The South African Index Investor
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Newsletter: December 2007
Emerging Markets: The Saviour of Global Economic Growth?
By Daniel R Wessels
Watching the current slide in the market values of the major stock markets amidst the evolving subprime debacle and growing concerns that the US economy is heading towards a recession or at least a significant slowdown, one cannot but wonder whether one should avoid stock markets altogether or whether we are perhaps in the grip of a bearish stock market.
In the past an American recession usually spilled over to the other major economies of the world which eventually resulted in disappointing stock market returns all around. If such a recession (two successive quarters of negative economic growth) in the US economy is about to transpire somewhere in 2008, will it again have a knock-on effect on the rest of the world’s economy? Or, is there perhaps another dominant force, namely the spectacular growth of the emerging market countries, notably the BRIC countries (Brazil, Russia, India and China) keeping the momentum of global economic growth intact?
Martin Wolf, chief economics commentator of the Financial Times, argues that nobody can be sure if the US is going to experience a recession, but perhaps more important is the question whether the US economy will continue to experience a “growth recession”. The latter refers to a lengthy period of sub-trend economic growth.
“Most analysts believe that the trend rate of growth of the US economy is around 3 per cent a year. Growth at below that rate, then, is a growth recession. This year, the expectation is for growth of about 2 per cent. Next year, suggests the consensus, it will be a little above 2 per cent. That would mark a cumulative shortfall of about 2 per cent of gross domestic product over two years. So the US is already in a growth recession.”
The US domestic demand should continue to be weak: house prices have fallen by about 8 % from their peak in real terms and may fall further. Ben Bernanke, chairman of the US Federal Reserve, has put write-offs from the bad mortgage lending at $150bn, up from the $50bn to $100bn he estimated earlier; and as bank capital shrinks, credit is likely to remain tight.
The Fed can cut interest rates aggressively to prevent a full-blown recession, but they remain cautious over inflationary pressures, especially following the record prices of oil and the tumbling dollar, now lower against the world’s important currencies than it has ever been.
Wolf believes what will happen to the US economy depends on two things: how weak domestic demand is going to be, and the extent to which any shortfall in demand is offset by a stimulus from net exports.
Between 1996 and 2004 the US domestic purchases (GDP plus imports less exports) grew faster than GDP and the current account deficit exploded upwards. (See chart 1.) The US was the principal recipient of the surplus savings of the rest of the world, especially from Asia and the oil exporting countries. The US household sector contributed largely in recent years to the deficit by increasing their debt against the rising value of houses. That process has now come to an end with declining house prices.
Chart 1: Snapshot of the major trends in the US economy
Source: Financial Times, 21 November 2007
“So what might offset such a slowdown in spending by the household sector? Normally, businesses do not invest more when the economy is weak, even if their financial position is healthy. A bigger government financial deficit is likely, as a result of the slowing of the economy. But an aggressive fiscal boost is improbable. That leaves net exports.”
“The declining dollar helped net exports to contribute a quarter of US growth between the first three quarters of 2006 and the first three quarters of 2007. Without this contribution, growth would have been only 1.5 %, instead of 2 %. “But exports are only some 12 % of GDP. They must grow by considerably more than 10 % a year, in real terms, if the contribution of net trade to the rate of growth is to be as much as 1 percentage point. It is likely to be much less.”
Wolf thinks a plausible view of the future is that the US will experience a lengthy period of sluggish growth in domestic private demand, partially offset by fiscal expansion and an improvement in net exports.
What does it mean for the rest of the world? They will adjust either by increasing demand, relative to potential supply, or by reducing supply relative to demand. The former adjustment is clearly the preferred choice. In this regard the emerging markets in particular must now become the demand engines of the world economy.
But just how realistic is such an expectation? First, let us look at some startling facts and major trends about the emerging market economies, as reported by The Economist:
Emerging countries today are playing a much larger role in the world economy than a couple of decades ago. (See chart 2.) For example, their share of world exports has jumped to 43% from 20% in 1970. They consume over half of the world's energy and have accounted for four-fifths of the growth in oil demand in the past five years. They also hold 70% of the world's foreign-exchange reserves.
Chart 2: Emerging economies in a global context
Source: The Economist, 14 September 2006
When measured at purchasing-power parity the emerging economies now make up over half of world GDP; at market exchange rates their share is less than 30%. But even at market exchange rates, they accounted for well over half of the increase in global output in 2005. And this is not just about China and India: those two together made up less than one-quarter of the total increase in emerging economies' GDP over the past years.
Before the industrial revolution which gave Britain its industrial lead, today’s emerging economies dominated world output. Until the late 19th century, China and India were the world's two biggest economies. Estimates by historians suggest that in the 18 centuries up to 1820 these economies produced, on average, 80% of world GDP. (See chart 3.) But then they were left behind by Europe's technological revolution and the first wave of globalisation. By 1950 their share had fallen to 40%.
Chart 3: The re-emergence of emerging economies
Source: The Economist, 14 September 2006
“Now these economies are on the rebound. In the past five years, their annual growth has averaged almost 7%, its fastest pace in recorded history and well above the 2.3% growth of the developed economies. If the current growth rates are extrapolated into the future, in 20 years' time emerging economies would account for two-thirds of global output.”
“Emerging economies’ prospects look promising; as long as they continue to move towards free and open markets, sound fiscal and monetary policies and better education. Because they start with much less capital per worker than developed economies, they have huge scope for boosting productivity by importing Western machinery and know-how. When America and Britain were industrialising in the 19th century, they took 50 years to double their real incomes per capita; today China is achieving the same feat in nine years.”
But then, emerging economies as a group have been growing faster than developed economies for several decades. So why would they now make so much more of a difference? The Economist argues that the gap in growth rates between the old and the new world has widened. (See chart 4.) But more important, emerging economies have become more integrated into the global system of production, with trade and capital flows accelerating relative to GDP in the past ten years.
Chart 4: Emerging and developed economies’ growth rates
Source: The Economist, 14 September 2006
For example, China joined the World Trade Organisation only in 2001. It is having a bigger global impact than other emerging economies because of its vast size and its openness to trade and investment with the rest of the world. China's total exports and imports amount to around 70% of its GDP, against only 25-30% in India or America. This year China is likely to account for 10% of world trade, up from 4% in 2000.
Furthermore, technological innovations in communications networks have made it possible not only to re-organise production across borders, but also historically non-tradable services, such as accounting, can now be outsourced to a country like India, thus exposing more sectors in the developed world to competition from developing markets than before.
Ultimately, the success of the emerging economies will boost both global demand and supply and contrary to some perceptions the rich countries should gain from poorer ones getting richer. Rising exports give developing countries more money to spend on imports from richer ones. And although their average incomes are still low, their middle classes are expanding fast, creating a vast new market. Over the next decade, almost a billion new consumers will enter the global marketplace as household incomes rise above the threshold at which people generally begin to spend on non-essential goods.
“Emerging economies have already become important markets for the developed world firms: over half of the combined exports of America, Europe and Japan go to these poorer economies. The rich economies' trade with developing countries is growing twice as fast as their trade with one another.”
“This increased vitality in emerging economies is raising global growth, not substituting for output elsewhere. The newcomers boost real incomes in the rich world by supplying cheaper goods, such as microwave ovens and computers, by allowing multinational firms to reap bigger economies of scale, and by spurring productivity growth through increased competition.”
Furthermore, the integration of China and other developing countries into the world trading system is causing a radical shift in relative prices and incomes (of labour, capital, commodities, goods and assets), and in turn, is leading to a big redistribution of income. For example, whereas prices of the labour-intensive goods that China and others export are falling, prices of the goods they import, notably oil, are rising.
As these newcomers become more integrated into the global economy and their incomes catch up with the rich countries, it is expected that they will provide the biggest boost to the world economy since the industrial revolution.
Does the aforementioned imply that global economic growth, largely driven by the emerging economies, will continue unabated irrespective of what happens to US economic growth? In other words, will the growth in emerging markets become disconnected from that of developed economies? John Kay of the Financial Times believes it is unlikely that a significant slowdown in US economy will not have an important effect on emerging markets.
Recent comments have suggested that the performance of the emerging economies of Brazil, Russia, India and China, and of Asia generally, is now largely “decoupled” from that of developed economies. For example, trade among Asian economies is expanding more rapidly than trade between these economies and the rest of the world. As a result, the setbacks to growth expected in America and perhaps Europe will have little impact on emerging markets.
But Kay argues that even in small economies such as those of Switzerland and the Netherlands, most economic activity takes place domestically. Your country of residence is where you buy your clothes, eat your meals, and draw up your accounts, etc. “But the volume and value of all these domestic operations depends on the role the country’s producers play in the global economy. The scale of domestic and intra-regional trade should not blind us to the dependence of both on what is happening elsewhere.”
However, these small European economies are completely integrated within their own national boundaries and into the international economy. This of course is by far not the case in Brazil, Russia, India and China, where a wide dispersion in wealth and economic development is found between those living in the cities and those in the rural areas.
Thus, it may well be that to a certain extent the decoupling thesis may be true. “The growth of countries such as China and India is the result of changes that occurred there. Western countries did not (except by example) create the momentum for growth in these economies. Nor, except temporarily, can Western countries block their gradual transition into the developed world.”
The synopsis? It seems probable that global economic growth will remain largely on track due to the pertinent role of emerging market economies. The transitional socio-economic developments are already well-embedded and have built some momentum in these economies. But it is likely that this global growth rate will slow down from its current levels – at about 5% – with a “recessionary growth” US economy at the helm. This moderation could very well continue for some time still until the major imbalances in the US economy (e.g. high current account deficits and household debt or low saving rates) have been addressed.