The Corona Virus should accelerate a carbon transition for developing economies
Synopsis: The coronavirus, (Covid-19) has spread to several continents and Italy has in recent days become Europe’s worst-affected country. Whilst the humanitarian costs leave little to desire, the economic impact has halted manufacturing supply chains across China and the world, caused imports of crude oil to fall by 25% and global economic activity to slow. In the meantime, central banks have cut interest rates in an attempt to reduce the adverse effects of a slowing global economy. Rather than stimulate domestic economies via interest rate cuts, central banks should emphasize the need for targeted fiscal reforms that prioritize higher value-added products such as green technologies, consumer and non-consumer products, intermediate products, and components for industrial machinery. Such an approach will increase the number of people employed in formal sectors and improve the pass-through from monetary policy to economic activity and inflation.
The economic impact of the Corona Virus
The Coronavirus has had an adverse impact on manufacturing, health care, transportation, consumer demand, and services such as cinema and shipping. Private sector firms across the U.S. signaled a slight decline in business activity in February. The overall contraction was driven by a notable worsening of service sector performance, where output fell for the first time in four years. Meanwhile, the Flash U.S. Composite Output Index also fell to 76-month low at 49.6 from 53.3 points in January. As such, the global economy will likely feel the adverse effects of a slowdown in Chinese exports caused by the negative spillovers from the Coronavirus on manufacturing, construction, transportation, and services ranging from tourism to transportation. Meanwhile, the impact on emerging and developing economies will likely be more severe over the medium term. Commodity exporting countries such as Cameroon and Nigeria will likely see exports to China fall in the short-term, weaker currencies as well as falling FX reserves. This trend will become more evident with a lag as commodity exports are not only priced in dollars but their impact on fiscal deficits tend to become more apparent over the medium term. As a result, while the synchronized cyclical slowdown abated following a truce between the U.S. and China, Covid-19 has only served to exacerbate the adverse impacts of lower commodity prices and slower pace of growth in the global economy. As such, the virus is causing the global economy to slow even as the Federal Reserve remains upbeat about the U.S. economy and continues to cut interest rates in other to reduce funding constraints for banks and financial institutions.
Commodities such as oil and copper are feeling the brunt of the virus
According to CNBC, the most active Brent crude contract for May was down 2.4%, at $50.93 a barrel, a 14-month low. Meanwhile, West Texas Intermediate (WTI) crude futures fell 3.3%, to $45.51 per barrel. U.S. crude has fallen about 14% for the week, the biggest weekly decline since May 2011. As such, inflation will rise in emerging markets and developing economies such as Cameroon and Nigeria as their currencies depreciate. Additionally, copper, a bellwether for the global economy has also been affected by the Virus. January PMITM data signaled a further deterioration in operating conditions for global copper users, with new orders notably falling for the second month running. Job numbers also declined, while production expanded only slightly from December. Rising metal prices meanwhile led to a sharper uptick in input costs, with firms in response raising output charges at the quickest pace since March 2019.
The balance of risks for global oil was pointing downwards long before the virus
The trade war and the waning impact of the U.S. procyclical stimulus caused the global economy to grow at a slower pace from Q4 2018. Since then, Brexit has dragged Euro Area GDP in addition to falling external demand as China transitions to a consumer and innovation-led economy. Whilst these trends occurred at varying intensities, with implications for U.S., Chinese, and EM emerging markets, OPEC output restriction kept oil prices at float, and tensions at the gulf added a natural risk premium as I argue here. This natural premium has kept oil prices between the $55–65 range for Brent and WTI. In addition to the above, OPEC output cuts saw Saudi Arabia further restrain output by 400, 000 barrels per day in other to prop-up prices. This tempered fears of oversupply even as the balance between short term price dynamics and longer-term supply signals suggest greater market share for the United States, which is now energy sufficient in the long run. According to CNBC, the most active Brent crude contract for May was down 2.4%, at $50.93 a barrel, a 14-month low. The front-month April contract expires later on Friday. Meanwhile, West Texas Intermediate (WTI) crude futures fell 3.3%, to $45.51 per barrel. U.S. crude has fallen about 14% for the week, the biggest weekly decline since May 2011. As such, inflation will rise in emerging markets and developing economies such as Cameroon and Nigeria as their currencies depreciate.
Reliance on oil increases fiscal deficits and reliance on global macroeconomic conditions
As such, energy self-sufficiency has seen the U.S. reduce demand for crude oil from developing economies such as Cameroon, Nigeria, Chad, Gabon, and Congo. Similarly, China is Cameroon’s second-largest trading partner (12%), which suggests adverse impacts on its fiscal balance in the near term. Meanwhile, public debt is poised to an average of 38% between 2020–2024 from 36% between 2016–2019. This trend will likely impact the non-oil balance in the Cemac zone that is also poised to increase by 2.4% to -2.9% between 2020–2024. Consequently, fiscal spending, however necessary, will cause the deficit to rise over the near term. As such, Covid-19 suggests the need to urgently diversify away from fossil fuels, with rigorous investment screening to support investments in technology-related sectors spanning machine learning in energy production, artificial intelligence in health care, and robotics in manufacturing.
Not only does the reliance on oil prices suggest near-term balance-sheet and valuation effects, but it also reduces the effectiveness of IMF programs and increases the risk of debt distress for developing economies. Furthermore, oil prices also suggest an increasing dependence on global macroeconomic conditions, which do little to increase domestic demand as the increases in oil prices suggest higher dividend payments for investors instead of higher incomes for employers. As such, it is important for policymakers in developing markets to prioritise job retraining, with targeted legislation to increase employment from market-based sources of finance and explicitly forbid FDI flows into fossil fuels such as natural gas and other environmentally costly investments.
Depreciating currencies will not boost export competitiveness
COVID-19 and tepid global growth have caused oil prices to fall while the currencies in developing economies have depreciated. Nevertheless, exports are unlikely to get competitive as the global economy is growing at a slower pace and business sentiment has waned in most advanced economies. While the U.S. economy has held up due to a tight labor market, the British and Eurozone economy is growing well below trend and China is transitioning to an innovation-driven economy, which suggests a structural slowdown in the near term. The implications for continued demand for commodities are wide-ranging as floating solar panels and wind farms will reduce the demand for oil from countries such as Cameroon. If emerging markets pursue targeted reforms that quantify the up-skilling of the labor market and higher value-added exports spanning consumer goods, machinery, integrated circuits and components for green technology such as solar nodules, their economies can enjoy greater competitiveness over the longterm
This is particularly salient for countries such as Cameroon at risk of high debt distress despite being on an extended credit facility currently costing 669 million. It is, therefore, imperative that policymakers in developing economies explicitly target climate technology as a significant portion of global manufacturing is driven by robotics, which will create more high-quality jobs as the global economy is increasingly driven by artificial intelligence and machine learning. This can be achieved by committing to upskilling 1000 people a year, via online learning and public exams to hire skilled individuals and ensure a digitized workforce facilitates the transition towards a more competitive economy.
Targeted fiscal policy will reduce the adverse economic impact of the virus
The most likely trend for emerging and developing economies will be transitioning via manufacturing while advanced economies transition to high-tech manufacturing, which suggests higher value-added imports and little gains in the auto or aerospace sector for developing economies. As such, deficits will likely remain a recurring trend for emerging markets, but governments should explicitly plan and implement reforms in a specific, measurable, achievable and time-bound manner to ensure that a majority of labor market participants are employed in high-tech and knowledge-intensive sectors. For example, solar panels can be deconstructed by employees and individual components can be designed to facilitate competition with China, Japan, and China. It is important to note that labor and raw material cost are significantly cheaper in developing economies, which can enable them to compete more effectively with advanced economies. Admittedly, developing economies leapfrogged following the emergence of the internet and smartphones, as such governments should employ a more quantitative approach to fiscal spending. One that prioritizes regional convergence and higher productivity. In doing so, domestic demand will increase and the reduced reliance on external demand will boost export competitiveness if the currency depreciates due to external drivers.
FX reserves will fall and prices will rise at a faster pace
Meanwhile, FX reserves are already falling in China and lower import coverage can amplify financial stability risks. As such, policymakers must move to diversify their reserves by ensuring that payments to China, African countries, Europe, and other major economies are cleared in their respective currencies instead of the dollar as I previously argued here. In doing so, the impact of a depreciation in the value of the currency will not increase the cost of holding dollar reserves. As a result of economies becoming increasingly dependent on dollar financing, FX depreciation and the cost of holding reserves are incredibly costly. Meanwhile, depreciation in the value of the currency inevitably causes food prices to rise and this trend is exacerbated by low agricultural output and increasing import competition. As such, the inability to carefully plan legislation to protect domestic incumbents and the employees as well as mechanize agriculture or grouping sole traders is exacerbating the impact of macroeconomic headwinds such as global trade tensions or the Covid-19. As I argue in an earlier paper, central banks should implement circular monetary economics, whereby short term liabilities at commercial banks are linked to liquidity infusions. Nevertheless, these transactions should incentivize greening commercial banks’ loan books in other for them to fund green projects, which are sometimes deemed intangible. In the absence of a more flexible approach to reserve management and money market operations, central banks can reduce the cost of conducting monetary policy.
Additional fiscal spending and domestic demand
Admittedly, lower interest rates will not result in significant economic growth due to the large number of people employed in the informal sector i.e. over 45%. As such, targeted fiscal spending should be sought in other to ensure a sustained convergence towards green energy and technology. Economic theory dictates that developing economies must develop agriculture and manufacture first, but such an approach is misguided, archaic, and ill-suited to the developmental needs of Cameroon with a growing youth population and a workforce not sufficiently digitized to leverage the fourth industrial revolution. Policymakers should ensure that infrastructure comprises at least 40% domestic import content and clear and transparent proposals are available to stakeholders, energy demand and supply are driven by machine learning, and manufacturing is supported by robotics and artificial intelligence. These might seem ambitious at first, but the government should have clear and explicit targets in the coming years.
1) Digitize 2000 people in the workforce every year, via targeted approaches to health care, manufacturing, research and development, energy, and waste management.
2) Boost agricultural output such as corn, beans, wheat, and rice by a specific number with clear guidelines and step by step plans to ensure such a process is inclusive and accessible to rural communities.
3) Ensure 50% of our energy is generated from renewable sources, with demand and supply of electricity-driven by machine learning by 2030.
4) Ensure all universities create 5–6 implementable research questions that can be addressed with technology and ensure these are phased into the process by facilitating interaction with professionals in the field.
A more digitized workforce will facilitate the transmission is interest rates
Such an approach will ensure that the government digitizes its workforce, boost economic growth, and address climate vulnerabilities in a much more targeted manner. Furthermore, central bankers in emerging and developing countries such as Cameroon must explicitly emphasize the need for targeted labor market reforms that digitize between 1.5% — 2.5% of the population annually. Not only will such an approach to boost the potential growth rate, but it will also increase the tax base, boost productivity and wages across green technology, health care, transportation, manufacturing, and energy. Furthermore, as the number of people employed in the formal sector increases, they are likely to take credit for homes and other expensive capital investments such as cars, washing machines, or solar panels.
How should EM Central banks react to slowing economic growth?
Before challenging the narrative suggested by the Taylor rule, it is important to note that stimulating the economy and the resulting transmissions determine the rationale for central bank policy moves when the economy slows. However, several factors will determine the effectiveness of interest rate cuts. The Cov-19 has caused the global economy to slow and most advanced economies such as the U.K, the United States, and the European Union are increasingly driven by domestic demand unlike developing economies with a high import-content and unskilled workforce. Due to the low concentration of bank account penetration and a high number of people employed in the informal sector, lower interest rates are unlikely to cause businesses to invest significantly due to the uncertainty caused by COVID-19. Furthermore, the transmission from policy rates to SME financing remains blurry and other sources of finance such as Fintech are not particularly developed. As such, the adverse impacts of the virus might be more fleeting depending on how central banks manage FX interventions, money market interventions, and interest rates.
On the one hand, the signaling mechanism can reduce the adverse impact of the credit and bank lending channel as these appear more driven by short term changes in business and consumer sentiment. However, a depreciation in the currency not only causes interest rates to rise, but it also causes interest payments to increase significantly. This can amplify financial stability risks in the near term, reduce the effectiveness and transmissions of monetary policy to the real economy and lessen the ability of central banks to intervene in the event of another crisis. Rather than follow the trend in developed markets of pre-emptive or “insurance cuts” as termed by the Federal Reserve, the central bank should only cut interest rates if the economy faces a pronounced downturn. It should instead emphasize the need for targeted fiscal policy to prioritize investments and employment in knowledge-intensive sectors, manufacturing, health care, and construction. A rate cut should only follow a 15–25% correction in global stock markets, a 10–15% correction in global house prices as well as a slight uptick in unemployment or falling wages. In other terms, a more marked reversal of the current trend of tepid growth and lackluster increases in wages i.e. 3.6%, 3.8 %, and 2.7% in the U.K, United States, and EU respectively.
Rather than reflect global macroeconomic conditions, monetary policy in the Cemac zone should pre-empt its effects on economic activity as well as inflation. In doing so, the central bank will be able to leverage other tools to ensure an ample supply of liquidity in financial markets, whilst ensuring the spillovers from the virus are assuaged by fiscal policy. The latter will ensure that the workforce becomes digitize and wages support domestic demand over the long term. Furthermore, central banks must emphasize the forward path of interest rates in future meetings in other to reinforce the signaling mechanism to market participants.