The Great Economic War (GEW) (Part 5: Global economic breakdown and monetary disorder)

The Great Economic War (GEW) (Part 5: Global economic breakdown and monetary disorder)

Phuah Eng Chye (24 September 2022)

Tumultuous events act as watershed to mark the ending of an era and the beginning of another. The end of World War 2 was followed by the Cold War between the West and Communist spheres. In the 1970s-1980s, financial liberalisation laid the foundation for the rise of markets, the victory of Western governance and culminated in the Goldilocks globalised economy. In 2022, the GEW marks the end of market-driven globalisation, the ascendancy of geopolitics over economics and markets and the fragmentation of the global economy into separate spheres.

Global economic breakdown

GEW plunged a dagger into the heart of globalisation. It shattered any remaining beliefs that governments would be sensible in avoiding serious rapture of economic interdependencies. Instead, there is likely to be further escalation. The West are preparing secondary sanctions to enforce compliance. China[1] worry sanctions similar to those imposed on Russia could be extended to them. While taking steps to insulate their economies, China and Russia are preparing counter-sanctions. The outcome is to intensify beggar-thy-neighbour attacks; reverse the trend of globalisation, financialisation and informationalisation; and cause global market mechanisms to break down; thus raising the spectre of a global depression.

Few countries, firms, industries, markets or products will be untouched by the unwinding of globalisation. Western MNCs are restructuring, downsizing or exiting from countries with high sanction risks. Russia and China are switching their focus from OECD to the global south. This reconfiguration of supply chains, logistics[2] and trade will be accompanied by similar shifts in financing, investment and currency usage patterns. These trends will cause the global growth, debt and liquidity multipliers to contract.

Problems are surfacing in the once finely-tuned global economy. Once relied upon for innovation, competition and cost efficiencies, businesses and markets now struggle to cope with the volatile, large shifts in demand and supply. Shortages and excesses (of workers[3] and goods) occur frequently[4]. While partly caused by the pandemic, natural disasters and war, a large part of the blame can be placed on capricious and vindictive government policies. Instead of relying on markets to find solutions, governments behave as though they are operating under “war-time”[5] conditions and exercise over-reach in implementing policy solutions. The outcome is a reminder of why government “command and control” have unintended consequences. Policy uncertainties, bureaucracy and clumsiness override market and competition mechanisms and cause financing, production and delivery costs to soar. Subsequently, governments are surprised to find the private sector responding by rationing supply and investments; demanding assurances, subsidies and premiums (profiteering), or simply choosing to exit (closure). All these actions create further artificial scarcity and higher prices. Many economies have earlier exhausted policy resources to cope with the pandemic. They are badly positioned to cope with the additional strains from beggar-thy neighbour disruptions, financial distress, political and civil turmoil.

Monetary disorder

While the depth and pace of deglobalisation will determine the extent of disruption in the real sector, the emergence of monetary disorder will accentuate market volatility and financial instability to magnify threats to economic growth.

  • Debt crises

Larry McDonald points out global debt jumped from USD226 trillion in 2019 to USD303 trillion in 2021. Rising interest rates and a strong dollar “multiply interest rate risk…Global banks have to mark to market most of these assets”. Emerging economies, suffering from the high costs of commodities and oil priced in USD, will be further burdened by rising debt servicing expense and repayments. “A quarter-trillion dollars of distressed debt is threatening to drag the developing world into a historic cascade of defaults. The number of developing nations trading distressed has doubled, with El Salvador, Ghana, Egypt, Tunisia and Pakistan appearing particularly vulnerable…about 17% of the $1.4 trillion emerging-market sovereigns have outstanding in external debt denominated in dollars, euros or yen”. “So now we have global bank balance sheets, stressed by $20T to $30T in mark to market losses from Equities, Treasuries, European government bonds, Crypto, Private equity and Venture capital – in the middle of the worst emerging market credit crisis in decades. All after just 150bps of rate hikes from the Fed?”.

There are differences from past financial crises. Some (previously crisis-hit) economies and generally US and Asian banks are comparatively more disciplined and resilient. The main source of risks emanates from markets rather than loans. The rise of China’s banks is reminiscent of Japanese banks at their peak. Then, Japanese banks were badly hit by the collapse in domestic property and equity prices. The government was criticised for slowness in implementing genuine structural reforms. The attempts of their banks and brokers to consolidate and transform into global investment banks was unexceptional. Will China’s banks suffer a similar fate now that they have reached the top?

Chinese banks have generally stuck to their knitting, focusing on Asian-style traditional bank credit mainly to support the Belt and Road Initiative (BRI). Sebastian Horn, Carmen Reinhart and Christoph Trebesch note “China’s state-owned banks and enterprises have invested in and lent heavily to Russia, Ukraine, and Belarus. Cumulative Chinese lending to Russia since 2000 exceeds $125 billion and has mostly financed Russian state-owned enterprises in the energy sector. Total Chinese lending commitments to Ukraine are estimated at $7 billion and have largely supported projects in agriculture and infrastructure. In addition, Chinese banks also have considerable exposure towards Belarus, with around $8 billion in cumulative lending since 2000. Taken together, the three countries account for close to 20% of China’s overseas lending during the past two decades”.

Views are geopolitically polarised on China’s rise as a major lender and its implications for sovereign debt crisis resolution.

  • Sebastian Horn, Carmen Reinhart and Christoph Trebesch note “China’s state banks now hold a large amount of potentially ‘distressed’ debt…the share of China’s total credit portfolio to borrowing countries in distress, which has increased from about 5% in 2010 to 60% at present”. However, “China’s overseas lending and credit relationships remain exceptionally opaque[6]. Chinese lenders require strict confidentiality from their debtors and do not release a granular breakdown of their lending. Moreover, Chinese official loans and related credit events are not on the radar screen of major international credit rating agencies and no systematic data on related defaults are collected by international organisations such as the OECD, the IMF, or the Paris Club. Most Chinese debt-restructuring deals are arranged bilaterally and with little or no publicly available information. As a result, there is a substantial knowledge gap on what happens to Chinese claims in situations of debt distress and default”. “Since 2008, Chinese creditors arranged at least 71 distressed debt restructurings – more than three times the number of sovereign restructurings with private creditors (we record 21 bond and bank debt restructurings) and higher than the total number of Paris Club restructurings with distressed debtors (68 cases) during the same period”. “China has become the most important official player in international sovereign debt renegotiations. Moreover, Chinese lenders follow a crisis resolution approach reminiscent to Western lenders in the 1980s and 1990s. Except for symbolic, debt cancelations of small zero-interest loans, Chinese lenders almost never provide deep debt relief with face value reduction. Like their predecessors, they arrange reschedulings that offer some grace period, or short-term cash flow relief. Nominal debt write-downs are extremely rare as are reductions in the interest rates charged. The result is often serial debt restructurings…China’s state banks use innovative contractual designs with elaborate safeguards against financial and political risk. In this sense, they are better poised to deal with the financial fallout they are now facing…a significant share of China’s lending is collateralised, especially to commodity exporting countries. This implies that Chinese lending to distressed countries is not necessarily in default or non-performing but might be serviced through the proceeds of commodity exports. Russia is a case in point: an important share of Chinese lending took the form of advance payments for oil deliveries. Under a 2013 agreement, the state-owned China National Petroleum Corporation (CNCP) made advance payments of at least $30 billion to Rosneft in exchange for long-term oil deliveries…It is highly probable that Russia may continue to service the loans in kind, even if it were to default on other creditors (as was the case with Venezuela) and despite the sanctions imposed by Western governments”. “The available evidence suggests that China’s multi-year overseas lending boom had already largely ended and is hitting fresh roadblocks with the Russia-Ukraine war. This is especially bad news for EMDEs, at a time when global financial conditions are poised to tighten as major central banks attempt to rein in rapidly rising inflation. Such a sudden stop impacts much of the developing world who owe large amounts of debt to China. Net transfers from Chinese bilateral creditors to developing country public sector recipients have turned negative in 2019 and 2020 after peaking in 2016. This means that principal and interest repayments to China now exceed fresh disbursements. Chinese policy banks have turned from a source of developing country growth into net global debt collectors. The Russia risks could amplify that trend. The Global South faces new risks of a sudden stop in Chinese lending and ripple effects may be substantial. As Chinese banks face pressure both at home and abroad, their appetite to provide fresh financing and meaningful debt relief to developing countries is poised to decrease. Moreover, it may become more challenging to refinance existing debts that are coming due. Chinese loans have comparatively short maturities and need to be rolled over frequently. For many poor and highly indebted countries this implies a growing dependence on Chinese debt evergreening, because alternative sources of financing may be unavailable or prohibitive in cost”.
  • Vijay Prashad argues “Sri Lanka has been dragged into the U.S.-imposed hybrid war against China, whose investments have been exaggerated to shift the blame for the country’s debt crisis away from Sri Lanka’s leaders and the IMF. Official data indicates that only 10 percent of Sri Lanka’s external debt is owed to Chinese entities, whereas 47 percent is held by Western banks and investment companies such as BlackRock, JP Morgan Chase, and Prudential (United States), as well as Ashmore Group and HSBC (Britain) and UBS (Switzerland). Despite this, the IMF and USAID, using similar language, continually insist that renegotiating Sri Lanka’s debt with China is key. However, malicious allegations that China is carrying out debt trap diplomacy[7] do not stand up to scrutiny”.
  • Vasuki Shastry and Jeremy Mark note IMF estimates “30 percent of emerging market countries and 60 percent of low-income countries already are in or nearing debt distress”. However, “the international community doesn’t seem prepared to do much about it” and “the Group of Twenty (G20) finance ministers failed to even to issue a communiqué”. “This difficulty has only become more complex as global economic power has shifted over the past two decades from the West toward China. Similarly, the role of bondholders and other commercial lenders has increased in importance since the 2008 global financial crisis”. “The COVID-19 crisis – which hit the poorest developing countries hardest – forced the G20 to jury-rig a combination of a debt-service moratorium (which ended last year) and a restructuring process called the Common Framework, which is built around creditor committees of government lenders. But that process has been exceedingly slow to get off the ground in the first three countries to seek restructuring – Chad, Ethiopia, and Zambia – in large part because Beijing is resistant to debt reductions (as opposed to delayed payments). Private-sector lenders have done little to contribute to a solution to the debt problem since the pandemic hit. Despite holding a large proportion of developing-country debt, they refused to join the debt-service moratorium and often oppose debt reduction. In Chad, for example, the giant Swiss commodities trader Glencore, which holds over one-half of the country’s debt, has refused to agree to a debt reduction. Delays in the debt-restructuring process are costly for the affected countries: The IMF requires creditors to provide financing assurances of debt restructuring or refinancing in order to proceed with its own loans. When it was just G7 governments hammering out deals through the Paris Club of sovereign lenders, the process often could be completed in weeks; now it’s taking months – resulting in deeper pain among those most exposed to the human impact of a default, as has occurred in Sri Lanka. Ironically, Beijing was rebuffed by the IMF when it called for a Zambia lending program to proceed before a debt agreement had been reached”. “To its credit, the international community has taken steps to free up resources to assist countries facing severe economic difficulties. Last year, the IMF approved the issuance of $650 billion in reserve assets to member countries, with wealthy countries slowly starting to make their shares of the issuance available to poorer nations. But even a process as unwieldy – and so far ineffective – as the G20 Common Framework is only available to the poorest countries. There is no systematic path forward for emerging-market countries like Sri Lanka and others that may yet default. The key stumbling block is China, which – despite its professed commitment to international standards – is likely to remain resistant to international rules that affect its massive exposure as a sovereign lender. There have been recent examples of effective debt workouts for middle-income countries: Ecuador in 2020, for instance, and Suriname last year. The lessons of those two restructurings, which involved Chinese loans, need to be closely examined. Otherwise, more countries like Sri Lanka will be left without recourse. One immediate need is to consider a return to temporary suspension of interest payments – for both poor and middle-income countries – to give countries breathing room, and to introduce some form of bridge financing if financial assurances to the IMF are not forthcoming in a timely fashion”.
  • Cynthia Chung notes SAIS-CARI[8]’s report Debt relief with Chinese characteristics “found that between 2000 and 2019, China has cancelled at least US$3.4 billion of debt in Africa. There is no China, Inc…We found that China has restructured or refinanced approximately US$ 15 billion of debt in Africa between 2000 and 2019. We found no asset seizures and despite contract clauses requiring arbitration, no evidence of the use of courts to enforce payments, or application of penalty interest rates.” “During the debt crisis of the late 20th century, we saw that many sovereign borrowers simply did not service the interest-free loans lent by the Chinese government. Because the interest-free loan program was diplomatic in nature, a core part of China’s foreign aid, pressing hard for loan repayment was simply not done. As of 2019, with a much wider variety of loans in play – many commercial-rescheduling is no longer so easy, although it is happening. Beijing’s main tool to press for payments when a country goes into arrears is to suspend disbursements on projects currently being implemented (which slows their completion but also hurts Chinese contractors), and to withhold approval of new loans”. The cost for violating the contract is actually quite low for the borrowers as “Beijing is concerned with its international reputation and its long term political and diplomatic relationship with individual countries. In addition, Chinese contractors, who usually advance their own money to get a project launched before being reimbursed through Chinese bank disbursements, suffer from project suspensions. Although loan contracts provide for arbitration in case of default, there is no evidence that Chinese banks have ever used this option, or that a judgment could actually be enforced, were it to be in their favor. We also see no evidence of penalty interest rates”. In comparison “with eurobonds, you don’t play around when the payments are due. Chinese debt can easily be renegotiated, restructured or refinanced”. “The efforts of debt-cancellation advocates seem to continue to fall on deaf ears, as the IMF and the World bank refuse to make any move towards cancelling the debt of African countries. The Bank’s hypocrisy is observed in the fact that it continues to pressure China, Africa’s largest creditor, to cancel its debt to poor countries while itself has yet to cancel the debt it is owed.” “China is Africa’s largest creditor, it is also Africa’s largest debt canceller and is the most flexible in its renegotiation of debt and does not penalise through interest rates”. “It is in fact the IMF and World Bank loans, who refuse to be flexible in repayment of these debts. It is they who refuse to make any significant cancellation of debt owed to them by Africa, and who maintain these loans at exorbitant interest rates, which are behind the debt problem in Africa. In addition, contrary to the enforced conditionalities that come from IMF and World Bank loans that discourage essential infrastructure like electrical grids, China is actually building infrastructure in Africa”.
  • Harry Verhoeven notes at a recent Forum for China Africa Cooperation ministerial meeting, China “committed to no longer demanding repayment of concessional loans that in the recent past had reached maturity, but which 17 African states had failed to pay off”. He thinks “the cancellation of loan balances that were unlikely to be serviced in full, anyway, therefore appears at this moment to be a low-cost political move for China to reaffirm its deep ties with African sovereigns and emphasize mutual goodwill. In the short term, that might be the case. But fundamentally, Beijing’s decision does little to alter Africa’s growing indebtedness” nor ease the pressure on African sovereign yields and exchange rates. “Amid geopolitical posturing by China and the US, there is still little sign that global powers or the international financial institutions will finally tackle the systemic drivers of the resurgence in African debt”.

Previously, international debt workouts were managed by a select group of financiers representing OECD interests. Past workouts have been criticised for conditionalities that worsened economic conditions, letting global lenders off too easily and forcing the assets at fire-sale prices to foreign buyers. China’s emergence as a major lender changes the situation. The West and China worry about the other side free riding on their efforts. Geopolitical conflicts are increasing the complexity of and hampering sovereign debt restructuring[9].

  • Changing patterns in global savings recycling

The core of monetary disorder relates to USD centrality and the changing patterns of global savings recycling. Michael Pettis notes “while there has been much debate over whether or not the world – or at least part of the world, including countries like China, Iran, Russia, and Venezuela – can live without the dollar, there has been much less attention on an equally important issue: what the trade impact would be of a world less tied to the U.S. dollar. The two issues cannot be separated. The issue of the dollar is part of the debate over global capital flows, but capital flows are just the obverse of trade and current account flows. Savings, after all, can only be expressed as the excess production of goods and services”. In this context, US sanctions “limit the ability of foreigners to use U.S. financial markets as the absorber of last resort of global savings imbalances”. However, “a global economy without the U.S. dollar – or some unlikely alternative – as the currency lingua franca also would be a global economy in which large, persistent trade and savings imbalances are impossible…with so many major economies locked into structural domestic demand deficiencies, any policy that forces an elimination or sharp reduction of global trade imbalances also would force deep institutional changes in the global economy – changes which also would likely be politically disruptive for many countries. This is especially the case for countries whose economies have grown around persistent trade surpluses”.

Michael Pettis explains “surplus economies must acquire foreign assets in exchange for their surpluses…A country can only import net foreign savings by exporting ownership of assets, and the United States and other similar economies are the only stable, mature economies that are both willing and able to allow foreigners unfettered access to the acquisition of local assets. To put it another way, they are the only major economies both willing and able to run the permanent trade deficits that accommodate the needs of foreign surplus-running countries to acquire foreign assets…these countries account for 70–75 percent of the world’s current account deficits (with the developing world accounting for most of the rest), this would also mean that, unless some other large economy proves willing to convert its surpluses into massive deficits, the world would have to reduce its collective trade surpluses by 70–75 percent…This just reinforces how it is the willingness and ability of the United States to run large, persistent deficits that underpins the role of the dollar as the world’s dominant currency, and how it is these deficits that most benefit, directly or indirectly, the countries that claim to be most eager to dethrone the U.S. dollar. These are also the countries – especially China – who claim to be most keen to have their currencies replace the U.S. dollar even as their domestic economic policies make this impossible”.

But there is a geopolitical loophole in the “there is no alternative (TINA) to the US dollar” argument. While Western economies continue to chalk up large trade and fiscal deficits, they are no longer willing to guarantee the sanctity of ownership rights of adversaries; thereby turning OECD safe assets into conditional assets. In addition, they discourage adversaries from buying their assets. This turns the TINA question on its head. What happens when surplus countries like Russia – and perhaps China later – are no longer allowed to invest in US and OECD currencies and assets. There can only be two adjustments. First, Russia and China must find new homes for their excess savings within the global south. Second, since non-OECD capital inflow into OECD will drop substantially, OECD economies will find it difficult to sustain large deficits[10]. The outcome is to reduce imports and aggregate demand at the global level – with ominous implications for the global economy.

The new pattern of savings recycling (investment), together with production and trade, will generally be predisposed to circulating within spheres. This is disadvantageous to the matured US, European and East Asian markets. It also points to the intensification of strategic competition for influence, resources and markets in the Global South. Overall, rising geopolitical conflict is introducing frictions that will result in non-optimal reinvestment of savings and will result in net losses for the global economy.

On the monetary front, the changing patterns of global savings recycling implies a transition from large-scale sterilisation (QE) to an era of global central bank balance sheet normalisation (QT). This implies an exit from the goldilocks economy and a return to the post 1970s high inflation and high interest rate environment. In this environment, central bank balance sheet expansion is constrained by the threat of imported inflation while spreads and hedging costs widen as investors require higher returns to compensate for higher risks. Global intermediation – especially short-term, low-margin carry trade arbitrage – will diminish in tandem with firm and investment deleveraging. De-dollarisation will accentuate deleveraging and accelerate a shift in financial intermediation among non-OECD countries, intermediaries and currencies. As OECD liquidity shrinks, policy-makers will need to ensure the orderly unwinding of the overhang of financial products in their markets.

  • Inflation-to-deflation conundrum

Policymakers and market players see it coming. After decades of a Goldilocks economy, the reappearance of inflation[11] is the outcome of factors such as the pandemic; the overextension of QE and accumulated deficit imbalances; rising geopolitical tensions, deglobalisation[12], the changing patterns of global savings recycling and war. There are several interesting features of the inflationary phase.

First, inflationary pressures are more evident in developed countries. Luca Fornaro and Federica Romei explain that since the pandemic, exceptionally high global demand for tradable goods relative to non-tradable services “push the global economy into stagflation, driven by scarcity of tradable goods. Countries running trade deficits export high inflation abroad, while policies that boost production of tradable goods and current account surpluses act as a benign disinflationary force. Due to a free riding problem, national monetary authorities may fall into a coordination trap leading to excessively high unemployment. High energy prices exacerbate all these effects”.

Second, the paradox of strong USD and high US inflation. Peter Schiff[13] points out “the overall dynamics make no sense whatsoever. The US has the highest inflation in 40 years, and yet it also has the strongest dollar in 20 years. How can that be? How can the dollar be so weak and yet be so strong at the exact same time?” He explains that “inflation is the loss of a currency’s purchasing power…That’s what’s happening in the US. It’s not so much that prices are going up. The value of the dollar is going down. There are trillions more dollars in the economy than there were a few years ago and therefore the value of each dollar is falling. But while the dollar is losing value, it’s not been this strong in decades. It’s gaining value relative to other currencies. That is the dichotomy. It’s a tale of two dollars. You have the domestic dollar that is weak and losing value. And then you’ve got this international dollar that is strong and is gaining value. The strength of the international dollar is helping Americans somewhat, but the weakness domestically is outstripping that international strength”. “Where is all the demand for dollars coming from? Foreigners don’t need dollars to buy US products. The US is running a massive trade deficit. The demand is coming from speculators”. “All of the world’s central banks have expanded their money supply. For people outside the US, the dollar looks like a solution to that problem”. From the European and Japanese perspective, “yields in the US are very positive because they’re looking at the appreciation of the US dollar.” While “right now, the dollar is acting as an inflation hedge for everybody outside of the United States. It’s not an inflation hedge inside the United States. You can’t buy the dollar to hedge inflation if you’re an American living in the US because there’s no hedge. The dollar is losing value”.

My hypothesis is the strong USD-high inflation paradox arises due to market failure and monetary disorder. Market failure occurs because its mechanisms are being damaged by government policies focusing on geopolitical, pandemic and climate change objectives over economic considerations. As a result, high prices do not incentivise supply expansion. Instead, markets react by rationing supply until prices rise. A  strong USD translate into higher prices in other currencies.

From a monetary viewpoint, strong USD is not reflecting a shortage of USD but rather a shortage of liquidity. From an intermediation viewpoint, the cost of unmatched trades (inventories) is negligible at near-zero or negative levels. Intermediaries are therefore willing to hold large inventories. Inventory costs are high at 4% and therefore intermediaries will significantly downsize their inventories. This will cause hedging costs to rise and as it becomes more costly to cover large positions, trade sizes will shrink and reduce market liquidity.

Third, there is a need to consider the significance of inflation as a wartime and geopolitical phenomenon. Drawing on analysis by Nicholas Mulder[14] and Isabella Weber[15], Esfandyar Batmanghelidj highlights John Maynard Keynes’ insight, in his 1919 tract Economic Consequences of the Peace, that attempts to keep “Germany in a state of perpetual crisis, the European economy would never recover. Tearing up Germany’s fabric would keep Europe on the path to another great war…Keynes’ polemic, vindicated by World War II and frighteningly relevant today, is driven by two insights. First, wars do not only reshape political orders, but also the organization of economic orders. Second, the consequences of such economic disorganization tend to persist even after wars end, whether because of deliberate acts, such as the economic punishment imposed on Germany or now being meted out to Russia, or because of the entropic tendency of economic systems”.

Esfandyar Batmanghelidj notes the Chinese were aware of the “menace of inflationism” in “provoking economic pressure it could cause war to escalate…Here, the vicious cycle between economic war and conventional war becomes clear”. “When Chinese forces sought to push out the Japanese invaders, they were subjected to a blockade. The consequences of that blockade were profound…hyperinflation was a key factor in the fall of the Nationalist regime. Inflation began with the outbreak of the Sino-Japanese War in 1937 and by the mid-1940s had evolved into chronic hyperinflation… helped to pave the way for communist forces to cement their hold over China”. Chen Yun, who became a key architect of China’s economic reforms of the late 1970s and early 1980s, was aware of the dangers of hyperinflation and began to stress “the importance of trade and commodity circulation for economic development…In 1950, Chen would coin a highly influential economic slogan that captured his approach to economic policymaking: Rising prices are not good, falling prices, too, are not good for production. It is better to be groping for stones to cross the river more steadily”. In 1980, at a time, when international economists were pushing China to pursue rapid price liberalization or shock therapy, “Chen prevailed – his speech earned the full endorsement of Deng Xiaoping, who presided over China’s opening to the world from 1978 to 1989. In this way, China’s escape from shock therapy owes something to the wartime experiences of Chen, who witnessed both the limits of autarky and the importance of stable prices during a war when inflation itself was being weaponized”.

Welcome to the war economy, where heads of state matter more than heads of central banks, Zoltan Pozsar[16] wrote, in…War and Interest Rates…The low inflation world stood on three pillars…Cheap immigrant labor keeping service sector wages stagnant in the US, cheap goods from China raising living standards amid stagnant wages [and] cheap Russian gas powering German industry and the EU more broadly…China and Russia, two of the world’s largest producers of commodities and consumer goods, provide two pillars of the low inflation world and as such can be viewed as the main guarantors of macro peace, providing all the cheap stuff that was the source of deflation fears in the West, which, in turn, gave central banks the license for years of money printing.” “If we’re right that the economic war is the right context to understand inflation, then Western central banks will not have any good options to slay inflation, Pozsar remarked, noting that monetary policymakers can surely reduce demand by raising rates, but what if supply curves shift inward faster than demand curves?” Pozsar argues if you think inflation is cyclical caused by inflated demand against a temporarily supply-constrained backdrop, then “inflation has likely peaked”. However, if you think it is structural arising from “a messy transition to a multipolar world order, where two great powers are challenging the might and hegemony of the US”, then “inflation has barely started, and could actually be understood as an outright instrument of war.” In any case, it is evident that “we need a recession to curb inflation” and Instead of the question of whether, why don’t we think about the depth of the recession needed to curb inflation?”

While the consensus is that the inflationary phase will be followed by a deflationary phase, there are interesting questions on the details.

  • Cost-push inflation and geopolitical risk aversion has triggered demand destruction and there are signs of a recession emerging. But there is no visibility on when inflationary pressures will be eliminated or when inflation will finally be replaced by deflation?
  • Higher interest rates and cross-border deleveraging triggered a meltdown across most asset classes (equities, bonds, property and crypto). The crystallisation of losses has severely impaired private and public sector balance sheets. Will central banks be able to stem a further collapse in asset prices and the contractionary effects from wealth losses, growing illiquidity and risk aversion? What are the consequences if the free-fall in asset prices cannot be stemmed?
  • The consensus view is that interest rates are near their peaks and then should reverse as demand destruction and recession sets in. But central banks face a tension between normalising their balance sheets (QT) to restore policy credibility versus monetising fiscal deficits (QE) to prevent the economy from a deep recession. Interest rates will rise if central banks do not buy more government debt but cutting fiscal spending combined with private sector retrenchment would give rise to liquidity trap conditions and cause interest rates to revert to near-zero levels. Hence, the task of central banks is to set interest rates at a level most likely to stabilise monetary conditions.
  • The strong USD trend would naturally reverse course at some point. My view is that trend reversion would occur once the tension between the high US interest rates and the monetary policies of other countries are resolved and/or once the unwinding of cross-border leverage is completed. In the following phase, the USD will depreciate as external demand for USD will be weak. The USD is unlikely to recover without a recovery in cross-border re-leveraging and re-dollarisation.


Central banks face tremendous policy challenges in navigating the treacherous journey from an inflationary to a deflationary environment. The uncertainty relates to how long inflation will stay stubbornly high and how fast and sharp the economic deceleration will be. The quandary for the central banks is that if they stop raising interest rates and inflation doesn’t fall sufficiently, then they would be blamed for being behind the curve. However, if they continue to raise rates and the economy contracts severely, they would be blamed for worsening the recession. Hence, monetary policy challenges should be framed with the context of global monetary disorder, the transition from an inflationary to a deflationary environment, and rising geopolitical tension.


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Phuah Eng Chye (5 June 2021) “Global reset – Two whales in a pond”.

Phuah Eng Chye (19 June 2021) “Global reset – Monetary decoupling (Part 1: Sterilisation and QE)”.

Phuah Eng Chye (3 July 2021) “Global reset – Monetary decoupling (Part 2: Economics of large central bank balance sheets)”.

Phuah Eng Chye (17 July 2021) “Global reset – Monetary decoupling (Part 3: Consequences of diverging policies)”.

Phuah Eng Chye (31 July 2021) “Global reset – Monetary decoupling (Part 4: Lessons from Plaza Accord)”.

Phuah Eng Chye (14 August 2021) “Global reset – Monetary decoupling (Part 5: The end of USD supremacy – Will it be different this time?)”

Phuah Eng Chye (28 August 2021) “Global reset – Monetary decoupling (Part 6: The forthcoming currency war)”.

Phuah Eng Chye (11 September 2021) “Global reset – Monetary decoupling (Part 7: Currency wargame scenarios)”.

Phuah Eng Chye (25 September 2021) “Global reset – Monetary decoupling (Part 8: Sovereign digital currencies and networks in the currency war)”.

Phuah Eng Chye (4 December 2021) “Global reset – Monetary decoupling (Part 13: Intermediaries in the era of globalisation and decoupling)”.

Phuah Eng Chye (30 July 2022) “The Great Economic War (GEW) (Part 1: The beginning)”.

Phuah Eng Chye (13 August 2022) “The Great Economic War (GEW) (Part 2: Strategic concepts and implications)”.

Phuah Eng Chye (27 August 2022) “The Great Economic War (GEW) (Part 3: The financial nuclear bomb)”.

Phuah Eng Chye (10 September 2022) “The Great Economic War (GEW) (Part 4: Battles reshaping the global monetary order)”.

Sebastian Horn, Carmen Reinhart, Christoph Trebesch (8 April 2022) “China’s overseas lending and the war in Ukraine”. Voxeu.

Therealheisenberg (2 August 2022) “Zoltan Pozsar: Welcome to the war economy.”

Tyler Durden (18 July2022) “Peter Schiff: A tale of two Dollars”.

UN Conference on Trade and Development (UNCTAD) (28 June 2022) “Maritime trade disrupted: The war in Ukraine and its effects on maritime trade logistics”.

Vasuki Shastry, Jeremy Mark (21 July 2022) “The world isn’t ready for the looming emerging-market debt crisis”. New Atlanticist.

Vijay Prashad (6 August 2022) “How Sri Lanka is being dragged into US-China conflict”. Consortium News.

Yakov Feygin (9 January 2021) “The deflationary bloc”. Phenomenal World.

[1] See Frank Tang.

[2] See UNCTAD report on how the war in Ukraine has affected maritime trade logistics.

[3] See MN Gordon on the impact on work when income is outpaced by rising costs.

[4] Examples include rationing of flour, sunflower oil and sugar by stores in Greece , shortages of eggs and dairy products in Spain, and possible natural gas rationing In Italy and Germany. See Michael Snyder.

[5] Andrew Yamakawa Elrod explains how during war, government make decisions on a non-price basis to allocate resources “to wherever they can expand the necessary composition of final goods required by the program”. See also Mariya Grinberg.

[6] See Anna Gelpern, Sebastian Horn, Scott Morris, Brad Parks and Christoph Trebesch.

[7] See Deborah Brautigam and Meg Rithmire.

[8] Johns Hopkins School of Advanced International Studies (SAIS)-China Africa Research Initiative (CARI).

[9] Kris James Mitchener and Christoph Trebesch for an overview.

[10] See Chad P. Bown on the deterioration in trade between US and China, as hardening geopolitics impacts global trade.

[11] See Yakov Feygin provides a historical perspective on monetary theories on inflation.

[12] See Charles Hugh Smith “Deglobalization Is inflationary”.

[13] See Tyler Durden.

[14] Nicholas Mulder (2022) The economic weapon: The rise of sanctions as a tool of modern war (Yale University Press).

[15] Isabella Weber (2021) How China escaped shock therapy: The market reform debate. Routledge.

[16] See Therealheisenberg. See also Michael Lebowitz.