Concerns about further supply-chain troubles are on the rise. Just a few months ago the “temporary disruptions” stemming from COVID-19 were predicted to work themselves out in 2022. However, businesses are now faced with the possibility of disruptions much more severe than those experienced to date. These stem from two sources: interrupted supplies in essential raw materials and agricultural commodities resulting from Russia’s invasion of Ukraine and the potential for a rapid (and massive) spread of COVID in China resulting in suspensions to manufacturing operations there.
In this commentary, I examine both of these in a bit more detail and then speculate on implications for global economic conditions in 2022.
As we have learned over the last month, Russia and Ukraine are large suppliers of important basic materials. For example, Russia is the second largest crude oil exporter behind Saudi Arabia and supplies 32% of the natural gas consumed in Western Europe.1 Oil and gas are important for households but also for commercial output — powering industrial production and serving as an input for manufacturing and transportation services. While there are other long-term energy sources available, it will be impossible for other suppliers to replace all Russian energy in the short-run.
Russia is also a major producer of many metals and industrial minerals including aluminum, chromium, cobalt, iron, lithium, palladium, titanium, and vanadium which are essential for a wide variety of industrial and manufacturing purposes.2
Finally, both Russia and Ukraine are major players in the global agricultural commodity markets producing significant percentages of global exports of wheat, corn, and sunflower oil. But perhaps the biggest impact could come from a disruption to potash and other chemical fertilizers from Russia which constitute an essential input to agricultural production in many countries.3 Declines in agricultural output will not only risk famine in many lower-income countries but also disrupt production of livestock which is an important source of protein for many middle- and high-income countries.4
In addition to the supply chain disruptions stemming from Ukraine and Russia, there is a real risk that major parts of the Chinese economy could go off-line for weeks or months. Vaccination rates in China are relatively high, but Chinese vaccines are generally less effective at preventing COVID-19 infection.5 Combine this with lower efficacy rates of all vaccines against the omicron variant, less effective risk mitigation with other means (distancing, masks, lockdowns), and the continued “zero-COVID” policy, and China is poised for a difficult next few months.
China has already locked-down Shenzhen, a tech manufacturing hub, significantly reducing output of some key electronics. Attempts to create so-called “closed-loop” factory bubbles are not sustainable for more than a few weeks.6 Consequently, it is almost a forgone conclusion that the spread of omicron variant in China will lead to a shutdown of large parts of the country’s manufacturing capacity, if only temporarily.
At some point China will probably be forced to “play through the pain” and operate business with omicron still spreading. But even in this case, large parts of the workforce are likely to be out sick and this will disrupt production for weeks if not months. The bottom line is an almost inevitable second major global supply shock in 2022 from a decline in Chinese manufacturing output.7
These dual supply shocks will have two primary economic effects, and both are negative. First, disruptions will affect an increasing number of industries. This will result in a widening slowdown of economic activity and potential for increasing unemployment rates. For countries like the U.S. which are running hot, it will be easier to absorb the slowdown in employment. For Europe, it remains unclear how widespread the disruption will be, but there is clearly the potential for a substantial decline in output and employment. For example, just the disruption to energy supplies from Russia could severely impede production of many intermediate and final goods in Europe. In fact, German Chancellor Olaf Scholz has warned that an immediate halt to Russian energy imports would send Europe into a severe recession.8 Effects on the rest of the world will depend largely on how dependent economies are on imported raw materials (including energy) and Chinese manufactured goods, but for most large economies the effects will be negative.
The second big effect from the dual shocks is a further stoking of inflationary pressures. Inflation, already a substantial problem in most countries, will accelerate further. This will put increased pressure on those households most at risk of being displaced by weakening economic conditions. While the risk of stagflation has been discussed for months, the current situation poses the largest risk to date. This comes as economic stimulus from fiscal policy is fading and central banks, led by the Federal Reserve, are starting to tighten monetary policy.
Perhaps most challenging for policymakers is the potential breadth of the supply shock. As compared to an energy shock (e.g., of the 1970s), where the impacts are widespread, but the source is easy to identify and track, the sources of the COVID-related disruption have already been much wider. And, it is only going to widen further. Looking at the current situation, it is hard to see a sector that is not going to be significantly affected. Only a few (such as energy and basic materials) will be positively impacted. Most industries will be experiencing both higher costs and greater supply-chain headaches. While there are short-run effects, we also need to be increasingly mindful of long-run effects on productivity and inflationary expectations.
So, what should households and businesses do? Households need to brace for impact. Despite the roaring economy experienced by many parts of the world in 2021, this year will bring increased risks for weaker labor markets and sustained inflation. Households should assess their ability to weather a slowdown and plan accordingly. Businesses have a harder problem to solve. First, businesses need to trace back through their own supply chains how they may be unexpectedly dependent on newly-scarce raw materials from Russia and a wider range of manufactured products from China. Once understanding specific risks, businesses will need to develop contingency plans to minimize operational impacts. Likewise, businesses will need to gauge the possible effects on demand for their goods and services in the event of a slowdown in the global economy and/or a longer than expected spell of high inflation.
1 See, https://www.iea.org/reports/russian-supplies-to-global-energy-markets/oil-market-and-russian-supply-2.
2 See, https://pubs.usgs.gov/myb/vol3/2017-18/myb3-2017-18-russia.pdf.
3 Natural gas is also used to generate ammonia and urea, key components of fertilizer.
4 See, https://foreignpolicy.com/2022/03/24/russia-war-ukraine-food-crisis-wheat-fertilizer/.
5 See, https://www.reuters.com/business/healthcare-pharmaceuticals/chinas-most-used-covid-shots-effective-against-delta-variant-study-2022-01-31/. Though it should be noted that the Chinese vaccines seem to be quite effective at preventing serious illness, hospitalization and death which is very good news for China’s populace.
7 It’s also worth noting that China is also a major producer of many critical minerals.
The Mother of All Supply Chain Shocks