Wed. May 25th, 2022

After trade wars and the pandemic depression, the West’s aggressive sanctions and US rate hikes will derail economic prospects worldwide. The devastation has only just begun.

Prior to the Ukraine crisis, the Biden administration promised targeted sanctions that would inflict pain on Russia. However, Russia’s broader economy, its people and the world economy would not be harmed. Yet, that’s precisely what has happened.

Ukraine is the means. The maximum sanctions were designed to default the Russian economy (see my “The avoidable Ukrainian crisis, the unavoidable global hit,” TMT, March 14, 2022). US allies will take a severe hit in Europe, but Asia will not remain immune.

The world economy will shoulder the collateral damage. Developing economies will suffer the most. The recent shocks are a prelude to the global tsunamis to come.

Energy and food shocks

Commodities reached a high of 4,160 in early March and have soared 42 percent since the beginning of the year. Food prices have climbed to an all-time high, nearly 21 percent above their level a year ago. The United Nations had warned of a meltdown of the world’s food system. At the same time, energy prices have shot up in global markets.

Crude oil climbed to a high of $125 in early March and has increased to $114 per barrel, or almost 50 percent since the beginning of the year. In Europe, the most exposed region to Russian energy, natural gas quintupled to a high of over $250 and is hovering around $108 (99 euros). But these data are predicated on the assumption that energy security will improve, another naïve assumption (Figure 1).

FIGURE 1 COMMODITY, OIL AND NATURAL GAS SHOCKS COMMODITIES OIL NATURAL GAS (EU)

Sources: Commodities: The Commodity Index; food prices: oil: Crude oil; natural gas, March 25, 2022

Russia is the world’s 11th-largest, $1.8-trillion economy. Given its key role in global energy supply, Goldman Sachs has warned that the global economy “could soon be faced with one of the largest energy supply shocks ever.”

If things don’t improve anytime soon, the world economy may inch toward a severe scenario, reminiscent of the OPEC (Organization of the Petroleum Exporting Countries) oil embargo. In the still-worse-case scenarios crude prices could climb up to $200; a third higher than in summer 2008.

US: Slowing growth, stagflation, rate hikes

In 2021, US real GDP (gross domestic product) increased 5.5 percent, the fastest since 1984 as the economy continued to recover from the adverse pandemic effects. Wages grew at the fastest pace in decades, but prices increased even more, so the net effect was negative.

In 2021, most GDP expansion was accounted for by increased inventory investment and service spending. In the past two years, the pandemic has lowered the economic output potential. During the ongoing year, GDP growth will slow because the level of fiscal support is smaller and the economy is closer to maximum employment.

Worse, inflation has proved stickier than anticipated because the Federal Reserve began to cut rates belatedly in March 2020, ignoring the World Health Organization’s early warnings.

The second mistake ensued after mid-year 2021, when the Fed left the ultra-low rates intact despite rising inflation. By last December, the galloping inflation had soared to 7 percent, the fastest since 1982.

Now America was coping with low interest rates plus high inflation: self-induced stagflation (Figure 2).

FIGURE 2 TWO POLICY MISTAKES: SOARING INFLATION BELATED FED RESPONSE

Source: Bureau of Labor Statistics; Federal Reserve; Difference Group, March 25, 2022

In addition to rate hikes, the Fed will also start reducing its balance sheet, perhaps already in May, and those reductions could happen twice as fast as the last time.

The painful consequences were predicted by Thomas Koenig, a former member of the Fed’s Committee, years ago. But they were ignored.

China: Hedging vs energy, food risks

Early in the year, China’s economy, despite the overseas Omicron threat, was still fueled by strong data on trade and investment and further opening of capital markets. Foreign holdings of government bonds were at record levels, fostering the yuan’s appreciation. Export-led industrial expansion and retail sales rebounded.

On the supply side, government’s fiscal spending and infrastructure investment contributed to improving fixed asset investment. As policies have been refined in the property markets, the goal has been to facilitate the completion of presold homes and support new purchases.

Despite strong vigilance, the Covid-19 infections, due to spillovers from Hong Kong, have led to the lockdown of major cities, including Shanghai and Shenzhen in the Guangdong province where factories account for almost a fourth of exports.

Nevertheless, the Government Work Report indicates solid support for the economy and fiscal spending. The central bank will further ease the monetary policy. Premier Li Keqiang announced the new growth target for the year of “around 5.5 percent.”

China is promoting front-loaded policy support to strengthen the economy amid the global headwinds. Some key investment areas will now concentrate on food and energy security.

Last year, more than half of China’s energy imports (almost $425 billion) comprised crude oil. Since energy imports are diversified, losses could be offset in part by cheaper imports from Russia, China’s second-largest oil supplier. Recently, Beijing and Moscow also signed a new 30-year $112-billion natural gas deal. Saudi Arabia, China’s largest source of oil, is considering accepting payments for some oil purchases in the Chinese currency.

As the yuan has strengthened from about 7.18 in June 2020 to 6.37 to the US dollar, it will allow China to secure the imports of other commodities at lower costs.

US interest payments: A time bomb

After trade wars, the pandemic depression, aggressive sanctions and rate hikes, the Biden administration has dramatically accelerated debt-taking to pay for its multitrillion-dollar infrastructure initiative while spending ever more in the post-9/11 wars.

Concern in the markets about a US recession is growing as soaring commodity prices, reduced fiscal spending and rising interest costs risk economic expansion.

Since December 2020, the White House has said that aggressive debt-taking is tolerable because the burden of servicing it has fallen. But the guidance was naïve (see my “Contradictions of the ‘Biden doctrine,'” TMT, Oct. 25, 2021).

Here’s why: Net interest payments are becoming the fastest-growing element of the US federal budget. That’s an economic time bomb.

In a decade, interest costs are set to exceed 12 percent of the entire federal budget, while almost tripling to $910 billion (Figure 3a). By 2050, the sum total of net interest costs is likely to exceed $60 trillion as interest payments will take up almost half of all federal revenues (Figure 3b).

FIGURE 3 RISING INTEREST COSTS

3a. Net interest costs will rise sharply… Net Interest as % of GDP, 2020-30 3b. and take up a rising share of revenues Net Interest as % of Federal Revenues, 1970-2050 Source: Congressional Budget Office; Office of Management and Budget; Difference Group

Sanctions compound global risks

In the West, the Russian economic sanctions are portrayed as a solution to the Ukraine crisis with minimal harm to the world economy.

In reality, they will globalize and thus significantly worsen the adverse impact of a regional war, which itself was unwarranted and avoidable.

These negative spillovers have potential to undermine global prospects in the short term while contributing to untenable global risks over time.

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This article that appeared in the Manila Times on March 28, 2022 is an updated and abbreviated version of a commentary published by China-US Focus on March 22, 2022.

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