August 6, 2021

Central Bank Research Hub

The transmission of Keynesian supply shocks

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Originally published on by Bank of International Settlements . Link to original report

Sectoral supply shocks can trigger shortages in aggregate demand when strong sectoral complementarities are at play. US data on sectoral output and prices offer support to this notion of 'Keynesian supply shocks' and their underlying transmission mechanism. Demand shocks derived from standard identification schemes using aggregate data can originate from sectoral supply shocks that spillover to other sectors via a Keynesian supply mechanism. This finding is a regular feature of the data and is independent of the effects of the 2020 pandemic. In a New Keynesian model with input-output network calibrated to three-digit US data, sectoral productivity shocks generate the same pattern for output growth and inflation as observed in the data. The degree of sectoral interconnection, both upstream and downstream, and price stickiness are key determinants of the strength of the mechanism. Sectoral shocks may account for a larger fraction of business-cycle fluctuations than previously thought.

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Bank of England Working Papers by Ambrogio Cesa-Bianchi and Andrea Ferrero

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Africa in the news: Energy and climate finance updates, Mozambique’s debt write-off, and US COVID-19 vaccine donation

( 4 mins) Africa proposes expanding and tracking climate finance; Egypt and Greece plan to link electrical grids; South Africa seeks low-cost financing for clean energy
Frustrated with a lack of climate-related funding from wealthy nations, Africa’s lead climate negotiator proposed this week to build a new system to track climate finance contributions by country. Indeed, funding has fallen short of the 2006 agreement to raise $100 billion per year for climate change-related financing by 2020. From the existing pool,  African countries only received 26 percent of the funding in 2016-2019, compared to 43 percent on average by Asian countries. African countries are now pushing to scale up funding tenfold by 2030 for global climate change mitigation and adaptation finance, calling the $100 billion package a political commitment and “not based on the real needs of developing countries to tackle climate change.”

Following the signing of an agreement on October 14, 2021 between Egypt and Greece to construct undersea interconnectors, transmission cables used to link electrical grids between countries, the Greek Prime Minister Kyriakos Mitsotakis pledged on Tuesday to connect Egypt with the European Union’s electricity market via an undersea cable network running beneath the Mediterranean Sea. Although formal details of the project have not been released,  Prime Minister Mitsotakis is confident that connecting Egypt’s energy grid to Greece, and ultimately Europe, will promote energy security during times of global turbulence in the energy market and energy diversification.
In related energy news, South Africa continues its search for low-cost financing to develop its clean energy infrastructure and decommission coal-burning power plants. The world’s 12th largest carbon emitter seeks 400 billion rand ($27.6 billion) of electricity infrastructure for its energy transition, earmarking 180 billion rand for cleaner energy technology and 120 billion rand for transmission gear. The rest of the funding will go toward transformers, substations, and electrical distribution technology. With more than 80 percent of South Africa’s electricity generated by burning coal, the state energy company, Eskom, plans to decommission between 8,000 to 12,000 megawatts of coal-derived electricity over the next decade and replace this electrical capacity with other energy sources such as wind, photovoltaic, and natural gas.
Credit Suisse to write off $200 in Mozambican debt after defrauding prosecutors
Regulators announced on Tuesday, October 19, that Credit Suisse will forgive $200 million worth of Mozambican debt as part of a settlement with UK, Swiss, and U.S. authorities due to corruption issues. The regulators alleged that Credit Suisse employees received and paid bribes while they arranged industry loans totaling $1.3 billion. According to U.S. prosecutors, three Credit Suisse bankers, two middlemen, and three Mozambican government officials diverted at least $200 million of the  loans for their private use. The debt write-off is part of a settlement agreement with regulators that includes a $175 million fine to the U.S. Justice Department, a $99 million fine to the U.S. Securities and Exchange Commission (SEC), and a $200 million fine to Britain’s Financial Conduct Authority. The SEC indicated on Tuesday that the Credit Suisse staff and their intermediaries have been indicted by the U.S, Department of Justice.
On Thursday, October 21, the Budget Monitoring Forum (FMO), an independent public finance organization based in Mozambique, called Credit Suisse’s offer insufficient and instead demanded the “full cancellation of illegal debts.” As of Friday, October 21, Mozambican officials have yet to comment publicly on the debt forgiveness.
US announces COVID-19 vaccine donations for Africa as South Africa rejects Sputnik V
On October 14, U.S. President Biden met with President Kenyatta of Kenya where Biden promised an additional donation of 17 million doses of the Johnson and Johnson (J&J) vaccine to the African Union . Indeed, this announcement is timely as the World Health Organization (WHO) announced in September that in order to fully vaccinate 70 percent of the continent by September 2022, COVID-19 vaccine shipments must increase from 20 million per month to 150 million.
In other related news, South Africa’s drug regulator has rejected the Russian Sputnik V vaccine due to safety concerns. According to the Associated Press, regulators asked the makers of Sputnik V for data proving the vaccine’s safety but their request was not suitably addressed. Sputnik V is currently being reviewed for authorization by WHO and the European Medicines Agency. Both AstraZeneca and J&J have been approved in South Africa.

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Greater transparency for development finance institutions

( 2 mins) Development finance is critical to global development, including for the achievement of the sustainable development goals, low-income countries’ recovery from the pandemic, and the $100 billion commitment for climate finance. But to know whether finance and development goals are being met—and to keep institutions on track—we need better information on financial flows and how they impact development. Despite the scale of financing by development finance institutions (DFIs), few share ​detailed information on their private sector portfolios. This makes it difficult to assess their development impact and to foster learning within this space. Greater transparency will lay the foundation for more informed decisionmaking, more accountability, and better allocation of resources.
On November 3, the Center for Sustainable Development at Brookings will host a virtual event to create space for DFIs, civil society organizations, and the private sector to engage with key issues on DFI transparency. As part of the event, Publish What You Fund will launch the report “Advancing DFI Transparency – The rationale and roadmap for better impact, accountability, and markets.” A panel will discuss recommendations for greater global disclosure and how donors can better engage with national stakeholders and improve the publication of their development financing. The event will introduce a new DFI Transparency Tool.
Questions for the panelists may be submitted with registration. During the live event, the audience may submit questions by emailing [email protected] or by using the Twitter hashtag #DFItransparency. 

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Financial risk assessment and management in times of compounding climate and pandemic shocks

( 6 mins) More than 4 million people have died from COVID-19, and many others face long-lasting effects on their lives and livelihoods. While the full social, economic, and financial implications of COVID-19 are yet to be seen, millions have lost their jobs, and incomes in many countries have sharply declined. This raises concerns about sovereign debt sustainability and financial vulnerability in the medium term, particularly in developing countries and emerging markets.

The pandemic diverted the attention from another ongoing crisis: Climate change has affected the lives of more than 130 million people and resulted in over 15,000 deaths since the beginning of the COVID-19 crisis. Natural hazards such as tropical cyclones, floods, and wildfires are expected to become more frequent and intense in the coming years.
Understanding the economic and financial impacts of compound risks
With worsening climate change, compound risks (e.g., floods and droughts or pandemics and hurricanes hitting the same country shortly thereafter) could be more likely in the future. This should be the main concern for governments and financial supervisors because compound risks could exacerbate social and financial vulnerabilities. For instance, natural hazards destroying socioeconomic infrastructures, such as hospitals, provide a fertile ground for pandemics to spread, thus strengthening the pandemic’s socioeconomic toll and delaying recovery. In countries with limited fiscal space and capacity to respond, compound risk can lead to substantial fiscal impacts and slowed recovery.

The assessment and management of compound risks require a better understanding of how shocks of different nature (e.g., pandemics, climate change) are entering and passing through the economy. Eventually, we need to identify which assets and sectors are most vulnerable yet relevant in shocks’ transmission and amplification, in the economy and finance. This information would support policymakers and financial supervisors, answering the following questions “What are direct and indirect impacts of compound COVID-19 and climate physical risks, and how do they affect socio-economic and financial stability?” “Under which conditions can effective recovery policies be implemented?” “To what extent can countries strengthen their financial resilience to compound risks?”
Fit for purpose tools to assess compound risk
Answering these questions calls for macroeconomic models where heterogeneous agents—such as banks, firms, households, government, and a central bank—interact and adapt their investment and financing behavior, based on available information and on their expectations about the future. Consistently with the real world we live in, agents differ with regard to access to information (for instance, asset managers may have better information about financial market reaction to COVID-19 than car dealers) and risk management tools. Agents endowed with different access to information, preferences, and expectations, may diverge in their risk assessment and management strategies, with implications for the shock recovery.
Compound risk can amplify losses
A recent paper applies such a macroeconomic model to Mexico and shows that when shocks compound, such as the case of COVID-19 and natural disasters, losses could get amplified. Economic impacts are shock dependent, as a hurricane that might affect the supply side first by destroying productive plants and infrastructure differs from COVID-19 that enters as an aggregate demand shock by curbing people’s ability and willingness to spend money. The interplay between supply and demand shocks in the case of compound risk matters for the shock transmission through the economy and thus overall economic, private, and public finance impacts. This amplified impact is captured by the compound risk indicator in Figure 1, which compares GDP impacts of compound risks versus the sum of individually occurring pandemic and climate risk. A value of the indicator higher than 100 signals that the impact of the compound shocks is higher than the impact of the sum of individual shocks. In the case of a compounding strong climate physical shocks with COVID-19, non-linear amplification effects emerge.
Figure 1. Compound risk indicator for Mexico

Source: Dunz et al. 2021.
Drivers of shocks mitigation and amplification
Diverging preferences, expectations, and risk assessment are a main driver of compound shock amplification. Timely governments’ fiscal response is crucial to support the economic recovery and influence economic expectations. However, procyclical banks’ lending can counteract the effectiveness of fiscal stimulus by limiting firms’ recovery investments, creating the conditions for public finance distress (e.g., public debt sustainability). For instance, banks may revise their lending conditions to firms due to the uncertainty about the duration of the crisis, despite government and central banks’ actions (e.g., credit guarantees, recovery investments). By limiting the ability of firms to invest and of households to consume, procyclical lending can trigger persistent and nonlinear macroeconomic effects, such as higher unemployment and lower GDP (Figure 1).
Banks’ lending behavior is thus relevant for the success of government fiscal policies, and for their financial sustainability. Indeed, government’s recovery funds, financed by issuance of debt, are less effective in fostering the economic recovery in presence of credit and labor constraints. Coordination of fiscal and financial policies could help to tackle the complexity of the implications of compound risk, creating the conditions for functioning credit markets, and preserving sovereign debt sustainability.
Insights to build back better
Introducing compound risk considerations in fiscal and financial risk management can help governments and financial authorities build resilience to compounding shocks that could be more likely in the near future. Nevertheless, the assessment of compound risks requires an adaptation of the analytical tools that support policy making. Accounting for adaptive expectations and finance-economy interactions (e.g., bank lending conditions) that affect economic and financial agents’ response (e.g., investment, consumption) in times of crises could improve our understanding of how and why individual and compounding shock impacts might amplify. Such a new generation of macroeconomic models can thus support investors and policy makers in the assessment of risk and in the design of better-informed risk financing strategies. This, in turn, would enable the role of public and private finance in building resilience to compounding climate, pandemic, and other risks, for the benefit of the environment, the economy, and society.

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Focus – China’s continuing growth slowdown

( < 1 min) China’s era of rapid economic growth dated from 1979 until about a decade ago. Main drivers were: rapid growth in the working-age population; increased participation; employment; longer working hours; and rapid productivity growth. However, over

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CHINA: Power shortages lead to durable market reforms

( 5 mins) Severe power rationing has led to significant long-term reforms to China’s electricity pricing system that go beyond emergency stop-gap measures. Under the new system, coal-powered generators can pass on higher coal prices to electricity users;

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