Back to the Future

The Chinese economy is stumbling. Oil prices dropped below $40 a barrel last week. Asian exports have stalled because commodity demand has slumped. The fall in oil prices means that net oil exporters in Emerging Markets will have substantially reduced revenues. There seems little chance of avoiding an Emerging Market currency war following the depreciation of the Yuan and successive copycat depreciations across Central and South East Asia.  EM equities seem set for a further fall as we enter into the final week of August.

There seems to be a perfect storm brewing in Emerging Markets but this is not news and may not be quite as tempestuous as analysts currently believe.

Back in 2011 I forecast that China’s export trade growth would be just 3.3% by 2015 and that other Asian markets would follow similar patterns of flattening trade.  This was not, I argued, because these economies were converging with developed markets. Instead, my view was that the process of catch-up growth would slow because post-crisis growth was shallow-based and highly dependent upon commodities, infrastructure and intermediate manufactured goods.

For any trade or development or trade economist this would seem obvious. But I lost a substantial contract as a result of my contrarian view.  This makes it all the more worthwhile re-examining the reasons why behind my views back then.

I was arguing that all emerging economies had to go through a period of catch-up that transitioned them from a commodity-trade economy to a high value economy.  This is a more complex view of the world than capital investment- based catch-up in that it incorporates the technology component of growth.[1]  I was applying this concept to trade generally and exports in particular.

The central idea was that until you saw a higher technology and skills component of trade, these economies were bound to see their export-led growth slow because they would remain dependent on world demand for primary and secondary goods. At the time, correlations between skills, innovation and trade were relatively weak in many emerging economies. For example at the time, the correlation of innovation with trade in Brazil was just 35% and in China was 52%.

The picture has changed. The correlation now between trade growth and innovation in Brazil is 0.45 while the correlation with skills for Brazil is -95%. That is, higher skills are having a negative impact on trade. Brazil, it seems has not made the expected progress towards higher skills as a component of trade and only modest progress in terms of the technology component of trade.

China, in contrast has made very rapid progress towards increasing the skills & innovation components of its trade. Now the correlations of both with trade are above 95%. China is quite explicit in the fact that it is in a process of transition to a modern during which its growth will slow.  It put in place many years ago large scale government Research and Development (R&D) and skills development and the tight correlation now with trade suggests that after the current crisis has worked through, China will be competing at the higher end of the global supply chain.

So the issue is not China’s longer term growth prospects because these are likely to be positive after 2017-18. Rather, it is the spill-over effects that its policy now is likely to have on the rest of the emerging markets – particularly in terms of provoking an aggressive currency war which is of little help to any of the emerging market economies.  As the chart shows, the correlation between EM currency spot prices and trade is largely weak or positive for most emerging markets meaning that aggressive currency depreciations will not have the desired impact on exports. The notable exceptions are China, Brazil and Thailand.

Source: Rebecca Harding, Delta Economics, Trade View, March 17th 2015

A longer term perspective suggests that China in particular is not just reforming its financial systems at the moment but is also putting in place the mechanisms to guarantee its place at the top table as a high value economic superpower. It is, perhaps too early to claim that the Chinese model is "nearing it's end"; the model is adapting, and that takes time.

But, as the fact that I lost my contract all those years ago shows, markets are not about the long term.  Markets have been looking for a trigger to go through a major correction arguably since January when the Syriza victory in Greece put the Eurozone centre stage and the prospect of a June hike in US interest rates was mooted.

Bad data from China, a currency war in Emerging Markets and the prospect of a September rate hike may now be the trigger that causes a major correction this week.  But equally, there is a strong argument to say that Emerging Markets have over-performed as analysts have mis-read the reasons why growth was so rapid post-crisis.  If the same analysts pause for breath, they will realise that the longer term prospects as China resumes growth are good and in the short-term, the current correction may have gone far enough.

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[1] This is an approach derived from Romer (1990): “The origins of endogenous growth theory” The Journal of Economic Perspectives Vol. 8, No. 1 (Winter, 1994), pp. 3-22 and Audretsch and Kielbach (2008).