By Louis Gave
Talking about the Russian Revolution, Lenin once said that “there are
decades when nothing happens and there are weeks when decades happen.” The
last quarter of 2001 looks in retrospect like one of those exciting periods:
three events occurred which set in motion the main economic trends of the
ensuing decade. Successful investors latched on to at least one of these
trends. The problem is, all three trends are now over. The investment
strategies that worked over the past decade will not continue to work in the
next. What comes next?
The three big events of 2001 were:
• The terrorist attacks of 9/11. This unleashed a decade of bi-partisan “guns and butter”policies in the US and produced a structurally weaker dollar.
• China joined the WTO in December 2001. China’s full entry into the global trading system signaled a re-organization of global production lines and China’s emergence as a major exporter. Export earnings were recycled into the mother of all investment booms, which drove a surge in commodity demand and a wider boom in emerging markets.
• The introduction of euro banknotes. The introduction of the common currency unleashed a decade of excess consumption in southern Europe, financed unwittingly by northern Europe through large bank and insurance purchases of government debt.
But today, all three trends have stalled—and this
perhaps accounts for the discomfort and uncertainty we find in most meetings
with clients. Indeed:
• US guns and butter spending is over. For the first time since 1970, real growth in US government spending is in negative territory:
• Chinese capital spending is slowing. China still needs to invest a lot more, but future growth rates will be in the single digits.
• Excess consumption in southern Europe is done. Money is clearly flowing out to seek refuge in northern Europe.
Thus, like British guns in Singapore, investors whose
portfolios still reflect the above three trends are facing the wrong way.
Instead of lamenting over the past, investors should be coming to grips with
the trends of the future: the internationalization of the RMB, the rise
of cheaper and more flexible automation, and dramatically cheaper energy in the
US.
1- The internationalization of
the RMB
China is now the centre of a growing percentage of
both Asian, and emerging market trade (a decade ago China accounted for 2% of
Brazil’s exports; today it is 18% and rising). As a result, China is
increasingly asking its EM trade partners why their mutual trade should be
settled in US dollars? After all, by trading in dollars, China and its EM trade
partners are making themselves dependent on the willingness/ability of Western
banks to finance their trade. And the realization has set in that this menage à
trois does not make much sense. Indeed, for China, the fact that Western banks
are not reliable partners was the major lesson of 2008 and again of 2011.
As a result, China is now turning to countries like
Korea, Brazil, South Africa and others and saying: “Let’s move more of
our trade into RMB from dollars” to which the typical answer is
increasingly “Why not? This would diversify my earnings and make our
business less reliant on Western banks. But if we are going to trade in RMB, we
will need to keep some of our reserves in RMB. And for that to happen, you need
to give us RMB assets that we can buy”. Hence the creation of the
offshore RMB bond market in Hong Kong, a development which may go down as the
most important financial event of 2011.
Of course, for China to even marginally dent the
dollar’s predominance as a trading currency, the RMB will have to be seen as a
credible currency—or at least as more credible than the alternatives. And here,
the timing may be opportune for, today, outshining the euro, dollar, pound or
even yen is increasingly a matter of being the tallest dwarf.
Still, China’s attempt to internationalize the RMB
also means that Beijing cannot embark on fiscal and monetary stimulus at the
first sign of a slowdown in the Chinese economy. Instead, the PBoC and
Politburo have to be seen as keeping their nerve in the face of slowing Chinese
growth. In short, for the RMB to internationalize successfully, the
PBoC has to be seen as being more like the Bundesbank than like the Fed.
Following this Buba comparison, China has a genuine
opportunity to establish the RMB as the dominant trade currency for its region,
just as the deutsche mark did in the 1970s and 1980s. But interestingly, China
seems to consider that its “region” is not just limited to Asia (where China
now accounts for most of the marginal increase in growth—see chart) but encompasses
the wider emerging markets. How else can we explain China’s new enthusiasm in
granting PBoC swap lines to the likes of the Brazilian, Argentine, Turkish and
Belorussian central banks?
China’s attempt to move more of its trade into RMB is
interesting given the current shifts in China’s trade. Indeed, although the US
and Europe are still China’s largest single trade partners, most of the growth
in trade in recent years has occurred with emerging markets. And China’s trade
with emerging markets is increasingly not in cheap consumer goods (toys,
underwear, socks or shoes) but rather in capital goods (earth- moving
equipment, telecom switches, road construction services, etc; see China
Bulldozes a New Export Market). In short, yesterday China’s trade
mostly took place with developed markets, was comprised of low-valued-added
goods, and was priced in dollars. Tomorrow, China’s trade will be oriented
towards emerging markets, focused on higher value-added goods, and priced in
RMB.
This would mark a profound change from China’s old
development model: keeping its currency undervalued, inviting foreign factories
to relocate to the mainland, transforming 10-20mn farmers into factory workers
each year, and triggering massive labor productivity gains—gains which the
government captures through financial repression and redeploys into large-scale
infrastructure projects. But China’s change in development model may be less a
matter of choice than of necessity.
2– Virtue from necessity: the
rise of robotics
The first harsh reality confronting China is that the
country is now the world’s single largest exporter. Combine that impressive
status with the reality that the world is unlikely to grow at much more than 3%
to 4% over the coming years and it becomes obvious that the past two decades’
30% average annual growth in exports just cannot be repeated.
Beyond the limits to export growth, the other
challenge to China’s business model is the second step, namely the transforming
of farmers into factory workers. Not that China is set to run out of farmers
(see The Countdown for China’s Farmers). But the coming years may prove more
challenging for unskilled workers as robotics and automation continue to gather
pace. Over the coming decade, cheap labor may not be the comparative
advantage it was in the previous decade, simply because the cost of
automation is now falling fast (see The Robots Are Coming).
Of course, factory and process automation is hardly a
new concept. What is new is the dramatic recent shift from fixed
automation to flexible automation.For decades we have had machines
that could perform simple repetitive tasks; now we have machines that can be
reprogrammed easily to perform a wide range of more complicated functions. With
improved software and hardware, robots can do more, in more industries; and the
purpose of automation has shifted from improving crude productivity (making
more of the same things at lower cost) to more sophisticated targets like
adaptability across product cycles, and improved quality and consistency.
One consequence of cheaper and more flexible
automation is that some manufacturing that fled the developed world for
cheap-labor destinations like China may return to the US, Japan and Europe, as
firms decide that the benefits of low-cost labor no longer outweigh the
advantage of better logistics and proximity to customers. Even if this does not
occur, factories in places like China may become ever more automated (e.g.:
electronics assembler Foxconn, Apple’s main supplier and one of the world’s
biggest employers with some 1mn workers, has started to talk about building
factories manned with robots). This then raises the question of what China’s
hordes of manufacturing workers will do should Chinese factories automate
and/or re-localize to the developed world. One obvious conclusion is that
China’s leaders will thus have to deal with slowing growth through further
deregulation, rather than stimulus and currency manipulation. The remedies of
2008 (large fiscal and monetary stimulus) will not work again.
This dilemma implies that the robotics trend dovetails
with the RMB internationalization trend. To understand just why, it is
important to recognize one aspect of policymaking which makes China unique: the
country’s leaders wake up every morning pondering how to return China to being
the world’s number one economy and a geopolitical superpower in its own right (few
other world leaders harbor such thoughts). And ever since Deng Xiaoping, the
answer to that question has typically been to sacrifice some element of control
over the economy in exchange for faster growth.
Today, China faces the imperative of making just such
a trade-off between control and growth: the old model of cheap labor and vast
capital spending is near exhaustion, so the only way to sustain growth is to go
for more efficiency, especially through financial sector reform. For China’s
leaders, reform will be painful but the cost of missing out on the global power
that comes with further growth would be even more painful. Hence we are
convinced Beijing will eventually bite the financial reform bullet, and RMB
internationalization is the leading edge of that reform. In that
light, the creation of the RMB offshore bond market is an event of much greater
significance than is currently acknowledged by the general consensus.
3– Cheap US energy
Along with the possibility of manufacturing returning
to the developed world from China and other low labor-cost countries, another
key trend of the coming decade should be the gradual achievement of energy
independence by the US. Given the discoveries of the past few years in the
exploitation of shale gas and oil, and assuming the existence of political will
to invest in reshaping US energy infrastructure, such a development is now
within reach.
These large natural gas discoveries have two potential
global impacts. First, the combination of low-cost automation and low-cost
energy could encourage manufacturers to locate their plants not in countries
with the lowest labor cost, but in those with the lowest energy cost. For
example, on a recent visit to Germany we kept hearing how chemical plants would
have a tough time competing with American plants if the price of US natural gas
stayed below US$2.50. In fact, with Germany having decided to pull away from
nuclear and bet its future on high-cost wind power, energy- intensive
industries in the country could be in for a challenging decade.
Second, the return to manufacturing and energy
independence should lead to sustained improvement in the US trade deficit.
Energy imports account for around half of the US trade deficit (while the other
half is broadly manufactured goods from China). Today the US, through its trade
deficit, sends roughly US$500bn worth of cash to the rest of the world every
year. This money helps grease the wheels of global trade since more than two-thirds
of global trade is still denominated in dollars. But what will happen if, in
the next ten years, the US stops exporting dollars, thanks to its new strengths
in manufacturing and cheap energy? In such a scenario, the dollars would run
scarce.
In fact, this may already be happening. This would
explain why the growth of central bank reserves held at the Fed for foreign
central banks has been in negative territory for the past year—and why, over
the past two quarters, the Fed has been exceptionally generous in granting swap
lines to foreign central banks (notably the ECB).
This does not make for a stable situation. And given
that the RMB is unlikely to replace the dollar as the principal global trading
currency for many years to come (see History Lessons and the Offshore RMB), the
likely combination of expanding global trade and a shrinking US trade deficit
should mean that either the dollar will have to rise, or US assets will
outperform non-US assets to the point where valuation differnces make it
attractive for US investors to deploy dollars abroad (since US consumers won’t).
4– Conclusion
Obviously, we do not claim to have identified all the
big trends of the coming decade. The next several years will doubtless deliver
many more important changes and investment opportunities (monetization of
Japan’s debt and a collapse in the yen? Demographic challenges in numerous
countries? Reform and modernization in the Islamic world? Political upheaval
and regime change in Iran? Water shortages in China, India and other Asian
countries? Possible energy independence for India through thorium-based nuclear
energy plants?). But we are nonetheless confident on these main points:
• The three key macro trends of the past decade have
come to a screeching halt. This explains why financial markets seem to lack
conviction and direction.
• The internationalization of the RMB and the birth of
the RMB bond market is likely to be one of the most important developments of
the decade. The closest analogy is the creation of the junk bond market by
Michael Milken in the 1980s. Interestingly, just as in the early 1980s, few
people are taking the time to work through the ramifications of this momentous
event. Understanding this new market will prove essential to understanding the
world of tomorrow.
• The likely evolution of the US from record high twin
deficits to much smaller budget and trade deficits should help push the dollar
higher over the coming years. And this in turn will have broad ramifications
for a number of asset prices.
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