Navigating Fragmentation, Conflict, and Large Shocks

IMF News, June 21, 2024

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Published: June 21, 2024

Introduction

Focus: impacts of Russia’s invasion of Ukraine on Ukraine, neighboring countries, and the global economy; implications for monetary policy in a more shock-prone environment.
Key judgments:
- The war is now in its third year.
- The war has increased fragmentation pressures and raised defense spending.
- Compared with decades of efficiency-driven economic integration, recent measures will likely make the global economy more shock-prone with higher inflationary pressures, reduced potential output growth, and precarious public finances.
Policy questions posed:
- How should central banks conduct monetary policy in this more shock-prone environment?
- What is the role of additional tools such as foreign exchange intervention?
- How should fiscal, financial, and structural policies be deployed to support macroeconomic and financial stability?

Effects of war on Ukraine

Macroeconomic outcomes and policy responses:
- Strong global support and policies, including actions by the National Bank of Ukraine, helped Ukraine avoid deep macroeconomic instability and "kept inflation from spiraling."
- Output is roughly 25 percent below its pre-war level.
- Much of the capital stock has been destroyed by war.
- Ongoing help is needed; the Ukraine Recovery Conference in Berlin (June 11-12) discussed global assistance.
Recent policy moves noted:
- Emergency monetary and FX policies: raising interest rates, fixing the hryvnia to the dollar, introducing FX and capital controls.
- Use of some monetary financing to finance the war; negotiated official and private debt standstills; rationalized discretionary public expenditures.
- Later steps: monetary financing ceased; exchange rate peg replaced by a managed float; FX controls cautiously eased.
- Multiyear financing arrangement with the IMF anchors macro policy; a 4-year 50-billion euro Ukraine Facility with the EU; large contributions from the US and other partners.

Wider impact of the war

Inflation:
- The war has been a major supply shock, especially for CESEE and other European countries reliant on Russian natural gas.
- When gas stopped, energy prices skyrocketed, boosting inflation; disruptions in Ukraine’s grain exports contributed to food inflation.
- CESEE experienced the largest inflationary impact over the past two years (see Figure 2).
- Higher cumulative inflation rates in CESEE have left them with a potential competitiveness problem.
Growth:
- The conflict has derailed recovery from the COVID-19 pandemic via adverse terms-of-trade effects and tighter monetary policy.
- Trade has been hit, especially for CESEE countries with major trade links to Russia.
- CESEE countries have experienced the biggest setbacks to growth performance since the onset of the war (see Figure 3).
Defense spending and public finances:
- Defense spending is likely on a permanently higher trajectory.
- Effects particularly pronounced in the CESEE region, especially the Baltics (see Figure 4).
- Higher defense spending compounds fiscal pressures from COVID-19, green transition, and demographics, requiring difficult steps to keep debt sustainable.

Turning point for geoeconomic fragmentation

Acceleration of fragmentation:
- Russia’s invasion of Ukraine has been a catalytic turning point accelerating geoeconomic fragmentation away from efficiency-based global trade.
- Number of new trade restrictions in each of the last two years has tripled relative to 2019 (see Figure 5).
Trade and FDI realignment:
- Trade has fallen much less between geopolitically aligned groups than between more divergent countries (see Figure 6); similar patterns for FDI.
- Firms must now account for national-security constraints and geoeconomic uncertainties when structuring supply chains.
Macroeconomic model-based scenarios and risks:
- April 2023 WEO model-based analysis suggests fragmentation could reduce the level of output in a bloc centered around China by over 3 percent in the long run (left-hand panel of Figure 7).
- Financial fragmentation scenario: real interest rates in a U.S.-centered bloc could increase due to waning flows of savings from surplus economies in a China-centered bloc; some decline in real interest rates in the China bloc as they invest more domestically (right-hand panel of Figure 7).
- Fragmentation can weaken risk-sharing and diversify less, leading to more volatile capital flows (left-hand panel of Figure 8); effects especially pronounced for emerging markets (right-hand panel of Figure 8).
- Simulations where trade in commodity groups is banned between blocs show large first-year inflation impacts for some commodities and blocs (Figure 9).
Implication: a less integrated global economy will be poorer and more shock-prone, reinforcing the need for policy preparedness.

Implications for monetary policy

General implications:
- A more fragmented global economy implies inflation will deviate from target by larger magnitudes and for more prolonged periods.
- Supply-driven shock volatility complicates tradeoffs for central banks between stabilizing inflation and employment; employment expected to be more volatile around potential.
- Protracted high inflation can change transmission: "intrinsic" persistence in the Phillips Curve may rise via indexation and dislodged inflation expectations; nonlinearities may become pronounced in high-pressure, high-inflation environments.
- Resulting asymmetry: large shocks may produce substantial upward skewness in inflation responses.
Policy rule considerations:
- Forecast-based policy rules that set policy rates based on medium-term inflation forecasts have appeal but may perform poorly when uncertainties are large and asymmetric.
- A risk-management strategy that accounts for tail risks is preferable to focusing heavily on a central forecast.
Model illustration and lessons:
- A New Keynesian model with nonlinear Phillips Curve and endogenous indexation shows:
- Cost-push shocks have small/transient effects when inflation near steady state, but large/persistent effects if shocks are persistent and indexation rises.
- Policymakers must estimate persistence (Kalman filter); reacting only to medium-term forecasts can delay response and allow inflation to surge (Figure 10).
- Reacting to realized core inflation preempts inflation surges but at some output cost (orange lines in Figure 10).
- Practical implication: central banks must balance underreacting to persistent shocks against overreacting to transient ones; more focus on nearer-term forecasts and realized inflation may be warranted, accepting some short-run output/employment costs.
- Anchoring medium- and long-term inflation expectations remains important but does not guarantee appropriate risk balance.

Responding to higher capital flow volatility

Emerging market concerns:
- Capital flow volatility and exchange rates likely to be more volatile in a conflict-prone environment.
- The Fund’s Integrated Policy Framework (IPF) helps identify when FX intervention (FXI) and inflow capital flow management measures (CFMs) may improve policy tradeoffs for EM central banks.
Guidance on FXI:
- The bar for FXI should be set fairly high; flexible exchange rates desirable if FX markets are deep and financial stresses modest.
- Stronger case for FXI if FX market depth is low and the economy faces external shocks with deteriorating investor sentiment and tighter financial conditions.
- Central banks must consider intertemporal tradeoffs: supporting the exchange rate today may compromise future ability to provide FX liquidity, especially when reserves are limited and shocks may persist or intensify (a key risk in military conflicts).

Need for supportive financial, fiscal, and structural policies

Financial stability and resilience:
- Monetary tightening required to contain inflation may fuel financial market stress and risk "financial dominance."
- High premium on enhancing financial system resilience: deepen monitoring of financial risks, focus on the sovereign-bank nexus, nonbank risks, payments system risks (including cyber).
- Ensure adequate prudential buffers; build capital where profits are strong.
- Readiness for emergency liquidity assistance (ELA) and effective resolution strategies is essential.
Fiscal policy:
- Responsible fiscal policy is critical: expansionary fiscal stances increase pressure on monetary policy and can amplify financial vulnerabilities and fiscal dominance risks.
- Given potential ratcheting up of defense spending and refugee support, governments should balance needs by paring spending elsewhere while protecting vulnerable populations.
Structural reforms:
- Structural reforms can strengthen potential output and shock resilience (Figure 11).
- Larger, more economically integrated regions are less prone to shocks; deepening links with the EU is beneficial for non-EU European economies.
- For the EU, moving closer to a true "single market" by lowering barriers to cross-border mobility in services, goods, and labor will add to strength and resilience.
- Mobility on certain dimensions, especially labor, remains far below that in the United States.

Closing remarks

Early lessons from Ukraine’s response (preliminary assessment on four fronts):

1. Macroeconomic stability aligned with national security: rapid, tough, innovative decisions preserved core state functions—pensions paid, bank branches open, tax ratios remained high. 2. Agility and adaptability: monetary financing ceased; domestic bond market revitalized; domestic revenue mobilization and external debt restructuring underway; peg replaced by managed float; FX controls cautiously eased. 3. Coordination while maintaining independence: coordinated monetary and fiscal policy was and remains essential for a shock of this magnitude. 4. Resource mobilization and reforms: turned to external donors; multiyear IMF arrangement anchors macro policy; 4-year 50-billion euro EU Facility and large contributions from partners; sustained structural reforms to build institutions for post-war future.

Conclusion:
- Singular focus on maintaining macro stability with policy agility, ownership, sustained reforms, and external support has supported Ukraine through wartime challenges and sets the stage for a robust recovery toward EU accession.
- Policymakers must prepare to navigate a more volatile world shaped by fragmentation and conflict—central banks, fiscal authorities, and structural reform agendas all have critical roles.

Remarks by Gita Gopinath, IMF First Deputy Managing Director, at the NBU-NBP Annual Research Conference, June 21, 2024.