A Russian default would stack risks onto a stressed world

This piece was originally posted in BARRON'S on April 1, 2022

The global economy is facing a combination of challenges seldom seen before, and Russia’s war against Ukraine piles a host of new risks onto the pre-existing ones created or exacerbated by a once-in-a-century pandemic.  Rising global inflation and an uneven economic recovery from the 2020 crash that widened the gap between rich and poor nations figure prominently in the long list of risks that mark 2022.

The war is already stoking global inflation. Its immediate economic impacts were forcefully felt in commodity markets in a supply shock reminiscent of the 1970s oil shocks—except this time it also involves spiking food prices.  We know that the pandemic has seriously impaired global supply chains and led to soaring transport costs. Government and central bank intervention supported aggregate demand but did little to repair aggregate supply. This imbalance added to costs and set the stage for the return of global inflation. Disruptions from the war have further damaged trade links and stalled the agricultural production of two key global providers.This will fall hardest on developing countries and the poor, who will see much higher prices for food and other basic goods. However, the war’s adverse effects on advanced economies in Europe should not be underestimated, either.

Added to this pre-existing problem is a new one—the potential fallout in financial markets from a likely default by Russia at some point. Here, the more recent past does not necessarily provide a good road map, as the collapse of Lehman Brothers and the implosion of the housing market in 2008 were very much about advanced economies. This time, many emerging markets and developing countries are likely to be the most affected. Often, those impacts are underestimated because they occur in countries that are off the radar screen and not deemed as systematically important. They are the antithesis to too big to fail.

As for the first challenge, prior to the war, inflation was already proving to be much higher, more persistent, and broader-based than major central banks initially thought possible. In more than half of advanced economies, 12-month inflation through February 2022 was running above 5%. Over 70% of emerging markets and developing economies saw inflation at that level or above, more than double the share prior to the Covid-19 outbreak.

Food inflation is running particularly hot. The risks of a re-emergence of food crises in many parts of the globe and attendant social unrest loom large and should not be underestimated.  About 80% of emerging market economies saw food price inflation over 5% in the year leading up to the war.  Furthermore, the impacts of the war are likely to be persistent, as the ongoing conflict will continue to interrupt cycles of planting, production, and transport of food, making a bad situation worse. Inflation is a very regressive tax, and food inflation even more so. In lower-income countries, as in poorer households within countries, food and energy spending accounts for a much larger share of expenditure, and higher prices eat up a much larger share of their income. In many developing countries, government finances are poised to deteriorate as the pressure for higher food and fuel subsidies intensifies.

On the second challenge, the possibility that Russia will default on its sovereign external debt due to sanctions, the risks may be clustered on what we don’t see and can’t quantify. While markets are focused on the sovereign, Russian corporates also face the prospect of default. So far, financial spillovers have been limited, but it is premature to declare victory on that front. According to the Bank for International Settlements, European banks have limited exposure to Russia, but the extent of nonbank exposure is far more difficult to ascertain. Nonbank interlinkages are often revealed only at the time of default. The market volatility that ensued from the Russian default in the summer of 1998 took down the U.S. hedge fund Long-Term Capital Management and prompted the Federal Reserve to intervene to calm international capital markets.

The financial consequences of a Russian default may also fall disproportionately on emerging markets and developing countries, where economic recovery from the pandemic has been mostly disappointing.  Many have simply not recovered yet. Developing countries were already finding it harder and harder to pay their debts. Almost 60% of the world’s poorest countries eligible for the Debt Service Suspension Initiative that ended last year are either in, or at high risk for, debt distress. More risk-averse investors and rising international interest rates will make it more costly to attract new financing and service existing debt. According to the World Bank’s International Debt Statistics, total external debt servicing relative to exports roughly doubled from 2010 to 2020. And this was during a period of exceptionally low international interest rates.

A developing-country crisis is not inevitable, but the risks are stacked. It is never a good time for war, but this one comes at a time with some glaring fault lines in the global economy.