Is it now China’s turn to spook the globe with inflation? It’s hard not to wonder as Omicron prompts Asia’s biggest economy to institute new lockdowns that are sure to upend supply chains and intensify global price pressures.
If that happens, it could shift China from an economic hero of the Covid era to its villain. Until now, the mainland’s massive factory economy acted as a giant shock absorber to keep prices “quite manageable,” note leading China economists like Grace Ng at JPMorgan.
Chinese producers effectively ate double-digit surges in raw material pricing, judging that the fallout from consumer price spikes would be worse than reduced corporate profits.
This dynamic seems sure to change as President Xi Jinping’s “zero-Covid” absolutism collides with new shutdowns. Much has been said about how China’s response to Covid-19 in 2020 and the 2021 Delta variant could backfire in the Omicron era, given that the latest variant’s high transmissibility makes it virtually impossible to contain.
Yet, recent events in Xi’an suggest Xi has no intention of recalibrating Beijing’s response. Despite having fewer than 2,000 infections, Team Xi confined Xi’an residents – numbering 13 million – to their homes. If this is a harbinger of things to come, hopes China will grow 5% this year might be dashed.
As Eurasia Group president Ian Bremmer puts it: “China is in the most difficult situation because of a zero-Covid policy that looked incredibly successful in 2020, but now has become a fight against a much more transmissible variant with broader lockdowns and vaccines with limited effectiveness.”
This could lead to the “mother of all supply chain stumbles” as China triggers a domino effect across the region, warns economist Frederic Neumann at HSBC.
“The Asian production networks, hitherto impressively resilient, may be thrown into a funk as Omicron grips the region – and all at a time when, faintly, faintly, supply chain issues appear to be easing in the West,” Neumann says.
“The risk, then, is that over the coming months we’ll experience an ‘Omicron-driven stall’ in Asian factories.”
The inflation wave
The US is already seeing the worst inflation spikes in 40 years. The 7% surge in consumer prices in 2021 was the highest since 1982 and too broad-based for comfort. Costs of everything from cars to energy to food to furniture crushed hopes that inflation would prove “transitory.”
As most see it, the world’s biggest economy is suffering a trifecta of price shocks: surging raw materials costs, supply chains squeezed by worker shortages and rising demand from vast infusions of government aid and ultra-low interest rates.
“US inflation pressures show no sign of easing,” says James Knightley at ING Bank. “It hasn’t been this high since the days of Thatcher and Reagan. We could be close to the peak, but the risk is that inflation stays higher for longer.”
It’s fast becoming a global problem. In the 19 European countries using the euro, inflation jumped 5% in December year-on-year, the most on record. This has companies large and small scrambling to adapt as best they can. And it has analysts marking down corporate profits projections across industries.
Not everyone is convinced US inflation is careening out of control. International Monetary Fund Managing Director Kristalina Georgieva says prices will ease by the second quarter.
“This is subject to dealing with supply chain constraints, and what we are seeing are some promising signs that some progress is being made in that regard,” Georgieva says.
Edward Moya, an analyst at OANDA, argues that “inflation is not slowing down just yet, but the peak is getting close.”
Regardless, Western economies ending 2021 hoped rising vaccination rates would ease supply chain-driven delays in goods and transportation and ease labor shortages.
But now, new lockdowns in China and beyond could wreak greater havoc on an already stressed supply chain network. Omicron, HSBC’s Neumann warns, could be far more disruptive than other variants.
“With slower moving variants, many governments were able to shield essential manufacturing operations, limiting the impact on the output of essential goods and components,” he says.
“But that will be harder to do with Omicron, which races through populations at unrivaled speed – and even if it presents a somewhat less acute health risk compared to earlier variants, it is still potent enough to deprive Asia’s factories of a critical number of workers during their convalescence.”
China’s possible pivot from inflation shock absorber to inflation generator raises risks for 2022. Until now, Beijing’s policy of “stabilization of prices of strategic commodities has played a major role in enabling China to achieve rapid economic growth without inflation,” says Isabella Weber, author of “How China Escaped Shock Therapy: The Market Reform Debate.”
With China helping to curb inflation, there was hope, Weber says, that it “could come to the rescue as the Biden administration seeks to open the fiscal floodgates,” with its Build Back Better scheme.
Now, China might soon be upping Washington’s inflation risks. This, in turn, could add to pressures on the Federal Reserve in Washington to accelerate its monetary tightening timeline.
PBOC vs Fed in tug-of-war
The two biggest economies generating faster inflation than gross domestic product (GDP) is a nightmare scenario for global markets. In a recent report, economists at Morgan Stanley warned of the “stagflation risk” stalking the global economy.
“Disruption of global supply chains has caused shortages in areas such as energy and semiconductors,” they argue. “These situations could drag” into 2022, “which would likely keep inflationary pressures high in the short term.”
That would complicate what might be called history’s greatest game of tug of war.
On one side, the Jerome Powell-led Fed is beginning to pull ever harder in the direction of austerity. Last year’s 7% inflation surge has Fed officials digging in with intensifying urgency.
On the other side, the People’s Bank of China (PBOC) has been pulling toward increased liquidity. Just as much as Governor Yi Gang is working to support growth, he’s endeavoring to calm markets traumatized by corporate default risks.
The stand-off matters because central banks, not Covid-19, look likely to be the biggest driver of global economies in 2022. How might things work when the two most important are veering in opposite directions, leaving world markets vulnerable to the turbulence to come?
Though Omicron is still raging, the pandemic is unlikely to be the deciding factor. The real risk is how rising inflation catalyzes policymakers to respond – and the high odds they will call recoveries from Covid wrong.
Debates are raging about whether the global economy is strong enough for governments to throttle back on crisis support and for central banks to scale back unprecedented stimulus. A big deciding factor will be whether inflation turns out to be transient or a persistent problem that slams confidence.
New growth complexities
Conventional wisdom among economists is that the globe will generate about 4.5% worth of GDP this year after expanding 5.8% in 2021. But now, growing risks of central bank tightening have forecasters thinking GDP could come in as low as 3.5% in 2023.
Yet the idea of GDP as the be-all-and-end-all indicator is now even more complicated than usual.
The normal relationships between growth, inflation and borrowing costs have completely broken down. Though labor markets seem drum-tight, job vacancies across the US topped 10 million at the end of December.
Such dislocations are making Fed chairman Powell’s decision-making process harder than ever. Yet so is the divergence between Fed and PBOC policies that are causing tensions in currency markets.
The Fed’s pivot toward tightening, for example, isn’t stopping the Chinese yuan from rising. Whereas the Japanese yen is sliding versus the dollar, the yuan is on the up.
And there’s still some hope that Chinese inflation won’t explode.
Analyst Zerlina Zeng at advisory CreditSights points to hints inflationary pressure eased in late December. China’s producer price index fell to 10.3% year-on-year as of December 21 from a 12.9% annual rate a month earlier.
“We expect the Chinese authorities will continue to adopt targeted and calibrated macro easing measures in the first quarter against the backdrop of property sector weakness, Covid outbreaks and easing inflationary pressure,” Zeng says.
Yet price risks in China are indeed shifting to the upside at the worst possible moment for global investors.