I was at a garden party recently, on a beautiful Sunday afternoon in September, where talk centered around the economy, politics, favorite movies, and the latest in electronic gadgets. Yet one conversation that struck a particular chord with me was the “case for China.”
You’ve heard it repeated in various forms. The Chinese economy is booming, while the developed economies are in a funk. Chinese infrastructure is gleaming and new, while U.S. infrastructure is falling apart. Output from the Chinese economy will soon exceed U.S. output, signaling the end of American influence and prominence in the world. The argument is actually much broader and about emerging markets in general. The emerging economies are ascending, and the U.S. and other rich countries are washed up.
What strikes me about this narrative is its stark, black versus white rhetoric—and its one-sided view of the state of the world.
It’s true that the U.S. and other developed economies have suffered a major setback with the financial crisis. What happened in the U.S. has occurred numerous times in the developing world, but the lessons of those crises never seemed to apply to us (until they did). A classic scenario for a financial crisis in an emerging economy is the arrival of cheap foreign money, triggering a domestic investment boom, a bubble in local property markets, and a surge in domestic spending. This leads, in the face of lax monetary and fiscal policy, to rapid inflation, a depreciating currency, and a financial crisis. (Latin America in the 1980s is a good example.)
The U.S. crisis didn’t have all of the components of a classic, small-economy crisis, but at times it seemed quite similar: Cheap money (in the form of purchases of U.S. Treasury bonds lowering long-term interest rates) arrived from China and elsewhere, and it combined with lax regulation to encourage a massive real estate boom and subsequent crash.
But in recounting this narrative, it’s worth keeping in mind the broader picture. Within China, the large accumulation of Treasury bonds is reflective of other economic imbalances. A fixed exchange rate has driven the large accumulation of dollars and has limited consumer consumption of expensive foreign goods. A wave of labor moving from the country to the city made it possible to generate large manufacturing output while constraining domestic wages and consumption. A huge pool of savings—which has been attributed to both lack of consumption opportunities, an underdeveloped consumer financial system, and the lack of social welfare systems like health and retirement plans—drove large domestic investment spending.
All of these trends seem in the process of slowing or reversing and pose a challenge for China and other countries as they set to transition from poor to middle-income to rich. The problem of over-investment in the export-driven model of growth is a particular concern. Banks and government agencies have allocated large pools of cheap capital to projects that may, in retrospect, have low economic value. Think of expensive high-speed trains with not enough rich customers to pay for them.
On top of this, many emerging countries are aging just as fast as Western countries and facing pressures for greater public spending on old-age financial security. They confront these pressures, not as rich countries debating issues like health or retirement reform, but as lower-income countries seeking to create a basic safety net.
I happen to believe that much of this narrative is largely a function of the investment climate over the past decade. U.S. stocks have been in a funk for over ten years; emerging-market stocks have surged by double digits. So naturally, this decade of underperformance needs an investment story, and what better one than the dawning of China and the emerging markets and the decline of the West?
But the story is not as simple as it seems. China is already an economic powerhouse yet faces major challenges climbing up the income ladder. The U.S. and other Western countries—who remain ten times as rich as the emerging economies today—have to dig out of their debt holes and deal with their long-term spending on old-age retirement security.
In terms of the “case for China,” the implication for investors is simple. Developed-economy stocks will be mired in volatility and low returns—until they aren’t. And emerging markets will continue to grow to the sky—until they don’t.