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What We're Reading:

Counting the cost of Vietnam’s Covid collapse. Vietnam has swung from Covid-containing success to failure with implications for the ruling Communist Party's standing. (Asia Times)

'You are playing with fire': EU faces crisis over Polish court ruling. A Polish court ruling challenging the supremacy of European Union law plunged the EU into an existential crisis on Friday, increasing fears among EU policymakers and many Poles that Poland could eventually leave the bloc. (Reuters)

US Senate averts crisis by voting to extend debt ceiling. The US Senate has voted to temporarily raise the nation's debt limit, avoiding a historic default that experts say would have devastated the economy. (BBC)

Supply chain volatility in the automobile industry. Vehicle production is taking a toll due to the ongoing computer chip shortage. According to a report by Goldman Sachs and forecasts by advisory experts, they predict the shortfall to persist throughout the rest of 2021, into 2022, and 2023, since demand will remain strong and supply will remain restricted. (Global Risk Insights)

Ireland ends 12.5% tax rate in OECD global pact. Low-tax policy of past 18 years had attracted multinationals such as Google and Facebook to Dublin. (The Guardian)

China crackdown: How much pain can the economy take? Beijing has taken aim at its high-tech, energy and property sectors in recent months, spooking investors who were used to decades of unprecedented growth. How much self-inflicted pain can China's economy endure? (DW)

Middle East economies suffer $200bn in losses from Covid, World Bank warns. Due to the pandemic, the economies of the Middle East and North Africa region will continue to incur losses of around $200 billion until the end of 2021, the World Bank announced Thursday. (MEMO)

N.Korea's food situation appears perilous, experts say. North Korea's food situation remains perilous according to analysts and a United Nations expert who raised doubts this week about its harvest, and there are signs that it is receiving large shipments of humanitarian aid from China. (US News & World Report)

Canada shrugs at China’s application to join Pacific Rim trade agreement. Canada is giving China the cold shoulder over its interest in joining an 11-country Pacific Rim trading bloc that is viewed as an important gateway to diversifying Canadian trade with other Asian countries. (EIN News)

Post-pandemic social movements to hamper trade in emerging markets. An expected surge in post-pandemic political and civil unrest could hamper international trade in the coming years, new research warns, with exporters in emerging markets anticipated to be some of the worst affected. (Global Trade Review)

How COVID-19 in Southeast Asia is threatening global supply chains. Fresh coronavirus outbreaks in Southeast Asia have hurt factory activity across industries, threatening the region’s recovery from the COVID-19 pandemic and disrupting global supplies of goods such as apparels, automobiles, and electronics. (HSN)

Biden’s long-awaited China policy ‘no dramatic shift’ from Trump era. US Trade Representative Katherine Tai has for the first time set out the Biden administration’s “new approach” to trade with China, though experts suggest the strategy largely maintains policies introduced during the Trump era. (Global Trade Review)

UK regulators’ trade finance crackdown could have unintended consequences, industry says. An influential trade finance industry group says pressure from UK regulators to strengthen risk management processes could have unintended consequences for receivables finance and trade credit insurance. (Global Trade Review)

Key global events to watch in October. A list of key upcoming meetings and events that have implications for global affairs compiled by the Global Observatory. (Global Observatory)

‘The supply chains are everything at this point,’ economist explains. Supply chain tightness is causing heightened concern over the growth of the U.S. economy while companies mired in trucking and shipping delays scramble to find alternative routes. (HSN)

The Kamakura Troubled Company Index for September reflects “very low” short-term default risk, but an increase in long-term risks—new and old. The index measures the percentage of 40,500 public firms in 76 countries that have an annualized one- month default risk of more than 1%. 

Short-term risks have remained fairly low due to low interest rates, narrow spreads and a generally good macro-economic environment supported by both government fiscal stimulus and Federal Reserve bank actions, said Martin Zorn, president and chief operating officer of the Kamakura Corporation. However, risks of inflation and the need for central banks to quickly and aggressively raise interest rates or taper bond purchases could produce a liquidity shock that will impact more leveraged firms first, Zorn added.

“September ended with an increase in crosscurrents for portfolio managers to digest,” Zorn said. “As of the end of the month, there were an estimated 500,000 containers sitting on cargo ships off the Southern California coast, providing a daily reminder of the continuing challenges plaguing the supply chain,” he said. Among the litany of other risks, Zorn included the S&P500’s worst monthly performance since March 2020; China’s power crisis; the Evergrande debt crisis; and global energy markets’ commodity shortages.  

Despite the challenges, credit quality in September only decreased slightly, going from 2.61% in August to 3.56% (an increase in the index reflects declining credit quality). Worldwide corporate credit quality remains at the 99th percentile for the period of 1990 to 2021, with 100 indicating “best conditions.”

At the close of September, the percentage of companies with a default probability between 1% and 5% was 3.24%, an increase of 0.81% from the previous month. The percentage with a default probability between 5% and 10% was 0.26%, an increase of 0.26%. Those with a default probability between 10% and 20% amounted to 0.05% of the total, representing an increase of 0.05%; and those with a default probability of over 20% amounted to 0.01%, an increase of 0.01% prior month.

 Among the 20 riskiest-rated firms, nine reside in China, seven in the U.S. and one each in Brazil, India, Ireland and Spain. The index also identifies GTT Communications, Inc., a U.S. multinational telecommunications and internet service provider, as the riskiest-rated firm with a one-month default probability of 14.19%--up 1.69% from the previous month. Three global defaults also were noted in the Kamakura coverage universe: two in China and one in the Philippines. 

“Given the number of risks that are arising in the market, the first step to hedging them is to determine the macro-economic factors that have the highest correlation to payment risks or default risks that one is exposed to,” Zorn said. For example, he added, the value of the dollar as part of foreign exchange rates or interest rates that should correlate to inflation expectations. Zorn also suggests credit insurance as a viable option.

“Determine what risks you are exposed to and whether they correlate to the market, are specific to your counterparty or relate to your contractual terms,” he said. “The increasing number of economic crosscurrents are a red flag telling you to look at your risks a little more closely.”

Based on commentary by Nouriel Roubini (Goldilocks Is Dying) and Mohamed El-Erian (Taming the Stagflationary Winds), Zorn outlined four possible outcomes for today’s macroeconomic crosscurrents:

1. Supply chain bottlenecks will disappear and no new Covid variants will emerge.  
2. We could see growth accelerating as bottlenecks clear, with inflationary pressure continuing to build and central banks scrambling to catch up.
3. Stagflation could force central banks to walk a tightrope as they try to normalize rates without triggering a crisis amid high public and private debt ratios.
4. Pressures on the demand side will lead to a global slowdown.

“In sum, looming ahead, there is one possible good outcome and three possible bad ones,” Zorn said. “The Kamakura Expected Cumulative Default Rate continues to show very low short-term default risk and very high long-term risk. We need to heed these warnings. even if we think the risks can be managed.”

A strong recovery in the supply chain can help avoid these long- and short-term risks, he explained. In the meantime, Zorn recommends credit professionals to focus on other drivers of the economy. “The implication is to stay flexible and nimble, and employ risk management practices appropriate for the set of uncertainties that currently exist in the market. The main takeaway for credit managers that have longer term exposures is a return to fundamentals to ensure that the counter-party is financially sound with both a good track record and good management.”

The withdrawal of support measures for companies sets the stage for a gradual normalization of business insolvencies, according to a new Euler Hermes report.

“Our Global Insolvency Index is likely to post a 15% year-on-year rebound in 2022, after two consecutive years of decline,” the trade credit insurer reported. The report finds that government interventions prevented one out of two insolvencies in Western Europe and one out of three in the United States—leading to a 12% drop in 2020.

The firm expects “a fine-tuned and step-by-step withdrawal of support,” which should keep insolvencies at low levels for 2021 in most countries. Although the expectation is for business insolvencies to gain traction in 2022, the numbers should “remain blow pre-Covid-19 levels in most countries,” Euler Hermes said.

The report also finds:

• Several European countries and emerging markets could see a resurgence much sooner than the U.S. and parts of Asia. 
• Africa should see business insolvencies exceed pre-Covid-19 levels by 2021 itself, while Central and Eastern Europe and Latin America will follow suit in 2022. 
• Western Europe will post mixed trends: Spain and Italy are likely to see a large recovery of insolvencies by 2022 (5,110 and 10,500 insolvencies, respectively) due to their higher shares of sectors sensitive to Covid-19 restrictions. In contrast, France (37,000), Germany (16,300), Belgium (8,150) and the Netherlands (2,400) will take longer to return to pre-crisis levels because of large support packages and/or the extension of support measures. 
• The U.S. is the main outlier, with a low number of insolvencies likely both in 2021 and 2022 due mainly to the combination of massive support (notably the Paycheck Protection Program in 2020 and the recovery plan in 2021-22) and the fastest economic rebound in over three decades.
•  Asia will also record fewer insolvencies in 2022, compared to 2019, thanks to its faster exit from the pandemic and its economic recovery.

Euler Hermes has identified five factors that will set the tone of the path ahead for global insolvencies:

• The global momentum of the economic rebound, which will be decisive for the pace of removal of state support measures, and in turn impact the pace of business insolvency normalization: Most advanced economies should see GDP growth above the 1.7% required to stabilize insolvencies in 2021-22. As a reminder, Euler Hermes estimates that global GDP will grow by 5.5% in 2021 and 4.2% in 2022;
• The pace of withdrawal of state support, since it will also influence the cash burning dynamic of companies;
• This point is even more important as many fragile companies will still be at high risk of default, notably the pre-Covid-19 “zombies” kept afloat by emergency measures and the companies weakened by extra indebtedness from the crisis;
• The deterioration of companies’ financials, which is adding to debt sustainability issues;
• The quick recovery of business creation, since the increase in the number of businesses will mechanically increase the base for potential insolvencies, particularly in sectors where creation is highly related to meeting new needs arising from the pandemic (i.e., home delivery) but with uncertain viability.

The economic recovery has fueled a rapid acceleration in inflation this year for advanced and emerging market economies, driven by firming demand, supply shortages and rapidly rising commodity prices.

We forecast in our latest World Economic Outlook that higher inflation will likely continue in coming months before returning to pre-pandemic levels by mid-2022, though risks of an acceleration do remain. The good news for policymakers is that long-term inflation expectations are well anchored, but economists still disagree about how enduring the upward pressure for prices will ultimately be.

Some have said government stimulus may push unemployment rates low enough to boost wages and overheat economies, possibly de-anchoring expectations and resulting in a self-fulfilling inflation spiral. Others estimate that pressures will ultimately be transitory as a one-time surge in spending fades.

Inflation dynamics and recovering demand 

We examine if headline consumer price index inflation has moved in line with unemployment. Although the pandemic period poses many challenges to estimating this relationship, the unprecedented disturbance doesn’t seem to have substantially altered this relationship.

Advanced economies are likely to face moderate near-term inflation pressure, with the impact softening over time. Estimates of the relationship between slack, the amount of resources in an economy that aren’t being used, and inflation for emerging markets instead seem to be more sensitive to the inclusion of the pandemic period in the estimation sample.

Anchoring expectations

Inflation during the pandemic has been well anchored, according to measures of long-term expectations known as breakevens drawn from government bonds in 14 nations. These closely watched gauges have been stable so far during both the crisis and the recovery, though uncertainty about the outlook remains.

A key question is what combination of conditions could cause a persistent spike in inflation, including the possibility that expectations become unanchored and help spark a self-fulfilling upward spiral for prices.

Such episodes in the past have been associated with sharp exchange-rate depreciations in emerging markets and have often followed surging fiscal and current account deficits. Longer-term government spending commitments and external shocks could also contribute to expectations becoming de-anchored, especially in economies with central banks that aren’t believed to be able or willing to contain inflation.

Moreover, even when expectations are well anchored, a prolonged overshoot of the inflation target that policymakers have set could cause a de-anchoring of expectations.

Sectoral shocks

The pandemic has triggered large price movements in some sectors, notably food, transportation, clothing, and communications. Strikingly, the dispersion or variability in prices across sectors has so far remained relatively subdued by recent historical standards, especially compared with the global financial crisis. The reason is relatively smaller and shorter-lived swings in fuel, food, and housing prices post the pandemic, which are the three largest components of consumption baskets, on average.

Our forecast is that annual inflation in advanced economies will peak at 3.6% on average in the final months of this year before reverting in the first half of 2022 to 2%, in line with central bank targets. Emerging markets will see faster increases, reaching 6.8% on average then easing to 4%.

The projections, however, come with considerable uncertainty, and inflation may be elevated for longer. Contributing factors could include surging housing costs and prolonged supply shortages in advanced and developing economies, or food-price pressure and currency depreciations in emerging markets.

Food prices around the world jumped by about 40% during the pandemic, an especially acute challenge for low-income countries where such purchases make up a big share of consumer spending.

Simulations of several extreme risk scenarios show prices could rise significantly faster on continued supply chain disruptions, large commodity price swings, and a de-anchoring of expectations.

Policy implications 

When expectations become de-anchored, inflation can quickly take off and be costly to rein back in. Ultimately, central bank policy credibility and price expectations are difficult to precisely define, and any assessment of anchoring can’t be decided entirely based on relationships in historical data.

Policymakers therefore must walk a fine line between remaining patient in their support for the recovery and being ready to act quickly. Even more importantly, they must establish sound monetary frameworks, including triggers for when they would reduce support for the economy to rein in unwelcome inflation.

These thresholds for action could include early signs of de-anchoring inflation expectations, including forward-looking surveys, unsustainable fiscal and current account balances, or sharp currency swings.

Case studies show that while strong policy action has often tamed inflation and expectations for it, sound and credible central bank communication also played an especially crucial role in anchoring views. Authorities must be alert to triggers for a perfect storm of price risks that could be individually benign but when combined may lead to significantly more rapid increases than predicted in the IMF’s forecasts.

Finally, a key feature of the outlook is that there are significant differences across different economies. Faster inflation in the United States, for example, is projected to help drive the acceleration for advanced economies, though pressures in the euro area and Japan are estimated to remain relatively weak.

Francesca Caselli is an economist in the World Economic Studies Division of the IMF Research Department. 
Prachi Mishra is an Advisor in the Research Department at the IMF.
Reprinted with permission by the IMFBlog.

 

Week in Review Editorial Team:

Diana Mota, Editor in Chief and David Anderson, Member Relations