Emerging macro instability

Global economy is reeling from new supply shocks

The global economy, which has barely begun its recovery from the multiple shocks inflicted on it during the first two years of the Covid-19 pandemic, is now facing three fresh challenges. The first is the effect of Russia’s invasion of Ukraine; the former is a major supplier of oil and gas and member of OPEC Plus, while both countries are crucial producers of wheat, which is central to the food security of many nations. The second is the impact of the sanctions imposed on Russia as a consequence of the invasion, which will serve to cut the country out of many physical and financial chains of globalisation. And the third is the long-delayed impact of the pandemic on mainland China; that country is having to face the potential unravelling of its Covid Zero strategy, with the crucial global production hub and port of Shanghai having to enter a phased but strict lockdown over the next week in an attempt to curb the spread of the highly infectious Omicron variant. These disruptions to global supply come at a time when production and trade are already under strain, producing inflationary pressures in countries around the world; and when government financial resources are exhausted by efforts to preserve production and welfare during the pandemic.

The fallout of these developments has been stark, and it is fair to compare them on some level to the global financial crisis of 2008. Certainly the bond markets seem to be in freefall, the magnitude of which is unparalleled in the modern era. Bloomberg reports that its global aggregate benchmark for the total returns on global and corporate debt has fallen 11 per cent since its last peak early in 2021, which is greater than the 10.8 per cent fall in aggregate value during the financial crisis. Value worth about $2.6 trillion has been wiped out in this bond market rout. Certainly, given concerns about future growth and inflation and Western governments’ new-found willingness to cut off central banks from their reserves in US Treasuries, it appears that even the US gilt is not being seen as enough of a safe haven at this point. Investors have also come to the conclusion that major central banks will hike interest rates quicker and higher than was expected earlier. In several countries, the cost of living has become a major political issue, and from a central banker’s point of view, it is important to react to inflationary pressures swiftly before inflation expectations become entrenched.

The deeper question is whether the world is entering stagflation, or recession, or neither. Certainly, the normal response to a major supply shock would be stagflation. What is not yet known is whether the legacy effect of the pandemic on crucial inputs such as semiconductors will combine with new heights in the prices of food and fuel, alongside additional supply disruptions caused by closures in mainland China to create a supply shock of sufficient magnitude and duration to lead to stagflation. While it may be argued that central banks understand the mechanics of stagflation much better than they did in the 1970s, it is also true that they might feel they are running short of ammunition. It is thus easy to understand why investors are feeling so cautious. For India, an extended period of concern about the twin deficits and external vulnerabilities is likely to present itself. The Reserve Bank of India will have to make sure it is not out of step with the approach of other major central banks to the new macro instability.