Category: China

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.

 

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 New Global Monetary Regime

The U.S. dollar has been the lynchpin of the global monetary system since the end of World War II, promoting the geopolitical strategic interests of the United States and serving as a “public good” to facilitate the globalization of trade and finance. However, today the rise of China and growing threats to globalization present significant challenges to the long-term hegemony of the dollar. At a time when China aims to change the present dollar-centric monetary order, the dynamics of economic and domestic political forces in the U.S. also put into question its usefulness.

The weight of the dollar in global central bank reserves peaked in 2000 and has been falling gradually since then (chart 1). Today, the global economy has returned to a state of multipolarity last seen prior to WW1 when both Germany and the United States threatened the hegemony of pound sterling. In terms of its share of global GDP and trade and its status as a primary creditor to the world, China’s desire to shape a less dollar-centric global monetary system is legitimate (chart 2). China today has become the largest trading partner of most countries around the world and is the dominant importer of most commodities, so it is not surprising, given growing tensions with the U.S., that it does not want to have to rely on dollars to transact foreign trade (chart 3)

Chart 1

Chart 2, Countries share of world GDP, trade and capital exports

Chart 3, The largest trading partner of countries around the world

The current dollar fiat global monetary order also has become a burden for the U.S. economy. Since the 1950s, the U.S. has gone from being the dominant manufacturing power and exporter of the world and its primary creditor to the present day hyper-financialized and speculative economy with net debts  of $30 trillion to the world. Moreover, the political mood in America has turned against the neoliberal policies of the past decades — anchored on the free flow of trade, capital and immigration and current account deficits  — which seriously undermined American labor.

The gradual strengthening of a multipolar global monetary order will add  instability and costs and further the geopolitical deterioration and rising inflation that we have seen so far in the 2020s. A world of less trade, more of it non-dollar centric, and declining global trade imbalances will be very different from the experience of past decades. Over the short-run, the  dollar’s strength is likely to continue, driven by its safe-haven status in unstable times and the diminished supply of dollars resulting from more balanced global trade. Over the longer term, the dollar could weaken considerably from its currently overvalued levels. A decline in dollar hegemony implies a weaker dollar over time, but it is good to remember that because of powerful network effects reserve currency regimes are very sticky (e.g.,  more reserves were still held in pound sterling than in dollars until 1963).

The 75-year U.S. dollar reserve currency system has been unique in terms of its global reach, but in myriad ways it appears to be following in the steps of the previous regimes centered around the pound sterling, the Dutch florin and others before it.  These currency regimes lasted for around a century going through distinct phases:

  1. Economic, trade and creditor dominance. Expansion of productive capacity and capital accumulation.
  2. Excess capital accumulation, leading to financialization and speculation at the expense of the productive sector.
  3. Economic decline, as new powers seek hegemony.

The  current dollar reserve currency regime has followed this pattern since its launch at the Bretton Woods Conference in 1944.

Bretton Woods I (1945-1971)

The U.S.  imposed a dollar-centric monetary system at the Bretton Woods Conference. Disregarding the argument made by John Maynard Keynes for a global bank that would resolve current account imbalances,  all currencies  were anchored to the dollar at a fixed price for gold. The U.S. came out of the war with by far the largest economy in the world, as a huge net creditor to the world and as the dominant manufacturing and trading nation, all of which secured reserve currency status for the dollar.

In the 1950s, the U.S. ran current account surpluses with its major global trading partners, which were largely rechanneled into aid and direct investments for the reconstruction of the war-torn economies of Europe and Asia. However, by the early 1960s, Japan and Europe had recovered and were running current account surpluses with the U.S., which were registered as increases in each country’s “gold” reserves held at the U.S Federal Reserve. Growing opposition to the system was best expressed by France’s finance minister Valerie Giscard D’Estaing who decried the “exorbitant privilege” enjoyed by the U.S. (the supposed advantage of paying for imports by printing dollars). The system showed its first crack when France sent a navy frigate to New York to repatriate its gold reserves. The depletion of U.S. gold reserves at a time of “American malaise” (e.g., political assassinations, racial riots, the Vietnam War fiasco), led President Richard Nixon to “close the gold window”  in 1971, putting an end to Bretton Woods I.

The Chaotic Interlude (1971-1980)

America’s insouciance with regards to unilaterally breaking the dollar’s tie to gold and imposing a pure fiat currency system was expressed by Treasury Secretary John Connally’s comment, “it’s our currency but it’s your problem.” The result was a collapse of confidence in American monetary stewardship and a flight to dollar alternatives. Dollars as a percentage of total central bank reserves fell from 50% in 1971 to 25% in 1980, replaced mainly by gold but also by Deutsche mark and Japanese yen.

The Petrodollar System and The Golden Age of the dollar (1980-2000)

An agreement between Saudi Arabia and the United States in 1974 (the U.S. Saudi Arabian Joint-Commission on Economic Cooperation) committed Saudi Arabia to invoice petroleum sales in U.S. dollars and hold current account surpluses in U.S. Treasuries in exchange for defense guarantees and economic support. The pact  guaranteed ample global demand for dollars and reinstated America’s  “exorbitant privilege”  of running perpetual current account deficits (chart 3).

Fed chairman Paul Volcker’s success in quelling inflation and President Ronal Reagan’s neoliberal pro-business agenda put an end to the 1970s malaise and set the stage for the golden age of the dollar. This period was characterized by a persistent decline in inflation and interest rates, underpinned by stable prices for oil and gold and deflationary forces from both domestic sources (deregulation, lower taxes, decline of unions, immigration) and international sources (globalization, lower tariffs, free flow of capital) (chart 4)

Confidence in the dollar returned and central banks increased the weight of dollar reserves, from a low of 25% in 1980 to a peak of 60% in 2000, while gold reserves fell from 60% in 1980 to 12% in 2000. Low and declining inflation gave birth to the Fed’s “great moderation” thesis and allowed it to promote the great financialization of the economy, all buttressed by growing current account deficits and foreign capital inflows. With Wall Street at the core of the process, this period saw the U.S. become a huge net debtor as foreign countries accumulated surpluses and became the financiers of U.S. debt and other assets. This period also saw the widespread elimination of capital controls around the world and the growing influence of “hot money” tourist capital flows into foreign assets (chart 5).

Chart 5

Bretton Woods II (2000-2012)

China’s “opening up” under Deng Xiaoping during the 1980s, the maxi-devaluation of the RMB in 1994 and accession to the WTO in 2000 drove China’s “economic miracle” and the commodity super-cycle (2002-2012). China’s rise inaugurated a new global monetary regime which has been dubbed Bretton Woods II. Like in Bretton Woods I, the U.S. promoted the growth of a potential rival through trade and investment (under the premise that China would become more democratic and market-oriented over time).  Once again imbalances emerged, as China’s mercantilist policies led to massive current account surpluses with the U.S. which were parked in U.S. Treasury bills.  “Chimerica,” as the symbiotic relationship came to be known, made China the factory floor for the U.S. consumer.  The China “trade shock” accentuated the deflationary forces of the 1990s. This enabled the Federal Reserve to pursue loose monetary policy despite soaring commodity prices, which broke the “petrodollar” anchor of price stability of the prior twenty years.

Without the stability of the price of oil and gold that was at the core of the “Petrodollar system” Bretton Woods II was an anchorless pure Fiat Reserve Currency Model relying entirely on the faith and credit of the Federal Reserve. Since 2000, recurring financial crises (2001, 2007, 2020) have been met by a desperate and increasingly unorthodox Federal Reserve determined to combat deflationary forces by supporting extremely high levels of debt and equity prices through quantitative easing and international swap lines.

Rising tensions between China and the U.S. since Xi Jinping took power in China in 2011 have undermined “Chimerica.” Since 2017, China has been reducing its holdings of Treasury bills, and no longer recycles its current account surpluses into Treasury bills.  The sanctions imposed on Russia after the invasion of Ukraine and acrimonious relations with Saudi Arabia have further undermined the appeal of recycling current account surpluses into Treasuries.

In Search of a New Regime: Bretton Woods III?

 As Nobel Laureate Joseph Stiglitz has said, “the system in which the dollar is the reserve currency is a system that has long  been recognized to be unsustainable in the long run.” Eventually the “exorbitant privilege” and its geopolitical benefits turn into an “exorbitant burden” of deindustrialization and foreign liabilities.  Moreover, for the first time since WWII, the world’s largest trading nation, China, does not support the  regime. This raises the question of what comes next?

China has declared its determination to move the current world monetary order towards a less U.S. centric model. Given the deterioration in China-U.S. relations and the prospect of economic decoupling, it is likely that China’s trade and current account surpluses with the U.S. will dwindle over the next decade.  Without a reliable substitute for the U.S. consumer, China now aspires to a symbiotic relationship with natural resource producers, whereby it ‘barters” manufactured goods in exchange for commodities. China’s rapprochement with Russia and its diplomatic advances in the Persian Gulf and the steppes of Central Asia are evidence of this focus on creating a new global payments system which focuses on commodities and bypasses the highly financialized dollar correspondent network promoted by the U.S. China aspires to do the same with large economies like Brazil and Indonesia. A Xi visit to Saudi Arabia, rumored to be scheduled for next month, would be of great concern to Washington.

Zolltan Pozsar of Credit Suisse has recently written about a new global commodity anchored reserve currency model which he calls Bretton Woods III. The idea is that in a world torn by geopolitics, sanctions and financial instability  countries will do more trade in other currencies than the dollar and prefer to hold reserves in commodities. Geopolitical tensions this year  — Russia’s invasion of Ukraine and the imposition of sanctions on its trade and foreign reserves, and growing tension in the Taiwan Strait which have resulted  in the  imposition of draconian controls by the U.S. on semiconductor exports  — may have been a watershed which will accelerate financial decoupling.

Does China want the renminbi to serve as a reserve currency?

China, at least in the short run, “wants to have its cake and eat it too.”

China would like to reduce its vulnerability to U.S. sanctions by promoting a new monetary order that is not dollar-centric and do this in a way that allows it to continue to expand its geopolitical influence on Asia and its primary trading partners, mainly commodity producers. However, facing a decade of low growth due to debt, a real estate crisis, poor demographics and plummeting productivity, it also wants to preserve the millions of jobs tied to exports of manufacturing goods. Like all Asian Tigers (Japan, Korea, Taiwan) it needs to pursue the mercantilist policies of the past: an undervalued currency and export subsidies. For now, these mercantilist tendencies imply current account surpluses, which would make it difficult for China to create the expansion of RMB liabilities required in a reserve currency system.

However, under the firm hand of Chairman Xi, China is now rapidly moving to a different economic model that is different from the one followed since the 1980s and at odds with the East Asian model. As it ages rapidly and faces a sharp decline in its workforce, China  will cease to be both the “factory of the world” and the major creditor to the world. This trend will accelerate this decade as China adopts widespread autarkic policies to reduce its vulnerability to potential sanctions from geopolitical adversaries. Over the next decade, China is likely to move to a less production-oriented and more consumer- and finance -oriented economy. This implies more balanced trade and more appropriate conditions for promoting the RMB as a reserve currency.

Conclusion

The move to a multipolar world and parallel monetary regimes will add instability to the global economy during the coming decade. Though declining global trade imbalances are positive in the medium run, the reduction in global dollar liquidity will support dollar strength at first but accelerate alternative reserve currency holdings over time. Commodities will probably play a more important role in future monetary regimes, which will benefit the major global commodity producers.

There is great uncertainty about the reshaping of a new monetary order, but certainty about one thing: more instability.  The quote from Stiglitz concludes: “The system in which the dollar is the reserve currency is a system that has long been recognized to be unsustainable in the long run. It’s a system that is fraying, but as it frays it can contribute a great deal to global instability, and the movement from a dollar to a two-currency or three-currency, a dollar – euro [sic], is a movement that will make things even more unstable.”

Long Technology Waves and Emerging Markets

The poor performance of many developing economies in recent decades has many explanations. Thought leaders such as prominent mainstream economists, the World Bank and the IMF tend to attribute failure to weak “institutions” which engender corruption, bureaucracy, lawlessness and poor human capital formation, and, consequently, result in a difficult environment for productive investments and capital accumulation to occur. In the countries themselves structural reasons often are preferred which tend to blame external forces: the legacy of colonialism and foreign oppression or the inequitable dependency of the “periphery” (developing countries) on the “center”  (rich countries). A third approach, put forward by experts on historical technological cycles, gives significant incremental insights on the question, and, more importantly, guidance on a path to better performance in the future.

The Russian Nikolai Kondratiev and the Austrian Joseph Schumpeter developed the idea during the 1920s that  long technological waves drive  the course of economic growth. Both of these “political economists” sought to understand the miraculous growth created by the industrial revolution over the previous century to better explain the post W.W. I  environment.

Schumpeter is best remembered for the idea that “creative destruction” is fundamental for progress and occurs in a recurring process: innovations made by scientists and tinkerers are turned into inventions by profit seeking entrepreneurs; eventually, the wide diffusion of disruptive technologies lead to widespread creative destruction as entire industries and sectors are transformed.

The chart below, from Visual Capitalist, summarizes the long-term technological cycles defined by Kondratiev and Schumpeter. Though the precise dates are debated by historians, the chart seeks to cover the entire era of the “Industrial Revolution.”  Five distinct “long waves of innovation” are described, each one of which was deeply transformative, not only for the firms and industries involved but also for the socio-political fabric of society. This framework puts us today in the fifth wave of technological progress, the Information and Communication Technologies Age (ICT).

Following  in the path of Schumpeter, the Venezuelan economist Carlota Perez and others have advanced the discussion of technological waves by incorporating the role of capital markets and exploring the implications for the development of “periphery” countries. Perez’s book, Technological Revolutions and Financial Capital (2001), has been hugely influential and is required reading in Silicon Valley boardrooms and venture capital firms.

Perez talks about technological revolutions as “great surges of development” which cause structural changes to the economy and profound qualitative changes to society, and she sees capital markets at the core of the process. Her “revolutionary waves,” as shown in the chart below are in line with Schumpeter’s, but she increases the scope to show the broad reach of these technologies on communications and infrastructure and, consequently, trade and commerce and society as a whole.

Perez’s technological cycles are divided into three distinct phases, which are determined by the diffusion rate of technologies.

During the initial phase – Installation – new innovations are slowly adopted by entrepreneurs with disruptive business models. As the kinks are worked out and the technologies become cost effective more entrepreneurs adopt the technologies with the backing of financiers (e.g. venture capital) who seek the high potential payoff of backing a future champion. This leads to a frenzy of capital markets speculation, which invariably results in overinvestment, hype, financial bubbles and financial crisis.

As shown below, every Installation phase has ended in a bubble, followed by a financial crisis, which Perez call the Turning Point. The canal mania of the British industrial revolution, the British railway mania of the Age of Steam, the global infrastructure mania (sometimes called the Barings mania) of the Age of Steel, the roaring twenties stock market bubbles of the age of mass production and the  Telecom, Media and Technology (TMT) bubble of  the ICT revolution all ended in financial crises.

For illustration purposes, the chart below shows Perez’s process at work for the current Information and Communications Technologies (ICT) revolution that we are currently living. The cycle is a typical S-curve which has a long incubation period of slow growth, followed by a sharp ramp up and an eventual flattening.  The current cycle can be said to have started in 1971 with the launch of the first commercial micro-processor chip by Intel, but this was only possible because of a prior decades-long incubation period of scientific research and tinkering. Financial speculation built up between 1995-1999 led to the great TMT bubble and the crash in 2000-2001. Following the crash, the Deployment Phase has caused the rise of the major winners through a consolidation process (FAANGS). (These consolidations are normal, according to Perez. For example, hundreds of auto companies engaged in brutal competition before consolidating into the three majors in the 1920s).

The Deployment Periods, which Perez calls the “Golden Ages”, is when the technologies become cheap and ubiquitous, and their benefits are widely diffused through business and society. Perez argues that we are on the verge of another “golden age” today, as we approach broad access to smartphones and the internet and massively powerful micro-chips are becoming almost ubiquitous in basic consumer products (the chip in an Iphone has a trillion times the computing power of those used by IBM’s mainframe computers in 1965.)

If it doesn’t feel now like we are entering another “Golden Age” it is because we are still experiencing the after-shocks of the previous phase of financial frenzy and economic collapse and its consequences: high inequality and populism. Perez argues that the successful countries of the next decades will be those that have governments that understand the moment and can actively promote the diffusion of ICT technologies to achieve broad societal goals (e.g. “green” technologies).

Technology Cycles and Emerging Markets

Looking back at history, one can see how this process has played out before for developing countries. We will focus on the last three technology cycles: The age of steel and mass engineering, the age of oil and mass production and the current ICT revolution.

The age of steel and mass engineering (1875-1908): This was the age of the wide diffusion of the steam engine and steel through mass engineering to provide the infrastructure for the first wave of trade globalization. The rise of Japan (the first of the Asian Tigers) occurred over this period as it methodically diffused all of the technologies developed in the West.  Latin America experienced its own “Belle Epoque,” as steamships and railroads made its commodities competitive in global markets. During this time, Argentina and Brazil were considered at the level of development of most European countries and attracted millions of European immigrants.

The age of oil and mass production (1908-1971) – Interrupted by two devasting world wars and marked by profound socio-political change, this age still generated wide-spread prosperity, though China, India and Eastern Europe did not participate. Initiated by the launch of Henry Ford’s Model T automobile in 1908, it saw the diffusion of the internal combustion engine, electrification, and chemicals under the structure of the modern corporation. Following the Second World War, broad diffusion of these technologies led to a “Golden Age” of capitalism throughout the Western World. This was also a period  of “miraculous” growth throughout Latin America as the wide diffusion of the mass production process, supported by import substitution policies and foreign multinationals, created abundant quality jobs in manufacturing and the rise of the middle class consumer.

The  Information and Communication Technologies  (ICT) Revolution (1971-today): All phases of technological revolutions overlap with their predecessor and follower as the diffusion process plays out. In the case of the ICT revolution the overlap has been particularly important and has created unexpected winners and losers. China’s economic reforms (1982) and the fall of the Berlin Wall (1989) had the effect of radically expanding the length and scope of the Mass Production Age at a time when the “creative destruction” of the ICT Age should have been undermining it. Instead of increasing productivity German corporations moved mass production to Eastern Europe and American corporations outsourced to China, to exploit cheap labor. Companies also were able to avoid expensive environmental costs by offshoring carbon-intensive, heavily polluting industries to China and the Middle East, delaying the diffusion of “green” technologies for decades. The Mass Production Age, with its high environmental costs, was extended to the enormous benefit of China and a few countries in Eastern Europe, at the expense of workers in Europe and America who were pushed into low-productivity service jobs, and the “Golden Age” of the ICT revolution has been delayed. ( U.S. productivity and growth have declined and inequality has risen sharply while Amazon makes it ever easier to buy Chinese-made goods.)

The slow diffusion of the ICT age and the extension of the mass production age has had very uneven consequences for emerging market countries. The winners of the ICT age have been those countries that were late comers to the mass production paradigm and understood that the ICT revolution would lead to massive reductions in communication and transport costs and a new wave of globalization. The Asian Tigers (Korea, Taiwan, China, Vietnam) and to a lesser degree Eastern European countries (Poland, Czech, Hungary) have been the champions by integrating themselves in global mass production value chains and assiduously working to add value. South-East Asian countries (Indonesia, Thailand, Malaysia) initially did well but increasingly find themselves sandwiched between newcomers like Vietnam and Bangladesh, which are competitive in low value-added products, and China for higher value-added products. Both India and the Philippines almost completely missed out on the mass production age revival but have made small niches for themselves in the ICT world with Business Process Outsourcing (BPO) and IT Services Outsourcing.

The big loser of the ICT age has been Latin America, which has undergone severe deindustrialization and has become mired in the middle-income trap. Mexico has suffered the greatest frustration. This country, led by its brilliant technocrats, did everything right to position itself for the mass production to ICT transition, entering into the groundbreaking NAFTA trade agreement with the U.S. and Canada. The thinking behind NAFTA was brilliant. It would facilitate a smooth transition out of mass production to ICT for U.S. firms while extending the benefits of the mass production age to a friendly neighbor operating under controlled conditions (labor, local content, subsidies, environmental, etc…). Unfortunately for Mexico, the dramatic rise of China as the factory of the world undermined all of these objectives, as China successfully dominated global value supply chains without having to meet any of the conditions Mexico had to comply with.

South America has not fared better. As high-cost producers with very volatile currencies and economies, these countries were unprepared to compete with China. These disadvantages were compounded by (1) the false hope created by the commodity boom  (2002-2012) which resulted in a typical boom-to-bust cycle and a vicious case of Dutch Disease (natural resource curse) that these countries have yet to recover from and (2) the adoption of “Washington Consensus” financial opening dogma (free movement of capital) which increased volatile flows of hot money and destabilized currencies.

The following chart shows economic convergence since 1980 (in terms of USD GDP/Capita) for a sample of developed and emerging market countries, which is illustrative of the winners and losers of the ICT Revolution.

The Golden Age of ICT

If Perez is correct and we are on the verge of a Golden Age of  extensive diffusion of ICT technologies through all segments and geographies what should countries be doing?

Perez and Raphael Kablinsky in his recent book, Sustainable Futures, An Agenda for Action, argue for activist government using its resources to incentivize private investment to achieve desirable societal goals (e.g., environmental sustainability, equal opportunity). The Biden Administration’s recent Inflation Reduction Act (IRA) and the Chips and Science Act are both in that spirit, aiming to promote investment in clean energy and energy efficiency and the re-shoring of  semiconductor production away from the Asian mass production value chain. These initiatives, as well as President Xi’s Made in China 2025 Plan, all assume that the great Mass Production Age extension through China-centric global value chains has run its course, and that ICT diffusion will now result in, without excess short-term costs, a return to more local/regional manufacturing and a more autarkic or segmented global trade system. Through massive state subsidies China already has taken a commanding lead in the production of “green” products such as electric vehicles and batteries and solar panels.

The return of activist government, coming after a 40-year period of neo-liberalism and government retrenchment, raises the question of what policies countries should pursue to fully reap the benefits of this final phase of the ICT Revolution.

Perez recommends two basic courses of action that many emerging economies and developing countries can pursue. First, governments should be active in promoting ICT diffusion in industries where competitive advantages are evident. For example, commodity rich countries like Brazil, Argentina and Chile can increase productivity by being at the forefront of ICT innovations applicable to farming and mining and, at the same time, aggressively move up value chains for these products. (Brazil, with its low carbon-dependent economy and enormous potential in solar, wind and biofuel energies, is well positioned to become a global leader in “green” farming and mining).  Second, Perez sees large opportunities for countries or regional groups to capitalize on climate change initiatives by deploying alternative energy sources and capturing their value chains through localized production. (Once again, Brazil with its large local market opportunity can achieve leadership).

The consulting firm McKinsey provides a roadmap for the future in a recent article, “Accelerating Toward Net-Zero; The Green Business-Building Opportunity” (Link). The following chart from McKinsey maps out the sectors expected to have the largest economic importance in a “greening” economy and, consequently, where governments and firms are advised to focus their efforts.

Another Emerging Markets Debt Crisis?

After ten years of extraordinary accommodative monetary policy, marked by a 2020 peak of $19 trillion in negative yielding debt, it is understandable that debt levels have grown to record high levels. Markets have been complacent about this accumulation of debt because of low servicing costs and persistent deflationary trends. However, recent developments that point to resurging inflation are now forcing central banks to seriously consider restrictive monetary policies, including positive real rates, that would lead to much higher servicing costs for highly leveraged governments, households and corporations. This is worrisome for emerging markets which do not tend to fare well during tightening cycles occurring after long periods of debt accumulation.

As the following chart from the Financial Times shows, developing countries debt levels are at record levels and have grown precipitously since the Great Financial Crisis. The total debt to GDP ratio for developing markets has more than doubled since the GFC.

 

The following chart shows the evolution since the GFC in more detail for EM countries. Debt  to GDP ratios  have nearly doubled for total debt as well as for government, household and corporate debt. These ratios would be even worse if not for the extraordinary policies of financial repression and negative real interest rates pursued in 2021, as central banks allowed inflation to surge.

 

Debt levels of many key EM countries, shown in the chart below, are now at levels which leave them highly vulnerable to economic stagnation and financial crisis. Asian EM countries (with the exception of Indonesia) and Chile and Brazil are all at very high levels in absolute terms and relative to their histories. China (considering SOE debt and overstatement of GDP), India (considering overstatement of GDP),  Brazil and Argentina all have levels of government debt close to 100%, a level which is considered highly debilitating by students of debt dynamics. China, given its capital controls and state-controlled banking system, may have the means to avoid financial disruptions but that is less true for the others, particularly for Latin American countries which have a history of rapid and profound shifts in capital flows and currently face strong capital flight from their own citizens.

 

The pace of increase in debt levels in recent years is also cause for concern. The chart below shows the increase in debt to GDP ratios over the past five years and during 2021.  Historical precedents point to countries facing high risk of debt-related crisis following a surge of their debt to GDP ratio  of 20% or more over a 5-year period. Last year was a year of acute financial repression by most central banks, so it is no surprise that debt levels came down for most countries. We can see the positive impact that this had for Brazil, in the next chart which shows how interest rates lagged inflation. Unfortunately, as the Scotiabank chart projection below shows, this effect will reverse in 2023, leading to high real rates.

Below, we focus on several key EM countries, each with its own vulnerabilities.

China

Debt levels have more than doubled since the GFC. If we assume that GDP figures need to be adjusted downwards by 20-25% to make them comparable to other countries, then debt ratios could be approaching 350%. Government debt has more than doubled over this period, and if we consider that almost all corporate debt is held by SOEs, then government debt would be well above 100%. The issue in China is not government solvency as the state has all the tools to keep the financial system operating smoothly. Rather, the vulnerability is that very high debt levels are choking the economy, and that the economy relies on unproductive debt-fueled growth to sustain growth. The consequence is that future growth levels can be expected to be low.

Brazil

Brazil’s debt levels are much too high for the economy to function properly and condemn the economy to low growth unless a serious fiscal reform or a productivity miracle occurs. Brazilian debt levels are at record high levels and they have risen by 60%  since the GFC, a period during which growth and investments have been very poor. The government debt ratio has risen by 50%, to finance current spending, while corporate debt  has risen by 70% and household debt has doubled. Government debt will likely reach 100% over the next year, which is much too high for a country with a structural deficit and which suffers from capital flight and political turmoil. Unlike in China, Brazil’s banks are private and managed very conservatively.

Korea

Kore’s debt ratio has risen by 50% since the GFC and is now one of the highest in the world. The government debt ratio has doubled over this period but remains at reasonable levels, and corporate debt has risen by 30%. Household debt has risen by 50% to 107% of GDP, an exceptional level, even higher than that of the consumption-happy United States. These very high debt levels would become a significant burden for the economy if interest rates rise, and could be a source of popular unrest with political consequences.

The Fed’s decade-long experiment in free money now may be at its end, leaving behind mountains of debt everywhere. Already weakened by the pandemic, political tensions and slowing growth, many emerging markets will add higher interest bills to their woes.

Global Growth Prospects

The World Bank has significantly reduced its growth outlook for 2022 and is  concerned that we may be facing “global stagflation.”  The World Bank’s “Global Economic Prospects June 2022″ report   highlights  the vulnerability of lower income economies in the current environment of lower growth and rising food and energy prices. Nevertheless, the bank  retains a relatively sanguine view, as it sees a persistently vibrant U.S. economy and declining commodity prices in both 2023 and 2024.

The chart below resumes the World Bank’s latest real GDP forecasts for emerging market economies  and several  important frontier markets (Nigeria, Pakistan, Bangladesh and Vietnam.) The bank’s forecast provides growth estimates through 2024. The chart ranks countries in terms of their 3-year average real GDP growth for the 2022-2024 period. The two columns on the right show the changes since the bank’s prior forecast six months ago which was made prior to the Ukraine invasion and the COVID lockdowns in China. Given its mandate, the bank tends to be “politically correct” in its forecasts. Historically, this has resulted in the bank usually accepting China’s official targets, and in this case it may explain the optimistic forecast for the U.S.  The relatively low economic cost to Russia  for the invasion of Ukraine (well below most other estimates) is difficult to explain.

As we have come to expect, most of the world’s growth will come from Asia where the bank expects stellar GDP growth in India, Bangladesh, Vietnam, the Philippines and Indonesia. This kind of growth is probably not priced in for the stock markets of Indonesia and the Philippines.  Egypt’s high expected growth is also surprising good news for this normally struggling economy and should be supportive of  higher asset prices. Though Malaysia’s expected growth is not as stellar, stock prices there are very low and also provide good prospects.

Also, in what has become the  “new normal,” growth prospects in Latin America and South Africa are dismal. Chile and Brazil are at the bottom of the chart, and would be last if not for the dramatic woes inflicted by Putin on Russia. In the case of both Chile and Brazil these GDP forecasts are likely optimistic if Chile’s new constitution is approved as currently expected and if Lula wins the election in Brazil as is also the most likely scenario. The one  Latin American exception — Colombia — is a big if, as the World Bank’s forecast is certainly wildly optimistic should the former guerilla fighter Gustavo Petro win the election on June 19. As in the case of Chile, Colombia faces capital flight and low investments for the foreseeable future.

Can China Avoid the Middle-Income Trap?

Over the past 60 years few countries have grown their economies at a faster rate than the United States and improved their citizens’ incomes relative to those of Americans. This process of convergence has happened almost exclusively in the poorer countries of Europe. In developing economies, we can count the success stories on one hand (Singapore, Hong Kong, Taiwan and Korea). In recent decades China has experienced extraordinary growth, which raises the question of whether it can join the club of rich countries.

Undoubtedly, the rise of China’s economy over the past 40 years has been miraculous.  China’s GDP per capita increased from $200 in 1980 to $10,500 in 2020, taking it from 10% to 160% of Brazil’s level or from 1.5% to 16% of the U.S. level.

However, China’s ability to sustain high levels of growth in the future is far from certain. The history of the global economy in the post W.W. II period shows that growth for the majority of developing countries falters after reaching middle income status ($10,000-$12,000 PC income). Once countries  reach this level they tend to have exhausted the easy gains from rural migration, basic industrialization and urbanization. Sustaining growth then requires an institutional framework that promotes social inclusion, efficient markets and innovation. Countries like Brazil and Mexico utterly failed in developing these institutions and they have become emblematic of  the “middle-income trap.”

The chart below shows the elite group of “convergers” over this long period. The list can be separated into three distinct groups: 1. Beneficiaries of European economic integration (which, starting in the 1980s, will also include Eastern European former Soviet Block economies); 2. Beneficiaries of special economic ties with rich countries (Hong Kong, Bermuda, Puerto Rico, St. Kitts); 3. Countries of special geo-political importance to the United States (Taiwan, Korea, Israel). If we take out European countries and territories closely dependent on rich countries, we can further focus on the exceptionality of the few countries that have succeeded: Hong Kong, Singapore, Korea, Taiwan and Oman.

  • Hong Kong and Singapore are small islands that prospered as reliable trading and service hubs for the expansion of global commerce.
  • Korea and Taiwan were of major geopolitical importance to the United States, received considerable financial support and were allowed to engage in mercantilist policies that may not be available for other developing countries.
  • Israel benefited from waves of highly educated immigrants, abundant foreign investment and generous U.S. geopolitical and financial support.
  • Oman started from a very low level and made important oil discoveries in the 1960s. It has been a important strategic ally of the United States in the Middle-East.

 

 

None of these special conditions apply to China. Though the U.S. was initially supportive of China’s growth (1970-2016), it now considers China to be a key economic competitor and a major geopolitical rival. Therefore, the U.S. cannot be expected to give China the slack that was awarded to Taiwan and Korea in the past (as well as to Japan and probably to India in the future).

China’s leaders are fully aware of the challenges ahead and the importance of reforms. They have consistently expressed concerns about the imbalances of the economic model and the sustainability of growth.  As early as 2007,  premier Wen Jiabao argued  that “the biggest problem with China’s economy is that the growth is unstable, unbalanced, uncoordinated and unsustainable.”  Shortly after taking the helm in 2013,  President Xi Jinping warned that China faced a “blind alley without deepening reform and opening to the world.”

In the early days of the Xi Administration in 2013 two important government policy statements outlined the strategic path required for China to avoid the “blind alley.” In his comments at the Third Plenum of the Party Central Committee in November 2013, President Xi proposed reforms to increase the role of markets and the capacity for state regulatory oversight. Xi’s comments were in line with the report issued earlier by the World Bank and the Development Research Centre of China’s State Council titled China 2030: Building a Modern Harmonious and Creative Society which highlighted the need for more reliance on markets and free enterprise and openness to world markets and scientific research.

However, since 2013 the Xi Administration has veered off the planned reform path. Perhaps, powerful political and economic groups with vested interests have resisted the changes; or it may be that the reforms were not considered timely or politically expedient.  At the same time, an increasingly acrimonious relationship with the United States marked by tariffs and severe sanctions on technology transfers altered the Xi Administration’s view on “opening to the world.”

The recent messaging from the Xi Administration is autarkic. China is said to face a “protracted struggle” with America and cadres are encouraged to “discard wishful thinking, be willing to fight, and refuse to give way.” President Xi now touts a “new development concept” based on self-reliance aimed at securing domestic control over the key technologies of the future and their supply chains.

The hope is that China can avoid the pitfalls faced by almost all developing countries that have pursued “import substitution” strategies.  This may be the case because of China’s particular characteristics: A high degree of internal competition; enormous  economies of scale provided by 1.4 billion consumers; world-class manufacturing capacity achieved as the “factory of the world” ; and a heavy tradition of investment in research and development. Moreover, China has considerable experience with the East-Asia “Tiger” model in corralling investments into priority areas through credit and fiscal subsidies and control over banks and resourceful state firms.

In any case, the “new development concept” implies expanded state control over investments and markets. The Xi Administration’s policy about-face was recently acknowledged by Katherine Tai, the Biden Administration’s top trade official: “China has doubled down on its state-centric model…It is increasingly clear that China’s plans do not include meaningful reforms.”

The main risk for China is that autarkic ambitions, particularly those relating to complex efforts to replicate frontier technologies, will prove prohibitively costly and divert resources away from more basic priorities such as bridging the enormous wealth gap between rich coastal provinces and the rural interior provinces.

The Wikipedia chart below shows the discrepancy in wealth between China’s prosperous coastal provinces and Beijing and the rest of the country. Stripping out the rich provinces,  GDP per capital falls to around $8,400, a level similar to Mexico.

 

This divide is illustrated by the contrast between the high educational standards in provinces like Shanghai, which ranks at the top of the OECD’s PISA (Program for International Student Assessment),  and the generally low schooling of most of the population. For example, as shown in the OECD data below, China’s overall educational achievement, as measured by the percentage of the population which does not complete High School, is very low, near Indian levels and worse than Mexico. The difference between China and recent convergers like Poland and Korea (at the far right of the table below) is telling.

The extreme divide between the rich and educated and the masses of uneducated poor has proven to be a critical growth barrier for developing countries and a root of the middle-income trap in Latin America. In the mid-1970s both Brazil and Mexico (the “next Taiwan”) were considered “miracle” economies on the verge of high-income status. Both countries had enjoyed high growth since the early 1960s, relying heavily on import-substitution strategies, and reached per capita incomes near 20% of the U.S. level (China’s PC GDP has gone from 1.6% of the U.S. level in 1980 to 16% today). Unfortunately, since then both Brazil and Mexico have lost ground, now standing at 11% and 13% of U.S. GDP per capita.

One of the fundamental reasons for the failures of Brazil and Mexico (Turkey, South Africa and others as well) is the inability to incorporate the bulk of the population into the formal economy, either as productive labor or as sources of demand. This situation is encapsulated in the description of Brazil as a “Belindia”:  a combination of Belgium (some 10-20% of the population working and living the lifestyle of rich Europeans), and India (the remainder having more in common with poor Indians.) Of course, this situation leads to low productivity, social and political tension and a large underground economy where crime prevails. None of this was intentional, but it happened because of political choices dictated by powerful vested interest groups seeking to protect their benefits and economic rents.

To avoid this path China should do all it takes to incorporate its 950 million low-income citizens into the economy as productive workers and new consumers. Though these policies may not be popular with elites, they are  the key for assuring sustained growth in the future.

Emerging Markets are Loaded with Debt So Pick Your Countries Carefully

The world is awash in debt. Much of this debt has been accumulated over the past 20 years, and has served to support consumption, government spending and financial markets during a period of declining productivity and slowing economic growth.  Unfortunately,  because this debt was not acquired to increase productive activities, it is not self-sustaining and has become a drag on economic activity.

The chart below shows the steady accumulation of debt in both advanced and emerging market economies. Advanced economies had steady debt accumulation over the past twenty years with peaks around the Great Financial Crisis and the Covid pandemic. Emerging markets saw most of the debt accumulated over the past decade, a period that has had depression like characteristics for most countries and has seen a dramatic decline in the level and quality of China’s economic growth. (All data is from the Bank for International Settlements, BIS Link)

 

The growth in debt in emerging markets has been general. We can see in the following chart that practically all emerging market countries have ramped up debt over the past decade and now find themselves at record levels.

However, not all emerging economies are in the same condition. We can differentiate by both debt levels and rate of accumulation, which is shown in the next two charts.

 

Several countries stand out in having very high debt levels and accelerated accumulation: China, Korea, Chile and Brazil. In none of these countries has the debt been used to increase productive activities. In China, debt mainly supports the real estate bubble and infrastructure investments of marginal utility; in Korea, debt increases have flowed mainly to support consumption. In Chile and Brazil, debt has served to support government current spending and capital flight. Moreover, China, Brazil and Chile face serious economic challenges. Both Brazil and Chile will likely be in recession in 2022, and China’s sustainable growth level is in steep decline.

On the other hand, Indonesia, Mexico, Turkey, Poland Russia and Colombia all have lower debt levels and slower debt accumulation. These economies are coming out of the pandemic in relatively good shape and with the prospect of healthy economic rebounds in 2022-23.

Given a world awash in debt and suffering from low GDP growth, investors should focus on the few countries with good debt profiles and positioned for a rebound.

The Next Commodity Cycle and Emerging Markets

 

The stars may be aligned for a new cycle of rising prices for industrial and agricultural commodities. It has been nine years since the 2002-2011 “supercycle” peaked, and the malinvestment and overcapacity from that period has been largely washed out. Over the past several months, despite economic recession around the world, commodity prices have started to rise in response to supply disruptions and the anticipation of a strong global synchronized recovery in 2021. Moreover, in recent weeks the victory of Joe Biden in the U.S. elections has raised the prospect of a combination of loose monetary policy and robust fiscal policy, with the added benefit that a good part of the fiscal largess will be directed to infrastructure and “green” targets which will increase demand for key commodities. Finally, global demographics are once again becoming supportive of demand.

The chart below shows 25 years of price history for the CRB Raw Industrials Spot Index and the Copper Spot Index. Not surprisingly, these indices follow the same path. Interestingly, they are also closely linked with emerging markets stocks. This is is shown in the second chart. (VEIEX, FTSE EM Index). This is clear evidence of the highly cyclical nature of EM investing, and it is the explanation for why EM stocks outperform mainly when global growth is strong,  commodity prices are rising and the USD is declining.

Since the early 2000s, China has been the force driving global growth and the cyclical dynamic. Since that time China has been responsible for generating most of the incremental demand for commodities. Starting in 1994, China embarked on a twenty-year stretch of very high and stable GDP growth which took its GDP per capita from $746 to $7,784. In 1994, China’s GDP/capita was in line with Sudan and only 15% of Brazil’s. By 1994, China’s GDP/capita reached 65% of Brazil’s. By 2018, China had surpassed Brazil.

By the turn of the century, China’s coastal regions which dominate economic activity had already reached the transformation point when consumption and demand for infrastructure and housing result in a surge of demand for commodities. This transformation point typically occurs  around when GDP/capita surpasses $2,000, which happened for Brazil in 1968 and in Korea in 1973. In 2005 China’s overall GDP/capita reached $2,000 and the commodity super-cycle was well under way. (All GDP/capita figures cited are from the World Bank database and based on 2015 constant dollars.)

Moreover, China was not the only significant country to enter this commodity-intensive phase of growth during the 2000s. The chart below shows the list of new entrants to the $2,000/capita club since the late 1960s. During the 2000s, three large EM countries, Indonesia, the Philippines and Egypt,  also broke the barrier. These three countries added fuel to the commodity boom created by China’s hyper-growth and infrastructure buildout, generating the commodity “supercycle.”

The historical link between rising commodity prices, a falling dollar and the incorporation of large amounts of new consumers into the world economy can be seen in the following three charts which cover the 1970-2020 period.. The first chart shows the rolling three-year average of the total annual increase in the population of global citizens with an annual income above $2,000. The second chart shows the  increase in commodity prices relative to the S&P 500; and the third chart shows the evolution of the nominal effective U.S. dollar. The connection between the three charts is clear: every period of rapid growth in new developing world consumers coincides with both rising commodity prices and a weaker USD. Not surprisingly, every bull market in EM stocks (1969-1975, 1987-92, 2002-2010) also follows this pattern.

 

The bull case for emerging markets investors today is that we are on the verge of entering a new cycle as five more countries pass the $2,000/capita barrier.  Already this year, Kenya and Ghana will reach this level. These two countries in themselves are not that significant but they point to the importance of Africa for the future. Then in 2021 India (pop. 1.4 billion) reaches the benchmark, followed by Bangladesh (pop. 170 million) in 2022. The following chart shows the evolution of the total global population with per capita GDP above $2,000 and the annual increases for the past 50 years and the next five years. The potential significance of India and Bangladesh are clear.

India will likely have an  impact on a different set of commodities  than China had. India is unlikely to achieve the pace of infrastructure growth that China had, and has significant iron ore resources. This means the impact on iron ore and other building materials will not be as great. On the other hand, India imports most of its oil and will have an increasing impact on the oil markets. India also faces great urgency to electrify the country and to do this with clean energy. This points to growing demand for copper , cobalt and silver, three markets that already appear to be undersupplied in coming years.

The Yuan’s Run has Legs

It has been an interesting year in global currency markets. Early in the year, the U.S. dollars spiked, as the combination of the pandemic and fears of discord within the European Union triggered a trade to “safe haven” assets. However, since May, following a friendly resolution of tensions in the EU, the euro rallied strongly, taking with it the DXY index, which is the market bell-whether for the relative value of the USD. The significant weakening of the dollar against the euro, and to a lesser degree against the Japanese yen, has raised hopes for international investors that the strong-dollar cycle started in 2011 may have ended, which would be supportive of better performance for non-U.S. assets. The chart below shows the DXY’s evolution for the past twenty years: a sharp downcycle for the dollar from 2001 to 2011, followed by a persistent dollar upcycle from 2011 to this year until the recent sharp correction.

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Unfortunately for EM investors, when looked at on a broader basis the USD is not as weak as it is against the euro-heavy DXY index. For example, on a trade-weighted basis, as shown below, the dollar has strengthened by 2.1% since the beginning of the year.

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In the case of a currency index based on the country component weights in the MSCI EM equity index, the USD has appreciated by 4.2% this year. The yuan has appreciated by about 1% against the USD over this period, while the rest of EM has experienced currency losses of 6.2%.The evolution of the MSCI EM currency index is shown in the chart below from Yardeni.com. We can see that EM as a whole still appears to be in a downtrend relative to the dollar, and both the EMEA and Latin American regions have currencies which are persistently weak relative to the USD.

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So, the important question is why is the yuan strengthening at this time and is its rise sustainable? This is what matters to EM investors as China is now 42% of the MSCI index. The answer is in the two charts below. The first chart shows the yuan on the left side and the interest rate differential between China and the U.S. for 2-year government notes on the right side. In a world of negative real rates in both developed and emerging markets, China now has real rates and a growing differential in its favor. The second chart shows China’s trade surplus back at record levels (at a time when both tourism and capital outflows have come down sharply).

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It is logical that a combination of high rates and strengthening trade and current accounts would lead to currency yuan strengthening. Given trade tensions with the U.S. (and the rest of the world) and a clear commitment to boosting consumption and moving up the manufacturing value-added chain, it is likely in Beijing’s interest to let the yuan move higher.

Hamilton, Xi Jinping and Microchips

Alexander Hamilton, the first Secretary of the Treasury of the United States (1789), argued for tariffs and subsidies to promote domestic industry. In a society dominated by farmers and powerful commodity exporters (cotton and tobacco), this was not an easy argument to make. Nevertheless, the case made by Hamilton in his seminal “Report on Manufacturers” had a profound influence on  policy makers for the next century.  Hamilton argued that the case for free trade made by Adam Smith relied on ideal conditions that did not exist in the real world of commerce. He asserted that Britain, which was the main trading partner of the United States, imposed “injurious impediments” on commodity exports from the United States and “bestowed gratuities and remunerations” in support of its own manufacturers. Hamilton argued subsidies were fundamental for “military and essential supplies” of importance to national security. His report to Congress singled out coal, raw wool, sail cloth, cotton manufacturers and glass (windows and bottles) as industries meriting subsidies. He also encouraged support for “infant manufacturers”:  “new inventions…particularly those which relate to machinery.”  In response to criticism of the fiscal burden of these subsidies, Hamilton responded:  “There is no purpose to which public money can be more beneficially applied, than to the acquisition of a new and useful branch of industry; no consideration more valuable, than a permanent addition to the general stock of productive labor.”

The U.S. heeded Hamilton’s recommendations throughout during the 19th century and until W.W. II, sheltering its industry behind a wall of tariffs. The German economist Friedrich List applied Hamilton’s framework to the case of Germany in the 1840s in his book The National System of Political Economy  (1841).  List echoed Hamilton in arguing that Britain’s defense of “laissez faire” economics was a disingenuous stratagem to contain the development of rivals. He promoted the idea of state-fostered industrial planning as necessary for a country to achieve the capability to compete on equal terms with foreign industries. To transition an economy to the more developed stage, List argued, it is imperative that governments (1) develop public infrastructure, (2) provide incentives for savings and for the accumulation of capital and the channeling of capital into productive industries and (3) promote “mental capital” (education and research). List’s ideas, which came to be known as the German Model, were very influential during Bismark’s Germany (1870s) and Japan’s industrialization (1860s) and later for the development models espoused by Taiwan, Korea, and Singapore. In developmental economics, this model is known as the East Asian Model of Capitalism. Since its opening under Deng Xiaoping in the 1980s, China has, by-and-large, followed the course of its East Asian neighbors, with astonishing results.

The success of the East Asian Model of Capitalism  is an anomaly in developmental economics which is not easy to explain. Korea, Taiwan and Singapore are the only countries in the 20th Century that have joined the club of developed industrialized nations, leaving behind other emerging markets which cannot overcome the “Middle-Income Trap” and the  myriad other forces which impede economic convergence (Eastern Europe, with its rapid integration with Western Europe is a different case). Many of the policies pursued by the East Asians have been tried, to one degree or another,  in most developing countries, but have tended to mainly benefit entrenched elites at the expense of the public. For example, Brazil adopted something quite similar to the East Asian Model framework in the late sixties and enjoyed a decade of high growth labeled the Brazilian “Economic Miracle.” However, political and economic instability, malinvestment and corruption have discredited the model in Brazil. In a bizarre evolution, Brazil has now gone to the opposite extreme and is flirting with Chicago School free-marketism. The one fundamental success which Brazil had in terms of promoting a world class company in a frontier industry, the aeronautics concern, Embraer, has lost government support.

One of the main challenges of development that the East Asian model seeks to address is the creation of world class companies in “infant industries.”  Naturally, the targeted sectors change constantly. What Treasury Secretary Hamilton considered to be critical for national security and to ensure industrial development (coal, sail cloth, glass) is now considered mundane. Fifty years ago, every country wanted to dominate the steel and automobiles industries; these are now considered mature and of lesser importance.

In harmony with Hamilton, China has boldly outlined its own list of essential “infant industries” in its “Made in China 2025” initiative. China today finds itself in a position similar to that  the  U.S. faced  relative to Britain in the 19th Century, and  which Germany and Japan faced relative to Britain and the U.S. in the late 19th Century and the first half of the 20th Century. As is to be expected, the dominant commercial power of today (United States) preaches free trade and reacts with outrage to the newcomers use of tariff and subsidies to support “infant manufacturers.”  China, like the U.S., Japan and Germany did before, objects that the U.S.  is  determined to unfairly contain its development. This dynamic between rising states and hegemons is a recurring pattern described as “the Thucydides Trap”  by Harvard’s Graham Allison in his book Destined for War.  Thucydides, an historian of ancient Greece, attributed the cause of the Peloponnesian Wars to Sparta’s inability to accept the rise of Athens as an equal. In his book, Allisson reviews 16 cases of rivalries between rising and established powers over the past 500 years, and he notes that 12 of the cases ended in wars.

Semiconductors are a pillar of “Made in China 2025.” If sail-cloth and coal were considered vital in Hamilton’s time, it is no wonder that semiconductors are the same for China today. Semiconductors are the “new oil” because they are at the core of the modern economy and drive all critical frontier technologies (communications, 5G, quantum computing, artificial intelligence, autonomous vehicles, drones, etc…), many of which have obvious military uses.  No country can aspire to play a leading role in any of these industries without having secure access to state-of-the-art microchips. China imported $350 billion in semiconductors in 2019, almost entirely from the United States, Taiwan and Korea. Furthermore, it relies on U.S. technology for the vast majority of its own semiconductor industry, which is two to three generations behind market leaders.

One of the main fronts of the semiconductor industry wars is currently being  fought in East Asia, so it is interesting to understand the history.

Korea and Taiwan are key global players in semiconductors. Both countries singled out semiconductors in their industrial planning and provided vital government support (logistics, financial, fiscal, R&D). In 1974, following the government designation of electronics as one of six strategic industries,  Korea’s Samsung entered the memory chip industry (integrated circuits) by partnering with Kang Ki-Dong, an electronic engineer with a PHD from Ohio State University, who had worked at Motorola before starting a chip fabrication line in Korea. Samsung faced huge challenges in securing technology and invested heavily to reverse engineer advanced technologies. Defying the odds, by 1993, Samsung Electronics became the largest manufacturer of memory chips in the world. Samsung today is one of the very few fully integrated semiconductor firms, from foundry to design.

Taiwan Semiconductor Manufacturing Company (TSMC) is another outstanding outcome  of the East Asian Model. TSMC is now the world’s most valuable semiconductor firm, with a market value of $240 billion. It was founded by Morris Chang, a native of China who studied electrical engineering as an undergraduate at MIT and as a doctoral students at Stanford University. Chang worked for decades for Texas Instruments, an American company at the forefront of semiconductor technology, and he rose to the ranks of senior management after making important contributions to the company’s success. Chang was eventually lured to Taiwan to head the country’s technology research institute (ITRI). With extensive logistical and financial support and subsidies from the government, Chang started TSMC in 1987.  TSMC has been hugely successful, carving for itself a niche as the dominant independent semiconductor foundry (both Intel and Samsung are fully integrated) and as the primary supplier to independent chip designers. In fact, because of the importance it has for “fab-less” U.S. chip designers, TSMC is a significant geopolitical concern for the United States, given Taiwan’s unique relationship with the mainland.

Neither Samsung Electronics nor TSMC were sure bets. In addition to requiring massive and long-term government support, they faced stiff competition from established players and frequent litigation for patent infringement. They would never have been successful without extensive  access to American  technology and American markets

China’s leading semiconductor firm, SMIC (Semiconductor Manufacturing International Corporation), has an origin story similar to TSMC’s. The company was founded by Richard Chang (no relation to Morris Chang), a native of Taiwan, who also studied electrical engineering in the U.S.  and worked at Texas instruments for over 20 years. Like Morris Chang, he was lured  back to Taiwan by ITRI where he ran a rival to TSMC until the two government-supported firms were merged. Finally, with the support of the Shanghai government and financial investors from the U.S., Taiwan and Singapore, he took on the mission to create a Chinese version of TSMC. SMIC has basically followed TSMC’s non-integrated foundry model, with the objective of providing a domestic alternative for Chinese chip designers.

However, in spite of abundant capital and government support, SMIC has not found it easy to follow in TSMC’s path.  From its start in 2001, SMIC encountered obstacles rooted in the different objectives of its shareholders: financial backers saw a road to quick profits for SMIC in using older generation technology that could easily be secured from the U.S.; government backers wanted the company to invest heavily to climb the technology ladder and promote regional dispersion in collaboration with municipalities. Richard Chang left SMIC in 2009 having failed in reconciling the interests of the different shareholders.

Moreover, from the beginning SMIC has been stalled by restricted access to advanced technologies, always remaining two generations behind the industry leaders. Unlike TSMC, the company was severely handicapped by export restrictions tied to the Wassenaar Arrangement (WA), a multinational pact set up in 1996 to limit dissemination of technology that could have military use.  SMIC also was embroiled in litigation with TSMC and other technology suppliers who were determined to slow its progress.

SMIC’s difficulties highlight some of the particular  barriers that China faces in climbing the technology ladder to compete in strategic industries. Most importantly, unlike Korea and Taiwan, which are important strategic geopolitical allies of the United States, China has been considered to be a rival and a potential threat to Pacific Basin stability. The United States is disposed to promoting the development and prosperity of South Korea and Taiwan to an extent that it will never be for China which is much bigger and a much greater ideological and commercial adversary. Inevitably, as China’s economic clout grows and its diplomacy becomes more assertive, the probability of confrontation with the U.S. becomes more likely.

The arrival on the scene of Xi Jinping as paramount leader in 2012  brought a new sense of nationalism, bravado and urgency to China’s government and contributed to triggering a more confrontational relationship with the U.S.  This became immediately apparent in semiconductor policy with the announcement in 2013 of the  new Guidelines to Promote National Integrated Circuit Industry (National IC Plan) and the establishment of the National Integrated Circuit Investment Fund (National IC Fund). China’s growing dependence on semiconductor imports ($311 billion in 2018) was identified as a serious vulnerability to be addressed through the identification of “national champions,” increased investment in research and the promotion of both inbound and outbound FDI. This was followed in 2015 by the “Made in China 2025” initiative, setting a roadmap for “the main segments of the IC industry . . . to reach advanced international levels” by 2030.

Xi’s ambitions have ruffled feathers in Washington. The Office of the United States Trade Representative (USTR) recently commented: “China’s strategy calls for creating a closed-loop semiconductor manufacturing ecosystem with self-sufficiency at every stage of the manufacturing process—from IC design and manufacturing to packaging and testing, and the production of related materials and equipment.”  According to the U.S. based Semiconductor Industry Association, China threatens to :

“ (1) force the creation of market demand for China’s indigenous semiconductor products; (2) gradually restrict or block market access for foreign semiconductor products as competing domestic products emerge; (3) force the transfer of technology; and (4) grow non-market based domestic capacity, thereby disrupting the fabric of the global semiconductor value chain.”

As the China-U.S. relationship has spiraled downwards during the Trump Administration, the U.S. has become  increasingly determined to thwart China’s  “Made in China” initiative.  The U.S has campaigned aggressively against Huawei, China’s leader in both 5G technology and  smartphones, blocking its sales in the U.S. and lobbying for other countries to do the same, and cutting off its access to Google’s software for its smartphones.

The Bureau of Industry and Security (BIS), an agency under the US Department of Commerce, has put Huawei on an Entity List, requiring that any US firm wanting to sell American tech components or software to Huawei obtain a license from the U.S. government. Moreover, the BIS announced that all foreign firms that supply semiconductors to Huawey will also need a license if they in any way rely on U.S technology, which they all do.

The BIS licensing requirement puts China’s technology development at the mercy of America’s increasingly jingoistic politicians. For China’s leaders it confirms their worst fears that the U.S. will stop at nothing to contain Chinese development.

Ironically, the only certain consequence of the U.S.’s war against Chinese technology companies is that it will motivate China to double down on its efforts to reach the technological frontier in the key industries of the future.

Two weeks ago, SMIC announced that it has secured an additional $2.2 from government funds to accelerate investment. SMIC now appears to be the domestic champion in the sector.

The U.S. and China appear to be entering into a “great decoupling” with profound consequences for global trade and the tech sector.

What to Expect for the 2020s in Emerging Markets

A decade seems like a long time but in investing it should be considered a reasonable period for evaluating results. Ten years covers several economic/business cycles and allows both valuation anomalies and secular trends to play out. Moreover, it gives time for the fundamental investor to show skill. Though over the short-term – the months and quarters that the great majority of investors concern themselves with – the stock market is a “voting machine,” over the long-term the market becomes a “weighing machine” which rewards the patience and foresight of the astute investor.

When we look at the evolution of markets over a decade we can clearly see how these big long-term trends play out. The chart below shows the evolution of the top holdings in the MSCI Emerging Markets Index over the past three decades. We can appreciate how constant and dramatic change has been in the twenty years since 1999, and we should recognize that the next decade will be no different.

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The top holdings at the end of each decade reflect the stocks and countries that have been favored by investors and, presumably, bid up to high valuations.

At the end of 1999, countries in favor were Taiwan, Korea, Mexico and Greece, and the hot sectors were telecommunications and utilities.

By year-end 2009, the new craze was for anything commodity related, and Brazil was the new craze. Banks, which benefited from a global liquidity boom also came into favor.

By year-end 2019, telecom/utility stocks and commodities were all deeply out of favor.  The high-flying markets of the previous decade (eg. Brazil) suffered negative total stock market returns for the whole period. The past decade has been all about the rise of China and the internet-e.commerce platforms and the chips and storage (the cloud) required to make it all work.

What will the next ten years bring.  Only one thing is certain: the pace of change and disruption will accelerate. Whether this will benefit the current champions or create new ones is anyone’s guess.

One difference from ten years ago is that emerging markets are not expensive. Unlike in 1999, the market leaders don’t seem to be at unsustainable valuations. On the other hand, there a few markets that sport very low valuations. These are mainly either commodity producers (Colombia, Chile, Brazil, Russia) or markets that have been through tough economic/political cycles (Argentina, Turkey, India).

Good luck to all!

Explanations for the Middle-Income Trap in Emerging Markets

Only a few middle-income countries have been able to graduate to high-income status, a phenomenon which has been labeled the “middle-income trap.”  We discussed the data on economic convergence in a previous post (link) and now look at the possible explanations for the “middle-income trap.”

The literature on economic convergence and the “middle-income trap” is extensive, as this is a contentious debate in developmental economics. Most economists agree that many middle-income countries find themselves caught between low-wage poor countries that are competitive in mature industries and high-income rich countries that dominate the technologies that drive frontier industries. There is also agreement that for middle-income countries to continue to converge they need to improve institutions, governance and human capital. Moreover, it is widely accepted  that savings-poor middle- income countries suffer from frequent economic slowdowns caused by  unstable cross-border financial flows.  Beyond this consensus, the debate broadly separates commentators into two camps with different policy recommendations:

  • The institutionalists argue that countries are held back by weak institutions, which include rule of law, governance, public sector focus and efficiency, and transparency (democracy and press freedom). The problem for middle-income countries is that the reforms that are necessary to improve the institutional framework may be strongly opposed by entrenched interest groups. The quality of the institutional framework can be described in terms of whether institutions are “extractive” of “inclusive.” (Acemoglu and Robinson, Why Nations Fail). “Extractive” institutions empower the few at the expense of the public good, and the favored elites resist reforms with tooth and nail. Brazil and Argentina are countries which have stalled because of poor institutions that are structured to benefit narrow interest groups.
  • The Structuralists argue that the key issue that middle-income countries face is the development of innovation capacity. Those middle-income countries that import all their technology or rely on multinational corporations eventually hit a wall (e.g.  Malaysia and Mexico). The question is how does a country promote innovation?  The institutionalists focus on guaranteeing strong intellectual property protection. The structuralist’s  disagree and argue that strong and dirigiste governments are necessary to implement  an industrial policy with incentives/subsidies to attract domestic capital and training programs to upgrade the skills of workers. In order for these interventionist policy initiatives to not turn into boondoggles for crony capitalists, companies must face the discipline of both domestic and international competition.  Therefore, the structuralists argue for trade openness and export-driven growth.

On the surface, the arguments of the institutionalist seem more straight-forward and implementable. For this reason, the standard advice of the IMF and World Bank has relied heavily on promoting institutional reforms that improve governance and the delivery of quality public goods (justice, property rights, healthcare, education, infrastructure). Though these reforms are often blocked by entrenched interests, most newly-elected governments spout a ready-made agenda of improving justice, reducing regulation, cutting bureaucratic waste and improving public services. India’s president Modi famously promised at the beginning of his first administration that he would improve the country’s ranking in the World Bank’s “Ease of Doing Business” Index from the high 120s to the 50s, and it appears that he will achieve it.  Brazil, which has made no progress on its “Ease of Doing Business” in 15 years and holds a miserable 124th position, now has a finance minister determined to address this.  However, for those countries with more reasonable rankings (Malaysia,12; Thailand,21; Turkey,33; China, 31) those opportunities are  more limited.

The structuralists argue that improving institutions is necessary but not sufficient, and  only a stop-gap measure for middle-income countries with very poor governance, such as most Latin American countries. Chile is a warning for countries following this simple path: though at one point reaching the 25th position in the “Ease of Doing Business” rankings, it has fallen to 54th  as the domestic consensus for reforms has softened in line with slowing GDP growth and growing social demands.

The nice thing about the arguments made by the structuralists is that they are solidly backed by empirical evidence. In effect, the structuralists look to the “Asian Tiger” model that has worked historically for Japan, Hong Kong, Singapore, Taiwan and Korea, and is now espoused by China and Vietnam.

The Asian Tiger model follows a few simple steps:

  • Harness agricultural surplus and forced savings through financial institutions closely controlled by the government and seen to be at the service of nation-building.
  • Manufacturing supported by state-driven industrial policy and credit.
  • Exports supported by competitive currencies
  • Capital controls to Foreign capital “hot money” flows seen as leading to financial instability

China’s “Made in China 2025” industrial plan to achieve competence in ten key high-tech frontier sectors is straight out of the structuralists game-plan. In fact, China has largely followed the “Asian Tiger” model for the past three decades of its accelerated development.

Unfortunately, the future of the Asian Tiger model is unclear. The worse-kept secret about the success of the Asian Tigers is that, either because they were small (Hong Kong, Singapore) or key American strategic geopolitical allies (Japan, Taiwan, Korea) they were allowed to flout the rules, as Washington looked the other way on intellectual property theft and industrial subsidies. Until recently China was also given some leeway, but those days are gone because Washington now sees China as a key strategic rival. The “Trump Doctrine,” which is likely to remain after he leaves office, is that the U.S. will no longer tolerate interventionist policies, particularly if they affect American companies.

Moreover, structuralist policies have a bad name in many countries where attempts to implement them in the past were undermined by incompetence and corruption. For example, Brazil has a tradition of subsidizing and protecting sectors but it has done this without weeding out the underperformers or demanding export competitiveness. The consequence is that in Brazil and many other countries these policies are deeply associated with crony capitalism. Ibid for “financial institutions at the service of nation building,” In most countries these policies are seen as mainly benefiting politicians and their cronies.

Also, for structuralist policies to function countries need strong governments that can pursue initiatives over the long term and stable economies which facilitate long-term planning by public officials and firms. Unfortunately, these are rare attributes. In Latin America we see the opposite of this, with brusque changes of policies with every incoming government and economies prone to repetitive boom-to-bust cycles.

The Case of Emerging Markets

The table below shows the countries that are considered middle-income on the basis of having per capita incomes between 10% and 50% of the per capita income of the United States. EM countries of significance to investors are highlighted in bold and make up the majority of EM countries of importance to investors.


The low-income EM countries (India, Indonesia, Vietnam, Nigeria) should face fewer challenges to  high relative growth and convergence simply because of demographic dividends and technology leapfrogging.

In terms of EM countries, which ones are likely to be middle-income trapped? A few comments on the main countries in EM.

China

China’s future growth path is debatable, with strong views on both sides. On the one hand, the country is assiduously following the path of the Asian Tigers with a keen focus on innovation and human capital. Also, it still benefits from urbanization and the development of backward geographies. On the other hand, rising tensions with the U.S. are leading to trade and technological decoupling which will be a burden. Moreover, a massive debt build-up to finance increasingly unproductive investments is unsustainable. My guess is that, if a financial crisis can be avoided, China’s growth will stabilize around the 3-4% level, still well above expected U.S. growth of 2%

South-East Asian

Thailand and Malaysia are dependent on export, which is a negative in a de-globalizing world. Moreover, they suffer increased competition from new low-cost producers but have very limited innovation capacity of their own.

Europe, Middle-East and Africa

The Eastern European countries have mostly been strong convergers, and Poland is no exception. They still benefit from relatively low costs and opportunities to integrate with Western Europe and have the human capital to participate in high-tech innovation.

Russia’s situation is different, as is it increasingly isolationist. Bad demographics, weak institutions and an overbearing state sector are additional challenges.

Turkey suffers from political and financial instability, a significant brain drain and weakening transparency (democratic and press freedoms).

South Africa appears to be in prolonged decline, with weakening institutions.

Latin America

The region has poor institutions, and political and economic instability, characterized by frequent policy changes and boom-to-bust economies. Innovation capacity is lacking, with the exception of some tech savvy which should be strongly supported by governments. For Latin America, those countries able to improve institutions and business conditions have some upside. Today, it seems Brazil and Colombia are best positioned for this. Mexico is exceptionally placed to take advantage of the current global trade environment but faces declining governance and institutions.

 

For further reading on convergence and the middle-income trap:

“Convergence Success and the Middle-Income Yrap,”  byJong-Wha Lee, ERBD, April 2018 (ERBD)

“Growth Slowdowns and the Middle-Income Trap,” by Shekk Aariyar ; Romain A Duval ; Damien Puy ; Yiqun Wu ; Longmei Zhang, IMF, March 2013 (Link)

“Middle-Income Traps A Conceptual and Empirical Survey,” by Fernando Gabriel Im and David Rosenblatt, The World Bank, September 2013 (Link)

“Avoiding Middle-Income Growth Traps,” by Pierre-Richard Agénor, Otaviano Canuto, and Michael Jelenic, World Bank, November 2012. (Link)

A Blueprint for a China-U.S. Detente

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

 

Brazil Watch

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)

 

 

 

Domestic Capital is Fleeing Emerging Markets

Plutocratic elites in emerging markets often “hedge” their bets by funneling financial assets out of their home countries into “safe havens” such as Switzerland and the United States. Maintaining bank accounts and second homes offshore and educating their children in foreign schools provides an insurance policy to protect against eventual political and economic turmoil at home.

In recent years this “keeping-one-foot-out-the-door” mentality seems to have spread dramatically since the great financial crisis. Slowing global growth and high risk-aversion have contributed to the strengthening of the U.S. dollar and the rise of dollar-denominated assets. This period has seen the rise of several very large new contributors, namely China, Turkey and Brazil, to the migration of wealth to safe-havens..

Not one of these countries played a big role in flight capital in the past. Rich Brazilians, for example, historically have had a preference for high-yielding domestic bonds and local real estate, unlike their fleet-footed Argentine neighbors who for decades have taken their assets offshore. But today, these countries are the primary drivers of capital migration. If you add the South Africans, who have been systematically moving both their assets and brain-power out of the country for decades, all of the BRICS (Brazil, Russia, India, China and South Africa), the supposed engines of emerging markets, are seeing persistent capital flight. India is possibly an exception, only because wealth creation is still greater than the funds leaving the country.

The anecdotal evidence on this is overwhelming. Chinese buyers are reported to have spent around $200 billion on foreign real estate in 2018 ($32 billion in Australia alone) and are the major drivers of real estate markets in popular destinations such as Sydney and Vancouver. Russian are known to favor Dubai, Cypress and London; and Brazilians love South Florida, Lisbon and New York. Realtor transaction data point to one-third of total real estate transactions in Lisbon and Vancouver being transacted by Brazilians and Chinese buyers, respectively.

Afrasia Bank’s “Global Wealth Migration Review 2019”( Link ) a compilation of data on the transaction flow of wealthy individuals around the world, provides some color on recent trends in capital flight. The report estimates that in 2018 108,000 High Net Worth Individuals (HNWI) with net assets above $1 million emigrated from their home countries, mainly emerging markets.

The map below, prepared by VisualCapitalist.com, graphically shows the origin and destination of migrant flight capital using Afrasia’s data.

More detailed data on the origin and destination of flows is shown below. A few destinations are highly preferred as safe-havens, with Australia, the U.S., Canada, Switzerland and the U.A.E. receiving most migrant flows. In the case of Australia, the inflows are enough to have a material impact on the total stock of HNWI. Though China and India are seeing significant outflows they also continue to generate many new HNWI. That is not the case in Brazil, Russia and Turkey where the outflows are resulting in a net decrease in the HNWI population. The situation is particularly dire in Russia and Turkey where outflows represent a large part of the home HNWI population and have been persistent in recent years. Other countries cited by the report as important sources of HNWI migrants are Venezuela, Nigeria and Egypt. In the case of Venezuela, HNWI’s have practically abandoned the country, resettling mainly in Spain and South Florida.

Though Afrasia’s data may be a good indication of trends, it probably understates the volume of migrants. This can be seen by looking in more detail at one segment: Brazilians in Florida.

The Case of Brazilians in South Florida

Every country’s HNWI migrants have distinct geographical preferences. As mentioned above, Brazilians have a strong affinity for South Florida. Realtor data for the Florida market indicates that the Afrasia Bank report significantly understates flight capital from Brazil.

A report from the National Association of Realtors on international real estate activity in Florida in 2018  (Link)  cites Brazilians as the most active foreign buyers in Florida in 2018. According to the report, Brazilians accounted for 17% of all real estate transaction in Miami-Dade County, equivalent to 2,400 residences for a disbursement of $1.5 billion.

Moreover, Brazilians are active buyers in other Florida markets, specifically Fort Lauderdale, Palm Beach and Orlando. According to the NAR report, Brazilians bought 2,280 homes outside of Miami-Dade County in 2018. This brings the total of Florida homes purchases by Brazilians last year to 4,680. Total disbursements in the Florida market in 2018 are estimated at $2.87 billion.

The chart below shows the persistent rise of Brazilian buyers in Florida since the great financial crisis. Over this period, Brazilian are estimated to have spent between $18-20 billion in Florida for a total of some 38,000 homes.

The chart below shows the strong presence of Brazilians  buyers in Miami and Orlando.

Interestingly, as the chart below shows, Brazilians are paying significantly more for Florida residence than other foreigners. This is probably an indication that purchases are meant to be primary residences and not vacation homes.

Trade Wars

India Watch

China Watch:

  • Chinese investors are inflating foreign real estate (Business Insider)
  • China’s voracious appetite for Russia’stimber (NYT)
  • China is a stock picker’s paradise (WSJ)
  • China’s middle-income consumer (WIC)
  • China’s tourism boom (WIC)
  • China commits to Russian LNG (SCMP)
  • America’s false narrative on China (Project Syndicate)
  • FBI Director Wray on China threat (CFR)
  • For the US to dismiss BRI is a mistake (Politico)
  • Time for a new approach towards Beijing (Der Spiegel)
  • China internet weekly (Seeking alpha)

China Technology

  • China’s food delivery war (Bloomberg)
  • How China took the lead in 5G technology (WP)
  • China’s MIC 2025 plans are roaring ahead (SCMP)
  • China’s EV future (The Econoist)
  • China’s EV bubble (Bloomberg)

Brazil Watch

EM Investor Watch

  • Why do investors keep on coming back to Argentina (FT)
  • Malaysia cuddles up with China (SCMP)
  • Erdogan’s new Turkey (Bloomberg)
  • Turkey will recapitalize state banks (FT)
  • Turkey’s bubble has popped (Forbes)
  • Istanbul’s new airport (The Economist)
  • Turkey’s key role in the Mediteranean gas market (GMFUS)
  • Malaysia restarts China rail project (SCMP)

Tech Watch

  • Investing in Asian Innovation (Oppenheimer)
  • Trends in battery prices (BNEF)
  • Germany is losing the battery war (Spiegel)
  • Does automation in Michigan kill jobs in Mexico? (World Bank)

Investing

 

China’s Temporary Stimulus

China’s stock market is leading the world this year, rising by 22% compared to 16% for U.S. stocks. China’s A-shares market, which represents a broader sample of mainland-listed stocks, is up a whopping 39% since the beginning of the year.  This bullish market has been propped up by confidence in a forthcoming trade deal with the U.S. and optimism that the economy is recovering from a recent lull.  This week’s announcement of  first quarter GDP growth at a sturdy 6.4% and a recent firming of manufacturing output data has provided support for the bulls. Moreover, news of record steel production and a ramp-up in iron ore prices have raised hopes of an old-style stimulus effort based on infrastructure spending which could translate into  a sustained move upwards for  commodities and emerging market stocks. This wishful thinking is most likely misplaced. Chinese policy makers are aware of the declining marginal returns on fixed capital formation investments and the lack of debt-capacity to fund them. Moreover, a return to the debt-fueled investment model of the past would go directly against the clear government policy of transitioning the economy from dependence on gross capital formation to greater reliance  on consumption. Furthermore, the government’s priority is to promote investment in the value-added frontier industries highlighted in its “China 2025” policy, which are considered of much greater strategic importance. So, what is going on and what can we expect for the future?  Most likely, we are seeing now a  coherent and moderate response by policy makers to the economy’s sharper than expected deterioration last year. Beijing was certainly surprised by the effectiveness of Trump’s trade war strategy and the broad support it has received from Europe and business interests. The tension and loss of confidence caused by the trade war came at a time when China’s economy was already feeling the pressure from the  difficult economic transition away from debt-fueled growth. In addition, a significant slowdown in the global economy did not help. In typical bureaucrat-central-planning mode, Beijing immediately responded with stimulus to maintain growth on its preordained path. Both fiscal and monetary measures were introduced throughout 2018 and they appear to have worked their magic. Though policy makers would have probably preferred to apply stimulus to the consumption side of the economy, several factors conspired against this. First, at the beginning of 2018 housing prices were  significantly above trend.  Beijing is very determined to maintain price stability in this crucial sector which represents  the core of private savings and was reluctant to fuel further housing inflation.  Second, the effectiveness of consumer stimulus is difficult to predict, as the consumer may save more instead of spending the boost in income. In any case, the stimulus has largely found its way to fixed asset investment in both infrastructure and real estate development, reverting the recent downward trend. These are areas where the government has great control over decisions and typically an abundance of shovel-ready projects, and they also immediately generate employment. This is shown clearly in the following chart from Gavekal. The chart shows clearly the downward trend in infrastructure and real estate development spending between 2012 and 2018. This has been an intrinsic element in Beijing’s effort to control debt levels and redirect spending towards consumption. In mid-2018 this trend was reverted, and further data points to a strong upsurge under way (shown in the chart below). However, this upsurge in fixed assets investing is most likely of an emergency nature. Once Xi and Trump sign their trade deal and a modicum of normality returns to China-U.S. relations confidence will return. At that time authorities will be able to recalibrate and adjust policies, and it is likely they will seek to return to the previous path of managing the transition to a more consumer and service-driven economy.

Trade Wars

  • After the deal “Cold War II” will continue (SCMP Stephen Roach)
  • The reemergence of a two-bloc world (FT)
  • The deepening U.S. China crisis (Carnegie)

India Watch

China Watch:

  • China’s economic Challenge (Barrons)
  • China’s bad debt problem (marcopolo)
  • Beijing’s new airport (Economist)
  • China’s laid-off optimists in Chongqing (NYT)
  • China’s economy increasingly pulls all of Asia (Nikkei)
  • China’s wig firm takes over Africa (WIC)
  • Does China have feet of clay (Project Syndicate)
  • Martin Wolf on China’s prospects (FT)
  • Chna stimulus is not what it used to be (FT)
  • Japanese firms are leaving China (WIC
  • China’s Gree going fully private (WIC)
  • The privatization of Gree (SCMP)
  • Shanghai consolidates position as global leader (SCMP)
  • Chinese students U.S. visa problems (WIC)
  • The debate on China’s BRI (Carnegie)
  • China’s voracious appetite for Russia’stimber (NYT) 

China Technology

  • The debate on China’s BRI (Carnegie)
  • China’s voracious appetite for Russia’stimber (NYT
  • China internet weekly (Seeking Alpha)
  • China’s food delivery war (Bloomberg)
  • How China took the lead in 5G technology (WP)
  • China’s MIC 2025 plans are roaring ahead (SCMP)
  • China’s EV future (The Econoist)
  • Chinna’s EV bubble (Bloomberg)

Brazil Watch

  • The bear case for Brazil (seeking alpha)
  • Business optimism returns to Brazil (FT)
  • Brazil digital report (McKinsey)
  • Brazil’s finance guru (FT)

EM Investor Watch

  • Erdogan’s new Turkey (Bloomberg)
  • Turkey will recapitalize state banks (FT)
  • Turkey’s bubble has popped (Forbes)
  • Istanbul’s new airport (The Economist)
  • Turkey’s key role in the Mediteranean gas market (GMFUS)
  • Malaysia restarts China rail project (SCMP)
  • Mexico’s back-to-the-past energy policy (NYT)
  • Nigeria’s urban time-bomb (Bloomberg)
  • Indonesia’s Economic slack (FT)
  • The strongmen strike back (Washington Post)

Tech Watch

  • Investing in Asian Innovation (Oppenheimer)
  • Trends in battery prices (BNEF)
  • Germany is losing the battery war (Spiegel)
  • Does automation in Michigan kill jobs in Mexico? (World Bank)

Investing

 

Bond market risk and emerging markets

 One of the most salient concerns with the current state of the the global economy  is the very high level of corporate debt. This past week the OECD, the Dallas Federal Reserve and the Bank for International Settlements all warned that in an eventual economic downturn the solvency of corporate debt issuers  is likely to deteriorate quickly and deepen the contraction. 

The warning is highly relevant for emerging markets investors for two reasons; first, EM corporates have been active particants in the ramp up of debt, eagerly satisfying the chase for yield that lenders have pursued in response to quantitative easing policies; second, EM borrowers can be expected to suffer disproportionately if the lending cycle were to turn sour.

Rob Kaplan of the Dallas Federal Resrve did not mince his words this week (Link) in issuing a stark warning of the risk to the economy caused by the buildup of U.S. Corporate debt. Kaplan is concerned that the current high level of corporate debt will sharply deepen an eventual economic downturn. He points out that a preponderance of recent debt issuance has been used for non-productive and non-self-liquidating activities, mainly dividends, debt buy-backs and M&A activity. In addition, to an unprecedented degree, the debt has been rated BBB (barely one notch above high-yield, “junk”), and has come with more relaxed covenants. This is shown in the following chart two charts. The first shows the cyclical behavior of the corporate debt market and the current very high level relative to GDP, and the second shows the growing preponderance of lower quality issuers.

  Kaplan notes that “in the event of an economic downturn and some credit-quality deterioration, the reduction in bank broker-dealer inventories and market-making capability could mean that credit spreads might widen more significantly, and potentially in a more volatile manner, than they have historically.” As in past recessions, downgrades of BBB-rated debt may flood the relatively illiquid market for high-yield bonds and cause severe dislocations.

Unfortunately for investors in EM debt, the U.S. high-yield bond market and the market for EM debt are extremely correlated. Therefore, any disruption in the U.S. high-yield market will be felt immediately in an accentuated fashion in the EM debt market.

This is the view expressed in the recently published OECD study, “Corporate Bond Markets in a Time of Unconventional Monetary Policy.” The report  describes in ample detail a “prolonged decline in overall  bond quality…and  decrease in covenant  protection” and  predicts that many corporates issuers will suffer a downgrade to “junk” in an eventual economic downturn  and face amplified borrowing costs. The report repeats the concerns expressed by Kaplan with regards to the size and low quality of global corporate debt. In addition, it focuses on the specifics of the EM debt market.

The OECD points to an “extraordinary acceleration of corporate bond issuance in emerging markets,”  from$70 billion/year in 2007 to $711 billion in 2016. This is shown in the chart below.

  The rise in borrowing has been particularly acute in China, but also highly significant across the rest of the emerging markets. Total EM corporate debt reached $2.78 trillion in 2018, up 395% in ten years. 

 The OECD identifies an alarming decline of the overall quality of the global corporate bond market. According to OECD analysis, by historical standards the quality of bonds is exceptionally low for where we are in the economic cycle. This is shown in the chart below.

 The decline in quality is particularly severe for the overall quality of EM bonds, which just barely qualify as investment grade in 2018 after falling into junk status in 2017. The chart  below compares the quality of EM bonds to developed market bonds, according to the rating methodology ued by the OECD.

To make matters worse, the repayment profile for emrging markets is considerably worse than for DM, with 80% of loans due over the next five years.

 Interestingly, even though concerns of a global slowdown are growing, high yield bonds in general are  performing well, displaying very low premiums by historical standards to risk-free bonds. This is partially because of QE (especially in Europe) but also because of desperate efforts to secure yield in a low-return environment. Look, for example, at the chart below of the HYEM, the emerging markets high yield bond ETF, which has rallied strongly since last September.

Conclusion

 Investors in emerging markets should be aware of the considerable risks presented by the bond market. Any significant downturn in the global economy would likely lead to significant downgrades to high yield bonds and a strengthening of the U.S. dollar, and this may cause severe disruption of the high-yield market. The performance of emerging market equity markets, which are highly correlated to the EM high yield market, would suffer accordingly.

Trade Wars  

  • Xi needs a trade deal (FT)
  • Should the U.S. run a trade surplus (Carnegie, Michael Pettis)
  • Why the U.S. debt must continue to rise (Carnegie, Pettis)
  • Turkey and India denied preferential U.S. trading status (FT)
  • China, India and the rise of the civilisation state (FT)
  • When democracy is no longer the only path (WSJ)
  • The tremendous impact of the China-U.S. tech war (Lowy)
  • Huawei hits back at the U.S. (FT)

India Watch

  • Modi’s track record on the economy (The economist)
  • Increasing Indian demand for copper (Gorozen)
  • India’s growing share of oil imports (blog)
  • India turns its back on Silicon Valey (Venture beat)
  • India is right to resist cancerous U.S. tech monopolies (venture beat)
  • 5 more years of Modi? (Lowy)

China Watch:

  • Quality will drive China A- share returns (FT)
  • China breaks world box office record (SCMP)
  • Why China supports North Korea (Lowy)
  • China’s PM frets about the economy (The Economist)
  • China has no choice (Alhambra)
  • China’s economy is bottoming (SCMP)
  • MBS in Beijing (WIC)
  • The story of the world’s biggest building (The Economist)
  • U.S. cars are strugling in China (NYT)
  • China’s tourist have political clout (The Economist)

China Technology

  • Huawei’s big AI ambitions (MIT Tech)
  • China’s EV startup Xpeng (WIC)
  • An interview with fintech Creditease CEO (Mcinsey)

Brazil Watch

EM Investor Watch

  • OECD Report on Global Corporate Debt (OECD)
  • Russia’s global ambitions in perspective (Carnegie)
  • South Africa stagnates as confidence wanes  (Bloomberg)
  • Postcard from Malaysia (Foreign Policy Journal)
  • South Africa slumps (Barrons) South Africa Innovation (FT)
  • Make hay while the sun shines in emerging markets (FT)
  • Globalization in Transition (mckinsey)

Tech Watch

Investing

 

 

 

 

 

Does China have a Debt Problem?

For many years concerns have been raised that imbalances in China’s financial system are a threat to economic stability.

Way back in 2007, Premier Wen Jiabao, asserted  that China’s economy was  “unstable, unbalanced, uncoordinated and unsustainable”. This idea was reiterated by a People’s Bank of China report this week that warned of an “arduous task to prevent and defuse financial risks.”

The sentiment is echoed by prominent U.S. hedge funds that for years have bet that the financial system’s fragility would cause a collapse of the yuan. Prominent China bear, Kyle Bass of Hayman Capital Management, recently repeated his case to CNBC, saying “China is running the largest financial experiment the world has ever seen. And the economic tides have turned negative for them.” Hedge Fund, Crescat Capital, echoed this sentiment last week, opining that”the Chinese banking asset bubble is currently the largest of any country ever with 400% on-balance-sheet banking asset growth relative to GDP in the last decade to $40 trillion.”

At the center of the concerns lies an unprecedented accumulation of total debt.  The chart below from the Bank for International Settlements (BIS) shows that China’s debt as a % of GDP  has more than doubled over the past decade. This is a high level of debt for a developing country like China, putting it at a level in line with many advanced economies. The concern is that the economy has become over-reliant on credit, of which much is mis-allocated to low-return activities. The risk is that at one point the debt could become an impediment to growth, leading to a “Japanification” of the economy, characterized by over-leveraged “zombie” companies.

Much of the criticism revolves around the nature of the Chinese financial system, which, in the tradition of the East-Asia developmental model, is much more driven by official policy goals than by the profit motive. In China the banks are seen as the instrument to channel household savings to the government’s priority activities.

Like Japan, the Chinese financial system is fully anchored in domestic savings, and, therefore not vulnerable to the mood-swings of foreign investors.

But, the Chinese may have additional advantages over Japan. Regulators are powerful and highly credible and have enormous flexibility to fix problems.  Their power and effectiveness is enhanced by the reality that the banks are owned by the state and can  rely on the government for capital injections. This means that bank liabilities – mainly loans to state entities – can be restructured at will.

Also, Beijing has the advantage of being exceptionally asset rich, because of the Communist legacy of state-ownership of productive assets.  The following chart from a recent IMF report, illustrates this clearly. Imagine if the United States government owned 80% of corporate America; concerns over the U.S. national debt would probably not exist. In any case, the Chinese authorities are well aware of market concerns with the high-rate of debt-accumulation and they are trying to manage them. Since the huge stimulus implemented during 2009-10 in the wake of the global financial crisis, China has consistently slowed down credit growth, as shown below in the chart from Goldman Sachs. Monetary authorities have sought to gradually slow credit growth, while at the same time using temporary stimulus to smoothen business cycles.  The following chart, from Macro-ops, shows how monetary authorities have eased on two occasions since 2010 but then returned to the credit- tightening trend. In late-2018, the PBOC initiated a third easing phase which continues to today. In addition to sharply reducing the rate of credit growth, the government has also redirected lending to households. As the BIS data shows in the first chart above, about half of credit growth has been funneled to households, mainly for mortgages. Since 2011, credit to households has risen from nearly zero to 58% of GDP. Credit for residential construction also makes up a large part of new loans. Adding these two items together, we see that a significant part of credit expansion has gone to support residential housing. The chart below shows the strong ties between Total Socal Lending — the Chinese term for total lending — and construction activity. In essence, since the great stimulus period after the GFC the Chinese financial system has become increasingly tied to residential real estate.  This is a natural development of the government’s efforts to transition the economy from dependence on infrastructure and exports to one that is driven by household consumption. While in the past  the  very high savings of the population had been channeled to state companies for nation-building investments, increasingly they are going to households in the form of mortgages and personal loans.

This is not exceptional by international standards. The quirk in the Chinese system, is that residential real estate also serves as a primary destination for long-term investments. This is also the case in many developing countries like Brazil and Turkey, where savers see residential investments as a safe harbor for long-term savings, but it may be going to extremes in China. We see this in reports of 65 million empty apartments.

The enormous amount of savings that the Chinese have in real estate means that the government is very concerned with maintaining consistent appreciation for housing and is careful to manage supply and demand for through financial measures. This can be seen in the chart below from Gavekal, which shows clearly how the monetary policy cycle is adjusted according to the trend of residential real estate prices, the objective being to engineer steady appreciation. It appears that, to a considerable degree, Chinese monetary policy is now aimed at guaranteeing stable returns for China’s owners of real estate. The current dilemma for monetary authorities is that, though the economy needs stimulus, the real estate market does not. In general, housing prices are relatively high at this time and are in no need of stimulus, as we see in the following chart.

However, the Chinese monetary authorities have many tools available. Given the current need for stimulus, the authorities are clearly rechanneling lending to SOE’s for recently announced large infrastructure investments. This means we are likely to see a temporary boost in total lending growth, with a focus on economic stimulus through traditional fixed asset investments, as the authorities try to steer through the current economic malaise.  

Trade Wars  

India Watch

  •  Increasing Indian demand for copper (Gorozen)
  • India’s growing share of oil imports (blog)
  • India turns its back on Silicon Valey (Venture beat)
  • India is right to resist cancerous U.S. tech monopolies (venture beat)
  • 5 more years of Modi? (Lowy)
  • China is leading FDI in India (SCMP)
  • India curbs create chaos for Amazon and Walmart (Bloomberg)

China Watch:

  • China’s economy is bottoming (SCMP)
  • MBS in Beijing (WIC)
  • The story of the world’s biggest building (The Economist)
  • U.S. cars are strugling in China (NYT)
  • China’s tourist have political clout (The Economist)
  • MSCI boosts China A-share weight in EM index (WSJ)
  • Chinese consumers; your country needs you (FT)
  • China’s property market slowdown (WSJ)
  • Cracking China’s asset management business (Institutional Investor)
  • Haier’s turnaround of GE Appliances (Bloomberg)

China Technology

  • China will corner the 5G market (Wired)
  • CTrip’s strategy (Mckinsey)
  • DJI’s rise (SCMP)
  • China’s decade-long Bullet-train revolution (WIC)

Brazil Watch

  • Brazil’s crucial pension reform (Washington Post)
  • Brazil’s finance guru (FT)
  • The rise of evangelicals in Latin America (AQ)

EM Investor Watch

Tech Watch

Investing

Shedding Some Light on China’s GDP Data

China watchers have long debated the reliability of the country’s GDP numbers, and for many years the pessimists have argued that official figures are overstated. This is not a trivial debate anymore because China has become a major driver of global growth over the past decade, on par with the United States. Recent signs of slowing growth in China, blamed on trade wars and declining consumer confidence, have only heightened the debate.

The first thing to understand  about China’s GDP is that the concept of GDP targeting in China is very different from what investors are familiar with,  and this leads to confusion. One insightful  China watcher, Michael Pettis, who is  professor at Peking University’s Guanhua School of management, makes this argument in a recent article (What is GDP in China?). Pettis reminds us that the Chinese, with their deep tradition of economic planning, think of GDP as a pre-determined input figure not as a variable output. It is not a coincidence, therefore, that magically year after year the Chinese meet their GDP growth goal. Part of the reason for this may be some window-dressing for political reasons but much of it comes from active intervention. For instance, if the economy appears to be running below expectation, the authorities will respond quickly with increased spending and lending to set it back on target.

Unlike the U.S. Fed, which has only the blunt tool of monetary policy to achieve its pretentions of smoothing out the economic cycle (eg. Ben Bernanke’s “Great Moderation”), the Chinese authorities have an expanded toolkit of monetary policy, bank lending and fiscal spending which they have immediate access to.

Of course, achieving such fine tuning is easier said than done. The pessimists on China will argue that the Chinese authorities have exhausted the utility of these tools.  This may be because of a combination of excess debt and declining returns on fixed capital investments in real estate and infrastructure, and also because saturated foreign markets have become a much more volatile driver of growth. This state of affairs increasingly has raised the issue of the “quality” of China’s GDP growth. If the GDP numbers are being achieved by increasing debt that won’t be repaid – either for domestic investments or for ports in Pakistan – and the end-result is more empty real estate and under-used bullet trains, than the effort is counterproductive. The Chinese have long been aware of the unbalanced nature and the limits of their debt-driven fixed-asset investment model, but it is not easy to change behavior. China’s vice president, Wang Qishan, reiterated the government commitment to its GDP growth target this week in Davos. Wang pledged,   “There will be a lot of uncertainties in 2019, but something that is certain is that China’s economy, China’s growth, will continue and will be sustainable.” In other words, the authorities commit a-la-Draghi to do “whatever it takes” to meet the 6.5% annual growth target.

Nevertheless, foreign observers are always skeptical of China’s growth figures and seek alternative yardsticks to corroborate the official data. For example, electricity consumption is looked at in comparison to GDP growth. The recent numbers forelectricity consumption, shown below, at least have the merit of displaying year-to-year variability.

Along this line,  Barclay’s bank looks at a series of alternative indicators to provide a comparison to official figures. Based on this exercise, Barclay estimates that China’s economy has been performing well below targets for the past five years.

 A new paper by Yingya Hu and Jiaxiong Yao  of John Hopkins University  (“Illuminating China’s GDP Growth) uses a very innovative methodology and arrives at the same conclusion. Hu and Yao analyse  satellite-reported nighttime light over time to measure changes in economic activity. As shown below, they estimate that China’s GDP may be some 20% overstated. The authors have done this for a wide variety of markets and find the data in China to be one of the most overstated. As shown below, India is also slightly overstated while both Brazil and South Africa are actually understated. 

It is not clear what is causing this discrepancy in China. One theory is that a significant part of the real-estate stock remains dark, as properties are being bought for investment purposes and not occupied.

In any case, these theories of overstated GDP growth raise several worrisome questions. First, this may be evidence that the authorities may be pursuing unproductive policies as marginal returns from debt accumulation and fixed asset investments have declined.  Second, the country’s very high credit/GDP ratio of 300% may be significantly understated, and could be closer to 360%.

Trade Wars

India Watch

  • Amazon adapts to India (WSJ)
  • India’s love of mobile video (WSJ)
  • India’s potential in passive investing (S&P)
  • India’s food-delivery startup, Swiggy, backed by Tencent (SCMP)
  • Modi’s election troubles (WSJ)

China Watch:

  • What next for China’s development model (Project Syndicate)
  • An entrepreneur’s tale of adaptation (NYT)
  • China boosts new airport spending (Caixing)
  • An analysis of nightlight points to overstated Chinese GDP (JHU)
  • China’s slowdown (CFE)
  • China’s GDP (Carnegie Pettis)
  • Zero growth in car sales expected for 2019 (Caixing)
  • Looking back on 40 years (Ray Dalio)
  • China steps up bullet train spending (scmp
  • On sector investing in China (Globalx)
  • The Future Might Not Belong to China (FT)
  • Will China reject capitalism (SCMP
  • The rise of China’s steel industry (WSJ)

China Technology Watch

Brazil Watch

  • John Bolton’s Troika of Tyranny (The Hill)
  • The rise of evangelicals in Latin America (AQ)

EM Investor Watch

  • Indonesia’s economic populism (The Economist)
  • EM’s Corporate debt bomb (FT)
  • Holding’s digital transformation (Mckinsey)
  • Lowy Institute Asia Power Index (Lowy
  • In pursuit of prosperity (Mckinsey)
  • What drives the Russian state? (Carnegie)
  • Russia’s big infrastructure bet (WSJ)

Tech Watch

Investing