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Inflation, Sanctions and Debt Distress: the Economic Face of the Russo-Ukrainian War

Inflation, Sanctions and Debt Distress: the Economic Face of the Russo-Ukrainian War
 Hélène Rey
Professor of Economics at the London Business School

Russia’s invasion of Ukraine is a major blow to the global economy that will hurt growth and raise prices. Though Institut Montaigne's series Ukraine Shifting the World Order mostly dives into the geopolitical aspect of the conflict, the economic dimension cannot be omitted - it is essential to any geopolitical development. This is why we asked, Hélène Rey, Lord Bagri Professor of Economics at the London Business School (LBS), to shed light on the intersection of economics and geopolitics. She does not claim to offer insights into the post-war world, however, because no one can predict how long the present conflict will last.

Our first concern is rising inflation. The war in Ukraine, triggering a rise in energy prices, especially in Europe, accelerated this trend already underway. This led to a surge in interest rates. We are not just seeing a rise in nominal rates, but also in real rates (inflation-adjusted), a tectonic change for our economies since we have been used to very low rates. Some believe it to be only temporary, confident that demography and other factors will bring those rates back down. What's your take?

There has been an unlikely succession of shocks: the Covid crisis, followed by an unbalanced recovery that created price tensions with supply bottle-necks, and last of all, the war in Ukraine. The Covid shock was very hard to predict and led to unbalanced recoveries during which preferences shifted out of services and into manufactured goods, in the US especially - though that was also true in the EU to some extent. We witnessed global value chain disruptions and rising energy prices because the supply side did not recover as quickly as the demand side in the manufactured goods and energy sectors. After that, Russia unexpectedly invaded Ukraine. On top of that, Putin is manipulating energy and food prices. The succession of these unlikely shocks was challenging for central banks. After 2008, they got used to a relatively weak demand-side economy where inflation remained below its target, while they were busy repairing the financial system. They were generally thinking of inflation in terms of the demand-side Phillips curve, but now they find themselves facing large supply-side shocks.

The conventional wisdom is that central bankers should not take action in the face of transitory supply-side shocks. For example, if economies are going through an inflation spike caused by a commodity price shock that might subside, it would not be advisable to change the monetary policy stance. This is because a monetary tightening will have no effect on commodity prices and may create an unwarranted recession. The issue however is that with the succession of these unusual shocks, we have been in an inflationary situation for quite a while so it becomes harder to describe the supply shocks as "transitory". The large US fiscal stimulus has also contributed to inflation from the demand side. The dominant view among central bankers has become that they might lose credibility if they do not take action, which they have now started to do

Central banks are in a key but difficult position because they have to decide just how much tightening they should be doing.

Depending on how long this inflationary period lasts, central banks might need to dampen inflation expectations, as, if unanchored, they can cause a wage-price spiral, which is a central banker's worst nightmare: when high inflationary expectations go into wage-setting, this filters through prices in turn, and back to wages and we find ourselves stuck in a damaging loop. All major central banks are now tightening, putting a lot of strain on the world economy. 

This tightening, paired with the withdrawal of liquidity in the world economy, causes interest rate spreads to widen and puts pressure on highly indebted countries, especially in vulnerable places (low-income economies, emerging markets, but also some developed economies). Central banks are in a key but difficult position because they have to decide just how much tightening they should be doing.

In terms of real interest rates, they had been on a downward trend since the 1980s. Leading explanations include either demographic trends (aging population), lower productivity growth, or, and I developed this point with IMF Chief Economist Pierre-Olivier Gourinchas, the influence of financial cycles on the real interest rate. We are now in a financial cycle not unlike what we had seen in the 1920s with a boom followed by a bust in the 1930s when deleveraging was exerting downward pressure on real rates. While it is true that supply shocks might shift upward the trend of real interest rates, the same fundamentals are still there. If we believe in the negative influence of aging populations, of productivity on real rates, we should infer that the previous trend in interest rates is unlikely to have shifted. It is also unlikely that the deleveraging trend underway since 2008 would have reversed because of current events. During and after the Covid pandemic, there is more precautionary saving than before, which may even amplify the previous deleveraging trend. But in contrast, if we think that there will be large investment needs for the green transition and more leveraging to meet those needs then the trend in real rates could change. 

Which of these forces, supply-side shock, demography, and the financial cycle, the green transition will dominate economic trends? It’s hard to single out one; all four can have a role. I will not venture into the predicted effect of technological change because it is even more conjectural than all the above-mentioned factors. It remains unclear how significant the technological progress (for example because of remote work or new vaccines) achieved in the pandemic will show up in long-term productivity growth.

The United States implemented a large-scale expansionary fiscal policy. Since the US economy affects global inflation, some might want to blame the West for the inflation we are suffering from. Could this fuel tensions between the Global South and the West?

One particular US factor has been a more aggressive fiscal stimulus, stimulating demand when there were supply-side constraints. Increased demand via fiscal stimulus played a role in driving up inflation in the US economy, much more so than in the Euro area, where inflation is mostly coming from the supply side and is imported via energy and food prices. However, after the initial shocks, endogenous inflation dynamics have come into play. 

So, if it is true that the fiscal stimulus in the US is a part of the story, it is only a fragment of it. First of all, it is still unclear how much of the money distributed by the US fiscal stimulus was saved rather than spent by consumers; and second, the timing can be confusing. There are other successive shocks that fueled inflation, many of them linked to the war in Ukraine and price manipulations by Russia. Therefore, attributing the surge of global inflation to US economic policies tends more toward propaganda than reality.

Attributing the surge of global inflation to US economic policies tends more toward propaganda than reality.

If I had to designate a culprit for most of the problems arising in the world economy, I would say the Russian invasion of Ukraine. Especially with price manipulation in the food sector, it is having the most negative impact on the Global South. It is the democracies' responsibility to ensure everyone understands that the food and energy prices resulting from this war have major negative effects on the world population and economy. Those prices account for a large part of the difficult situations of emerging markets. Debt distress, inflation and hunger in the world are linked to the Russian invasion of Ukraine. 

There is a word you refrain from using, "sanctions". Do sanctions not play a part? Is it all about price manipulation (food, especially)?

Sanctions do play some role in energy prices, but I find it is important to remind ourselves that we should not blame the sanctions’ impact on the West. Russia deserves to be held accountable for its actions, and therefore Russia is responsible for the negative impact of sanctions on the world economy. I will note that Russia has also decided to stop sending gas to a number of European countries. We can however remark that these sanctions were not very well designed. One design flaw lies in the early announcement of future sanctions, which allowed Russia to prepare for their implementation and ultimately benefit from price increases in energy markets. Democratic countries did not play their cards right, and to that extent, we are partly responsible for the price increase, but I squarely put the responsibility on Russia, first and foremost. For food, Russia is the chief manipulator by preventing Ukraine’s production to be shipped. I will also note that sanctions on exports to Russia, especially in the technology sector are likely to be successful in the medium run as they strangle the Russian economy and its productive capacities. 

The appreciation of the dollar against all currencies is linked to the rise of oil and gas prices and to the Fed tightening. How will a strong dollar impact emerging economies, which are largely in the dollar zone and are struggling with the depreciation of their currencies? Should we look at this more carefully given the rising tensions between the Global South and the West?

The Fed tightening monetary policy has been historically associated with a stronger dollar and wider spreads between local and US interest rates. This is a phenomenon that is closely linked to what I called the "global financial cycle" in a 2013 contribution to the Jackson Hole Policy Symposium. When it comes to risky assets (and emerging markets debt is considered a risky asset) risk and specifically credit risk gets priced in the yields of bonds issued by this country. When times are good, investors seem to be optimistic and the price of risk is very low across all kinds of assets. But when liquidity starts to be withdrawn, the price of these risky bonds in emerging or low-income countries goes up. 

In the first few months of the war in Ukraine, the Fed started tightening policy, which tends to appreciate the dollar.

In the first few months of the war in Ukraine, the Fed started tightening policy, which tends to appreciate the dollar, which in turn causes a lot of capital to flow back to the US where the return has become higher than abroad. What is striking in these periods is that the differentiation in risk gets magnified: suddenly, the difference across assets becomes larger. More vulnerable countries have a much harder time borrowing. Sometimes, financial actors do not want to lend at all and we are faced with episodes of "sudden stops" of capital flows into emerging markets with no way to roll over the debt.

That puts countries in a difficult situation. What we have observed in recent years is that dollar appreciation tends to tighten financial constraints even more. Studies from the BIS show that dollar appreciation makes borrowing more expensive, especially in low-income and emerging markets. When those countries go into partial or total default, we need to do some debt restructuring. Of course, Sri Lanka has been in distress for a while, but African countries are also struggling, as the IMF has been pointing out, just as Argentina is, or even Turkey… That is, of course, very damaging to the lives of millions of people. 

Given current political tensions, the return of credit distress can only make things worse, which leads us to discuss globalization. With the loss of confidence in the supply coming from China (but not only) where are we heading? And while everybody is focusing on goods, trends are also reversing for capital flows… On these two facets of globalization, what is your holistic view? How can we be smart about the reversal of globalization? Does that also apply to capital flows? 

China is the big player here. It has been preparing for its emergence as a global power and we have been seeing different bits of its strategy: the Belt and Road Initiative, of course, but beyond that, a lending strategy to emerging and low-income countries. In the specific case of Sri Lanka, debt restructuring negotiations are delicate because China is not part of the Paris Club and often asks for collateral to back its loans, which are often made through state-owned entities. China is a tough negotiator and will not necessarily coordinate with other creditors to accept haircuts or losses. That can be a big obstacle in negotiations because if just one lender refuses to take the haircut, then the free-rider problem can lead to a stalemate and debt restructuring is delayed or does not happen. Though some debt relief to African countries has been agreed upon by China the bulk of Chinese lending in Africa, which is made in the form of concessional loans and commercial loans has not been canceled. Sri Lanka will not be the only instance where the multilateral system of sovereign debt restructuring will struggle because of China's strong position as a global lender. Carmen Reinhart and her co-authors, as well as Anna Gelpern, have uncovered a lot of Chinese lending that is not always evidenced in official statistics. For African economies and the Belt and Road Initiative, Chinese lending represents a large portion of the GDP of recipient countries with huge collateral: if the country defaults on its debt, it will lose large infrastructure (ports, for example) to the benefit of China for a very long time. 

With geopolitical fragmentation, the extent to which China will cooperate in a truly multilateral situation like sovereign debt restructuring is unclear, though figures since 2020 and Covid-19 indicate China has greatly increased its share of global exports. It is its demand side that is currently stalling. China may well use its financial leverage to further its status as a global power. We face the danger of regional fragmentation with the emergence of a Chinese block.

 China may well use its financial leverage to further its status as a global power.

Similarly, fundamentally cooperative efforts needed to minimize climate change might suffer from the degradation of the global political environment. On the climate issue, China concedes or withdraws concessions according to domestic priorities - made evident with its use of coal which in 2021 accounted for 56% of the country's total energy consumption. And it does not undertake binding legal commitments that it couldn’t easily rescind. But if we believe China withholds climate cooperation because of geopolitical issues, we are getting it wrong. China acts according to its interests, including on climate: short-term economic factors may dictate over anything else.

In order to talk about the globalization of the goods market, we typically use a measure of globalization of exports plus imports divided by GDP. The reason why this indicator is decreasing since 2008 and we discuss deglobalization can be largely found in China. After it joined the WTO, Chinese economic globalization (measured as the sum of exports and imports over GDP) peaked, and then went down again, because China did not buy as many intermediate goods as it used to, but it continued to sell exports to the world. Mainly though, China is pursuing a decoupling strategy in many sectors, where it seeks import substitution, global leadership and near self-sufficiency. The fact that China has changed the management of its supply chains, making them more asymmetric, has impacted global trends. We might also want to note that this shift in Chinese goods trade towards fewer imports of intermediates while still selling lots of intermediate goods to the rest of the world seems to be aiming at decreasing the reliance of China on the rest of the world. The dependence of the rest of the world on China is however still very high.

We have to start taking into account the importance of speaking the same language and operating within joint, or at least compatible, legal frameworks.

Based on Richard Baldwin’s analysis, we can see that globalization is increasing in the services market. The decrease in face-to-face costs (with Zoom, for example) has led to a rise in intermediate services trading, and it does not seem to be slowing down. There is a clear potential for more globalization of services but the geographical distribution of that is not so clear. We have to start taking into account the importance of speaking the same language and operating within joint, or at least compatible, legal frameworks. 

Regardless, services are becoming more important in all economies, and intermediate services now represent a large share of imports and will drive globalization in the years to come.

Turning to capital flows, what is happening is quite fascinating. At the very beginning of the Covid crisis, we witnessed a reduction in capital flows, much like what happened during the 2008 crisis: retrenchment, that is investors and firms repatriating money. But there was a rapid recovery, which is now jeopardized by the monetary tightening. The 2008 crisis has however led to a long-lasting downward effect on capital inflows and outflows compared to the 2003-2007 period. Basel III and the regulation of banks after 2008 led to a change in the composition of cross-border capital flows. After the reforms, there was a compositional shift due to the fact that before 2007, there had been a large and probably unsustainable increase in cross-border bank flows, followed by retrenchment and re-regulation. The share of capital flows from banks shrunk, and the share of capital flows from asset managers and institutional investors increased. There are two global common components in this network of capital flows: (1) a global component linked to financial activity that goes up and down with asset valuations - when asset prices go up, cross-border flows go up as well, especially for advanced economies and off-shore centers; (2) a second global component linked to commodity prices, and in particular oil prices and international trade. 

When you look at which central banks' activity drives which of these flows, it is unsurprising that the Fed drives the financial flows and some of the commodity flows, while the People’s Bank of China drives commodity-related flows much more. The ECB is ‘in-between". If we think of the structure of global capital flows, we should expect a change going forward: financial transaction flows are linked to the role of the dollar in the global financial system, which may change with the reconfiguration of trade blocks and the emergence of the Chinese block. The Chinese authorities have taken a number of steps to increase the internationalization of the RMB by boosting its role as an invoicing currency, creating regional swap lines, and liberalizing (slowly) some financial flows. The RMB is also part of the IMF SDR basket. These efforts have not been nearly enough to displace the Dollar or even compete with the euro as an international currency for the moment, but we know from history that the International Monetary System is slow-moving. Additionally, if we expect changes in our high-carbon world economy with a substitution away from fossil energy, then global flows will have to change too. It will be a new geographical pattern, no more recycling of petro-dollars but new flows such as lithium or copper dollars or something else… I think that the global pattern of capital flows will be disturbed in the medium to long term, both because of geopolitics, and because of climate change and the green transition.

The long period of low rates, including real rates, has led to an accumulation of debt in the private sector and the public as well. As a systemic risk expert, what are your thoughts on the huge amount of debt coupled with the sometimes uncooperative behavior of some lenders? What about the financial systemic risk? Do we have the tools to deal with it? 

There are some difficult times ahead because of the high level of debt in many economies. In emerging and low-income economies, there is a clear danger: these countries have to pay for food and energy imports but have already accumulated a lot of debt because of the loss of economic activity during the pandemic. A lot of that debt is US dollars denominated, so the appreciation of the dollar is making debt servicing much more expensive since governments’ tax basis is in local currency. Rising food prices should also be a cause for concern, in that it puts a lot of strain on people. The risk of social unrest in many countries should not be underestimated.

In advanced economies, we also have a lot of debt and we know that some of the worst crises in the past come with a banking crisis: banks tend to be exposed to the real estate sector and tend to not have enough loss absorption capacity. When the banking system goes down the drain, the economy goes down with it (2008 is still very fresh in our minds). Since 2008, we have developed macro-prudential policies, a new set of tools that can help, we have to hope that they will be enough.

The risk of social unrest in many countries should not be underestimated.

In the Euro area specifically, we also have the so-called "doom loop" between sovereign debt and the banking system that we have not fully resolved in spite of reforms in banking regulation and fiscal rules. When the spreads on sovereign debt between Germany and other countries (for example Italy) widen too much and the dynamics get unstable, we can enter a doom loop because banks in some euro area countries tend to be very exposed to domestic debt. When banks get into trouble, the sovereign lacks the fiscal capacity to recapitalize the banking system, and that can lead to a disastrous financial crisis. 

What can you say about the future of the Russian economy? 

Given the brain drain of its experts and the sanctions, in particular, in the technological field, the Russian economy can only seriously weaken over time. Russia’s economy is not diversified. It is heavily reliant on fossil fuel exports. If we remain committed to decarbonizing our own economies and stick to economic sanctions that prohibit exports of technology and intermediate goods, it is hard to see how this economy can become afloat again. Of course, the main issue is its big neighbor: what role will China play? Is Russia going to let China mine minerals and fuels on its territory in exchange for Chinese technology and financial help? It is hard to guess the evolution of the political dynamics. Finally, part of the ability of democracies to sustain the sanctions will depend on big countries like India. Will they play the game? The course of the war and our ability to build a political relationship with India and the future of our relationship with China will inform how long a weakened Russia can keep itself standing up.


Copyright: Spencer Platt / Getty Images via AFP

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