The Super Cycle Theory - The Rise of the Emerging Markets: A Critique
One would be slightly behind the curb, to suggest that emerging markets are going to be outpacing the developed world in GDP growth. According to the World Development Indicators published by the World Bank in 2008, developing countries produce 41% of the world’s total output of approximately $60 trillion. The central tenant of the super cycle theory[1] is Newton’s third law; ‘every action has an equal and opposite reaction’. This is the basis for the arguments in favour of long term cycles or ‘super-cycles’ in the economic trajectory of nations.
The Super Cycle hypothesis rests upon the historical fact that before WW2, Britain was the centre of the financial world, and the main economic powerhouse. After the war however, it was America’s time under the sun in terms of worldwide economic dominance, and indeed New York fast overtook London as the financial capital of the world. Now the emphasis is shifting to the emerging economies, or so the Super-Cyclists believe, and it time to prepare for another change of guard, because nothing is permanent but a long term boom and bust cycle for every economy.
Ever since Goldman Sachs chief economist Jim O’Neill coined the term BRIC countries in late 2001, there has been a fantastic amount of exuberance surrounding emerging markets, and especially around China, Brazil and India.[2] It would be foolish to get in the way of such exuberance and term it irrational, at least in the short to medium term. However, looking at the economics behind the growth of the emerging world, it is hardly surprising to see double digit GDP growth in places. Very few people choose to look at the long term, because it is very hard to apply the harsher lessons of globalisation learnt in the past in order to change course for a more sustainable future.
There have been psychological studies done to prove that most investors in the markets are optimists, for at least the item they have invested in. It takes some unconventional thinking on part of the average investor to believe that the prices of the assets which have been invested in by him/her will not rise. It is not unusual to see the bears in the short/medium term; but there are only a chosen few who are likely to have total faith in probabilities, and accept that there may be as much rationale for being bearish in the long term as for being bullish. Perhaps this same psychological barrier can be used to explain why people are so inherently scared of deflation and at the same time, ready to accept steady inflation as has been argued in the past by Jeffery Christian of the CPM Group.
Some Simple Economics:
Robert Solow, the Nobel Prize winning economist created the Solow Growth Model, which is extensively used by undergraduate and graduate economics students to study the reasons behind economic growth. In my view all those commentators who choose to ignore economic fundamentals are either being journalistic in their approach towards the super-cycle theory or are so deeply hypnotised by the Austrian business cycle school of thought that they don’t even rely upon the building blocks upon which they stand to analyse the world around them.
The stripped down Solow Model can be seen with the help of some simple graphs. It may be worthwhile to note that the main components of the simplified model illustrated below (figure 1) are investment, savings rate, population growth, capital per worker, rate of depreciation. This model helps to illustrate the growth of a country with a closed economy.
In the Solow Model, the break even investment is the amount of capital per worker required to sustain investment in the economy, given the population growth rate and the depreciation of capital. The point where the investment curve meets the break even investment line is known as the ‘steady state’ level of capital denoted by K*. The steady state amount of capital is the amount required to sustain output in an economy. All the variables grow at the same rate at this point.
According to figure 1, the consumption is maximised at the point where the tangent to the curve exists. According to the Solow Model, if one were to increase the growth rate of population, the break even investment curve would shift up like in figure 2.
This increased rate of population would lead to the economy reaching is ‘steady state’ level of capital at a lower level of capital per worker. Thus the model rightly predicts that countries with higher population growth would have lower levels of GDP per person. This theory is very clearly verified from the following table:[3]
| Country | Gross Net Income Per Capita as of 2008 (Current US$) |
| USA | $47,240 |
| UK | $41,520 |
| Brazil | $8,040 |
| China | $3,590 |
| India | $1,180 |
Hence, using the building blocks of growth theory, one can establish why countries with higher populations are predominantly poor, albeit the confounding factors could vary from country to country, and it is hard to establish one-way causality. The other factors at play are of course diverse, ranging from education and productivity to nutrition, health and political stability. But the reason why it is important to notice what happens with higher population growth as in figure 2, is because it also points towards the reasons why the so called emerging countries are growing faster.
As the level of capital per worker required to reach the steady state of growth is lesser in countries with higher populations, it helps such countries in maintaining a sustained level of growth in total output. [4]This is because in the steady state, output per worker is constant and as there are more workers, there is more total output. This standard result holds for open economies as well, and helps to illustrate the brilliance of such a simple and elegant model. Hence, the need for super-cycles does not arise when trying to explain the emergence of high GDP growth rates amongst the emerging economies according to basic economic growth theory.[5]
Moreover, in the case of Brazil, China and India, the growth in output is highly correlated with the tremendous environment for domestic demand. The fact that over 400,000 cars are sold in Delhi on a monthly basis, helps to clarify the scope of the demand in the emerging markets.
Globalisation and Inter-dependence:
There has been a lot of talk about debts and deficits and re-structuring in the last couple of years since the collapse of Bear Stearns and Lehman Brothers propelled us into a veritable global recession. The Stability and Growth Pact [6]of the European Economic and Monetary Union has been made a mockery of, and countries are seeing unprecedented levels of debts and deficits. This has lead many commentators to believe that the onus for growth is shifting to the emerging markets. In the following table, one can see exactly how bad things are for the developed world:[7]
| | % of 2009 nominal GDP | ||||
| | Gross debt | Net debt | Budget balance | Structural balance | Cyclically adjusted |
| Greece | 115.1 | 87.0 | -13.6 | -11.7 | -7.1 |
| Ireland | 64.0 | 27.2 | -14.3 | -9.9 | -8.2 |
| U United Kingdom | 72.3 | 43.5 | -11.3 | -8.6 | -7.0 |
| Unites States | 83.9 | 56.4 | -11.0 | -9.0 | -7.6 |
The above numbers indicate a high level of debt, and indeed the bond vigilantes are out on their witch hunt these days. First Greece had to be bailed out, now it seems Ireland will be, and maybe Portugal is next in line as the spreads of all the aforementioned grew to all time highs recently with respect to the German Bunds.
On the back of all these possible defaults, and money being constantly injected into economies in the developed world by their central banks, the Brazilian Finance Minister has dubbed the current situation as a ‘currency war’. The developed world has reached the zero lower bound in interest rates, while the developing world economies are raising their rates in this zero –sum dance. I attempt to illustrate this vicious cycle in the following diagram:
However, one must stress that this does not automatically mean that the so called super-cycle is altering the fate of the developing world even as markets in Europe and America remain on icy footing. To see this, one can compare the effects of the crisis on the major indices between 2008 and 2009 in developed and emerging markets (for details and charts please refer to the appendix):[8]
| The Developed World | Emerging Markets |
| S&P 500 (USA) fell by approximately 53.25% | BOVESPA (Brazil) fell by approximately 54.53% |
| FTSE 100 (UK) fell by approximately 45.26% | SENSEX (India) fell by approximately 150.78% |
| Dow Jones Composite Average (USA) fell by approximately 49.15% | SSE Composite (China) fell by approximately 68.95% |
One may note that all the emerging markets listed above saw a bigger percentage sell off on the back of the crisis than the developed markets. What does this mean for the super cycle theory?
Globalisation has lead to the integration of the financial markets across the globe. The fact of the matter is that globalisation is a force which is much too strong to ignore or abhor (much like democracy!) for lack of a better alternative. However, this has lead to some unsustainable dependence between markets. One can see how the above cycle is easily reversed in stable boom times in the developed economies:
Countries like Brazil have awoken to the reality behind capital flows. The country imposed a flat 2% tax in October 2010 on all money entering the country to invest in equities and fixed income instruments. Brazil has been facing consistently high inflation and a lot of it is due to the foreign inflows and upward pressures on the Real. This same story can be seen in China, which has been at the centre of the raging currency debate, because it has artificially controlled the Yuan, and has not let it appreciate as much as it should have in a free floating exchange to protect its exports. India has also seen its exporters bleeding dry due to a higher Rupee to the Dollar, and so far it has not put any flat taxes like Brazil. As long as the emerging countries remain heavily dependent upon capital inflows through foreign institutional investors in this unsustainable way, and there is no sustainable way of decoupling from this scenario in financial markets, the Super-Cycle theory remains to be truly proved.
Emerging countries traditionally like to hedge against consumption volatility and exchange rate volatility by buying up international currency reserves. This can be seen in the following table that illustrates a rapid build up in foreign currency reserves in emerging Asia:[9]
The above illustrated currency reserve build up seen in Asian countries, especially gathered momentum after the Asian Financial Crisis. Therefore, this build up is one again a hedge against volatility of foreign inflows, coupled with a need to keep currencies from appreciating to a certain extent to gain competitiveness in exports. Off late China in particular with its 2 trillion dollars or so of reserves can be seen utilising this policy aggressively to tame its currency.
However, like any quick fix solution, build up of currency reserves comes with inevitable economic side effects. A developing country with a large reserve of developed world currencies, would be forgoing the higher interest available locally on the domestic currency for the lesser returns of the foreign currency. Furthermore, if capital flows are not sterilized, the build of reserves eventually trigger inflationary pressures in emerging countries. This effect is indeed being seen in the biggest rising Asian economies; India and China. This increases the chance for a domestic financial crisis. Hence, in an effort to combat global volatility, emerging countries are accumulating foreign exchange reserves rapidly, and this can lead to excessive exposure to inflationary threats. Hence even more reason for believing in the old adage; together we rise and together we fall.
Monetary Policy and Interest Rates:
Central Banks of the developed world have maintained consistently low interest rate over the past few decades compared to their emerging counterparts. In fact since the 1980s, the developed world has seen predictable monetary policy in the form of consistently low interest rates, and low inflation along with stable GDP growth. This non-volatility in the aforementioned variables has been dubbed “the great moderation” by Harvard economist James Stock in his 2002 paper “Has the Business Cycle Changed and Why?”.
In the table below[10], the real interest rates (%) are given, which are roughly calculated as the nominal rate of interest with inflation subtracted. One may notice the predominantly higher rates in emerging countries, with Brazil taking the cake because of its hyper inflation past and it is hard to take the numbers for it on face value (the cumulated inflation rate for the 1964-1994 period is calculated at 1,000,000,000,000,000%).
| Country | 2001 | 2002 | 2003 | 2004 | 2005 | 2006 | 2007 | 2008 | 2009 |
| India | 9 | 8 | 8 | 2 | 6 | 6 | 7 | 6 | 8 |
| China | 4 | 5 | 3 | -1 | 2 | 2 | 0 | -2 | 4 |
| Brazil | 45 | 47 | 47 | 43 | 45 | 42 | 36 | 37 | 38 |
| USA | 4 | 3 | 2 | 0 | 3 | 5 | 5 | 3 | 2 |
| UK | 3 | 1 | 1 | 2 | 3 | 2 | 3 | 2 | -1 |
| Japan | 3 | 3 | 3 | 3 | 3 | 3 | 3 | 3 | 3 |
With the low interest rates prevailing in the developed world the consequences are twofold:
Firstly, the low rates lead to borrowers having to pay back lesser amounts, and this leads to firms and individuals borrowing more to fund activities that stimulate stable GDP growth. It helps in fostering a business friendly environment, and since most developed countries are facing the moderation for some time now, there are no problems in inflation targeting by the central banks.
Secondly, the low rates lead to investors taking their money to other countries, aka emerging markets where the rates of return are high. This in turn sparks an artificially propelled growth in emerging economies. The Emerging Markets Bond Index created by JP Morgan is an index which tracks emerging market bonds. On the following graph one can see the returns of the EMBI, and one immediately notices the high correlation of the index with financial collapses. After the collapse of Lehman Brothers etc, the index saw a sharp upward trend, as there was an immediate knee jerk reaction with investors running away in a flight to quality.
Meanwhile, US 10 year treasury yields saw the opposite effect at the time of the crisis, as investors pulled out of equities and put their money in arguably the safest government bonds in the world:
The above graphs show that the emerging markets are entangled in a catch 22 situation. When the going is good and the developed world is busy cultivating an asset bubble of some form, investment money flows freely, and globalisation seems to be working according to plan. However, when the going gets tough, a large proportion of investors flock back to their developed world roots as a hedge against the volatility. The Super-Cycle does not point towards a distinct path for the emerging markets just yet. It does not account for the wide range of possibilities that exist as possible growth paths for the emerging markets. It is not a given by any measure, that the emerging markets will continue to have the same charm that they posses 20 years from now for investors.
The Commodities Surge:
Since the global recovery has been taking place, commodity prices have started rising again, making a case for a super-cycle of commodity prices. The commodity markets are largely unregulated compared to their advanced cousins; the equity and bond markets, and provide an attractive incentive to investors who may feel they have an upper hand in trading them due to asymmetric information. The interesting thing about investing in commodities is that investment demand goes up with the price of the commodity, and this is particularly true of precious metals such as gold. In particular we have seen gold, silver and oil rebound significantly over the past two years:[11]
However, there are a few things to take under consideration when talking about cycles in commodities. Countries which are rapidly expanding manufacturing activities such as China provide a large amount of demand in the commodities market, thereby driving the prices up. But one can often forget that there can be demand reversals just as soon as the resources are found within countries that provide the bulk of the demand. For instance, in 2003-2004, China was a big importer of steel and in 2005 it turned into a big exporter.
Besides the fact that demand for commodities can lead investors askew as soon as there is a change in the resource and provision structure, there is another important thing to consider, and that is correlation. For instance, the positive correlation between gold and oil prices is caused due to certain basic economic principles. A higher price of oil stimulates inflationary pressures on economies. If we take the example of the US, the largest consumer of energy in the world (followed by China), a higher price of oil stimulates a weakening of the dollar, and thereby a flight to safety in gold. Forget about gold being a hedge against inflation, because the developed world is not really facing that problem right now and prices of gold are at all time highs when adjusted for inflation. Gold is now simply a hedge against the falling dollar. Furthermore, there is no reason to believe that increases and decreases in the demand for oil or steel or any other commodity might occur at a fixed rate. There can be exogenous and endogenous demand and supply shocks that may drive the prices of correlated commodities either way.
In Conclusion:
There is no hard evidence to make a case for the theory as discussed. There is no evidence that the developed world as a whole is experiencing a very long term cycle in unison. So far as the rapid growth of America post WW2 as compared to the rest is concerned, between 1948 and 1972, Japan saw an 8.2 percent output growth per person compared to 2.2 percent in the US[12].
I have analysed the case for the Super-Cycle theory with focus on the rise of emerging economies today. The main conclusion that I would like to highlight is that even though it is not debatable that emerging markets are a big part of the next global growth wave, there are far too many factors that can detract any one of the markets from their projected growth paths. Brazil has to deal with inflation, India has to deal with extremely low per capita income, and China has to deal with a big pension problem and the possibilities of overheating of its economy and all of them have to deal with managing inflows and foreign exchange reserves in a more sustainable way.
Furthermore, globalisation has played a big role in the way business cycles overlap and effect intertwined nations. As analysed earlier, it is increasingly clear that markets are highly correlated across the globe and the fall of one market does not necessarily benefit another. Monetary policy has evolved a lot from the days of Bretton Woods, and yet there seems to be a rapidly increasing need for some sort of moderation between countries, in order to reap the benefits of being inter dependant without impeding on competitiveness and vertical innovation.
The world tends not to be a simple place, and economies cannot be sectioned into black or white without many shades of grey in the middle. Boom and bust cycles do not necessarily imply a long term moderation of income inequality across nations, and they certainly don’t imply that emerging markets will rise in unison.
Appendix:
The Developed World Markets:
S&P 500 (USA): The index fell from Jan 2nd 2008 till 9th March 2009 from 1447.16 to 676.53 by approximately 53.25%.
FTSE 100 (UK): The index fell from January 2nd 2008 till March 3rd 2009 from 6416.70 to 3512.10 by approximately 45.26%.
Dow Jones Composite Average (USA): The index fell from January 2nd 2008 till March 9th 2009 from 4317.89 to 2195.30 by approximately 49.15%.
Emerging markets:
BOVESPA (Brazil): The index fell from May 19th 2008 till October 28th 2008, from 73,439 to 33,387 by approximately 54.53%.
SENSEX (India): The index fell from January 2nd 2008 till March 9th 2009, from 20465.3 to 8146.39 by approximately 150.78%.
SSE Composite (China): The Shanghai Composite index fell from January 14th to November 4th 2008, from 5497.9 to 1706.7by approximately 68.95%.
[1] The theory is not formalized. The term is derived from the Elliot Wave Theory in physics to describe the rise and fall of economies according to long term waves or ‘super-cycles’.
[2] Russia’s growth trajectory has fallen off in the past decade, owing to structural problems and overdependence on oil resources.
[3] Source: World Bank
[4] Output is written as a function of labour and capital in the Solow model.
[5] I am excluding growth in productivity as a variable in the model for a simplified argument.
[6] The SGP lists debt limits at 60% and deficit at 3% of GDP respectively.
[7] Source: Eurostat
[8] Graphs sourced from Yahoo Finance.
[9] Source: Bank for International Settlements, Basel.
[10] Source: World Bank
[11] Charts source: www.livecharts.co.uk
[12] Source: Macroeconomics, 5th Edition by Greg Mankiw
No comments:
Post a Comment