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Review 2015: Growth in unexpected places 

In a year when concerns over a 'Grexit' and a 'China hard landing' were top of the financial headlines, it might be surprising to note that both China's and the Eurozone's economies grew faster than originally expected in 2015.

China slowed, but our forecast of 6.8% growth proved marginally pessimistic: we now think it will end the year at +6.9%. And Eurozone growth of +1.5% is likely to surpass our original projection of +1.2%.

The US disappointed expectations (+2.5% vs +2.9% expected), primarily due to harsh weather in 1Q. Growth for the remainder of the year has met our positive expectations. Elsewhere, Japan disappointed greatly (+0.5% vs 1.2% expected), as the economy failed to gain steam after last year’s consumption tax hike, and India surpassed expectations, though the country’s new GDP calculation methodology makes comparison difficult. The major shortfalls came in commodity- exporting emerging markets.

Our forecast of close-to-zero growth in Russia and Brazil was instead met with deep recession in both countries; Russia is likely to contract by 3.7% and Brazil by 3.0%.

In 2016: Expect accelerated growth

We expect global growth to accelerate next year to 3.4%, from 3.1% this year.

The growth “impulse” for 2016 is likely to be more evenly distributed than in 2015, when developed markets took much of the burden of accelerating growth.

We expect around half of the rise in global growth next year to be distributed across developed markets, with the other half from emerging markets, in particular due to the ongoing pickup in Indian output, and stabilization in Brazil and Russia. China’s slowdown will represent the single biggest drag on global growth relative to the previous year.

Key risks to global growth

The countries and regions driving the expected acceleration in 2016 growth are relatively broadly spread. As such, the risks to this forecasts are relatively broadly spread too.

As the key potential risks to our forecast of a global growth acceleration for 2016, we see some combination of:

  • US consumption and investment suffering as a result of higher interest rates.
  • A renewed political crisis in the Eurozone affecting consumer confidence.
  • Japan’s economy continuing to fail to respond to stimulus measures.
  • China’s manufacturing sector slowing more rapidly, and damaging consumption, leading to a faster than- expected slowdown in overall growth.
  • Commodity prices continuing to slide, affecting exporting nations, while importing consumers do not spend their savings.
  • A financial crisis in the emerging markets resulting from escalating capital outflows.
  • A geopolitical event which affects confidence, potentially involving Russia and the Middle East.

And beyond: World in transition

Fifty years ago, Germany had more than five workers per retiree, today there are only three and in 2045 there will be less than two. Three years ago, European quantitative easing was considered illegal, and now it is going on at 1.4 million euros every minute. Meanwhile, the world’s largest hospitality company now offers more than one million rooms globally, yet has less than one-fifth of the employees of some Las Vegas hotels.

Choosing sides

In a “world in transition," things will not always be smooth. Some groups will benefit, and others will lose. Policymakers will be forced to choose sides.

As populations age, governments must decide who will carry the burden of rising healthcare spending, pension liabilities, and mounting debts. The choice of fiscal policy, and the mix of tax or spend will define who feels the pain, and how markets respond.

Ultralow interest rates and quantitative easing may be the answer for some, but they drive inequity too – by subsidizing borrowers and the owners of financial assets at the expense of savers, or those who own little.

And as new technologies accrue huge benefits to software creators, the technological transition is affecting jobs and creating income inequality. Some countries will choose to regulate against these new companies and markets, while others won’t.

Diversification

Diversification, specifically across political economies and monetary regimes, will be vital in the years ahead. The famous value investor Warren Buffett once said “Keep all your eggs in one basket, but watch that basket closely.” Yet in recent years even Mr. Buffet has been diversifying internationally. Changing demographics, high levels of debt, and greater income disparities will force nations to make increasingly difficult – and increasingly political – decisions about which interest groups will win, and which will lose. Investors can neither assume that every nation will choose to pay its debts and maintain stable exchange rates, nor that they will be unaffected by changing fiscal policies or regulations.

The world’s big questions

Presently it is difficult to judge how political decisions will drive specific investment gains and losses over the longer term, but it is possible to see how economic factors are shaping the political journey. As such, in this years ahead, we look at some of the key questions and themes confronting policymakers and the potential paths they imply.

In the US, the years ahead are likely to resolve the country’s status as a “global leader.” After close to a century as the world’s largest economy, and a surprisingly resilient recovery following the financial crisis, are innovation and entrepreneurialism enough to maintain global leadership, or will political dysfunction and structural debt be too much to bear?

China is moving to internationalize the yuan. The country’s expansion in the past decade has been remarkable; it is now the world’s second-largest economy, and the biggest in terms of trade. But despite efforts to improve the international infrastructure for yuan trading, it remains a relatively minor currency. A more open capital account could change that, but it could also cause capital flight, domestic instability, and an inability for some to pay debts. Will China maintain a slow and steady approach, or will it open up more quickly?

A demographic crisis looms in Europe, and we look at how this will affect the way economic and political power is distributed on the continent. The debt crisis has already transferred economic power from south to north; demographics could shift things further and put more strain on a union already troubled by fiscal austerity debates and migration. Europe’s overall power will shrink too, limiting its say in global affairs.

Switzerland is confronted by similar demographic challenges, and while government debt is not a major problem, pension liabilities are. Moreover, the recent approval of anti-immigration policies raises the question of how an isolationist Switzerland might fare. We forecast that, with no net immigration, the Swiss working population could decline by almost 25% by 2050 – forcing higher retirement ages and lower public spending. The country, along with many in Europe, will face a difficult choice between higher immigration and weaker growth.

Finally, within the emerging markets, we consider the way forward for growth, and the role of policymakers in this process. Protectionism or populism may prove tempting, although economic pain may help build up the necessary will to unwind vested interests built up during the boom times.

Choosing sides

In a “world in transition," things will not always be smooth. Some groups will benefit, and others will lose. Policymakers will be forced to choose sides.

As populations age, governments must decide who will carry the burden of rising healthcare spending, pension liabilities, and mounting debts. The choice of fiscal policy, and the mix of tax or spend will define who feels the pain, and how markets respond.

Ultralow interest rates and quantitative easing may be the answer for some, but they drive inequity too – by subsidizing borrowers and the owners of financial assets at the expense of savers, or those who own little.

And as new technologies accrue huge benefits to software creators, the technological transition is affecting jobs and creating income inequality. Some countries will choose to regulate against these new companies and markets, while others won’t.

Diversification

Diversification, specifically across political economies and monetary regimes, will be vital in the years ahead. The famous value investor Warren Buffett once said “Keep all your eggs in one basket, but watch that basket closely.” Yet in recent years even Mr. Buffet has been diversifying internationally. Changing demographics, high levels of debt, and greater income disparities will force nations to make increasingly difficult – and increasingly political – decisions about which interest groups will win, and which will lose. Investors can neither assume that every nation will choose to pay its debts and maintain stable exchange rates, nor that they will be unaffected by changing fiscal policies or regulations.

The world’s big questions

Presently it is difficult to judge how political decisions will drive specific investment gains and losses over the longer term, but it is possible to see how economic factors are shaping the political journey. As such, in this years ahead, we look at some of the key questions and themes confronting policymakers and the potential paths they imply.

In the US, the years ahead are likely to resolve the country’s status as a “global leader.” After close to a century as the world’s largest economy, and a surprisingly resilient recovery following the financial crisis, are innovation and entrepreneurialism enough to maintain global leadership, or will political dysfunction and structural debt be too much to bear?

China is moving to internationalize the yuan. The country’s expansion in the past decade has been remarkable; it is now the world’s second-largest economy, and the biggest in terms of trade. But despite efforts to improve the international infrastructure for yuan trading, it remains a relatively minor currency. A more open capital account could change that, but it could also cause capital flight, domestic instability, and an inability for some to pay debts. Will China maintain a slow and steady approach, or will it open up more quickly?

A demographic crisis looms in Europe, and we look at how this will affect the way economic and political power is distributed on the continent. The debt crisis has already transferred economic power from south to north; demographics could shift things further and put more strain on a union already troubled by fiscal austerity debates and migration. Europe’s overall power will shrink too, limiting its say in global affairs.

Switzerland is confronted by similar demographic challenges, and while government debt is not a major problem, pension liabilities are. Moreover, the recent approval of anti-immigration policies raises the question of how an isolationist Switzerland might fare. We forecast that, with no net immigration, the Swiss working population could decline by almost 25% by 2050 – forcing higher retirement ages and lower public spending. The country, along with many in Europe, will face a difficult choice between higher immigration and weaker growth.

Finally, within the emerging markets, we consider the way forward for growth, and the role of policymakers in this process. Protectionism or populism may prove tempting, although economic pain may help build up the necessary will to unwind vested interests built up during the boom times.

United States

In 2016: US demand improving

We expect US growth to accelerate in 2016, to 2.8% from 2.5%. Consumer demand will be supported by an improving labor market, a pickup in lending growth, positive wealth effects, and rising household formation. 

We expect business investment to rise at a modest pace, though companies are still generally cautious. Uncertainty due to the presidential election in November could affect investment spending in the latter part of the year, but we do not expect major post-election changes to materialize until 2017.

As in other regions, US inflation is likely to rise in 2016, thanks to more stable commodity prices. But the risk of higher core prices in the US is greater than in other regions, due to the relatively low level of unemployment and higher levels of growth than in other
regions.

The Fed is likely to raise interest rates in response, but cautiously, we think, only raising rates if this shows no detrimental impact on growth.

And beyond: Will the US maintain global leadership?

The US recovered from the financial crisis exceptionally well. While growth overall has been disappointing, the relatively rapid recovery in the US has caught some by surprise.

The crisis had its epicenter in the US as overextended consumers and overleveraged financial institutions triggered the deepest recession since the Great Depression. Yet the US has somehow managed to forge ahead and is now setting the pace for the global economy. The question from here, of course, is whether it will be able to retain that leadership position in the years ahead.

Still a great deal to like

Keep in mind that there is still plenty of good news about the US economy. US-based companies are driving a whole new wave of technological innovation. And this isn’t just about the hottest app for ordering food or hailing a cab. Staffed with some of the brightest graduates from the very best universities and technical institutes from around the world, American companies and start-ups are leaders in a host of emergent industries including software development to biomedical engineering, advanced optics, 3-D printing, artificial intelligence, advanced material science, and nanotechnology. Ample pools of accessible capital also allow for these innovations to move from development to market faster than anywhere else in the world. This fortuitous combination of talent and resources ensures that the US will remain a leader in cutting-edge technology for years to come.

There is also an extraordinary transformation under- way within the energy industry. Breakthrough developments in extraction technologies have put the US on the verge of energy independence for the first time in nearly a century. This has triggered not only massive investment spending and job creation within the energy sector itself, but also economic development in industries and regions well beyond the oil patch. This, in turn, is prompting a repatriation of manufacturing activity and reducing the economy’s dependence on less stable energy supplies from abroad. In fact, the US is likely to become a net exporter of energy within the next five years, thereby further improving the balance of trade and stimulating growth.

The US also reaps significant benefits from the dollar’s status as the primary reserve currency. US-based businesses can transact for most global commodities in their base currency, while the federal government can fund deficits at a lower cost of capital. While some view the dollar’s primacy among the reserve currencies as threatened by potential successors, the greenback’s relative weighting among total reserve assets has remained remarkably constant. For the foreseeable future, there are few alternatives that could match the depth, breadth and transparency of US markets.

Challenges to tackle

Of course, the US must also take on daunting challenges in the years ahead if it is to maintain its global leadership position.

According to the World Economic Forum’s (WEF) most recent Global Competitiveness Report, the US has actually risen one notch, from fourth to third place. But that improved ranking belies some troubling trends in several key measures for future prosperity. The three top factors cited as the most problematic for doing business in the US were tax rates, regulation and an inefficient government bureaucracy. Corporate America has continued to rail against a byzantine tax code that perversely disincentivizes businesses from expanding domestically by maintaining high marginal rates and preventing the repatriation of funds from foreign operations. Meanwhile, the Competitive Enterprise Institute estimates that federal regulation and intervention alone cost American consumers and businesses nearly USD 2trn each year in lost productivity and higher prices.

Demographic trends are also contributing to concerns about fiscal policy. Although the federal budget deficit fell from a peak of nearly 10% of GDP in 2009 to under 3% during the 2015 fiscal year, this decline is only temporary in nature. The Congressional Budget Office (CBO) estimates that the deficit will begin to rise within the next three years: baby boomers are heading into retirement and this is increasing entitlement spending and healthcare costs. The CBO projects that federal spending for social security and the government’s major healthcare programs will rise to 14.2% of GDP by 2040 – about double the 6.5% average of the past 50 years. Keep in mind that, according to the WEF Competitiveness Report, the US is already ranked 134 of 144 countries in terms of the ratio of government debt to GDP. Any additional deterioration in the fiscal position of the US would only further undermine US competitiveness.
Finally, the increasingly dysfunctional environment in Washington also represents a material threat to US leadership. Political polarization and partisan bickering have made it progressively more difficult for elected officials to find common ground on issues critical to the future economic health and security of the country. Failure to address problems with the tax code, entitlement spending and immigration policy would weigh heavily on the US’s ability to compete on the world stage. It has already taken a toll on potential US growth and will become more of a burden in the years to come.

Dynamic enough to lead, not strong enough to carry

In much of the postwar era, the US has been the locomotive for global growth. But that dynamic is changing. After the financial crisis, the US has once again assumed the role of global growth leader thanks to an adaptable corporate sector, flexible labor force, and creative entrepreneurial class. But the benefits that accrue to other economies appear more limited than at any time since the dawning of the American Century. While the US economy remains dynamic enough to lead, it may no longer be strong enough to take the rest of the world along for the ride.

Europe

In 2016: European recovery to continue

For the Eurozone, we expect growth to rise to 1.8% in 2016, from 1.5% in 2015. Growth in the UK should remain good, at 2.4%. 

We believe monetary stimulus will continue to boost GDP momentum, and private consumption is set to remain strong, given exceptionally low borrowing costs and strong consumer confidence.

Capital expenditure should strengthen substantially as the recovery becomes more established. Business confidence is improving, and recent lending surveys suggest that bank lending is becoming more accessible.

Exports are unlikely to prove a major boon for the region, given that the bulk of euro weakness is now behind us, but fiscal policy is set to become a mild tailwind for growth. The EUR 315bn European Fund for Strategic Investment should provide some stimulus in the quarters ahead.

And beyond: How will Europe look in 2050?

The world faces a major demographic transition. While many regions have rapidly aging populations, perhaps nowhere else will the issue prove as transformative as in Europe even if demographic projections are subject to uncertainty. In Europe, demographics will shift the balance of power within the continent, but also away from it, exacerbating the ongoing decline of Europe’s importance on the world stage. European leaders are working on the response by targeting bold structural reforms to lift growth, but the path to a more robust Europe will take time and likely include some rough patches.

According to estimates by British economist Angus Maddison, from the year 1000 to 1820, Europe (excluding Russia) comprised a small but constant part of both the global population (slightly above 15%) and global GDP (roughly 20%). By 1900, Europe’s contribution to the latter had jumped to over 30%, while its contribution to the former remained below 20%. In 2015 Europe accounted for 8.1% of the global population and almost a quarter of global GDP, and by 2050 these ratios are likely to decline to 5.9% and less than 10% respectively.

Decline of the relative importance of Europe

There are three reasons why this trend toward a “less important” Europe is expected to continue.

First, according to the UN’s median population projection, Europe (excluding Russia) will lose more than 15 million people (roughly the current population of Holland) between 2015 and 2050, while global population should increase during the same period by 2.4 billion.

Second, the European working-age population will decline at an even faster pace. According to the UN, the ratio of working people aged 15–64 to the overall population will decline from 67% to 56% between 2015 and 2050. This will weigh on European growth. Upward shifts in the retirement age could help, but will not eliminate the issue.

Third, the emerging markets growth story isn’t broken. Even under very conservative assumptions, both India and China should significantly surpass the EU’s GDP (measured at PPP). Moreover, countries like Mexico, Brazil or Indonesia will have significantly higher GDP than Germany, the UK or France.

The European portion of global GDP (at PPP) could fall to less than 15% by 2025 and less than 10% by 2050. Moreover, the gap between the US and the EU will continue to widen. By 2050, the US could have a GDP that is 25–30% higher than that of the EU. The US will add another 60 million people (roughly Italy’s current population) to its population. That said, in terms of GDP per capita, Europeans will remain among the richest on the planet.

Shifts within Europe

Along with Europe’s loss of relative importance on the world stage comes a demographic power shift within the continent itself. According to UN projections, the UK’s population could increase by up to 10 million to a projected 75 million people in 2050, while France’s is expected to climb by 7 million (to 71 million). At the same time, Germany is forecast to lose 6 million (to 74 million), thereby surrendering its status as the most populous European nation. Italy is expected to shrink by 4 million (to 56 million), and Spain by 1 million (to 45 million).
For most European countries, GDP will move broadly in sync with population. This means that while the economic center of gravity of the world economy is moving south and east, the center for Europe will move in opposite directions: north and west.

Political consequences

The projected decline in Europe’s population and its share of the world economy is already acting as a driving force for the integration impetus of the EU as fundamental reforms are needed to improve the low growth prospects, in particular in the Eurozone. How- ever, generational changes since World War II mean that Europeans are not prepared to integrate at any cost. The willingness of most Eurozone leaders to let Cyprus go in 2013 or Greece in 2015 "if necessary" is a case in point.

This will likely mean that integration will be a protracted and uneven process, especially considering the conflicts of interests arising from debtor-creditor positions among Eurozone countries and the political hurdles for changing the Treaty of the European Union. As recent history shows, it will probably take crises to produce some of the changes. Further debt issues should be considered as likely on the path to an integrated Eurozone: a future global shock could hit Europe hard given exhausted debt capacities in many places, already high unemployment, and the need for house price adjustments in some countries.

It will likely prove difficult for immigration to fix the problem, given that subdued economic growth might increase political aversion to higher migration. Against this backdrop, the five leaders of the European institutions (ECB, Eurogroup, European Parliament, EU Commission and European Council) laid out, in their five presidents’ report, their vision on the way forward as the focus shifts from expansion to consolidation. This entails the completion of the Banking Union, the Capital Markets Union, the Fiscal Union, and the Political Union by 2025 to reap the full benefits of an integrated Eurozone.

This vision of Europe would mean a much more robust and solid region, one that could even attract further states into the Eurozone. Achieving this level of integration will undoubtedly be challenging, but will be essential to ensure the Eurozone remains an important global player.

Switzerland

In 2016: Domestic strength in Switzerland

The Swiss economy has skirted a recession after the EURCHF shock at the beginning of 2015.

The booming domestic economy is acting as a buffer, absorbing the bumps and jolts in export sectors created by the strong Swiss franc. Yearly immigration of roughly 1% of the population, together with the Swiss National Bank’s still super-loose monetary policy stance will continue supporting consumption and construction spending.

Net exports and investment spending will, however, weigh on real GDP growth, which we expect to come in at 1.4% in 2016. Consumer prices, already down 1.2% in 2015, will likely retreat further, but at a lower rate as the base effects from lower oil prices and a strong currency are expected to fade only slowly. No reason, though, for the SNB to tighten its policy stance anytime soon.

And beyond: How might an isolationist Switzerland fare?

Like its neighbors, Switzerland faces a tough demographic transition. While government debt is not a major problem, pension liabilities are, and the recent approval of anti-immigration policies leads us to question how an isolationist Switzerland might fare in the future.

Without net immigration, we forecast that the Swiss working population could decline by almost 25% by 2050, forcing higher retirement ages, and lower public spending. The country, along with many others in Europe, will face a difficult choice between higher migration and weaker growth.

Despite having probably the strongest currency on Earth, Switzerland’s economy has outpaced all its European neighbors in terms of economic performance over the last 10 years. Most of this outperformance can be explained by strong immigration. Switzerland witnessed a surge in demand for qualified workers during the boom years shortly before the financial crisis. With the free movement of per- sons in 2007 came an annual influx of foreign workers of roughly 1% of Switzerland’s population. This boosted the domestic economy, especially housing construction and consumer demand. Increased immigration also helped mitigate some of the emerging demographic challenge of financing the pay-as-you-go pillar of the Swiss pension system.

The flipside of these developments has been the increasing feelings of unease about the side effects of immigration. The so-called “mass-immigration initiative,” narrowly passed in a referendum in February 2014, calls for the reintroduction of a quota- based immigration policy. Switzerland must implement this initiative by February 2017, but it remains to be seen whether the country will pursue the isolationist economic policy described in the initiative or maintain the current, more open approach of economic integration. To consider possible outcomes, we have run several long-term simulations of the Swiss economy, mapping out the likely path of economic output, population size and other variables until 2050.

The first scenario assumes a rather mild reduction in immigration to Switzerland. The second looks at a strict implementation of the mass-immigration initiative, assuming that a combination of the new quota system and lower demand for foreign workers leads to zero-net immigration throughout the simulation period. To counter the likely fast deterioration in the country’s demographics, an increase in Switzerland’s retirement age may become unavoidable.

We have therefore run a third scenario in which we look at a step wise increase of the retirement age from currently 65 to as much as 69 starting in 2025. According to the results of our base scenario, the Swiss population should increase from today’s roughly eight million to around 10 million in 2050. This corresponds to an average yearly growth rate of 0.5% starting from the current, immigration-driven 1% and then gradually declining over time. The implicit assumption in this base case is a rather mild curb on immigration which would correspond to a rather flexible implementation of the mass-immigration initiative. If we assume productivity growth of 1.1% over the long run, it would allow the Swiss economy to continue growing at between 1.5% and 1.7% over the next 35 years and would lift the country’s real annual GDP from the current CHF 650bn to CHF 1.1trn by 2050. In terms of the demographic implications of this scenario, the working-age population would increase a bit from the current 5.6 million to 5.7 million. That means that the share of working-age people in relation to the total Swiss population would decline from today’s 67% to around 57% in 2050. The challenge of financing the Swiss pension system will be substantial even when allowing for immigration to mitigate the demographic trends. Our zero-net-immigration scenarios would correspond to a strict implementation of the mass-immigration initiative, meaning a reduction in immigration to the point that net immigration is zero for the foreseeable future. In this case Switzerland’s population would peak at around 8.45 million in 2028 and then gradually decline to below eight million toward 2050. This would have dramatic implications for the working-age population, which would start to decline within a few years, falling from its current 5.6 million (or 67% of the population) to below 4.3 million (or 53%) by 2050. Faced with such a decline and assuming the same productivity growth of 1.1% over the long run, Swiss annual real GDP would increase from the current CHF 650bn to only CHF 880bn, a considerably lower resource base from which to finance pensions and other public expenditures compared to the base case described above.

These problems could be addressed by increasing the pension age. In our simulation we increased pension age gradually to 69 years starting in 2025. This would push out the decline in the working population to 2030, but it would not stop its gradual decline thereafter. The simulations show that Switzerland will face some tough choices when deciding the course of immigration and foreign policy over the next two-to-three years. The ideal policy to deal with its demographic challenges might turn out to be a mix of all measures: tolerating some immigration while gradually increasing the retirement age.

Asia Pacific

In 2016: Ongoing slowdown in Asia

Overall, we expect Asia’s growth to slow slightly in 2016, for the third consecutive year, stalled mainly by China’s slowdown.

In the first half of 2016, we believe that high levels of inventory in China are likely to mean that new investment and industrial activity will be weak, with fixed asset investment decelerating further.

By year end, as the property destocking process ends, we look for stable single-digit fixed asset investment growth.

China should also receive support from government policies which promote new investment in health, utilities, and high-tech investment sectors. However, a considerable drag will remain from maintaining large excess capacity in certain heavy industries, which will take years to reduce.

While China’s core inflation is likely to remain around zero, headline inflation may stay elevated due to stabler commodity prices. Weak underlying inflation means there is scope for monetary policy to be eased further.

And beyond: How will China internationalize the yuan?

China’s economic ascent has made it the world’s second-largest economy, and the biggest in terms of trade. Its currency, the yuan, has made great strides too, but remains a relatively minor player, still less traded than the US dollar, euro or British pound.

China has global ambitions for the yuan, setting up swap lines with a series of major central banks. The next step may be to begin paying for oil imports in its own currency, ushering in the “petroyuan” era. Of course, the final stage would be to fully open up its capital account. But this would not be without its risks. In our world in transition, the way China tries to internationalize its currency and its speed in doing so will be central to the years ahead.

It’s interesting to recall how unimportant the Chinese yuan was 35 years ago, or even at the beginning of this millennium. Many might not even be aware that between 1981 and 1994, China devalued the CNY by a staggering 83% against the greenback, from 1.5 to 8.7 per USD. Back then, China didn’t matter much to the rest of the world; it was a largely closed economy accounting for less than 3% of global trade in 1994, far behind the US (14%), Germany (9%) and Japan (8%).

It wasn’t until China joined the World Trade Organization in December 2001 that it took the fast track to becoming the world’s second-largest economy, and the manufacturing hub for the rest of the world. With a population five times that of the US, and the average Chinese worker being paid only 2.8 cents for every dollar an American employee earns, China’s share of global trade grew exponentially from 4% in 2001 to 11.3% in 2014. In the process, China over- took the US in 2013 to become the largest trading country. So today, the outlook of the CNY has become far more important, if not crucial, for investors and businesses alike.

The rise of the CNY over the next decade should be no less eventful than the last one. The CNY has already risen to second place as a world trade finance currency, fourth place as a world payments currency, and, at the time of writing, looks likely to be included into the IMF’s coveted Special Drawing Rights (SDR) currency basket. As the CNY moves ever closer toward\ full currency convertibility and capital account opening, what can investors expect over the years ahead?

The rise of the “petroyuan”

The term “petrodollar” was coined in 1973 after the US (then the largest oil importer) signed a landmark deal with Saudi Arabia (the largest oil exporter) to denominate all Saudi oil exports in US dollars. By 1975, all OPEC members had agreed to sell their oil only in US dollars. This led to the rise of the petrodollar (which refers to the USD revenue earned by oil-exporting countries) and the corresponding need for oil-importing countries to own USD to pay for their imports.

Today it’s looking increasingly like we’re ushering in the era of the “petroyuan.” China overtook the US to become the world’s largest net oil importer in September 2013. Since then it has been flexing its muscle in pushing to switch its payment currency for oil from US dollars to Chinese yuan. For instance, Russia, the world’s second-largest oil exporter, agreed with China to switch from accepting USD to either CNY or RUB for China-bound Russian oil, not least due to Western sanctions imposed on Russia for its role in the Ukrainian crisis. While Middle Eastern countries might be slower to follow suit (since their currency
regimes are still pegged to the USD), the risk of losing out on market share to the world’s largest oil importer should make them seriously reconsider.

The true hallmark of a global currency: deep, broad and unrestricted capital markets. China’s dominance in global trade has brought the CNY this far, and the petroyuan could bring it further still. But for the currency to rise to the next level, the next necessary step is to open up China’s financial markets. To put things in perspective, the size of global financial markets stood at a striking USD 156trn as of end-2014, which is twice the value of all goods and services produced in the world. And it is no coincidence that the top-three most traded currencies (USD, EUR, and GBP) have the largest and deepest fixed income and equity markets for the international community to invest in. Opening up its capital markets over the next decade is therefore crucial if the CNY wants to join the ranks of the world’s dominant currencies.

An open capital account would have its attractions of course, allowing Chinese citizens to access inter- national markets and encouraging even greater foreign investment into China itself. But open capital accounts pose a risk too, making it easier for foreign money to wash in and out with speed. Witness the recent case of the emerging market Fragile Five; China surely does not wish to be among their number. In our view, the economic danger of rapid “hot money” flows is precisely the reason why China is internationalizing the CNY at a managed pace. In fact, the choice of Hong Kong as the primary experimental lab for CNY currency and capital account opening is in itself a firewall that shields Mainland China from rapid capital flows.

For China and its yuan, it seems to be a case of slow and steady wins the race.

Emerging Markets

In 2016: Subdued stabilisation in emerging markets

Growth in EM will remain subdued, but should improve in aggregate. We expect 4.3% growth for developing economies, relative to 4.1% in 2015.

The plunge in many currencies in 2015 has boosted competitiveness. From here, weaker currencies should improve current account positions and the potential for positive growth surprises.

However, private sector deleveraging will need to continue in several countries. Furthermore, the falls in many EM currencies mean that USD debts are now more burdensome. Some countries could see downgrades in credit ratings or outlooks in 2016.

EM policy makers will look for opportunities to ease fiscal and monetary policy, but the scope to do this will be more limited in those countries which have experienced the most severe currency depreciation.

And beyond: Will emerging markets transition their growth models?

The first decade of the 21st century was the decade of the emerging markets (EM). But the EM “growth premium” is now half of what it was relative to 2000–2010. The imbalances that built up in the good times are slowly unwinding. Will EM be able to make the transition to a new growth model in the years ahead?

The rising tide

The current predicament of many emerging markets has been years in the making. It came about in part because of their success in the rising tide of the boom years.

China’s demographic dividend and industrialization process drove the enormous demand for commodities and for the products of China’s Asian trading partners. This had a knock-on effect on global commodity prices which allowed exporters, particularly in Latin America, to benefit from rising metal prices. In addition, institutional reforms enacted after the EM crises in the 1990s and improving debt levels and credit ratings encouraged greater investment. This was turbocharged by the substantial boost in global liquidity following the financial crisis, as lower interest rates sent money flows toward EM, in search of yield and return.

“You never know who’s swimming naked until the tide goes out.”

A rising-tide environment can easily cover up structural flaws with strong economic data. Warren Buffett’s famous quip holds particularly true in EM.

Emerging markets now need to look for new drivers of growth. These will require some combination of reduced reliance on investment, commodities, and cheap capital, and a greater focus on structural and political reform. The way each country manages its own transition will define its years ahead.

It is now evident that China faces both significant industrial overcapacity and high levels of private- sector debt. Policymakers will attempt to improve competitiveness in higher-value-added industries and sectors and foster domestic consumption. This adaptation should eventually also reduce the private- sector leverage ratios to more sustainable levels.

But setting the pace of it will be a balancing act. If it’s too fast, China risks instability; if it’s too slow, it won’t be enough to address overcapacity, structurally weak growth, and rising debts.

Some emerging markets, in Latin America in particular, will now need to adapt to lower demand from China and lower prices. Years of strong demand and high prices led to significant investment and strong terms of trade and currencies. While helpful for the commodity sector, this has hurt competitiveness and investment in other areas.

In these countries, weaker currencies are critical to the adjustment process, because they will help improve dynamics of trade and current account deficits. But this will be fraught with difficulties. The stock of USD-denominated bonds from emerging market corporate issuers is currently at USD 1.3 trn, more than double the 2009 total. We see great vulnerabilities for companies that are heavily indebted in foreign currencies but do not generate a significant part of their revenues abroad.

As the tide of global liquidity ebbs, we should also expect several EM central banks to tighten monetary policy conditions further and domestic banks to curb lending. This will force a prolonged adjustment in private-sector leverage, which has seen an unprecedented increase in recent years.

The good news here is that emerging markets still have comparatively favorable loan-to-deposit ratios, and EM banks are well capitalized on average. However, tighter lending standards domestically and internationally will likely impede a quick economic recovery in a number of emerging markets.

All of these adjustments will hurt. We are likely to see periods of low or even contracting economic growth in the years ahead in addition to corporate defaults and restructurings, rising unemployment, and renewed inflationary pressure. Although arduous, and not over yet, it might prove to be the faster way out of the current misery than an interventionist path.

Finding some new clothes

The decisions of policymakers will be critical to the transition process. In times of upheaval it may be tempting for them to resort to protectionism or populism. On the other hand, the current economic pain might be exactly what is needed to build up enough political will and courage to unwind many of the vested interests and power blocs that built up during the boom times.

Favorable demographics in many emerging market countries mean that their growth story should be far from over. But only through this transformation will EM be able to find new drivers of growth.

In our world in transition, many countries will have to change, but perhaps none more so in the near term than in the emerging markets. The jury is still out as to who the winners and losers of this crisis will be. The winners will likely be the ones that achieve structural reforms, attract foreign investment, and maintain monetary and fiscal discipline amid political and popular pressure.

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