Why stagflation is an economic nightmare

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this period, rising unemployment and reduced business activity meant everyone had less money, yet surging inflation meant every dollar was worth a little bit less every day.

Moreover, this experience with stagflation fundamentally altered Americans’ way of life and ushered in an era of fuel conservation and rationing not seen since World War II.

WHAT CAUSES STAGFLATION?

The causes of stagflation are still hotly debated by economists. Before the 1970s, they generally didn’t believe it was possible to have both high inflation and high unemployment from a stagnating economy. Economists had thought that unemployment and inflation were inversely linked.

There are a few different theories on how both high inflation and a stagnating economy can coexist, however.

The most common is that stagflation happens when there is a so-called negative supply shock. That is, when something that is crucial to an entire economy, such as energy or labor, is suddenly in short supply or becomes more expensive. One obvious example is crude oil.

Oil is a key input into the production of many goods and services. When some event, like the Russian invasion of Ukraine, reduces the supply, the price of oil rises. Businesses in the U.S. and elsewhere that produce gasoline, tires and many other products experience rising transportation costs, which makes it less profitable to sell stuff to consumers or other companies no matter the price.

As a result, a great number of producers decrease their production, which decreases aggregate supply. This decrease leads to falling national output and an increased unemployment rate together with higher overall prices.

CAN THE US DO ANYTHING ABOUT IT?

For policymakers, there’s almost nothing worse than the specter of stagflation. The problem is that the ways to fight either one of those two problems – high inflation, low growth – usually end up making the other one even worse.

The Federal Reserve, for example, could raise interest rates – as it’s widely expected to do on March 16, 2022 – which can help reduce inflation. But that also hurts economic activity and overall growth, because it puts the breaks on borrowing and investment. Or policymakers could try to spur more economic growth – whether through government stimulus or keeping interest rates low – but that would likely end up fueling more inflation.

Put another way, you’re damned if you do, damned if you don’t. And that means solving the problem may simply depend on circumstances out of U.S. policymakers’ control, such as an end to the crisis in Ukraine or finding ways to immediately increase oil supply – which is tricky.

In other words, stagflation is a nightmare you never want to live through.

ECONOMY

PAN Finance Magazine Q2 2022

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Emmanuel Macron: Why France’s economy may secure his re-election

Niccolò Pisani

Professor of Strategy and International Business, International Institute for Management Development (IMD)

Emmanuel Macron remains ahead in the polls after the first round of the French presidential election, even if a second term is not the formality that it appeared to be a couple of months ago. With the world going through turbulent times as a result of Russia’s invasion of Ukraine and the fall-out from the COVID pandemic, the state of France’s economy and its future outlook are likely to play a key role in the election.

So how has France done recently? The numbers suggest it has been performing well compared to the world’s other major economies, and surely way better than initially expected when the pandemic hit. Macron seems to have invested the public funds largely derived from increased debt intelligently, trying to make the business environment more attractive for existing and new enterprises – not least those in tech.

ECONOMY The below chart compares changes in French PAN Finance Magazine Q2 2022 GDP with some other indicators related to demand, ranging from household consumption to foreign demand for French goods. You can see that the rate of GDP growth had returned to pre-COVID times by the fourth quarter of 2021, implying that the economy has been growing significantly. GDP growth for the first half of 2022 is expected to be 3.2%, after annual growth of 7% in 2021.

France is a leading exporter of pharmaceuticals, military equipment and cars, among other things, but exports is the only one of the indicators in the chart that is still below pre-COVID figures. It is also likely to be further hit by the EU’s Russia sanctions, given that Russia buys just over 1% of French produce.

That damage will be somewhat offset by the growing shift away from globalisation, which is likely to further incentivise French multinationals to grow their businesses within France itself. Having said that, France already imports more than it exports, and with the French trade deficit recently widening, imports are becoming even more dominant. This is something the next president may well need to tackle as self-sufficiency becomes more of a virtue.

Two other economic indicators are also particularly important to understanding France under Macron: unemployment and inflation. Both are relatively favourable.

UNEMPLOYMENT

The French unemployment rate fell to 7.4% in the fourth quarter of 2021, a level not seen since 2008. This is testimony to Macron’s reforms during his first term in office, among the most important of which has been cutting corporation tax from 33.3% to 25% and pushing for the French labour code to be changed to make it easier for firms to make people redundant. The labour reforms have increased workers’ job insecurity, but they also made for a livelier job market by encouraging businesses to hire people.

Economy minister Bruno Le Maire hailed as historic the fact that nearly 1 million businesses were created in France in 2021. Others pointed out that the majority of these were actually micro-enterprises with just one or very few employees. Either way, people’s willingness to create new businesses has been largely seen as an indicator of the economy’s vitality. Macron is pushing this as one of his biggest wins during his first term, and it could be one of the factors that carries him over the line on April 24. French inflation spiked to 4.5% in March, and the chart below shows a worrying upward pattern since last summer. Having said that, this remains one of the lowest rates among European countries – with Germany at 7.3% and Spain at 9.8%, for example. One reason is that France derives most of its power from its fleet of nuclear power plants, so it has been relatively insulated from the rises in oil and gas prices that have been causing problems elsewhere.

We should also not forget that just like many other countries responding to the pandemic, France’s public debt to GDP ratio rose: from 98% in 2019 to 116% in 2021. Higher inflation is one way to reduce this growing debt burden, although the levels of price rises that France and other countries are experiencing right now goes well beyond what central bankers would have liked.

Inflation also looks likely to get worse before it gets better, depending also on the evolution of the war in Ukraine. Coping with that problem is going to be another challenge for whoever is running France over the next five years. If that does turn out to be Macron, the French economy’s revamp under his management may well be seen as one of the main reasons why.

ECONOMY

PAN Finance Magazine Q2 2022

David Gann

Pro-Vice-Chancellor, Development and External Affairs, and Professor of Innovation and Entrepreneurship, Saïd Business School, University of Oxford

Marina Yue Zhang

Associate Professor of Innovation and Entrepreneurship, Swinburne University of Technology

Mark Dodgson

Visiting Professor, Imperial College Business School, and Emeritus Professor, School of Business, The University of Queensland

China’s ‘innovation machine’: how it works, how it’s changing and why it matters

China has had the world’s fastest growing economy since the 1980s. A key driver of this extraordinary growth has been the country’s pragmatic system of innovation, which balances government steering and market-oriented entrepreneurs.

Right now, this system is undergoing changes which may have profound implications for the global economic and political order.

The Chinese government is pushing for better research and development, “smart manufacturing” facilities, and a more sophisticated digital economy. At the same time, tensions between China and the west are straining international cooperation in industries such as semiconductor and biopharmaceutical manufacturing. pandemic, and particularly China’s rapid and large-scale lockdowns, these developments could lead to a decoupling of China’s innovation system from the rest of the world.

BALANCING GOVERNMENT AND MARKET

China’s current “innovation machine” began developing during the economic reforms of the late 1970s, which lessened the role of state ownership and central planning. Instead, room was made for the market to try new ideas through trial and error. The government sets regulations aligned to the state’s objectives, and may send signals to investors and entrepreneurs via its own investments or policy settings. But within this setting, private businesses pursue opportunities in their own interests. declining. Last year, the government cracked down on the fintech and private tutoring sectors, which were seen to be misaligned with government goals.

BUILDING QUALITY ALONGSIDE QUANTITY

China performs well on many measures of innovation performance, such as R&D expenditure, number of scientific and technological publications, numbers of STEM graduates and patents, and top university rankings.

Most of these indices, however, measure quantity rather than quality. So, for example, China has:

produced a huge number of scientific and technological publications, but lags far behind the US in highly cited publications, which indicates the influence and originality of research

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substantially increased R&D expenditure. However, the proportion of its R&D expenditure on basic research, especially by enterprises, is still far lower than in many industrialised countries

educated many more STEM graduates than any other country in recent decades, but still lacks top-tier talent in many areas such as AI and semiconductors

has applied for the most international patents of any country, but the quality of these patents measured by scientific influence and potential commercial value still lags international competitors.

Adding “quality” alongside “quantity” will be crucial to China’s innovation ambitions.

In the past, policies have aimed to “catch up” with known technologies used elsewhere, but China will need to shift focus to develop unknown and emerging technologies. This will require greater investment in longer-term basic research and reform of research culture to tolerate failure.

DEVELOPING SMART MANUFACTURING

Chinese firms can already translate complex designs into mass production with high precision and unmatched speed and cost. As a result, Chinese manufacturing is appealing to high-tech companies such as Apple and Tesla.

The next step is upgrading towards “industry 4.0” smart manufacturing, aligned with the core industries listed in the government’s Made in China 2025 blueprint. By 2020, China had built eleven “lighthouse factories” – benchmark smart manufacturers – the most of any country in the World Economic Forum’s “global lighthouse network”.

Building an advanced digital economy China’s giant tech companies such as Alibaba, Tencent and Huawei are also using machine learning and big data analytics to innovate in other fields, including pharmaceutical research and autonomous driving.

In China the regulations for biotechnology, bioengineering and biopharmaceuticals are relatively relaxed. This has attracted researchers and investors to several leading biotechnology “clusters”.

China’s population of more than 1.4 billion people also means that, even for rare diseases, it has a large number of patients. Using large patient databases, companies are making advances in precision medicine (treatments tailored to an individual’s genes, environment, and lifestyle).

The rising power of China’s big tech firms has seen the government step in to maintain fair market competition. Regulations force digital firms to share user data and consolidate critical “platform goods”, such as mobile payments, across their ecosystems.

International collaboration is key As we have seen in the recent triumph of COVID-19 vaccines, global collaboration in R&D is hugely valuable.

However, there are signs that such collaboration between China and the West may be under threat. The semiconductor manufacturing industry – making the chips and circuits which drive modern electronics – is currently global, but at risk of fragmentation.

Making chips requires huge amounts of knowledge and capital investment, and while China is the world’s largest consumer of semiconductors it relies heavily on imports. However, US sanctions mean many global semiconductor companies cannot sell in China.

China is now investing vast sums in an attempt to be able to make all the semiconductors it needs.

If China succeeds in this, one consequence is that Chinese-made semiconductors will likely use different technical standards from the current ones.

DIFFERENT STANDARDS

Diverging technical standards may seem like a minor issue, but it will make it more difficult for Chinese and Western technologies and products to work together. This in turn may reduce global trade and investment, with bad results for consumers.

Decoupling standards will increase the fracture between Chinese and Western digital innovation. This in turn will likely lead to further decoupling in finance, trade, and data.

At a time of heightened international tensions both China and the West need to be clear on the value of international collaboration in innovation.

ECONOMY

PAN Finance Magazine Q2 2022

Stefan Wolff

Professor of International Security, University of Birmingham

Tatyana Malyarenko

Professor of International Relations, National University Odesa Law Academy

Ukraine war: rising food prices are not the only global economic fallout

As the war in Ukraine heads into its fourth month, its economic consequences are becoming more apparent and begin to move up on the global political agendas. And in the same way in which Russia’s aggression has had political ramifications far beyond Ukraine, so do the economic repercussions. This is not to belittle the economic and infrastructural devastation of Ukraine, which will necessitate an enormous reconstruction effort, but to highlight the far-reaching impact of the war and how it is amplified by the global economic dynamics associated with it.

Some predictions anticipate Ukraine’s GDP in 2022 shrinking by between 30% and 45%. While an end to the war would reverse this negative trend, extensive damage to Ukraine’s infrastructure – estimated at close to US£80bn by early May – will slow the country’s recovery, regardless of how well and by whom it will be financed.

Similarly, a ceasefire or peace agreement may stop the exodus of Ukrainians from their homeland, but a swift return of the currently more than 6 million refugees, and around 8 million internally displaced people, will take time. Among those who return, many of them will not find their homes or jobs or any operational public services. Add to this the high casualty rates that Ukraine is suffering in the war and the trauma inflicted on the population at large, and it becomes clear that the country will also be depleted of significant human capacity needed for economic recovery.

Beyond Ukraine, the war has already led to gloomy predictions about a slowdown of the global economy, and possibly a recession. This is primarily driven by the surge in the price of oil and gas and the instability in international markets since the start of the war as well as the lack of certainty about how and when it will end.

WIDE-RANGING FOOD CRISIS

The other global economic fallout from the war in Ukraine is a major food crisis affecting many of the world’s most vulnerable populations. Ukraine is a major exporter of agricultural products, especially sunflower oil and wheat, but key export routes, through the country’s Black Sea ports, are now blocked because of a de-facto Russian naval blockade.

In addition, there have been reports that Russia, itself a major exporter of wheat, has stolen approximately 400,000 tons of grain from storage facilities in Ukraine. But it is not simply the current lack of Ukrainian agricultural products that contributes to the impending global food crisis, it is also a market expectation that this will continue, with the upcoming harvest in Ukraine greatly reduced. This is driving prices up for grain and cooking oil, making imports less affordable in poorer countries and contributing, together with rising energy prices, to a cost-of-living crisis even in rich economies, thereby further increasing the likelihood of a global recession.

The possibility of a prolonged global recession rather than the expected rapid post-pandemic recovery will have additional repercussions

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for global political stability. This is, of course, not entirely due to the war in Ukraine, but the consequences of the war have a potentially catalytic and exacerbating effect on already existing economic and political problems.

Among them, western economic sanctions on Russia, and secondary sanctions on companies and countries circumventing these sanctions, will go some way in decoupling major economies and scaling back the current level of globalisation, leading to a degree of longterm structural change in the global economy.

This is evident in the impending EU ban on oil imports from Russia and efforts to stop using Russian natural gas. At the same time, a large – and growing – number of western companies are leaving the Russian market.

FUTURE US-CHINA RELATIONS

Ukraine is also likely to accelerate the decoupling of the Chinese and US economies. One of the lessons China is learning from the western response to the war in Ukraine is the relative ease with which nearly half of Russia’s US$630 billion (£500bn) in foreign exchange and gold reserves have been frozen by sanctions from the US, EU, and their allies. In future, China will be more wary about having dollar reserves held abroad that could potentially be seized in this kind of manoeuvre.

This changing relationship would have an even more significant impact, further increasing an existing trend in which geo-economic and geopolitical developments are becoming more and more aligned and pitting the US and China against each other in a new global struggle for supremacy.

The speed with which this trend of US-China decoupling will continue, and whether it might be reversed, will depend, among other things, on how – and how quickly – the war in Ukraine comes to an end. The longer the war goes on and the less likely a negotiated outcome is, the more economic divisions will align with political ones and the more deeply divided will be the new European and global security order that eventually emerges.

It will be critical in this context how China will act and whether it will prioritise its economic interests (continuing trade with Europe and the US) or current ideological preferences (an alliance with Russia that makes the world safe for autocracies). If China manages to forge a solid alliance with Brazil, Russia, India and South Africa, known as the Brics countries, as envisioned by the Chinese foreign minister, Wang Yi, a new world order will have emerged.

ECONOMY

PAN Finance Magazine Q2 2022

Job Omagwa

Lecturer - finance and accounting, Kenyatta University

Kenya’s fuel crisis: how the country’s subsidy system works

HOW DOES KENYA GET ITS FUEL?

Kenya, like most of its East African neighbours, depends on imported refined petroleum products (petrol, diesel, jet fuel and kerosene) mainly from the Middle East. Oil marketing companies are the importers. The state estimates demand for the next import cycle and issues an open tender for the supply of petrol, diesel and kerosene.

Official records show that in 2021 the country imported 6.149 million litres of refined petroleum worth US$3.48 billion. The imports came mainly from the United Arab Emirates (US$ 1.41bn) and Saudi Arabia (US$1.14bn). Other sources included India, the Netherlands and Kuwait.

The tender is only open to the country’s 93 oil marketing companies. The winner orders the products, which it stores and distributes via the network of the state-owned Kenya Pipeline Company to other marketers, according to demand quotas. The established marketers do not have a countrywide reach. Smaller players have cropped up to fill that gap. These small retailers get their fuel from the established oil marketers.

HOW ARE THE OIL PRICES SET?

Kenya has an oligopolistic petroleum market structure. A few big firms are able to influence prices. In Kenya, about four marketers can influence prices.

The government implemented a maximum price cap in 2011. It did this because marketers had raised the price of fuel in response to increases in international crude oil prices between 2007 and 2008, but didn’t reverse them when international prices fell at the end of 2008.

The price cap is managed by the Energy and Petroleum Regulatory Authority. It sets maximum pump prices every 14th day of the month for various towns and cities in Kenya. The regulatory price takes care of the international crude oil cost, exchange rate, transport, storage and the marketer’s margin.

But the actual retail prices are set by individual firms based on their unique circumstances. These cannot exceed the regulator’s caps.

WHAT IS THE STABILISATION FUND AND HOW DOES IT WORK?

The stabilisation fund was envisaged in Kenya’s price control policy, right from the start, as a mechanism for cushioning the economy when global crude prices skyrocketed.

The fund became operational in 2021. It is meant to cushion consumers from unpredictable swings in global oil prices.

In particular, the fund was to remain operational as long as international crude oil prices rose above US$50 per barrel. By early 2021, international crude oil prices had risen to $55 per barrel. From each litre of petrol and diesel sold by oil marketing firms, KSh 5.40 would go towards the stabilisation fund.

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Without the fund, the forces of demand and supply would push retail prices beyond the regulatory caps, making the business untenable for oil marketers. In its absence, a litre of petrol currently retailing at KSh 142 in Nairobi would, for instance, be going for about KSh 173.

Compensation from the fund to oil marketing firms is based on a certain percentage of their respective fuel costs. Since the fund became fully operational in April 2021, the government has paid oil marketers a total of KSh 49.164 billion.

WHY THE FUEL SHORTAGE NOW?

The shortages were initially attributed by the Energy and Petroleum Regulatory Authority to hoarding by the oil market companies in anticipation of higher international prices. This is because the established marketers had stopped supplying fuel to small retailers at the countryside, prompting consumers to crowd nearby towns.

But the government later accused the four major oil marketers of economic sabotage. There have also been claims by the petroleum ministry that the four big oil marketers exported some of their stock to neighbouring countries.

However, the problem is that the stabilisation fund had not paid oil marketers for some time. By early April, the government had accumulated KSh 13 billion in unpaid fuel subsidies.

Despite approval of the release of KSh 34.44bn by President Uhuru Kenyatta to replenish the fuel stabilisation fund, the threat of another national shortage looms large as international prices continue to rise.

Oil marketing firms have often experienced stockouts due to a significant mismatch between demand (largely driven by panic buying) and supply. It would equally take a few more days to get their next supply, hence dry pumps for some days.

In addition, these firms would not exceed their allocation of stock by government despite increased demand for fuel. This could also explain why their pumps would run dry for some days. HOW DOES KENYA PREVENT A FUTURE CRISIS?

In my view, the government can forestall future shortage by:

Compensating oil marketing firms (out of the stabilisation fund) on time to avoid settlement in arrears, which is believed to have compelled most of the oil marketing firms to export much of their oil supply to the international market, where they would be paid cash upfront.

Increasing the capacity of the state-owned National Oil Corporation to store much more in fuel reserves. Such a reserve would stabilise supply in the event the private oil marketing firms engage in hoarding or opt to export their stock to the international market.

Scrapping the stabilisation fund, which, though legal, is not entrenched in the Kenya Energy Act 2019 or the Petroleum Act 2019. This would mean higher pump prices but supply might be much more assured.

BANKING & INVESTMENT PAN Finance Magazine Q2 2022

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What is an inverting yield curve and does it mean we’re heading for a recession?

Luciano Rispoli

Teaching Fellow in Economics, University of Surrey

One key predictor of downturns in the economy is what is known as the yield curve. This typically refers to the market for what the US government borrows, by issuing bonds and other securities that mature over different time horizons ranging from weeks to 30 years.

Each of these securities has its own yield (or interest rate), which moves up and down in inverse proportion to the security’s market value – so when bonds are trading at high prices, their yields will be low and vice versa. You can draw a chart that plots the yields of securities at each maturity date to see how they relate to one another, and this is known as the yield curve.

BANKING & INVESTMENT PAN Finance Magazine Q2 2022

In normal times, as a compensation for higher risk, investors expect expect higher rates of interest for money they lend over a longer time horizon. To reflect this, the yield curve normally slopes up. When it instead slopes down – in other words, when it inverts – it is a sign that investors are more pessimistic about the long term than short term: they think a downturn or a recession is coming soon.

This is because they expect the Federal Reserve, the US central bank, is going to cut short-term interest rates in future to stimulate a struggling economy (as opposed to raising rates to cool down an economy that is overheating).

Most closely watched is the relationship between two-year and ten-year US treasury debt. The so-called spread between these two metrics can be seen in the chart below, with the grey areas indicating recessions that have tended to follow shortly after.

Spread between two-year and ten-year treasuries

As you can see, the yields of these two securities are getting very close to being the same, and the trend suggests that the two-year will soon have a higher yield – meaning the curve is inverting. The key question is, does an inverted yield curve hint at an upcoming downturn? Not necessarily. Let me explain why.

INFLATION EXPECTATIONS

One complication is that bond yields don’t only reflect what investors think about future economic growth. They also buy or sell debt securities depending on what they think is going to happen to inflation. It’s generally assumed that prices will increasingly rise in the years ahead, and investors need to be compensated for bearing that risk, since higher inflation will erode their future purchasing power. For this reason, bond yields contain an element of inflation premium, normally with an increasingly higher premium for bonds with longer maturity dates.

Inflation expectations (ten-year vs two-year treasuries)

The following chart shows the spread between the inflation expectations built into 10-year and 2-year treasuries. The fact that it is in negative territory suggests the market thinks that inflation may fall, and this

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may also explain why yields on longer-dated treasuries are lower than on shorter-dated ones. And although inflation would fall in the event of an economic slowdown or recession, there could be a situation where inflation fell but the economy remained buoyant. Hence a yield curve inversion doesn’t have to mean that we are up against an imminent recession.

QUANTITATIVE EASING

Another factor that is potentially affecting the yield curve is the Federal Reserve’s moves to buy government debt as part of its quantitative easing programme (QE). The idea behind QE is that by buying long-term bonds, the Fed is able to keep long-term interest rates low, which decreases the rates on mortgages and other loans, thereby stimulating the economy. Conversely, when sold, lending rates will go up and economic activity will be reduced.

Earlier in March, the Fed started raising the benchmark US interest rate and stopped the asset purchases under the QE programme that it launched in 2020 in response to the COVID pandemic. But it also indicated that it would only start selling these assets after several months of hiking the benchmark rate. Since the benchmark rate is a short-term rate, the yield curve inverting might indicate market expectations that short-term interest rates will be higher than long-term ones for the foreseeable future.

WHICH YIELD CURVE SHOULD WE CONSIDER?

It is also sometimes argued that two-year/ten-year spreads are not the most useful ones to watch, and that instead one should focus on yields at the shorter end of the yield curve. In this set up, if you look at the difference in yields between two-year and three-month treasuries, it is actually steepening: in other words, it is hinting that economic growth is going to increase in the short term.

Economists sometimes argue that these near-term yield curve movements have stronger predictive power than those further out. At the very least, the fact that these are saying something different shows the need to be careful because different data about treasury yields can depict a different (or even opposite) picture depending on what time horizon you are considering.

Spread between two-year and three-month treasury yields

To summarise, it doesn’t necessarily follow that an inverted yield curve will be followed by a recession. It certainly could mean that, in which case unemployment would likely rise and inflation would potentially come down more quickly than many are expecting. But for now, it’s too early to say. The debt market is certainly signalling that change is coming, though it’s often easier to say in hindsight what it meant than at the present time.