Report from the IMF Spring Meeting: We have reached key tipping points
The Spring Meeting of the International Monetary Fund clearly showed how profoundly the global economic order is shifting. The war in Ukraine has set in motion a trend towards a more pronounced division of countries into blocs. This underpins the expectation of Union Investment that the international order is about to undergo a paradigm shift. The capital market environment will thus remain challenging.
An article by Christian Kopf,
Head of Fixed-Income Portfolio Management at Union Investment
The Spring Meeting of the International Monetary Fund (IMF), which took place from 18 to 24 April 2022, inspired conflicting emotions. On the one hand, it was great to be able to engage in direct personal dialogue again after a pause of more than two years due to the pandemic. I had the opportunity to spend three days having personal conversations with partners such as representatives from the US Federal Reserve, the European Central Bank and other central banks, IMF employees, economists, political scientists, historians and lawyers from leading universities, and other market participants.
On the other hand, it felt like the gloomiest IMF meeting that I have attended in 22 years, despite the glorious spring weather. There has been no shortage of crises in recent decades – from Russia’s payment default in 1998 and crises in Argentina, Brazil and Turkey to the global financial crisis of 2008, the eurozone debt crisis of 2011, and the Trump administration’s assault on the global order. Regardless, the discussions at the meetings of the IMF always used to be focused on ways to promote international cooperation and global trade and dialogue in order to improve economic conditions for everyone. Sometimes there was a broad consensus about what measures ought to be taken, for example at the meetings following the financial crisis of 2008. At other times, for example during the eurozone debt crisis, there was disagreement. But the objective of strengthening cooperation in the economic and monetary arena, which is entrenched in the IMF’s Articles of Agreement, was never really questioned. That is no longer the case. We have reached a historic turning point, driven in no small part by Russia’s invasion of Ukraine.
Formation of new geopolitical blocs
A speech given by US Treasury Secretary Janet Yellen to the Atlantic Council a few days ahead of the IMF Spring Meeting spelled out this shift with striking clarity. Her core arguments were:
- The goalposts have moved from stopping the war in Ukraine to mitigating the economic impact of this war.
The focus has shifted from a rules-based order for global trade to ‘friend-shoring’. Janet Yellen has thereby formulated an alternative to globalisation (‘off-shoring’) and deglobalisation (‘on-shoring’) in the form of strategic independence through integration among like-minded economic blocs, which no longer include China and Russia. Instead of simply free trade, the objective now is secure trade. In her speech, Yellen said: “We cannot allow countries to use their market position in key raw materials, technologies, or products to have the power to disrupt our economy or exercise unwanted geopolitical leverage. Let’s build on and deepen economic integration and the efficiencies it brings – on terms that work better for American workers. And let’s do it with the countries we know we can count on. Favouring the ‘friend-shoring’ of supply chains to a large number of trusted countries, so we can continue to securely extend market access, will lower the risks to our economy, as well as to our trusted trade partners.”
Heather Conley from the German Marshall Fund explained the new position of the Biden administration as follows: As recently as two or three weeks ago, the focus of the US was still on ending the war in Ukraine as soon as possible. Now, the objective is to ensure that Russia will be defeated and remain economically isolated for the long term. This marks a fundamental reorientation of US foreign policy and international economic policy. Over decades, it was the stated aim of the US to contribute to the creation of a more open society by promoting globalisation and free-market reforms. This ideal was central to the consensus in Washington. Now, the focus has shifted to shoring up and protecting a smaller group of liberal societies.
Various experts agree that the US is therefore now openly pursuing the goal of forming new geopolitical blocs. To name but a few indications:
There are clear efforts under way to not only keep the US dollar reserves of the Russian central bank frozen but to confiscate these reserves. Until now, this was possible only if the US was being attacked directly by the country in question. However, there are plans to change these rules, as Gary Hufbauer and Jeff Schott from the Peterson Institute explain in this article. All experts I spoke to believed it was out of the question that Washington would release the US dollar reserves of the Russian central bank again.
The US government is trying to cause the Russian Federation to default on payments through tactics that can be described as ‘destructive ambiguity’. This involves making it harder for Russia to make coupon payments. Formally, the current rules of the US Office of Foreign Assets Control seem to permit Russia to make coupon payments from accounts that have not been frozen yet. However, the US Department of the Treasury is being extremely vague on this point, suggesting that affected US correspondent banks may well refuse to execute any such payments.
US government delegates walked out of the meeting of the G20 Finance Ministers and Central Bank Governors on 20 April in protest when Russia’s deputy finance minister addressed the meeting. US Treasury Secretary Janet Yellen personally spoke out in favour of excluding Russia from the G20 group of nations. If it came to that, China would most likely also leave the G20 group, which would effectively mark the end of this forum.
The US is putting intense pressure on China to also cut or at least curb its ties with Russia. Economic sanctions against China are becoming increasingly likely in this context.
Weaker growth in the EU and China
Even though Germany and the EU are affected much more severely by a confrontation with Russia than the US, it is likely that they will have to take further action against Moscow. The IMF still predicts economic growth of 2.8 per cent for the eurozone for 2022. But in personal conversations, it turned out that many economists and market participants already anticipate a significantly lower growth rate. This is because companies have been cutting their investment activities substantially since the beginning of the war, real disposal incomes of private households have come under pressure from high energy prices, and uncertainty about the further trajectory of the conflict is weakening consumer spending. Our own economists at Union Investment are also less optimistic than the IMF and now expect the eurozone’s economy to grow by 2.5 per cent in 2022. A potential imposition of sanctions on Russian oil exports would further weaken economic growth in the eurozone.
Not unlike Germany, China is also facing a dilemma. The confidence of a country that thought it had managed the coronavirus crisis significantly better than many others has been thoroughly shaken by renewed outbreaks of the pandemic in Shanghai and other parts of the country. In addition to fresh lockdowns to curb the spread of the virus, the economy is being strained by high energy prices, persistent problems in the real estate market and weak growth in exports. The IMF is currently still maintaining a growth forecast of just over 4 per cent but sees the risk of a much lower level of growth, not least because the Chinese government is not doing much to counteract the downturn with fiscal measures due to concerns about excessive borrowing and unproductive infrastructure investments. And Beijing knows that western sanctions on technology imports and the transfer of technologies across borders would deal a painful blow to China’s potential for growth. According to reports from the Institute of International Finance (IIF), Russia’s invasion of Ukraine marks the first incidence of foreign investors withdrawing funds from China, most likely due to concerns about financial sanctions. This could be one of the factors behind the weakness of the renminbi in recent days.
China attempts to save multilateral order
Against this backdrop, the Chinese government seems to be aiming for de-escalation – as far as is possible to tell. No representatives from Beijing made their way to Washington for the Spring Meeting, so while there were many discussions about China, very few of them actually involved anyone from China. However, the statement of the governor of the Chinese central bank, Yi Gang, at the meeting of the IMF’s International Monetary and Financial Committee expressed support for many international initiatives, including a surprise announcement that China would participate in a debt forgiveness project for Zambia. A Chinese state bank will co-chair the committee of creditors handling the project. This was perceived as an attempt to rebuild trust after China had previously been unwilling to move on this subject for a long time. In a personal conversation, a leading European government representative commented to me: “China does want to weaken the West, but at the same time, it wants to preserve the international financial order, because it benefits more from global trade than almost any other country in the world.”
At the Spring Meeting, the US government responded positively to the relatively constructive tones from China and on Friday raised the prospect of import tariffs being lowered on certain Chinese goods.
Risks and opportunities in emerging markets
China’s participation in upcoming debt rescheduling negotiations with emerging economies is very significant because Chinese state banks have been handing out substantial volumes of loans in recent years, much of which will not be recoverable. A number of emerging economies are likely to become unable to service their government debt amid the overlapping impacts of the coronavirus pandemic, the energy crisis and food crises. Ethiopia, Zambia and Chad will thus need to restructure their debt, with support from China, under a new Common Framework procedure for the poorest countries.
Ghana, Sri Lanka, Tunisia and potentially Pakistan could also be headed for national bankruptcy. By contrast, Egypt may be able to avert default with support from Gulf states, although this is becoming increasingly uncertain. The IMF wants to drive forward these debt restructuring initiatives by amending its lending policy in a way that will make it easier for the organisation to make payments to countries that have fallen into arrears with payments to other creditors.
For investments in emerging markets, this means that the avoidance of default risks will continue to have a strong influence on active returns.
Otherwise, there are currently no strong signs pointing towards a broader crisis in the emerging markets. Quite the opposite in fact. Most of these countries export commodities and thus stand to benefit from high prices for energy commodities and metals. The IMF estimates that the national debt of oil-exporting emerging economies will fall from around 56 per cent of GDP in 2021 to 50 per cent of GDP in 2024 (Fiscal Monitor, April 2022). In addition, the exclusion of Russia and concerns about sanctions against China are reducing the size of the investment universe, meaning that countries with comparatively smaller political issues, such as Brazil or Chile, are suddenly regaining significant appeal for investors. Overall, Latin America could benefit from these shifts, especially as real rates of return in most of the countries in this region are already relatively high.
Monetary policy set to tighten
Last but not least, there is one more tipping point that has recently been reached. For months, western central banks stood back and waited as inflation continued to soar. In the US and the eurozone, inflation rates have now reached their highest levels since 1981. The time for decisive action has come if we want to avoid losing stable inflation expectations as an anchoring point. Fed Chair Jerome Powell already hit the nail on the head in his speech on 21 March 2022 when he said that the Federal Reserve would now need to raise interest rates “expeditiously”. Former Fed Vice Chair Richard Clarida argued along very similar lines in his speech in Washington.
How far the Fed will go with its cycle of interest-rate increases is hard to predict at this stage. The bank is determined to raise the base rate above a ‘neutral’ level. For a long time, this neutral level was pitched at around 2.5 per cent. However, the key metric from an economic perspective is the neutral real interest rate. And if inflation settles at an elevated level in the medium term, this would mean a higher nominal neutral interest rate. Medium-term inflation expectations in the US are already up by half a percentage point year on year, suggesting that the base rate could rise to a high of 3 per cent in the current cycle.
Statements from eurozone central bankers at the IMF Spring Meeting consistently indicated that the European Central Bank will raise interest rates too. But whether the looming threat of a recession in the eurozone will spur the ECB into raising its deposit interest rate from minus 0.50 per cent to plus 0.50 per cent this year, as currently priced in by the market, remains to be seen.
Three shifts with far-reaching consequences
The IMF Spring Meeting has shown that we have recently reached a number of economic policy tipping points that will lead to significant changes in the international financial system:
- Geopolitics – winning the war: The focus of the US is no longer exclusively on ending the war in Ukraine as soon as possible, but also on defeating Russia – although it remains unclear why it would be in the strategic interests of the West to push Russia into a position where it becomes a cheap fuel station for China. The EU will have to follow suit and there are signs that suggest an embargo on Russian oil might be in the offing.
- Trade policy – friend-shoring: We are experiencing the formation of new geopolitical blocs and a departure from the objective of a common global economic order. Greater emphasis will be placed on independence and resilience, at the cost of slower growth, persistent shortages and higher prices.
- Monetary policy – expeditious tightening: The central banks are running out of patience and will start to counteract rising inflation more decisively.
The result will be an environment of rising commodity prices, weaker growth, elevated inflation and higher key interest rates. This means that conditions for investments in interest-rate markets will remain challenging for now. In the emerging markets, there are winners and losers.
Research Paper – A new world order
Find out more on our theories of how the world will reshape itself and what opportunities and challenges this may present, for example in connection with an anticipated investment boom. In six propositions, we outline the impact we expect the war in Ukraine to have on the economy and the capital markets.
As at 26 April 2022.