September 2019 – The Emerging Markets Investor

As China has reached middle-income status its rate of economic growth has slowed down sharply. For the past four decades China adroitly took advantage of powerful drivers of growth, but several of these have exhausted themselves or turned into headwinds. For example, a huge demographic bonanza has morphed into a drag on growth, as the working-age population has started to decline, and China now faces the prospect of becoming the first major economy to grow old before it gets rich. Also, global trade, for long a boon to China’s wealthy coastal economy, is now dwindling, and rising trade tensions and protectionism make further gains implausible. Moreover, previously fruitful growth strategies based on fixed capital formation, debt-accumulation and environmental degradation have lost traction as volumes have reached levels where marginal returns are unattractive. Policy makers in China are well aware of the predicament they face. One of their most publicized responses to the growth slowdown has been President Xi Jinping’s “China 2025” strategy, which is a firm commitment to use concerted state-led promotion and support with the objective of moving up industrial value chains and making China dominant in high tech frontier industries. However, “China 2025” has contributed to the growing acrimony between China and the United States, as Washington has assailed the initiative as a violation of the norms of global capitalism and sees it as designed to undermine strategic business sectors in America. U.S. sanctions on Chinese tech companies and restrictions on access to technologies implemented by the Trump Administration have only increased the conviction of Chinese leaders that technological autarky is now a question of national security, and has further deepened the sentiment that the two countries are engaged in a new “cold War .”

It is in this context of slowing growth, trade tensions and tech sanctions that the World Bank has issued a report, “Innovation in China,” (Link) which provides a blueprint for sustaining Chinese growth in a non-confrontational manner. The World Bank, which has been very active in China since the 1980s and sees itself as a trusted and impartial advisor and is now run by the Trump-appointed David Malpass, co-authored the report with the Development Research Center of the State Council of the People’s Republic of China, (DRC), a think tank which advises China’s senior leadership. The combined effort, therefore, is meant to provide a technically-based proposal which reflects the sensibilities of both Chinese and U.S. policy makers.

The conclusions reached by the report are highly significant because they show a path forward which is very different from the “Cold War” clash now assumed to be inevitable in Washington. Whether this faithfully expresses the conviction of either President Xi Jinping or Damald Trump is unknown but the report does show that there is considerable support within China’s top leadership for avoiding a confrontation with the U.S. by pursuing a technical approach that diminishes the current areas of tension.

The World Bank/DRC report’s primary message is that China can best achieve its objectives by focusing on traditional developmental strategies that have not been fully exploited. The report advocates for deepening governance and institutional reforms in order to facilitate a three-pronged strategy of: 1. Accelerating the diffusion of currently available technologies (the traditional “catching-up” process available to developing countries which operate well below the “technology frontier”); 2. Reducing distortions which currently affect market prices and result in poor resource allocation and 3. Promoting technological innovation (discovery) on the global technological frontier.

The report espouses a market friendly agenda to promote an innovation economy: the removing of Distortions in the allocation of resources; the acceleration of Diffusion of existing technologies; and fostering the Discovery of new technologies. This “3D” strategy, as it called in the report, defines the government’s primary role as the supporter of markets.

The report emphasizes that the potential benefits from the first two Ds are ample and relatively easy to achieve and should be the main drivers of growth over the midterm, while discovery on the global technological frontier will gain importance over the long term as China becomes richer. It argues that China could more than double its GDP simply by catching up to the OECD average in Total Factor Productivity, by propagating existing technologies and eliminating the distortions in resource allocation which are endemic to an economy dominated by central planners, state-owned firms (SOEs) and state banks. Moreover, the report supports changing the focus of industrial policy away from targeted support for preferred firms and towards industrial policies that promote level competition. Though SOEs are seen as an integral part of the economy, the report advocates that they be fully exposed to competitive pressure.

This clear statement of priorities expressed by the World Bank/DRC report is highly significant in the context of Washington’s condemnation of current “discriminatory’ policies regarding foreign investments, technology transfer and the protection of intellectual rights in China. In essence, the report insinuates that it is today in the best interest of China to address these concerns in order to accelerate the adoption of foreign technology and best practices and keep China on a path of high GDP growth.

Of course, China has frequently expressed these views in the past: pro-market reforms have been formally espoused in all the government’s policy statements. However, progress has been slow, and there is now a widely-held outside of China that there has been backtracking during the Xi Administration. For whatever reason, China continues to “talk the talk but does not walk the walk.” However, the World Bank/DRC report shows that a significant portion of the Chinese political establishment still sees a “win-win” outcome based on self-interested accommodation. Let us hope that politics and personalities will facilitate this outcome.

Trade Wars

The great decoupling (Oxford Energy)
KKR sees opportunity in China decoupling (KKR)
Banning technology will backfire on the U.S. (FT)

India Watch

India’s digital transformation (McKinsey)

China Watch:

Expected returns in China (UBS)
China-Russia: cooperation in Central Asia (AsanForum)

China Technology

China’s Digital Economy (IMF)
China’s Digital Trends (McKinsey)
Interview with Alibaba’s CEO (McKinsey)
Inside China’s biopharma market (McKinsey)
China Internet Weekly (Seeking Alpha)

Brazil Watch

Brazil-U.S. ties with Trump-Bolsonaro (The Dialogue)
The bear case for Brazil (seeking alpha)

EM Investor Watch

Naspers strategy to create value (FT)

Tech Watch

Risks and opportunities in the battery supply chain (squarespace)
Investing in Asian Innovation (Oppenheimer)
Trends in battery prices (BNEF)

Investing

The age of wealth accumulation is over (FT)
A taxonomy of moats (reaction wheel)
An investment thesis for the next decade (Gavekal)

The most remarkable aspect of Argentina’s latest financial meltdown is the feigned surprise expressed by economists and investors. The truth is that Argentina’s crisis largely repeats the steps of previous ones, including economic mismanagement, dysfunctional politics, too much debt, and a terms-of-trade shock caused by a plunge in grain prices.

As happens after every crash in asset prices, scalded investors claim the outcome was unforeseeable. In the days following the collapse of Argentina’s financial markets financial newspapers quoted investors referring to “black swans” and “6+ sigma” events, implying the improbability of the event was so great that no investor could possibly have foretold it. Given that Argentina undergoes financial crises on a routine basis — every decade or so — this claim seems ingenuous.

Famed economist Paul Krugman, seeking an explanation for this crisis, generated an interesting exchange on his Twitter feed (@paulkrugman).

Krugman noted that President Macri was vulnerable from the start, as he was dealt a hand of elevated fiscal and current account deficits, the infamous “twin deficits,” which always should raise concerns for emerging market investors. According to Krugman, the recommended course of action for Macri at the launch of his administration in 2016 was to cut the deficit and devalue the currency. However abetted by yield-hungry foreign investors enthused by his pro-market reform agenda, Macri opted for foreign borrowing.

As economist Brad Setser noted in a response to Krugman, Macri’s policy option resulted in a sharp rise in foreign debt, which, given Argentina’s precarious export base, dramatically increased its vulnerability.

For the first two years of Macri’s term (2016-2017) the strategy seemed to be working, and Argentine asset prices boomed. In July 2017 Argentina successfully issued a $2.75 billion 100-year bond which was highly oversubscribed and appreciated sharply during the rest of the year. But, as Krugman notes, the fundamental issues were not addressed and Argentina succeeded only in digging itself into a bigger hole.

Unfortunately for Macri, the global economy turned down in early 2018, resulting in a strengthening dollar and falling commodity prices. As they are wont to do, fickle foreign investors suddenly cooled on Argentina, and by the summer Macri had agreed to an $56 billion bailout from the IMF aimed at supporting “expansionary austerity.” According to Krugman, time ran out on Macri and his final desperate measure to bring the situation under control by drastic interest rate hikes and last-minute austerity created a nasty slump and a loss of popular support.

Krugman blames the crisis on “neoliberalish reformers” and a naïve IMF. Krugman’s followers on Twitter responded in different ways. Some took offense to Macri being labeled a “neoliberal,” arguing that, if anything, he was a shy on reforms. Most commentators expressed a fatalistic anguish, stating that because of political polarization and a high dependence on fickle foreign savings these crises will routinely recur no matter who the leaders are. Most everyone seemed to agree that the IMF blundered, though perhaps only because it was pressured by a pro-Macri Trump Administration.

So, what really happened in Argentina?

A good place to start is to review the history of emerging market blow-ups and recognize the patterns. Ray Dalio’s Principles for Navigating Big Debt Crises (Link) provides a good template to do this, as it analyses 23 emerging market crises since the 1980s and identifies commonalities.

The chart below shows the macro characteristics of each country-specific crisis at the time of maximum vulnerability.

Dalio identifies six primary indicators that appear repeatedly.

Expansion of the Debt to GDP Ratio of at least 5%
Foreign Debt to GDP of at Least 30%
Fiscal Deficit at least 2% of GDP
GDP Output Gap of at least 5% (GDP 5% over trend growth)
Currency at least 10% overvalued
Current Account Deficit over 3% of GDP

Not every crisis is identical, but by-and-large they follow the same pattern, meeting the criteria over 80% of the time. Russia, with its structural current account surplus, is the only anomaly, with both booms and busts dictated by oil-driven terms-of-trade shocks.

When a country meets most of these criteria its economy is considered very overheated and vulnerable to a serious downturn. A crisis is usually triggered when a slow-down in GDP growth unnerves investors.

How does Argentina’s present collapse fit into this framework? To begin, we note that Argentina has had three crises since 1980, all of them fitting nicely into the template. As discussed by Krugman and his Twitter-followers, Argentina’s twin deficits, debt accumulation and reliance on foreign debt put it at high risk. A near-doubling of the country’s debt/GDP ratio from 2015-2018 and a heavy reliance on foreign debt were reckless. The following charts illustrate the deficits and debt profiles.

Twin Deficits

Total Debt and Foreign Debt

Moreover, as shown below, when Macri assumed office the Argentine economy was overheated. After years of irresponsible populist policies, Argentina’s GDP was well above trend and the current account deficit was elevated, meaning that cautious austerity measures were in order.

Where Argentina breaks the template is with regards to the valuation of the currency. As shown in the chart below, both in terms of its REER (Real Effective Exchange Rate) and the Big Mac Index, the peso was cheap relative to its history and in comparison to EM currencies.

Macri may have seen the cheap peso as his trump card, and it may well have been if the global economy had not weakened and if grain prices had risen. Unfortunately, the global economy did turn down and grain prices went into free-fall. Moreover, Brazil’s endless recession also weighed on Argentina’s manufacturing sector which depends heavily on this border trade

As the chart below makes clear, investors should have heeded the warning from falling commodity prices. By the time Macri took office, grain prices had already plummeted and they continued to fall, so that today they lie 60-70% below the 2012-2015 period.

What lessons can be drawn from the latest Argentine fiasco? First, in retrospect Macri’s task was probably thankless. With the mess left by the previous administration and collapsing farm prices his best strategy would have been to follow Krugman’s advice and bite the austerity bullet early. But in Argentina’s fractious political climate that may well have been a suicidal option. Instead he took the risky bet that favorable markets would sustain a gradual economic transition. Unfortunately, Macri’s luck ran out.