Paradigm Shift in Global Macro Pattern Brings New Challenges to China's Economy

When the COVID-19 pandemic has severely hurt the global labor supply，the Russia-Ukraine conflict has rapidly reduced the supply of cheap energy for Europe，and the average growth rate of total factor productivity (TFP) has declined. As a result，the global macro environment of "low inflation，low interest rate，and low volatility"，lasting for the past decades，has rapidly switch to a new one featured with "high inflation，high interest rate，and high volatility". Major economies in Europe and the US are faced with the dilemma of hiking the interest rates to fight inflation or reducing the rates to stabilize the financial market. Meanwhile，the rising populism and conservatism would like to bring headwinds to the globalization. Under such circumstances，China is facing new challenges to achieve high-quality growth，to deal with not only shrinking global demand，but also the risk of higher imported inflation，and these requires coordinated efforts of fiscal and monetary policies.

The global macro paradigm is facing a huge shift

Recently，in order to alleviate the impact of soaring energy costs，the HM Treasury of the UK announced a large-scale income tax cut plan，but did not specify the source of complementary financing. The market treated the action as that the future fiscal gap would rely on the issuance of government bonds. In the context of high inflation and rapidly rising interest rates，the market began to concern about the risk of fiscal stability due to the scale of government bond issuance. Soon，their confidence in UK assets has collapsed. Investors competed to sell off gilts to pay those collateral calls，and bond values fell even further，which in turn raised the risk of a full-blown market crash.

Public pensions have been levered high to conduct the liability-driven investment strategy (LDL) strategies，greatly affected by the decreasing values of the collateral，which is always the government bonds. In order to meet the conditions for future payments，most pension plans use the LDI，and the allocation of assets is mainly bonds. In this type of portfolio，long-term asset allocation is extremely sensitive to the volatility of interest rates，and in the past 20 years，a large number of interest rate swaps (IRS) that "pay floating interest rates and charge fixed interest rates" have been purchased. The recent surge in interest rates on government bonds has triggered a requirement to replenish margins，causing a massive liquidity run on UK pensions "tragic". When pensions were on the verge of bankruptcy，the Bank of England announced an "unlimited" bond-buying plan，dramatically reversing most of the tax cuts and spending plans that Prime Minister Liz Truss announced less than a month ago，which temporarily quelled the turmoil. The further cause of the UK pension crisis is that the inflation risk has changed the volatility of risk-free assets，and the deeper reason is that the global macro paradigm is facing a change.

Since 2021，the global macro paradigm has shifted gradually. Two decades of low inflation have turned to high inflation，forcing policy makers to shift from low to high policy rates，and this turns to drive the financial markets from low to high volatility. Since the past two decades，the participant structure in the global financial market have also undergone major changes. According to the research conducted by Goldman Sachs，two decades ago，non-bank financial institutions consisting of asset managers，pension funds and insurance companies held financial assets worth of about US$51 trillion，and banks held about US$58 trillion; two decades later，non-bank’s holdings have grown to US$227 trillion，surpassing the US$180 trillion held by banks. Unlike markets before the global financial crisis，leverage exists in different parts of the financial ecosystem，and low-cost liquidity is the key to maintain the financial stability.

Rapid globalization has greatly lowered the supply costs in advanced economies，and widened the market boundaries of advanced economies. As developed economies take the initiative to disrupt the global supply chain and energy supply，the Pareto improvement brought by globalization seems to be coming to an end. The de-globalization voices are emerging one after another，WTO reforms are hesitant，and the two decades-long macro paradigm is facing change.

The supply of production factors shrinks

The changes in the global macro paradigm are manifested in two aspects: in the real economy，the global industrial chain and supply chain have been artificially disrupted，and the world economy as a whole has not achieved optimal equilibrium in input-output，falling into sub-optimal choices，leading to a cost-imported inflation. Meanwhile，long-term low inflation has brought long-term low interest rates，resulting in the deep penetration of global liquidity into the financial markets of various countries，and the global financial leverage is at the peak. Therefore，the key to understanding the global macro paradigm shift is to grasp the rise and fall of globalization. Since the disintegration of the Soviet Union，the accelerated expansion of globalization led by the US and Europe has generally gone through three stages:

Expansion (1990-2007): This stage is an early globalization driven by supply chains. After the end of the Cold War between the US and the Soviet Union，China，Eastern Europe，Southeast Asia and other regions provided a large number of labor for globalization，resulting in an inflexible global labor supply and shrinking manufacturing workers in developed countries. From 2000 to 2007，the US had lost 5 million manufacturing jobs，reducing the US manufacturing employment base by nearly one-third，and these job losses and their causes have been well-reported in the mass media and academia proof. Commodities brought by the global industrial chain and value chain are of high quality and low price. Developed economies such as the US have been able to maintain a long-term low interest rate，stimulated the continued prosperity of consumption，and promoted the outflow of the US dollar liquidity around the world; Russia’s oil and gas energy has channeled to Europe，extremely reduce the manufacturing costs. According to the World Energy Statistics，natural gas consumption in Europe increased from 4,827 TWh in 1990 to 6,174 TWh in 2007.

Deepening (2007-2018): This stage is mainly driven by the growing demand in emerging markets. After the global financial crisis，emerging markets and developing countries recovered rapidly，China continued to upgrade its industrial technology，and the growth rate of TFP increased thereby. From the perspective of the H-O trade model，China’s comparative advantage of abundant labor is still existing，and at the same time，the comparative advantage of in-flowing capital and technology is on the rise. However，the growth rate of TFP in the US has not continued to rise，and the productivity gap between China and the US has narrowed，which is reflected in economic data. The ratio of GDP per capita in China versus the US rose to 17% from 5.6% during the stage.

Headwind (2019-present): Europe and the US are prone to de-globalization，and emerging markets are going all out to maintain globalization. Europe and the US are striving to prevent China from using the existing globalized value chain to achieve industrial upgrading. Countries like China still have huge room for technological improvement. They prefer that the WTO could continue to play a role in coordinating the global trade order. The interests of the two groups of countries are somewhat different，which leads to the pending of WTO reform. Together with conflicts in geopolitical issues，traditional inter-country cooperation began to weaken，for example，pipeline gas from Russia fell to 9% of EU gas imports from as high as 41% last year，according to the European Commission.

High debt cannot afford to bear higher interest rates

The increase in demand under the post-Covid-19 pandemic economic stimulus，the rise in commodity prices stemming from geopolitical conflicts，and the disruption of the global supply chain under the control of the COVID-19 pandemic are the main reasons for this round of inflation. However，tight monetary policy is largely powerless to affect the latter two factors. In the face of protracted geopolitical conflicts and the adjustment of the global supply chain，the Federal Reserve (Fed)'s tightening policy has to bear the top priority in curbing demand，and the high global debt cannot afford to raise interest rates.

Global debt is historically high. Since the global financial crisis，major central banks have implemented zero-interest rate policies for a long time，and global debt had risen rapidly. Combined with the extraordinary fiscal and monetary stimulus policies during the COVID-19 pandemic，global debt has climbed to an all-time high. According to the data by the US Department of Transportation (DOT)，the latest US government debt has reached US$31 trillion (as of end of this September). According to the IMF，global debt soared to US$226 trillion in 2020，an increase of 28% from the previous year，and accounted for 256% of global GDP. The dollar is increasingly at risk of a debt crisis as potential risks from Fed rate hikes soar due to the combined cause including borrowing outstanding，tighter monetary policy，and rising service costs during the pandemic. Roughly 30% of the developing countries and emerging markets and 60% of low Income countries are in or near debt distress，and financial crises repeating historically appear to be imminent.

The fragility of the financial market，based on the government bonds，has strengthened. The real economy is weak，and the COVID-19 pandemic relief policies has provided huge liquidity，which has led to a decline in the credibility of government bonds. Geopolitical conflict further increased the inflation in Europe，greatly disturb the financial stability. In September，the eurozone Harmonised Index of Consumer Prices (HICP) rose by 9.9% YoY，and the UK CPI rose by 10.1% YoY，still on the upward trend. While the market of the UK government bonds imploded，the US bond yields also moved in the same direction. Since this October，the 10-year UK government bond yield hit 4.6% at its highest，and the 10-year US bond yield hit 4.28%，hitting a record high after 2007. Affected by the rising volatility of US government bond yields，the bond markets of other countries in the world began to face much trouble. The Bank of Japan has continuously used the large amount of Japanese yen to purchase government bonds，and the Swiss National Bank has also borrowed liquid