While the world still relies heavily on hydrocarbons for over 80% of its energy requirements, the renewable energy transition looks to be increasingly shaping the investment landscape in emerging markets.
Podcast
Nick Robinson: Hello, everybody and welcome to the abrdn Emerging Markets Equity Podcast. I'm Nick Robinson from the emerging market equity team. In this podcast series, we explore the factors that underpin our thinking on emerging markets. From key individuals to evolving trends, we seek to answer the five W's who, what, where, when, and why, that are shaping investment opportunities in the region. In today's episode, we're going to discuss the energy transition, and how this is impacting the investment landscape in emerging markets. Regular listeners will know we've discussed renewables several times, we've also talked about the ESG issues that are accelerating the transition. But we've not really brought that together yet to talk about the challenges of the transition, and particularly what this means for some of the legacy hydrocarbon producers. And it's worth remembering that the world still relies on hydrocarbons for over 80% of its energy requirements. And that percentage is likely to be pretty large for a number of years going forward. So joining me today to tackle this subject is my colleague, William Scholes. Well, welcome to the podcast. How are you?
Bob:Great. Thanks, Nick. Thanks for having me on.
Nick:It’s great to have you on. So let's get started on Russia. So, with Russia, we're a few months into the conflict now. And we've seen a steady escalation with no ceasefire in sight. You know, I think we're all pretty familiar with some of the first order impacts of the conflict, the terrible loss to human life, the disruption to supply chains that we've seen that’s lead to some inflation, and we'll talk about that a bit later. But I really wanted to ask you a bit about some of the other impacts the second order impacts of this conflict that are perhaps a bit less well considered. So perhaps starting with the freezing of US dollar reserves that the Russian Central Bank and what extent that could change the shape of central bank reserves going forward? And the impact that possibly that could have?
Bob:Yeah, it's a great question. I think probably for most countries, reserves are still going to effectively remain in US dollars. I mean, why do we want reserves or why central banks want reserves? For the most part, it's a kind of insurance policy against currency crises. And clearly, you know, as well as being a kind of technocratic reason guarding against kind of currency crises. There's also sometimes the domestic political reason, not wanting to go kind of cap in hand, to the IMF still provides a rationale for kind of holding a reasonable amount of reserves, even if your currency is actually moved to be more floating than fixed, as was in the case in the Asia financial crisis.
US dollars will provide a lot of liquidity in the global financial system that just to be honest, is quite hard to replace with other currencies. So, if you were a country worried about, you know, sanction risk, having watched what's happened to Russia’s Central Bank, I think there's a question of kind of where else do you go? So, sanction risk could be just as high in Euros, for example, other markets outside of the West may just kind of not be deep and liquid enough.
Potentially, over time, I guess this could accelerate moves away from the US dollar, you know, maybe encourage some degree of regionalization of financial systems to. It could renew, for example, a bit of interest in the Chinese authorities pushing Renminbi, internationalization. Potentially, we could see a few more steps, I think, coming to promote its own homegrown payments transfer network. So that's the cross border, interbank payment system, the SIPS, rather than kind of relying on the SWIFT network. And we've kind of seen how damaging that has been to the Russian economy more recently. But you know, I think we need to bear in mind historical lessons suggests that there's going to be a long time before China probably is able to supplant the US dollar, and really kind of internationalise. The US economy, for example, was way bigger than the British economy when the when the dollar became the reserve currency for the world.
Nick:Thanks. I think you've made an interesting point before about how, after a country loses its primacy in terms of the world order, it takes a while for currencies to adjust or central bank currencies to adjust to that and the pound was a global reserve currency for a lot longer after the fall of British Empire.
Bob:Yeah, exactly. That's pretty much exactly how that happened. I think it was 40,50 years probably for the dollar to kind of overtake the pound despite the British economy’s kind of dwindling importance in the world economy there. So I think that triangulation that you can go through the dollar from any currency. That kind of liquidity advantages just means it's there's a lot of inertia to overcome, potentially in the global financial system. Yeah.
Nick:Okay, thanks for that. And then another thing I wanted to ask you about was the very broad sanctioning of individuals from Russia, who have made their wealth by being associated with Putin and essentially essential suspension of property rights for those individuals. Could that have an impact in terms of future sanctions on people who is perceived to be close to other bad acting dictators?
Bob:Yep, potentially, it's a difficult one to know, it's a difficult one to know for sure. I think maybe some people will be thinking twice. So is this a kind of a rewriting of the rules of the International Monetary financial system? Where can money go that is deemed to be kind of safe? Could the margin, influence some capital flows or kind of individual decisions there. I guess it's kind of question about whether you think sanctions are kind of the genie that's out of the bottle now. And could, I guess, views or perceptions about kind of more minor transgressions, ultimately end up kind of limiting flows, limiting investments, maybe by individuals too, worried about their ability to, to retain ownership. So it's kind of not just about yachts and the like, kind of investment in kind of companies abroad too, could potentially kind of suffer. From economic point of view, because we were wondering about whether this is significant enough to really cause some sort of damage to kind of economic efficiency and, and kind of capital flows. But yeah, maybe those who are cozying up to autocrats might be feeling a little bit more nervous than they were, until Russian sanctions started getting on.
Nick:And then moving on to China. Early on in the Russia, Ukraine conflict, the link was made to China and Taiwan, and the potential for unification to occur at some point in the future by, by potentially by force, do you think that's more or less likely now, given what we've seen in Russia?
Bob:Yeah, it's a difficult one, I think Russia's invasion of Ukraine or hasn't kind of materially changed our view of Taiwan risks there. So I mean, it's still, of course, possible that missteps lead, I think, to conflict over Taiwan, you know, the US is, of course, running a policy of quote, unquote, ‘strategic ambiguity’. So there's a possibility that this leads to kind of missteps or contributes to missteps by either side, those who like that kind of game theory, would know the ‘trembling hand’ equilibrium were kind of mistakes on either sides could potentially force you into kind of positions you didn't, didn't want to be in.
I mean, one could potentially imagine scenarios, which can follow on from Ukraine crisis, which increased the odds either intentionally or unintentionally. So, for example, I don't know - the US was spurred on by what it sees in Ukraine, ramping up sales of advanced weapon systems, China could maybe then react to a kind of closing window of opportunity. So, in this kind of situation, Beijing might conclude that the likelihood of a kind of successful invasion could actually decline rather than rise over time, alongside the kind of steady rise in its military prowess, the size of its economy, and the like.
And I guess, before the Ukraine invasion, US withdrawal from Afghanistan, might have led, you know, Beijing to doubt the US commitment to his allies too. But I think, you know, the strength of the Western response more recently, probably counters that narrative. But I think, you know, overall, why, why we're not really very concerned about this risk, or we think this risk has often been overstated, by many commentators and markets. You need to really think about kind of the whether the authorities in China will really be willing to take such a risk. So even if conflict over Taiwan was somehow avoided, the US didn't opt to intervene. Now, if it did, that could clearly be catastrophic – for not just China and the US, but kind of worldwide.
The potential cost I think to China now just seems much higher, given the Western sanctions went further than anyone expected. China is also much more integrated into the west than Russia is. So, the economic damage from western sanctions, the dismantling of Western supply chains, could be an order of magnitude higher for China. And then I think it's also important to distinguish between the short and the long run here. Much of China's kind of long run, both kind of hard as military power and also it's kind of soft political power, is directly related to the size of its economy. So why would you be willing to jeopardise that, at this, at this stage? It's still possible, of course, I think, you know, over the medium to long run risks are likely to rise. As I said, before, you know, China's military is certainly growing in kind of both size and I think sophistication, too, we do expect some continued deterioration in US China relations. But it's not really clear I think, that Ukraine kind of changes the trajectory of that kind of distribution of risks alongside it.
Nick:Yeah, that's interesting, I suppose one thing you mentioned about Russia, and essentially the excommunication of the Russian financial system from most of the rest of the global financial system is something that gives us a bit of comfort on China, in that, the private sector has been a really big driver of a lot of China's economic growth over the last decade, and the private sector is very much reliant on capital markets to fund that growth. So, I suppose my question would be, can China still continue with the target level of growth without access to global capital markets?
Nick:Yeah, it's a tough one that. I think if it was to lose access to the dollar base global financial system, it could be extremely damaging. I guess I probably put capital markets under kind of like, a broader umbrella of kind of China's development model here. You know, within that, you know, trade, the ability to kind of sell to the west. There's obviously the knowledge transfer that comes with foreign direct investment, and also just a heightened competition that helps kind of spur on innovation amongst its private sector, as you kind of mentioned there that's become increasingly important within the economy over the last sort of 15,20 years.
I mean, there's a similar aspect, I think that applies to capital markets. And, you know, generally tend to think that the private firms in China are being very careful to adhere to Western sanctions, they really don't want to be hit by secondary sanctions, to be seen to be helping Russia evade sanctions in any way.
On the other hand, I think you also need to kind of think about the kind of more fundamental needs of any country such as China's, kind of infrastructure and kind of financing needs. You know, China has been running a lot of current surplus for many years now. In essence, you know, that tells you that national savings are above national investments. You've also got an asymmetric capital account opening, meaning that domestic savings are still largely kind of trapped in China. So, these sort of things kind of reduce, I guess, the, the essentialness of access to the global financial markets, but you know, competition and finance, the ability for financial flows to go in and out of China helping FDI, finance just helping China’s financial deepening. Over time, I think this should help improve risk pricing will reduce those risks, around capital misallocation. That could be a big barrier to China breaking the middle-income trap.
And really one example of this. I think there were some steps in April to kind of clarify the audit rules. So, to reduce the risks of Chinese firms actually being delisted from the New York Stock Exchange. I don't think we're 100% there in that kind of the delisting risk. But you know, I think there are some kind of positive steps in the right direction, you know, at least one indication that the Chinese authorities do take that capital market access pretty seriously.
Nick:Yeah, we saw that, that rule change back in April. And that gave us a fair bit of comfort that China was taking steps in terms of making sure that capital market access wasn't limited. And we took that as a fairly significant step forward, given you know, that that issue has been kind of locked for, for quite a while. And I suppose it also comes down to the issue that China has enough problems at the moment without adding capital markets back to the list. And maybe I'd like to touch on that which is, what we're hearing from companies at the moment on the ground in China is that 2022 is worse than 2020 in terms of disruption from COVID due to this zero COVID policy, coming at a time when other economies have more or less opened up. What's your take on how long this policy is likely to last?
Bob:Yeah, it's a great question. It's a really tough call, I think and you know, it's a key part of our, our China and global economic forecasts, actually, you know, for that matter. To me always has a bit of a feel of kind of forecasting how long untenable strategy last, I think best guess at the moment is zero COVID, is probably going to continue and it's in its current guise. So at least until the 20th Party Congress - at that point President Xi will, kind of secure his unprecedented third term, I think, then we could maybe see a change towards a more living with the virus approach in China as we've seen elsewhere. This also gives a bit of a chance to roll out boosters to the over 60s, assuring that the kind of vaccination amongst that more vulnerable age group is kind of ensured.
I mean, I think, you know, Omicron clearly has got lower virulence, lower incidence of kind of death, and severe health complications. But, you know, I think we've got quite an unfortunate and stark lesson there from Hong Kong. And if you sort of applied, I guess, kind of the mortality rates from that or even more cautious mortality rates, given a slightly higher vaccination rate to the mainland China, we could be talking about awful lot of deaths, unfortunately, perhaps in the kind of region of around about 1.5 million.
Now, China's got a lot of people around 1.4 billion, that's still relatively low scale to population. But I think just the absolute numbers here are potentially a difficult one for the authorities to tolerate, particularly in the run up to kind of the 20th Party Congress. I mean, there's also risks, I think, here on the kind of other side, so while we don't think its very likely will be an easing before the 20th Party Congress. There is, I think, some risk here, the desire for going to zero actually persists for even longer. So if, for example, the authorities really want to roll out domestically made mRNA technology, well, you know, then we could really be pushing back kind of zero COVID policy being maintained well into kind of 2023. And that could come with, frankly, quite a large economic cost, in terms of, you know, just a need to - even if we hold even if we avoid the kind of Shanghai type situation, I think the need to kind of preemptively react aggressively to relatively small case numbers in cities given how transmissible Omicron is, that kind of suggests we could just be in line for a relatively kind of large number of restrictions being put in place, even if you know, the absolute cost or disruption isn't, you know, hopefully, as large as what we're seeing, or what we have seen in in Shanghai there.
Nick:Let's move on to inflation. First question here, and certainly a question that clients have been asking is, it's really on the inflationary pressures that we're seeing in the world of a moment, and a lot of these inflationary pressures are coming from the supply side. So, the conflict between Russia and Ukraine and the supply chain disruption, that that's causing and supply of crops and food and the like. And then also, these lockdowns in China are now causing some issues with supply chain there. So, what essentially can be done there, you know, in terms of the Fed raising rates in order to try and resolve a supply side issue? That it sounds like, it will inevitably result in quite a meaningful demand slowdown and likely to push the US at least into recession and cause quite significant global economic slowdown.
Bob:Yeah, I think it's kind of an interesting one, in a couple of dimensions there. So first of all, the framework that the Fed introduced before the pandemic, average inflation targeting was clearly kind of touted as bringing with it some kind of supply side benefit. So you know, for example, you run the economy a little bit hotter, you can bring in more workers, you know, you lower the cost of financing for firms, in theory you can spur a bit more investment there in machinery, software, you increase your supply capacity. But I think now, we're just in a situation where those kind of supply demand imbalances, as you've described, they need to be brought down much more aggressively given where cap inflation is and that really needs to be kind of, by taking some of the heat out of the demand side of the economy, there's really very little the Fed can really do to kind to meaningfully influence the supply side, particularly in the kind of short run when you're faced with such unusual dynamics around kind of goods and services demand within the economy, huge shifts there, working from home curtailed opportunities to go out and spend on services, clearly then also, you're limiting you know, your ability to consume goods to some extent, just because the supply chain bottlenecks, semi conductor shortages, all those sort of things really kind combine into some sort of perfect storm. So I think we're clearly beyond the point where the kind of running an economy hot, kind of brings benefits given you know, where, where core inflation is. So ultimately, you know, the Fed can bring this imbalance between supply and demand back into line. But the process of doing so really runs a very dangerous gauntlet, you know, everything from the kind of, I guess, the benign, kind of relatively painless process to more of an inducing resection, as they had to do in the 1980s to kind of bring inflation back down fairly sharply.
Nick:And so do you think that the primary concern is likely to shift to growth at some stage from inflation? Or do you think, actually, even if the economy goes into recession, inflation will be the primary concern?
Bob:Yeah. Unfortunately, I think your inflation is going to be still a key concern. But I think you're right, actually, in many ways, markets have become increasingly concerned about recession risk already. And I think that's been feeding into why we've seen such kind of brutal sell offs across, you know, both bonds and equities, kind of unusual combination there.
I mean, you know, it is possible, we end up with a slightly more benign scenario, Chair Powell, at one of the press conferences a few months ago, noted a few soft landings that the Fed has been able to pull off, such as in ‘94. But the ‘94 hiking cycle, and others kind of didn't really have any of the kind of characteristics or dynamics of the kind of COVID shock and recovery that we're living through the moment. So, there's a real tight rope here, I feel.
On the one side, there's this risk of not acting aggressively enough, then having to actually hike rates much more aggressively at a later date. On the other hand, it could turn out that the Fed over tightens too. Now, I know we're not allowed to see transitory with regards to inflation anymore. But you know, if we did find out the inflation is somewhat less persistent, we could find out the policy tightening has kind of done too much in the face of kind of multiple price level shocks. And dare I say it, some degree of transitoriness within the reopening dynamics, too.
And you know, I think there's also some extent, there's that old adage that high prices solve high prices - that could kick in. So, you know, higher prices do squeeze real incomes, they can also encourage supply to come back on streams, you know, your service sector is charging higher prices, airlines are charging much more for holidays, you know, that can bring more aeroplanes back on onto the system. So, there is this risk, I think, you know, tightening dynamic just goes too far and expunging demand from the system. So really amplifying, that kind of business inflation cycle.
Now, I remember, you know, Governor King of the Bank of England used to describe the 2000s as they call the ‘nice decade’, which stood for non-inflationary consistently expansionary - it could just be that you know, we've entered a much more kind of volatile economic environment with reference to kind of activity and also the policy dynamic there. I'm sure there's some sort of nasty acronym, which maybe evades me at the moment. But you know, we at the research institutes certainly put the recession risks as exceptionally elevated, perhaps in the region, sort of 30 to 50%. And it's going to be a key focus for us in our upcoming forecast round two, as to whether in fact, we actually put a US recession in as our central case. So still to be debated. But, you know, one to definitely have on your radar.
Nick:Okay, yeah. And I suppose bringing it back to the emerging markets. What's been striking about this cycle is just how quick a lot of emerging markets were to raise rates in the face of inflationary pressure, you know, happening quarters before the Fed started talking about tapering or raising rates. So how does the cycle look in emerging markets? And is there scope for maybe easing in emerging markets a bit earlier?
Bob:Yeah. Quite, quite possibly. I mean, you know, markets are often thinking about inflation very much to develop market lens, really focusing in there on the US. But yes, as you can alluded to the swings, could be operating in a slightly different frequency, and perhaps be even more stark for some emerging markets.
I probably say, you know, we quite often group emerging markets into two to one bucket. But clearly, it runs a huge spectrum of very different economies, operating and kind of very different environments. So, I'd probably kind of distinguish here between two regions kind of bookending the spectrum if you will, so LATAN being on the more aggressive side, as you say having front run the hiking cycle and kind of Asia, on the other hand, not really feeling as much pressure to kind of hike rates. Now, you mentioned there before LATAN had actually already tightened very aggressively. So the Brazilian central banks already raised rates by over 10 percentage points. Our modelling does suggest there is some risk here without higher degree of kind of persistence of an underlying inflation within Brazil that could keep inflation maybe a bit more uncomfortably high over the course of this year.
But we also think maybe the markets are underestimating, do we have tightening, that's actually already going through the economy, it's not just across the monetary side, fiscal dynamics can be, can be much less supportive, too. So you know, we might well see inflation coming down a bit more sharply going into next year, that could kind of then open up that space for emerging markets, which is time to start, start taking their foot off the brakes. And, you know, giving the economy a little bit more support, then. And then you're just to wrap up their - Asia is in a very different place, shouldn't be grouping everyone together, you know, low inflation in many Asian economies plus later reopening has allowed kind of central banks to tighten by less thus far. In some emerging markets, central banks in Asia are only just beginning, their kind of tightening moves. And we think generally, those could actually remain still quite, quite modest. So, a couple of countries such as India, standout with quite high core inflation, but actually remains the case that there's many large emerging market countries in Asia, where core inflation actually remains kind of well below rates that we think of as being consistent with their inflation targets. So, you know, I think, in that sense, kind of suggests inflation will not be the kind of defining issue that it has become in the West, particularly in Asia.
Nick:Okay, great. Well, thanks. I feel like we should probably end it there on that more positive note towards emerging markets. So, with that, I'd like to thank my guest, Bob, thanks very much for joining today.
Bob:Thanks, Nick.
Bob:Great. Thanks, Nick. Thanks for having me on.
Nick:It’s great to have you on. So let's get started on Russia. So, with Russia, we're a few months into the conflict now. And we've seen a steady escalation with no ceasefire in sight. You know, I think we're all pretty familiar with some of the first order impacts of the conflict, the terrible loss to human life, the disruption to supply chains that we've seen that’s lead to some inflation, and we'll talk about that a bit later. But I really wanted to ask you a bit about some of the other impacts the second order impacts of this conflict that are perhaps a bit less well considered. So perhaps starting with the freezing of US dollar reserves that the Russian Central Bank and what extent that could change the shape of central bank reserves going forward? And the impact that possibly that could have?
Bob:Yeah, it's a great question. I think probably for most countries, reserves are still going to effectively remain in US dollars. I mean, why do we want reserves or why central banks want reserves? For the most part, it's a kind of insurance policy against currency crises. And clearly, you know, as well as being a kind of technocratic reason guarding against kind of currency crises. There's also sometimes the domestic political reason, not wanting to go kind of cap in hand, to the IMF still provides a rationale for kind of holding a reasonable amount of reserves, even if your currency is actually moved to be more floating than fixed, as was in the case in the Asia financial crisis.
US dollars will provide a lot of liquidity in the global financial system that just to be honest, is quite hard to replace with other currencies. So, if you were a country worried about, you know, sanction risk, having watched what's happened to Russia’s Central Bank, I think there's a question of kind of where else do you go? So, sanction risk could be just as high in Euros, for example, other markets outside of the West may just kind of not be deep and liquid enough.
Potentially, over time, I guess this could accelerate moves away from the US dollar, you know, maybe encourage some degree of regionalization of financial systems to. It could renew, for example, a bit of interest in the Chinese authorities pushing Renminbi, internationalization. Potentially, we could see a few more steps, I think, coming to promote its own homegrown payments transfer network. So that's the cross border, interbank payment system, the SIPS, rather than kind of relying on the SWIFT network. And we've kind of seen how damaging that has been to the Russian economy more recently. But you know, I think we need to bear in mind historical lessons suggests that there's going to be a long time before China probably is able to supplant the US dollar, and really kind of internationalise. The US economy, for example, was way bigger than the British economy when the when the dollar became the reserve currency for the world.
Nick:Thanks. I think you've made an interesting point before about how, after a country loses its primacy in terms of the world order, it takes a while for currencies to adjust or central bank currencies to adjust to that and the pound was a global reserve currency for a lot longer after the fall of British Empire.
Bob:Yeah, exactly. That's pretty much exactly how that happened. I think it was 40,50 years probably for the dollar to kind of overtake the pound despite the British economy’s kind of dwindling importance in the world economy there. So I think that triangulation that you can go through the dollar from any currency. That kind of liquidity advantages just means it's there's a lot of inertia to overcome, potentially in the global financial system. Yeah.
Nick:Okay, thanks for that. And then another thing I wanted to ask you about was the very broad sanctioning of individuals from Russia, who have made their wealth by being associated with Putin and essentially essential suspension of property rights for those individuals. Could that have an impact in terms of future sanctions on people who is perceived to be close to other bad acting dictators?
Bob:Yep, potentially, it's a difficult one to know, it's a difficult one to know for sure. I think maybe some people will be thinking twice. So is this a kind of a rewriting of the rules of the International Monetary financial system? Where can money go that is deemed to be kind of safe? Could the margin, influence some capital flows or kind of individual decisions there. I guess it's kind of question about whether you think sanctions are kind of the genie that's out of the bottle now. And could, I guess, views or perceptions about kind of more minor transgressions, ultimately end up kind of limiting flows, limiting investments, maybe by individuals too, worried about their ability to, to retain ownership. So it's kind of not just about yachts and the like, kind of investment in kind of companies abroad too, could potentially kind of suffer. From economic point of view, because we were wondering about whether this is significant enough to really cause some sort of damage to kind of economic efficiency and, and kind of capital flows. But yeah, maybe those who are cozying up to autocrats might be feeling a little bit more nervous than they were, until Russian sanctions started getting on.
Nick:And then moving on to China. Early on in the Russia, Ukraine conflict, the link was made to China and Taiwan, and the potential for unification to occur at some point in the future by, by potentially by force, do you think that's more or less likely now, given what we've seen in Russia?
Bob:Yeah, it's a difficult one, I think Russia's invasion of Ukraine or hasn't kind of materially changed our view of Taiwan risks there. So I mean, it's still, of course, possible that missteps lead, I think, to conflict over Taiwan, you know, the US is, of course, running a policy of quote, unquote, ‘strategic ambiguity’. So there's a possibility that this leads to kind of missteps or contributes to missteps by either side, those who like that kind of game theory, would know the ‘trembling hand’ equilibrium were kind of mistakes on either sides could potentially force you into kind of positions you didn't, didn't want to be in.
I mean, one could potentially imagine scenarios, which can follow on from Ukraine crisis, which increased the odds either intentionally or unintentionally. So, for example, I don't know - the US was spurred on by what it sees in Ukraine, ramping up sales of advanced weapon systems, China could maybe then react to a kind of closing window of opportunity. So, in this kind of situation, Beijing might conclude that the likelihood of a kind of successful invasion could actually decline rather than rise over time, alongside the kind of steady rise in its military prowess, the size of its economy, and the like.
And I guess, before the Ukraine invasion, US withdrawal from Afghanistan, might have led, you know, Beijing to doubt the US commitment to his allies too. But I think, you know, the strength of the Western response more recently, probably counters that narrative. But I think, you know, overall, why, why we're not really very concerned about this risk, or we think this risk has often been overstated, by many commentators and markets. You need to really think about kind of the whether the authorities in China will really be willing to take such a risk. So even if conflict over Taiwan was somehow avoided, the US didn't opt to intervene. Now, if it did, that could clearly be catastrophic – for not just China and the US, but kind of worldwide.
The potential cost I think to China now just seems much higher, given the Western sanctions went further than anyone expected. China is also much more integrated into the west than Russia is. So, the economic damage from western sanctions, the dismantling of Western supply chains, could be an order of magnitude higher for China. And then I think it's also important to distinguish between the short and the long run here. Much of China's kind of long run, both kind of hard as military power and also it's kind of soft political power, is directly related to the size of its economy. So why would you be willing to jeopardise that, at this, at this stage? It's still possible, of course, I think, you know, over the medium to long run risks are likely to rise. As I said, before, you know, China's military is certainly growing in kind of both size and I think sophistication, too, we do expect some continued deterioration in US China relations. But it's not really clear I think, that Ukraine kind of changes the trajectory of that kind of distribution of risks alongside it.
Nick:Yeah, that's interesting, I suppose one thing you mentioned about Russia, and essentially the excommunication of the Russian financial system from most of the rest of the global financial system is something that gives us a bit of comfort on China, in that, the private sector has been a really big driver of a lot of China's economic growth over the last decade, and the private sector is very much reliant on capital markets to fund that growth. So, I suppose my question would be, can China still continue with the target level of growth without access to global capital markets?
Nick:Yeah, it's a tough one that. I think if it was to lose access to the dollar base global financial system, it could be extremely damaging. I guess I probably put capital markets under kind of like, a broader umbrella of kind of China's development model here. You know, within that, you know, trade, the ability to kind of sell to the west. There's obviously the knowledge transfer that comes with foreign direct investment, and also just a heightened competition that helps kind of spur on innovation amongst its private sector, as you kind of mentioned there that's become increasingly important within the economy over the last sort of 15,20 years.
I mean, there's a similar aspect, I think that applies to capital markets. And, you know, generally tend to think that the private firms in China are being very careful to adhere to Western sanctions, they really don't want to be hit by secondary sanctions, to be seen to be helping Russia evade sanctions in any way.
On the other hand, I think you also need to kind of think about the kind of more fundamental needs of any country such as China's, kind of infrastructure and kind of financing needs. You know, China has been running a lot of current surplus for many years now. In essence, you know, that tells you that national savings are above national investments. You've also got an asymmetric capital account opening, meaning that domestic savings are still largely kind of trapped in China. So, these sort of things kind of reduce, I guess, the, the essentialness of access to the global financial markets, but you know, competition and finance, the ability for financial flows to go in and out of China helping FDI, finance just helping China’s financial deepening. Over time, I think this should help improve risk pricing will reduce those risks, around capital misallocation. That could be a big barrier to China breaking the middle-income trap.
And really one example of this. I think there were some steps in April to kind of clarify the audit rules. So, to reduce the risks of Chinese firms actually being delisted from the New York Stock Exchange. I don't think we're 100% there in that kind of the delisting risk. But you know, I think there are some kind of positive steps in the right direction, you know, at least one indication that the Chinese authorities do take that capital market access pretty seriously.
Nick:Yeah, we saw that, that rule change back in April. And that gave us a fair bit of comfort that China was taking steps in terms of making sure that capital market access wasn't limited. And we took that as a fairly significant step forward, given you know, that that issue has been kind of locked for, for quite a while. And I suppose it also comes down to the issue that China has enough problems at the moment without adding capital markets back to the list. And maybe I'd like to touch on that which is, what we're hearing from companies at the moment on the ground in China is that 2022 is worse than 2020 in terms of disruption from COVID due to this zero COVID policy, coming at a time when other economies have more or less opened up. What's your take on how long this policy is likely to last?
Bob:Yeah, it's a great question. It's a really tough call, I think and you know, it's a key part of our, our China and global economic forecasts, actually, you know, for that matter. To me always has a bit of a feel of kind of forecasting how long untenable strategy last, I think best guess at the moment is zero COVID, is probably going to continue and it's in its current guise. So at least until the 20th Party Congress - at that point President Xi will, kind of secure his unprecedented third term, I think, then we could maybe see a change towards a more living with the virus approach in China as we've seen elsewhere. This also gives a bit of a chance to roll out boosters to the over 60s, assuring that the kind of vaccination amongst that more vulnerable age group is kind of ensured.
I mean, I think, you know, Omicron clearly has got lower virulence, lower incidence of kind of death, and severe health complications. But, you know, I think we've got quite an unfortunate and stark lesson there from Hong Kong. And if you sort of applied, I guess, kind of the mortality rates from that or even more cautious mortality rates, given a slightly higher vaccination rate to the mainland China, we could be talking about awful lot of deaths, unfortunately, perhaps in the kind of region of around about 1.5 million.
Now, China's got a lot of people around 1.4 billion, that's still relatively low scale to population. But I think just the absolute numbers here are potentially a difficult one for the authorities to tolerate, particularly in the run up to kind of the 20th Party Congress. I mean, there's also risks, I think, here on the kind of other side, so while we don't think its very likely will be an easing before the 20th Party Congress. There is, I think, some risk here, the desire for going to zero actually persists for even longer. So if, for example, the authorities really want to roll out domestically made mRNA technology, well, you know, then we could really be pushing back kind of zero COVID policy being maintained well into kind of 2023. And that could come with, frankly, quite a large economic cost, in terms of, you know, just a need to - even if we hold even if we avoid the kind of Shanghai type situation, I think the need to kind of preemptively react aggressively to relatively small case numbers in cities given how transmissible Omicron is, that kind of suggests we could just be in line for a relatively kind of large number of restrictions being put in place, even if you know, the absolute cost or disruption isn't, you know, hopefully, as large as what we're seeing, or what we have seen in in Shanghai there.
Nick:Let's move on to inflation. First question here, and certainly a question that clients have been asking is, it's really on the inflationary pressures that we're seeing in the world of a moment, and a lot of these inflationary pressures are coming from the supply side. So, the conflict between Russia and Ukraine and the supply chain disruption, that that's causing and supply of crops and food and the like. And then also, these lockdowns in China are now causing some issues with supply chain there. So, what essentially can be done there, you know, in terms of the Fed raising rates in order to try and resolve a supply side issue? That it sounds like, it will inevitably result in quite a meaningful demand slowdown and likely to push the US at least into recession and cause quite significant global economic slowdown.
Bob:Yeah, I think it's kind of an interesting one, in a couple of dimensions there. So first of all, the framework that the Fed introduced before the pandemic, average inflation targeting was clearly kind of touted as bringing with it some kind of supply side benefit. So you know, for example, you run the economy a little bit hotter, you can bring in more workers, you know, you lower the cost of financing for firms, in theory you can spur a bit more investment there in machinery, software, you increase your supply capacity. But I think now, we're just in a situation where those kind of supply demand imbalances, as you've described, they need to be brought down much more aggressively given where cap inflation is and that really needs to be kind of, by taking some of the heat out of the demand side of the economy, there's really very little the Fed can really do to kind to meaningfully influence the supply side, particularly in the kind of short run when you're faced with such unusual dynamics around kind of goods and services demand within the economy, huge shifts there, working from home curtailed opportunities to go out and spend on services, clearly then also, you're limiting you know, your ability to consume goods to some extent, just because the supply chain bottlenecks, semi conductor shortages, all those sort of things really kind combine into some sort of perfect storm. So I think we're clearly beyond the point where the kind of running an economy hot, kind of brings benefits given you know, where, where core inflation is. So ultimately, you know, the Fed can bring this imbalance between supply and demand back into line. But the process of doing so really runs a very dangerous gauntlet, you know, everything from the kind of, I guess, the benign, kind of relatively painless process to more of an inducing resection, as they had to do in the 1980s to kind of bring inflation back down fairly sharply.
Nick:And so do you think that the primary concern is likely to shift to growth at some stage from inflation? Or do you think, actually, even if the economy goes into recession, inflation will be the primary concern?
Bob:Yeah. Unfortunately, I think your inflation is going to be still a key concern. But I think you're right, actually, in many ways, markets have become increasingly concerned about recession risk already. And I think that's been feeding into why we've seen such kind of brutal sell offs across, you know, both bonds and equities, kind of unusual combination there.
I mean, you know, it is possible, we end up with a slightly more benign scenario, Chair Powell, at one of the press conferences a few months ago, noted a few soft landings that the Fed has been able to pull off, such as in ‘94. But the ‘94 hiking cycle, and others kind of didn't really have any of the kind of characteristics or dynamics of the kind of COVID shock and recovery that we're living through the moment. So, there's a real tight rope here, I feel.
On the one side, there's this risk of not acting aggressively enough, then having to actually hike rates much more aggressively at a later date. On the other hand, it could turn out that the Fed over tightens too. Now, I know we're not allowed to see transitory with regards to inflation anymore. But you know, if we did find out the inflation is somewhat less persistent, we could find out the policy tightening has kind of done too much in the face of kind of multiple price level shocks. And dare I say it, some degree of transitoriness within the reopening dynamics, too.
And you know, I think there's also some extent, there's that old adage that high prices solve high prices - that could kick in. So, you know, higher prices do squeeze real incomes, they can also encourage supply to come back on streams, you know, your service sector is charging higher prices, airlines are charging much more for holidays, you know, that can bring more aeroplanes back on onto the system. So, there is this risk, I think, you know, tightening dynamic just goes too far and expunging demand from the system. So really amplifying, that kind of business inflation cycle.
Now, I remember, you know, Governor King of the Bank of England used to describe the 2000s as they call the ‘nice decade’, which stood for non-inflationary consistently expansionary - it could just be that you know, we've entered a much more kind of volatile economic environment with reference to kind of activity and also the policy dynamic there. I'm sure there's some sort of nasty acronym, which maybe evades me at the moment. But you know, we at the research institutes certainly put the recession risks as exceptionally elevated, perhaps in the region, sort of 30 to 50%. And it's going to be a key focus for us in our upcoming forecast round two, as to whether in fact, we actually put a US recession in as our central case. So still to be debated. But, you know, one to definitely have on your radar.
Nick:Okay, yeah. And I suppose bringing it back to the emerging markets. What's been striking about this cycle is just how quick a lot of emerging markets were to raise rates in the face of inflationary pressure, you know, happening quarters before the Fed started talking about tapering or raising rates. So how does the cycle look in emerging markets? And is there scope for maybe easing in emerging markets a bit earlier?
Bob:Yeah. Quite, quite possibly. I mean, you know, markets are often thinking about inflation very much to develop market lens, really focusing in there on the US. But yes, as you can alluded to the swings, could be operating in a slightly different frequency, and perhaps be even more stark for some emerging markets.
I probably say, you know, we quite often group emerging markets into two to one bucket. But clearly, it runs a huge spectrum of very different economies, operating and kind of very different environments. So, I'd probably kind of distinguish here between two regions kind of bookending the spectrum if you will, so LATAN being on the more aggressive side, as you say having front run the hiking cycle and kind of Asia, on the other hand, not really feeling as much pressure to kind of hike rates. Now, you mentioned there before LATAN had actually already tightened very aggressively. So the Brazilian central banks already raised rates by over 10 percentage points. Our modelling does suggest there is some risk here without higher degree of kind of persistence of an underlying inflation within Brazil that could keep inflation maybe a bit more uncomfortably high over the course of this year.
But we also think maybe the markets are underestimating, do we have tightening, that's actually already going through the economy, it's not just across the monetary side, fiscal dynamics can be, can be much less supportive, too. So you know, we might well see inflation coming down a bit more sharply going into next year, that could kind of then open up that space for emerging markets, which is time to start, start taking their foot off the brakes. And, you know, giving the economy a little bit more support, then. And then you're just to wrap up their - Asia is in a very different place, shouldn't be grouping everyone together, you know, low inflation in many Asian economies plus later reopening has allowed kind of central banks to tighten by less thus far. In some emerging markets, central banks in Asia are only just beginning, their kind of tightening moves. And we think generally, those could actually remain still quite, quite modest. So, a couple of countries such as India, standout with quite high core inflation, but actually remains the case that there's many large emerging market countries in Asia, where core inflation actually remains kind of well below rates that we think of as being consistent with their inflation targets. So, you know, I think, in that sense, kind of suggests inflation will not be the kind of defining issue that it has become in the West, particularly in Asia.
Nick:Okay, great. Well, thanks. I feel like we should probably end it there on that more positive note towards emerging markets. So, with that, I'd like to thank my guest, Bob, thanks very much for joining today.
Bob:Thanks, Nick.
Podcast
Nick Robinson: Hello, everybody and welcome to the abrdn Emerging Markets Equity Podcast. I'm Nick Robinson from the emerging market equity team. In this podcast series, we explore the factors that underpin our thinking on emerging markets. From key individuals to evolving trends, we seek to answer the five W's who, what, where, when, and why, that are shaping investment opportunities in the region. In today's episode, we're going to discuss the energy transition, and how this is impacting the investment landscape in emerging markets. Regular listeners will know we've discussed renewables several times, we've also talked about the ESG issues that are accelerating the transition. But we've not really brought that together yet to talk about the challenges of the transition, and particularly what this means for some of the legacy hydrocarbon producers. And it's worth remembering that the world still relies on hydrocarbons for over 80% of its energy requirements. And that percentage is likely to be pretty large for a number of years going forward. So joining me today to tackle this subject is my colleague, William Scholes. Well, welcome to the podcast. How are you?
Bob:Great. Thanks, Nick. Thanks for having me on.
Nick:It’s great to have you on. So let's get started on Russia. So, with Russia, we're a few months into the conflict now. And we've seen a steady escalation with no ceasefire in sight. You know, I think we're all pretty familiar with some of the first order impacts of the conflict, the terrible loss to human life, the disruption to supply chains that we've seen that’s lead to some inflation, and we'll talk about that a bit later. But I really wanted to ask you a bit about some of the other impacts the second order impacts of this conflict that are perhaps a bit less well considered. So perhaps starting with the freezing of US dollar reserves that the Russian Central Bank and what extent that could change the shape of central bank reserves going forward? And the impact that possibly that could have?
Bob:Yeah, it's a great question. I think probably for most countries, reserves are still going to effectively remain in US dollars. I mean, why do we want reserves or why central banks want reserves? For the most part, it's a kind of insurance policy against currency crises. And clearly, you know, as well as being a kind of technocratic reason guarding against kind of currency crises. There's also sometimes the domestic political reason, not wanting to go kind of cap in hand, to the IMF still provides a rationale for kind of holding a reasonable amount of reserves, even if your currency is actually moved to be more floating than fixed, as was in the case in the Asia financial crisis.
US dollars will provide a lot of liquidity in the global financial system that just to be honest, is quite hard to replace with other currencies. So, if you were a country worried about, you know, sanction risk, having watched what's happened to Russia’s Central Bank, I think there's a question of kind of where else do you go? So, sanction risk could be just as high in Euros, for example, other markets outside of the West may just kind of not be deep and liquid enough.
Potentially, over time, I guess this could accelerate moves away from the US dollar, you know, maybe encourage some degree of regionalization of financial systems to. It could renew, for example, a bit of interest in the Chinese authorities pushing Renminbi, internationalization. Potentially, we could see a few more steps, I think, coming to promote its own homegrown payments transfer network. So that's the cross border, interbank payment system, the SIPS, rather than kind of relying on the SWIFT network. And we've kind of seen how damaging that has been to the Russian economy more recently. But you know, I think we need to bear in mind historical lessons suggests that there's going to be a long time before China probably is able to supplant the US dollar, and really kind of internationalise. The US economy, for example, was way bigger than the British economy when the when the dollar became the reserve currency for the world.
Nick:Thanks. I think you've made an interesting point before about how, after a country loses its primacy in terms of the world order, it takes a while for currencies to adjust or central bank currencies to adjust to that and the pound was a global reserve currency for a lot longer after the fall of British Empire.
Bob:Yeah, exactly. That's pretty much exactly how that happened. I think it was 40,50 years probably for the dollar to kind of overtake the pound despite the British economy’s kind of dwindling importance in the world economy there. So I think that triangulation that you can go through the dollar from any currency. That kind of liquidity advantages just means it's there's a lot of inertia to overcome, potentially in the global financial system. Yeah.
Nick:Okay, thanks for that. And then another thing I wanted to ask you about was the very broad sanctioning of individuals from Russia, who have made their wealth by being associated with Putin and essentially essential suspension of property rights for those individuals. Could that have an impact in terms of future sanctions on people who is perceived to be close to other bad acting dictators?
Bob:Yep, potentially, it's a difficult one to know, it's a difficult one to know for sure. I think maybe some people will be thinking twice. So is this a kind of a rewriting of the rules of the International Monetary financial system? Where can money go that is deemed to be kind of safe? Could the margin, influence some capital flows or kind of individual decisions there. I guess it's kind of question about whether you think sanctions are kind of the genie that's out of the bottle now. And could, I guess, views or perceptions about kind of more minor transgressions, ultimately end up kind of limiting flows, limiting investments, maybe by individuals too, worried about their ability to, to retain ownership. So it's kind of not just about yachts and the like, kind of investment in kind of companies abroad too, could potentially kind of suffer. From economic point of view, because we were wondering about whether this is significant enough to really cause some sort of damage to kind of economic efficiency and, and kind of capital flows. But yeah, maybe those who are cozying up to autocrats might be feeling a little bit more nervous than they were, until Russian sanctions started getting on.
Nick:And then moving on to China. Early on in the Russia, Ukraine conflict, the link was made to China and Taiwan, and the potential for unification to occur at some point in the future by, by potentially by force, do you think that's more or less likely now, given what we've seen in Russia?
Bob:Yeah, it's a difficult one, I think Russia's invasion of Ukraine or hasn't kind of materially changed our view of Taiwan risks there. So I mean, it's still, of course, possible that missteps lead, I think, to conflict over Taiwan, you know, the US is, of course, running a policy of quote, unquote, ‘strategic ambiguity’. So there's a possibility that this leads to kind of missteps or contributes to missteps by either side, those who like that kind of game theory, would know the ‘trembling hand’ equilibrium were kind of mistakes on either sides could potentially force you into kind of positions you didn't, didn't want to be in.
I mean, one could potentially imagine scenarios, which can follow on from Ukraine crisis, which increased the odds either intentionally or unintentionally. So, for example, I don't know - the US was spurred on by what it sees in Ukraine, ramping up sales of advanced weapon systems, China could maybe then react to a kind of closing window of opportunity. So, in this kind of situation, Beijing might conclude that the likelihood of a kind of successful invasion could actually decline rather than rise over time, alongside the kind of steady rise in its military prowess, the size of its economy, and the like.
And I guess, before the Ukraine invasion, US withdrawal from Afghanistan, might have led, you know, Beijing to doubt the US commitment to his allies too. But I think, you know, the strength of the Western response more recently, probably counters that narrative. But I think, you know, overall, why, why we're not really very concerned about this risk, or we think this risk has often been overstated, by many commentators and markets. You need to really think about kind of the whether the authorities in China will really be willing to take such a risk. So even if conflict over Taiwan was somehow avoided, the US didn't opt to intervene. Now, if it did, that could clearly be catastrophic – for not just China and the US, but kind of worldwide.
The potential cost I think to China now just seems much higher, given the Western sanctions went further than anyone expected. China is also much more integrated into the west than Russia is. So, the economic damage from western sanctions, the dismantling of Western supply chains, could be an order of magnitude higher for China. And then I think it's also important to distinguish between the short and the long run here. Much of China's kind of long run, both kind of hard as military power and also it's kind of soft political power, is directly related to the size of its economy. So why would you be willing to jeopardise that, at this, at this stage? It's still possible, of course, I think, you know, over the medium to long run risks are likely to rise. As I said, before, you know, China's military is certainly growing in kind of both size and I think sophistication, too, we do expect some continued deterioration in US China relations. But it's not really clear I think, that Ukraine kind of changes the trajectory of that kind of distribution of risks alongside it.
Nick:Yeah, that's interesting, I suppose one thing you mentioned about Russia, and essentially the excommunication of the Russian financial system from most of the rest of the global financial system is something that gives us a bit of comfort on China, in that, the private sector has been a really big driver of a lot of China's economic growth over the last decade, and the private sector is very much reliant on capital markets to fund that growth. So, I suppose my question would be, can China still continue with the target level of growth without access to global capital markets?
Nick:Yeah, it's a tough one that. I think if it was to lose access to the dollar base global financial system, it could be extremely damaging. I guess I probably put capital markets under kind of like, a broader umbrella of kind of China's development model here. You know, within that, you know, trade, the ability to kind of sell to the west. There's obviously the knowledge transfer that comes with foreign direct investment, and also just a heightened competition that helps kind of spur on innovation amongst its private sector, as you kind of mentioned there that's become increasingly important within the economy over the last sort of 15,20 years.
I mean, there's a similar aspect, I think that applies to capital markets. And, you know, generally tend to think that the private firms in China are being very careful to adhere to Western sanctions, they really don't want to be hit by secondary sanctions, to be seen to be helping Russia evade sanctions in any way.
On the other hand, I think you also need to kind of think about the kind of more fundamental needs of any country such as China's, kind of infrastructure and kind of financing needs. You know, China has been running a lot of current surplus for many years now. In essence, you know, that tells you that national savings are above national investments. You've also got an asymmetric capital account opening, meaning that domestic savings are still largely kind of trapped in China. So, these sort of things kind of reduce, I guess, the, the essentialness of access to the global financial markets, but you know, competition and finance, the ability for financial flows to go in and out of China helping FDI, finance just helping China’s financial deepening. Over time, I think this should help improve risk pricing will reduce those risks, around capital misallocation. That could be a big barrier to China breaking the middle-income trap.
And really one example of this. I think there were some steps in April to kind of clarify the audit rules. So, to reduce the risks of Chinese firms actually being delisted from the New York Stock Exchange. I don't think we're 100% there in that kind of the delisting risk. But you know, I think there are some kind of positive steps in the right direction, you know, at least one indication that the Chinese authorities do take that capital market access pretty seriously.
Nick:Yeah, we saw that, that rule change back in April. And that gave us a fair bit of comfort that China was taking steps in terms of making sure that capital market access wasn't limited. And we took that as a fairly significant step forward, given you know, that that issue has been kind of locked for, for quite a while. And I suppose it also comes down to the issue that China has enough problems at the moment without adding capital markets back to the list. And maybe I'd like to touch on that which is, what we're hearing from companies at the moment on the ground in China is that 2022 is worse than 2020 in terms of disruption from COVID due to this zero COVID policy, coming at a time when other economies have more or less opened up. What's your take on how long this policy is likely to last?
Bob:Yeah, it's a great question. It's a really tough call, I think and you know, it's a key part of our, our China and global economic forecasts, actually, you know, for that matter. To me always has a bit of a feel of kind of forecasting how long untenable strategy last, I think best guess at the moment is zero COVID, is probably going to continue and it's in its current guise. So at least until the 20th Party Congress - at that point President Xi will, kind of secure his unprecedented third term, I think, then we could maybe see a change towards a more living with the virus approach in China as we've seen elsewhere. This also gives a bit of a chance to roll out boosters to the over 60s, assuring that the kind of vaccination amongst that more vulnerable age group is kind of ensured.
I mean, I think, you know, Omicron clearly has got lower virulence, lower incidence of kind of death, and severe health complications. But, you know, I think we've got quite an unfortunate and stark lesson there from Hong Kong. And if you sort of applied, I guess, kind of the mortality rates from that or even more cautious mortality rates, given a slightly higher vaccination rate to the mainland China, we could be talking about awful lot of deaths, unfortunately, perhaps in the kind of region of around about 1.5 million.
Now, China's got a lot of people around 1.4 billion, that's still relatively low scale to population. But I think just the absolute numbers here are potentially a difficult one for the authorities to tolerate, particularly in the run up to kind of the 20th Party Congress. I mean, there's also risks, I think, here on the kind of other side, so while we don't think its very likely will be an easing before the 20th Party Congress. There is, I think, some risk here, the desire for going to zero actually persists for even longer. So if, for example, the authorities really want to roll out domestically made mRNA technology, well, you know, then we could really be pushing back kind of zero COVID policy being maintained well into kind of 2023. And that could come with, frankly, quite a large economic cost, in terms of, you know, just a need to - even if we hold even if we avoid the kind of Shanghai type situation, I think the need to kind of preemptively react aggressively to relatively small case numbers in cities given how transmissible Omicron is, that kind of suggests we could just be in line for a relatively kind of large number of restrictions being put in place, even if you know, the absolute cost or disruption isn't, you know, hopefully, as large as what we're seeing, or what we have seen in in Shanghai there.
Nick:Let's move on to inflation. First question here, and certainly a question that clients have been asking is, it's really on the inflationary pressures that we're seeing in the world of a moment, and a lot of these inflationary pressures are coming from the supply side. So, the conflict between Russia and Ukraine and the supply chain disruption, that that's causing and supply of crops and food and the like. And then also, these lockdowns in China are now causing some issues with supply chain there. So, what essentially can be done there, you know, in terms of the Fed raising rates in order to try and resolve a supply side issue? That it sounds like, it will inevitably result in quite a meaningful demand slowdown and likely to push the US at least into recession and cause quite significant global economic slowdown.
Bob:Yeah, I think it's kind of an interesting one, in a couple of dimensions there. So first of all, the framework that the Fed introduced before the pandemic, average inflation targeting was clearly kind of touted as bringing with it some kind of supply side benefit. So you know, for example, you run the economy a little bit hotter, you can bring in more workers, you know, you lower the cost of financing for firms, in theory you can spur a bit more investment there in machinery, software, you increase your supply capacity. But I think now, we're just in a situation where those kind of supply demand imbalances, as you've described, they need to be brought down much more aggressively given where cap inflation is and that really needs to be kind of, by taking some of the heat out of the demand side of the economy, there's really very little the Fed can really do to kind to meaningfully influence the supply side, particularly in the kind of short run when you're faced with such unusual dynamics around kind of goods and services demand within the economy, huge shifts there, working from home curtailed opportunities to go out and spend on services, clearly then also, you're limiting you know, your ability to consume goods to some extent, just because the supply chain bottlenecks, semi conductor shortages, all those sort of things really kind combine into some sort of perfect storm. So I think we're clearly beyond the point where the kind of running an economy hot, kind of brings benefits given you know, where, where core inflation is. So ultimately, you know, the Fed can bring this imbalance between supply and demand back into line. But the process of doing so really runs a very dangerous gauntlet, you know, everything from the kind of, I guess, the benign, kind of relatively painless process to more of an inducing resection, as they had to do in the 1980s to kind of bring inflation back down fairly sharply.
Nick:And so do you think that the primary concern is likely to shift to growth at some stage from inflation? Or do you think, actually, even if the economy goes into recession, inflation will be the primary concern?
Bob:Yeah. Unfortunately, I think your inflation is going to be still a key concern. But I think you're right, actually, in many ways, markets have become increasingly concerned about recession risk already. And I think that's been feeding into why we've seen such kind of brutal sell offs across, you know, both bonds and equities, kind of unusual combination there.
I mean, you know, it is possible, we end up with a slightly more benign scenario, Chair Powell, at one of the press conferences a few months ago, noted a few soft landings that the Fed has been able to pull off, such as in ‘94. But the ‘94 hiking cycle, and others kind of didn't really have any of the kind of characteristics or dynamics of the kind of COVID shock and recovery that we're living through the moment. So, there's a real tight rope here, I feel.
On the one side, there's this risk of not acting aggressively enough, then having to actually hike rates much more aggressively at a later date. On the other hand, it could turn out that the Fed over tightens too. Now, I know we're not allowed to see transitory with regards to inflation anymore. But you know, if we did find out the inflation is somewhat less persistent, we could find out the policy tightening has kind of done too much in the face of kind of multiple price level shocks. And dare I say it, some degree of transitoriness within the reopening dynamics, too.
And you know, I think there's also some extent, there's that old adage that high prices solve high prices - that could kick in. So, you know, higher prices do squeeze real incomes, they can also encourage supply to come back on streams, you know, your service sector is charging higher prices, airlines are charging much more for holidays, you know, that can bring more aeroplanes back on onto the system. So, there is this risk, I think, you know, tightening dynamic just goes too far and expunging demand from the system. So really amplifying, that kind of business inflation cycle.
Now, I remember, you know, Governor King of the Bank of England used to describe the 2000s as they call the ‘nice decade’, which stood for non-inflationary consistently expansionary - it could just be that you know, we've entered a much more kind of volatile economic environment with reference to kind of activity and also the policy dynamic there. I'm sure there's some sort of nasty acronym, which maybe evades me at the moment. But you know, we at the research institutes certainly put the recession risks as exceptionally elevated, perhaps in the region, sort of 30 to 50%. And it's going to be a key focus for us in our upcoming forecast round two, as to whether in fact, we actually put a US recession in as our central case. So still to be debated. But, you know, one to definitely have on your radar.
Nick:Okay, yeah. And I suppose bringing it back to the emerging markets. What's been striking about this cycle is just how quick a lot of emerging markets were to raise rates in the face of inflationary pressure, you know, happening quarters before the Fed started talking about tapering or raising rates. So how does the cycle look in emerging markets? And is there scope for maybe easing in emerging markets a bit earlier?
Bob:Yeah. Quite, quite possibly. I mean, you know, markets are often thinking about inflation very much to develop market lens, really focusing in there on the US. But yes, as you can alluded to the swings, could be operating in a slightly different frequency, and perhaps be even more stark for some emerging markets.
I probably say, you know, we quite often group emerging markets into two to one bucket. But clearly, it runs a huge spectrum of very different economies, operating and kind of very different environments. So, I'd probably kind of distinguish here between two regions kind of bookending the spectrum if you will, so LATAN being on the more aggressive side, as you say having front run the hiking cycle and kind of Asia, on the other hand, not really feeling as much pressure to kind of hike rates. Now, you mentioned there before LATAN had actually already tightened very aggressively. So the Brazilian central banks already raised rates by over 10 percentage points. Our modelling does suggest there is some risk here without higher degree of kind of persistence of an underlying inflation within Brazil that could keep inflation maybe a bit more uncomfortably high over the course of this year.
But we also think maybe the markets are underestimating, do we have tightening, that's actually already going through the economy, it's not just across the monetary side, fiscal dynamics can be, can be much less supportive, too. So you know, we might well see inflation coming down a bit more sharply going into next year, that could kind of then open up that space for emerging markets, which is time to start, start taking their foot off the brakes. And, you know, giving the economy a little bit more support, then. And then you're just to wrap up their - Asia is in a very different place, shouldn't be grouping everyone together, you know, low inflation in many Asian economies plus later reopening has allowed kind of central banks to tighten by less thus far. In some emerging markets, central banks in Asia are only just beginning, their kind of tightening moves. And we think generally, those could actually remain still quite, quite modest. So, a couple of countries such as India, standout with quite high core inflation, but actually remains the case that there's many large emerging market countries in Asia, where core inflation actually remains kind of well below rates that we think of as being consistent with their inflation targets. So, you know, I think, in that sense, kind of suggests inflation will not be the kind of defining issue that it has become in the West, particularly in Asia.
Nick:Okay, great. Well, thanks. I feel like we should probably end it there on that more positive note towards emerging markets. So, with that, I'd like to thank my guest, Bob, thanks very much for joining today.
Bob:Thanks, Nick.
Bob:Great. Thanks, Nick. Thanks for having me on.
Nick:It’s great to have you on. So let's get started on Russia. So, with Russia, we're a few months into the conflict now. And we've seen a steady escalation with no ceasefire in sight. You know, I think we're all pretty familiar with some of the first order impacts of the conflict, the terrible loss to human life, the disruption to supply chains that we've seen that’s lead to some inflation, and we'll talk about that a bit later. But I really wanted to ask you a bit about some of the other impacts the second order impacts of this conflict that are perhaps a bit less well considered. So perhaps starting with the freezing of US dollar reserves that the Russian Central Bank and what extent that could change the shape of central bank reserves going forward? And the impact that possibly that could have?
Bob:Yeah, it's a great question. I think probably for most countries, reserves are still going to effectively remain in US dollars. I mean, why do we want reserves or why central banks want reserves? For the most part, it's a kind of insurance policy against currency crises. And clearly, you know, as well as being a kind of technocratic reason guarding against kind of currency crises. There's also sometimes the domestic political reason, not wanting to go kind of cap in hand, to the IMF still provides a rationale for kind of holding a reasonable amount of reserves, even if your currency is actually moved to be more floating than fixed, as was in the case in the Asia financial crisis.
US dollars will provide a lot of liquidity in the global financial system that just to be honest, is quite hard to replace with other currencies. So, if you were a country worried about, you know, sanction risk, having watched what's happened to Russia’s Central Bank, I think there's a question of kind of where else do you go? So, sanction risk could be just as high in Euros, for example, other markets outside of the West may just kind of not be deep and liquid enough.
Potentially, over time, I guess this could accelerate moves away from the US dollar, you know, maybe encourage some degree of regionalization of financial systems to. It could renew, for example, a bit of interest in the Chinese authorities pushing Renminbi, internationalization. Potentially, we could see a few more steps, I think, coming to promote its own homegrown payments transfer network. So that's the cross border, interbank payment system, the SIPS, rather than kind of relying on the SWIFT network. And we've kind of seen how damaging that has been to the Russian economy more recently. But you know, I think we need to bear in mind historical lessons suggests that there's going to be a long time before China probably is able to supplant the US dollar, and really kind of internationalise. The US economy, for example, was way bigger than the British economy when the when the dollar became the reserve currency for the world.
Nick:Thanks. I think you've made an interesting point before about how, after a country loses its primacy in terms of the world order, it takes a while for currencies to adjust or central bank currencies to adjust to that and the pound was a global reserve currency for a lot longer after the fall of British Empire.
Bob:Yeah, exactly. That's pretty much exactly how that happened. I think it was 40,50 years probably for the dollar to kind of overtake the pound despite the British economy’s kind of dwindling importance in the world economy there. So I think that triangulation that you can go through the dollar from any currency. That kind of liquidity advantages just means it's there's a lot of inertia to overcome, potentially in the global financial system. Yeah.
Nick:Okay, thanks for that. And then another thing I wanted to ask you about was the very broad sanctioning of individuals from Russia, who have made their wealth by being associated with Putin and essentially essential suspension of property rights for those individuals. Could that have an impact in terms of future sanctions on people who is perceived to be close to other bad acting dictators?
Bob:Yep, potentially, it's a difficult one to know, it's a difficult one to know for sure. I think maybe some people will be thinking twice. So is this a kind of a rewriting of the rules of the International Monetary financial system? Where can money go that is deemed to be kind of safe? Could the margin, influence some capital flows or kind of individual decisions there. I guess it's kind of question about whether you think sanctions are kind of the genie that's out of the bottle now. And could, I guess, views or perceptions about kind of more minor transgressions, ultimately end up kind of limiting flows, limiting investments, maybe by individuals too, worried about their ability to, to retain ownership. So it's kind of not just about yachts and the like, kind of investment in kind of companies abroad too, could potentially kind of suffer. From economic point of view, because we were wondering about whether this is significant enough to really cause some sort of damage to kind of economic efficiency and, and kind of capital flows. But yeah, maybe those who are cozying up to autocrats might be feeling a little bit more nervous than they were, until Russian sanctions started getting on.
Nick:And then moving on to China. Early on in the Russia, Ukraine conflict, the link was made to China and Taiwan, and the potential for unification to occur at some point in the future by, by potentially by force, do you think that's more or less likely now, given what we've seen in Russia?
Bob:Yeah, it's a difficult one, I think Russia's invasion of Ukraine or hasn't kind of materially changed our view of Taiwan risks there. So I mean, it's still, of course, possible that missteps lead, I think, to conflict over Taiwan, you know, the US is, of course, running a policy of quote, unquote, ‘strategic ambiguity’. So there's a possibility that this leads to kind of missteps or contributes to missteps by either side, those who like that kind of game theory, would know the ‘trembling hand’ equilibrium were kind of mistakes on either sides could potentially force you into kind of positions you didn't, didn't want to be in.
I mean, one could potentially imagine scenarios, which can follow on from Ukraine crisis, which increased the odds either intentionally or unintentionally. So, for example, I don't know - the US was spurred on by what it sees in Ukraine, ramping up sales of advanced weapon systems, China could maybe then react to a kind of closing window of opportunity. So, in this kind of situation, Beijing might conclude that the likelihood of a kind of successful invasion could actually decline rather than rise over time, alongside the kind of steady rise in its military prowess, the size of its economy, and the like.
And I guess, before the Ukraine invasion, US withdrawal from Afghanistan, might have led, you know, Beijing to doubt the US commitment to his allies too. But I think, you know, the strength of the Western response more recently, probably counters that narrative. But I think, you know, overall, why, why we're not really very concerned about this risk, or we think this risk has often been overstated, by many commentators and markets. You need to really think about kind of the whether the authorities in China will really be willing to take such a risk. So even if conflict over Taiwan was somehow avoided, the US didn't opt to intervene. Now, if it did, that could clearly be catastrophic – for not just China and the US, but kind of worldwide.
The potential cost I think to China now just seems much higher, given the Western sanctions went further than anyone expected. China is also much more integrated into the west than Russia is. So, the economic damage from western sanctions, the dismantling of Western supply chains, could be an order of magnitude higher for China. And then I think it's also important to distinguish between the short and the long run here. Much of China's kind of long run, both kind of hard as military power and also it's kind of soft political power, is directly related to the size of its economy. So why would you be willing to jeopardise that, at this, at this stage? It's still possible, of course, I think, you know, over the medium to long run risks are likely to rise. As I said, before, you know, China's military is certainly growing in kind of both size and I think sophistication, too, we do expect some continued deterioration in US China relations. But it's not really clear I think, that Ukraine kind of changes the trajectory of that kind of distribution of risks alongside it.
Nick:Yeah, that's interesting, I suppose one thing you mentioned about Russia, and essentially the excommunication of the Russian financial system from most of the rest of the global financial system is something that gives us a bit of comfort on China, in that, the private sector has been a really big driver of a lot of China's economic growth over the last decade, and the private sector is very much reliant on capital markets to fund that growth. So, I suppose my question would be, can China still continue with the target level of growth without access to global capital markets?
Nick:Yeah, it's a tough one that. I think if it was to lose access to the dollar base global financial system, it could be extremely damaging. I guess I probably put capital markets under kind of like, a broader umbrella of kind of China's development model here. You know, within that, you know, trade, the ability to kind of sell to the west. There's obviously the knowledge transfer that comes with foreign direct investment, and also just a heightened competition that helps kind of spur on innovation amongst its private sector, as you kind of mentioned there that's become increasingly important within the economy over the last sort of 15,20 years.
I mean, there's a similar aspect, I think that applies to capital markets. And, you know, generally tend to think that the private firms in China are being very careful to adhere to Western sanctions, they really don't want to be hit by secondary sanctions, to be seen to be helping Russia evade sanctions in any way.
On the other hand, I think you also need to kind of think about the kind of more fundamental needs of any country such as China's, kind of infrastructure and kind of financing needs. You know, China has been running a lot of current surplus for many years now. In essence, you know, that tells you that national savings are above national investments. You've also got an asymmetric capital account opening, meaning that domestic savings are still largely kind of trapped in China. So, these sort of things kind of reduce, I guess, the, the essentialness of access to the global financial markets, but you know, competition and finance, the ability for financial flows to go in and out of China helping FDI, finance just helping China’s financial deepening. Over time, I think this should help improve risk pricing will reduce those risks, around capital misallocation. That could be a big barrier to China breaking the middle-income trap.
And really one example of this. I think there were some steps in April to kind of clarify the audit rules. So, to reduce the risks of Chinese firms actually being delisted from the New York Stock Exchange. I don't think we're 100% there in that kind of the delisting risk. But you know, I think there are some kind of positive steps in the right direction, you know, at least one indication that the Chinese authorities do take that capital market access pretty seriously.
Nick:Yeah, we saw that, that rule change back in April. And that gave us a fair bit of comfort that China was taking steps in terms of making sure that capital market access wasn't limited. And we took that as a fairly significant step forward, given you know, that that issue has been kind of locked for, for quite a while. And I suppose it also comes down to the issue that China has enough problems at the moment without adding capital markets back to the list. And maybe I'd like to touch on that which is, what we're hearing from companies at the moment on the ground in China is that 2022 is worse than 2020 in terms of disruption from COVID due to this zero COVID policy, coming at a time when other economies have more or less opened up. What's your take on how long this policy is likely to last?
Bob:Yeah, it's a great question. It's a really tough call, I think and you know, it's a key part of our, our China and global economic forecasts, actually, you know, for that matter. To me always has a bit of a feel of kind of forecasting how long untenable strategy last, I think best guess at the moment is zero COVID, is probably going to continue and it's in its current guise. So at least until the 20th Party Congress - at that point President Xi will, kind of secure his unprecedented third term, I think, then we could maybe see a change towards a more living with the virus approach in China as we've seen elsewhere. This also gives a bit of a chance to roll out boosters to the over 60s, assuring that the kind of vaccination amongst that more vulnerable age group is kind of ensured.
I mean, I think, you know, Omicron clearly has got lower virulence, lower incidence of kind of death, and severe health complications. But, you know, I think we've got quite an unfortunate and stark lesson there from Hong Kong. And if you sort of applied, I guess, kind of the mortality rates from that or even more cautious mortality rates, given a slightly higher vaccination rate to the mainland China, we could be talking about awful lot of deaths, unfortunately, perhaps in the kind of region of around about 1.5 million.
Now, China's got a lot of people around 1.4 billion, that's still relatively low scale to population. But I think just the absolute numbers here are potentially a difficult one for the authorities to tolerate, particularly in the run up to kind of the 20th Party Congress. I mean, there's also risks, I think, here on the kind of other side, so while we don't think its very likely will be an easing before the 20th Party Congress. There is, I think, some risk here, the desire for going to zero actually persists for even longer. So if, for example, the authorities really want to roll out domestically made mRNA technology, well, you know, then we could really be pushing back kind of zero COVID policy being maintained well into kind of 2023. And that could come with, frankly, quite a large economic cost, in terms of, you know, just a need to - even if we hold even if we avoid the kind of Shanghai type situation, I think the need to kind of preemptively react aggressively to relatively small case numbers in cities given how transmissible Omicron is, that kind of suggests we could just be in line for a relatively kind of large number of restrictions being put in place, even if you know, the absolute cost or disruption isn't, you know, hopefully, as large as what we're seeing, or what we have seen in in Shanghai there.
Nick:Let's move on to inflation. First question here, and certainly a question that clients have been asking is, it's really on the inflationary pressures that we're seeing in the world of a moment, and a lot of these inflationary pressures are coming from the supply side. So, the conflict between Russia and Ukraine and the supply chain disruption, that that's causing and supply of crops and food and the like. And then also, these lockdowns in China are now causing some issues with supply chain there. So, what essentially can be done there, you know, in terms of the Fed raising rates in order to try and resolve a supply side issue? That it sounds like, it will inevitably result in quite a meaningful demand slowdown and likely to push the US at least into recession and cause quite significant global economic slowdown.
Bob:Yeah, I think it's kind of an interesting one, in a couple of dimensions there. So first of all, the framework that the Fed introduced before the pandemic, average inflation targeting was clearly kind of touted as bringing with it some kind of supply side benefit. So you know, for example, you run the economy a little bit hotter, you can bring in more workers, you know, you lower the cost of financing for firms, in theory you can spur a bit more investment there in machinery, software, you increase your supply capacity. But I think now, we're just in a situation where those kind of supply demand imbalances, as you've described, they need to be brought down much more aggressively given where cap inflation is and that really needs to be kind of, by taking some of the heat out of the demand side of the economy, there's really very little the Fed can really do to kind to meaningfully influence the supply side, particularly in the kind of short run when you're faced with such unusual dynamics around kind of goods and services demand within the economy, huge shifts there, working from home curtailed opportunities to go out and spend on services, clearly then also, you're limiting you know, your ability to consume goods to some extent, just because the supply chain bottlenecks, semi conductor shortages, all those sort of things really kind combine into some sort of perfect storm. So I think we're clearly beyond the point where the kind of running an economy hot, kind of brings benefits given you know, where, where core inflation is. So ultimately, you know, the Fed can bring this imbalance between supply and demand back into line. But the process of doing so really runs a very dangerous gauntlet, you know, everything from the kind of, I guess, the benign, kind of relatively painless process to more of an inducing resection, as they had to do in the 1980s to kind of bring inflation back down fairly sharply.
Nick:And so do you think that the primary concern is likely to shift to growth at some stage from inflation? Or do you think, actually, even if the economy goes into recession, inflation will be the primary concern?
Bob:Yeah. Unfortunately, I think your inflation is going to be still a key concern. But I think you're right, actually, in many ways, markets have become increasingly concerned about recession risk already. And I think that's been feeding into why we've seen such kind of brutal sell offs across, you know, both bonds and equities, kind of unusual combination there.
I mean, you know, it is possible, we end up with a slightly more benign scenario, Chair Powell, at one of the press conferences a few months ago, noted a few soft landings that the Fed has been able to pull off, such as in ‘94. But the ‘94 hiking cycle, and others kind of didn't really have any of the kind of characteristics or dynamics of the kind of COVID shock and recovery that we're living through the moment. So, there's a real tight rope here, I feel.
On the one side, there's this risk of not acting aggressively enough, then having to actually hike rates much more aggressively at a later date. On the other hand, it could turn out that the Fed over tightens too. Now, I know we're not allowed to see transitory with regards to inflation anymore. But you know, if we did find out the inflation is somewhat less persistent, we could find out the policy tightening has kind of done too much in the face of kind of multiple price level shocks. And dare I say it, some degree of transitoriness within the reopening dynamics, too.
And you know, I think there's also some extent, there's that old adage that high prices solve high prices - that could kick in. So, you know, higher prices do squeeze real incomes, they can also encourage supply to come back on streams, you know, your service sector is charging higher prices, airlines are charging much more for holidays, you know, that can bring more aeroplanes back on onto the system. So, there is this risk, I think, you know, tightening dynamic just goes too far and expunging demand from the system. So really amplifying, that kind of business inflation cycle.
Now, I remember, you know, Governor King of the Bank of England used to describe the 2000s as they call the ‘nice decade’, which stood for non-inflationary consistently expansionary - it could just be that you know, we've entered a much more kind of volatile economic environment with reference to kind of activity and also the policy dynamic there. I'm sure there's some sort of nasty acronym, which maybe evades me at the moment. But you know, we at the research institutes certainly put the recession risks as exceptionally elevated, perhaps in the region, sort of 30 to 50%. And it's going to be a key focus for us in our upcoming forecast round two, as to whether in fact, we actually put a US recession in as our central case. So still to be debated. But, you know, one to definitely have on your radar.
Nick:Okay, yeah. And I suppose bringing it back to the emerging markets. What's been striking about this cycle is just how quick a lot of emerging markets were to raise rates in the face of inflationary pressure, you know, happening quarters before the Fed started talking about tapering or raising rates. So how does the cycle look in emerging markets? And is there scope for maybe easing in emerging markets a bit earlier?
Bob:Yeah. Quite, quite possibly. I mean, you know, markets are often thinking about inflation very much to develop market lens, really focusing in there on the US. But yes, as you can alluded to the swings, could be operating in a slightly different frequency, and perhaps be even more stark for some emerging markets.
I probably say, you know, we quite often group emerging markets into two to one bucket. But clearly, it runs a huge spectrum of very different economies, operating and kind of very different environments. So, I'd probably kind of distinguish here between two regions kind of bookending the spectrum if you will, so LATAN being on the more aggressive side, as you say having front run the hiking cycle and kind of Asia, on the other hand, not really feeling as much pressure to kind of hike rates. Now, you mentioned there before LATAN had actually already tightened very aggressively. So the Brazilian central banks already raised rates by over 10 percentage points. Our modelling does suggest there is some risk here without higher degree of kind of persistence of an underlying inflation within Brazil that could keep inflation maybe a bit more uncomfortably high over the course of this year.
But we also think maybe the markets are underestimating, do we have tightening, that's actually already going through the economy, it's not just across the monetary side, fiscal dynamics can be, can be much less supportive, too. So you know, we might well see inflation coming down a bit more sharply going into next year, that could kind of then open up that space for emerging markets, which is time to start, start taking their foot off the brakes. And, you know, giving the economy a little bit more support, then. And then you're just to wrap up their - Asia is in a very different place, shouldn't be grouping everyone together, you know, low inflation in many Asian economies plus later reopening has allowed kind of central banks to tighten by less thus far. In some emerging markets, central banks in Asia are only just beginning, their kind of tightening moves. And we think generally, those could actually remain still quite, quite modest. So, a couple of countries such as India, standout with quite high core inflation, but actually remains the case that there's many large emerging market countries in Asia, where core inflation actually remains kind of well below rates that we think of as being consistent with their inflation targets. So, you know, I think, in that sense, kind of suggests inflation will not be the kind of defining issue that it has become in the West, particularly in Asia.
Nick:Okay, great. Well, thanks. I feel like we should probably end it there on that more positive note towards emerging markets. So, with that, I'd like to thank my guest, Bob, thanks very much for joining today.
Bob:Thanks, Nick.