpd. But Russia, too, is already producing oil at historic levels – nearly 11.2 million bpd in early July – so its excess capacity may be lower than normal.



In theory, given that Iran and Venezuela have an estimated 1.5 million to 2 million bpd in offline oil supplies combined, global spare capacity should cover this shortage until additional transport infrastructure in the U.S. becomes operational in 2019. Still, any potential shortages resulting from, say, the protests in Basra would have a bigger impact.
Geopolitical Implications
Even the mere possibility of limited excess capacity has political consequences in the U.S. and, therefore, geopolitical implications in the Middle East. In response to the U.S. threat to curtail Iran’s global oil exports, Iran has threatened to close the Strait of Hormuz to all oil transport. (Part of the strait is controlled by Oman and patrolled by the U.S. Fifth Fleet, but Iran could still block passage by, for example, laying mines across the strait.) This isn’t the first time Iran has threatened to close the strait, and it hasn’t actually done so yet. But given that nearly 20 million bpd out of the total 100 million bpd produced globally pass through the Strait of Hormuz, Iran could cause a major disruption to global supplies if it makes good on its threat.

This may be part of Tehran’s strategy to push back against U.S. sanctions. If the strait were closed, it would cause a significant spike in oil prices, which would have an impact on the U.S. economy and, as midterm elections approach in November, on U.S. politics. Even the sanctions themselves are likely to cause some increase in global prices. The U.S. Congress will therefore be exceptionally wary of any action that risks a radical increase in the price of oil. The economy will likely be a major issue in U.S. midterm elections, especially considering the trade dispute between China and the United States. Lower spare capacity, therefore, also gives Tehran more leverage as the U.S. withdraws from the nuclear deal and other signatories consider their next moves.