Transcript: Macro Bytes: Omicron - the economic impacts on China, supply chains and inflation.
Luke Bartholomew 00:06
Hello and welcome to Macro Bytes the economics and politics podcast from abrdn. My name is Luke Bartholomew, and today we are kicking off a new two-part series around the economics and financial market implications of Omicron. So in this episode, we'll be talking about the impact of Omicron on China in particular, both because of the size and importance of China itself, but also because the particular strategy that China has used to confront COVID has quite important implications for global supply chains. And so in the second half of this conversation, we'll delve a bit more deeply into the supply chain issues, and what they mean for inflation. Then in the next episode of this series we'll focus on some of the policy dilemmas that these developments have thrown up for policymakers and how policy is likely to evolve over the next couple of years. But in the meantime, I am delighted to say I am joined today by my colleagues, Robert Gilhooly, who is our Senior Emerging Markets Economist and Sree Kochugovindan who is also a Senior Economist and has spent a lot of time thinking about the drivers of inflation. So Bob, starting with you, as I sort of alluded to, at the start there, China's had quite a particular strategy when it comes to dealing with COVID. One that sort of makes it stand out from much of the rest of the world now, at least when much of the rest of the world has got to this so called zero COVID strategy. So my first question is just what exactly does zero COVID involve? And how did that strategy evolve over 2021?
Bob 01:49
I mean, zero COVID, kind of, as it implies, it's not necessarily aiming for zero and a complete eradication, I mean, it is a bit more recently specifying, because zero is like a dynamic clearing. When they identify cases they can do basically everything they can to get cases down to zero, so people can go back to kind of living, hopefully a relatively uninterrupted Covid-free life and, you know, I mean, you take a step back zero COVID has effectively kept cases, you know, relative to the size of the Chinese population, pretty much around zero, since after the initial burst in early 2020. But, you know, it has required I think more restrictions probably. Delta was more transmissible and required a few more restrictions in 2021 and the second half of 2020. Yeah, I mean, certainly, it's not been without its cost, of course, I mean, if we look at the year-on-year GDP growth rates and the headline numbers there - back in Q1 2021 is was at one of the highest rates ever recorded at 18.3% year-on-year. But the real news there is actually in the sequential quarte- on-quarter growth rate, which gives a much better sense of how curtailing Lunar New Year last year, led to this kind of new year stalling of growth. That number was about 18 percentage points lower - only 0.3%. You know, of course, as you and I were discussing, with Paul Lukaszewski back in December, it's quite difficult to disentangle the COVID shock from other shocks that are hitting the economy, we had quite a lot property sector weakness, that was definitely a factor in the latter half of the year. And I guess also additionally, you know, it's difficult to disentangle kind of how COVID and zero COVID has interacted with the service sector. One might have thought that essentially closing the borders would have boosted domestic tourism, but your staycations actually proved to be kind of relatively not that popular. So it could be a sign that it's just the policy dynamics weren't particularly supportive for households, and were playing a role there too.
Luke Bartholomew 03:55
Perfect. So the evidence, so far seems to be the Omicron is, without a doubt, much more transmissible than previous COVID waves, but also much less severe, leading to sort of lower hospitalisation-rates versus the number of cases. And also, those waves seem to pass through extremely quickly, notably, in South Africa, the UK, in both of which cases are falling, or have fallen quite sharply. And that's allowed these countries to start scaling back restrictions. And, you know, the UK looks set to remove most of its restrictions, at least in England by the end of January. So given these particular dynamics of Omicron,= and how it is rather different to say the delta or other previous waves, how is China responding to these specific dynamics?
Bob 04:42
Yeah, I mean, so far, the authorities I don't think are taking much comfort from that kind of lower health impact that you've described there. And, you know, China's got very high levels of vaccination - over 85%. Many children are vaccinated too. But despite that, and authorities do seem to be committed to maintaining the zero COVID strategy. Indeed, we've seen an increasing number of travel restrictions between what are deemed to be higher risk areas ahead of a Lunar New Year, given that kind of risk that large scale migration potentially poses for a more transmissible variant. It does seem to be a bit more of a targeted approach than we saw at the start of last year. So the Winter Olympics is another reason why authorities might not want to change approach in the near term. But beyond that, I think you're really talking about uncertainty about the efficacy of Chinese vaccines. And the flip side of having successfully held cases around zero, so virtually no exposure amongst the general population to and this kind of seems like a stronger reason, if you will, that the authorities may well keep going with their current approach. And then of course, there's also a key political event towards the end of the year. President Xi is widely expected to take an unprecedented third term at the 20th Party Congress - so another potential motivation to keep the zero strategy going over 2022.
Luke Bartholomew 06:08
So I understand those reasons why zero COVID might be kept in place over 2022. But I guess, taking a slightly longer term view, there is this sense that fundamentally, it is not a strategy that can be retained for ever and I'm somewhat reminded of what we call an economic Stein's law, you know, if something cannot go on forever, it will stop. And so I suppose my question is like, how does China ever move past the pandemic? What is it that causes this strategy to ultimately stop?
Bob 06:40
Yeah, it's a really good point, and it is very interesting that China seems to have set this exceptionally high bar for itself. But as you say, you know, it's not tenable to hold at zero, forever. So kind of how might that change? I think one way could be the authorities looking to more likely domestically made mRNA vaccines or boosters, before potentially considering a kind of, I think, probably a gradual shift away from zero. China certainly does have a very large manufacturing capacity has shown it can roll out vaccines very quickly too. But even so I think this could still imply, you know, a significant delay versus other countries. You might be talking end 2022, or even sometime in 2023. And then I guess, aside from the kind of practicalities of vaccination, you know a lot has been invested, I think, in the narrative of the importance of zero within China, you know, it's a demonstration, the government's handled the crisis better than other countries. So potentially communications could be a challenge. And your case numbers and hospitalizations could be high in absolute terms, even if they are able to kind of keep it low relative to population, or if Omicron was to be let loose, you could easily be talking about a million cases, a day in China. Now, obviously, the state does have very powerful communication tools to put it lightly. And, you know, the regulatory shocks in 2021, an example of how kind of the closed nature of China's political system, tightly controlled public discourse can result in kind of policy shifts, kind of seemingly kind of coming out of nowhere and surprising there.
Luke Bartholomew 08:27
So I sort of Yeah, I get the idea that there's this way to open up domestic restrictions gradually, but then there's still the issue of international travel, as well. Right, and the speed in which China can open up to the rest of the world. So is there a sense in which they're going to be forced to change tactic because of what's going on in the rest of the world? Or, you know, perhaps to put it slightly glibly, do these border restrictions become something of a of a new great wall as it were?
Bob 08:54
Yeah, no, I think I think there's a I think that's a good, good way of framing it. I think the border controls are probably going to be one of the last things that really get kind of eased off given the kind of difficulty of tracking and tracing visitors. I would say you know China has shown its got a pretty effective track and trace system, certainly the kind of political will to put in large scale lockdowns, but you know, there is this risk that Omicrons higher transmissibility, what seems to be a shorter incubation period, with its milder symptoms, and possible asymptomatic carriers might make it harder to kind of maintain zero. So you're right, we could get some sort of kind of forced move there. I think this probably implies, though, more frequent restrictions over the course of this year, I think to be put in place, rather than necessarily being forced to change. But on the other hand, you know, Omicron, did just emerge effectively just ahead of Lunar New Year travel period. So there is some risk I think that cases start surprising. There's a risk here I think that the targeted approach to travel restrictions is maybe too reactive, rather kind of proactive. I think as well there's some doubt out there about kind of the assertions of COVID being imported by the mail or kind of coming in on frozen food, perhaps they're indicating some cracks in the wall. As as, as you put it.
Luke Bartholomew 10:19
Brilliant. So turning to you then Sree. I mean, as we were talking about there, the fact that China has this domestic zero COVID policy has quite important implications as to how it relates to the rest of the world, that kind of restrictions that it has, but also, in terms of its own economic activity, areas of significant economic production suddenly shutting down. So my question is, what are the global spillovers of China maintaining zero COVID? I mean, how do we go about assessing the risks to global supply chains from there?
Sree 10:52
It's worth maybe starting with a quick review of some of the most important supply constraints that we saw during the pandemic and how they evolved just to bring a bit of context into this question. So if you remember, last year, there were a combination of factors at play and these included an increase in consumer demand for goods related to remote working and home schooling, and so on. And there were disruptions across transport networks, semiconductor production was a key bottleneck, labour shortages, factory outages. This combination led to very severe delays across the global production network, and the distribution of goods. Now, the main areas where bottlenecks were most intense, were in the supply of key intermediate inputs, such as semiconductors, as I mentioned, but also major shipping routes. And in particular, there were issues around the US ports. And this increased the cost of freight for long shipping routes, particularly from Asia to the west coast of the US. Now, these were issues that were already there - the roots of which were at the beginning of the pandemic, but they were starting to resolve and then we over the late summer, we saw the COVID spread across Asia are starting to derail the recovery across those goods production and distribution networks. Now, in particular, China has, as we all know, a very important role within the global supply chain. And the Delta wave had a knock on impact in terms of port closures across China, but also factory closures across ASEAN. And some of the key semiconductor producers were hit quite hard in that period. So what we're seeing right now is that there's a risk that a resurgence of these delays as a result of Omicron being so highly transmissible, as you mentioned earlier, and combine that with continued zero tolerance, so this could lead to some renewed delays, and intermittent bouts of disruption going forward.
Luke Bartholomew 12:53
Sure. I was interested in that you say renewed delays, because I think I'm writing saying for as much as sort of these global supply chain issues plagued us for a lot of last year and were an important driver of higher inflation sort of by October, November time, there was sort of early evidence that some of those issues were starting to be resolved. I mean, is that fair to say that the evidence was that things had started to get better before Omicron kicked in?
Sree 13:20
That is true, that is correct. We were starting to see the signs that the green shoots of recovery were emerging as early as October, November. And we were starting to see that in transport and some of the measures of freight costs. They're still elevated, but they had declined from their highs that we'd seen during September, October time. And there are a number of measures that have taken place in order to alleviate some of the pressures and that, for example, across L.A. ports, there was increased coverage there, they shifted to 24/7 coverage to help alleviate some of the congestion. We were also seeing business surveys across many countries starting to improve. Now some of the key questions there focus on, you know, the stocks of finished goods - and the stocks of work in progress. And what we saw was that the stocks of finished goods were incredibly low, but there was still some inventories, very elevated inventories of work in progress. Now, this signals that the the bottlenecks were really hitting those intermediate inputs. And a key example of that would be semiconductors. But that gap had started to narrow and finished goods inventory started to pick up. So that was showing that goods were starting to actually flow and the production of semiconductors had improved. And in turn that led to an increase in production of motor vehicles. So there were a number of different signs of improvement that had begun. But much of this data that we're seeing now refers back to December, November, so it's quite backward looking. So these surveys don't actually reflect the impact of the Omicron wave just yet. So it's old data that we're seeing out of the surveys now.
Luke Bartholomew 15:07
So if that's old data, and there are good reasons, as you say, to expect, at least in principle, why this new wave would lead to a renewal of some of those constraints and issues that we've seen. But have we actually seen it in the data yet? Are there any signs that this reversal has gone into recovery, in any of the high frequency measures that we track to measure this kind of thing?
Sree 15:30
Well, it is still very early days. And as you say, we are monitoring some high frequency data. And initially, we are seeing very early evidence of some increased congestion around some of the ports in China, and particularly the port of Ningbo that was where we had a closure back in late summer which extended some of the delays last year. We've seen that there is an increase in congestion at the port of Ningbo as well as some of the neighbouring ports, including Shanghai. And there are reports that ships that have been re-routed in an attempt to try and reduce queuing times. So this isn't enough on its own to signal a continued trend or escalation. But it's definitely something that needs to be monitored quite closely. But then turning to the to L.A. and a number of different countries actually, across ASEAN, what we're seeing is the impact of absenteeism as that Omicron wave really starts to take hold. We're seeing some temporary staff shortages starting to delay the production process or delay the, you know, the improvements at the ports. So, you know, we were already seeing countries struggling with labour shortages. But against that backdrop, we've seen these, this extra pressure of absenteeism as the Omicron wave takes hold. And that's particularly a problem in the US, as I said in those key ports. Now, that's quite important to monitor because that Asia to US shipping route was where we saw the most intense congestion. That's where we saw freight costs were very elevated along that route. And then it could have spillovers across to other routes and impact the global shipping network and the issues with getting containers back onto ships and into other countries and so on. So this could be quite important in terms of the trend going forward and whether those green shoots of recovery are actually sustainable. But it could prove to be temporary, given that one piece of good news is that the Omicron cycle does seem to be running its course quite quickly in some countries. And we can see that across Europe, UK, we saw that some evidence of that in South South Africa. So it could be less disruptive this time around. But the key issue is as Bob has mentioned earlier is the case of China. And with zero tolerance policy, we could see more intermittent bouts of disruption going forward. So that's something we cannot predict but need to monitor on an ongoing basis.
Luke Bartholomew 18:12
So So bringing this all together - and as I sort of said there previously, these global supply chain issues were an important driver of the higher inflation last year, I think higher inflation that came as a surprise to many people and does seem to be somewhat longer lasting than at least we originally expected. So sort of how do these latest developments change our outlook on inflation more generally, and sort of putting all the various drivers of inflation together? How important are the supply chain issues versus all the other issues that we're currently facing?
Sree 18:48
Yes, there are a number of different issues here. Supply chains were quite important last year. We did start seeing one impact, quite famous impact, was on used car prices which started to become quite elevated as we saw the semiconductor disruptions, delaying new car production. So there are signs of feed through into inflation. However, we need to put this into the context of the other drivers of inflation. Energy price pressures are quite important, probably more important at that moment. And this is something that we had highlighted in a series of notes that we wrote last year. We had spoken about the risks of energy price spikes during the northern hemisphere winter, and this is likely to continue it through Q1 to Q2 - there are geopolitical risks there. But as we move into the second half of next year, we'll see those energy prices really starting to unwind from inflation and they'll really start to drag headline inflation numbers lower. So even if all prices remain quite elevated, what we call the base effects which drag headline inflation figures lower. And that'll be quite a powerful driver of inflation through the rest of this year. Supply/demand imbalances are particularly extreme in the US. So it's not just a case of talking about shipping costs and delays in production, but it's also the increased demand in goods that has been part of the story. And we've seen that that demand has been quite strong in the US. So we need to look at this in the context of different countries, we may not see the same sort of inflationary pressures across Europe that we're seeing at the moment in the US. So that really sort of leads to the key question of, you know, will it contribute to faster withdrawal of policy support, because inflation is also a function of the policy outlook. And as we're already seeing that central banks across different countries have become more hawkish in response to the developments across supply chains, Omicron, and also the demand backdrop as well.
Luke Bartholomew 20:59
Sree, I think that is a brilliant place to end it, not least because you've done a very good job of setting up our next episode in this series on the policy responses and the kind of trade offs that policymakers might be facing as a consequence of these dynamics. So we will leave it here this week. So all that remains for me to do is thank Bob and Sree for their excellent insight. And thank you all for listening. And to remind you to please do subscribe, like, review, rate our podcast on your favoured podcast platform, and we look forward to speaking to you again soon. So thanks very much for listening.
21:50
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