[The Boeckh Investment Newsletter Vol. 2.6]
Is this the emerging markets (EM) century? Will China rule the world? Are debt ridden Western economies with broken growth drivers and rapidly ageing societies on an irreversible path towards stagnation and decline?
These penetrating issues are too weighty for the cut and thrust of an Asset Allocation committee’s regular investment meeting. But in the volatile and unpredictable post-crisis world—witness the eruption of U.S. trade law proposals, currency wars, U.S.-China political tensions, inward capital controls—they are the nuts and bolts of how the global economy and asset markets are going to behave in the next few years.I argue below that the consensus view about the future of emerging markets isn’t as robust as it believes, and investors need to be especially careful.
Looks Simple Enough
If you buy into the view that EM are the future, and that the biggest will shed their ‘emerging’ status in the next 10-15 years, asset allocation should be a no-brainer. The historical returns on EM equities are compelling, rising by over 12% per annum over the last 5 years, and half as much again in the case of the BRICs.
In 2010, the EM story has shifted to bonds. Equities are up only 3.3% on average, while the Citi EM Sovereign Bond Index has gone up by over 12.5% so far this year. Commodities and resources, of course, have continued to benefit from the EM story. The strong implication is that investors should be building EM asset positions in their global portfolios. This assertion is bolstered, of course, because advanced economy equity markets will labour, by comparison at least, as a result of higher capital costs, the implications of sustained deleveraging, weak nominal GDP growth, and the consequences of rapid ageing.
The economic fundamentals underpinning EM assets hardly merit yet another airing here. Because the EM universe is diverse, not all of those fundamentals exist in every case, but in general, they include stronger growth, higher total factor productivity, better demographics, rising levels of urbanisation and modernity, resource endowment, and in some cases, Latin America for instance, improving governance. Importantly, their fiscal positions are, generally, far stronger than those of Western countries.
So, why do typical institutional investors have EM weightings of no more than 5-10% in their portfolios, when EM market capitalisation has already risen over the last decade from 1% to about 13% of the MSCI World Index? What is there not to like?
Institutions and Imbalances
I’m not questioning the long-run fundamentals, which lend themselves to the ‘wow-like’ exclamations of visitors to Shanghai, Mumbai or Rio, and to the rosy-looking linear extrapolations of economists. But these same fundamentals don’t exist in a vacuum. They are always exploited, or compromised, by governments and by local institutions, in which I include various phenomena that drive total factor productivity (TFP) growth, such as the operation of contract law, the quality of the judiciary, governance, corporate organisation, labour and social institutions, and the infrastructurethat serves innovation.
The focus on TFP is a bit nerdy, but it’s the elixir of sustainable growth, especially in rapidly growing countries where the contributions from labour and capital productivity may be peaking or waning. Remember the spat in 1994 caused by Paul Krugman’s The Myth of Asia’s Miracle (1), in which he argued that the then Tiger economies had pretty much exhausted their ‘factor input’ contribution to growth?
GDP growth slowed on cue, then got crushed by the Asia crisis, and resumed but along a lower trend path. TFP in the Tigers faltered badly between 1997 and 2002, and has since rebounded, but some of this may well be the post-crisis rebound, not any longterm enhancement in growth prospects. Krugman’s argument now echoes for several Asian emerging markets (see, for example, the Asia Development Bank’s Latest Economic Update).
As a general point, the quality of institutions is far more important than GDP or the number of cranes on the skyline, or the ownership of resources in explaining long term economic success—especially as economies modernise rapidly and become increasingly complex. Just consider the economic performance of south-east Asia and Latin America over the last 40 years, at the start of which they had identical demographics and comparable per capita incomes.
Improvements in the quality of institutions will play an important role in offsetting, to some extent, the natural decay in economic growth that comes with maturity. They have played a vital role in Brazil’s more recent economic success, make businessmen and investors in India irritated, and will play an especially significant role in China. I say this because weak institutions were one of the main reasons that China long ago ceded its place in the world to Europe, and as things stand nowadays, unreformed and weak, institutions are likely to hold back the change that China needs to embrace to fulfil its potential. I will elaborate on this below.
The qualification about government and institutions is important in a more immediate sense too. In a post-crisis world that has become more unstable, unbalanced and nationalistic, the ability to reform and change economic direction will be significant. With this in mind, it's quite likely that the sometimes-feverish debate about EM prospects and potential may not be as obvious as is, often self-servingly, asserted.
The central economic issue concerns global imbalances. The West has been shocked by the crisis. Households and governments have to reduce or restructure debt, and increase savings, and bank balance sheets are de-leveraging. It’s painful but no debt crisis evolved any other way.
The BIS recently added empirical weight to the worthy Rogoff and Reinhart work on financial crises, pointing out that the work-out after a debt crisis takes years, in which growth is lower and debt has to be destroyed. But the global economic system comprises both Western debtors and EM creditors, notably China, which is the world’s biggest, and which will account this year for about 90% of the net balance of payments surplus accruing to all emerging and developing countries.
The West can’t be shocked into saving more without China, in particular, saving less. Otherwise, output and employment in the global economy will fall, probably accompanied by the tri-menaces of deflation, social and political instability and protectionism. This includes the recent outbreak of currency wars, in which it hasn’t just been China trying to hold its currency down—so have Japan, Korea, Taiwan, Singapore, Brazil, Malaysia, Indonesia, Israel, South Africa and Turkey—none of whom want their currencies to appreciate against either the U.S. dollar or the yuan.
America’s tolerance of China’s structural trade surplus and what it perceives as China’s curmudgeonly concessions on exchange rate flexibility, is already fracturing, as evidenced by the recent passage of the Levin bill (2) and other manifestations of bilateral tension.
Understandable though it is, the row over the yuan is both risky and narrow. It’s risky because it could backfire on both China, and the U.S. If China makes only grudging concessions, the political climate will deteriorate and encompass other touchy non-economic issues, such as intellectual property and human rights, Tibet and Taiwan, China’s naval build-up, climate change, and so on.
If it makes more significant, though still minor, moves towards currency appreciation, it could try to mitigate any negative effects on exports and unemployment by relaxing credit policy and increasing assistance to exporters. This would only underpin the imbalance between the manufacturing and household sectors, and cause the trade surplus to rise further. Back to square one. And in the process, investors would doubtless fret more about incipient asset bubbles in China.
It’s narrow because the exchange rate is only one tool in an economy that has a strong structural proclivity to save. The real issue is not the yuan, per se, but why China saves so much, and whether it has the political will to take on vested interests, embrace the comprehensive reforms needed to rebalance the economy towards households and services, and risk the instability that would accompany this shift.
Seen in this light, it is questionable whether there is anything the U.S. and others could do realistically to influence Chinese decision-making, other than to engage with Beijing and offer constructive advice and dialogue. But this is not the mood of the moment.
Why China saves 53% of GDP
There are several reasons for China’s elevated savings rate. First, China’s dependency ratio (young and old as a share of the working age population), although bottoming out, is still consistent with high national savings, even though in time, rapid ageing will push the dependency ratio up and sap those savings.
Second, China’s development model, based around exports and capital investment requires a relatively inflexible exchange rate regime and an undervalued exchange rate to effectively tax consumption, and subsidise exports. Much of China’s additional savings since 2002 has come from the earnings of companies.
Third, 800 million people still live in rural areas where living standards, incomes and social benefits are a country mile apart from urban areas. Moreover, the gap between rural and urban incomes is historically high, and wider than that experienced by Japan, S. Korea and Taiwan in the post-war period, when they were at comparable development stages to China today. Rural citizens have no option but to be high savers.
Fourth, the ‘hukou’ or alien registration system in towns and cities, introduced under Mao to guard against migrant overflow, keeps about 200 million migrants as second-class urban citizens without access to free public services, and as higher savers. Pilot schemes are in place in a few cities to ease some of the restrictions, but change will be gradual.
Fifth, the social security system is gradually being reformed with regard to pension and healthcare benefits, but it is still weak, narrowly focused, and inadequate as a substitute for high personal savings. Coverage is also limited, with little more than half of urban workers and less than 10% of rural workers included. Combined pension assets in state, company and other schemes are around 7-8% of GDP, which is worrisome for a country at the cusp of a demographic transition, in which the dependency collapse from 70% to 38% in one generation is about to surge back to 65% in the next.
Sixth, although households are the biggest savers with gross savings of over 23% GDP, the biggest rise in savings in recent years has emanated from companies and the government, which account for about 19% and 11%, respectively. The government could save less by switching some of its spending away from capital projects to current consumption (wages and transfers) but this would require a major change in thinking about the relative merits of, say, infrastructure versus social security. And the earnings of companies remain largely locked inside the sector because of the absence of an adequate dividend distribution mechanism (that would boost household incomes).
Seventh, the one child policy, while gradually being relaxed in some cities, isn’t that easy to change politically, and it’s being underpinned by more traditional factors that reduce fertility rates in modernising economies. But the legacy effects are going to be around for a long time, and these include the high proportion of young men, estimated by the Chinese Academy of Social Sciences at 5% now, rising to 20% by 2020 and 40% by 2050, who may never find a marriage partner or have a family. These chaps are bound to save more than their married
What to do?
China would have to implement wide ranging economic and social reforms to effect the transfer from manufacturing to consumption. These would include measures to liberalise the exchange rate regime, not just the rate, and use interest rates actively to control credit, and price capital, savings and risk appropriately. Higher rural incomes and expanded social security would be additional priorities, as would efforts to unlock the high savings in the enterprise sector, and reform social mechanisms that support high savings.
The rebalancing of China won’t happen without intervention, the robust political will of the Communist Party (CP), and an improvement in the quality of institutions that facilitate change. The idea of rebalancing is well understood in China, where the recent 12th Five-Year Plan includes (non-binding) goals to increase the consumption and services shares of GDP, as well as a series of objectives relating to higher wages and
better income distribution, ‘hukou’ reform, energy, pollution, rural development and new industries.
The plan, though, will also emphasise industrial upgrading and regional development, which is code for sustained high levels of capital investment. But the rebalancing issue is not whether China ‘gets it’, but whether the CP structure has the will and the institutional tools to risk radical change in the face of growing external pressure and criticism, and rising domestic stability and unemployment risks, which such change will entail.
Undeniably, Deng Xiao Ping’s reforms after 1978 opened China up and paved the way to the economic miracle that has become part of today’s folklore. His ideological pragmatism with regard to reform was emphasised in a statement he once made to the effect that ‘I don’t care if it’s a black cat or a white cat, so long as it catches mice’. But historically, China has often blinked in the face of external and internal threats to stability, becoming defensive and feeling vulnerable, and prone to withdrawal.
Cross the River by Feeling the Stones
I started out by querying the apparent underweight in most institutions’ EM portfolios, bearing in mind the consensus optimism about EM. But the Chinese proverb, at the head of this section, advising caution and gradualism, is highly relevant to investors in the post-crisis global economy, regardless.
A spontaneous return of risk oriented investing and the imminent resumption of confidence-inspiring co-operation between the U.S. and China, and generally in the G20 seem rather fanciful. The current enthusiasm for EM assets, derived from expectations about a new round of quantitative easing by the Fed, looks like it has some staying power, but in the end, investors will have to look beyond even this and sense where and how the world’s political and policy directions are changing for the better, or worse.
An Asset Allocation committee can’t price this kind of uncertainty or discount the sort of shocks that might arise in the event of bad political and economic outcomes. But its investment strategy might well adopt a core position for the time being, based around three ideas.
First, EM demographics and development are driving the growth and expansion of local companies, and the commodity and resource stories. There are now 91 companies headquartered in EM in the Fortune 500. In the EM corporate universe, over 110 companies now have sales in excess of $10 billion, and 8 have sales of over $100 billion. And the commodities story won’t change materially until the supply side strengthens, or unless the world economy succumbs to a new economic downturn.
But strong demand is ruling the roost for now, and is being supported inevitably by China, which, this year, has acquired stakes in the metals and oil and gas sectors, in a number of African economies, Australia and Canada, and recently it paid an elevated price for a 40% share of Repsol Brazil.
Second, the world is bifurcating between a deflation-prone West and an inflation-prone EM bloc. Further increases in local interest rates in EM should be expected, but public debt levels in most EM are still very low, of the order of 38% of GDP on average. Sooner or later, EM currencies should appreciate against the U.S. dollar and the euro.
Third, to the extent that the economic switch towards domestic consumption is encouraged and sustained, for example in China, stocks linked to an expanded output of education, healthcare, and insurance services, as well as to consumer goods and up-market food and drink should fare well. Financial deepening suggests that banks, and asset gatherers should be represented in portfolios too.
These ideas should be good for most muddling-through scenarios. If the ‘spontaneous return of confidence’ tail risk (low probability but extreme outcome) seems a bit far-fetched, the alternative tail risk that we might call ‘de-globalisation’, arising from policy intransigence, inertia or error, looks more plausible. And the trouble with tail risks in unpredictable times is that they are quite likely to occur.
The uprising of emerging markets and the BRICs specifically, during the last 10 years or so of rapid globalisation and the primacy of markets over politics (including China) has served investors well. The next decade offers no such assurances without strong qualifications.
October 25, 2010
(1) Foreign Affairs, The Myth of Asia’s Miracle, November/December 1994.
(2) The Levin bill authorizes the U.S. Government to impose countervailing duties on countries (read China) that manipulate their currencies to keep them undervalued.