The Rise and Fall of Nations: Forces of Change in the Post-Crisis World. Ruchir Sharma. 2016.
Ruchir Sharma, head of emerging markets and chief global strategist at Morgan Stanley Investment Management, spent 25 years traveling to analyze the economies of the world for investment. In his introduction, he lists the principles he formulated for this task, which include the following: impermanence is the norm; forecasts are limited to 5 to 10 years; biases are stifled; ideological single factor theories are avoided; economies are likely to return to long-term averages; multifactor growth should be balanced, and dynamic indicators used should be manageable and not subject to political or marketing manipulation. As an unsentimental businessman, he then presents ten rules, each with its own chapter, to use in identifying the next big winners and losers in the global economy.
- People Matter: Is the talent pool growing? Population gains together with productivity gains determine the rate of economic growth. For much of the post-World War II era, the rate of global economic growth has been almost 4%—half from population growth and half from productivity gains. However, population growth since 1990 and productivity gains since 2005 have each decreased to about 1%. Hence, overall growth has decreased to about 2%, and this lower rate is projected into the foreseeable future. In the US, working age population decreased from 1.7% to 0.5% and productivity decreased from 2.2% to 1.3% after 2005.
Changing demographics exacerbate this trend for working age population. Since 1960, average life spans have increased from 50 to 69, with the fastest growing portions over 65 and particularly over 80. At the same time, due to aggressive birth control policies, births per woman have decreased globally from 4.9 to 2.5, even in India and Mexico. The fertility rate is actually less than the replacement rate of 2.1 in 83 countries, including the US, Japan, and much of Europe. Consequently, the portion of working age people (15-65) who drive the economy is decreasing, while the portion of nonproductive older people is increasing.
This problem has been partly offset in some developed countries like the U.S., Canada, Germany, and Australia by immigration. In the US, immigrants account for only 13% of the population but 25% of new businesses (30% in Silicon Valley). Increased participation of retirees and women in the workforce also helps. Automation, which is viewed as a threat to jobs (47% at risk in the US in one to two decades), may actually be important to counter workforce shortages. Government programs, such as baby bonuses in Russia or extensive paid leave for mothers in Sweden, have had little effect on fertility.
- The Circle of Life: In national politics, particularly in developing countries, crisis forces reform, reform leads to growth and good times, and finally, good times encourage arrogance and complacency that lead to new crises. The bold new leaders who emerge often have early successes from reform, but if they stay for long, this is followed by staleness and corruption. Many examples of this pattern are reviewed, such as Putin in Russia, Erdogan in Turkey, Suharto in Indonesia, and Mohamad in Malaysia. Even worse, populists without reform arise in some countries, such as Chavez in Venezuela and Kirchner in Argentina.
Vladimir Putin is an example of this sequence. He was elected president in 2000 during the severe depression after Russia’s transition to a market economy. His reforms of taxation, debt reduction, management of Russia’s oil wealth, and reigning in oligarchs led to doubling the size of the economy and increasing average Russian annual salaries from $2,000 to $12,000. However, by 2008, he transitioned to demagoguery, corruption, and aggressive nationalism, with the result that average income fell to $8,000, the economy slowed to negative growth, inflation increased to 16%, and billionaire wealth connected to government was 70%.
- Good Billionaires, Bad Billionaires: “…Whatever one’s ideology, it is hard to dispute the growing view that low levels of inequality fuel long runs of strong economic growth, and that high or rapidly rising inequality can prematurely snuff out growth.” Moreover, inequality is presently very high and getting higher. In 2014, the top 1% had 48% of global wealth (50% of financial wealth in the U.S.). The much smaller fraction of super wealthy is getting an even more disproportionate share. The number of billionaires has doubled in the last 5 years and tripled in the last 10. Good billionaires are not necessarily bad for the economy, but bad billionaires are.
Good billionaires are in industries like technology, manufacturing, pharmaceuticals, telecoms, retail, e-commerce, and entertainment. These industries make the most positive contributions to productivity, have fewer corrupt ties to government, and are less likely to generate popular backlashes. Bad billionaires are in rent seeking industries like construction, real estate, gambling, mining, metals, oil, and gas that may compete for access to national wealth and that may be tied to government corruption. The 70% portion of bad billionaires in Russia is by far the largest. Bad billionaires are also more likely to have inherited wealth from families with close ties to corrupt government, such as in Indonesia.
- Perils of the State: The checklist for governments includes the following: 1) the level of government spending, which can be too much or too little, and whether it goes to productive investment or giveaways, 2) misuse of state companies and banks to pump up growth and contain inflation, 3) activities that are either choking or encouraging private business.
For spending in developed nations, France tops the list with 57%. Greece’s bloated spending has decreased to 47% after forced reforms. Sweden, Finland, Belgium, Denmark, and Italy have around 50% spending, but mostly with better management. The US, Austria, and Australia at 35-40% are light spenders. For spending in developing nations, Russia probably tops the list at close to 50% (official figures claim only 36%). Other big spenders from 41-35% include Brazil, Argentina, Poland, Saudi Arabia, and Turkey. Light spenders include Mexico, Taiwan and South Korea at 22%. Too much spending may include lavish subsidies, wasteful state corporations, and other inefficiencies. Too little spending, as in Mexico, Pakistan, Nigeria, and Egypt, may include inadequately funded law enforcement, large black markets (more than 30% in Pakistan Venezuela, Russia, and Egypt compared to 8% in the U.S.), and civil war (62 conflicts from 1979 to 1997 averaged 15 years duration and 30% decreased GDP).
State-owned companies and banks may be sources of artificial creation of jobs, artificial suppression of prices, inefficient subsidies, and bad or corrupt loans. For government and state company employment, highest levels are 33% in Norway, Saudi Arabia and Russia and 30% in China, and lowest levels are less than 10% in Japan, Korea, and Taiwan. Wasteful Energy subsidies (gas, oil, etc.) amount to more than 10% of GDP in Saudi Arabia, Iran, Iraq, and Turkmenistan and 28% of GDP in Uzbekistan. Enthusiasm for state companies has faded in emerging stock markets from 30% in 2008 to 15% in 2013. In China their share of GDP has decreased from 70% to 30%, and 73 million state jobs have been eliminated in the last few decades. Assets controlled by state banks are 75% in India, 50% in Russia, Hungary, Taiwan, and Malaysia, and 40% in China, Thailand, Indonesia, and Brazil. Reportedly, China’s recent stimulus to maintain unrealistically high growth targets has generated $6.8 trillion in wasted investment, including a great deal of empty real-estate.
- The Geographic Sweet Spot: Nations that qualify as geographic sweet spots combine the pure luck of an advantageous location for trade with the good sense to make the most of it. For the largest emerging nations, combined import and export trade account for 70% of GDP. Profitability from proximity has occurred between Dubai and Iran, Hong Kong and China, Eastern Europe and Western Europe, Southeast Asia and the US, and Mexico and the US. To benefit from their locations, countries must open their borders to trade with their neighbors, the wider world, and their own provinces and second cities. Also, nations have redrawn trade routes to their advantages, such as when China created six of the world’s ten busiest ports, all of them man-made. Other regions, such as parts of Africa and South Asia, have lost out due to inadequate policies and infrastructure.
- Factories First: Is investment rising or falling as a share of the economy? Investment is the strongest driver of economic growth. Best investments to support growth are in new technology, new roads and ports, and especially new factories. However, investment becomes increasingly nonproductive above about 35% and results in slower economic growth. This is particularly concerning for China, where investments have grown from 37% of GDP in 2002 to a remarkable 47% in 2014 to maintain unrealistic growth targets. Investment binges that lead to crashes can be good or bad depending upon what they leave behind. In the US, the dot-com bubble of the late 1990s, funded by venture capital and stocks rather than debt, left behind a vast network of fiber optic cables important for future growth, but the housing market bubble of the 2000s, funded by staggering debt, left behind the deepest post World War II recession.
For emerging countries, investments are optimal at 25-35% of GDP and weak at 20% or less, and manufacturing ranges from 10% of GDP in Chile to 30% in China. South Korea, Malaysia, China, and Indonesia are four of the top five for both investment and manufacturing. For developed countries investments average only about 20% of GDP, from 17% in Italy, to 20% in the US, to 26% in Australia. For these countries, manufacturing amounts to about 20% or more in only a few, particularly Germany, which has increased exports from 26% to 46% of GDP since 1995 and which is ranked in the top three for 27 of the top 51 global industries, compared to 21 for the US and 19 for China.
It is becoming tougher and tougher for developing nations to get in the manufacturing game and stay there. The entire manufacturing sector has shrunk from 24% to 18% of global GDP since 1980. In addition, rich nations have a big lead in advanced manufacturing, have less need for cheap labor due to automation, and have learned to block tricks like export subsidies, undervalued currencies, and reverse-engineering. Consequently, some developing countries have tried to replace the manufacturing escalator to growth with a service escalator. However, the rise of these service industries has been insufficient to drive mass modernization. Even India’s IT services employ only about two million people, or less than 1% of the workforce.
- The Price of Onions: Is inflation high or low? In the postwar era, low inflation has been a hallmark of every long run of strong economic growth. Of the fifty-six nations that, since 1960, have had runs of GDP growth greater than 6% for at least a decade, 3/4 had inflation rates lower than the emerging-world average. The miracle economies of South Korea, Taiwan, Singapore, and China had booms lasting three decades or more and rarely saw inflation at greater than the emerging-world average. In recent times, a boom cannot last if inflation is rising because the central bank will have to raise interest rates and likely choke off growth.
Global average annual inflation was 1% from 1210 to 1933, but this concealed sharp and frequent swings between high inflation and deflation. After 1933, deflation disappeared and was replaced by unbroken inflation. For developed countries, inflation peaked at 15% in 1974 (with the OPEC embargo), then fell to 2% since 1991. In developing countries, inflation peaked at a staggering 87% in 1994 (with Russia, Turkey, and Brazil in triple digits), then fell to 6% since 2002. Inflation was tamed largely by the rise of politically independent central banks that enforce inflation targets of around 2% for 92% of global GDP. Outliers in 2015 include Argentina at 30%, Russia at 16%, Nigeria at 9%, and Turkey at 8%. After World War II, extended bad negative demand-driven extensive deflation has occurred only in Hong Kong from 1998 to 2005 and in Japan for two decades after 1990 when high debt and oversupply of everything resulted in steadily falling consumer prices and prolonged low growth. Good positive supply-driven deflation occurs as well, such as in the English industrial revolution when prices fell by half and output rose sevenfold and in the digital revolution when prices plummeted as quality skyrocketed.
Today, importance is decreasing for consumer prices and increasing for asset prices (stocks and real estate) as signals of sharp economic downturns. Globalization has stabilized consumer prices by international shopping but destabilized local asset markets by introduction of foreign high end buyers that lead to bubbles. Every major economic shock in recent decades has been preceded by an asset bubble, with increased severity when fueled by debt. Five years later, the economy will be below its previous trend by 1-1.5% for a bubble not fueled by debt, by 4% for a stock market bubble fueled by debt, and by 9% for a housing bubble fueled by debt. Consequently, the Fed needs to consider asset markets as well as consumer goods when stabilizing prices, particularly since the composite valuation of stocks, bonds, and houses in the US is now at a fifty year high, well above the highs of 2000 and 2007.
- Cheap is Good: Does the country feel cheap or expensive? An overpriced currency will encourage locals and foreigners to move money out of a country and sap its economic growth. A currency that feels cheap will draw money into a country and boost its economic growth. The critical category to watch is the current account, which captures how much a nation is producing compared to how much it is consuming. This consists of the trade balance (exports minus imports) plus other currency flows, such as interest payments to foreigners, foreign aid, and remittances from locals working abroad. Cross-border capital flows were $280 billion or 2% of GDP in 1980, increased to $9 trillion or 16% of GDP in 2007 with globalization, and decreased to $1.2 trillion or 2% of GDP in 2014 with deglobalization.
A country with a current account deficit of 5% for five years is highly likely to have a significant slowdown and some kind of crisis. To predict changes, watch whether the locals are moving money into or out of the country, including by illicit channels that show up in the errors and omissions column of the balance of payments. China is the leading exporter of illicit capital at $125 billion per year until 2013, increasing to an annual rate of $320 billion at the beginning of 2015—an alarming sign.
The collapse of an overpriced currency in Thailand in the 1990s provided an example of a currency crisis. The strong baht led to extravagant spending, real-estate and stock bubbles, and heavy borrowing in foreign currencies. The current account hit 8% in 1995-6. When the bubble burst, investors pulled money out of the country, the baht fell 50% against the dollar, and foreign loans couldn’t be repaid. Subsequent events provided an example of a currency contagion, when investors pulling money out of Thailand triggered a pullout from neighboring countries that could pay their bills and eventually from emerging countries everywhere. For developed countries the current account deficit as a percent of GDP was 6% for the US in 2006 and 1.6% for the Eurozone in 2008 but has fallen to 2.5% in the US and a surplus of 1.6% for the Eurozone.
Conversely, devaluation to encourage exports usually does not lead a country to prosperity. Negative consequences include higher prices for foreign goods, difficulty repaying foreign debt, and possibly even a trade war if others retaliate. China was a rare exception when it devalued the yen in 1993. But China had little foreign debt, little reliance on imports, and, most important, a strong manufacturing sector. Japan and Germany in the 1980s and 1990s showed a path to strong growth despite massive currency appreciation by engaging in high quality advanced manufacturing for which customers were willing to pay a premium.
- The Kiss of Debt: Is debt growing faster or slower than the economy? Economic slowdowns and financial crises are most often preceded by excessive growth of private debt (companies and individuals) not government debt, as shown by studies of 30 credit binges in 150 countries and of 430 severe financial crises. The usual pattern is excessive private sector borrowing (credit mania), often in response to some invention or innovation, which leads to overproduction, such as of fiberoptic cables in the late 1990s, and careless extension of credit, such as in the subprime lending of the 2000s. Eventually, some financial accident occurs, typically after the central bank is forced to raise interest rates, and the bubble bursts. As a result of the financial crisis from excessive private debt, government debt subsequently increases due to decreased tax revenues, increased public safety net spending, and shifting of bad debt to government books. Hence, there is no historic basis for the idea that financial crises typically have their roots in fiscal government borrowing.
Obviously, credit is essential for economic expansion but only at a rate that is reasonably proportionate to growth of GDP. The magic number for spotting coming trouble is a five year increase in private credit of 40% as a share of GDP (or 20% per year). For instance, the Thailand financial crisis of the late 1990s was preceded by five years of robust 10% annual economic growth but an excessive growth of private debt of 67% of GDP. After the financial crisis of 2007, a few countries and industries cut back, such as in the US, but total global debt (combined private and public) has continued to grow from $142 trillion to $199 trillion or from 269% to 286% of GDP. In 2015, the US total debt of around 250% of GDP (150% private, 100% public) is pretty normal for a developed country with a per capita income over $50,000, but the Chinese total debt of over 250 % of GDP (232% private, 40% public) is by far the largest for an emerging nation with a per capita income of $10,000.
The most alarming credit binge is in China, which accounted for $21 trillion of the $57 trillion increase in global debt since 2007 and resulted in a record 80% five-year increase of private debt by 2013 with associated real-estate and stock market bubbles. This is a threat to the global economy. One possible outcome would be like that of Taiwan, which crossed the 40% threshold in the late 1990s. Taiwan responded by sharply pulling back on lending and reigning in crony capitalism, which limited the damage to slowed growth from 9% to 7% for the next five years. An alternate worse outcome would be that of Japan in the 1990s after rising debts led to collapse of its stock market and real-estate bubbles. Rather than sharply reducing debt, Japan increased borrowing to subsidize failed companies, which resulted in two decades of stagnating growth and increased total debt from 250% of GDP in 1990 to 400% today.
- The Hype Watch: How is the country portrayed by global opinion makers? The basic rule: the global media’s love is a bad sign, and its indifference is a good one. From 1980 to 2010, 122 Time magazine covers featured the economic status of a country or region. When the story was upbeat, economic growth slowed in 66%, and when it was downbeat, it increased in 55% in the next five years. A similar pattern was found in other publications, with the exception of the Economist, which did somewhat better with improvement in two-thirds after an optimistic cover and slowing in more than half after a pessimistic cover.
This pattern occurs because periods of rapid or slow growth are often near the ends of their runs and about to return to baseline by the time they come to the attention of the media. Mainstream opinion about which nations are rising or falling typically gets the future wrong, because it extrapolates recent trends into the unknowable future and gets more convinced the longer a trend lasts. IMF extrapolation for continued high growth at a slightly more modest rate for China and India predicts quadrupling in size for a combined expansion of $53 trillion by 2030. The historically much more realistic expectation of return to baseline (regression to the mean) would result in only doubling for an expansion of $11 trillion. This results in an enormous $42 trillion gap between predictions by the two techniques. Also, poor economies have much more potential for rapid “catch-up” growth, which encounters the likelihood of slowdown when per capita GDP reaches 75% of that of the US.
- The Good, the Average, and the Ugly—Summary. For three decades before 2008, global economic annual growth was 3.5%. However, the future potential growth rate is estimated to be limited to 2.5% due to structural changes of depopulation, deglobalization, and the need for deleveraging. Although the post 2008 recovery has been weak, recovery in the US has been stronger than in most developing nations and needs to be judged by the new standards. The “kiss of debt” rule of growth of debt by over 40% of GDP in five years is the single most reliable indicator of a coming major economic slowdown. China’s economic growth prospects now rank among the ugliest in the emerging world and are a threat to the global economy, since China has displaced the US as the leading source of global growth. Selected countries are listed below according to the author’s view of their economic prospects:
Good: US, Germany, India, Mexico, Peru, Argentina, Poland, Romania, Pakistan, Vietnam, and the Philippines.
Average: Japan, South Korea, Taiwan, UK, Spain, Italy, Czech Republic, Hungary, Kenya, Sri Lanka, and Columbia.
Ugly: China, Russia, France, Turkey, Canada, Brazil, Saudi Arabia, Nigeria, South Africa, Thailand, Malaysia, and Australia.