The Age of Disruption Part 3: It’s Getting Hot In Here

We are on the precipice of two global crises that will have significant bearing over the next decade: the climate crisis and the sovereign debt crisis.

According to the most conservative models, the climate crisis will cause historic and unpredictable weather patterns, endangering supply chains and the food supply. The result will be increased food insecurity, political instability, mass migration, and record levels of government spending to adapt. 

The record levels of government spending is arriving at the most inopportune time. Global sovereign debt is also at an all-time high, with 32 countries’ debt to GDP ratio exceeding 100%. 

Lender nations are responsible for the vast majority of greenhouse gas emissions, while debtor nations are expected to bear the brunt of the climate crisis. This makes it impossible to view these issues in isolation. 

The Climate Crisis is Driving Inflation the World Over

The climate crisis has already arrived as is a primary driver of inflation, driving both an energy crisis and an emergent food crisis.

Energy

Over the past year, a historic cold winter drained natural gas inventories the world over. Hurricane Ida knocked out 96% of crude oil production and 94% of natural gas production in the gulf, which has been slow to return to previous levels. The Hoover Dam is producing 25% less electricity due to a lack of rain. For the first time in 70 years, the winds in the UK didn’t blow the way they have historically, cutting wind power contribution from 25% to 7% and driving natural gas demand through the roof. In China, extreme rains are destroying dams, hurting renewable energy, and increasing demand for coal. At the same time, those rains flood coal mines and hamper their ability to meet supply demands. China has responded by putting limits on power consumption, causing factories to switch to diesel generators, which in turn, increases the demand for oil. High energy consumption from steel and aluminum smelters have been throttled back, increasing the cost of essential commodities. These factors are coalescing on the cusp of China having a colder and wetter winter due to the La Nina weather patterns.

Food

The food supply is at the nexus of many global influences. As a result, international food prices are now back to 2011 levels, which are believed to be a cause of social unrest and a contributing factor of the Arab Spring. 

In China, the historic typhoons are drowning crops and sending some vegetable prices higher than pork. Also, natural gas is used in fertilizer production. With natural gas prices spiking in Europe, fertilizer plants have been shut down or have had their production significantly curtailed, sending prices skyrocketing. High natural gas prices make it difficult for French farmers to dry their corn and bring it to market. Farmers in South America and Southeast Asia are planning spring crops with 50 to 100% less fertilizer. 

In the US, along with higher fertilizer costs, parts are in short supply and some farmers are resorting to buying tractors at auction to cannibalize for parts. Additionally, minor issues can sideline necessary equipment due to the lack of right to repair legislation combined with John Deere workers being on strike. Dairy cows are becoming too expensive to feed and herd counts are plummeting. The fall harvest is expected to be rough this year, and the spring harvest is expected to be even worse next year.

Surging food prices in emerging markets

The Great Sovereign Debt Crisis

Emerging Markets

Emerging markets have $86 Trillion in debt, with many developing countries leveraged to the hilt with short-term COVID debt that expires in the next two years. 

Government debt as a percent of GDP

If we have learned anything from the pandemic, it is that when governments see a clear and present danger of economic catastrophe they will do whatever is necessary to avoid or defer that reality. Case in point, the IMF and World bank will most likely extend much of the global loans until those countries have had time to recover from the pandemic.  Recovery could take several years, as it will take time to roll out vaccine distribution globally. Yet, the world might not be able to wait that long.

Rising interest rates in the US and Europe will place the international community in a double bind. They must either: 

• Increase interest rates to preserve the value of their currencies to stay competitive against US treasuries, but then risk a recession or
• Hold interest rates stable in the face of capital flight, the devaluation of their currency, while the cost of repaying their dollar-denominated debt soars. The result is a ticking time bomb. 

That bomb has already gone off in Lebanon. Lebanon’s debt to GDP ratio reached 170% when a series of political blunders caused capital to flee the country resulting in overnight hyperinflation. Matters were only made worse when their largest port exploded in a chemical accident. The World Bank is calling it the worst financial disaster since the 1800s. The Lebanese Lira has lost 90% of its value, with food costing 10x more than in 2019. Over 70% of Lebanese can’t afford or don’t have access to enough food or water. The government can’t afford to run critical infrastructure like power plants to run water pumps causing a humanitarian crisis. At the same time, political gridlock has brought the country to a standstill, unable to make progress on resolving these issues.  

The largest sovereign debt crisis in recent history was in Greece in 2009. The repair playbook included extensive austerity measures, partial debt restructuring owed to private banks, and additional loans to the IMF, ECB, etc. These measures resulted in an economic recession and a worse debt to GDP ratio today than during the crisis, fixing nothing. 

That playbook won’t work for developing countries, either. Those nations will be unable to pursue austerity or repay their debts. They cannot pursue austerity due to the need to spend heavily to adapt to the climate crisis, e.g., repairing and maintaining critical infrastructure, food security programs, etc. It will also be politically infeasible to repay debts to nations responsible for their distress, with industrial countries responsible for most emissions. COVID is expected to cost the global economy $2.3 Trillion, with emerging markets accounting for 2/3rds of that. While failing to act on climate change is expected to cost the Southeast Asian economy more than $28 Trillion. The best path forward is extensive debt forgiveness and restructuring, but that will also come at a cost. 

There is hope. The G20 recently established a global debt restructuring initiative called the Common Framework to set rules for restructuring sovereign debt. So far, three countries have applied, with Chad in the early days of going through the process. 

While developing countries might be seen as too small or distant to affect the global financial system, en masse, they could very well be the first domino that topples the house of cards.

China

China, through state-owned government banks, is the world’s biggest government lender in the world. More than 44 countries owe over $800 billion to China, accounting for at least 10% of the debtor nation’s GDP.

They have spent the past decades implementing Belt and Road infrastructure projects in the region. They convinced foreign governments to take on excessive debts to pay Chinese firms to build infrastructure projects in their own countries for the promise of increased GDP that often never materialized. 

China sees this as projecting financial power in the region with all roads leading to the Chinese manufacturing base, yet this strategy will likely backfire. The combined effect of the pandemic and the climate crisis is marching those same countries into insolvency. Default on those loans is likely in the next several years. The Chinese financial system is thought to be insolvent as it exists today, with creative accounting techniques and financial engineering used to paper over that fact. 

In response, it seems that the Chinese government has been on a systematic deleveraging program to de-risk and modernize their economy. China’s working-age population peaked in 2012 and is walking a tight rope of attempting to eliminate jobs in line with its demographic decline. They engage in controlled demolitions of corporate entities, picking winners and losers, mobilizing the balance sheets of State-Owned Enterprises(SOEs) for bailouts, debt-for-equity swaps where necessary, and targeted liquidity injections to prevent contagion. As long as China can control the outcome, they will dictate the outcome. 

Yet, the offshore bond market is beyond their control and mass defaults in rapid succession could easily tip their balance sheets over the edge. 

How Companies Can Thrive During Disruption

If this information leaves you with a sense of despair, fear not. The sheer scale of these problems will result in international cooperation and agreements not seen in nearly 100 years – since the Bretton Woods agreement and system. While many of our key industries are being disrupted, new systems and agreements will emerge, crafted to respond to our current crises. 

While it’s nearly impossible to predict how everything will play out, there are actions companies can take to prepare:

• Create a culturally agile organization focused on adapting to the current environment rather than continuing to do things how they have always been done. 
• Keep supply lines short and vertically integrated wherever possible. 
• Be prepared for natural disasters. The HEB grocery store chain has an emergency preparedness department that plans out potential crises and actively monitors storm systems 365 days per year. They readily adapt to emergent situations and have been known to beat FEMA and the Red Cross to disaster zones. 
• Assess your supply chain for geopolitical, water, power, and food security risk. I once had a project that involved shipping a storage tank to Venezuela. The tank arrived at the client site with a .50 cal round in its side and had to be replaced. 
• Evaluate your company’s emissions impact, and don’t be surprised by cap and trade tax laws. The worse the climate crisis gets, the more stringent climate policy will become. 
• Don’t be solely reliant on the banking system for liquidity. 
• Hedge currency risk.