For pretty much all of my career, the rise of emerging markets has been a dominant theme. One of the first books I remember reading after my studies was Hamish McRae’s The World in 2020, which outlined many of the trends we’ve seen in recent years in terms of China’s unstoppable rise onto the world economic stage. It’s been a fascinating period in history, not least because in some ways we are slowly turning full circle. You have only to go back a thousand years, to a time when China’s per capita income was slightly above that of Europe. Two hundred years ago, it was around half. It then bottomed out around the 1960s at a mere eight percent of European levels. That which gave Europe such power in those intervening years (technology, land and empires) has diminished, but this was not necessarily seen as a problem, given that the rise of once-dormant emerging nations brought benefits to Western nations. From here though, I can’t help thinking that the credit crisis has brought about a major shift in the relative dynamics of the developed and emerging nations. The gap between them will continue to close, but it will owe more to the burden holding back developed nations than the unstoppable economic expansion of the emerging nations. This will be quite a shift in the dynamics of the emerging and developed markets, one which has yet to be fully grasped by the investment community.
The rise of emerging nations in the period since the Asian crisis brought benefits to the West. As Asia shifted to running current account surpluses and building up substantial FX reserves (all part of the post-Asia crisis repairs), the West was subjected to an ever-greater inflow of capital from emerging nations (US Fed Chairman Bernanke referred to this as the “savings glut”). The most prominent manifestation of this was China’s growing investment in the US bond market, which in some ways contributed to the ensuing housing crisis by pushing down borrowing costs for businesses and households to a level that was quite detached from the underlying risks (especially in housing). There was also the benefit of falling goods’ prices. UK clothing and footwear prices nearly halved in the period between 1995-2008, which took 0.26 percent from headline inflation in each and every year during this period.
Deflationary dynamics
This was a considerable deflationary force (also replicated in other goods besides), one which has ceased over the past two years and is unlikely to return. At supermarkets, you can get denim jeans for around five pounds, which leaves little room for further price falls. Furthermore, with wage rises in China comfortably outpacing its already elevated inflation rate, if anything the risk is that we will see further price increases. This is one of the many reasons why UK inflation has persistently surprised to the upside in the past couple of years; the deflationary dynamics that we had come to take for granted disappeared rather abruptly.
The gap between the developed and emerging worlds was narrowing during the boom and also during the subsequent bust. While Asia concentrated on making things, the West (to varying degrees) concentrated on financing things, hence why it was hurt more in relative terms by the downturn. The G7’s share of world output declined from 70 percent in 1970 to 61 percent in 2007, falling to 58 percent in 2010. The BRICs (Brazil, Russia, India and China) doubled their share of world output between 1998 and 2010. Furthermore, those who thought that the emerging world would not be able to de-couple from the downturn in the West were proven woefully incorrect. Between 2007 and 2010, the G7 had yet to reach its pre-crisis peak in output (1 percent real contraction), whereas the BRICs have powered ahead, output increasing 24 percent over this period. In other words, it’s not just a story of emerging market strength – it’s just as much a story of developed market stagnation.
But this isn’t just a temporary setback from which the developed nations will throw off the shackles of the credit crisis and rebound back to the prosperity levels of the pre-credit crisis era. The West has just about won the battle of the credit crisis, but the war is far from over. Private household debt remains well above the historical trend, and for many countries public debt is far from on a sustainable path. The IMF sees government debt/GDP ratios for the advanced economies moving above 100 percent at the end of this year and up to 106 percent in five years time. At the same time, emerging and developing economies are set to see debt fall from 35 percent of GDP to 29 percent.
Furthermore, whilst the West may have lagged behind in output terms during the boom years up to 2007, it benefited in a number of ways previously mentioned, such as lower prices and plentiful capital (although the latter can also be viewed as a curse). With regards to the pricing benefits of emerging markets, those have all but disappeared. Outsourcing to Asia provides a one-off benefit and all the signs are that the West has saturated these. Indeed, some companies are now moving production out of China as rising wage costs diminish the advantages of locating there.
Asia’s surplus
The other factor that may well diminish in the coming years is the surplus of savings in Asia. There’s more debate on this one, both in terms of the potential speed this could happen and also whether it’s overwhelmingly a good thing. Putting it simply, this is a reflection of the global imbalances that world leaders have talked about a lot, but managed to do little to resolve. It is summed up as the West’s penchant to consume and spend beyond its means (Germany being the main exception) and Asia’s preference for saving and exporting capital to the West. China appears to be aware of the dangers of investment running to nearly 50 percent of GDP and wants to move to a more consumption-based society. However, to achieve this, proper state systems of insurance and healthcare are required, something which has taken the West decades rather than years to achieve. China’s latest five-year plan presented earlier this year, recognised the need to grow less, export less, spend more on healthcare and boost consumption.
This sounds like a good thing from China’s perspective, but reduced saving in one area must also equate to reduced borrowing elsewhere. Globally, imbalances are a zero-sum game. A too rapid run-down of global current account surplus would leave countries like the US facing rising borrowing costs and an even longer period of sub-par growth. But in my view it’s a fear that is often over-hyped. Despite the relentless rise of cities (21 are over five million in population), the majority of China is still excluded from this. The pace of urbanisation and growth of social infrastructures is such that China will remain an exporter of capital for many years to come yet. The urban population will exceed the rural one by 2015 (according to an estimate by China’s Population and Family Planning Commission in July 2010), but at this pace it would take until 2060 for China’s ratio of urbanisation to reach the same as the US (not that this is necessarily achievable or desirable).
Nevertheless, this shift towards reducing saving and increasing consumption is something the West, and in particular the US, needs to prepare for. There will come a day when China is no longer a net buyer of US government securities and the best way to prepare for this is to stop issuing as many of them, as an alternative buyer can’t be guaranteed to be waiting in the wings. So far, as the impasse over the debt ceiling showed, it’s pretty clear that many US politicians have not grasped the implications of this situation. But if the US chooses to shift more slowly than China, then borrowing costs will rise, due both to less demand from China and also from higher supply as the US lacks a solid budget-consolidation plan.
US debt burden
The debt ceiling issue in the US was the epitome of this, with the incentives in the political sphere not sufficient to deal with the structural budgetary issues that many Western nations face. The burden being placed on the working population of the US is ever-growing, but the working population itself is declining. At present, only 58 percent of the US population is in the labour force and less than half is in employment. It’s going to be difficult to reverse the declining trends of both these numbers in the face of population ageing. Yet the political elite appear almost oblivious to the issue.
The current decade will be one in which emerging markets continue to benefit from younger populations, positive resource allocation, far lower debt burdens and competitive labour costs. But developed markets, with political malaise, ageing populations and rising debt burdens, will be just as responsible for closing the gap. At the same time, the benefits of emerging market growth will be far more limited for Western nations than was the case previously. For many, the world of 2020 is not necessarily going to be a pretty one.
Simon Smith is Chief Economist at FxPro.
