Treading a tightrope

Russia's invasion of Ukraine since 24 February has raised economic risks for all countries. Far more so for Russia, which has been isolated economically by growing sanctions from both governments and large multinational corporates, and Ukraine, where loss of human lives and infrastructure is setting their economy back in time as the war rages on.

What are the global economic consequences likely to be?

Not too long ago, we experienced the global financial crisis, made in the USA, dragging economies down long enough to be called "secular stagnation". Then came the "sudden stop" from the pandemic, originating from China. Public health hazards and human interactions came face to face to disable the supply and demand sides of the economy. This depressed both incomes and prices, but not too long. A rapid transition from the pandemic towards a new public health normal, most notably by vaccination and infection, brought inflationary growth as supply failed to keep up with demand.

The Russian invasion and the economic retaliation by NATO countries and several others are threatening to shave off the growth part of the transition while flaming the inflation part.

It is indeed ambitious, if not foolhardy, to speculate on the details of the economic impact of a fluid global political crisis, without decisively graduating from the Covid crisis, that directly and indirectly involves major nuclear and economic powers of the world. Yet, as in life, guessing goes on!

The return of stagflation

The International Monetary Fund has warned that the already serious economic consequences of the conflict can get much worse in a pandemic scarred global economy. Energy and commodity prices have added to inflationary pressures from supply chain disruptions and the demand rebound from the pandemic. The economic damage would deepen, with significant spillovers to other countries, if the war prolongs on the military and economic fronts.

The crisis has brought back the possibility of a phenomenon not experienced in the last 40 years – stagflation. Simply stated, this term describes an adverse shock to both inflation and activity. Aggregate demand was rising faster than supply before the war, resulting in falling unemployment (equivalently rising growth) and increasing inflation. Policymakers were faced with a relatively easy task of deciding how fast to wrap up the fiscal and monetary stimulus put in place in response to the pandemic induced recession. Central banks began to revisit policy rates and governments were getting ready to reset to a path of fiscal consolidation (read deficit reduction).

The global economy was exposed to high inflation and jittery financial markets when the war sirens rang. The invasion aftershocks are rubbing toxic salts on both the wounds. Associated with sanctions, the ongoing war is disrupting trade and financial markets while heating up commodity prices. Households are spending an ever-larger chunk of their incomes on food and energy. In many countries they are squeezed once again; this time as incomes fail to keep up with higher prices. Plunging markets could add another drag, hitting household wealth and business confidence.

A cost-price spiral, the driver of the inflation part of the 1970s stagflation episode, is looking probable. Countries that have close economic links with Ukraine and Russia are at particular risk of scarcity and supply disruptions (in addition to being most affected by the increasing inflows of refugees). Surge in energy prices threatens to fuel inflation across Asia, a net importer of energy. Inflation in Asia in turn will ripple through the global economy as Asia accounts for 40% of global exports. Everything in the world is connected where a perturbation in one-part echoes in most others.

Policymakers' nightmare

The war has nightmarishly changed the policy calculus. A Bloomberg Special (10 March) tried hard to remain optimistic: "The world economy has a decent shot at escaping a full rerun of 1970s-style stagflation – and that's about as far as the good news goes."

Policymakers are facing Sophie's choice. Policy measures aimed at curbing inflation risk puncturing the growth recovery. Continuing the stimulus to assist recovery will further accelerate an already unbearable inflation.

I cannot think of a better time when politicians may feel blessed to be in the opposition bench in electoral democracies. No matter what the government does, the opposition will have plenty of ammunition to bash. If the policymakers side with growth, the opposition can rebuke them for stoking inflation. Going hard to tame inflation could subject them to bashing for derailing growth. Stabilisation policies are largely incapable of stabilising both employment and prices at the same time when faced with a supply shock.

There is no easy and immediate escape from either of the two. Businesses often behave opportunistically by gouging prices. Government controls on the prices of essentials work in theory, but not so well in practice. Several countries are using fiscal policy, with price subsidies and income transfers, to help households with higher inflation bills. Central banks are revisiting their forward guidance on monetary policy and deferring the "tapering" (read increasing policy rates) plans.

Bottomline: if the tanks roll and the guns continue to fire, human suffering and market volatility will remain the winners.

Bangladesh's vulnerability

Bangladesh depends on the global economy for export of basic manufactures and labour services, import of key food items and the inputs required in manufacturing, agriculture, and services. The extent of Bangladesh's global connectivity is not fully captured by its low trade to GDP ratio. The energy intensity of the Bangladesh economy is no longer as low as it used to be in the 70s.

Prices in domestic commodity markets are shooting up. This is evident from persistent long lines to get subsidised food from TCB trucks every day. The knock-on effects of the latest increases in international and domestic commodity price increases are by no means done yet. The government has responded by waiving VAT on edible oil, sugar, and chickpeas in the run up to Ramadan and expanding the subsidised food distribution programme.

Commodity price increases of the magnitude seen in recent weeks, if durable, can have effects beyond inflation. The pandemic induced spike in import prices was already having an impact on external balances in Bangladesh. Import bills for goods and services were surging, leading to over $10 billion deficit in the external current account in July-January despite a strong rebound in exports. Consequent pressure on the exchange rate has induced Bangladesh Bank to offload nearly $3.5 billion from its foreign exchange reserves so far while allowing 1.4% depreciation in the average interbank Tk-USD rate since end-June 2021. The additional war shock on global commodity prices will exacerbate external imbalance.

Risk to sustaining growth recovery is amplified and the distribution of risk appears tilted towards the vulnerable segments of the society. Rising prices of intermediate inputs and investment goods discourage capacity building and utilisation. External demand could fall due to the persistence of stagflation in our major export markets. This is bad news for employment in manufacturing.

The one upside is the prospect of rising demand for low-skilled Bangladeshi workers in the oil exporting economies. Outmigration picked up significantly in recent months. Bangladesh will most likely see a reversal of the recent decline in remittances sooner than later.

What to do?

There is hardly any room for misplaced optimism under the prevailing state of the world economy. Nor are there easy answers. Continuing sound macroeconomic policies, addressing structural impediments, and modernising implementation processes will be key to treading the tight and uncertain economic future. Foreign exchange reserve coverage is still adequate, though barely. Limiting the use of reserves only for monetary purposes is needed for ensuring that the inevitable further depreciation of the taka does not disrupt markets and the real economy.

The reform wish list includes policies focusing on diversifying exports, increasing FDI, enhancing productivity, investing in human capital, supporting the vulnerable, addressing corruption and getting the administered pricing regime right. Fiscal prudence, without backtracking on inclusion, to maintain a low risk of debt distress requires implementing tax policy reforms accompanied by measures to improve spending efficiency.

Plumbing policy reforms to reduce the cost of doing business hold great promise if they can be unlocked from the cage of vested interests. The pandemic increased existing vulnerabilities in the banking sector. Orderly exit of the expanded regulatory forbearance is just about due. This should be followed by a quick and candid asset quality review.

Strengthening banking regulation and supervision, improving corporate governance, and reforming legal systems to stem the rising flow of non-performing loans, especially in the state-owned commercial banks, are long-standing priorities. Phasing out caps on interest rates will improve access to credit and the conduct of monetary policy.

The experience with structural reforms is laden with initiatives that have struggled to cross the finish line. Mid-course corrections go with the territory, but the emergence of "reform orphans" with regularity is unfortunate.