If, as many proclaim, this is the emerging markets (EM) century, it hasn’t had a particularly auspicious start. The cyclical problem of slower growth is overshadowed by a much bigger problem. Economic frailties reflect increasingly structural flaws in the development models they have exploited so successfully for the last two decades. Past performance, as every investor should now know, is no guide to the future.
Lingering, stagnant growth in advanced economies is a problem for some export-dependent EM. Many EM are courting financial and balance sheet instability risks as their financial policies, especially in the wake of western quantitative easing, raise the credit intensity of GDP growth, and lead to more alarming increases in their credit to GDP, and bank loan to deposit ratios.
But the most complex issues arise for those countries, notably China, that are reaching the point where the benefits of deployment and mobilization of physical labour and capital are limited, or at or close to the point of exhaustion. Fixing this requires new, smarter political and economic thinking. In China and other middle income countries, far-reaching political reforms are needed to implement successful rebalancing policies, and to prevent human and economic development from stalling in the proverbial middle-income trap.
Structural weaknesses already validate a concern about the significant downturn in EM total factor productivity growth (TFP), except in Latin America where it is nonetheless anaemic. TFP is the all-important residual in economic growth that captures the impact of technological change and institutional efficiency and organisation.
Slower TFP growth speaks to a reform agenda which includes the dominant and stifling impact of the state sector on enterprise, technology and innovation; unsustainable savings and investment imbalances; large income inequalities and weak income security and healthcare programmes; low labour market inflexibility and labour force participation, and high unemployment rates; tax and subsidy distortions to factor prices, including capital, land and key resources, such as energy and water; weak legal and immature financial systems; low or must-try-harder educational attainment levels; and infrastructure deficiencies. Fixing these complicated issues is a matter of urgency if EM are to live up to spreadsheet- and pundit-based predictions - and nowhere more so than in China.
Take the threat to China’s dominance of manufacturing and its economic competitiveness as an example of the need for comprehensive change in China’s political and economic model. Slowly but surely, China is ceding ground to a hatching American phoenix egg. Since 2007, productivity-adjusted unit labour costs in the US have fallen relative to China and other developed markets, helping to raise the US export share of GDP to the highest level for 50 years. Average manufacturing costs will fall further because of significantly lower gas and industrial electricity prices, in the wake of America’s strong lead in shale gas and oil extraction technologies.
Further, the US is set to dominate an embryonic industrial and materials revolution, known as additive manufacturing, or 3D printing, which assembles products, layer by layer, from computer-generated designs. Companies won’t need to hold large inventories. They won’t need to bear the costs of shipping resources into and products out of China. More firms will bring outsourced manufacturing back home to be close to markets and centres of technological excellence. Manufacturing costs, including capital, labour, packaging, and transportation, will decline.
Think of this as a struggle between the Shenzhen model of global supply chains, large-scale process manufacturing and economies of scale versus the Silicon Valley model of innovation, advanced design and commercialization. The latter will emphasise customized production, quality control, protection of intellectual property rights, and “after service” such as consulting and maintenance - none of which are high on China’s achievement list.
Meanwhile China’s standard cost advantages are slipping. Wage and non-wage costs are rising rapidly because of demographic change, especially shortages of skilled female labour, and expanding income security and healthcare policies. Many of the structural weaknesses cited earlier are present in China, and exacerbated by long-standing social and cultural norms, which have typically rewarded good administrators rather than free-thinking innovators, and suppressed the disruptive culture that drives manufacturing revolutions.
This is a real “carpe diem” moment. America’s elections must throw up political leadership and credible budgetary reforms that won’t strangle the manufacturing renaissance. China’s leadership change must steer a course towards a technology- and innovation-led economy that might not be compatible with the Communist Party’s raison d’etre.
George Magnus is an economist, a senior adviser to UBS Investment Bank, and author of Uprising.