Abstract: The Ukraine crisis brings three major risks to the world economy: stagflation in developed economies, economic deterioration in emerging market economies, and political unrest in low-income economies with food shortages. Facing an increasingly grave global environment, China should maintain independency with its macroeconomic policies. This article suggests that China implement stronger policies to maintain growth, build a more flexible RMB exchange rate regime, protect people’s livelihood, and relieve profitability pressure on SMEs caused by commodity price hikes.
The Ukraine crisis has limited direct impact on the world economy given the minuscule, less than 2% share of the Ukrainian and Russian economies combined. However, it could deal significant blows to the global supply chain considering that both countries are important exporters of energy and agricultural products. The crisis, together with the full-fledged sanctions against Russia, could induce chain reactions indirectly, bringing three major risks to the world economy: stagflation in developed economies, economic deterioration in emerging market economies, and political unrest in low-income economies with food shortages.
I. PERSISTENTLY HIGH INFLATION COULD PLUNGE DEVELOPED ECONOMIES INTO STAGFLATION
Russia is a major energy and metallic ore exporter in the world. Supply constraints as a result of the ongoing military conflicts and sanctions imposed by Western countries will push up commodity prices on an ongoing basis.
According to trade statistics of the United Nations (UN), Russia accounts for 27.0%, 15.5%, 12.0%, and 8.1% in global total export of natural gas, coal, oil and liquefied natural gas (LNG) respectively. Among metal products, Russia supplies 24.6%, 21.9% and 9.9% of the world’s palladium, nickel and aluminum. At the moment, global commodity prices have already surged, but it remains highly uncertain how the tensions between Ukraine and Russia will evolve. In the best-case scenario, if the two countries reach a truce, the geopolitical balance is restored, and sanctions on Russia are removed, then the spillover effect on the global economy from commodity price hikes will be transitory and limited. But this scenario isn’t very likely.
Under normal conditions, as long as Russia remains strong on its security interests, the conflicts between Russia and Ukraine are expected to continue while Western countries sanction Russia and Russia retaliates. That means the commodity prices are unlikely to fall back down in the short run, and rising inflation expectations may force the United States and European Union to speed up policy tightening. Before the Ukraine crisis broke out, enormous stimulus and recovering demand had already driven overheats in these economies, but the monetary authorities had been slow in response. As a result, inflation in the U.S. and Europe has kept hitting new highs, and the commodity price hike as a result of the Ukraine crisis may add to the pressure, forcing faster monetary tightening.
Fed chair Jerome Powell said on March 2 that the central bank was prepared to raise the interest rate by more or more frequently if inflation showed no sign of slowing. According to the minutes of the monetary policy meeting for February released by the European Central Bank (ECB), policymakers believed that inflation could stay high for longer than expected, and ECB President Christine Lagarde also scrapped previous promise of not raising interest rates this year.
However, rate hikes by the two central banks will lead to a certain extent of economic contraction and add to stagflation risk, to which Europe is especially vulnerable. On one hand, Russia is an important trading partner and destination of investment for the EU. Spillovers from the Ukraine crisis and sanctions on Russia will drag consumption growth, batter investor confidence and suppress economic recovery, which means that liquidity support from the ECB will be critical for the Eurozone to weather the blows. On the other hand, the EU is more dependent on Russian energy, and the surging energy prices will force it to tighten monetary policies at a faster pace.
II. MOUNTING PRESSURES IN VARIOUS ASPECTS COULD AGGRAVATE ECONOMIC AND FINANCIAL RISKS IN EMERGING MARKET ECONOMIES
Emerging markets, already lagging behind developed economies in post-Covid recovery, face a “perfect storm” triggered by the Ukraine crisis: as commodity price hikes worsen their balance sheets, investors turn more risk-averse, driving capital outflows and currency depreciation, while rate hikes by developed economies further exacerbate the situation and threaten the debt sustainability of emerging market economies. Under multiple pressures, these economies are facing significantly higher economic and financial risks, and the road toward recovery could become much bumpier.
We can find such lessons in history. When the 1979 Oil Crisis broke out, the Fed tightened its policy and interest rates around the global went up, directly triggering the Latin American debt crisis. Iran’s Islamic Revolution took place at the end of 1978 and led to a sharp drop in oil supply, which triggered the 1979 Oil Crisis and exacerbated the stagflation problem in Western countries. Paul Volcker, then the chairman of the Federal Reserve, adopted a very tight monetary policy to curb inflation. In June 1981, Volcker raised the US federal funds rate from an average of 11.2% in 1979 to a record high of 19%, and the lending rate to 21.5%. In 1982, the federal funds rate still remained at an all-time high.
During this period, although the United States successfully contained inflation, the tightening policy resulted in rising interest rates, capital flight from Latin America, and depreciation pressure on the currencies of Latin American countries, giving a fatal blow to Latin America’s unhealthy debt structure that was mainly denominated in foreign currencies. After Mexico first announced it would suspend repayment of its foreign debt in 1982, countries such as Brazil, Venezuela, Argentina, Peru and Chile also went through debt crises one after another. The economies of Latin American countries were hit hard, unemployment and inflation soared, currencies depreciated, and national income growth stagnated.
Today, the conflict between Russia and Ukraine has increased risk aversion in the international financial market and led to a lower risk appetite. Emerging markets have seen accelerated capital outflows and growing currency depreciation pressure. In addition, the commodity price hikes will also bring pressure on the balance of payments of raw material importing countries in emerging markets, hampering their economic growth. Moreover, the United States and Europe have accelerated their pace of monetary policy tightening, and the resulting reflux of capital to the United States and rising interest rates will further exacerbate economic and financial risks in emerging markets.
III. DISRUPTION TO FOOD SUPPLY COULD AMPLIFY THE RISK OF POLITICAL TURBULENCE IN LOW-INCOME COUNTRIES WITH FOOD SHORTAGES
The Russia-Ukraine conflict is expected to disrupt global food supply and push up food prices through three channels: crop yields reduction, shipping restrictions and cost hikes. This can intensify social conflicts in low-income countries suffering food shortages, and cause political turmoil.
First, Russia and Ukraine are both important grain exporters, and military conflicts may delay the planting cycle and lead to reduced production in the two countries. In 2021, Russia and Ukraine exported 32 million and 20 million tons of wheat respectively, together accounting for 25.7% of global exports; the two countries also exported 4 million and 25 million tons of corn, accounting for 14.4% of global exports. In normal times, winter wheat is sown between September and October and harvested around June of the following year, while the planting of corn usually begins in April. If the current military conflict continues, it will affect both planting and harvesting of crops.
Secondly, with the conflict and sanctions, grain exports of the two countries face many obstacles. For example, the Port of Odessa, Ukraine's largest port along the Black Sea, has been suspended from commercial shipping since February 24. In addition, since the Black Sea is an important channel for Russia and Ukraine to export grain to West Asian and North African countries with low food self-sufficiency rates, the obstruction of traffic may significantly increase food prices in these countries.
Finally, rising energy prices will increase the costs of food production and transportation worldwide. Since the outbreak of the conflict, energy prices have soared. Crude oil is an important raw material and energy source for agricultural production goods such as chemical fertilizers, agricultural films, and agricultural machinery. In addition, fuel cost is also an important component for agricultural product transportation. The rising agricultural production and transportation costs will further push up food prices.
In 2010, when crop production failed and food prices surged, it significantly affected the lives of people in countries with low food self-sufficiency rates in North Africa and West Asia, and intensified social conflicts which then led to the Arab Spring movement, a political turmoil in the Arab world. At that time, record high temperatures and floods hit major wheat producing countries globally (Ukraine, Russia, Canada and Australia) and caused a 5.4% drop in global production (USDA statistics). By February 2011, the international spot price of wheat had reached 9.76 US dollars/bushel (US Department of Commerce), up 95.2% from the end of June 2010.
In 2010, the ratio of dependence on foreign crops of Tunisia, Egypt, Libya, Iraq and Yemen was 62%, 44%, 58%, 54% and 95% respectively. High international food prices significantly affected the lives of people in these countries. Starting with the self-immolation protest in Tunisia at the end of 2010, more and more people in a number of Arab countries joined demonstrations on the streets, demanding reform of their political systems, which eventually evolved to what was later known as the Arab Spring.
The protests forced rulers from power in countries such as Tunisia, Egypt, Libya and slowed economic growth. According to the International Monetary Fund, the average growth rate of per capita GDP in Arab countries fell significantly behind the rest of the globe after the Arab Spring, from 2010 to 2013.
Fast-forward to today and the Ukraine crisis has bumped up the food prices, with the international spot price of wheat reaching 11.19 US dollars per bushel on March 1, 2022, up 57.6% from the same period in 2021 and 14.7% higher than Arab Spring’s peak. Impaired food supply could impact the food security of the poorest people in low- and middle-income countries with limited food self-sufficiency, exacerbate social tensions and trigger political unrest in these countries, and ultimately drag down the global economic recovery.
Ⅳ．POLICY RECOMMENDATIONS
The Ukraine crisis would only have minor economic repercussions in China, but it could exacerbate global economic and political uncertainty by driving up inflation, hindering emerging market recovery, and compromising food security. Chinese policymakers should be China-oriented, and take proactive actions to stabilize domestic demand and economic growth through expansionary macro polices. In particular, the hazards associated with commodity price increases must be addressed.
First, with the Ukraine crisis complicating the global situation, China’s macro policy should be "self-centered", focusing more on promoting investment and consumption, and stabilizing aggregate demand and economic growth. Since the outbreak of the pandemic, with strict Covid control measures and a complete industrial system, the country has been able to sustain its production and meet external demand which provided strong support to economic growth. However, the Ukraine crisis has complicated the international economic and political scenes, adding to external uncertainties for China. In order to maintain stable domestic economic and social functioning, China should focus on strengthening domestic demand. Monetary policy should demonstrate a firm commitment to growth stabilization through a clear path of interest rate adjustments to enhance business confidence, as well as promote credit expansion to lower the operational costs of brick-and-mortar businesses. In the face of growing external uncertainties, fiscal policy should be more proactive in order to stabilize investment and ensure that China's can maintain steady aggregate demand and high quality development.
Second, the RMB exchange rate should be flexible to guard against external shocks and systemic risks. In the following phase, China should enhance the flexibility of the RMB exchange rate as a buffer against external shocks while also allowing for room of active macro-control policies. Furthermore, we must be vigilant about the "herding effect" of speculative cross-border capital flows which can lead to aberrant exchange rate fluctuations. If that happens, prompt intervention is necessary to avoid the formation of expectations of capital outflow and exchange rate depreciation which could reinforce each other and result in systemic risks.
Third, in the case of commodity price hikes, subsidies for low-income groups' essential consumption should be provided to protect basic livelihoods. Commodity price increases may cause domestic agricultural production inputs like fertilizers, pesticides, agricultural films, and agricultural machinery fuel to rise in price, increasing the cost of production and hurting farmers' income. In addition, commodity price increases raise the cost of production for the whole society, which may be transmitted to the consumer goods sector, raising the prices of oil, food, and fuel, and increasing residents' consumption expenditure on basic goods. Attention should be paid to protecting people's livelihoods and subsidizing the consumption of essential goods by agricultural producers as well as urban middle- and low-income groups.
Fourth, structural policies should be put in place to relieve the strain on SMEs' profitability as a result of high commodity prices. The stress on SMEs' profitability due to upstream commodity price hikes and a lack of demand has been noticeable since the second half of 2020 with few signs of recovery. The adoption of a combination of fiscal and credit policies is recommended. On the one hand, we should fully implement the tax relief and payment delay policies that are already in place for SMEs to help them reduce cash outlay; on the other hand, we should smooth the flow of credit funds and lower financing costs to help them increase cash flow.
This article first appeared on CF40’s WeChat blog on March 21, 2022.
