Can emerging markets go the distance?
What happens after 10 per cent growth? The history of emerging market growth shows few economies last the distance, according to Chris Watling.
One of the greatest dangers of the economics profession, especially those operating in financial markets, is its inclination to extrapolate trends, good or bad.
In March 1999, this was typified by The Economist’s infamous front cover (‘Drowning in Oil’) with a forecast of a US$5 oil price.
A year to 18 months later, the Dow 36,000 theory was published just as the stock market was reaching its bubble peak in 1999/2000 (a level the Dow has failed to meaningfully break through since). In 2008, as oil surged to US$150, forecasts for a price of US$200 and then US$500 followed.
More recently, the extrapolation phenomenon has been focussed on China and other key emerging markets.
Economists and strategists have outdone themselves in forecasting an ever-sooner date by when China will become the largest and most dominant economy in the world.
Within that extrapolation exercise, the most important assumption is regarding China’s long-term growth. Clearly, accurately estimating the future growth trajectory of China is critical.
The speed of economic growth (as well as the shape) will influence multiple investment trends over coming years including the growth rate of many other emerging markets which export to China; global commodity demand growth; the sales growth rate of European and US luxury goods and cars; and the fate of Australia and many other economies.
But the evidence to support the ‘extrapolasionists’ is far from clear. Indeed, the history of emerging market growth does not support their case.
Few emerging economies have lasted the distance, generating meaningful and lasting catch-up (ie, income convergence) with the relevant economic superpower of the day, and few are able to grow rapidly for more than one or two decades.
Rodrik’s 200 years of evidence
Dani Rodrik (2011) showed how exceptional the growth performance of emerging market economies as a group has been over the last decade. Relative to the last 60 years, the last decade is the outlier, not the norm.
Equally, Rodrik also shows that there are very few economies that sustain average real per capita GDP growth of 4.5 per cent or higher over three decades.
Across all countries for which there is data, he found only two examples prior to 1900 – interestingly, they are neither the industrialising economies of Great Britain, the US, Germany nor Russia.
Between 1900 and 1950, only Venezuela grew at that high growth level, albeit global growth trends were disrupted by two world wars.
Since the 1950s, there are many more examples. They can be grouped into three categories:
- Commodity economies – including Saudi Arabia, Libya, Iraq in the Middle East as well as Botswana (diamonds) and Equatorial Guinea (Oil) in Africa;
- European economies undergoing their post-WWII industrialisation catch-up phase – including Spain, Portugal, Greece and Italy as well as Ireland;
- Asian examples – primarily Japan and Asian tigers South Korea, Taiwan, Singapore, and Hong Kong.
The implication of Rodrik’s analysis is, firstly, that there are only a handful of examples of economies that have been able to achieve high economic growth rates for a sustained period of time.
Second, there has been significant geographic concentration of the success stories.
Indeed, there have only been two regions that have sustained long-term high growth rates without being reliant upon a commodities price boom (ie, Southern Europe and parts of Asia).
While encouragingly, China – which has averaged real GDP growth of 9.9 per cent per annum for just over three decades – sits in Asia and arguably holds many of those Asian-centric features, the Asian industrialisation model points to a slowdown in Chinese trend growth, at this current juncture, to around 4 per cent to 5.5 per cent trend growth.
Fifty years of emerging markets growth
To supplement Rodrik’s conclusions, we analysed economic growth of all major emerging market economies using World Bank data (where available) as far back as 1960. Three observations emerged.
Firstly, Asian economies have produced superior sustained growth phases when compared to other key emerging market regions of the world.
Over 40 per cent of Asian growth decades (that is, sorting average real GDP growth rates by country and decade) are in the high average growth range (defined as five per cent to 12 per cent average growth).
The next best emerging market region on this measure is Central and Eastern Europe with 26 per cent of growth decades in the high average growth range.
The region also has the highest percentage of growth decades in the 0 per cent to negative 5 per cent band – in other words, it’s the most polarised emerging market growth region.
The worst region on this measure is Africa.
Secondly, many of the examples of high-growth economies are either economies growing from a very low base – for example, Africa and Central Europe – or economies recovering from major economic contractions, often as high as 60 per cent to 70 per cent contractions in GDP.
Most notable amongst these are the African economies post-war and central Eurasian economies after the break-up of the Soviet Union.
These are not, therefore, valid comparisons for China and other fast-growing Asian emerging market economies.
Thirdly, many examples of economies that have grown rapidly have done so primarily as a result of a commodity price boom.
This occurred in resource-rich economies in Latin America in the late 1960s and 1970s. It’s also been the driver of 40 years of high growth in Botswana from 1961 to 2004 and, more recently, Equatorial Guinea since its major oil discovery in 1996.
Indeed, Botswana had the longest period of sustained high real GDP growth of all the 100 or so emerging market economies we examined – but its growth has been wholly related to its large diamond reserves.
Equatorial Guinea’s impressive growth has been driven almost wholly by the large oil discovery in 1996.
Once commodity prices revert to their mean, however, commodity economies have historically almost all experienced significantly slower growth rates.
China and most other high-growth Asian economies are not, however, resource rich, with the exception of Indonesia.
Therefore while they are not vulnerable to a collapse in commodity prices, they are also not beneficiaries of long, sustained high growth rates as a result of commodity booms.
Finally, the key conclusion is that China is most likely to follow the path of other, previously industrialised, Asian economies.
Indeed, to date, China has already closely followed the Asian industrialisation template with an initial three decades of approximately 10 per cent per annum average real GDP growth.
As the example of Japan, South Korea, Taiwan, Singapore and others illustrates, the initial three decades of high 10 per cent average growth rates is eventually then followed by one to three decades of real growth at around four per cent to 5.5 per cent per annum.
- Japan was the first Asian economy to industrialise, starting post-World War II. Early industrialisation lasted 25 to 30 years with real GDP growth averaging 9.7 per cent per annum. It then decelerated to average real growth of 4.6 per cent per annum during the late industrialisation through to the early 1990s. Since then, in its post-industrialisation phase, real growth has averaged 0.9 per cent per annum.
- South Korea averaged real GDP growth of 11.6 per cent in its early industrialisation phase (from 1970 to 1997). After the early phase of industrialisation, growth decelerated to an average of 4.2 per cent.
- Like Japan, Taiwan also grew rapidly at approximately 9 per cent per annum during early industrialisation. After three decades, that growth rate decelerated to sub-5 per cent (albeit that the transition from 10 per cent to 5 per cent lasted approximately five years).
- Singapore followed a similar industrialisation path to the other Asian success stories. Indeed, longer-term World Bank data shows that early industrialisation growth began in 1965 and carried on until 1997 (ie, it lasted 32 years).
- Indonesia’s high growth rates of approximately 7 per cent per annum from the late 1960s through to 1996 was derailed by the Asian crisis in 1997 and the associated change in leadership and reform. It has since reasserted itself at around 5 per cent.
In terms of high growth longevity, the Asian template points to a likely downshift in Chinese growth rates in coming years.
That conclusion is supported by two key factors which suggest that China’s transition from high trend growth to lower trend growth is probably already underway.
Firstly, the key source of China’s rapid economic growth in the last decade was investment spending, which is unlikely to persist in coming years.
In particular, the stated intention of the Chinese authorities is to rebalance the economy towards consumption and away from investment.
This comes at a time when China’s investment as a percentage of GDP is close to 50 per cent, which is overextended and extreme (and notably above levels reached by prior Asian industrialising economies, with the exception of Singapore).
Any normalisation of that rate back towards 30 to 35 per cent would act as a growth headwind.
In particular, consumption growth would probably continue to be relatively modest, particularly without social welfare reforms and a meaningful fall in household savings.
Our prior analysis of the extent of the build-out of Chinese infrastructure also supports China’s need to reduce investment as a share of GDP, with many sectors significantly built out.
Examples include power generation capacity which is currently twice the needs of the Chinese economy, and the approximate 20 per cent excess supply in residential housing.
Further acting as a growth headwind, China’s demographic profile is deteriorating with the workforce due to peak next year and slowly contract in coming decades.
While the working age population (those aged between 15 and 65 years) has risen by around 6 per cent in the past 15 years, in the next 15 years, almost half of that increase will reverse, creating a major headwind to economic growth.
The case for China’s transition to slower growth, therefore, is clear.
The history of emerging market growth – particularly the evidence around the longevity of Asian 10 per cent growth rates – along with China’s worsening demographics and evidence for excessive investment spending and infrastructure build-out in recent years, supports the case for slowing growth.
Key counter arguments
We would accept that certain other metrics are less clear in supporting the contention that China will slow.
In particular, trend growth in prior Asian industrialisation examples slowed from 10 per cent to 5 per cent, at much higher GDP-per-capita levels.
For example, Japan was at a GDP per capita of US$19,500 (in constant 2000 prices) when it kicked down to a slower growth rate. South Korea was at US$10,400.
China today is only at US$2,600 per capital GPD (2000 prices).
Equally, levels of steel and copper consumption per head were also generally higher than China’s is today when countries transitioned to slower trend growth (ie, also signalling that industrialisation had reached a more advanced stage).
However, China is now close to Taiwan’s level of steel consumption per capita. These factors clearly add a degree of uncertainty to our central expectation.
Chris Watling is is CEO and Chief Market Strategist with Longview Economics, available exclusively through PortfolioConstruction Forum.
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