China’s COVID-Zero Strategy Risks Global Stagflation

The threat of never-ending, rolling lockdowns in the world’s second largest economy is a fixture of the post-pandemic macro environment.

That sentence is oxymoronic, which underscores the point. The Chinese leadership is still fighting the COVID war as though it’s 2020. For Beijing, this isn’t a “post-pandemic” world. Not yet, anyway.

Earlier this month, during a video address marking the opening of this year’s Boao Forum, Xi Jinping said “more hard efforts are needed for humanity to clinch the final victory against the pandemic.” Most of the world doesn’t see it that way. Outside of China, the mRNA vaccines, along with subsequent therapeutic breakthroughs, constituted something close enough to “final victory” to allow for the relaxation of most containment measures and the resumption of normal life.

It’s still a war, but it’s now one of attrition. The virus continues to stoke fear, cause sickness and, tragically, claim lives, but most countries view it as an endemic condition — a vanquished army degraded to insurgency status. As some commentators suggested early on, there likely won’t be a “final victory” over COVID in the strictest sense.

China won’t concede that, though. Xi apparently still believes COVID can be eradicated like polio in the US, ironic considering Beijing is loath to import Western vaccines which are objectively (i.e., scientifically) superior to China’s homegrown jabs.

This was always a risk to the global recovery, but now it’s acute. The Shanghai lockdown and the rising odds of a similar effort in Beijing pose a serious threat to growth at a time when the war in Ukraine already prompted the IMF and the World Bank to slash their forecasts.

Xi’s refusal to abandon a strategy that isn’t working anyway is dramatically increasing the odds of a stagflationary outcome for the rest of the world. Monday was a testament to that. Oil took a hit, as did metals, and while that could be construed as a positive development given inflation realities, a slowdown in China isn’t going to bring down food prices.

Meanwhile, the logistical nightmares that invariably accompany lockdowns in “the world’s factory” will prolong supply chain disruptions, likely offsetting any price relief that accompanies reduced demand for crude and metals.

BMO’s Ian Lyngen and Ben Jeffery called this the “duality of a pandemic.” They’re rates strategists, so they addressed it in the context of the bond market, but their take, as delivered in a Monday note, was characteristically incisive. “The prospects of another meaningful wave of the coronavirus promises to further complicate investors’ interpretation of the overall health of the global economy and the forward path of yields,” they wrote, adding that,

It’s tempting to conclude that anything which undermines the recovery will be associated with a flight-to-quality comparable to the move seen overnight that brought 10-year [US] yields as low as 2.804% and 30s down to 2.874%. To a large extent, that is a fair initial take on the potential fallout from flagging demand in one of the world’s most significant economies. On the other hand, the potential for greater supply chain disruptions and the associated upward pressure on consumer inflation will function as an offset to the bond bullish impulse of another COVID surge. Alas, this isn’t the first time within the last two years in which the Treasury market has confronted the dueling narratives of the coronavirus. It goes without saying that the war in Ukraine has contributed significantly to the perception that the confluence of 2022’s developments thus far have meaningfully altered the forward path of inflation expectations. The flipside of the current notion that all roads lead to higher consumer prices holds that there will be an inflection point at which attempts to damper demand by global monetary policymakers cross the proverbial Rubicon. In such a scenario, the decision to moderate the pace of rate hikes could prove insufficient to protect the recovery. This outcome wouldn’t represent a textbook policy error; rather a reflection of the fact the Fed has been called on to address the fallout from a global pandemic with monetary policy tools. When layering in the reality that not every country is at the same point in the post-pandemic rebound, developments such as the potential for a lockdown in Beijing reinforce our core tenet that events rarely unfold in a linear fashion.

That’s an elegant exposition. What I’d suggest is that while it was inevitable that every nation’s path out of the pandemic would be different depending on a variety of factors, including national wealth, Xi’s refusal to deviate from “COVID zero” increasingly leaves China as a complete outlier.

Absent a strategic pivot in Beijing, the end result could be a stagflationary quagmire for everyone. Perhaps it’s possible to justify Xi’s position with hard data, but there’s a very real sense in which the existence of a debate about the efficacy of a strategy aimed at cutting the incidence of something undesirable to “zero” is evidence that the strategy isn’t working. Just ask America’s war on drugs.

Addendum: Plainly, lockdowns were (and remain) an effective way to combat the spread of a highly transmissible pathogen. But thanks to the protection offered by the vaccines and the availability of therapeutics, the tradeoff between public health and economic considerations bears almost no resemblance to the calculus policymakers were forced to reckon with in 2020. Part of the problem in China may be low vaccination rates and suboptimal vaccine efficacy, but even a generous interpretation that describes Xi’s efforts as genuine and well-meaning might also include another adjective: Quixotic.