Emerging Markets are Re-Shaping the Global Economy, But Also Shaking It

By George Magnus

From global tourism to manufactured products, and from industrial processes to modern technologies order, the re-convergence of emerging markets and their economic dynamism are re-shaping the world, and they are simultaneously shaking it.

The rise of emerging markets constitutes the biggest peacetime shock to the global system in a long time, perhaps since the Industrial Revolution spawned the Western ascendancy of the last 250 years. While the quest for certainty tempts us to extrapolate recent economic and political trends into the future, history and experience suggest we should retain a more cautious perspective. The emergence of China as a global power, for example, and of new regional powers, such as Brazil, Turkey, and India, is a fact. But we cannot predict how they will integrate into a global system still characterised by strong US and European interests, or how the latter will accommodate them.

We can say with certainty that the financial crisis and its aftermath are accelerating the Great Re-convergence between emerging and advanced Western economies and that the economic consequences of the crisis will take many years for Western nations to overcome. The current existential crisis in the EU and the Eurozone in particular could have far-reaching implications not just for the region but also for the global economy. Less well understood, and less obvious, though, are the political and economic shockwaves generated by the West’s predicament that are reaching into the emerging world too.

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China’s GDP will exceed that of the US by the 2020s, but in terms of income per head, China will remain a relatively poor country.

Geo-political shakes

In the geopolitical arena, there is no question that America’s ability to set and implement agendas, for example on issues from global financial regulation, and supervision, to trade imbalances, and food, energy and climate change security, has been compromised. China has certainly become sufficiently large economically and powerful to play a strong complementary role. Mutual interests suggest that these two large, populous and geographically separated continental powers have much to gain directly from cooperation in these and other areas, and much to offer the rest of the world in the form of leadership. But if the crisis has weakened America’s ability and willingness to lead, it hasn’t made China any more able or willing to do so.

In economic and trade matters, for example, although China has made some limited concessions to the US over alleged undervaluation of the Yuan, it doesn’t really want to change its basic economic development model, which is one of the causes of global trade imbalances. And while China, as the world’s biggest creditor, has persistently appeared willing to help Europe in managing the sovereign debt crisis, it hasn’t been willing to commit directly much of its $3 trillion war-chest of currency reserves to a region that is its biggest export market. China’s leaders have well-founded reasons for not putting money on the European table in the ways that many people have imagined or expected. But in this, as in every major debt crisis, the self-interest of creditors is to contribute in some way, directly or by example, to its resolution. And here too, China’s role has been found wanting, if only in international bodies, such as the International Monetary Fund.

In the coming decades, nearly all of the world’s extra 3 billion people will be born in emerging and developing countries, and most will be in a position to exploit their so-called demographic dividends.

In more strategic matters, China has become increasingly truculent in its foreign and domestic policies in the last two years. Examples include the harassment of US Navy vessels, the construction of military and industrial facilities from the South China Sea to the Indian Ocean, territorial maritime disputes with Japan, South Korea and Vietnam, the shelling of a South Korean island, water rights tensions with India, and ties to Pakistan, North Korea and Iran. And at home, China has demonstrated a new forcefulness, for example by clamping down on media and internet freedom, and suppressing human rights activists and a growing number of labour and rural migrant protests.

 

New shapes, but also challenges

Against this geopolitical background, we can see the dramatic effects that China and its emerging market peers are having on the global economy. But rapid economic and social changes also bring new sources of instability and uncertainty. From a rich vein of examples, consider the following six.

First, China’s GDP will exceed that of the US by the 2020s, but in terms of income per head, China will remain a relatively poor country for as far out as it makes sense to forecast. By 2030, on straight line predictions, China’s income per head will still be a third of the US. Size, per se, does matter but not always as much as you might think.

The key to successful and sustained economic development is high quality institutions to mix, manage and organise labour, and human and physical capital inputs.

Second, trade between emerging countries, so-called South-South trade, has risen from 7% to 17% of world trade since 1990, and the IMF expects this proportion to double in the next 20 years. But many of the most important emerging markets have taken their place in a China-centric global manufacturing supply chain, and remain heavily dependent on economic conditions in the West. In Asia, only a quarter of total exports end up as final demand outside the region, the rest comprising basic intermediate and semi-finished goods that end up in China and or as Chinese exports. The weakness in Europe that started at the end of 2011 is already showing up in flagging growth rates from Brazil to China.

Third, emerging markets cause global companies to salivate at the prospect of substituting sales to the world’s next billion consumers for those in a rapidly ageing Western world. But these would-be consumer markets will only flourish if emerging countries are able to reform their economic development models, and commit to building social safety nets and sophisticated capital markets.

Fourth, emerging markets will headquarter a growing number of companies that already account for about 20% of the Fortune 500 companies, a rising share of foreign direct investment, and a growing presence in new energy, manufacturing and medical technologies. But many countries, including China, still lack the capacity for broad-based innovation (as opposed to technological ability), and China lacks the tolerance for disruptive entrepreneurial transformation, which is acknowledged to be a key ingredient.

Fifth, one of the biggest ‘natural’ advantages that emerging markets enjoy resides in their demographics. In the coming decades, nearly all of the world’s extra 3 billion people will be born in emerging and developing countries, and most will be in a position to exploit their so-called demographic dividends. This refers to the economic advantages that flow when fertility rates are declining, the working age population is expanding, and before the old age dependency ratio has started to rise significantly. Major beneficiaries could include India, Indonesia, Malaysia, Brazil, Chile and Turkey. These countries won’t experience rapid ageing for at least another 25 years.

But there are three important things to bear in mind. First, while it took between 70-100 years for the share of the over 60s in Western countries to double to 15%, it will take a mere 20 years in most emerging countries. And because their starting position in terms of per capita income and social insurance is relatively weak, they face the now cliched danger of getting old before they get rich, along with a host of unresolved problems associated with job creation, income inequality, familial care structures, and pensioner poverty. Second, this demographic dividend could be wasted if the growing working age cohorts end up as poor, unemployed, or under-employed. The Arab Spring testifies to the extremes to which this can lead. Third, major exceptions to the emerging market demographic picture can be found in, for example, China and Russia. The latter’s population is ageing rapidly and declining now, while in the former, the most rapid ageing on Earth is occurring. China’s over 60s will nearly treble from 12% to 31% of the population by 2050, while the number of workers for every older citizen will collapse from 10 to just 2.5.

Sixth, and perhaps most important of all because it tends to get overlooked, the key to successful and sustained economic development needs something you can’t buy, manufacture or declare by law of diktat. And that is high quality institutions to mix, manage and organise labour, and human and physical capital inputs.

Institutions comprise the legal system, in particular the rule of law, respected property rights, neutral contract enforcement and an independent judiciary; sound political and economic governance; effective labour, economic and social organisations; trusted rules and regulations; and an innovative and transformational corporate culture. While poorer and more primitive economies can expand quickly even without them, successful middle income countries, with per capita incomes of between $3,000-12,000, tend to be characterised by better quality institutions. This is because bigger and more complex economies need stronger and codified rules and governance systems.

China’s approach to development has been pragmatic and relatively flexible. This was more than sufficient to evolve in to what China is today. The next phase of more complex economic and social development is likely to be even more demanding for change and adaptation.

In fact, as economies reach the upper limits of middle income, the role of institutions becomes increasingly important to the chances of breaking in to the higher income league. Poland, Turkey, Brazil and Chile, for example, stand at the cusp of making this leap, while China is predicted to be at this point by the end of this decade. Suffice to say, that some might make it, but many have already tried and become stuck in a middle income trap. This happened, for example, to the former USSR in the early 1980s, and it has bedevilled Argentina and Venezuela for many years.

China first per capita income leap over the last 30 years from $1000 to $4500 has gone hand in hand with key institutional advances in the functionality of the state, the development of state-owned enterprises, the rise of a few global companies, and the resources ploughed into education, R&D, and product development, for example, in consumer, low carbon, clean air and alternative energy technologies. The next surge to $13,000 by 2020, will have to be accompanied by further institutional change, especially as it applies to the legal system, courts and contracts, and to economic, corporate and social governance. If such change were suppressed, or deemed hostile to the interests of the Communist Party, China’s development would be materially affected, and possibly exacerbated by social instability as a result.

 

Rebalancing China

I have suggested above six key ways in which China and other emerging markets will shape the world economy in decades to come, and some of the obstacles to success, which could see them shaking things up at home and abroad too. Size of GDP is important but it doesn’t matter as much as the structure of trade and domestic output, employment levels, innovative prowess, demographics and the quality of institutions. Sustaining steady economic growth will become increasingly difficult, especially now that advanced Western economies are in a protracted economic funk. Nowhere does all of this matter more than in China, especially with the leadership of the Communist Party and the political apparatus of the state due to change this year.

By way of backdrop, the 12th Five Year Plan, adopted in 2011, enshrines broad goals to rebalance China away from a heavily investment and export-centric economy to one that is more consumer- and services- oriented, and more attentive to rural incomes and employment. The Plan also aims to be more sensitive to the growing demand and need for expanded social safety nets. China’s pension assets amount to roughly 3% of GDP, public pensions and coverage rates are still very low, and 60% of Chinese households pay their own medical bills.

The world system will only work smoothly if China and a few other emerging markets save less, that is, they have to pursue different economic and social policies to lower their external surpluses.

But rebalancing the economy poses two large threats to stability. The economic threat lies in maintaining steady growth while lowering the investment share of GDP from its current lofty level of 50% and raising the lowly consumption share of just 34%. This shift will require radical and disruptive changes to the system of corporate subsidies, underpriced capital, credit expansion, and repressed interest and exchange rates that underpins the current development model. This needs to pick up a few gears quite soon, for unless it does, China could be heading for a classic investment bust in 2013-2014. In any event, the rebalancing could entail an extended period of low growth and rising unemployment, if investment spending falls away faster than consumption picks up. And low growth is important, because it is the antithesis of China’s informal social contract.

The political threat derives from the fact that rebalancing entails a redistribution of power. The political and business groups that have benefitted from China’s development to date, that is, local and provincial party elites, state-owned enterprises and banks, and cities and coastal regions, will doubtless try to resist the loss of influence and power to other important interest groups, namely, consumers, migrants, rural areas, and inland provinces, not to mention the increasingly important 7 million new college graduates every year, many of which struggle to aspire to home ownership, and high quality jobs.

Ultimately, China’s success in rebalancing its economy is going to depend on the Communist Party’s pragmatism. Since Deng Xiaoping set China off on a course to become today’s global power, China’s approach to development and growth has been pragmatic and relatively flexible. This was more than sufficient to emerge from poverty and to evolve in to what China is today. The next phase of more complex economic and social development is likely to be even more demanding for change and adaptation, perhaps in ways that threaten the Party’s raison d’etre, which is to rule. And if the Party is resistant or miscalculates, what might China then look like and which way would it turn?

 

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Rebalancing the world

Rebalancing China is not only important for the country’s long-run stability and development, but also a critical factor in rebalancing the global economy’s large, if currently silent, trade imbalances. These imbalances are basically about domestic savings and investment levels.

In a nutshell, the US and the West have been shocked into a period of low growth and debt reduction, in which their national savings will have to rise, that is their external deficits will fall. The world system will only work smoothly if China and a few other emerging markets save less, that is, they have to pursue different economic and social policies to lower their external surpluses in a mirror image, as I have suggested already.

If Western nations try to save more, and emerging nations don’t save less, there will be no winners since global trade and output will weaken, unemployment will rise, and the potential for heightened international tensions and recourse to trade and capital controls will increase. So, it is just as important for China to act as a role model for rebalancing in the emerging world, as it is for advanced nations to reduce sovereign and private debt. If the world relies solely on the latter, new financial instability is assured, which would surely shake both the West and the East.

In the meantime, most of the shaking that’s going to happen in the next year or so will probably still emanate from the sovereign debt and banking crisis in the Eurozone, though the US presidential elections will doubtless be watched closely for clues as to if America will become more governable thereafter.

But a probably significant contraction in European GDP – perhaps around 2% – will weigh heavily on Chinese and other emerging country exports, and economic growth, aided and abetted by tighter monetary and credit policies that many emerging countries implemented in 2010-11. In Brazil, the economy stalled last autumn, while in China the tempo of growth may slow to around 6-6.5% in the first half of 2012. Many emerging countries will probably ease economic and monetary policies further. The major question on the minds of investors and strategists is whether China’s economy may run into a sharper slowdown in 2013-2014 as the investment side of the economy slows down, and later in the decade, whether it bumps into what we might call a BRIC wall because of an unwillingness to adapt its politics and institutions.

 

Conclusion

Short-term economic developments aside, we can say without equivocation that over the medium- to long-run, the re-convergence of emerging markets and their economic dynamism are re-shaping the world. From global tourism to manufactured products, and from industrial processes to modern technologies order, the footprint of emerging markets will become increasingly common. I conclude with two significant caveats.

First, the ‘decline of the West’ epitaph has most likely been written prematurely. In relative terms, yes, Western economic power and influence are in decline. But who is to say that over the next 10 years or so, US innovation and flexibility won’t again rise to the surface once, Medicare and the budget deficit have been fixed? It has, after all, managed to reboot economically several times before. Second, emerging markets are in pole position to capitalise on the Western predicament but they are being thrown new and challenging economic and foreign policy issues that are not guaranteed to end well or successfully. They are re-shaping the world, and they are simultaneously shaking it. Everything else is speculation.

 

About the author

George Magnus is Senior Economic Adviser, UBS, and author of Uprising: will emerging markets shape or shake the global economy? (John Wiley& Sons, 2010).

 

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