Three threats to the global economic recovery

THE NEWS, as the second anniversary of the pandemic nears, could be better. The emergence of a covid-19 variant, labelled Omicron, has sparked a wave of selling on financial markets, seemingly on concern that a new highly transmissible strain of the virus could set back economic recoveries worldwide. Yet even if Omicron proves manageable, 2022 will probably be an economically trying one, as countries are squeezed between two formidable economic forces: tighter American monetary policy and slower growth in China.

America and China loom over the global economy: together, they account for 40% of global GDP at market exchange rates. The two giants tend to influence other economies in different ways, however. For many emerging countries, strong growth in America is a double-edged sword. The expansionary effect of its households’ spending is often overshadowed by the effect of its monetary policy, given the critical role of the dollar and Treasury bonds in the global financial system. Tighter American monetary policy is often associated with a declining global risk appetite. Capital flows towards emerging markets tend to ebb; a strengthening dollar reduces trade flows because of the greenback’s role in trade invoicing.

China’s effect on the world is more straightforward. It is, by a large margin, the world’s biggest consumer of aluminium, coal, cotton and soyabeans, among other commodities, and a major importer of goods ranging from capital equipment to wine. When China falters, exporters around the world feel the pain.

The year ahead will not be the first time economies have been forced to navigate the treacherous waters between the two dangers. In the mid-2010s vulnerable emerging markets were squeezed by a rising dollar, as the Federal Reserve withdrew the monetary support provided during the global financial crisis, while a badly managed round of financial-market liberalisation and credit tightening triggered a slump in China. Growth across emerging markets, excluding China, sagged from 5.3% in 2011 to just 3.2% in 2015.

The squeeze this time could well be more painful. In the 2010s, a weak recovery and stubbornly low inflation forced the Fed to go slow. More than two-and-a-half years elapsed between the Fed’s announcement of its intention to reduce its asset purchases and the first rise in its policy rate. This time around, by contrast, the 12 months following the Fed’s announcement of its plan to begin tapering in November are likely to involve a complete halt to bond-buying and, according to market pricing, at least two interest-rate rises.

China, for its part, seems at greater risk of a hard landing today than it was a half-decade ago. Then, the government responded to slackening growth by opening the credit taps, helping reinflate a housing bubble. The property market has since become only more overextended, and the debt loads of households and firms have risen. Economic officials now deliver regular, ominous warnings about the adjustment ahead. Though the IMF still forecasts that China will grow by 5.6% in 2022, that would, with the exception of 2020, be the lowest rate since 1990.

China’s importance for the global economy has only increased since the 2010s. And the world remains vulnerable to shocks. Debt loads soared during the pandemic; the continued spread of covid-19 is likely to place further demands on governments. Analysis of past episodes of Fed tightening suggests that an increase in interest rates prompted by strong American demand is modestly beneficial to emerging economies on a sound macroeconomic footing. But for more fragile economies, it can be destabilising.

In order to assess which places face the biggest squeeze from tighter American monetary policy, The Economist has gathered data on a few key macroeconomic variables for 60 large economies, both rich and developing. Large current-account deficits, high levels of debt (and of short-term debt owed to foreigners especially), rampant inflation and insufficient foreign-exchange reserves all spell trouble for economies facing fickle capital flows as American policy tightens.

Combining countries’ performance on these indicators yields a “vulnerability index”, on which higher scores translate into greater fragility. The pressure is already on in some places. Argentina, which tops the list, faces an inflation rate above 50% and a deepening economic crisis. Turkey’s fundamentals look a little better, but its woes are compounded by the government’s stubborn desire to lower interest rates in the face of soaring prices. The lira has been hammered, losing nearly 40% against the dollar in 2021, diminishing the purchasing power of Turks’ wages and pensions.

Very high debt loads in some rich countries push them up the list. Markets typically extend the rich world more breathing room, but if global financial conditions tighten substantially, then European leaders may need to do more to persuade punters that Greece will not be allowed to fall into serious trouble. Among big emerging economies, Brazil looks most vulnerable.

Ranking the same 60 economies by their exports to China, as a share of their own GDP, yields an index of vulnerability to the mainland. Many of the biggest exporters to China, like Singapore and South Korea, are critical links in manufacturing supply chains. These should be untroubled as China’s domestic economy slows, as long as Americans keep shopping. Flagging Chinese growth could batter Australia, which exports resources to China, and Germany, whose industrial-equipment firms depend heavily on Chinese customers. But at greater risk are the poorer commodities exporters that have helped feed China’s population and provide for its building boom.

This gauge of exposure to China can then be compared with our measure of vulnerability to American monetary-policy tightening (see chart 2). Some countries’ fates are more linked to one of the giants than the other. Others, such as Brazil and Chile, appear most likely to suffer from a double whammy. Despite high levels of debt and soaring inflation, high commodity prices have enabled Brazil to just about maintain investors’ confidence. A softening Chinese economy could deprive Brazil of that benefit, leading to a tumbling currency, even higher inflation and the possibility of economic crisis.

Conditions might worsen if tighter American monetary policy exacerbates a Chinese slowdown. Though China’s enormous pile of foreign-exchange reserves provides it with a buffer, it has also received large financial flows over the past two years, which have boosted the value of the yuan. Global banks’ claims on China surged by nearly $200bn from 2020 to 2021, to nearly $1trn. A sudden unwinding of those flows could lead to a sharp depreciation—not unlike the one that destabilised markets in the mid-2010s.

The emergence of Omicron adds fresh uncertainty. Little is known yet about the economic damage that the variant might wreak. As equity prices tumbled on November 26th, investors nudged down their expectations of the pace of American rate rises next year. But this may not bring much respite to weak economies. Many currencies tumbled against the dollar amid a flight to safety. That, if it continues, is not dissimilar to the effects of sustained American monetary tightening. If Omicron were also to depress trade and growth, then its spread would further amplify the pressures facing vulnerable economies. The sailing will be anything but smooth.