Since the inflation of the 1970’s, economists have generally associated price increases with stagnation. The “misery index,” the sum of inflation and unemployment, as a shorthand for this intuition, became a household term at that time. More recently, so-called “market monetarism” has advocated for interest rate adjustment based on nominal GDP (NGDP), the sum of real GDP and inflation – with the implication that the sum of the two is more stable or reliable of an indicator than either part alone.
The post-2008 recovery broke this mold to a certain extent, as unemployment remained persistently elevated while inflation was subdued. Now, as employment remains much healthier than price indices, the US economy is challenging this association in an inflationary environment as well. This paradox is reflected in a divergence between the internal and external prices of the US dollar: despite headline-grabbing inflation, the US Dollar Index (a measure of the USD against several US trade partners) has surged from 96 at the beginning of this year to 106 in August.
The resilience of the domestic US economy to the inflation surge has important implications for non-exporting emerging markets, the part of the world which tends to be the most affected by tightening cycles in the world’s reserve currency. They now have the potential to be squeezed between not only the same supply-side factors causing inflation in the US, but also the US response to those same factors. At least one classic currency crisis has resulted, in Sri Lanka. At the same, several factors differentiate this situation from the frequent crises of the 1980’s and 1990’s, including the role of China and the ongoing carbon transition.
Squeezed from both sides
These factors have indeed caused capital to broadly retreat from emerging markets. A July report of the Institute of International Finance (IIF), a trade body for international financial institutions, highlighted a five-month trend of US$39.3 billion in portfolio outflows since March, the longest such record in the history of the organization. An August report of the IMF similarly found that global current account balances (the sum of national trade deficits and surpluses) is widening as a measure of global macroeconomic stability, and also forecast that they will continue to increase into 2023 until supply conditions ease.
Sri Lanka’s former President Rajapaksa was forced to flee the country after the government defaulted on its debt for its first time ever on May 20. Sri Lanka had faced severe pressure on key sectors for foreign exchange due to COVID, including tourism and remittances from labor in the Middle East. Analysts have pointed to several policy mistakes, including large tax cuts prior to the pandemic, and later a delay in recognizing the gravity of its foreign exchange problem. Most notably, it briefly banned imports of synthetic fertilizer before reversing course, affecting domestic food production.
Agriculture is an area of moderate importance to the green transition. Synthetic fertilizer that is not taken up by plants may leach into the atmosphere. Pound-for-pound and over the equivalent time period (i.e. accounting for its longer residence time in the atmosphere), nitrous oxide is 300 times more potent of a greenhouse gas than carbon dioxide. Invented around the turn of the 20th century to replace guano as a natural resource, nitrogen fertilizers enabled an explosion in global population, and also played a key role in the ‘green revolution’ of the 1960s. It is possible to drastically reduce synthetic fertilizer use, but doing so requires significant planning, taking various local factors into account – none of which was done in Sri Lanka.
Does ESG bear responsibility?
Green investing was however not the primary motivation for Rajapaksa’s fertilizer misstep. “Let me be clear – there was no wholesale embrace of ESG principles,” wrote Mel Sanderson, founder of Ethically Sustainable Growth (ESG+), in Investor Intel. “Had there been, regulations also would have been promulgated regarding salaries and working conditions for rural laborers, government institutions charged with enforcing such regulations and protecting workers’ rights would have been empowered, and the general working conditions on Sri Lankan farms would have been noticeably improved. None of that happened.” Instead, the government misguidedly sought to reduce imported fertilizer in order to preserve Sri Lanka’s foreign exchange reserves – even though fertilizer is a key input to tea, one of Sri Lanka’s important exports.
This marks the first tightening cycle for both ESG as a mainstream concept. Its potential macroeconomic significance has become clearer due to Sri Lanka’s widely derided policy response. ESG advocates can fairly claim to have clean hands in that particular crisis, but the episode nevertheless may highlight some blind spots in their approach. It may help to view Sri Lanka alongside another recent debt crisis. On July 14, Pakistan also announced that it reached a preliminary US$ 6 billion agreement with the IMF and would undertake politically difficult reforms in order pre-empt its own crisis.
Both countries had delayed assistance from the IMF due in part to its requirement to end fossil fuel subsidies. Fossil fuel subsidies are a popular, yet harmful method of public welfare provision around the world, including in Taiwan. Any money a government spends on subsidizing the price difference could instead be better spent on direct cash subsidies, which would be both greener and more equitable (since poor people tend to require less fuel anyway). The IMF rightly advises against such subsidies, but they are not in a position to advocate for the superiority of equivalent cash payments, only austerity. ESG investors are in a unique position to do both.
Some may argue that ESG is unrelated to macroeconomic stability, and should keep its mission more focused. Notwithstanding its social and governance functions, however, we should also recognize the current situation as an environmental crisis. Current supply-side pressures are based almost entirely on petroleum (although some African and Middle Eastern countries are seeing problems with imports of finished food products due to the war in Ukraine). Volatility in hydrocarbon supply can only become more pronounced as the energy transition progresses and the former becomes less central to the global economy.
While any marginal bit of greenhouse gas emission reduction helps, agriculture is mostly a standalone item in the green transition. Green electrification, in contrast, is a much more connected process, which will have a diverse variety of impacts. By ending subsidies, countries can attack the energy transition from both the consumption and production ends, yet sustainable finance taxonomies tend not to mention fossil fuel subsidies on a country level.
The panda in the room
An additional commonality between Pakistan and Sri Lanka is that they had both received large loans through China’s Belt & Road Initiative (BRI). As with the ESG concept, this tightening cycle also marks the first major test for China’s development lending. In a typical debt renegotiation program, lenders negotiate collectively to ensure that the borrower cannot play them off of each other. Any renegotiation of BRI projects takes place on a strictly bilateral basis, raising fears among multilateral institutions that their aid money might be simply used to pay off Chinese loans. The Paris Club, a group of creditor nations, excludes China.
In fact, the BRI may not only be a “debt trap,” as US diplomats have repeatedly warned, but also problematic for recipient countries’ trade balance as well, according to an analysis by Felix Chang of the Foreign Policy Research Institute. Thus, it impacts both of the main factors affecting a country’s ability to acquire and maintain foreign currency reserves. The infrastructure projects it produces tend to be used more for imports from China than for exports to other countries, both because of the connections they facilitate between the two countries, and also due to strong dependence on Chinese suppliers. Combined with the opacity of the BRI, some have speculated that a significant portion of its lending does not even involve foreign exchange, remaining entirely within the renminbi ecosystem. Nevertheless, the loans are paid back in renminbi.
In the bigger picture, the challenge from the BRI to both aid institutions and the global ESG model may turn out to be relatively ephemeral. China’s economy is under severe pressure from demographic and structural factors, and now a zero-covid policy that will be difficult to unwind, even if the political will existed. Alongside the capital withdrawals from emerging markets, a somewhat longer-term trend has emerged over the past two years of declining foreign capital positions in China, the most significant emerging market of them all.
The difference will likely be made up in foreign lending. With memories of the 2014-15 ‘taper tantrum’ firmly in mind, China’s capital controls are now as tight as ever. In the background of increased social control from anti-covid policies, it has refused to issue passports to high net-worth individuals. Regulators are reviewing overseas investment with increased scrutiny. As it cuts back on new lending, however, China’s internal factors may also make it less willing to negotiate terms on existing lending.
Regardless of any adjustments in the capital account, China’s trade surplus remains resilient to increasing geopolitical pressure. The persistence of this structural factor ensures that long-term inflation expectations in advanced economies remain subdued, but it also hampers diversification of supply chains into a more diverse set of global markets, which would give these source countries a sustainable source of foreign exchange from trade with which to cushion the impact of any supply stoppages. Due to a variety of institutional and economic factors, few expect a repeat of the rolling debt crises of the 1980s and 90s. Instead, investors should watch out for more subtle trends: stagflation exported from the US, and disputes of a more political nature at the periphery of international capital institutions.