Impending stagflation makes reform of the West-dominated international monetary system likely

Since early 2020, suffering from the combination of shocks from the COVID-19 pandemic, the economic policies of major countries, and geopolitical tensions, and the impact it has had on supply-demand relations, global inflation has experienced three stages.

In the first stage, after the outbreak of the pandemic in 2020, the inflation level touched the bottom before climbing and stabilizing. In the second stage, inflation picked up quickly in 2021, and the general trend of high inflation began taking shape in the West. And in the third stage, to curb the runaway inflation exacerbated by the Ukraine crisis since February this year, major developed countries tightened their monetary policies mainly through hiking their policy interest rates.

Europe is bearing the brunt of the energy crunch provoked by the Ukraine crisis, which has disrupted normal supplies of natural gas. After the crisis broke out in February, the United States-backed Western countries imposed several rounds of sanctions on Russia, and Russia hit back with countermeasures, pushing up natural gas prices. The crisis of natural gas supply is expected to peak this winter and even next year.

As the issuer of the world's dominant reserve currency, the US has tightened its monetary policy to tame its rampant inflation, creating spillover effects that have added to the difficulties of other economies in managing their macro-economies. The Federal Reserve's aggressive interest rate hikes since March have not only exerted depreciation pressure on the currencies of emerging economies and developing countries, but also led to sharp drops in the value of currencies of major developed economies, including the euro, British pound and Japanese yen.

Higher import costs as a result of currency depreciation has increased the difficulties in curbing inflation. Since the beginning of this year, most G20 members have seen their currencies depreciate to varying degrees. Among them, Argentina's peso and the Turkish lira have experienced the steepest declines, each depreciating by more than 30 percent against the US dollar. Meanwhile, the Japanese yen has depreciated by 21.3 percent against the greenback, the British pound has lost 18.1 percent of its value, and the euro 14.3 percent.

GDP growth rates in the West have declined with the US' GDP falling in two consecutive quarters on a quarter-over-quarter basis. With rising inflation and slower economic growth, the menace of stagflation is looming large.

In a report titled "Is a Global Recession Imminent?" released on Sept 16, the World Bank pointed out that with many countries raising their interest rates, the global economy will likely fall into recession in 2023. The disruptions to global supply chains caused by the pandemic and the energy crisis as well as the growing risk of stagflation in Western economies are having tremendous impact on the world economy.

As the world's largest emerging economy, China has seen an economic trajectory different from that of major developed countries such as the US. One prominent feature of the Chinese economy in recent years has been weak demand and low inflation. And stagflation is not expected to be a major headache for the country in the foreseeable future.

Facing the serious impacts of the COVID-19 pandemic, China has taken effective containment measures and a flexible macroeconomic policy, which has saved millions of lives while achieving economic growth and maintaining social stability. Bucking the trend, China's exports have shown remarkable growth during the pandemic, meeting the global demand and demonstrating the country's position as a manufacturing powerhouse.

Because of the pandemic, the Chinese economy has seen strong supply and weak demand, with the CPI reading even lower than the pre-pandemic level, in stark contrast with the surging inflation in Western countries. Although its economic growth suffered a setback amid the pandemic, especially in the second quarter of this year, China is capable of avoiding recession by boosting countercyclical measures and effectively implementing its macroeconomic policies.

While its risk of stagflation remains low, the Chinese economy stills faces the shockwaves sent from external stagflation.

The tightening monetary policies of major developed countries and the spillover effects brought by the risk of global stagflation will dampen external demand and affect China's exports. At a time when domestic demand remains sluggish because of the pandemic, the weakening external demand as a result of slowing down of developed economies will have negative impacts on the Chinese economy. Moreover, the tightened liquidity of the US dollar may trigger debt problems in developing countries with shaky economic fundamentals. As a major creditor of many developing countries, China will be affected by should-be sovereign debt defaults. Third, the economic policies to curb high inflation and possible stagflation in the US and Europe, the issuers of the two dominant international currencies, will probably trigger serious consequences globally, eroding the values of China's vast overseas financial assets.

Under the current circumstances, China should first ameliorate the pandemic prevention and control measures as well as macroeconomic policy, boost domestic consumption and investment to cement the recovering momentum of the economy, and reduce dependence on external demand.

Second, it should adhere to the principle of advancing international economic cooperation and uphold globalization, sum up the experience in international cooperation through the Belt and Road Initiative over the past decade, and put forward Chinese solutions to the sovereign debt problems plaguing developing countries to which China is a major creditor, thus creating favorable conditions for elevating the Belt and Road cooperation to higher levels.

Third, China should urge major developed countries to pay attention to the spillover effects of their tightening monetary policies on global platforms such as G20 and the International Monetary Fund, so as to mitigate the negative impacts on emerging markets and developing economies.

Currently, the high inflation and the risk of stagflation in Western countries indicate that there will be less space for them to stimulate economic growth via aggressive monetary policies by taking advantage of their dominant position in the international currency system, which is of implications for the reform of the West-dominated international monetary system. However, the old international monetary system can only be replaced with a new one when emerging economies and their currencies are able to withstand internal and external tests and challenges.

As such, under the current domestic and international economic circumstances, China should formulate holistic planning and make necessary adjustments and innovations in its economic structure, macroeconomic policies, and reform and opening-up and strive to build a high-level, open market economy that is based on the reality and with an eye on the future. It is imperative for the country to do its utmost to ensure that the international landscape, which is undergoing profound changes, evolve in a direction that will be conducive to the sound development of the global economy as well as to China's economic modernization.

Lu Feng is a professor of economics at the National School of Development at Peking University. Ren Hui is a post-doctoral student at the National School of Development at Peking University.

The authors contributed this article to China Watch, a think tank powered by China Daily.

The views do not necessarily reflect those of China Daily.

Contact the editor at editor@chinawatch.cn.