The Bear’s Lair: Emerging markets in an autarkic world

Five years ago, the future for emerging markets seemed set fair. Globalization was driving much of the world’s manufacturing to them, as Western companies sought optimal global supply chains. All they needed to do was avoid selecting lunatic Marxist or Islamist dictators as leaders. Yet the future has changed; globalization is in retreat, though it’s not yet clear how far the retreat will go. However, that does not mean that emerging markets are condemned to long-term penury.

By economic theory, the free movement of goods, people and capital is economically an unalloyed good. By David Ricardo’s Doctrine of Comparative Advantage, every country should produce the goods and services for which it is most fitted. Labor should move worldwide to where it has the greatest expected remuneration, and capital should seek advantages worldwide, taking account of risks and potential rewards in every national environment.

It appeared around 1995-96 that modern communications and the Internet had for the first time enabled companies to source globally, while the fall of Communism a few years earlier had opened up the remaining new potential sources and markets. The Ricardian dream seemed about to become reality and the world was finally becoming globalized. There would naturally be a dampening effect on Western living standards as new emerging market sources of supply came onstream, but that effect should surely be temporary, and by Ricardo’s theorem, every country in the world would be very much richer once the process had played out.

The emerging markets themselves would not in general initially be well managed. However, in a fully free global market, the influx of investment and increase in living standards would tend to improve the behavior of the country concerned. Countries whose governments wasted money on boondoggles, indulged in excessive corruption, or harassed their entrepreneurial classes would rapidly fall behind their more virtuous neighbors, and so public pressure would force their governments to straighten up and fly right.

This did not happen, largely because a world with large meddling governments is not a free market. First, international central banks have kept interest rates artificially low since 1995. This has made it artificially easy to finance assets in emerging markets, creating a huge pool of hot money and reducing risk premia between interest rates in emerging markets and rates in developed markets. Essentially, outsourcing has been artificially subsidized. Then the Internet and modern telecommunications came upon us so rapidly that the world economy could not adapt to so large a change quickly enough, and so pathological behaviors were created, which prevented the globalized market from operating as it should.

The pathological behaviors were most apparent in the BRICs (Brazil, Russia, India, China), the four largest emerging markets, which were identified in 2001 by Goldman Sachs’ Jim O’Neill as the most important growth economies of the coming decades. All four of these countries were badly run in 1997; they are worse run in 2017:
• Brazil had a center-right but somewhat corrupt government under Fernando Cardoso; since 2002 it has had a succession of even more corrupt far-left socialists who have bloated the public sector and run the economy into the ground.
• Russia had Boris Yeltsin, it now has Vladimir Putin; in certain respects this is an improvement, but at no point has honest free-market capitalism been on offer.
• China in 1997 was still under the influence of the great Deng Hsiao-Ping, who died that year; it has become much richer but much more corrupt, with resource allocation almost entirely controlled by the state and an unimaginably large bad debt problem in the state banking system.
• India in 1997 was about to elect Atal Bihari Vajpayee, its only truly reforming prime minister. After later rejecting Vajpayee in a shock election result in 2004 it has been run by the corrupt socialist Congress Party, followed by Narendra Modi, whose reforming instincts are at best half-hearted.

Thus, none of the BRICs has significantly improved its government since 1997 even though a huge influx of capital has meant that three out of the four became much richer (Brazil being the partial exception). If you want to add South Africa, which christened itself a BRIC in 2010, the conclusion becomes even more stark and the current picture more unpleasant. The influx of easy money and the influx of business opportunities from all over the world has done a considerable amount for the BRICs’ wealth, but nothing at all for their quality of governance, which has universally been marked by appalling corruption. In the Transparency International’s Corruption Perceptions Index, all five BRICs consistently rank below 100th out of 180 or so countries, behind countries with a tiny fraction of their opportunities, capital inflows and interconnectivity with global markets.

There are a number of other disadvantages to emerging markets that arise from a globalized world, not immediately apparent in free-market theory. First, if global immigration is relatively free, all the best graduates from poor countries migrate to rich countries. This deprives poor countries of entrepreneurial skills, capital and scientific capability, severe disadvantages in a competitive world. It also makes the poor countries’ politics more likely to be dominated by crooks and tyrants, because the best citizens of those countries are no longer present to exert a countervailing influence.

To take a relatively benign example, Poland as a country lost substantially from its 2004 integration into the EU, and the freedom which that brought for Polish citizens to travel to Britain and eventually other countries. It is a huge loss to global GDP as a whole, as well as to Bosnia’s GDP, if a trained Bosnian surgeon migrates to London to work as a janitor, even if that surgeon can improve his living standards by doing so.

A second disadvantage to poor countries of a completely globalized world is that their successful local companies may get bought up by multinationals and wrecked. Eastern European banks, for example, were mostly bought by Western European banks in the years after 1991; this removed the ability of Eastern Europeans to influence their own allocation of capital. More important was the Croatian drug company Pliva, which had an important research capability until it was bought by the Israeli generic drug company Teva Pharmaceutical. Teva closed most of Pliva’s independent research operations, thus wasting the specialized higher education facilities that had been developed at the University of Zagreb.

Western companies are not always better run and more capable than emerging markets companies; they may merely be richer. Both the world economy and the emerging market’s can be damaged by the absorption of a unique local capability into the maw of yet another bloated multinational.

Finally, it is notable in recent years that many emerging markets have fallen into the “middle income trap” whereby their economic development has stagnated when they can no longer supply absolutely the cheapest labor for the multinationals’ global sourcing. In a globalized world, where there are no barriers, if Vietnam can provide cheaper labor than Malaysia, the Malaysian economy may stagnate, as Malaysia finds it impossible, without effective local multinationals, to develop the higher-level skills that would allow the country to progress to developed status.

The level playing field beloved of free trade theorists destroyed the British merchant banks in the 1980s; it may also be stunting the development of emerging market companies, especially those with small home markets that cannot develop worldscale operations.

Autarky can unquestionably go too far. If it results in high tariffs into the world’s major markets, the damage to world output will be severe, as it was in the 1930s. However, if it merely comprises a sharp brake on international migration, an ability of emerging markets to prevent the takeover of the best companies by multinationals, and enough bumps in the playing field to prevent global oligopolies from steam-rolling their smaller competitors, then emerging markets will enjoy a net benefit.

If in addition global interest rates are raised to proper free market levels, above the rate of inflation, so that the gigantic pools of footloose capital are dried up, the emerging markets seeking funding will have to improve their business climates to get it. Macedonia under Nikola Gruevski in 2006-16 was an excellent example of this. Being a tiny country located at the less attractive end of the Balkans, without early prospects of joining the European Union, it was forced to improve its institutions to attract capital, which it did to such an effect that the country ranks 10th on the current World Bank Ease of Doing Business index, higher than any EU member except Denmark, Sweden and the United Kingdom (its richer southern neighbor, Greece, ranks 66th, and its much richer western neighbor Italy 50th.) It is to be hoped Gruevski rapidly returns to power from which he has been ousted by a Soros-funded, EU and Obama-backed conspiracy. More important, in a world of scarce capital, Macedonia, not Brazil (which ranks 123rd on the World Bank list) or India (130th) will be the example more likely to be followed.

Emerging markets that have maintained their quality of government, such as Colombia and the Philippines, have benefited considerably from two decades of globalization. However, a return to at least partial autarky is not bad news even for them. If accompanied by the end of “funny money” it will force the backsliding BRICs and others to raise their game, helped as they will be by improved domestic human resources through reduced emigration to the West.

(The Bear’s Lair is a weekly column that is intended to appear each Monday, an appropriately gloomy day of the week. Its rationale is that the proportion of “sell” recommendations put out by Wall Street houses remains far below that of “buy” recommendations. Accordingly, investors have an excess of positive information and very little negative information. The column thus takes the ursine view of life and the market, in the hope that it may be usefully different from what investors see elsewhere.)