G20 and Buffett’s Bet on Emerging Markets

The G20 Finance Ministers and Central Bank governors are meeting in St. Andrews, talking about the data they will need to look at in order to monitor each other’s economic performance and sustain growth (seriously).

The underlying idea is that if you talk long enough about the US current account deficit and the Chinese surplus, stuff happens and the imbalances will take care of themselves – or move on to take another form.

Warren Buffett seems to agree.

Buffett’s big investment in railroads looks like a shrewd way to bet on growth in emerging markets – which is where most incremental demand for US raw materials and grain comes from. It’s also a polite way to bet against the dollar or, even more politely, on an appreciation of the renminbi.

When China finally gives way to market pressure and appreciates 20-30 percent, their commodity purchases will go through the roof. You can add more land, improve yields, or change the crop mix of choice (as relative prices move), but it all has to run through Mr. Buffett’s railroad.

Of course, Buffett is nicely hedged against dollar inflation – this would likely feed into higher inflation around the world, and commodities will also become more appealing.

And Mr. Buffett is really betting against the more technology intensive, labor intensive, and industrial based part of our economy. If that were to do well, the dollar would strengthen and resources would be pulled out of the commodity sector – the more “modern” part of our production is not now commodity-intensive.

The G20 will stand pat, waiting for the recovery and hoping for the best; “peer review” will turn out to be meaningless. But this raises three dangers.

1. China will overheat, with capital inflows fuelling a giant credit boom. Books with titles like “China as Number One” and “The China That Can Say No” will appear. The boom-bust cycle will resemble that of Japan in the 1980s – you don’t need a current account deficit in order to experience a costly asset price bubble. Other emerging markets may follow a similar pattern (think India, Brazil, Russia.)

2. US and European banks will be drawn into lending to China and other emerging markets, directly or indirectly. In a sense this would be a re-run of the build-up of debt in Latin America and Eastern Europe in the 1970s, leading to the debt crisis of 1982 (remember Poland, Chile, Mexico). Banks with implicit government guarantees will lead the way.

3. We hollow out the middle of the global economy – with a few people doing ever better and most people struggling to raise their living standards. Increasing commodity prices hit hard at poorer people everywhere (recall the effects of the relatively mild run-up in food and energy prices in the first half of 2008). Global volatility of this nature helps big business but at the cost of undermining the middle class.

By betting on commodities, Mr. Buffett is essentially taking an “oligarch-proof” stance. Powerful groups may rise to greater power around the world, fighting for control of raw materials and driving up their prices further. As long as there is growth somewhere in emerging markets, on some basis, Mr. Buffett will do fine.

As for the G20, they are already a long way behind the curve.

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