The economic shock from the war in Ukraine has triggered growing risk and strategic complexity for boards and management as it fragments globalism. Greg Earl outlines four significant themes to watch.
Greg Earl is economic diplomacy columnist for the Lowy Institute’s The Interpreter and editor of the Asia Society Australia Briefing Monthly.
February 24 may well go down in history as the day a long and circumlocutory 21st-century debate about deglobalisation finally turned red hot. Russia’s anticipated quick takeover of Ukraine has instead turned into a global geopolitical showdown, which the International Monetary Fund (IMF) says threatens “the rules-based frameworks that have governed international economic relations since World War II”.
The modern system of global business with long, just-in-time supply chains underpinned by floating currencies and a web of trade and investment agreements, has many starting points. They range from the creation of the so-called Bretton Woods institutions such as the IMF and World Bank after WWII to the collapse of the gold standard for currencies in 1971. But the efficient exclusion of Russia from much of the global financial system by a US-led coalition as the world still recovers from the pandemic shutdowns has brought to a head the simmering dissatisfaction with globalisation. This can be traced back to China joining the World Trade Organisation (WTO) in 2001 and the management of the global financial crisis in 2008.
Former WTO Director-General Pascal Lamy is an increasingly lonely defender of global trade. He insists the losses from reshoring of manufacturing and the US-China technology decoupling are still outweighed by the gains from diversifying supply chains and the digitalisation of trade. “I still believe that efficient and painful globalisation is a better way to go than inefficient and painful deglobalisation,” the one-time French socialist says.
However, the current mood is better captured by Adam Posen, president of another vanguard of globalisation, the Washington-based Peterson Institute for International Economics, who concedes: “It now seems likely that the world economy really will split into blocs — one oriented around China and one around the US, with the European Union mostly, but not wholly, in the latter camp — each attempting to insulate itself from and then diminish the influence of the other. The economic consequences for the world will be immense
“There are four major areas where the Ukraine conflict has significantly changed the risk outlook for directors.
Greenback or bust
The US-led freeze on about half of Russia’s US$640b in foreign exchange reserves and the exclusion of some Russian banks from the SWIFT messaging system used for international money transfers has sparked a debate about whether this will reinforce the existing system or prompt alternatives. This is the first time such action has been taken against such a large economy — Russia now sits just outside the global top 10 economies —but is much more significant in several commodities sectors. It is also the fastest action of this type, affecting about half the total reserves held in Western central banks, but with the SWIFT action imposing additional constraints. Russia had been building up its foreign reserves to around fifth-highest in the world since it suffered trade sanctions over its takeover of Crimea in 2014, in the expectation these reserves would help it though any future trade sanctions.
Some experts, such as Credit Suisse analyst Zoltan Pozsar, a former US finance official, says the sanctions could result in a transformation of the global foreign reserves system not seen since the end of the gold standard in 1971, with countries trying to hold reserves in commodities that are outside the reach of US financial authorities.
“We are witnessing the birth of Bretton Woods III — a new world (monetary) order centered around commodity-based currencies in the East that will likely weaken the Eurodollar system and also contribute to inflationary forces in the West,” he said in a widely reported analysis after the sanctions. This would potentially weaken the demand for US currency, add to inflationary pressures due to demand for commodities and fragment the existing USD-led system. Whereas the old system was built around “insider money” created by central banks, this new system would be built around “outsider money”, including commodities and cryptocurrencies.
In a less dramatic but perhaps more significant development, one of the world’s most respected foreign reserve experts, Barry Eichengreen, with others, has released a study — The Stealth Erosion of Dollar Dominance — showing an already steady decline in the USD share of foreign reserves since the beginning of the century as central banks diversify their holdings. But contrary to the historical experience, where a new currency (USD) emerged to overtake the GBP as the reserve currency, this study argues that several currencies, including the AUD, will take up the slack rather than a competing currency such as the Chinese yuan (CNY).
The fact the rising currencies are generally diplomatically aligned with the US-led reserve system means the USD might wane — but not the system itself. Meanwhile, although China has struggled to create an alternative to the SWIFT system, it may encourage its trading partners to use CNY. India and Indonesia are looking at using non-USD payment mechanisms to buy Russian oil and Israel has slashed its USD reserves for CNY, showing that countries are at least considering new approaches.
While these developments suggest a more volatile foreign exchange market, they seem positive for the AUD and the demand for commodities as stores of value, as well as consumption.
Decouple or diversify?
The moves by most European countries to stop buying Russian oil — but in most cases, not yet gas — have fuelled the debate about trade dependence that had already been ventilated by the pandemic and China’s coercive actions against trading partners including Australia. Experts are divided over how much just-in-time overseas supply chains are being shortened by government initiatives to encourage more domestic manufacturing and stockpiling to insulate countries from the impact of future pandemics or wars. For example, the latest Kearney Reshoring Index shows a growth in US imports from Asia over the past two years after a sharp shift to reshoring in 2019 amid the China- US trade tensions. This is despite US efforts to encourage companies to decouple from China, especially in essential technologies.
A recent Australian Industry Group survey of CEOs — Australian Supply Chains: State of Play 2020–21 — showed 52 per cent of businesses expected their ability to source inputs, including imports, would be disrupted in 2022. However, while 28 per cent planned to build up inventories, 26 per cent planned no changes.
Australian exporters of two minerals and seven agriculture commodities subjected to coercive tariffs by China have mostly shown an unexpected ability to quickly diversify into new markets. “Australian business has been agile and competitive,” says University of Queensland agriculture economist and China specialist Scott Waldron. “We need open markets, not protectionism.”
Amid these mixed signals about the direction of global trade, two broad responses have been emphasised in the wake of the Ukraine war that will be important for directors to watch. The IMF’s World Economic Outlook, released in April, outlines new analysis showing supply chains held up better during the pandemic than is popularly believed — and that moves towards self-sufficiency could make countries more vulnerable to future shocks. It backs sourcing inputs for production from a wider range of countries and using components that can be substituted, rather than becoming more dependent on a narrower range of inputs produced domestically. “The fetishising of domestic manufacturing over advancing cross-border trade in services and networks is especially ironic, given that the latter sectors are what have truly advantaged the West over Russia in implementing effective sanctions,” notes Posen.
However, US Treasury Secretary Janet Yellen has sought to respond to this criticism amid Democratic Party nervousness about free trade by embracing a relatively new concept of friend- shoring in which close allies build trusted supply chains. “Favouring the friend-shoring of supply chains to a large number of trusted countries, so we can continue to securely extend market access will lower the risks to our economy as well as to our trusted trade partners,” she said in a warning to countries still considering trade with Russia.
The Australian government has supported some reshoring through its Modern Manufacturing Initiative, supply chain resilience in its critical minerals development initiatives, and friend-shoring in trilateral cooperation with India and Japan, but has mostly backed diversification through a China-plus strategy. Nevertheless, diversification may not be so straightforward when the three most favoured China-plus countries for trade and investment — India, Indonesia and Vietnam — have all shown a willingness to keep trading with Russia.
Now for greenflation
Just when a consensus appeared to be emerging on climate change that involved private investors moving ahead of governments in embracing cleaner energy, the Ukraine war has revealed three potential new risks to a new energy transition. The idea that climate change would be one of the few arenas where the US and China could cooperate rather than compete has been thrown into doubt. Russia, a major fossil fuel producer, is now even more of an outlier. The surge in the price of oil and gas has underlined how the declining investment in fossil fuel due to climate concerns is not being replaced fast enough by investment in alternatives. And the retreat from globalisation will likely restrict the research collaboration necessary to produce the clean energy technology that needs to be deployed around the world.
The latest IMF outlook says that the war- induced energy supply shortfalls and higher prices could mean an increased reliance on dirtier fossil fuels in the short term, but in the longer term, the strategic motives for energy independence could also speed investment in renewables. However, as central banks start to tighten interest rates to curb inflation, the IMF warns that policies to speed up the energy transition could be inflationary, which could weaken popular support for them. It calls for cooperation among fossil fuel consumer and producer countries, and divestment from fossil fuels at a pace equal to the adoption of renewable energy to keep this new “greenflation” at bay. But that looks harder to do in a time of declining global cooperation.
Overarching these new risks is the question of whether the increased influence of national security thinking in economic policymaking will elevate or undermine climate change as a government priority. A group of former Australian security officials — which includes former Defence chief Admiral Chris Barrie AC and former Director of Preparedness and Mobilisation Cheryl Durrant — has called for climate change to be at the heart of national security thinking to avoid the tensions Australia is facing with Pacific countries such as the Solomon Islands due to perceived lack of attention to rising sea levels. It says Australia has been “missing in action” while the US has “made climate change a key national security concern”.
From G20 to G-Zero
A very public test of how the Ukraine war is undermining global cooperation will be played out when Indonesia chairs the Group of 20 major economies in November. The G20 — which was formed in 1999, but only began meeting at the leaders’ level during the 2008 GFC — is the newest major part of the constellation of Bretton Woods institutions that have overseen the modern globalised economy. It seeks to bridge the old Group of Seven (G7) rich Western economies and the emerging market countries from Brazil to China that play an increasingly larger role in the world. But with the US and Europe reluctant to cede their control of institutions such as the World Bank and the IMF, and countries like China and India seeking a bigger say in climate change and trade policy, the G20 has come under strain. This is leading to more ad hoc groups of like-minded countries. For example, the Quad brings together the US, Japan, India and Australia on security; while the Comprehensive and Progressive agreement for Trans-Pacific Partnership might soon see Great Britain join a Pacific trade agreement before new Asian aspirants like South Korea. This has prompted Eurasia Group founder Ian Bremmer to declare the arrival of a G-Zero world with “an intensifying international battle for power and influence”.
The G20 has no clear rules on participation, so when Indonesia oversaw the G20 finance ministers and central bank governors meeting with Russian participation in April, representatives from the US, Britain, Canada and European Union walked out. This only underlined the dilemma President Joko Widodo faces allowing Russia president Vladimir Putin to participate in a November summit. The meeting reflected what Financial Times commentator Gideon Rachman has contrasted as an “axis of outrage” in the West over the Ukraine war, but an “axis of indifference” in the Global South. G20 members such as Indonesia, India, Brazil, South Africa and Mexico, as well as China, have all shown at best lukewarm support for the US-led sanctions on Russia. But the G20 remains a key piece of the global architecture for implementing measures including a minimum global company tax, exchange rate stability and debt relief for poorer countries. Similar tensions may also undermine the Asia-Pacific Economic Cooperation (APEC) summit in Thailand.
Gaining membership of the G20 global policy boardroom was once a diplomatic triumph for Australia, but the Morrison government has diversified its bets on newer ad hoc replacements, from an expanded “Five Eyes” security intelligence alliance to a mooted “D10” of democracies. Australian Institute of International Affairs president Allan Gyngell AO says Australia should be working with Indonesia on this dilemma to “ensure we are not seeing the collapse of the whole G20 structure when the global economy is going to get harder [which] would only put Australia on the outer.”
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