The stress in global macro

Business Standard, 13 June 2022

Crimping Russian energy exports and global energy prices

Before invading Ukraine, Russia was the world's biggest exporter of oil, at about 8 million barrels a day. In addition, about a third of Europe's gas supply came from Russia. There is regret among European leaders about mistakes made in energy policy in the past, where pipelines were built to the Russian oil fields. While Russia is sometimes thought of as a superpower, its GDP is of Spain's size, with strengths in two fields: Natural resources and food. The energy export cash flow is critical to the Russian economy and funds the war in Ukraine.

The West is chipping away at crimping it. Building a liquefied natural gas (LNG) terminal, storage or pipeline takes over two to three years, so changing course is hard. So far, the rise in prices has more than offset the decline in quantities, and Russian exports (expressed in billion dollars) have grown compared with pre-war conditions. But the restrictions are slowly getting through.

While authoritarian political parties are present all over Europe, 85 per cent of individuals there favour reducing energy dependence on Russia. The analogy between Austria, Czechoslovakia and then Poland, versus Georgia, Crimea and then Ukraine, is widely seen. The political leadership is able to justify the economic pain of the transition as part of the required "blood, toil, tears and sweat".

A game of chicken is underway. In recent months, Russian gas sales to Poland, Bulgaria and Finland have been shut off. Russia might desire a stronger military position by October, followed by a disruption of European support for Ukraine in November, by threatening a gas supply interruption in December. But at the same time, the Russian army needs to make it till October, for which the export proceeds are essential.

The optimal strategy for Russia is perhaps to:

  1. roil the world oil market, and drive up energy prices,
  2. influence European foreign policy by threatening supply interruptions, but
  3. actually negotiate an outcome where suzerainty over Eastern Europe is achieved alongside high revenues from energy sales.

Europe wants to cut back on energy imports from Russia. LNG imports into Europe have surged. There is a rush to establish LNG facilities. Carbon transition investments are taking place with unprecedented zeal, as this kills two birds with one stone. The pace of implementation of these projects will influence the European spine on Ukraine. The European demand for LNG is also driving up its global price, which influences all users [example], including those in India.

Strong men often see democracies as effete. We should not underestimate the intellectual, technological, economic and cultural might of democracies. While reducing energy imports from Russia is hard, Europe will achieve a lot towards that goal. Crimping Russian energy exports will create sustained stress in the global energy market. What this dive into energy thinking tells us is that barring a rapid end to the war, we are in for sustained high energy prices for a year.

The global macroeconomic situation

Let's connect higher energy prices to macroeconomics. For energy-importing countries worldwide, in the short term, there is negligible price elasticity. Therefore, higher import prices are tantamount to a consumption tax and reduction of savings. There is then a need for a corresponding increased capital inflow to finance the enhanced gap between investment and savings.

Long years of sustained low interest rates in the world economy, coupled with the pandemic, have led to a significant build-up of debt. Unexpected inflation has inflated some of this debt. It is not hard, however, to construct scenarios for many borrowers where the foundation of debt stability -- the comparison between nominal growth and the cost of capital -- turns adverse in 2023. As an example, in the short run, Italy has gained when high inflation eased its debt burden, but by 2023 it could be in the grip of an expanding debt/GDP ratio.

Central banks worldwide are freshly conscious about the problems of inflation and are tightening monetary policy. In the rest of 2022, while the US Fed is expected to hike interest rates by about 200 basis points (bps), the European Central Bank is likely to raise it by 130 bps. This adds up to an unusual period, when compared with recent decades, of a sharp increase in the short rate.

When DM interest rates go up, global capital retreats from exotic risks and illiquidity the world over, and increases holdings in mainstream assets in DMs, such as index funds and liquid debt. The required rate of return in emerging markets (EMs) has to go up to justify unchanged capital flows into them. This requires a combination of exchange rate depreciation and asset price declines.

The world economy then faces an unusual combination:

  1. The need for enlarged capital inflows to fund the gap between investment and savings in many energy importing countries,
  2. at a time when debt levels are unprecedentedly high,
  3. at a time of slow global growth in GDP and trade, and
  4. in a period of unprecedented DM monetary tightening.

This combination is new to us. Our datasets and estimated models have not seen this. We need to recognise the enhanced model risk; our familiar maps work less well.

Difficulties ahead

In countries with good institutions, there is capital account convertibility and inflation targeting. When investment goes up or savings go down, the exchange rate depreciates, and more foreign capital comes in frictionlessly. This happy outcome requires the `modern system' of a floating exchange rate, capital account convertibility, inflation targeting, and government borrowing which faces market discipline. In many places of the world, this machinery is not in place, and we may get some episodes of distress.

Some firms will face credit stress. Some ponzi schemes will get unveiled. There will be a winter in high-risk and illiquid assets. Some countries will mishandle macro policy and experience macroeconomic/financial crises.

On January 7, 2009, the Satyam scandal erupted. It was not just a story of one person or one firm: This unveiling was linked to the macro events from the choking of the London money market in 2007 to the Lehman Brothers default in 2008, and then the terrorist attack in Mumbai on November 26, 2008. There are causal connections between macroeconomic stress and practical outcomes.

Back up to Ajay Shah's 2022 media page
Back up to Ajay Shah's home page