The key characteristic of the world imbalances of the past two decades was the lending of capital by high-growth countries to low-growth countries in the guise of currency intervention or savings protection. Thus, the likes of China, Brazil and India recycled their trade or current account surpluses to the purchase of US and European government bonds or those of their agencies instead of investing in their own economies.
Age-old rules set by the International Monetary Fund (IMF) and other idiots were the main reason for this orthodoxy being practiced by the emerging countries. Reeling from a series of foreign investor runs on their banking systems in the 1980s and 1990s, many emerging counties adopted the IMF rules of weakening their currencies, increasing their export focus and reducing their total debt relative to the forced savings of foreign exchange reserves.
Going back to the first part of this article, readers will recall the illustration of two brothers who jointly owned a public bar: “Whenever one wanted a pint of beer, he would pay the other a dollar, who would then pay him back for his own draw of beer. Pursued ad nauseum, this meant that the same dollar could account for unlimited quantities of beer … the game could continue until the brewery sent its chap around to collect money for all the beer that had been drunk by the brothers.”
In effect, emerging market countries became the processors (the brewer in the first example) who depended on the pub owners and beer-consuming brothers for their eventual cash flows from the sale of beer. This vendor’s credit clearly created its own wave of working-capital shortages for the emerging market countries that were all too frequently borrowed over the short-term from the very people benefiting from one-dollar beer, namely the pub customers.
The second aspect of the story that is important to understand from the perspective of the brewery, that is a producer of goods such as China and South Korea in the global economy, is the distribution of profit margins. Selling goods at a fraction of their eventual sales price still generated enough profits (or marginal revenues at least) to sustain the production of Chinese and Korean factories over the ’90s and later on.
In effect, the pub owners in our starting example were not only grabbing cheap credit from the brewery, they also laid claim to the lion’s share of profits generated across the entire chain of value addition. Herein lay the secret of US and European corporate profits for much of the past two decades, namely the ability to generate profits on the strength of brand names, while squeezing the margins and leverage of their suppliers in various Emerging countries.
Tackling the aftermath
As the credit crunch rolls on, the effect on individual and corporate balance sheets across the US and Europe will materially impact the ongoing demand for goods and services from emerging countries. Worries of a complete collapse in such demand have led the stock and bond prices of emerging market corporate entities sharply lower in the past few months, in most cases far worse than what has been witnessed in the case of US and European counterparts on a currency-adjusted basis.
This makes sense from a short-term perspective, but provides logical inconsistencies when considered over the longer term. There are but limited alternatives to the replacement of the current globalization cognate, that is, the provision of cheap goods by emerging market countries to Group of Seven counterparts in the more industrialized world: firstly a change of suppliers from foreign to local and secondly a vast change in the price of products.
President-elect Barack Obama apparently ran on the platform of promising the first alternative but somehow also ensuring that the second alternative becomes more tenable. This is so because the idea of Americans and Europeans producing stuff at lower prices than what Asians can manage is ridiculous at best, but could well create enough administrative traction to change the distribution of profits.
As noted in the preceding paragraphs, Asian countries secured large volumes but low profits on their sales of goods to Group of Seven (G-7) countries. With demand falling in those countries the current imperative across emerging countries is to cut costs even further in order to remain competitive.
Emerging countries such as China have to invest proportionately less in their banking systems to keep financial flows stable. In contrast, the series of interventionist actions by the US and European governments will raise taxes and reduce efficiency over the longer term. This shifts the balance of economic power to emerging markets, rather than away from them as the stock markets appear to have concluded a tad too hastily.
The second route that is being opened now, especially by the likes of China and India, is to increase economic spending by the government. While this smacks of the same Keynesian thinking as the G-7 countries, the key differences arise from the consideration of profit potential and demographic advantages.
China not only has the ability to produce goods far cheaper than G-7 countries could manage, it also has to spend less on saving its banking system and on the overall generation of consumption expenditure in the country. Similarly for India, despite the current account deficits of late, the overall profit potential of the economy remains strong, while the high levels of deposits relative to loans help to shield banks from the kind of excesses witnessed in the US and elsewhere.
It heartens me to note that the Chinese government has prioritized infrastructure spending over mere welfare checks as part of its stimulus package. This is the right way to go, as the short-term employment benefits of such spending also lead to longer-term competitive advantages in the production and shipping of various products across China, Asia and the rest of the world.
Going into this weekend’s Washington summit, Asian countries will be well served by reminding G-7 members and other representatives about the longer-term economic potential of their countries.
In the first part of this article, I laid out the outline of the argument against Keynesian spending in G-7 countries. Simply put, the recuperation of G-7 balance sheets must be to the advantage of Asian countries, as investors pursue higher growth alternatives to their own moribund economies. This will help plug the financing hole of production-oriented Asian economies.
Much the same logic of investing in these higher-value producers should permeate the thinking of commodity producing countries such as Russia and Middle Eastern nations.