Thursday, August 12, 2010

China already the number one Catalyst of Global Economic Growth

1. Introduction

A lot of internationally operating firms across the globe presented their second quarter or half-yearly financial reports recently. Results were at best mixed. It became clear that the developed countries did not yet leave the period of Global Crisis behind them. What created a link between all those reports - even when the presenting firms were in different industries - is the fact that Emerging Markets have become more important for all of them. And these results were not coincidental. The role of Emerging Markets as a catalyst for Global Growth is growing.

A recent research report written by two IMF researchers about growth in China concluded that until the beginning of this century the world could basically ignore Chinese growth. But its far-above-average growth profile has resulted in a situation in which we cannot ignore it anymore. Maybe China is not THE catalyst yet, like the US has been for many years but they are getting there. The IMF researchers conclude that the catalyst role is quite similar in importance to that of Oil Prices, with the 1970s Oil Crisis period as an example of what that could mean.

How important are Emerging Markets as catalyst for other countries?

In this contribution we will address this issue by looking at 5 factors that are important identifiers of the linkage between countries: Imports, Exports, Foreign Reserves (incl Gold), External Debt and Direct Foreign Investments Abroad. We do not look at portfolio investments, because these are normally more short-term and have a tendency to be less stable. We believe that this will imply that their influence - albeit important at the overall level - can be less easily linked to specific countries over longer periods of time. In paragraphs 2 to 6 we will separately analyze the five variables mentioned above. In paragraph 7 we will wrap things up and conclude.

 2. Variable 1 : Exports

The  first factor we analyze is Exports. In our analysis of exports we use the most recent data set from the CIA Factbook of the US Government to get information about the five most important export partners per country for the 100 most important countries in the world. Countries that were the largest export market for a specific other country received 5 points, the number 2 spot was awarded 4 points, number 3 received 3 points etc..down to 1 point for number 5.

The table below gives the top-20 and their total number of points. The USA and Germany are globally still the most important export markets. These countries are - not really surprisingly - the big buyers of international products and services. China is indeed the most important Emerging Market when it comes to international buying sprees, but the difference with the USA and Germany is still substantial.

If we would be treating the European Union as a kind of United States of Europe, Europe would be clearly more important globally than the USA. Next to Germany, countries like Italy, France, the United Kingdom, the Netherlands and Spain made it all into the global top 10 of export destinations.

We gave the Emerging Markets countries a gray background. The BRIC nations (Brazil. Russia, India and China) - the largest Emerging Markets - are usual suspects. But they are not the only
Emerging nations that made it into the top-20. South Korea, Turkey and the United Arab Emirates are also in the top-20 of most important export destinations.

Remarkable: Switzerland, one of the richer countries in the World, is NOT in the top-20. The Swiss are an important destination for money through their exports of financial services and they are also important when it comes their own exports of watches, jewelry, food (Nestle), chemicals, machinery (Asea Brown Boveri), but as export destination for others the country is too small, albeit that other small nations like Hong Kong and UAE did make it into the top-20, which implies that 'size' was not the only issue explaining the Swiss absence.


Sub-conclusion: our first international variable - Exports- does indicate that China is a separate case in terms of international linkages when analyzing Emerging Markets. But all-in-all Emerging Markets are not dominant export destinations yet. This will of course improve because their above-average growth will translate into better positions for the middle classes and they will demand international products. But at the moment this first indicator makes it clear that the main catalysts are still the USA and the European Union. But China is more important than Japan already.



3. Variable 2: Imports

When looking at the Exports in the previous paragraph we found that China is the important leader of a group of 7 Emerging Markets that made it into the top-20, but countries like the USA and Germany were still dominating. In this paragraph we look at Imports and find out that this is not a mirror image of Exports. Within the top-3 - again quite clearly formed by China, Germany and the USA - China is now indeed the dominating force. It is by now the top producer of goods and services (mainly goods) that find their way into international markets. The role of China in export markets will obviously grow along with the increased wealth of the Chinese middle classes, but China is not leading the pack yet.

So different is the situation for Imports. For our group of 100 most important countries in the world from the LMG and CIA data bases, China is by far the most important when it comes to Import origins. 

 Germany and the USA are second and third. Note that the position for the US is less good than what we could have expected based on the size of the economy. The German economy is much smaller, but still about equally important as supplier of international products. Combining the import and export top-20's we can indeed confirm that China is as important as the US or Germany are. Quite an accomplishment when comparing this with the situation at the beginning of the 21st century.


Sub-Conclusion: Not surprisingly, Emerging Markets are already more important when analyzing the Import origins top-20 (as compared to Export rankings in the previous paragraph): 9 EM's made it into the top-20. It is of course not a big surprise that oil producing countries do play an important role in this top-20 of Import origins.

The export and import lists are nonetheless highly correlated in that 17 out of 20 spots in the top-20s are taken by countries that reside in both the export and import lists.

4. Variable 3: Foreign Direct Investments

The table below shows the top-20 nations of the world when it comes to their stock of foreign direct investments (FDI) abroad. Numbers are in billions of US Dollars and derived from the CIA Factbook.

Did we see earlier in the previous paragraphs - when studying Exports and Imports - that Emerging Markets were already a substantial factor to reckon with, we see here that direct investments in foreign firms is still the name of the game for firms and other investors from the West.

Only 2 Emerging Markets countries seem to be the exception when looking at the top-20. Russia (on place 15) and China, albeit the latter indirectly via Hong Kong (5th place). Obviously, the huge amount of investments via Hong Kong (more than USD 1 trillion in total) is not the result of the efforts of the city state alone. It includes Chinese investments that are often led via investment vehicles operating from Hong Kong like for example CITIC Pacific.

The USA is the dominant country here, which is no surprise. Remarkable is the second spot for the United Kingdom that fared less well when looking at Exports and Imports. A mirror image of the UK is Japan. Japanese firms tend to be better in exporting their products than in acquiring influence abroad via acquisitions.

When adding all numbers up the importance of EU is large. Actually: the US dominance is not that big when taking into account the economic size of the US economy. Something similar was visible when looking at Exports and Imports. Leadership of the US globally is therefore to a large extent based on the leading role that the US is playing politically and indirectly (as far as economics is concerned) via investments by other countries in the US economy.

Critical observers might state that we analyzed only the Foreign Direct Investments abroad and did not take into account how much was invested in a specific country. In the table below we subtract inbound Foreign Direct Investment stock to see what difference that will make. It will obviously reduce the role of Emerging Markets because the most successful growth stories in these countries are from a recent date.


Less than 20 countries in the world turn out to be net investors when subtracting the stock of received Foreign Direct Investments from Foreign Direct Investments Abroad! This is a clear indication of inequalities in the world.

Once again - just like when we looked at outbound FDI's - the USA leads the pack. Japan moves up the ranking substantially. When analyzing outbound investments we felt that - when comparing things to the size of the economy - the level of Japanese investments abroad was a bit disappointing. However: taking into account the structure of Japanese business it is still very difficult for foreigners to invest in Japan. Result: on a net basis Japan moves into second place, just before the United Kingdom (nr 2 on a gross basis).

There are only 2 Emerging countries in the top-20, which is actually just a top-15. The rest of the world is net receiver. The only Emerging countries that invest more abroad than that they receive from abroad are Kuwait and Taiwan. All the big BRIC countries did grow substantially and in all cases benefited from net foreign investments in their economy. Obviously these net investments did to some extent not lead but follow growth trends in the BRIC economies. It would require additional research if we were to find out which aspect (lead or lagged effects) dominates.

Sub-conclusion: the bottom-line is clear: the importance of Emerging Countries on an international scale is far bigger when looking at their Export-Import activities than when analyzing Foreign Direct Investments. Taking into account that FDI's are extremely useful vehicles for a) the dispersion of knowledge internationally, b) structural integration of a country into the global economy and c) improvements in governance and development of the middle classes, we can conclude that attractive growth figures and accompanying export-import activities will trigger POTENTIAL growth in FDI's. However, countries faced with such an improvement in their international economic profile will have to follow up with sound economic policies so as to create a good climate for international direct investments.

What we normally will see is that there will be an interim phase during which portfolio investments by international portfolio investors (e.g. pension plans and high net worth individuals) will provide an intermediate layer of first acquaintance with a newly discovered growth economy. It is clear that countries like China are already discovered (incoming FDI flow), with the next stage being a sharp increase in outgoing FDI.

In the table below we look at the bottom of our net FDI list: which countries attracted most foreign investments? 

China  is indeed the largest net receiver of investment capital with Mexico a good second. Countries that just entered EU or are playing with the idea to enter do also do well in terms of attracting foreign capital.

Emerging Markets are - of course - the main receivers of investment capital in this structurally changing world. Sixteen of the 20 largest net recveivers are Emerging Countries. Exceptions are Belgium, Singapore, New Zealand and Ireland. Caveat: we did once again treat Hong Kong as an indirect investment in China.

Sub-conclusion: so it is clear that Emerging Countries are getting more important in this globalized world of ours. But that is not the same as saying that they are true catalysts of Global Growth. China is the only country that - after analyzing 3 of the 5 variables that we are analyzing - is close to that role. The rest is follower, even as a group.


 5. Variable 4: Foreign Currency Reserves and Gold

Where are the big pockets?

In the table below we present an overview of the 20 richest countries in the world when looking at their foreign reserves and gold positions. Maybe your first thought is once again that the developed nations will be leading. However, those nations do of course have a bigger economic base, richer population, larger history of excess savings etc. But demographics and economic conditions have changed. Their populations have grown older as a result of which health costs have increased, pension plans are now in a phase characterized by relatively large capital outflows for pensioners and relatively lower inflows due to less favorable ratios of working population / retirees etc.

When we combine this with the debt positions of countries and the current account balances we get a ranking that already indicates quite clearly the growing importance of Emerging Nations.

Sub-conclusion: THIS is the variable that indicates their growing international importance. They are the ones with liquidity and big pockets. For many years Taiwan was known to be the number one country, but the last few years other Emerging Nations saw tremendous growth and combined with a larger size this translated in a ranking in which China is easily the richest country in the world when looking at international currency reserves and gold position. Just three developed nations make it into the top-10 and all are Asian: Japan, Hong Kong and Singapore. Note also the relatively low position of the USA. The world's largest economy is feeling the consequences of years of 'borrowed' growth, huge defense spending and deficits in its current account balance.

External assets are one side of the coin. In the next paragraph we will look at external debt, representing the other side of the coin. Will that lead to a different ranking? What happens when we compare them?


6. Variable 5: External Debt

In this fifth paragraph we look at the External Debt position of countries. What amounts have they been able to borrow abroad? Obviously, when you need money the first possibility - often misused by countries - is to print it locally. In the past many Emerging nations have built a terrible track record by doing so. Sky-high inflation and a deterioration of the international value of the local currency were always the result. A disastrous path to follow, especially for those countries that by necessity do have to import large amounts of goods abroad.

A more prudent approach is borrowing from investors. First locally, and then internationally. Actually: the ability to borrow internationally is to some extent also an indication that foreigners do believe in the payback capacity of your country. However: economies go through periods and payback capacities change. So let's take a look at the top-20 of largest IOU nations in the World.

The table cleary shows that Western nations dominate the rankings with the United States and United Kingdom leading the pack. In both cases governments and internationally operating firms have extensively borrowed money abroad.

The top-20 does also incorporate countries that are definitely 'suspicious' when it comes to their ability to repay everything without substantial support. The so-called European PIGS (Portugal, Ireland, Greece and Spain) are all four in this top-20!

The only Emerging nation in the top-20 is Russia on place nr 20. Big question therefore: is this top-20 another indication of a changing world in which - taking into account their low economic growth rates - many Western nations will be struggling with their international financial position while on the other hand Emerging nations will enjoy above-average growth and relatively better financial positions?

To answer that question we will need to go one step further with our Debt analysis. An analysis of absolute debt levels is nice and it resembles us of that Madison Square Garden clock telling the US population what the size of their National Debt is. It is the type of statistic that will always look impressive and scary for the biggest nations. But these big nations do also have bigger economies. And in the end debt positions are always relative. You have to compare them with the earnings generating capacity (i.e. size of the economy) of nations and the amount of liquid assets (for debt service) at hand.

In the second part of this analysis of external debt levels we correct  the previous table on external debt by subtracting foreign reserve and gold positions. Obviously countries with larger amounts of available liquid international assets can handle larger amounts of international debt.

Our initial reflection  that the dominance of developed nations in the gross external debt table was directly related to those countries being 'richer' in liquid assets turns out to be totally wrong.

Actually, to be frank: the table is more or less a one-on-one copy of the one in our previous contribution. And the only Emerging country that made it into the top-20, Russia, has even disappeared. Russia's foreign currency and gold reserves are so large that they are not in the top-20 anymore.

But  liquid assets are just one way of looking at the relative size of international debt burdens, though. We will now compare the net international debt position (external debt corrected for foreign currency and gold reserves) with the size of a country's GDP and rank countries based on this relative indicator.

The first thing that strikes us immediately is that the US is gone from the top-20 list. Sure, it had by far the largest external debt and a lot of people translated that into the belief that the US is the country borrowing too much. But: look at this! A lot of European nations are still in the top of the table and the US is gone. The US borrowed a lot internationally, but it is nothing compared to the size of the US economy. And true, there is also a lot of domestic borrowing within the US, but the latter is only an internal re-distribution of income.

Sub-conclusion: it is also clear that Emerging Nations are not really important in this list of external debts. Just a few smaller ones reside in the top-20. Summarizing: whenever there is any negative impact on international financial markets like for instance crowding out of prudent nations and/or internationally operating firms, it is caused by the usual suspects from the EU and not by Emerging Market countries.


7. Evaluation: Wrapping-up the 5 analyzed variables

 We conclude by wrapping up the 5 sub-analyses. We do so by assigning scores from 20 to 1 (20 for the highest ranked country in the relevant table; 1 for the lowest ranked country) with higher scores indicating a larger importance as global catalyst. For Foreign Direct Investments we look at the net values, but assign rankings from 20 to 1 for both the top of the list and the bottom of the list. Reason: the importance of a country can result from its attraction as a recipient of investments (e.g. China at the moment), which can thereby make it a kind of international magnet for investment money, or a country can derive its importance from the large amounts its investor allocate globally. We look at the Foreign Currency Reserves and Gold position on a net basis as well. For External Debt we use the scores of the two relative variables (External Debt related to Foreign Reserves and Gold - but this time the bottom-20 of the table - and External Debt as percentage of GDP). This leads to an overall score based on 5 rankings ranging from 20 to 1. The table below presents the top-20 overall:

 China is clearly in the lead, which we interpret as the country now really playing a role as global catalyst. However, the United States and EU (via Germany, France and to a lesser extent the United Kingdom and the Netherlands) are still important. This means that one of the reasons why markets are so nervous is also the simple fact that we have moved from a 2- to 3-block world order. And this re-arrangement of power balances does lead to uncertainty among investors and other decision takers.

All 4 BRIC nations make it into the top-15 which is a clear indication that Emerging Markets countries are now a force to reckon with when it comes to their international importance. The total number of Emerging Markets countries in the top-20 is 8, with Saudi Arabia, Mexico, Thailand and Taiwan completing the selection. This translates into a 40 percent representation within the top-20. Remarkable: this 40 percent is exactly the same as the global GDP weight of Emerging Markets. The total number of countries that made it into at least one top-20 within our analysis is 56, but in the bulk of cases the country score is solely the result of one top-20 ranking out of five.


Conclusion: Emerging Markets are indeed a force to reckon with when analyzing international economic and financial trends. It is impossible now to get your predictions and forecasts about market movements right when simply looking - like before - to what is going on in the United States and the European Union. The BRIC nations and especially the number one China are playing a role. Based on the relatively higher growth of GDP in those countries and their strong financial positions we can expect a further increase in importance of these countries in global economic analysis. Emerging Markets investments have thereby become clearly mainstream. Whoever will continue to treat them as 'niche' component of the portfolio will end up with a growing tracking error compared to the global representative indices and difficulties to understand what is going on. The world has structurally changed, and this implies that we will have to adjust our investment approaches accordingly. But the same does not only apply to us, as investors. It also applies to these nations themselves. China cannot afford a 'splendid isolation' like policy when the world is treating it as a catalyst. We believe that the Chinese understand this and that recent decisions to allow at least some exchange rate appreciation vis-a-vis other major currencies is the beginning of a Chinese move towards a bigger role within the international economic order.


No comments:

Post a Comment