Will Emerging Markets Come Back?

I don’t often make reference to these kinds of things in my blog, but Saturday’s terrorist attack in the Kunming train station – in which 29 innocent people were hacked to death (the toll was especially high among the elderly who were unable to run away quickly enough from the killers) – fills me with dread and dismay. This kind of brutal massacre is not about sending a message to Beijing or to the world but is rather aimed at getting the authorities to overreact so as to create hatred within the country.

I truly hope it does not succeed. There is a great deal of anger here in China but so far, I am glad to say, excluding some over-the-top responses in the internet world the authorities and Chinese people generally seem not to be overreacting. I wish there were some way that we as individuals could of respond to the Kunming train station massacre but what is among the most awful aspects of this kind of insane event is the feeling of helplessness it creates. As individuals there seems to be so little we can do either to prevent this kind of behavior or to console the victims.

And it is not just in Kunming that things seem unsettled. Recent events in the Ukraine have capped several years of social unrest, revolution, and war around the world, and these seem to have intensified since the beginning of the global crisis of 2007-08. This should not have surprised us, and we should probably brace ourselves for several more years of political uncertainty. In late 2001 I published an article with Foreign Policy discussing what I expected the world to look like following the global crisis that I, perhaps a little prematurely, was expecting imminently.

In the article I pointed out that in the past 200 years we had experienced a number of globalization cycles, driven largely by deep changes in monetary conditions, that followed a pattern regular enough to allow us to make some fairly confident predictions. We were, I argued, living towards the end of one such cycle, and when underlying liquidity conditions changed, we were likely to see the same sort of things that we had seen in previous cycles. Among these, I wrote:

Following most such market crashes, the public comes to see prevalent financial market practices as more sinister, and criticism of the excesses of bankers becomes a popular sport among politicians and the press in the advanced economies. Once capital stops flowing into the less developed, capital-hungry countries, the domestic consensus in favor of economic reform and international integration begins to disintegrate. When capital inflows no longer suffice to cover the short-term costs to the local elites and middle classes of increased international integration – including psychic costs such as feelings of wounded national pride – support for globalization quickly wanes. Populist movements, never completely dormant, become reinvigorated. Countries turn inward. Arguments in favor of protectionism suddenly start to sound appealing. Investment flows quickly become capital flight.

These predictions about what the world was going to look like in the next several years were easy to make, I argued, because they occurred so regularly. One of the predictions that I should have made, but didn’t, was that after the globalization process had been reversed we were likely to see an upsurge in war, revolution, conflict and social unrest. These, after all, were events we usually associated with the end of previous globalization cycles, but at the time I wrote the article (published less than two weeks before the 9/11 terrorist attack) it really seemed that the world had changed in some subtle but profound way and that we had become too sophisticated to engage in such disruptive behavior.

I should have known better. I have spend much of the past two decades trying to show how persistently historical patterns reemerge, and why the claim that “this time is different” is almost always wrong, and yet I believed that when it came to revolution and war perhaps this time really was a little different. International institutions were strong enough, I believed, to manage the kinds of pressures that normally emerged from a reversal of many years of globalization.

This turns out perhaps not to be the case. Watching the news on television, especially events unfolding in the Ukraine, leaves me with a sense that we haven’t figured out how to manage these pressures. The recent rout in emerging markets has left a lot of people very confused about the direction in which the global economy, and developing countries more specifically, are going, but it turns out that once again we should not have found recent events at all surprising. They are part of the globalization cycle.

There was no “decoupling”

But once again we wanted to argue that this time was different. For several years we had been hearing that the global crisis of 2007-08 marked some kind of inflection point that signaled the decoupling of developing countries from the advanced countries of North America and Europe. The argument, as I understand it, was that the developed countries of Europe and North America had got themselves caught up in a debt-fueled consumption boom, of which the crisis was the culmination and the beginning of the process of reversal.

The developing world had, according to this argument, managed to untie itself from developed-country demand and its growth was now more likely to be driven by domestic demand arising at least in part from the more favorable demographics of the developing world. The growing middle classes, especially in China and India, were emerging to become a major focus of demand, and not only were other developed countries benefiting from this new source of demand, but eventually all countries would benefit from demand generated in the developing world.

I never found this thesis very convincing and completely rejected the “decoupling” argument. As I see, it the decade before the crisis was characterized by a series of unsustainable processes driven largely by structural changes in the global economy that tended to force up savings rates globally. In my view, the 2007-08 crisis was just the first stage of the rebalancing process, in which overconsumption in the developed world was forced by rising debt to reverse itself. But of course this couldn’t happen without equivalent adjustments elsewhere. The crisis now affecting developing countries is, as I see it, simply the second stage of the global rebalancing, or the third if you think of the sub-prime crisis in the US as the first stage and the euro crisis in Europe as the second stage.

To understand the link, we need to go back to the pre-crisis period. Ever since the 2007-08 global crisis, the world has suffered from weak global demand. Demand had been strong before the crisis, but this largely reflected the credit-fueled consumption binge, combined with a huge amount of what proved to be wasteful real estate development, unleashed as a consequence of soaring stock and real estate markets that were themselves the consequences of speculative capital pouring into countries like the United States and peripheral Europe.

The crisis put an end to this. After stock and real estate markets in the United States and Europe collapsed, and once financial distress worries constrained the ability of households to borrow for additional consumption, the great consumption and real estate boom in many parts of the world also ended.

Normally slowing consumption growth should also cause slowing investment. The purpose of productive investment today, after all, is to serve consumption tomorrow, but at first this didn’t happen. Instead we saw an intensification in 2009-10 of the credit-fueled investment binge in China, as well as in developing countries that produced the hard commodities China needed. This increase in investment was supposed to offset the impact of declining consumption in the west, and it certainly had that effect. The collapse in China’s current account surplus, for example, had almost no impact on domestic employment because it was offset by an astonishing surge in domestic investment.

This is what set off talk of “decoupling”. As weaker consumption and real estate investment in Europe and the US forced down growth in global demand, it was counterbalanced by greater demand in the developing world, driven in large part by China. Not surprisingly this meant that a larger share of total demand accrued to poor countries at the expense of rich countries.

Decoupling in the 1970s

But the process was not sustainable. In China well before the crisis we were already experiencing the problem of excess investment in manufacturing capacity, real estate and infrastructure. In developing countries like Brazil this was matched by investment in hard-commodity production based on unrealistic growth assumptions in China. Weaker demand in the rich countries, especially weaker consumption, should have reduced whatever the optimal amount of global investment might have been, especially as we already suffered from excess capacity. To put it schematically:

  1. Before the crisis the world had already over-invested in real estate and manufacturing capacity based on unrealistic expectations of consumption growth.
  2. The global crisis forced consumption growth to drop. This should have meant that if investment levels were too high before the crisis, they were even more so after the crisis.
  3. Instead of cutting back on investment, however, the developing world reacted to the drop in rich-country demand by significantly increasing investment, driven at least in part by worries that the consumption adjustment in Europe and the US would cause a collapse in export growth which would itself force unemployment up to dangerous levels.

Clearly this wasn’t sustainable, and not surprisingly soaring debt is now forcing this investment surge to end. As a result, we are now going to experience the full impact of slower consumption growth in the rich countries, but instead of this being mitigated by higher investment growth in the developing countries, it will now be reinforced by slower investment growth in the developing world. Over the next few years demand will revive slowly in the US, not at all in Europe, and it will weaken in the developing world.

We’ve seen this movie before. In the mid-1970s the US and Europe were mired in recession as loose monetary policy in the 1960s, soaring oil prices, and many years of US spending on both the Great Society and the Vietnam War forced the US into an ugly adjustment. Instead of succumbing to reduced global demand, however, developing countries, flush with cheap capital driven by international banks eager to recycle burgeoning petrodollar deposits, intensified a developing-country investment binge that had already driven a decade of high growth for many countries. While the West suffered, they continued to grow, and for perhaps the first time in modern history excited bankers and businessmen spoke ecstatically about the decoupling of the developing world from growth problems in the US and Europe.

But the end result should have been predictable. Developing-country debt levels soared throughout the late 1970s, and once the Fed, concerned with US inflation, turned off the liquidity tap, excessive debt forced much of the developing world, and all of Latin America, into a “lost decade” of low growth, high unemployment, political turmoil and financial distress. In the 1970s of course the big capital push behind the surge in investment was driven by soaring savings in the Middle East, as oil revenues rose much faster than the ability of Middle-Easterners to increase consumption. Today the big capital push is driven by soaring savings in China, as structural constraints cause China’s production of goods and services to rise much faster than China’s ability to consume them.

The result is that over the next few years global demand will be even weaker than it has been since the crisis. Consumers in North America, peripheral Europe, and the newly rich middle classes around the world are still cutting back on consumption to pay down debt. Investors in China, Latin America and Asia are finally responding to overcapacity and soaring debt by themselves cutting back on investment. But if we all cut back our spending to service our debts, paradoxically, our debt burdens will only rise, and the great danger is that rising debt burdens will force us to cut back even more, thus making the debt burden worse (and, by the way, forcing at least some countries, in both the developing world and in Europe, to default).

Nothing fundamental has changed. Demand is weak because the global economy suffers from excessively strong structural tendencies to force up global savings, or, which is the same thing, to force down global consumption. Lower future consumption makes investment today less profitable, so that consumption and investment, which together comprise total demand, are likely to stagnate for many more years.

Squeezing out median households

Two processes bear most of the blame for weak demand. First, because the rich consume less of their income than do the poor, rising income inequality in countries like the US – and indeed in much of the world – automatically force up savings rates. Second, policies that forced down the household income share of GDP, most noticeably in countries like China and Germany, had the unintended consequence of also forcing down the household consumption share of GDP. This income imbalance automatically forced up savings rates in these countries to unprecedented levels.

For many years the excess savings of the rich and of countries with income imbalances, in the form of capital exports in the latter case, funded a consumption binge among the global middle classes, especially in the US and peripheral Europe, letting us pretend that there was not a problem of excess savings. The 2007-08 crisis, however, put an end to what was anyway an unsustainable process.

It is worth remembering that a structural tendency to force up the savings rate can be temporarily sidestepped by a credit-fueled consumption binge or by a surge in non-productive investment, both of which happened around the world in the past decade and more, but ultimately neither is sustainable. As I will show in my next blog entry in two weeks, in a closed economy, and the world is a closed economy, there are only two sustainable consequences of forcing up the savings rate. Either there must be a commensurate increase in productive investment, or there must be a rise in global unemployment.

These are the two paths the world faces today. As the developing world cuts back on wasted investment spending, the world’s excess manufacturing capacity and weak consumption growth means that the only way to increase productive investment is for countries that are seriously underinvested in infrastructure – most obviously the US but also India and other countries that have neglected domestic investment – to embark on a global New Deal.

Otherwise the world has no choice but to accept high unemployment for many more years until countries like the US redistribute income downwards and countries like China increase the household share of GDP, neither of which is likely to be politically easy. But until ordinary households around the world regain the share of global GDP that they lost in the past two decades, the world will continue to face the same choices: an unsustainable increase in debt, an increase in productive investment, or higher global unemployment, that latter of which will be distributed through trade conflict.

Emerging markets may well rebound strongly in the coming months, but any rebound will face the same ugly arithmetic. Ordinary households in too many countries have seen their share of total GDP plunge. Until it rebounds, the global imbalances will only remain in place, and without a global New Deal, the only alternative to weak demand will be soaring debt. Add to this continued political uncertainty, not just in the developing world but also in peripheral Europe, and it is clear that we should expect developing country woes only to get worse over the next two to three years.

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About Michael Pettis 166 Articles

Affiliation: Peking University

Michael Pettis is a professor at Peking University's Guanghua School of Management, where he specializes in Chinese financial markets. He has also taught, from 2002 to 2004, at Tsinghua University’s School of Economics and Management and, from 1992 to 2001, at Columbia University’s Graduate School of Business.

Pettis has worked on Wall Street in trading, capital markets, and corporate finance since 1987, when he joined the Sovereign Debt trading team at Manufacturers Hanover (now JP Morgan). Most recently, from 1996 to 2001, Pettis worked at Bear Stearns, where he was Managing Director-Principal heading the Latin American Capital Markets and the Liability Management groups.

Visit: China Financial Markets

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