The Rise and Fall of Emerging Markets

Nicholas Vardy

Nicholas Vardy has a unique background that has proven his knack for making money in different markets around the world.
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Looking back, the decade between 2000 and 2009 marked the glory years for emerging markets.

Investors were making a mint in the stock markets. Emerging giants India and China even hit economic growth rates above 10% per year.

Emerging markets as a whole were growing an average of 4.5% faster than rich countries. That was enough to push their share of gross domestic product (GDP) from just over a third to nearly half.

Throw those numbers into a spreadsheet, and you’d find that the pace of growth was enough for the average income per person to converge to U.S. levels in a scant 30 years — a blink of an historical eye.

“Convergence” with the rich world was inevitable.

Emerging Markets’ Secret Sauce

To mainstream economists, such success was no mystery. After all, it was the result of the application of textbook formulas of economists and policymakers who were educated at the same 10 universities in the world.

Here was the Secret Sauce. If you run an emerging market, open up your economy to global markets; adopt a business-friendly legal system and environment; invest in infrastructure; and educate your workers to compete cheaply with the best in the world.

Emerging Markets in the Post-Crisis World

Six years to the week after the collapse of Lehman Brothers, the picture looks very different. Growth rates in formerly red-hot emerging markets have plummeted. Chinese growth has dropped from a peak of 14% in 2007 to just over 7% now. Brazil and Russia today are both in recession.

Since 2008, the average GDP per head in the emerging world grew just 2.6% faster than American GDP in 2013. Exclude China, and the difference is just 1.1%. The Economist magazine calculates that if you put China back into the mix, emerging economies would reach rich-world income levels in just over 50 years. Without the boost from the Middle Kingdom, catch-up would take 115 years.

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Nor does 2014 bode well for these economies. Growth rates in emerging markets this year will be a mere 0.39% more than in their developed counterparts. If that holds, full convergence won’t come until 2320. That’s as far away as the year 1708 is from us today.

The Elephant in the Room

The sudden pause in the expansion of emerging markets leaves many economists scratching their heads.

That’s because they all think the same way. Textbook models of economic development parrot the insights of Nobel Prize-winner Robert Solow in 1956. For Solow, certain economies were poor simply because their workers had access to less capital. Once poor countries received this crucial input, productivity and income would converge inevitably.

Money wasn’t everything. But if channeled to increase an economy’s productivity, it was pretty close.

The Politically Incorrect Truth

My own view is that capital is necessary. But it’s not sufficient. After all, a lot of the capital that went into emerging markets went right back out into the local cronies’ Swiss bank accounts.

The elephant in the room is culture. And, of course, no mainstream academic economist writes about it, because they simply assume it away. And even behavioral economists, leavened by the insights of psychologists, pretend culture doesn’t exist.

That’s why I thought Francis Fukuyama’s book, “Trust: The Social Virtues and The Creation of Prosperity,” which he wrote after authoring “The End of History,” was so brilliant.

In his book about the creation of prosperity, Fukuyama cogently argues that social capital may be as important as Solow’s physical capital. Only those societies with a high degree of social trust will be able to create the flexible, large-scale business organizations that can compete in the new global economy.

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Yet, when I asked Fukuyama about his insights a few years ago at a Stanford University fundraiser in London, he seemed almost embarrassed to have made the argument in the first place. Perhaps it was because in today’s academia, it’s too politically incorrect to judge one set of cultural values as better than another, even if it involves, say, decapitating so-called infidels and posting the videos on the Internet.

Yet, it’s hard to argue that it isn’t high-trust societies characterized by hard work that succeed in the long run. Singapore didn’t achieve a per capita GDP of $78,000 because of its oil wealth. And although Qatar may be wealthier per capita thanks to its natural gas, I have no doubt who I’d bet on in the longer run.

Take the example of a country you never think of: Poland.

In 1998, Poland’s per capita GDP was just 28% of the United States’. Fifteen years later, that figure had risen to 44%. How did Poland do it? After all, Poland is stuck on the wrong side of slow-growth Europe, where economic growth is as scarce as a two-dollar bill.

My own view is that Poland’s success is due to its character and values as a country. Poles are known as the “Americans of Europe” for their drive and initiative. You can’t go a day in London without bumping into a hard-working Pole. You can say the same about kids from Singapore studying engineering at a U.K. university. The “social capital” of these values is huge, and economics doesn’t have the models to capture that impact.

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What’s the Long-Term Fate of Emerging Markets?

In 2008, I attended a panel presentation at London’s annual “Battle of Ideas.” An Oxford professor boldly predicted that China’s standard of living would match that of the United States by 2050.

He reminded me of the Oxford academics of the 1930s who visited Stalin’s Russia and declared Soviet central planning the economic model of the future. Sure enough, by the mid-1950s, the Soviet economy was on track to surpass the United States by the Orwellian year of 1984. By the time that date arrived, the Soviet Union was on its last legs, and it was Japan that was set to take on the mantle of economic leadership from the United States.

The lesson? Emerging markets are like teenagers who, giddy with the sudden realization of their elders’ flaws, think that they have it all figured out. Yes, every newborn baby can grow up to be President — but after they turn into obnoxious, pimply-faced teenagers with “behavioral issues,” few ever do.

You can say the same about most emerging markets.

To quote AC/DC, a heavy metal band of my teenage years, “it’s a long way to the top if you wanna rock ’n’ roll.”

In case you missed it, I encourage you to read my e-letter column from last week about whether the Alibaba IPO can kick-start the Chinese market. I also invite you to comment in the space provided below.

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