Emerging Market Miracles are Few and Fleeting

Much of the excitement that investors have for emerging markets is anchored in the idea that developing countries grow faster than the sclerotic rich countries of the West and that this growth brings opportunities for extraordinary portfolio returns. Unfortunately, this is largely wishful thinking, as the evidence shows that countries in the developing world have experienced mediocre growth. Nevertheless, there have been important exceptions. A select group of countries have achieved periods of “miracle growth,” allowing them to significantly reduce the income gap with rich countries.

Developing countries, including many key emerging markets, have grown at a slower rate than the bellwether economy of the United States since 1980. This period includes the entire modern era of emerging market institutional investing, which can be considered to have started in the mid-1980s with the launch of the IFC and MSCI indices. It covers the entire era of the “Washington Consensus” for free trade and capital movements, which theoretically should have favored developing countries, and also coincides with a significant decline in the rate of growth of the American economy. The data from the World Bank on GDP per capita growth in dollar terms from 1980-2023 is shown below. About two-thirds of countries have grown at a slower rate than the United States. In emerging markets, these laggards include most of Latin America and Africa—countries which, with the exception of Mexico, failed to participate in the globalization trend. On the other hand, the “convergers,” with the exception of India and Egypt, are all countries that deeply benefited from expanding global trade.

Of the convergers listed above, few achieved impressive growth levels; Turkey, Bangladesh, Egypt, Chile, Indonesia, Malaysia, and India all grew GDP per capita by less than 3% per year. Very few countries are achieving the kind of “miraculous” growth that can be transformational over a generation.

The chart below highlights the few countries that have aspired to “miracle” growth status. True economic “miracle” growth stories have been exceptionally rare in the past 60 years. Only five countries—Singapore, Taiwan, South Korea, and China—have achieved the high GDP growth over extended periods necessary to make giant leaps in the rankings of the wealth of nations. This group of countries, the so-called Asian Tigers, all pursued similar export-oriented mercantilist policies based on the repression of domestic wages and benefited greatly from U.S.-sponsored trade liberalism.

Several countries once labeled “miracles” have been unable to sustain growth. These countries have seen their miracle growth aborted for a variety of reasons related to poor governance and weak institutions. Latin American economies once considered to be on the “miracle” path, such as Brazil and Chile, have fallen into “middle-income traps” characterized by low growth and political and social instability. Brazil, in particular, rejected the globalization trend, doubling down on its reliance on commodity exports. Botswana, once considered the stellar success of Africa, has also slowed.

The integration of Eastern Europe into the rich economies of Western Europe has been an outstanding success, allowing countries like Poland to make significant strides toward convergence, which appears to be sustainable. Poland and other countries of Eastern Europe have benefited from exceptional financial assistance from Western governments and abundant access to private capital made possible by geopolitical and historical considerations.

Most of the miracle economies of the past decades have exhausted the high-growth phase and are now expected to experience mundane to low growth. The chart below shows the IMF’s GDP growth expectations for the remainder of the decade. The new growth hopefuls—Bangladesh, India, Vietnam, and the Philippines—will face more difficult conditions than in the past, as the U.S.-imposed “Washington Consensus” has been replaced by deglobalization and geopolitical conflict.

 

Income Inequality in Emerging Markets, Market Size and Consumption

A basic characteristic of emerging markets is a high level of income inequality. Most countries have small elites that dominate politics and business and control a large share of financial income and assets. Income concentration creates a chasm between the elites and the general population, significantly reducing the market potential for business, and thereby reducing investment, employment, and consumption.

The chart below shows the share of income held by the top 1% for emerging market countries and a selection of developed markets, using 2022 data from the World Inequality Lab (WIL). Latin American countries, India, and the United States stand out for high income concentration, while European countries and Asian “Tigers” (Korea and Taiwan) are more equal. These elites of top 1% earners are sophisticated and increasingly globalized in terms of their attitudes, customs, and where they get educated, invest, vacation, and  retire. They also typically are highly educated and enjoy much better health and longer lifespans than the rest of the population. Particularly in Latin America, where the elites often have generational ties to European nations, the chasm between elites and the population is growing wider, made ever easier by borderless communication technologies and ease of transport. Eastern European countries are different from both emerging markets and developed countries. They are homogeneous populations with scarce immigration and have a legacy of broad educational achievement and equitable  income distribution from the communist past.

The next chart shows the share of income held by the top 10% of earners. In most EM countries, this group controls around half of total income and almost all financial assets, and it represents the bulk of total consumption. Once again, the highest concentration is in Latin America and the lowest in Europe and East Asia.

The next two charts illustrate further the degree of wealth concentration by looking at the ratio of income of the top 1% and top 10% relative to the bottom 50%. The high concentration of income in Latin America compared to other emerging markets and in the United States compared to other developed countries is made more evident. Mexico stands out as an extreme case of income concentration, based largely on ethnicity and integration into the modern economy.

One consequence of income concentration is that many middle-income EM countries (i.e., Latin America, China) and the United States underconsume relative to the size of their populations. The chart below shows the percentage of the population that can be considered to be consumers, assuming USD 12,000 per capita income as the threshold. What we see in all of these middle-income countries, as well as the United States, is that a large part of the population never really enters the consumer economy unless it has the support of generous welfare support or abundant credit. However, unlike in the United States, both welfare and easy credit conditions tends to be temporary in emerging markets, only available in boom times.

High income concentration significantly reduces the consumption potential of most emerging market middle-income countries. For example, assuming that China, Brazil, and Mexico have a similar income distribution as Korea, their population of consumers would increase by almost 100 million for China, and around 20 million for both Brazil and Mexico. On this basis, in the chart below, which shows total potential consumers, Brazil would surpass France and Mexico would jump well ahead of Korea.

Of course, realizing such a shift of income in any country will never be easy, as inequality as deep rooted historical and social causes. Also, the losers from redistributive policies will fight tooth and nail to retain what is theirs. Talk about income redistribution to promote consumption has been prevalent in China for over a decade with scarce results, as elite groups, business lobbies, the bureaucracy, and regional interests impede change. In Brazil, Lula would love to raise taxes on the rich but faces fierce opposition. Any initiative of this sort in Brazil would trigger more capital and human flight from an elite that is already with one foot out of the door, comfortably ensconced in their homes in Florida, Texas or Lisbon with ready access to their foreign bank accounts.

 

 

2Q 2024 Expected Returns For Emerging Markets

 

Emerging market stocks underperformed the S&P 500 during the first half of 2024, extending a long losing streak. This is the seventh year in a row of EM underperformance, and the tenth out of the last eleven years. This leaves the valuation premium of the S&P 500 at its highest level since the peak of the tech bubble in 2000. The U.S. market appears to be enjoying a blow-off, driven by a consensual view on an immaculate soft landing for the U.S. economy and optimism about future AI-fueled productivity growth. The U.S. market is also enjoying a remarkable resurgence in profit margins driven almost exclusively by the Magnificent Seven technology titans.

The strength of the S&P 500 can be attributed to both multiple expansion and earnings growth. The valuation premium of the S&P 500, as shown below, is at very high levels, but still lower than in 2000 or 2015, which were the last two opportunities to make extraordinary relative returns in EM.

However, earnings growth has been by far the main contributor to S&P 500 outperformance over the past ten years, as shown below. While EM has been in a prolonged earnings funk, S&P 500 earnings have surged since 2014, mainly because of the spectacular margin expansion of the tech titans. Though the strong dollar has helped, it accounts for only some 20% of the relative outperformance. Therefore, the question all investors should ask themselves is how much longer the “Mag 7” phenomenon can continue?

The chart below estimates the current expected returns for EM markets and the S&P 500, based on a CAPE ratio analysis. The Cyclically Adjusted Price-Earnings Ratio (CAPE) is calculated using the average of inflation-adjusted earnings for the past ten years, which helps to smooth out earnings’ cyclicality. This tool is particularly useful for highly cyclical assets like EM stocks and has a long history of use among investors, gaining popularity through Professor Robert Shiller at Yale University. We employ dollarized data to capture currency trends. The seven-year expected returns are calculated assuming that each country’s CAPE ratio will revert to its historical average over the period. Earnings are adjusted according to each country’s current position in the business cycle and are assumed to grow in line with nominal GDP projections from the IMF’s World Economic Outlook (IMF WEO, April 2024).

As expected, countries with “cheap” CAPE ratios below their historical average tend to have higher expected returns than those considered “expensive” with CAPE ratios above their historical average. These expected returns are based on two significant assumptions: first, that the current level of CAPE relative to the historical level is not justified; second, that market forces will correct the current discrepancy. Historical data strongly supports the second assumption when considering seven-to-ten-year periods but not in the short term (one to three years).

Nevertheless, during certain periods when “cheap” markets on a CAPE basis exhibit short-term outperformance (one year or less), investors should take note, as the combination of value and momentum is compelling. As depicted in the chart below, the current environment is not particularly supportive of using CAPE as an investment timing tool. Over the past twelve months, holding the “cheapest markets” (on the left side of the chart) has had mixed results, working for Colombia and Turkey but not for Brazil, Chile, or the Philippines. On the other hand, expensive markets (right side of the chart) like the U.S., India, and Argentina have produced stellar results. It can be concluded that for the time being, liquidity and not value is driving performance.

Looking forward, Turkey, Colombia, and Peru look well-positioned to perform, having both cheapness and momentum and being in the early to middle phase of their business cycles. The Philippines looks compelling from a valuation and business cycle aspect but lacks price momentum.

Rising geopolitical tension and slow growth do not create a conducive investment environment. As always, a strengthening dollar signals the need to stay invested in dollar-denominated quality assets.

 

The Past, the Present and the Future of the Fiat Dollar

The U.S. dollar reserve currency regime in place since President Richard Nixon broke the dollar’s link with gold in 1971 is unique in nature and scope. It is the first fiat currency entirely reliant on the market’s trust in the issuer, which is the U.S. government, and it is the first truly global currency. Because of the lack of support from a traditional metallic anchor such as gold, U.S. monetary authorities have had to work hard to provide incentives for financial agents around the world to hold dollar assets. The policies required to preserve dollar hegemony have evolved over time as global conditions have changed. Today, the dollar system is once again experiencing significant pressures from multiple sources, including from the U.S. itself, which is questioning its usefulness.

To understand the current state of the dollar system, it is important to understand its history. The post-WWII dominance of the U.S. dollar can be broken up into six distinct phases.

Phase 1 – Bretton Woods Harmony, 1945-1964 – This period, following the Bretton Woods agreement (1947) which created a gold-anchored system centered around the U.S. dollar, was characterized by U.S. capital exports to rebuild war-torn Europe and Asia, and large U.S. current account surpluses.

Phase 2 – Bretton Woods Disharmony, 1964-1971 – The rapid recovery of European and Japanese industrial output during the 1950s resulted in manufacturing surpluses being exported to the U.S. and the beginning of U.S. trade deficits. Led by the French, who denounced America’s “exorbitant privilege” of seigniorage and trade deficits (1965), America’s main trading partners increasingly questioned the integrity of the Bretton Woods system and began to repatriate gold reserves held at the New York Fed. Rising inflation in the U.S. due to the Vietnam War and the “war on poverty” further increased concerns that the dollar was overvalued.

Phase 3 – Chaos and Inflation with the Launch of  the Fiat dollar system, 1971-1981 – The cutting of the gold anchor severely undermined the credibility of the dollar as a reserve currency. The 1970s saw a surge in demand for alternatives, including gold, the Deutsche mark, the Swiss franc, and the Japanese yen. Two key policy initiatives successfully checked the dollar’s decline. First, in 1974 the U.S. convinced Saudi Arabia to invoice oil exports in dollars and channel its central bank reserves into U.S. T-bills. In exchange, the U.S. agreed to provide defense guarantees and military hardware. This recycling of oil revenues into U.S. financial assets created a new anchor for the dollar sometimes called the Petrodollar system. Second, in 1981 U.S. Federal Reserve Chairman Paul Volcker jacked up interest rates to nearly 20% to shock inflation into decline. Concurrently, the elections of Ronald Reagan in the U.S. and Margaret Thatcher in the U.K. launched the Washington Consensus for free markets and free capital flows in global markets. These deflationary policies started a 40-year trend of falling prices and interest rates.

Phase 4 – The Heyday of the Dollar, 1981-2001 – This period can be considered the zenith of the dollar system. It starts with Reagan and Volcker and is marked by disinflation, the globalization of trade and capital flows, and the great financialization of the American economy. The pillars of this phase of peak dollar hegemony were (1) persistently high U.S. current account deficits that were recycled into U.S. financial assetss by America’s mercantilist trade partners (Japan, Germany, Korea, Taiwan) and commodity producers; (2) an increasingly activist and interventionist U.S. Fed that aimed to backstop Wall Street; and (3) a relatively stable oil price which buttressed the Petrodollar system. During this period the dollar’s share of total central bank international reserves went from 22% to 64% while gold’s share fell from 65% to 15%.

Phase 5 – Chimerica and Fed Adventurism, 2001-2012 – The entry of China into the WTO in 2001 heralded “hyper-globalization” and China’s economic miracle and infrastructure boom, resulting in a commodity super-cycle. The deflationary impact of China trade offset the inflation caused by the surge in the price of oil and other commodities, allowing the U.S. to pursue expansionary monetary policies. The extraordinary surge in China’s exports to the U.S. gave rise to the “Chimerica” concept, by which China’s enormous trade surpluses were recycled by China into U.S. treasury securities. The Great Financial Crisis saw the U.S. Fed doubling down on its commitment to buttress Wall Street and the Great Financialization, allowing Fed Chairman Bernanke to aggressively pursue expansionary monetary policies aimed at boosting asset prices to create a “wealth effect.”

Phase 6 – A New Cold War, Sanctions Diplomacy, The Anchorless Dollar, 2012-2023 – Xi’s rise to power in China in 2012 marked the end of the China “economic miracle” and resuscitated the traditional Leninist ideology abandoned in the 1980s, with a focus on reestablishing Party control over all aspects of Chinese politics and society. The shift in China completely undermined the premise of “Chimerica” and transformed what has been seen as a beneficial partnership into a bitter rivalry. Over the past decade, a new Cold War has spawned an alliance of anti-American countries (China, Russia, Iran, North Korea) all of them facing U.S. financial sanctions. Since 2012, the U.S. dollar has been essentially anchorless for the first time since the early 1970s, without a clear mechanism for recycling U.S. trade deficits into U.S. assets. Dollar hegemony has been threatened by a broad initiative by China and others to diversify reserves into alternatives. This has meant mainly a revival in interest in gold but also China’s efforts to create a “sinodollar” by recycling dollar reserves into loans as part of Xi’s Belt and Road Initiative. China has also structured several bartering agreements with Russia, Iran, Saudi Arabia, and others which aim to bypass the dollar system.

The dollar’s strength since 2015 has relied on a fortuitous combination of the two factors that historically have boosted the value of the greenback. First, growing geopolitical tensions have raised the dollar’s safe-haven status, leading to massive amounts of capital flight into U.S. assets. By some estimates, capital flight from developing countries into the U.S. has been in the order of $1 trillion annually, over half of that coming from China’s private sector (Brad Setser, CFR). Second, America has experienced a remarkable phase of economic exceptionalism underpinned by the shale oil boom and by the extraordinary global domination and financial success of its Silicon Valley tech titans. This powerful phase of American Exceptionalism has boosted growth and wealth creation in the U.S. and sucked in savings capital from around the world.

The chart below illustrates how the dollar has trended according to economic, political, and social factors related to growth, inflation, and cycles of American malaise and exceptionalism.

The next chart looks at the M2 measure of money supply in real terms in the U.S., highlighting how Fed policy became more and more activist and interventionist over time. From the end of Bretton Woods in August 1971 until mid-1997, the Fed pursued a tight monetary policy, with annual increases of M2 at 1.45%. In the mid-1990s Fed Chairman Alan Greenspan, facing “exuberant” markets and increasing leverage in the financial system, moved the Fed’s focus to monitoring systemic risk. In reaction to repeated “shocks” (e.g., the Asian and Russian financial crises, the collapse of the LTCM hedge fund, the bursting of the tech bubble, and the Great Financial Crisis), the Fed injected liquidity into the financial system. Under Greenspan, Bernanke, and Powell, the Fed has injected increasingly large amounts of liquidity to preserve financial stability. Starting in 1997, in sharp contrast to its previous behavior, the Fed has always increased the money supply during downturns. The annual real increase in M2 over the 1997-2024 period has been 3.82%, nearly three times the rate of growth of the 1971-1997 period of Fed monetary discipline.

The following chart shows the long-term evolution of the composition of reserves held by central banks around the world. Under the Bretton Woods system, central banks held mainly gold reserves while gradually increasing dollars and reducing sterling. After the collapse of Bretton Woods, central banks shifted reserves back into gold and into alternative currencies (mark, yen, franc), so that by 1980 the share of dollar reserves had fallen back to the 1962 level. During the dollar’s heyday, from 1981 to 2001, dollar reserves rose from 22% to 65%, mainly at the expense of gold. Since 2001, the dollar’s share of reserves has been gradually eroded by the euro and alternative currencies. Over the past ten years, central banks, led by China, have started to accumulate gold reserves, ending a 30-year period of neglect for the “barbarous relic.”

The defining characteristic of dollar hegemony has been large and chronic U.S. current account deficits, which are recycled by trading partners into U.S. financial assets, mainly T-bills. These deficits were initially denounced by the French and others as an “exorbitant privilege,” meaning that they gave America the ability to pursue growth and consumption without the discipline imposed by the classical British-run gold standard (1816-1914). As shown in the chart below, under the fiat dollar system these deficits have been persistent. During global downturns they have regularly been excessive, allowing the U.S. to serve as the consumer of last resort for the world and to promote the supply of cheap foreign goods for American consumers.

In recent years, however, under both presidents Trump and Biden, these chronic current account deficits have been blamed for the deindustrialization of America and the loss of millions of well-paid manufacturing jobs. Moreover, it is now argued that America’s loss of industrial capacity has made it very vulnerable to unreliable global supply chains and untrustworthy trading partners, leaving it weakened to address economic and security objectives. What was previously seen as an “exuberant privilege” is now widely considered an “exuberant burden,” and anti-trade policies such as tariffs and subsidies are easily justified by politicians. In the current presidential campaign, both parties have argued for “balanced trade” and justified tariffs to boost American manufacturing. Given that chronic and persistent deficits have been at the core of the dollar system, it is logical to believe that the world monetary system is in a phase of transition to something different.

The Future of the Fiat Dollar Reserve System

If the fiat dollar currency reserve model is no longer attractive for the U.S. and foreign central banks are diversifying into alternatives to the dollar, what will replace the current model? Some ideas being discussed by Washington insiders and policy think tanks are as fiollows:

  1. A return to a commodity-centric model.
    • Zoltan Pozsar, a prominent financial strategist, has argued that geopolitical conflict is driving the world to a multipolar monetary system where the dollar, alternative fiat currencies, and commodities will all be important. Pozsar sees gold and a variety of other commodities anchoring the yuan and other non-dollar currencies. He points to the accumulation of gold by Russia and China and China’s initiatives to build financial ties with commodity heavyweights Iran and Saudi Arabia. According to Pozsar, a new multi-polar order will take shape where regional financial systems will dominate, at the expense of the U.S. dollar.
    • Jeff Currie, a highly regarded Wall Street commodity analyst who is currently the Chief Strategy Officer of Energy Pathways at The Carlyle Group, also sees a prominent role for commodities in a new evolving global monetary system. According to Currie, the Petrodollar system which somewhat anchored the dollar from 1974 to 2001, is being replaced by  “superconductor” commodities which are replacing oil at the center of economic activity. The countries that control the supply and stock of the metals that are cost-effective to conduct electricity (copper, silver, gold, aluminum, and nickel) will play a key role in the new system. Unsurprisingly, given its significant lead in the electrification of its economy, China has been very active in building stocks of these metals and securing global supplies in Africa, Latin America, and wherever it can deploy capital and influence.
  2. A return to restricted international capital flows.
    • Prior to the 1980s and the rise of the Washington Consensus, almost all countries had controls on international capital flows. In many emerging markets, these controls were lifted only in the 1990s. In countries like Brazil, this has complicated monetary policy as “hot money” flows in during good times and leaves in bad times, and, in recent years, the deregulation of capital flows has greatly facilitated high levels of capital flight. Ironically, the U.S. has the opposite problem. With the largest and most liquid capital markets in the world and  attractive market returns available relative to the rest of the world, the U.S. is a magnet for global capital. Some analysts (e.g. Michael Pettis) have argued that the U.S. cannot address its current account deficit without taxing foreign inflows. This raises the possibility that in coming years the U.S. will be imposing regulatory restrictions on foreign inflows while countries like Brazil will be obstructing outflows.

The global monetary system may be in a phase of transition to a system that assures more balanced trade. This will produce a series of losers and winners, very different from those of the past 40 years. Mercantilist countries that repress their domestic consumption and capture foreign demand (e.g., the East Asia tigers, Germany) may have a difficult road ahead. Countries with large domestic markets and that can reindustrialize (e.g., the U.S., Brazil) may be better positioned. Regional groups with well-defined trade rules that assure balanced trade (NAFTA) may also prosper. None of this is certain, but countries should be planning for a new world monetary order.

Economic convergence’s Spotty Record

Poor countries with can sustain high levels of economic growth for decades as labor engaged in self-sufficiency farming migrates to more capital-intensive and productive urban jobs. This concept, which is at the core of Walt Rostow’s Stages of Economic Growth Model, has been a pillar of economics since the 1950s and a premise of the work of development institutions like the World Bank. The Solow model provides a simple framework for analyzing the successes and failures of developing countries.

Solow’s model is explained in the chart below. Over time, people move from rural to urban areas and contribute to capital accumulation and increased productivity. Concurrently, family size steadily decreases. Consumption follows a different pattern: initially, rural farmers consume 100% of what they produce. However, as abundant labor joins the modern industrial economy, significant capital accumulation occurs, and consumption as a share of GDP declines. Eventually, labor becomes scarce, wages rise, returns on capital decline, and a country enters a mass consumption phase. The time when labor becomes scarce and wages start to rise is called the Lewis Turning Point, and it heralds the beginning of the mass consumption society characteristic of developed economies.

This path of development has been followed faithfully by most countries. We can see in the chart below the surge in wages that has taken place in China around the Lewis Turning Point, which China reached around 2015.

The chart below shows the evolution of the consumption share of GDP for several successful Asian economies. It is noteworthy that China’s consumption share of GDP has not risen as expected. This is highlighted in the next chart, which shows the share of GDP for various countries at different income levels. The explanation for this is that China has found it difficult to abandon its debt-driven investment model, which channels resources into manufacturing exports, infrastructure, and armaments. This trend has been reinforced in recent years by policies aimed at promoting “productive forces,” particularly frontier industries considered to be the key sectors of the global economy in the future and military hardware. The two outliers in the data are China and the United States. While China has done everything to establish itself as the world’s dominant manufacturing power, the U.S. has prioritized finance and consumption.

The following chart shows the evolution of GDP, consumption, and manufacturing value-added for Europe, the United States, and China. This highlights the enormous growth in Chinese manufacturing that has occurred during the “China shock” of the past two decades. While GDP and manufacturing have surged, consumption has been repressed.

The Solow model assumes that over time countries will converge to similar levels of GDP per capita. This is premised on the idea that capital flows freely and that countries are institutionally prepared to attract this capital. In practice, this is not the case, which means that convergence is highly uneven.

Using the framework of the Solow Model, it is disheartening to see how uneven the process of convergence has been. As shown in the chart below, looking at averages for income classes, developing countries have tended to converge with high-income countries for the 1980-2023 period and even more so for the more recent 2001-2023 period of hyper-globalization started by China’s entry into the WTO in 2001. However, taking the United States as the benchmark for convergence, the results are less convincing. Over the 1980-2023 period, the U.S. handily outperformed all of the income classes when measured in USD terms. Economists generally attribute the absence of broader convergence to “institutional failure,” a vague term describing the difficulties many countries have in providing the appropriate conditions to attract investment capital.

Looking at the data on a country-by-country basis, the data is disappointing. This is shown in the chart below, which includes all the countries in the IMF database for the 1980-2023 period. Only one-third of the 135 countries in the IMF database grew GDP per capita at a faster annual rate than the U.S.

The data is much more supportive in the more recent 2001-2023 period, with 75% of the countries converging with the U.S. This can be attributed to lower growth in the U.S. and the widely shared benefits of hyper-globalization.

 In the two charts below, the focus is on the more economically important countries in both the rich world and emerging markets, as well as on some important outliers. The first chart covers the 1980-2023 period, which is characterized by the Washington Consensus for free trade and capital flows, the fall of the Iron Curtain and the subsequent integration of Eastern Europe and Western Europe, and the sustained financialization, indebtedness, and deindustrialization of most of the rich world, especially the Anglo-Saxon countries. The second chart covers 2001-2023, a period marked by “hyper-globalization,” the China “Miracle” and “China Shock” to global trade, the Great Financial Crisis, and the shale and Silicon Valley booms in the United States starting around 2015-2016, which brought about a powerful phase of “American exceptionalism.”

Considering the entire 1980-2023 period, well over half of the countries grew GDP per capita at a slower rate than the 1.4% achieved by the U.S. The convergers are led by the “Asian Tigers” (China, Korea, Singapore, Taiwan, Indonesia, Vietnam, and Thailand), countries that benefited from the transfer of mass-production manufacturing capacity away from the rich countries . Ironically, these countries have been the primary beneficiaries of the “Washington Consensus” while also openly pursuing anti-liberal protectionist policies aimed at controlling both capital and trade flows. Eastern European countries have also been winners, benefiting from the transfer of mass-production manufacturing from Western Europe. The remaining winners include emerging market countries India, Brazil, and Peru, and a few special cases in Asia and Africa starting from very low bases (Sri Lanka, Bangladesh, Ethiopia) and in Latin America (Panama, Dominican Republic, and Costa Rica). Israel is a rare “rich” country that has achieved good GDP PC growth.

The list of non-convergers over the 1980-2023 period is long. It includes almost all of the rich world in Europe and Asia, most of Latin America, and several poor countries in Asia (Philippines, Pakistan). Middle-East oil producers show sharply negative GDP PC growth only because they have all come to rely on huge amounts of temporary contract workers.

The decline in prosperity relative to the U.S. for many rich countries is stunning. The chart below shows the GDP per capita of Japan and France relative to the U.S. over this 43-year period. Japan has gone from a GDP per capita 1.6 times that of the U.S. in 1995 to 0.4 times in 2023.

Considering the more recent 2001-2023 period, 64% of countries grew GDP per capita at a higher annual rate than the 1% achieved by the U.S. The winners include the beneficiaries of hyper-globalization: all the Asian exporter-led economies (China, Vietnam, Indonesia, Thailand, Malaysia, Korea, and Taiwan) joined by Bangladesh and the Philippines; and all of Eastern Europe plus Turkey. Even Latin America did much better over this period, boosted by high commodity prices, though Mexico sputtered, and Venezuela suffered a total institutional collapse with the Chavez Revolution.

The most glaring loser during this period has been the U.K., which has suffered from severe deindustrialization and the institutional breakdown of Brexit.

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

Big Macs, Mercantilism and the Commodity Curse

 

As the world economy moves away from the globalization of manufacturing value chains and finance, the protection of domestic markets is back in favor with policymakers. However, the neo-mercantilists will have to overcome high costs, including overvalued currencies.

The case of TSMC’s investment in a new $40 billion semiconductor plant in Arizona is illustrative. The Taiwanese chipmaker gave in to pressure from the Biden Administration and agreed to build a “fab” in Arizona, but it does not seem to be happy about it. The company has complained about “exorbitant costs, unmanageable workers… and a lack of local expertise,” and it has repeatedly delayed the project and asked for more subsidies from Washington.

TSMC’s preference for manufacturing at home is not surprising. Taiwan is a model of successful mercantilist policies (repression of wages, directed credit, and a stable and highly competitive currency) that create fruitful conditions for manufacturing exports. Taiwan, and other Asian “tigers,” including China, carefully manage their currencies to assure export competitiveness. The U.S., on the other hand, has long favored consumers over manufacturers and has an overvalued currency, which serves as the safe haven asset for the rest of the world. Manufacturing powerhouses are all commodity poor, which facilitates currency management, while the U.S. is commodity-rich, which subjects it to repeated commodity boom-to-bust cycles. The latest of these often violent commodity cycles in the U.S. – the massive boost in shale oil and gas output from Texas’s Permian Basin – has been an important source of strength for the U.S. dollar over the past decade.

We can see the challenges faced by the U.S. and other aspiring mercantilists by looking at current and historical relative exchange rates. Below, we show the Real Effective Exchange Rate (REER) for the U.S., which measures the value of the dollar relative to the currencies of trading partners. The REER is at near-record levels for the U.S., the result of the shale oil boom, rising geopolitical risk, and a long period of economic “American Exceptionalism” marked by relatively higher GDP growth and the stock market success of America’s magnificent technology titans.

The chart below shows REERs for a sample of developed and emerging countries relative to their long-term histories (1987-2024), telling the same story. We can highlight the competitiveness of “producer” countries (Germany, Japan, Thailand, Malaysia, and Turkey) compared to “consumer” countries (e.g., the U.S., Australia, New Zealand). China and Vietnam have appreciated from very low levels but are not likely to let their currencies appreciate more in the future. Eastern European countries have lost competitiveness over this period but are unlikely to be allowed to manage their currencies downwards. The recent appreciation of the Mexican peso is probably explained by hot money flows exploiting currently high interest rates.

We look below at the annual volatility of currencies over this period. We highlight the stability of champion exporters of manufactured goods like Germany, Korea, Taiwan, Singapore, Mexico, and Malaysia.

The Big Mac Index ranking from The Economist Magazine is another good measure of the overall cost for businesses to operate in an economy, as it reflects costs from the farm, manufacturing and service sectors, including taxes and regulations. In the chart below, “producers” — countries with an established vocation for manufacturing exports — are labeled in green, while commodity producers that rely more on manufactured imports are labeled in bold black. The chart compares three data points — January 2024, 2020 pre-COVID, 2010, and 2000. We can see that across these periods exporters of manufactured goods generally have cheap Big Macs and importers have expensive Big Macs. The exemptions can be explained by either periods of excessive political turmoil and capital flight (South Africa, Argentina) or cycle-low commodity prices (2000). Mexico and Turkey, two countries that play a fundamental role in the manufacturing value chain for their respective regions, do not manage their currencies as well as the Asian “tigers.” Both suffer from more macro-economic instability than their Asian counterparts. The near-doubling of the price of the Big Mac in Mexico since 2020 is a cause for concern. In this regard, Poland is also apparently losing competitiveness in the European market. Contrast this with Taiwan’s remarkable ability to keep prices near the bottom of the table.

Brazil and the United States, two countries now enthusiastically pursuing neo-mercantilist agendas, are interesting cases with similarities. Both have severely deindustrialized while at the same time expanding energy production aggressively. Both went from being large importers of oil to self-sufficiency since 2010, which, all else being equal, should translate into stronger currencies. The implication is that neo-mercantilist policies may be pursued at a high cost, without the luxury of a weak currency.

The irony is that commodity prices are likely to remain high in the 2020s because of a more inflationary environment and production bottlenecks. This would mean stronger currencies for commodity producers and even higher costs to implement reindustrialization policies. The “commodity curse” is difficult to shed.

 

 

 

 

 

 

 

 

4Q 2023, Expected Returns in Emerging Markets

Emerging market stocks underperformed the S&P500 in 2023, for the sixth year in a row and the ninth  out of the last ten years. This leaves the valuation premium of the S&P500 at its highest level since the peak of the previous tech bubble in 2000. The U.S. market appears to be enjoying a blow-off, driven by a consensual view on an immaculate soft-landing for the U.S. economy and optimism on future AI-fueled productivity growth.

The chart below illustrates the current expected returns for EM markets and the S&P500, based on a CAPE ratio analysis. The Cyclically Adjusted Price-Earnings Ratio (CAPE) is calculated using the average of inflation-adjusted earnings for the past ten years, which helps to smooth out earnings’ cyclicality. This tool is particularly useful for highly cyclical assets like EM stocks and has a long history of use among investors, gaining popularity through Professor Robert Shiller at Yale University. We employ dollarized data to capture currency trends. The seven-year expected returns are calculated assuming that each country’s CAPE ratio will revert to its historical average over the period. Earnings are adjusted according to each country’s current position in the business cycle and are assumed to grow in line with nominal GDP projections from the IMF’s World Economic Outlook (IMF WEO, October 2023).

As expected, countries with “cheap” CAPE ratios below their historical average tend to have higher expected returns than those considered “expensive” with CAPE ratios above their historical average. These expected returns are based on two significant assumptions: first, that the current level of CAPE relative to the historical level is not justified; second, that market forces will correct the current discrepancy.

Historical data strongly supports the second assumption when considering seven-to-ten-year periods but not in the short term (one to three years).

Nevertheless, during certain periods when “cheap” markets on a CAPE basis exhibit short-term outperformance, investors should take note, as the combination of value and momentum can be compelling. As depicted in the chart below, we are currently in such a period. Over the past twelve months, holding the “cheapest markets” has generated alpha in an EM portfolio. The chart shows markets from left to right based on how cheap they appeared a year-end 2022. By and large, cheap paid and expensive did not, with the U.S. and India being the two outliers, both going from very expensive to even more expensive.

For 2024, Turkey, Taiwan and the Philippines look compelling. In addition to being “cheap,” their economies are in the early phase of the business cycle and earnings are expected to be strong.

The fact that cheap markets are now performing well is encouraging for EM investors. However, rising geopolitical tension and slow growth do not create a conducive investment environment. As always, a strengthening dollar signals the need to stay invested in dollar-denominated quality assets.

Lula’s Speech in Salvador

Lula’s speech in Salvador inauguration of Aeronautic Institute, in defense of a big activist welfare state working in benefit of the people and against the reactionary elites.

“I don’t know if you noticed that, after listening to everyone speak, it would be unnecessary to make speeches here about the Aerospace Technological Park of Bahia. But I think this is the first time I visit Bahia in 2024. And I wanted to tell you that visiting the states of the Federation will be a routine for me from now on. Unlike Jerônimo, who inherited a well-planted farm, with prepared seeds, meaning fertilizer already placed in the soil, and he is in the first year only harvesting what has been planted over the years.

I inherited a country devastated by a locust plague that destroyed almost everything we had done in thirteen years of government. I don’t know if you noticed that we no longer had the Ministry of Culture, we no longer had the Ministry of Fisheries. We never had a Ministry for Indigenous Peoples.

We not only eliminated Ministries, but we also ended public policies. Just so you have an idea, Jerônimo, it had been almost 7 years since there was a raise in the school lunch for 47 million children in this country.

Luciana knows, Luciana knows that in just one year, she had to invest much more in Science and Technology, in scholarship payments, than had been done in the previous 4 years because practically any possibility of investment in this country had been destroyed.

And what worries me is that a country the size of Brazil, with the quality of the Brazilian people and the size of the Brazilian people’s dream, cannot live on lies. We cannot live on recklessness, we cannot live on provocations, we cannot live on fake news, as if it were a 24-hour lie industry in this country.

This country needs to give itself a chance. This country is too big to be treated as if it were a small country. This country has extraordinary potential, and we have proven that twice. This country could have been recognized as the fifth-largest economy in the world long ago. But there are many people in this country who insist on regressing.

What have they done to our Petrobras? The privatization of Eletrobras. The privatization of Eletrobras, people don’t like it to be mentioned, but it was a mockery in this country in a strategic sector like the energy sector.

I am indignant because just last night I had a meeting of almost two hours with comrade Haddad discussing the economic future of this country, the perspective of what is happening in the world. And I want to tell you that I am more optimistic today than I was during the campaign, Wagner. I am much more optimistic. Because I think that we, who have taken on the role of governing an important state like Bahia, an important municipality, or an important country, cannot say that things cannot be done; we cannot say that we cannot do things.

What we need is the courage to assume our role. This country will never be the country we want if we do not consider that we need to improve the quality of life of 80% of the Brazilian population, that we need to improve the minimum wage, that the poorest people need the right and opportunity to study and work. We want to create a society of middle-class standards.

I don’t want a society with someone sleeping on the street, in the gutter, with people begging for soup at the end of the week at the city hall door. This is not the country we want. The country we want is one where everyone has equal opportunities, a chance to study, a chance to work, and take care of their lives. And we will not build this country if we are not stubborn. If we kept discussing whether we could do things, we wouldn’t do them.

So I wanted to tell you that I came here to announce the launch of an Aerospace Technological Park, and it’s not just anything. It’s important to understand, my dear Deputy Pastor Isidório, with your famous bible in hand. It is necessary to understand that we were placed in the world to persist, not to accept anything as impossible. The only thing impossible in the world is God sinning; everything else we can do, and we can do a lot. And this PAC, Jerônimo, this PAC has to be executed.

You saw what happened in Rio de Janeiro with the flood. And when any flood happens, the first response is always from the Federal Government. And people always need the Federal Government, and the Federal Government has to help.

But analyzing what happened in Rio de Janeiro, we realized that since 2013, there are several contracted works to take care of hills and streams that were not used. Most of the works were not done. Many works are only 15%, 20% complete. Only R$ 1 billion out of R$ 1.6 billion was used, and of that one billion, no work was finished, none.

So it is important, Jerônimo, that you inherited this state. You inherited a state administered for 16 years by PT people, by a person of the quality of Wagner and Rui. And you are very clever because what I saw, you have already improved a lot there. From the first speech I saw you make to today, you have already advanced a lot. You have to do more than both of them. What they did is already in the past. You know, Bahia has already used it, Bahia has already enjoyed it, and now you have to have something new.

And that’s why this year is the year of harvest. Last year we dealt with, we took over a country almost destroyed, with thousands of paralyzed projects, from daycare to university. From daycare to school, from UBS to hospitals, all paralyzed. Stubbornly paralyzed because it was not part of the logic of the past government to make this country grow. We decided to make this country grow.

So last year, we planted. We took care of plowing the land, fertilized it, planted the seeds, covered the seeds, and now the weather is good. I know that in the Northeastern sowed land, the weather is not good. The drought is affecting our small and medium producers. I want to say right now not to worry because the Federal Government will help you get out of this predicament. You can bring a piece of the bill to us; we will be partners in the reconstruction of production capacity.

So, this year is a year when I will travel a lot around Brazil. I am leaving here, going to Recife, visiting the refinery that was paralyzed for 14 years. It could already be refining 260 thousand barrels of oil per day, but it isn’t. I am going there to finish that refinery.

After that, I will launch the ITA (Aeronautics Institute) in Ceará. And why ITA in Ceará? For those who don’t know, ITA is located in the city of São José dos Campos, in São Paulo. It is perhaps one of the most important technological institutes we have in Brazil. People educated at ITA, people who graduate from ITA, know. Everyone says, “I’m a graduate engineer from somewhere.” But the ITA guy says, “I’m an engineer graduated from ITA.” Because it is a center of excellence.

And why are we going to do it in Ceará, Jerônimo? Because in Ceará, 40% of the young people who take the entrance exam to go to ITA are from Ceará. So I think we need to pay tribute to the state of Ceará by taking a branch of ITA so that it becomes as great as São Paulo.

And we will travel a lot; we will travel this country. Rest assured, Jerônimo, that if there is the inauguration of a toothpick factory, invite me, because it is necessary to show that good things happen in this country.

Sometimes you sit in front of a television, you almost fall into depression because it seems that nothing good is happening in the country, nothing good is happening in Bahia, nothing good is happening anywhere, despite the work. I want to tell you that I have never worked so much in eight years of presidency as I have this year. Because rebuilding is more difficult than doing something new. And we will rebuild this country.

Dear Alice Portugal, rest assured that you will be proud to have been a deputy again in my term as President of the Republic. And we will make this country grow again. We will make this country generate employment. We will increase the minimum wage. We will improve basic education. We will improve high school education. We will create more universities. And we will create a hundred more federal institutes in this country.

Because I want to prove once again, I apologize to the Brazilian elite, forgive me if this hits close to home, but the Brazilian elite never intended to educate our people. I say this repeatedly. And I will tell you why. This country was discovered in 1500. Spanish America was discovered in 1498, eight years earlier. By 1554, Peru already had its first university. And our first university came in 1920, 420 years after the discovery.

And why did we have the first university called “Universidade Brasil”? It wasn’t because they were worried that Wagner would take an engineering course there. It was because the King of Belgium was coming here. And at that time, the king, to travel, had to receive an honorary doctorate. So they gathered various faculties that Brazil had and created a university.

And I want to know if you know of any country in the world that developed without first investing in education? When will we have a Silicon Valley here in Brazil? How is it possible that China, until recently, had a GDP smaller than Brazil’s? China was a very poor country. What was the revolution that happened in China? First, investment in education. The number of Chinese and engineering students worldwide is much higher than what we have studying here in Brazil.

Because education was never considered essential. I never forget that in the first ministerial meeting of 2003, a minister said there was no money to spend on education. I said, “Look, let’s prohibit the use of the word ‘expense’ in education.” Every time we talk about education, it’s an investment, and investment has an extraordinary return.

So, comrades, I want you to know that this year is the year of harvest. We will harvest many things that we planted. I will travel many times. I will come to Bahia many times. I can’t come during Carnival because during Carnival, I will work. Someone needs to work in Brazil, so I will work. I will work and cannot participate in Carnival.

But the concrete fact is this: I will have to take a trip on the night of the 13th. I am going to Egypt. And from Egypt, I will go to Ethiopia to participate in the African Union Congress because Brazil needs, once and for all, to start repaying the historical debt we have with the African people. Since Brazil is a poor country that cannot pay its debt in money, we pay in the transfer of knowledge, in the transfer of successful public policies, in the transfer of technology. That’s what I want to do because now we are in an exceptional moment.

I want you to pay attention to something that you can hold me accountable for from now on. This country has never had the opportunity to become a great nation as we have now. I will repeat: in 500 years, this country has never had the opportunity to become a great nation as it has now.

Brazil has done an extraordinary thing by recovering its international relations. Today I can tell you that Brazil is again an international protagonist. I can tell you that Brazil is respected in the world again. It’s important to remember that this year we will host the G20 in Brazil. Next year, we will hold it in the state of Pará. And then, next year, I will hold a BRICS meeting here in Brazil.

“And why does Brazil have a chance to grow? Because there’s this thing called, you know, Planet Earth being destroyed by human irresponsibility. In fact, humans are fantastic because they are so creative that they can self-destruct. So what’s the problem? The world needs to make a gigantic effort so that we reduce the possibility of global warming. Those who don’t believe in global warming need to notice the changes in weather conditions in various parts of the world. It’s raining a lot where it didn’t rain. It’s raining little where it always rained a lot. It’s flooding where it never flooded. It’s drying up where it never dried up. Even worldwide, fires in places that were not prone to fires. And all of this is due to global warming. Have you noticed the heat we are experiencing? We have experienced periods where this heat in Brazil was the strongest in the last 100 years. In Europe, the heat reached 40 degrees.

And Brazil has the greatest potential in the world to help solve this problem with so-called renewable energy. This country already has 87% of its electrical energy renewable. No other country in the world has this; we do. But this country has ethanol; this country can have biodiesel; this country can have biomass. This country can produce a thousand types of fuels that other countries cannot.

Furthermore, this country is going to be the largest producer of green hydrogen in the world. And we don’t want to produce hydrogen just to sell. We want to be the major hydrogen producer so that industries come to produce their green products here in Brazil. If we want to reduce emissions and the aggravation of the greenhouse effect, Brazil is a chance. And then there’s the issue of the African continent, which is also an extraordinary opportunity.

That’s why we are very, very interested in discussing this issue of the ecological transition of this country, the climate transition of this country, the energy transition. It’s an opportunity, it’s an opportunity that God is giving us. So, friends, it’s an extraordinary chance.

I know that you are investing a lot in the potential of green hydrogen. I know that other states are investing. Piauí is investing, Ceará is investing, Rio Grande do Norte is investing. And when I talk about Brazil, I’m talking about the Brazilian Northeast as well. It’s a great opportunity in the Northeast. I think that since the Portuguese crown arrived here in Brazil, or since Brazil was discovered, possibly the Northeast has in this half of the 21st century, listen, governor, the chance to have the development potential equal to any state in the country.

The Northeast cannot accept that it was born to be seen by the world as the place with the highest infant mortality, the highest illiteracy, the highest school dropout, the most people receiving Bolsa Família, the most people dying of malnutrition. It’s not the Northeast we want to create, people. It’s not that Northeast. I can tell you from life experience that it costs very little, very little, to invest in the poor of this country and invest in improving their lives.

When we improve people’s lives, you know what will happen? There will be less robbery, less violence. Did you see, Rui, yesterday there was a crime spree in Rio de Janeiro at 3 o’clock in the afternoon? These phenomena that are happening, this abuse of organized crime, this growth of all this, I can say that there are a thousand cases, but the main one is the absence of the Brazilian state in not taking care of people at the right time.

And the right time starts with elementary education. Elementary education has to be a priority. If the child is well educated in the early years, that child will thrive and grow. If they are not well educated, they will have a genetic defect, they will have a defect of origin, and they will not be able to progress.

And you can help build this country. Rui believes a lot in this PPP thing. Let’s see if we can do it in Brazil. Let’s see if we can do it in Brazil, make this country take a leap in quality. Who takes pleasure in seeing people starving on the street? Who takes pleasure in seeing children begging on the street? Who takes pleasure in seeing women with children lying on a sidewalk? And often we pass by and even turn away because it’s ugly? Who is to blame for this? Is it the president? Is it the governor? Is it the mayor? No. It’s us. It’s us, the Brazilian society, who need to raise our heads and take care of this country because it is our responsibility. And may Bahia serve as an example for many things that I will do from now on in this country.

Congratulations to the Aeronautics, congratulations to the Governor, because now you will have an Aerospace Technological Park in Bahia. The name is so beautiful that Jerônimo couldn’t even say it right, “Technological Park.”

And this is what will happen all over Brazil. Get ready, folks, get ready, because I want to have. I have three years in office, and in these three years, I want to dedicate so that you still live in a country where people smile again. Don’t be afraid of violence, don’t sleep on the street, don’t beg for alms.

And then, Wagner, I see you there, we are going to create a special policy for the elderly. This is something that we are going to create. This is something that we are going to create a working group to think carefully because Brazil is becoming an old country. Brazil is having an old population. And not everyone is fortunate enough to be a strong old person like me, like Otto, like Wagner, like José Mucio. Not everyone has a young person at 78 looking like they’re 30.

But I am concerned about creating a working group to present to Brazil a proposal for special attention to people who are getting old and who have no one to take care of them. This is a problem that will arise. So, we have to take care of the child, the teenager. I don’t know if you saw this week, we approved the law, the law was sanctioned that every young person going to high school has a savings account. He will receive, you know, R$ 200 reais per month deposited in a savings account for him. And if he manages to graduate, he can only withdraw the total when he graduates; he can take a little bit during the study. Because the highest school dropout is in high school.

The boys can’t complete the entire course, or they don’t like to do it, or we can’t motivate them. So, we are trying to see if with the scholarship, we can motivate these boys to finish their technical courses, learning a profession. If not, we won’t take a leap in quality.

That’s why, Jerônimo, I’m here happy. I didn’t know it was Rui Costa’s birthday party because if I had known, I would have done it in Brasília last night, but I didn’t know. I want to tell you that I will come here to Bahia other times. This is a state that I have a relationship of love, a very affectionate relationship, not only for the people in this fight but because Bahia represents a lot for this country.

So, comrades from Bahia, I won’t say ‘long live Bahia’ because here I know that the governor cheers for Vitória. I also want to say that I didn’t know about the attachment of the people to Bahia. I also cheer for Vitória. Solidarity. We’re back to Serie A with the goal of being champions this year.

A kiss in the heart, a kiss to all of you, and until our next visit to Bahia. Have a good carnival!”

Argentina’s Milei at Davos

 

Nice speech by Argentina’s Milei at Davos. Not sure how any of this works in practice, but surely refreshing after 40 years of socialism in Latin America.

Good afternoon, thank you very much. Today I am here to tell you that the West is in danger. It is in danger because those who are supposed to defend Western values are co-opted by a worldview that inexorably leads to socialism and, consequently, to poverty.

Unfortunately, in recent decades, motivated by well-intentioned desires to help others and by the ambition to belong to a privileged caste, the main leaders of the Western world have abandoned the model of freedom for various versions of what we call collectivism.

We are here to tell you that collectivist experiments are never the solution to the problems affecting the citizens of the world; on the contrary, they are the cause. Believe me, no one better than us Argentinians can testify to these two issues.

When we adopted the freedom model around 1860, in 35 years, we became the world’s leading power. However, when we embraced collectivism over the last 100 years, we saw our citizens systematically becoming impoverished, falling to the 140th position globally. But before we can have this discussion, it’s important to look at the data that supports why not only is free-market capitalism a possible system to end world poverty, but it is the only morally desirable system to achieve it.

If we consider the history of economic progress, we can see that from year zero until around 1800, the world’s per capita GDP remained virtually constant throughout the reference period.

If one looks at a graph of economic growth throughout human history, it would resemble an exponential curve, remaining constant for 90% of the time and sharply rising from the 19th century onwards. The only exception to this stagnation occurred in the late 15th century with the discovery of America.

But aside from this exception, between the year zero and 1800, global per capita GDP remained stagnant.

Now, not only did capitalism generate an explosion of wealth since it was adopted as an economic system, but if you analyze the data, you’ll see that growth has been accelerating throughout the entire period.

During the period from 1800 to 1900, the per capita GDP growth rate remained stable at around 0.02 percent annually, almost no growth. From the 19th century with the industrial revolution, the growth rate increased to 0.66 percent. At that rate, it would take 107 years to double per capita GDP.

Now, if we look at the period between 1900 and 1950, the growth rate accelerates to 1.66 percent annually. We no longer need 107 years to double per capita GDP, but 66. And if we take the period from 1950 to the year 2000, we see that the growth rate was 2.1 percent annually, meaning we could double our per capita GDP in just 33 years. This trend, far from stopping, remains alive even today. If we take the period from 2000 to 2023, the growth rate accelerated to 3 percent annually, implying that we could double our per capita GDP in the world in just 23 years.

Now, when studying per capita GDP from 1800 to today, it is observed that, after the industrial revolution, the world’s per capita GDP multiplied by more than 15 times, generating an explosion of wealth that lifted 90 percent of the world’s population out of extreme poverty.

We must never forget that, by the year 1800, about 95 percent of the world’s population lived in extreme poverty; while that number dropped to 5 percent by the year 2020, before the pandemic.

The obvious conclusion is that, far from being the cause of our problems, free-market capitalism, as an economic system, is the only tool we have to end hunger, poverty, and destitution worldwide. The empirical evidence is unquestionable. Therefore, as there is no doubt that free-market capitalism is superior in productive terms, the left-wing doxa has attacked capitalism for its alleged moral shortcomings, claiming it is unjust.

They say that capitalism is bad because it is individualistic, and that collectivism is good because it is altruistic, advocating for “social justice.” But this concept, which has become fashionable in the first world in the last decade, has been a constant in the political discourse in my country for more than 80 years.

The problem is that social justice is not only unjust but also does not contribute to the general well-being. Quite the opposite, it is inherently unjust because it is violent. It is unjust because the state is funded through taxes, and taxes are collected coercively. Can any of us choose not to pay taxes? This means that the state is funded through coercion, and with a higher tax burden, there is more coercion and less freedom.

Those who promote social justice start from the idea that the economy is a pie that can be distributed differently. However, that pie is not given; it is wealth generated in what Kirzner calls a discovery process. If a product is of good quality at an attractive price, it will do well and produce more. Thus, the market is a discovery process in which the capitalist finds the right path on the go.

But if the state punishes the capitalist for being successful and hinders this discovery process, destroys incentives, the consequence is that less will be produced, and the “pie” will be smaller, causing harm to society as a whole.

Collectivism, by inhibiting these discovery processes and hindering the appropriation of what is discovered, ties the hands of the entrepreneur and makes it impossible to produce better goods and offer better services at a better price.

So how is it possible that from academia, international organizations, politics, and economic theory, an economic system that not only lifted 90% of the world’s population out of extreme poverty but does so increasingly faster is demonized, claiming it to be unjust?

Thanks to free-market capitalism, the world is currently in its best moment. There has never been, in the entire history of humanity, a time of greater prosperity than what we live in today.

Today’s world is freer, richer, more peaceful, and more prosperous than at any other time in our history. This is true for everyone but particularly true for those countries that are more free, respect economic freedom, and the property rights of individuals. Because those countries that are more free are eight times richer than the repressed ones; the lowest decile of the distribution of free countries lives better than 90% of the population of repressed countries, has 25 times fewer poor people in the standard format, and 50 times fewer in the extreme format. And as if that were not enough, citizens of free countries live 25% longer than citizens of repressed countries.

Now, to understand what we come to defend, it is important to define what we mean when we talk about libertarianism.

To define it, I take the words of the greatest proponent of freedom in our country, Alberto Benegas Lynch (h), who says: “Libertarianism is the unrestricted respect for the life project of others, based on the principle of non-aggression, in defense of life, liberty, and property of individuals. Its fundamental institutions are private property, free markets free from state intervention, free competition, the division of labor, and social cooperation. Where one can only be successful by serving others with better quality or better-priced goods.”

In other words, the capitalist is a social benefactor who, far from appropriating others’ wealth, contributes to the general well-being. Ultimately, a successful entrepreneur is a hero.

This is the model that we are proposing for the future of Argentina. A model based on the fundamental principles of libertarianism: the defense of life, liberty, and property.

Now, if free-market capitalism and economic freedom have been extraordinary tools to end poverty in the world, and we are currently in the best moment in human history, why do I say that the West is in danger?

I say that the West is in danger precisely because in those countries that should defend the values of the free market, private property, and other libertarian institutions, sectors of the political and economic establishment, some due to errors in their theoretical framework and others due to the ambition for power, are undermining the foundations of libertarianism, opening the doors to socialism, and potentially condemning us to poverty, misery, and stagnation.

Because it must never be forgotten that socialism is always and everywhere an impoverishing phenomenon that failed in all countries where it was attempted. It was a failure economically. It was a failure socially. It was a failure culturally. And it also killed more than 100 million human beings.

The essential problem of the West today is that we must not only confront those who, even after the fall of the wall and overwhelming empirical evidence, continue to advocate for impoverishing socialism, but also our own leaders, thinkers, and academics who, sheltered in a mistaken theoretical framework, undermine the foundations of the system that has given us the most spectacular expansion of wealth and prosperity in our history.

The theoretical framework I refer to is that of neoclassical economic theory, which designs an instrumental that, unintentionally, ends up being functional to state intervention, socialism, and the degradation of society. The problem with neoclassicals is that, as the model they fell in love with does not map to reality, they attribute the error to supposed market failures instead of reviewing the premises of their model.

Under the pretext of a supposed market failure, regulations are introduced that only generate distortions in the price system, hinder economic calculation, and consequently, savings, investment, and growth.

This problem essentially lies in the fact that not even supposedly libertarian economists understand what the market is, because if it were understood, it would quickly be seen that there is no such thing as market failures. The market is not a supply and demand curve on a graph. The market is a mechanism of social cooperation where exchanges occur voluntarily. Therefore, given that definition, market failure is an oxymoron. There is no market failure. If transactions are voluntary, the only context in which there can be market failure is if there is coercion. And the only one with the ability to coerce on a large scale is the state that has a monopoly on violence. Consequently, if someone believes that there is a market failure, I would recommend that they check if there is state intervention in the middle. And if they find that there is no state intervention in the middle, I suggest they analyze it again because it is definitely wrong. Market failures do not exist.

An example of the supposed market failures described by neoclassicals is concentrated structures in the economy. However, without functions that exhibit increasing returns to scale, whose counterpart is the concentrated structures of the economy, we could not explain economic growth from 1800 to today.

Notice how interesting. From 1800 onwards, with the population multiplying more than 8 or 9 times, per capita product grew more than 15 times. There are increasing returns, which led extreme poverty from 95% to 5%. However, the presence of increasing returns implies concentrated structures, what would be called a monopoly. How can something that has generated so much well-being for neoclassical theory be a market failure? Neoclassical economists, think outside the box. When the model fails, don’t get angry with reality, get angry with the model and change it.

The dilemma facing the neoclassical model is that they claim to want to improve the functioning of the market by attacking what they consider failures, but by doing so, they not only open the doors to socialism but also undermine economic growth. For example, regulating monopolies, destroying their profits, and smashing increasing returns would automatically destroy economic growth.

In other words, every time you want to correct a supposed market failure, inevitably, due to not understanding what the market is or falling in love with a failed model, you are opening the doors to socialism and condemning people to poverty.

However, in the face of the theoretical demonstration that state intervention is harmful and the empirical evidence that it failed – because it could not be otherwise – the solution that collectivists will propose is not more freedom but more regulation, generating a downward spiral of regulations until we are all poorer, and everyone’s life depends on a bureaucrat sitting in a luxury office.

Given the resounding failure of collectivist models and the undeniable advances of the free world, socialists were forced to change their agenda. They abandoned the class struggle based on the economic system to replace it with other supposed social conflicts equally harmful to community life and economic growth. The first of these new battles was the ridiculous and unnatural fight between man and woman.

Libertarianism already establishes equality between the sexes. The foundational stone of our creed says that all are created equal, that we all have the same unalienable rights granted by the creator, among which are life, liberty, and property.

The only result of this radical feminist agenda is increased state intervention to hinder the economic process, providing jobs for bureaucrats who contribute nothing to society, whether in the form of women’s ministries or international organizations dedicated to promoting this agenda.

Another conflict that socialists pose is that of man against nature. They argue that humans harm the planet and that it must be protected at all costs, even advocating for population control mechanisms or the bloody agenda of abortion.

Unfortunately, these harmful ideas have strongly permeated our society. Neo-Marxists have managed to co-opt the common sense of the West. They achieved this thanks to the appropriation of the media, culture, universities, and yes, also international organizations.

Fortunately, more and more of us dare to speak out. Because we see that if we do not confront these ideas head-on, the only possible destiny is more state, more regulation, more socialism, more poverty, less freedom, and consequently, a worse quality of life.

The West, unfortunately, has already begun to travel this path. I know it may sound ridiculous to suggest that the West has turned to socialism. But it is only ridiculous to the extent that one restricts oneself to the traditional economic definition of socialism, which establishes that it is an economic system where the state owns the means of production.

This definition should be updated to present circumstances. Today, states do not need to directly control the means of production to control every aspect of individuals’ lives. With tools like monetary issuance, debt, subsidies, interest rate control, price controls, and regulations to correct supposed “market failures,” they can control the destinies of millions of human beings.

This is how we reach the point where, under different names or forms, a good part of the generally accepted political offers in most Western countries are collectivist variants. Whether openly declaring themselves communist, socialist, social-democrats, Christian democrats, neo-Keynesians, progressives, populists, nationalists, or globalists. In essence, there are no substantive differences: all argue that the state must direct all aspects of individuals’ lives. All defend a model contrary to what led humanity to the most spectacular progress in its history.

We come here today to invite other Western countries to return to the path of prosperity. Economic freedom, limited government, and unrestricted respect for private property are essential elements for economic growth.

This phenomenon of impoverishment produced by collectivism is not a fantasy. Nor is it fatalism. It is a reality that Argentinians know very well. Because we have already lived through it. Because, as I said before, since we decided to abandon the model of freedom that had made us rich, we have been trapped in a downward spiral where every day we become poorer.

We have already experienced it. And we are here to warn you about what can happen if Western countries that became rich with the model of freedom continue on this path of servitude.

The Argentine case is the empirical demonstration that no matter how rich you are, how many natural resources you have, no matter how capable the population is, how educated it is, or how many gold bars are in the central bank’s vaults. If measures are adopted that hinder the free functioning of markets, free competition, free price systems, if trade is hindered, if private property is attacked, the only possible destiny is poverty.

In conclusion, I want to leave a message to all the entrepreneurs present here and those watching from every corner of the planet. Do not be intimidated by the political caste or the parasites living off the state. Do not surrender to a political class that only wants to perpetuate itself in power and maintain its privileges.

You are social benefactors. You are heroes. You are the creators of the most extraordinary period of prosperity we have ever experienced. Let no one tell you that your ambition is immoral. If you make money, it is because you offer a better product at a better price, contributing to the general well-being.

Do not yield to the advance of the state. The state is not the solution. The state is the problem itself. You are the true protagonists of this story, and know that from today, you have an unwavering ally in the Argentine Republic.

Thank you very much, and Long live freedom!

Why Did Korea Get Rich While Brazil Stagnated?

South Korea and Brazil followed similar development paths until the mid-1980s. Then, they separated, with South Korea progressing into the club of rich nations while Brazil languished in the “Middle-Income Trap.” South Korea took the arduous path of moving up value chains and conquering global markets for manufacturing exports; Brazil deindustrialized and reverted to its historic dependence on commodities.

Looking back to distant history, both South Korea and Brazil were regional laggards. Korea trailed Japan and Taiwan on the path to industrialization; Brazil fell behind its Southern Cone neighbors, Argentina, Chile, and Uruguay. Korea suffered the collapse of the Joseon Dynasty (1897), Japanese colonization (1910-1945), and a catastrophic civil war (1950-1953), entering the 1960s as one of the poorest nations in the world. Brazil meandered until the 1920s, destabilized by the abolition of slavery (1888) and the collapse of the Empire (1889).

The two charts below show the evolution of GDP per capita for Korea and Brazil relative to that of the United Kingdom, which was the first country to industrialize in the 19th century. Korea is compared to its regional peers—Japan, Taiwan, and Singapore; and Brazil is compared to other “Western Offshoots,” countries closely integrated financially and commercially with the North Atlantic countries leading the process of industrialization (Argentina, New Zealand, Australia, and Chile). In the East, Japan led the way, followed by Singapore and Taiwan. Korea only took off in the 1960s, some 80 years after Japan. For the Western Offshoots, Australia and New Zealand had fully converged with the UK by 1900, and, until the 1920s, Argentina and Chile were close behind. Brazil, set back by political instability and the legacy of slavery, lagged far behind until its take-off in the 1950s, and then caught up with its floundering Latin American neighbors.

The following chart shows GDP per capita (in 2011 USD) for Brazil and Korea over the past century. The two countries followed similar paths until Brazil distanced itself during its “economic miracle” (1950-1979). Korea took off in the 1960s, passed ahead of Brazil in 1982, and then left Brazil far behind during the culmination of the “Miracle on the Han River.”

The following chart shows more recent GDP per capita data, including IMF forecasts through 2028, at which time Korea’s GDP per capita is expected to be 3.1 times Brazil’s. This period for Brazil includes two lost decades (the 1980s and 2010s). Korea recovered quickly from two stumbles—the Asian Financial Crisis (1997) and the Great Financial Crisis (2008).

Over this period (1980-2023), Brazil became the “poster child” for the “Middle-Income Trap.” The Latin American Debt Crisis (1982) and the fall of the military dictatorship (1964-1985) enabled the rise of the socialist left and resulted in the passage of an illiberal and statist “welfare” constitution (1988) that severely debilitated public finances and dramatically increased the political and financial power of rural states at the expense of urbanized industrial states. The new constitution led to rising public sector spending, fiscal incontinence, and a sharp reduction of the capacity of the state to invest in public goods. While government revenues as a percentage of GDP rose from the mid-20s in the 1980s to the low 40s over the past decade, deficits have been chronic, and the capacity of the public sector to invest has fallen to near zero. As shown in the charts below, the contrast with Korea is shocking. The Korean public sector operates with half the revenue of Brazil yet achieves consistent fiscal surpluses and is able to deliver world-class public goods (infrastructure, education, healthcare, and support for cultural institutions).

The collapse in the state’s ability to invest in public goods can be seen in the deterioration of infrastructure and education and human capital. The next charts show the World Bank’s rankings for infrastructure and logistics, the OECD’s rankings for education assessment, and the World Bank’s Human Capital Index. In all these measures, Korea ranks near the top while Brazil does poorly even compared to emerging market peers.

In 1982, the year that Korea passed Brazil in terms of GDP per capita, the two countries were at similar levels of industrialization, with Brazil having a small edge. Both countries, relying on similar models of industrial policy, forced savings, and directed lending, had dominated basic industries (steel, petrochemicals, cement, etc…) and mass manufacturing (autos, appliances, etc…) and had made important strides in the production of capital goods. As the following table shows, a decade later, the situation had changed dramatically. Brazil experienced a significant reduction in its manufacturing value-added to GDP ratio between 1984 and 1994. This period coincides with the passage of the new illiberal constitution in Brazil, economic volatility and hyperinflation, and a widespread belief that the industrial policies and protectionism supported by the military regime had engendered inefficient and coddled oligopolies.

Starting in the early 1980s, the world entered a period of trade hyper-globalization underpinned by the Reagan-Thatcher Neoliberal “Revolution and the “Washington Consensus” for the liberalization of trade and financial flows. Unfortunately, Brazil, unlike Korea, was poorly positioned to benefit from the trend towards open markets. Brazil, in fact, was a primary loser of globalization. If one agrees that a key measure of economic development is the complexity of a country’s exports—the premise of the Economic Complexity Index (ECI) compiled by Harvard’s Growth Lab—then globalization has been a catastrophe for Brazil and a huge boon for Korea. The chart below shows the evolution of the ECI since 1995. While Korea and Brazil were at similar levels of ECI in 1995, by 2020 Korea has moved to the top 5 while Brazil had plummeted. Over this period, Korea became a leading exporter of advanced technologies (semiconductors, digital displays, electric batteries, etc…) while Brazil returned to being almost exclusively an exporter of commodities (Embraer’s regional jets being an exception).

The success of Korea, as well as all the Asian Tiger economies, has been based on capturing export markets for manufacturing goods. Foreign markets have been instrumental in providing both scale and discipline to domestic firms. As shown in the chart below, by 1985 Korea, with an economy less than half the size, already exported more than Brazil.

The accelerated rise of China in the 1990s presented a momentous threat to Korea, which found itself caught in a “sandwich” between advanced economies that dominate the high-end market and Chinese manufacturers that were quickly catching up.

Over the next crucial decade, Korean firms successfully moved up into frontier technologies while Brazil turned away from manufacturing, as shown in the next chart. While both Brazil and Korea have increased their exports to GDP ratio since the 1980s, for Brazil, all the increase has come from commodities, while for Korea, most of the increase has come from manufactured goods.

The deindustrialization of Brazil has had enormous and probably irreversible consequences for labor productivity and consumption. Highly productive and well-remunerated jobs in manufacturing and industry have been replaced by service jobs with low productivity, providing little training. As shown below, though productivity growth in Brazil had been in line with Korea’s, it collapsed in the 1980s and has been near zero over the past decade.

Manufacturing jobs and the training they provide created the middle-class consumer in Brazil. Without the expansion of the middle class, Brazil is now unable to grow as a consumer market unless state welfare handouts increase. We can see this in the inequality data collected by the World Bank and The World Inequality database shown below. Over the past 40 years, Korea has incorporated nearly the entirety of its population into the middle class (measured at annual GDP per capita of over $10,000 in 2015 USD) while Brazil’s middle class still is almost wholly concentrated in the top income decile of the population. This means Korea, with a quarter of Brazil’s population, has more “consumers” than Brazil and grows consumption at a faster pace.

While Brazil missed the boat on trade globalization, it did embrace the opening of financial flows. Unlike Korea, which has maintained capital controls, Brazil abandoned them in 1990, subjecting itself fully to the vicissitudes of “hot money” flows. The concurrent deindustrialization and financialization of the Brazilian economy led to generations of engineering graduates migrating from industry to financial engineering, while in Korea, they continue to build things. In a generation, Sao Paulo has repositioned itself from an industrial powerhouse to a city centered around the “Faria-Lima” financial casino.

Brazil’s economy has returned to a level of dependence on commodities last experienced in the early 1950s. There have been two major drivers of this process. First, while since the 1980s state support for industry has disappeared, support for agriculture has been consistently abundant. Ironically, while Brazil abandoned the East Asia-like state incentives for industry it had under the military regime (subsidies, directed credit, and market protection) for farm commodities, these kinds of policies continue to be embraced by Brasilia, in part because of the increased political clout given to farm states by the 1988 Constitution. Moreover, like in the case of Asian Tigers, state support is now being directed to a sector that is extremely competitive and export oriented. However, unlike Asian manufacturing exports, the commodity sector has low economic complexity and value added and provides few jobs.

The second driver was the discovery of enormous pre-salt offshore oil fields (2005) which have eliminated Brazil’s historical dependency on oil imports. Oil production and exports are expected to ramp up over the next decade providing structural support for the current account and the currency. As in the case of farm commodities, the oil sector is capital intensive and generates few jobs.

Both these commodities have volatile prices that cause economic and currency instability and other ills. The “Commodity Curse” and “Dutch Disease” are terms coined by economists to describe the malign influence commodity dependence has on institutions (law and order, corruption, etc…) and other drivers of growth.

Dependence on commodities creates a vicious cycle of deindustrialization through currency volatility. Manufacturing exporters like Korea manage their currencies to preserve competitiveness. Brazil with its exposure to hot money flows and commodity prices is a volatility machine which makes life impossible for exporters of manufacturing goods. We see this in the chart below. While Brazil’s currency is a roller coaster, soaring and diving in function of commodity prices and hot money flows, the Korean won is managed for stability and competitiveness.

Conclusion – What will the future bring?

Brazil missed the boat on the trade globalization of the past 40 years while Korea was a primary beneficiary. However, the world is now changing, as protectionism and industrial policy cycle back into favor.

Korea’s “sandwich” problem has not gone away, and its reliance on foreign markets may now be a liability. Moreover, Korea faces a severe demographic problem with the prospect of a declining population and workforce for decades to come. Regional geopolitical tensions may also be highly destabilizing. On the positive side, Korean society is highly homogeneous, collective, and collaborative and has proven highly adaptive to change.

Demography is a lesser issue for Brazil, though its “demographic dividend” of the past decades will become a drag in the coming years. Deglobalization and the newfound popularity of industrial policy may provide an opportunity for productive investment. On the negative side, Brazil’s highly heterogeneous population, a total lack of collective and collaborative spirit, and fractured politics do not promise an easy turnaround.

 

The Energy Transition in Emerging Markets. Part 2

 

Assuming current trends, the global annual growth rate of consumption of primary energy will nearly double this coming decade to 1.9%, compared to 1% over the past decade. This is solely because the slow-growing economies of the OECD, with high levels of per capita energy consumption but stagnant or declining growth in demand, are being supplanted by higher-growing emerging economies with very low per capita consumption levels.

A similar scenario can be painted for the growth of oil liquids oil and gas consumption. Since 2013, the emerging world, led by China and India, has consumed more oil and gas than the OECD countries. As shown in the chart below based on data from the Energy Institute Statistical Review, in 2022, non-OECD economies consumed 53% of global oil and gas production. Based on current trends,  this will reach nearly 60% over the next decade. Total demand for oil liquids can be expected to grow by 12 million barrels/day over the next decade to 112.5 million b/d. All of this increase will come from non-OECD economies, led by India, China, and Africa.

 

The transition to new forms of energy has always been slow and arduous, with the innovative fuel taking share by capturing marginal demand increases. We can see this in the chart below from Our World In Data. In all these transitions, the early adopters were the richest countries. Important transition fuels like hydropower and nuclear have stagnated because of high costs of adoption and political barriers. The same is happening today with coal and oil demand continuing to rise in developing countries where renewables are a costly alternative compared to coal and oil.

The scenario for coal consumption is worrisome, if CO2 emissions are the concern. Non-OECD countries already represent 82% of coal consumption. For leading consumers, China, India, and Indonesia, coal is by far the most abundant and cheapest fuel for generating electricity, and annual consumption is expected to continue growing at the trend of the past decade, 0.9%, 4%, and 9%, respectively.

The transition to green fuels in emerging countries is made difficult by the political commitment to industrialization. While in developed countries, about a third of primary energy consumption is committed to electricity generation and more room exists to substitute electricity for transportation and residential purposes, in Asia and the Middle-East, industry, much of it fueled by oil liquids, makes up half of primary demand. For example, India, following the path of China and the petro-states of the Middle-East, is becoming a major global player in petrochemicals, using Russian and Persian Gulf feedstocks.

The difficulty of reducing CO2 emissions to address concerns with global warming can be illustrated by the example of the United States. Despite conservation efforts and the deployment of wind and solar, the consumption of liquid hydrocarbons has grown its share of U.S. primary energy consumption over the past decade and is at the same level as in 1980. This is because gas has replaced coal for generating electricity. In terms of “clean” energies, nuclear output has been frozen since the mid-1990s while renewables have doubled their share to 13.5% since 2000. This evolution is shown in the chart below.

The exceptionally low cost of gas in the US and the low cost of capital, particularly over the past 15 years, has enabled a relatively smooth and affordable transition to cleaner fuels. Unfortunately, other countries don’t have this luxury. Except for France, which has embraced nuclear, in Europe, the transition is proving exceedingly costly and further undermining competitiveness. After decades of complacency, the cost of “green” politics has now become a big political issue in Germany.

Though China is highly committed to nuclear, it generates only 3% of its energy demand from this source. Also, despite massive political support for renewables, it meets only 13% of its demand from solar and wind, about the same as the US.

Other emerging markets do not have the financial or organizational capacity to follow China’s path because of much higher capital costs and the lack of local suppliers. These countries will find the transition to renewables prohibitively expensive unless prices for solar generation fall much further or the rich countries of the world hand out massive subsidies.

 

The Energy Transition in Emerging Markets, Part 1

That economic activity is transformed energy is a truism. Technological innovations, allowing the harnessing of wind, water, coal, oil, nuclear, and solar power, were the driving force behind the Industrial Revolution since the 18th century. Yet, because of environmental concerns, energy consumption growth has slowed, and political pressures are increasing to radically reduce the consumption of hydrocarbons, which are still by far the primary source of fuel.

The two charts below show the dramatic slowdown in global energy consumption growth, based on data from the Energy Institute Statistical Review of World Energy  (link). This decline has been partially voluntary to the extent that conservation policies and higher energy taxes since the 1970s have incentivized lower consumption. In effect, many “rich” countries have chosen to explicitly recognize the economic externalities related to hydrocarbon consumption (pollution, climate change), even if with some hypocrisy to the extent that polluting industries have simply moved offshore (e.g., petrochemicals to China and the Middle-East). Also, lower consumption growth resulted from the Great Financial Crisis (2007-08) and the decade-long period of sub-par growth that it engendered. Consumption growth in the OECD has been negative since the 2000 recession. This is the first time in 200 years that this has happened for such a long period of time and certainly has contributed to declines in productivity and GDP growth.

As primary energy consumption growth has stalled in rich countries, developing countries have taken up some of the slack, as shown in the following chart from the FT.

In addition to China and India, rapidly growing developing countries in South Asia and Africa representing about 30% of the world population also continue to grow energy consumption quickly. These countries all have per capita consumption levels well below the level of the OECD countries and the US, and their future growth and welfare are tied to increased energy consumption to raise living standards and acquire the basic comforts of modern life.

The Non-OECD countries consume about a third as much energy per capita as the OECD countries and 17% of the energy consumed by Americans, as shown in the following chart. Indians consume 15% and 9% of the per capita energy consumed in the OECD and the US, respectively. Africans consume less than 3% and 2% of the per capita consumption in the OECD and the US.

The negative impact on the growth of world energy consumption caused by stagnation in the OECD is losing strength for the simple reason that the OECD’s share of total consumption is rapidly declining, as we can see in the next chart. When consumption growth stalled in OECD countries some twenty years ago, the OECD had 60% of world consumption, but that has now fallen to 39%.

If we assume that the growth trends of the past decade persist for the next ten years, then world primary energy consumption annual growth would increase from 1.1% to 1.9%, and the Non-OECD share of total consumption will rise from 61% to 65%. As shown in the chart below, under this scenario, total primary energy consumption would rise a further 20% over the next ten years.

In a world facing increasing risks from global warming, ideally, this increased consumption will be met by “clean” energies, but so far only Europe seems committed to this goal. Both China and India remain wedded to coal, nuclear remains generally taboo, and most countries face political opposition to the high cost of transitioning to solar and wind.”

In the following blog, we will explore the role of hydrocarbons in the ongoing transition to clean energy.

 

 

Convergers and Laggards in Emering Markets

 

Recent decades have brought impressive gains in prosperity for many developing countries. By attracting investment and opening up to the world, many countries have been able to grow more quickly than rich countries that operate at the technological frontier. However, this process of growth has not benefited all countries. Worse, many poor countries have fallen behind, becoming relatively poorer.

Convergers in emerging markets can broadly be separated into two categories: first, countries attracting foreign direct investment and participating in the globalization of trade; second, countries starting from a very low base and achieving high growth because of successful economic reforms leading to increases in productivity. Highly successful convergers (e.g., China, Vietnam) have benefited both by launching economic reforms and by integrating into the global economy.

The chart below shows increases in GDP per capita, measured in 2015 constant USD, for the 1995-2022 period, as calculated by the World Bank. 1995 is used as a starting point because this is when the World Bank starts showing data for “Eastern Bloc” countries. We can see in the chart that the U.S., with GDP per capita growth of 50% over this period, is near the middle, so about half the countries in the sample “converged” by growing more than the U.S. benchmark, and about half fell behind. About 20% of the sample, typically countries undergoing revolutions, wars, or environmental disasters, had zero to negative growth. The chart highlights China and Vietnam as star convergers, Brazil as a laggard, and Zimbabwe as a country suffering a severe institutional breakdown.

Convergers

Northeast Asia, Southeast Asia and Eastern Europe have been the major beneficiaries of capital flows and trade liberalization and have all experienced GDP per capita growth well in excess of the United States. We show this in the charts below for the 1986-2022 period using data from the World Bank. 1986 is a convenient starting point as it marks the initiation of MSCI’s Emerging Markets Index and, approximately, the beginning of globalization and financialization of the world under the “Washington Consensus.” For Eastern Europe, the World Bank data is available only starting in 1995.

The Asian “Tigers” have all followed similar mercantilistic policies, subsidizing exports through subsidies and repressing domestic demand and wages to support competitiveness. All of them have benefited greatly from U.S. policy support and easy access to the U.S. consumer market. This U.S. support of China has been significantly reduced since 2019 when China was determined to be a strategic adversary, which raises serious doubts about future convergence. (Data for Taiwan is not included because the World Bank neglects to include the country in its database)

 

The chart below shows the growth of GDP per capita for the major economies in South-East Asia plus India. The countries in this region, with the exception of India and the Philippines, have largely followed the same policies as the East-Asia “Tigers,” including direct and indirect subsidies for exports and foreign direct investment (FDI), especially after the hard-earned lessons of the 1997 Asian Financial Crisis. These countries have all achieved significant convergence. The Philippines has traditionally been a more concentrated, financialized, and volatile economy with less attractiveness for FDI and less support for exports, but in recent years, it has improved its performance and also achieved some convergence. India has experienced strong growth since economic reforms in the 1980s and is starting to attract more FDI, even though its growth is driven more by infrastructure spending and rural support than by manufacturing. India, benefiting from a starting point of exceptionally low GDP per capita, has rapidly converged over this period. Pakistan’s efforts to grow by attracting FDI into manufacturing export industries have been undermined by political instability, but still, it has achieved some convergence.

The following chart shows the countries of Eastern Europe. These countries have all benefited from the collapse of the Eastern Bloc, which freed them to promote private investment and integration into western Europe. Greatly helped by support from the European Union, they have become manufacturing centers for global corporations, taking advantage of low wages to access the European market. All of these countries have experienced significant convergence relative to both the U.S. and the Euro Area since 1995.

Middle-East and Africa (EMEA)

The EMEA region is a motley group, including both rapid convergers and laggards. Turkey, which is more like an Eastern European country in its success in attracting FDI and exporting to the European market, leads thisregion in convergence. In the Middle East, Egypt has converged, starting from a very low level of GDP per capita and benefiting from ample U.S. support. On the other hand, the UAE and Saudi Arabia have significantly lost pace due to rapid population growth, volatile and declining oil prices, and costly initiatives to reduce dependence on the oil sector. In Sub-Saharan Africa, Botswana has achieved convergence through sound and consistent macroeconomic policies and successful diversification away from diamond exports. On the other hand, both South Africa and Nigeria have lost ground because of corruption, political instability, and sustained flight of human and financial capital.

Laggards – Latin America

Finally, Latin America is the major outlier in emerging markets in its sustained poor economic performance and lagging GDP per capita growth. This conundrum has been called by economists the “Middle-Income Trap” and is loosely attributed to inconsistent and poorly designed policies and deteriorating “institutions.” Other possible contributors to Latin America’s decline have been extreme wealth concentration and sustained human and capital flight. Also, the region’s excessive and increasing dependence on commodity exports have subjected countries to highly destabilizing boom-to-bust cycles (referred to in economics as the “Natural Resource Curse).

The three largest economies in Latin America—Brazil, Mexico, and Argentina—have all grown GDP per capita at a rate well below the U.S. and can be considered poster children for the “Middle-Income Trap.” Chile, the strongest economy in the region, has stagnated over the past decade and faces increased political discord and policy confusion. Colombia and Peru have also stagnated and face similar uncertain policy environments. The highlight of the region is Uruguay, a small economy that has avoided the pitfalls of its neighbors and quietly pursued prudent policies.

 

 

Why do Emerging Market Stocks Underperfom?

The earnings crunch suffered by emerging markets over the past decade (EM has an Earnings Problem) has been the cause of the dramatic underperformance of the asset class relative to U.S. stocks. Poor EM earnings have resulted from cyclical factors typically affecting all economically sensitive assets, such as commodities and industrial cyclicals. Furthermore, factors specific to the U.S. market have also contributed significantly to the outperformance of U.S. stocks. Most importantly, the flourishing of quasi-monopolistic technology giants (e.g., FAANGs, the Magnificent Seven, and a few others).

The chart below shows USD-denominated earnings for Emerging markets and the three principal U.S. indices: the S&P500, the Dow Jones Industrial, and Nasdaq. The data starts in 1986, which is the year that MSCI launched its institutional index for EM. Not surprisingly, periods of EM outperformance (1986-1996 and 2002-2012) are also periods of relatively strong EM earnings growth underpinned by a cycle of USD weakness. EM dollarized earnings grew in line with the S&P500 from 1986 to 2012. Since 2012, EM earnings have trended down by 7%, while U.S. earnings have increased by 99%, 69%, and 165% for the S&P500, the DJI, and Nasdaq, respectively.

The underperformance of EM earnings since 2012 can be attributed to various factors. First, EM started the period at a level of high unsustainable earnings, buttressed by high commodity prices and a weak dollar. The strong dollar since 2012 alone accounts for 30% of the underperformance. Second, EM had a lower weight in technology stocks, and this sector in EM was hit hard by the Chinese Communist Party’s crackdown on China’s tech sector in 2020. Third, and most importantly, U.S. companies benefited from extraordinary monetary and fiscal expansion over this period, boosting revenues and reducing financial costs.

The extraordinary performance of the dominant U.S. tech stocks and their growing weight in the indices has been the main story driving markets. The great commercialization and financialization of the Information and Communications Technology (ICT) cycle has resulted in a few firms each dominating their niche and very successfully diffusing and monetizing digital technologies not only in the U.S. but worldwide.

Future performance will be determined by how the trends outlined above develop from now on:

  1. Will the current strong dollar cycle revert?
  2. Will the U.S. tech sector lose dynamism because of product maturation, regulation, or other reasons?
  3. Can the extraordinary monetary and fiscal largess be sustained in an era of rising inflation and soaring deficits?

 

3Q 2023 Expected Returns for Emerging Market Stocks

Emerging market stocks are once again proving to be disappointing in 2023 due to increasing risk aversion. Geopolitical and domestic political factors, along with a strengthening dollar, are causing investors to seek the safety of U.S. blue-chip stocks and cash. Rising interest rates, concerns about a global recession, and weak earnings in many countries are all contributing to bleak short-term prospects. Investors can only find comfort in the expectation of longer-term returns.

The chart below illustrates the current expected returns for EM markets and the S&P500, based on a CAPE ratio analysis. The Cyclically Adjusted Price-Earnings Ratio (CAPE) is calculated using the average of inflation-adjusted earnings for the past ten years, which helps to smooth out earnings’ cyclicality. This tool is particularly useful for highly cyclical assets like EM stocks and has a long history of use among investors, gaining popularity through Professor Robert Shiller at Yale University. We employ dollarized data to capture currency trends. The seven-year expected returns are calculated assuming that each country’s CAPE ratio will revert to its historical average over the period. Earnings are adjusted according to each country’s current position in the business cycle and are assumed to grow in line with nominal GDP projections from the IMF’s World Economic Outlook (IMF WEO, October 2023).

As expected, countries with “cheap” CAPE ratios below their historical average tend to have higher expected returns than those considered “expensive” with CAPE ratios above their historical average. These expected returns are based on two significant assumptions: first, that the current level of CAPE relative to the historical level is not justified; second, that market forces will correct the current discrepancy.

Historical data strongly supports the second assumption when considering seven-to-ten-year periods but not in the short term (one to three years).

Nevertheless, during certain periods when “cheap” markets on a CAPE basis exhibit short-term outperformance, investors should take note, as the combination of value and momentum can be compelling. As shown in the chart below, we are currently in such a period. Over the past twelve months, holding the “cheapest markets” has generated alpha in an EM portfolio. Although Turkey is no longer “cheap,” it was clearly so a year ago and continues to enjoy that momentum. Nearly all the better performers are inexpensive markets. The one exception is India, which, despite very high valuations, continues to attract flows from investors enamored with EM’s “last growth story.” Chile is also an obvious anomaly, as it should be delivering better returns. It is very cheap relative to its history and, being the world’s leading copper producer, offers an excellent hedge against inflation.

The fact that cheap markets are now performing well is encouraging for EM investors. However, rising geopolitical tension and slow growth do not create a conducive investment environment. As always, a strengthening dollar signals the need to stay invested in dollar-denominated quality assets.

 

 

Emerging Markets Have An Earnings Problem

The past decade has been a disaster for investors in emerging markets because nominal earnings measured in dollars have not grown.

There are several reasons for this earnings stall:

First, the past 11 years have been a period of dollar appreciation. Due to its broad global use in invoicing and financing commercial flows, a strengthening dollar has had a depressing impact on most developing countries. Moreover, as typically occurs, a strong dollar has meant weak commodity prices and poor results for commodity producers (Latin America, Russia, South Africa, etc.).

Second, the fall in earnings and investor returns can be seen as a bearish cyclical adjustment after the prior decade of plenty. The weak dollar and commodity boom of the 2002-2012 decade provided outsized results for emerging markets, which were given back over the next ten years.

Third, profitless China has weighed down the asset class. China’s capital-intensive state-run economy has resulted in very low returns on capital and persistent dilution of investors in the stock market. This was a minor issue in 2000 when China was only a small part of the EM stock indices but became a huge burden over the past decade when Chinese stocks came to dominate the indices. The brief tech boom in China (e.g., Alibaba, Tencent, massive foreign private equity inflows) changed the perceptions of investors until it was crashed by Xi’s crackdown on the companies for their “socially destructive” behavior.

The following charts illustrate the evolution of nominal dollarized earnings over time for emerging market stocks. The first chart shows earnings data for the primary EM countries and the S&P 500 during the modern era heralded by the introduction of the MSCI EM index in 1986, including estimates for 2024. Over this long period, Mexico leads by a considerable margin, while India and Taiwan are neck-and-neck with the S&P 500. Before the S&P 500’s recent spurt (2020-2023), earnings growth in EM was broadly in line with the S&P 500.

The next chart shows earnings data starting in 1992 when China was included in the MSCI EM Index. Remarkably, China’s earnings in 2023 are below the level of 1992. Brazil leads the pack over this period, with the characteristic extreme cyclicality of commodity dependence, surging during the commodity supercycle (2002-2012), tanking during the commodity collapse (2012-2016), and recovering with the bounce in commodity prices starting in 2016. India stands out as the star performer over this period, as it has provided high earnings growth without the volatility of commodity producers. Also, unlike the capital-intensive, export-oriented businesses of China, Korea, and Taiwan, India’s mogul-controlled corporates enjoy strong market power, allowing for high and consistent returns. The S&P 500 experienced enormous volatility over this period marked by the combination of financialization of the Information and Communications Technology (ICT) cycle and monetary adventurism: two bubbles (tech, 1999-2001; real estate, 2003-2007), followed by crashes; an increasingly activist Federal Reserve, resulting in 15 years of negative real interest rates. Nevertheless, the enormously profitable tech giants supported the S&P 500.

The last chart shows the period after the Great Financial Crisis (GFC), 2010-2024. The post-GFC is characterized by “secular stagnation,” a period of low growth and low inflation which was met by the Federal Reserve with policies last seen in the Great Depression of the 1930s: massive money printing, negative interest rates (financial repression), and increasingly large interventions to support asset prices. This period also saw a persistent appreciation of the USD. The clear leader over this period has been the S&P 500, propelled not only by the rising USD but also by the remarkable expansion of profit margins for the monopolistic tech giants (FAANG) which saw profit margins rise from around 10% to the current 25%. Since 2019, earnings in both Taiwan and Mexico have recovered because of stellar results from TSMC in the former and a strengthening of the peso in the latter. Weighed down by China, EM nominal earnings have fallen over this long period. These years have been equally bad for commodity producers (low prices) and East Asian exporters (rising operating and financing costs and brutal competition from China). Even India, with its high GDP growth and booming asset prices, has seen no earnings growth over this period.

 

 

 

 

Financial Repression Has Won For Now

 

The world’s most prominent central banks operating in the largest and most liquid financial markets have successfully implemented financial repression policies over the past three years which have significantly reduced debt burdens.

The prize for the most agressive financial repression goes to the Bank of England. Negative interest rates over the past three years averaging -3% have reduced the U.K.’s total debt to GDP ratio by a whopping 71%, from 315% to 243%; and government debt to GDP was reduced by 47% , from 141% to 94%. As the chart below shows (data from the Bank for International Settlements, BIS) this pattern of financial repression has been the norm, and led by the world’s leading financial powers, the Euro Group and the United States in particular. The United States has has negative interest rates in 14 of the past twenty years, and since 2020, these policies teamed with “fiscal dominance” have caused a sharp fall in debt ratios.

In the case of emerging markets, Turkey, Poland, Malaysia, Argentina, Chile and Saudi Arabia stand out for their reductions in debt loads. Korea, China and Thailand are among the few countries that saw their debt burdens increase over this period. China, which faces strong deflationary forces caused by excess capacity, malinvestment, a real estate bust and a sharp decline in consumer confidence, has seen its debt ratios continue to rise from already extremely high levels. China’s total debt to GDP ratio rose over the past three years from 294% to 306%. Moreover, if China’s GDP is overstated by as much as 25% as many economists argue, China’s ratio may be approaching Japan’s stratospheric 407% ratio.

The case of Brazil is somewhat unique and points to the future for other countries. Brazil’s central bank has pursued ultra-orthodox policies, meaning that it has managed only a brief honeymoon with negative interest rates and now faces a long period with high real rates. Central bankers in Brazil don’t have room for financial repression, being as they are reined in by unstable “hot money” capital flows from both domestic and foreign investors.

The U.S. Fed, though in a much better shape than Brazil’s central bankers, is also facing challenges from new inflationary forces and fiscal deficits that are expected to rise consistently to fund the retirement of Baby Boomers.

The losers of financial repression (e.g., holders of government bonds and mortgage securitizations) have surely learned their lessons and, at any sign of a new crisis addressed with more quantitative easing, will flee to real assets that have a better chance of preserving value.

 

 

Chinese Auto Exports Threaten the Auto Industry Worldwide

Benefiting from technology transfers from multinationals and massive government subsidies, China has made itself the dominant force in the automotive industry over the past two decades. It has achieved this supremacy at a time when the industry is undergoing the most significant technological shift in 70 years: the transition from the internal combustion engine (ICE) to the electric motor. China had the foresight to anticipate this transition and leapfrog to the forefront of EV (Electric Vehicle) technology by harnessing subsidies and private capital. However, given the current reality of global geopolitical conflict and economic stagnation, China’s dominance of this critical industry may increasingly be seen by many countries as an unacceptable strategic and security threat.

Since the launch of Ford’s Model T in 1908, the automobile industry has been at the forefront of mass production manufacturing. By the 1950s, when the industry reached its peak impact on the American economy, the industry’s core technologies had been developed, and it entered its maturity stage. Since 1960, auto manufacturing has barely grown in the U.S., and the leading firms in the industry focused on disseminating their mass production skills around the world, a process that culminated with major multinational auto companies setting up plants in China between 1984 and 2004.

The chart below shows the auto industry’s annual growth rate since the 1950s. Global growth peaked in the 1960s, driven by Europe, Japan, and Latin America, and then has fallen every decade, except during the 2000s because of the precipitous rise in Chinese domestic demand. Growth for the twelve-year period ending in 2022 has been at a record-low 0.8% annually, despite a 50% increase in China’s output. U.S. production growth stalled much earlier, already in the 1950s, and only recovered in the 1980s and 1990s because protectionist policies were introduced to force foreign firms to make their cars in the U.S. There has been no increase in U.S. output since 1990.

The decline of the U.S. as a manufacturer of motor vehicles and the rise of China can be seen in the following chart (source: OICA, International Organization of Motor Vehicle Manufacturers). The U.S. emerged from World War II with nearly 80% of world output, was overtaken by Japan in the 1980s and 1990s, bottomed at a 10% share in 2010, and in 2022 had a 12% share. Since 1990, when the first joint-ventures with foreign firms began operating, China has grown its share of world output from 1% to 32%. The dominance of China in EV manufacturing is even more pronounced, reaching 59% of world output in 2022, compared to 19% for the United States. Germany, Japan, and South Korea followed, with shares of around 10%, 8%, and 6%, respectively (Canalys).

The following two charts show emerging market producers: first, mature players (Mexico, Brazil, Korea); and second, newcomers still enjoying growth (India, Indonesia, Thailand, Turkey, and Eastern Europe). Brazil’s share of global output peaked in 2010 but is now below 1980 levels. Mexico, despite NAFTA, is back to the level of 1990. Korea is also losing global share. In the case of countries growing their share of the global automotive pie, India and Eastern Europe stand out. Indian manufacturers benefit from trade protectionism (70% tariffs) and rapid economic growth. Eastern Europe has taken advantage of favorable EEU (Eurasian Economic Union) policies allowing firms to move production to places with lower wages.

The Market’s Reaction to the Inception of Chinese Vehicle Exports

The slowdown of China’s economy and low consumer confidence, combined with sustained investment in new production capacity, has caused excess manufacturing capacity and a surge in Chinese motor vehicle exports over the past two years. According to the China Association of Automobile Manufacturers, domestic sales of ICE (Internal Combustion Engine) vehicles peaked at 2.4 million monthly in 2018 and are now running at a monthly rate of 1.6 million, 36% lower. Exports of ICE cars have surged and are expected to reach 3.2 million units in 2023, an increase of 45% over 2022 levels. EV exports may reach 1 million units this year, a 60% increase. Remarkably, in three years, China has gone from almost no participation in auto exports to the leading position. China surpassed Korea in 2021, Germany in 2022, and long-time export leader Japan in 2023.

In the case of ICE cars, most of these exports are going to Russia, Eastern Europe, and developing countries in Asia and Latin America, undermining the competitiveness of manufacturers in those regions. EVs are mainly exported to more developed regions, such as Europe, which have high “climate change” incentives for EV sales, but this is also changing fast. For example, BYD has had enormous success exporting electrical buses to major emerging market metropolitan areas suffering from high pollution levels.

China’s increasing EV exports are creating a huge dilemma for traditional auto manufacturing countries around the world. In Europe, politicians are committed to promoting EVs but are also determined to support an important domestic industry that needs time to navigate the transition to EV technologies. This week the European Commission launched an anti-subsidy probe into EVs coming from China, aiming to protect European firms from “competitors benefiting from huge state subsidies.”

The situation today is different than in the 1980s when Japanese firms were required to build their cars in the U.S. At that time, the Japanese, a key strategic ally which had outcompeted U.S. firms with marginal improvements in manufacturing efficiency (just-in-time process) and better quality, were pressured into accepting a political concession. Today, Xi’s China is a strategic geopolitical adversary competing with “unfair” advantages and seeking dominion in a frontier technology of critical economic, social, and ecological importance.

Developing countries face, perhaps, even bigger challenges. Countries with long-established automotive industries cannot sustain competition from China’s ultra-competitive, modern, and highly subsidized auto sector, and, even in a best-case scenario, would lose regional customers in markets without the industrial base. For example, in Chile, a country that imports all of its cars, China has captured 40% of the market over the past few years. Half of the car models available for sale in Ecuador are Chinese, and these brands have captured nearly half the market since 2020. Also, China’s BYD has captured half of the bus markets of Santiago and Bogota with its electric buses over the past five years.

Moreover, any shift to EVs implies the importation of batteries and motors, which leaves only minimal value-added in final assembly. EVs also pose a mortal threat to local part suppliers that are an intrinsic part of the ICE value chain. The shift to EVs implies a transition from a mature industry with processes and technologies fully assimilated by countries like Brazil and Mexico to an industry on the technological frontier, which these countries have little hope of dominating.

 

If China’s Boom is Over, Where Will Demand for Commodities Come From?

China’s economy has experienced a multi-decade period of high growth, similar to “miracle” surges previously witnessed by other countries. Today’s wealthy nations once went through these surges as well: the U.K., the U.S., and Germany in the late 19th century; and Japan in the early 20th century and again in the 1960s. Various developing countries have also seen periods of so-called “miracle” growth, such as Brazil and Mexico in the 1960s, and Korea, Taiwan, and Malaysia since the 1970s, with China starting its own in the 1990s. A significant contributor to these periods of accelerated growth is a broad and powerful one-time build-out of physical infrastructure. This will be especially true in China, which has witnessed one of the greatest construction booms in history.

The amount of infrastructure investment undertaken by China is breathtaking. For example, Shanghai had four crossings of the Huangpu River in 1980 and now boasts 17. Shanghai did not possess a subway system in 1980, and now it encompasses over 800 kilometers of lines, making it the world’s longest. China claims eight of the top ten longest subway systems globally, with a total extension of 9,700 kilometers across 45 cities. In comparison, the U.S. has 1,400 km of subway lines in 16 cities. Since 2000, China has constructed 38,000 km of high-speed train lines, more than tripling the amount built by Europe since 1980. China’s National Trunk Highway System, primarily built over the past 20 years, now totals 160,000 km, compared to the 70,000 km of the U.S. Interstate Highway System.

China’s construction boom over the past decades can be measured by its share of the world’s production of basic building materials. For example, China consistently produced more than half of the total world cement output over the past decade, securing 56% in 2019. China also commands a similar share of the world’s steel output, reaching 57% in 2020, according to the American Iron and Steel Institute (AISI). The chart below illustrates China’s increasing share of world steel output, surpassing the level the U.S. had at the end of World War II.

The following chart displays steel output since 1950, with China’s ramp-up beginning in 2000.

Major infrastructure expansions do not need to be repeated. For instance, New York City’s infrastructure (bridges, tunnels, highways, subway system) was largely completed by the 1920s, and the bulk of the U.S. highway system was constructed between 1959 and 1972. The London Underground and the Paris Metro were built before the First World War, and France established most of Europe’s best high-speed train network between 1980 and 2000. The chart below illustrates this historical process and how it has impacted the production of steel in countries undergoing these surges in investment. Steel production surged in Europe in the late 19th century (railroads, steamboats, bridges, etc.) and again in the 1920s and 1930s (automobile infrastructure) and finally in the post-World War II “Golden Years.” The U.S. followed a similar path but also had a massive expansion of automobile infrastructure in the 1950-1970 period due to suburbanization and interstate highways. Brazil experienced an infrastructure boom in the 1960-1980 period, as did Korea in the 1970s. Invariably, these booms come to an end, and steel output plateaus, tapers, and eventually decreases.

The following table presents this data in percentage terms, with the total increase in steel output for the previous ten years. The data shows that multi-decade expansions in steel output are not uncommon: Europe and Japan (1970-1900); U.S. (1970-1940); Japan (1930-1970); Germany (1950-1980); Brazil (1950-1990); and Korea (1950-2010). China has been expanding steel output since the 1950s, which provided a high base for the mammoth expansion since 1980. India has been growing output at a swift rate even before reforms were launched in the 1980s, and it is already, with over 100 million in annual steel output, at a much higher level than China was when it started its “miracle” phase of economic growth.

Eighty-seven percent of the increase in world steel production over the past 22 years occurred in China, raising the question of which countries can pick up the slack if China’s construction boom is over. The hope is that India and emerging Southeast Asia can step up. Assuming China’s steel output remains flat, to maintain the 3.5% annual increase in global steel demand of the past twenty years, it will be necessary for India, Vietnam, Indonesia, and a few more high-growth economies to more than double their steel output every decade.

 

The Persistent Decline of Latin American Competitiveness

In a globalized world, capital will flow to the countries that provide the best conditions for businesses to operate. The IMD business school in Lausanne, Switzerland conducts a survey annually to measure how well governments  “provide an environment characterized by efficient infrastructures, institutions, and policies that encourage sustainable value creation by enterprises.” This survey is particularly significant because previous efforts by the World Bank (Doing Business) and the World Economic Forum (World Competitiveness Report) have been abandoned. The latest editition of the IMD World Competitiveness Report provides more damning evidence of the poor performance of many emerging markets, particulalry those in Latin America.

The IMD survey focuses on the 64 countries considered most relevant for multinational businesses. The latest rankings are shown in the chart below. Of the 15 largest countries in the MSCI Emerging Markets Index, only seven make it in the top half of the rankings (Taiwan, Saudi Arabia, UAE, China, Malaysia, Korea and Thailand). The two  in the top quintile (Taiwan and UAE) are rich countries, only included in the EM Index because of market access issues. On the other hand, in the bottom quintile, there are eight EM countries (Philippines, Peru, Mexico, Colombia, Brazil, South Africa, Argentina and Venezuela). Every Latin American country, except for Chile,  is in the bottom quintile, and four are in the bottom decile (Colombia, Brazil, Argentina and Venezuela. (Latin American countries are in bold and remaining EM countries in red)

The poor performance of Latin America has worsened over time. This can be seen in the following chart that shows IMD rankings since 1997 in decile form. There is a pronounced deterioration in the region’s rankings over this period, particularly after the commodity boom of the mid-2000s and the Great Financial Crisis. The decline of Argentina, Brazil and Chile, all commodity producers suffering from acute “Dutch Disease” (the commodity curse), is most pronounced, but even Mexico with the great advantage of NAFTA, has done poorly over the past ten years.

In addition to the devastating effects of the boom-to-bust commodity boom (2002-2012), the region suffers from multiple ills.

  • Political turbulence throughout the region, with the important exception of Mexico.
  • Poorly designed economic policies, often anti-business and generally poorly executed and unsustained.
  • Rampant capital flight, as elites and middle classes seek the security of Miami, Lisbon, Dallas, Punta del Este, etc…
  • The onslaught of Asian mercantilists, dumping manufactured goods in Latin American domestic markets.
  • Rising wealth inequality, as governments are unable to formulate and/or execute policies to provide employment or income to large segments of the population.