Genre: Non-fiction, Business
Author: Ruchir Sharma
Book Title: Breakout Nations (Buy the Book)
Table of Contents
Morgan Stanley’s Ruchir Sharma believes the coming years will see a divergence in the performance of developing economies. It is imperative that investors understand the factors making some countries more likely than others to become “breakout nations.”
These are countries that grow their per capita income faster than their peers and are thus able to ascend to higher economic strata. Breaking out is by no means easy to do, but it makes for fantastic investment opportunities when nations can pull it off.
Sharma believes the BRIC countries, Brazil, Russia, India, and China, are unlikely to be breakout nations. China can no longer rely on copying the West to grow, and it has an aging population and a large debt burden. India struggles with bloated public spending, underinvestment in infrastructure, and crony capitalism.
Russia suffers from underinvestment in its secondary cities and an unhealthy dependence on oil and gas. Meanwhile, Brazil has the horrid infrastructure, profligate government spending, and an uncompetitive currency. Other nations unlikely to break out include Mexico, which suffers from a tycoon economy with low domestic investment and high inflation.
South Africa, too, is not poised for a breakout due to an economy that is devoid of competition and strong unions that elevate wages and dampen business profitability. In Asia, Vietnam and Malaysia receive negative assessments from Sharma, as both countries have seen poor leadership repeatedly squander opportunities to elevate their nation’s economies.
On a more optimistic note, Poland and the Czech Republic, two former Soviet satellites that have leveraged EU membership and fiscal prudence to boom, are both likely to break out. Poland now has an elite domestic education system and boasts the most vibrant labor market in Europe, and the Czech Republic has developed a top-notch manufacturing sector, particularly in automobiles, that positions it well for future growth.
Outperformance is also likely for Indonesia, which Sharma dubs the world’s best-run commodity economy, and Sri Lanka, which is recovering nicely from civil war and leveraging its English-literate population and proximity to India and China to prosper. Elsewhere, South Korea is in a great position to continue its economic ascent due to its strong belief in creative destruction, its commitment to R&D, and its success in developing global mega-companies.
Sharma also sees opportunity in places like the Philippines, Thailand, and Nigeria provided structural impediments ranging from poor infrastructure to insufficient domestic consumerism can be addressed. While Sharma’s book also holds a positive outlook on Turkey, which was benefiting in 2011 from stability ushered in by Recep Tayyip Erdogan, subsequent increases in authoritarianism, which Sharma foresaw as a possibility, threaten Turkish success.
Sharma concludes by arguing that breakout nations also exist in the developed world. For instance, technology development, private-sector deleveraging, and energy independence position America well for the future. In Europe, Germany’s manufacturing prowess and low public debt and Ireland’s newfound embrace of fiscal prudence following 2008 bode well for growth.
In sum, there are many countries positioned well to grow their per capita income and advance into higher strata of economic development. Investors must understand the factors that make each unique and pick the ones best-suited to break out.
From 2003 to 2007, average emerging market GDP growth rose from 3.6% to 7.2%, as emerging countries boomed in unison. This led many to contend that developing economies had learned their lessons from the tumultuous 1990s and were universally poised for faster growth.
However, this view overlooked the main reason for widespread emerging market success: easy money following the collapse of the technology bubble. In the coming years, as monetary policy continues to tighten globally, investors will likely see mixed results in emerging markets.
In his 2011 book Breakout Nations, Ruchir Sharma, head of Emerging Markets and Global Macro at Morgan Stanley, gives his take on several emerging markets and why he believes these countries are likely or unlikely to be breakout nations in the future. Sharma defines a breakout nation as one that is able to grow per capita income faster than its current peers, succeed in reaching new economic thresholds, and ascend to higher strata of economic development.
According to Sharma, failure to sustain growth is the norm in developing economies, and fewer and fewer countries are able to break out at each subsequent stage of economic development as countries find it increasingly difficult to leapfrog their rivals into higher per capita income classifications. Thus, for emerging market investors to be successful they must understand the economic regimes present in different nations in order to pick those poised to break out versus those destined for mediocrity.
In the book, Sharma classifies various emerging markets in the following strata based on their 2010 per capita income in US dollars (note that no nations were discussed in the $15K-$20K range):
- Per capita income below $5,000: China, India, Indonesia, Philippines, Sri Lanka, Vietnam, Nigeria
- Per capita income between $5,000 and $10,000: South Africa, Thailand, Malaysia
- Per capita income between $10,000 and $15,000: Brazil, Mexico, Russia, Poland, Turkey
- Per capita income between $20,000 and $25,000: Czech Republic, South Korea, Taiwan
According to Sharma, Indonesia, Sri Lanka, Poland, the Czech Republic, and South Korea have the best chance to break out of their current per capita income classifications and deliver impressive economic growth consistently in the future. Turkey, too, was one of Sharma’s breakout candidates, but political developments since the book’s writing cast uncertainty on this prediction.
The Philippines, Nigeria, and Thailand all have breakout potential should various structural impediments be overcome. Finally, Sharma views it as improbable for India, Vietnam, South Africa, Malaysia, Brazil, Mexico, Russia, and Taiwan to break out from their current peer groups moving forward. China is a special case, as it will still deliver decent growth, but nowhere near the pace investors have come to expect, making it less of a breakout candidate.
Many signs point to China not being a breakout nation, at least not relative to its own historic growth standards. Debt-to-GDP is rising quickly, cheap labor is disappearing, and inflation is rising. Despite these signs, the investment community is largely split on China. Bulls extrapolate past success into the future and contend that double-digit growth will continue, while bears point to over-investment by the government, rising debt levels, and high real estate prices as impediments to growth.
Sharma sees the truth somewhere in the middle, contending that China will likely see annual economic growth fall to 6-7% in a manner similar to 1970s Japan, which saw rapid postwar growth taper off as the population aged. Thus, China will likely jump to higher per capita income strata in the future, but not nearly as quickly as many might expect.
While historically China has been able to piggy-back on the technological advancements of the West to grow its economy, it must now innovate for itself, which could cause it to experience the same deceleration experienced by Japan in the 1970s, Taiwan in the 1980s, and South Korea in the 1990s.
Furthermore, a major reason for China’s prolific growth in the 2000s was an investment as a percentage of GDP rising from 35% to 50%, which enabled China to become the largest exporter in the world. This spending spree cannot continue, however, and indeed Beijing has already started to scale back its infrastructure development plans.
Demographics also point to an impending Chinese slowdown. Many of China’s underemployed farmers have already moved to take more productive urban jobs, and any surplus rural labor pool is about to run dry. This is making urban labor more expensive. Already, hourly wages are growing twice as fast as productivity, forcing companies to raise prices to cover higher costs.
In turn, this is causing inflation to rise and making Chinese labor less globally competitive. Additionally, China’s postwar baby boom is aging, and because of one-child policies implemented in decades past, there are not enough young laborers to fill employment voids left by the elderly.
Other issues impacting China’s growth prospects include runaway housing costs, fueled by $4 trillion of fiscal stimulus following the 2008 financial crisis, which have made it prohibitively expensive for workers to move to cities. Debt is also a big issue in China, where officially reported private debt equals 130% of GDP and could exceed 200% of GDP if the shadow banking sector is included. Finally, after the death of Deng Xiaoping in 1997, China has become more focused on welfare than competitiveness, which could dampen economic growth.
While China’s deceleration will certainly feel significant, it is not an investor apocalypse. As a Chinese proverb states, “a dead camel is still larger than a horse,” and this is exactly the mindset that investors need to have when analyzing China in the coming years.
Analysts have long touted the potential of India. Given its elite schools and its proficiency in English, India has consistently been considered a prospective breakout nation. Unfortunately, these plaudits may have caused India to become blinded by hubris.
This overconfidence largely stems from India’s demographics. India is in the midst of a baby boom, which many views as a positive. Sharma sees things differently, contending that the likelihood of India using its demographic gifts to break out of its current economic stratification is only 50% due to several structural issues.
For one, India maintains a huge welfare program, but it generates insufficient income to support this system. It was easy for India to boost welfare spending in the 2000s, but today its exorbitant welfare system could easily result in the same hyperinflation that rocked Brazil in the 1970s.
India’s social spending has already increased public debt to 70% of GDP, one of the highest rates in the developing world, and it is also encouraging workers to stay on farms rather than find more productive employment in cities. For India’s population boom to benefit the economy, citizens must urbanize and take better jobs in services and manufacturing. Otherwise, the population boom will only serve to strain an already suspect welfare system.
Perhaps the biggest threat to Indian growth is crony capitalism. Today, Indian business deals often require government connections, causing many Indian businesspeople to increasingly look abroad for opportunities, which has led to investment in India falling to 13% of GDP, down from 17% in 2008. This decline in investment makes it far less likely that India will hit growth above 7%, and it also makes inflation more likely since supply will trail demand, causing prices to soar.
In the context of India, Sharma presents a rule of the road: “watch the changes in the list of top billionaires and learn how they made their billions and how many billions they made.” If the economy is generating too many billionaires given its size, e.g. India, Mexico, and Russia, the economy is not balanced, and government patronage is probably at play.
However, there are signs of hope, especially in India’s historically poor northern states. For one, there has been a trend in the north towards electing competent, fair leaders who shun the patronage that has long afflicted India’s economy. In Bihar, historically India’s poorest province, the election of Nitish Kumar ushered in a wave of cleaning up the graft that had long plagued the region.
Bihar is now growing at 11% per year, showing the effect that clean government can have on the Indian economy. The northern provinces today are in a great position to foster enterprises, invest in infrastructure, and expand education, planting the seeds for an economic boom.
In sum, India does indeed have massive economic potential. However, for India to become a breakout nation, the country must address its crony capitalism, excessive welfare spending, and insufficient urbanization. Otherwise, India will remain an also-ran for years to come.
Brazil is a leading exporter of every commodity that surged in price in the 2000s, causing many to dub it the next breakout nation. However, the ensuing rush of foreign money into Brazil made it enormously costly and overhyped as an investment hub. In discussing Brazil, Sharma presents another rule of the road:
“if the local prices in an emerging market country feel expensive… that country is probably not a breakout nation.”
Indeed, Sao Paulo’s restaurants now rival those of Paris in price, and apartments in parts of Rio are more expensive than those in Midtown Manhattan, showing that Brazil has questionable growth prospects and low breakout potential.
Today, Brazil is far too heavily reliant on commodities, and its track record shows the only times it has seen economic booms over the past 30 years have been when commodity prices have spiked. Brazil has largely been oblivious to this dependence, and it seems that strong commodity exports in recent years have planted seeds of instability for the Brazilian economy.
Demand for Brazilian commodity exports like coffee and iron have resulted in Brazil’s currency, the real, appreciating wildly, causing other export sectors, most notably manufacturing, to hollow out. This takes away cushioning Brazil would have in event of a commodity collapse. Brazil’s future largely hinges on how it uses its newfound oil reserves.
If it can utilize the proceeds from this sector to diversify the economy and invest in productivity-enhancing areas, there is room for optimism. If not, Brazil will likely suffer the fate of Saudi Arabia and see economic stagnation for decades.
Another issue Brazil faces is excessive state spending that has historically contributed to massive inflation, which in the 1980s and 1990s averaged 2,100%. In response, Brazil now keeps interested rates extraordinarily high, attracting foreign capital and causing the real to appreciate, a drag for Brazilian exports.
Today, Brazil has a welfare system it cannot afford, and public spending has risen to 40% of GDP. To pay for this, Brazil has dramatically raised taxes, making businesses unable to afford investments in technology and employee training. This has resulted in the Brazilian productivity growth of only 0.2%, compared to 4% in China.
Education similarly has been neglected, which has led to a massive skills shortage that also has inflationary effects since companies must pay huge wages to attract skilled workers, especially in engineering and technical jobs. These factors contribute to Brazilian inflation taking off at much lower growth rates than its peers, restricting growth prospects.
While it does have some things going for it, such as a corporate culture that is obsessed with profitability, Brazil is currently held back by factors surrounding the country’s business landscape. In particular, Brazil needs to address its decrepit infrastructure, its bloated state spending, and its expensive currency in order to have a chance at becoming a breakout nation.
Mexico is unlikely to break out of its current economic classification as its economy is dominated by a handful of powerful tycoons who extract high prices and profit margins. Historically, Mexico’s corporate behemoths have used these big domestic profits to become global players, but they have not invested much, if any, of this capital back into the Mexican economy, causing innovation and productivity to see minimal gains since the mid-1990s.
This tycoon economy arose in the 1980s and 1990s in the midst of numerous Mexican debt crises that led the government to sell off public monopolies to the private sector. These former public monopolies are now private monopolies that control as much as 80% market share in their respective fields. Today, these big businesses have become so entrenched that reform to make the economy more competitive is nearly impossible.
This has led to sticky inflation, as Mexicans pay higher prices for items like phones and food than Americans despite having only one-fifth the per capita income of the US. Also, economic stagnation has led many Mexicans to abandon Mexico to seek economic opportunity. From 2006 to 2010, Mexico had the largest outflow of migrants in the world, hollowing out the potential labor force Mexico needs in order to break out.
There is some room for optimism in Mexico, however. Recently, antitrust laws designed to curb anti-competitive trade practices have been passed, and smaller businesses have started to take on entrenched players like CEMEX and America Movil. Additionally, Mexico is well-positioned to capitalize on trends making China less competitive, and Mexican manufacturing could be a bright spot in the coming years.
In conclusion, while its tycoon economy poses challenges to breaking out economically, Mexico does possess some advantages that could allow it to take off should meaningful reform make it’s economy less concentrated and more competitive.
It is improbable that Russia will become a breakout nation. Russia stands out among emerging economies due to its extravagant display of wealth in Moscow and Saint Petersburg, yet elsewhere infrastructure is abysmal and local economies are decrepit due to underinvestment. Investment to GDP is only 20% in Russia, half the level of China. Russia thus suffers the same issue as Brazil: inflation setting in at low growth rates, and indeed Russia has historically seen inflation 3% higher than the emerging market average.
Furthermore, Russia is overly dependent on the state-run oil and gas sector, which provides 50% of government revenues. When Vladimir Putin took power in 2000, this problem looked set to be solved, as Putin sought to diversify the economy by welcoming outside investment, deregulating business formation, and lowering tax levels. Putin also initiated a “rainy day” fund for surplus oil revenues that promised to stabilize the Russian economy in its era of reformation.
These actions worked early on, as entrepreneurship in technology, retail, and media flourished, and per capita income rose from $1,500 to $13,000 in a decade. However, by 2007, Russia had become blinded by hubris amidst high oil prices, ending its efforts to diversify its economy. The 2008 financial crisis hit Russia hard, and the government began to bleed the oil revenue fund to soften the blow.
Today Russia needs $100 per barrel oil in order to breakeven and the country has run deficits of 4% of GDP in recent years, in no small part due to increases in state pension payouts implemented before the crisis. Thus, Putin has lost his ability to transform the economy, leading Sharma to offer another rule of the road:
“be alert to the moment when rulers have outlived their usefulness. It is a worrying sign when leaders try to extend their hold on power, as they… shift their focus to protecting vested interests or they simply run out of progressive ideas.”
Today, Russia wants to seem like it is remaking itself to fuel growth, but changes are only superficial, such as “privatizing” state-owned enterprises by reducing government ownership from 60% to 51%. For Russia to break out, it needs a political shakeup to fuel reforms to diversify the economy beyond oil, end the stranglehold of Russia’s oligarchs, and invest in cities beyond Moscow and Saint Petersburg.
The world has lost confidence in Russia, which now sees annual net investment outflows of $9.5 billion. New leadership is needed to bolster the middle class and raise business confidence. Otherwise, Russia will never be a breakout nation in the near term.
Europe’s Sweet Spot
While Russia keeps moving in the wrong direction, two of its former satellites, Poland and the Czech Republic, seem primed to break out. These two countries are largely free of debt and are leveraging membership in the European Union to unleash their economies. Fear of falling back under the influence of Moscow has been healthy, leading both nations to embrace fiscal discipline and helping enable political and economic reforms.
Poland was the only European economy that did not contract in 2008 and 2009 and now has the most vibrant labor market in Europe. It is well-positioned due to its strong education system, its well-run banks offering reliable credit, and its central bank being independent from political pressures.
The Czech Republic has more global exposure than Poland, which can lead to downturns when exports fall, but like Poland it has a sound domestic banking system and a well-run government that makes it well-positioned to weather storms. The Czechs are also uniquely advantaged by a strong domestic manufacturing sector, especially in automobiles with the Skoda brand being a top-seller across Europe.
Poland and the Czech Republic are now in the sweet spot of European growth, as both are members of the EU but are not yet in the Eurozone. Thus, both nations benefit from EU subsidies and support for infrastructure development, but they are not handcuffed by the Euro, which prevents nations from allowing their currency to depreciate. This enabled both nations to weather the 2008 financial crisis better than their European neighbors, as the local currency could fall instead of wages or exports.
These two European starlets provide Sharma the context to introduce another rule of the road: “watch for steady momentum behind economic and political reform, particularly in good times.” This is what separates Poland and the Czech Republic from nations like Hungary, which has flirted with communism since the fall of the Soviet Union and has been awful at controlling public spending.
Today, Hungary suffers from intense populist sentiment, a heavy debt burden, poor labor force participation, and an uncompetitive currency. With a willingness to retool their economies and shun communism, Poland and the Czech Republic are the rising stars of Europe.
Turkey is an ambiguous economic case. In 2011, at the time of this book’s writing, Turkish ruler Recep Tayyip Erdogan was leading a counterrevolution against the Westernization-at-all-cost ideology that previous Turkish leaders had adopted.
This helped stabilize Turkey, as, before Erdogan came to power, the nation was plagued by instability catalyzed by secular, coastal elites trying to lead a nation of pious Muslims outside the major cities of Istanbul, Ankara, and Izmir.
Erdogan used political stability and his penchant for relating to the masses to enact reforms that lowered government debt from 90% of GDP to 40%, brought inflation into the single digits for the first time in 30 years, and tripled per capita income. Stability also prompted infrastructure investment, setting the stage for a Turkish economic boom.
Furthermore, Erdogan has made it a focus of his government to promote business activity outside the wealthy Istanbul-Ankara-Izmir triangle. This is especially true in Turkey’s Anatolian heartland, which has seen a manufacturing boom amidst increasing trade with the Middle East and Asia.
However, one trend Sharma foresaw in 2011 that has become a real concern in Turkey is that economic strength has enabled Erdogan to become increasingly authoritarian. As prime minister, Erdogan pushed through a new constitution that increased the power of the president, a role that Erdogan subsequently assumed.
Increasingly, Erdogan is starting to feel like a Turkish Vladimir Putin. Unfortunately for Turkey, Russia’s fate shows what can become of a nation in which a wave of reform loses its momentum as the existing government becomes entrenched.
Other potential issues for Turkey include the heavy burdens imposed on employers to make Turkey a European-style welfare state and a tax system that is largely ineffective, forcing the government to rely on a few industries (like state-owned liquor stores and the heavily regulated telecommunications and automobile sectors) to provide the state with revenues. Turkey must address these issues to have a chance to break out in the coming years.
Indonesia was the hardest-hit economy during the 1997 Asian financial crisis, but now it is a likely breakout nation. In 2008, its low debt levels spared it from the financial crisis, positioning it well for subsequent growth. Indonesia is now the world’s best-run commodity economy with massive reserves of oil, coal, palm oil, and nickel.
Importantly, Indonesians have recognized their nation’s dependence on commodities and have kept public debt low (27% of GDP) while maintaining strong investment in other areas of the economy (32% of GDP). Indonesian businesses are also very calculated in their investments, and banks are careful about lending.
Using Indonesia as a case study, Sharma presents another rule of the road: “check the size and growth of the second city, compared to the first city… This ratio reflects regional balance in the economy.” It is a red flag if countries have weak secondary cities that are not growing, as this suggests all the money is flowing to capital-city elites and not permeating the economy.
Indonesia passes this test, as its second city, Surabaya, is strong and many other cities are emerging quickly to balance the power and wealth of the capital, Jakarta. This separates Indonesia from nations like Russia and makes it much more likely that Indonesia will be a breakout nation in the coming years.
The Philippines, after decades of lagging its Asian peers, could be ready for a period of strong economic growth. However, problematic new leadership since Sharma’s writing puts this in question. In 2011, the government had started entering public-private partnerships to revitalize the nation’s infrastructure. This could unlock the Philippines’ economic potential, which includes the fifth-largest natural resource reserves in the world and a large, young workforce that is largely proficient in English.
The latter could enable the Philippines to rival India for outsourced call centers, a $9 billion industry employing 350,000 people. Thus, the Philippines could see an economic boom depending on the direct current leadership takes the country.
Thailand has structural problems that could hold the nation back if they are not addressed. For one, the country is enormously imbalanced, with Bangkok, the capital, accounting for just 15% of Thailand’s population but over 40% of GDP. This has led to a lengthy political battle between rural “red shirts” and urban “yellow shirts,” which has catalyzed 18 coups in the past 75 years.
However, signs of progress are being made, as Yingluck Shinawatra, a “red shirt,” peacefully took power in 2011, leading many to believe Thailand could see sufficient stability for the economy to prosper. However, this overlooks a larger problem that Thailand exports too much without building up a domestic consumer class of its own.
Today, exports represent 72% of Thai GDP, which can lead to prolonged downturns when exports to the West fall, as they did in 2008. For Thailand to break out, it needs more investment in rural areas to create a balance between Bangkok and the rest of the country, continued political stability, and increasing consumerism amongst Thais.
Since the late 1990s, Malaysia has positioned itself poorly for the future. Following the 1997 Asian financial crisis, while other Asian nations were slashing spending and stabilizing their banking sectors, Malaysia took a different route, instituting currency controls and ramping up spending. These did nothing to help the Malaysian economy, which saw growth slow to 5% and public spending rise to 28% of GDP.
Malaysia has now become more commodity-dependent than ever, and manufacturing, once a bright spot for the Malaysian economy, has regressed to 26% of GDP. Furthermore, increasing government antagonism to Malaysia’s large ethnic Chinese minority drives many talented Malaysians abroad to find better opportunities.
The result is that Malaysia is now the only nation in Asia in which foreign direct investment is falling. Sharma uses this phenomenon to state another rule of the road: “watch the locals, they are always the first to know, they will be bringing money home to a breakout nation and fleeing one in trouble.” Unfortunately, Malaysia falls in the latter category and likely will not see a breakout anytime soon.
East Asia’s Historic Superstars
South Korea and Taiwan are the only economies in recorded history to post five consecutive decades of growth over 5% per year. Both are former Japanese colonies that have mimicked Japan to great success by investing heavily in R&D and reigning in income inequality, which can inhibit growth. Of the two, Korea is best positioned to remain a breakout nation.
South Korea is such a success because of its willingness to reinvent itself. Following the Asian financial crisis, while many nations sought to save their incumbent businesses, Korea was content to clean house and let new, stronger businesses arise. This mentality is largely the product of Korea being forced to take an IMF bailout of $58 billion in the thick of the Asian crisis, which became a source of public humiliation.
This made Koreans embrace creative destruction as a means to forge an economy that would never require a bailout again, and Korea let 40% of its businesses fail in the years following the crisis. Because of this ruthlessness, Korean companies are incredibly efficient today and have become more cost-competitive than their Japanese rivals.
Since the 1990s, South Korea has seen three of its homegrown businesses – Samsung, Hyundai, and LG – become some of the world’s largest manufacturing companies. Furthermore, South Korea is the only country whose companies have, on average, gained market share in China over the last decade. Most large businesses in Korea are owned by a strong dynastic family but run by independent professionals who are likely to stick with a single company for their entire career.
This unique model enables Korean companies to be bold and take risks when entering new markets, due to their visionary ownership, while becoming ruthlessly efficient once they are more established, due to their impeccable daily management. This system is a strong asset in an increasingly globalized world and positions Korea well to continue its historic boom.
Korea is also a great place to invest because many investors assign it a discount due to companies being family-owned and having low dividend payouts, but these factors are actually value- additive as they enable Korean companies to undertake bold R&D campaigns that have made Korean companies the leaders in their respective industries.
For these reasons, combined with Korea having the highest education rates in the world and low public debt (at only 34% of GDP), South Korea is primed to continue its impressive economic run.
In contrast, Taiwan’s best years might already be history. Taiwan remains a contract manufacturing outpost for the Japanese and the West. For example, Taiwan makes 80% of the world’s laptops but does not have a national brand of its own. Taiwan also has an investment problem as capital outflows from the country have hit $2 billion per month.
Finally, Taiwan is far less productive than Korea and has become too dependent on Chinese labor, which is now losing its cost competitiveness. This could easily cause Taiwan to lose manufacturing contracts to cheaper nations in the coming years, posing massive challenges to Taiwan remaining a breakout nation.
South Africa has largely failed to ride the wave of growth that has swept up other emerging markets and now has an unemployment rate of 25%. The country still suffers from the aftershocks of the apartheid regime, which placed much of the economy in the hands of the state or a few dominant cartels.
This has created an economic environment devoid of the competition that could drive necessary productivity gains and growth. Indeed, South Africa’s government still controls many industries and largely does so poorly. Telekom, the state-owned telecommunications company has been a disaster, with only 14% of South Africans enjoying internet access.
Eskom, the state power company, is plagued by rolling blackouts, and Transnet, the state rail network, is such a mess that it could not figure out how to ship iron ore in the midst of a global iron demand boom. This has created an economy in which productivity gains are rarely achieved, and global economic booms do not translate into local success.
South Africa also suffers from strong unions that have distorted the economy and siphoned economic gains to a select, unionized few, which could lead to societal discontent as the number of unemployed South Africans has risen to three times the union membership. Furthermore, these unions have demanded wage increases that have outpaced inflation and productivity gains.
The result of all of this is that South African businesses are increasingly eschewing South Africa to pursue opportunities abroad, and 56% of South African business earnings is now generated outside South Africa. Sharma uses this to lay out a rule of the road:
“the sight of companies ‘going global’ is often celebrated in the headlines as a national success, but the more accurate interpretation depends on the circumstances. Going global can be a sign of corporate strength or national weakness.”
Sadly for South Africa, the latter appears to be the case.
The Fourth World
Frontier markets are often lumped into a single category, but this ignores the diversity between these countries, including their potential for economic growth. Today, some Fourth World countries appear to be ready to break out, while others seem destined for stagnation.
One country that could break out is Sri Lanka, which is in the process of recovering from a civil war that broke out in the 1970s. The war devastated Sri Lanka, as the use of child soldiers and suicide bombers set Sri Lanka back demographically for decades, and the exodus of banks and manufacturing caused the economy to grind to a halt.
Today, Sri Lanka is gathering momentum, as the government has enacted reforms designed to leverage Sri Lanka’s educated, English-speaking population and its proximity to Indian and Chinese trade routes to re-enter global commercial circles. Banks are coming back to Sri Lanka, the government is opening its waters to oil exploration, and its ports are bustling with international shipping traffic.
Finally, the government has cleaned up its balance sheet, lowering public debt to 30% of GDP from 59% in the 1970s. All these factors point to Sri Lanka possibly becoming a breakout nation in the future.
Vietnam, on the other hand, is an emerging market economy that could not handle the immense hype it received in the 2000s. Today, Vietnam’s infrastructure is a mess. For example, Vietnam’s ports were built for river routes and are thus too shallow for oceangoing ships, inhibiting Vietnam from benefiting from the trade routes that pass right by its doorstep.
Refineries are another example of Vietnam’s infrastructure failures, as Vietnam constructed its refineries in the middle of the country despite oil reserves being located in the nation’s south. Further, the refineries were built to handle high-grade oil, despite the fact that Vietnam only produces low-grade oil. These failures have caused capital to flee Vietnam since 2008, making it impossible for Vietnam to build the infrastructure it desperately needs.
With a lack of foreign capital, the government has enacted extremely loose monetary policy, but providing easy money for unproductive means has driven inflation to 20%. Vietnam is also failing in education, and Vietnamese workers are still largely underqualified for jobs in the global economy.
When Intel built a plant in Ho Chi Minh City, only four of the first 1,200 workers hired could pass the company’s test on basic English and technical skills. Vietnam will not break out until its government can prove its competence in running a command economy. Sadly, it does not look like this will occur any time soon.
Nigeria, having largely overcome its history of political instability, seems to have breakout potential. Although Nigeria is primarily dependent on oil, the country is diversifying and now has the second-largest movie industry in the world. Furthermore, Nigeria has followed the lead of other nations by implementing a sovereign wealth fund to save surplus oil revenues for harder times, a sound move in a commodity-dominant developing economy.
For Nigeria to break out, however, it must address its underinvestment in infrastructure, which currently sits at a paltry 10% of GDP. Notably, Nigeria will need to expand its power grid, which currently has the same output as the city of Bradford, England, making blackouts common and disrupting business proceedings.
Nigeria appears to understand this weakness, however and is working to get $35 billion invested in new power infrastructure, partially by relying on funds from increased oil exploration. In sum, Nigeria has much low-hanging fruit. If it can even pick a fraction of it, the country will see stellar growth in the near future.
A popular myth at the time of this book’s writing was that the rise of China and other developing economies would continue driving a “commodity supercycle” that benefitted commodity exporters like Brazil, Argentina, Australia, and Canada.
However, this ignores history, which demonstrates that commodities follow a predictable pattern of one decade upward followed by two decades downward. In 2011, the upward cycle was coming to an end, especially given the efforts of
China to become more economical in its commodity usage, pointing to a commodity bust that would erase the gains commodity exporters had seen in prior years. Despite the misfortune countries like Brazil will experience in the commodity bust, many countries are set to gain from a decline in commodity prices. In particular, commodity importers like India, Turkey, and manufacturing economies in Asia could all benefit.
At a broader level, emerging markets are entering a new era in which developing economies will stop moving in tandem and start to see more boom-bust cycles as easy money and excessive optimism wane. Moving forward, emerging market average growth will likely fall to around 10%, down from 37% from 2003 to 2007.
Already, rising inflation has started to dampen the mood on some emerging market nations that tried to sustain the growth they experienced in the 2000s with loose monetary policy, which has led to higher prices. Across emerging markets, the average misery index, which sums inflation and unemployment, has risen from 10 in 2008 to 12.
This points to a new normal, in which performance across emerging market nations diverges. Some countries will boom by learning from past mistakes and growing from them; others will become complacent and underperform. The key will be understanding the difference between breakout nations and everyone else.
While the majority of the book discusses the developing world, Sharma concludes by arguing that breakout nations exist in the developed West as well. In particular, the US seems like it is picking up steam as the global economy recovers from the 2008 financial crisis. For one, while total debt in America is certainly high at 340% of GDP, the private sector is deleveraging rapidly.
The US also seems to be leveraging traditional strengths, such as innovation, adaptation to change, and application of technology. In oil and gas, these attributes have manifested themselves in the US becoming the global leader in the shale drilling revolution, which has provided cheap energy to the American economy and enabled the US to become a hydrocarbon exporter.
In the technology sector, revolutionary advances are being made in automation and 3D printing, which could drive productivity gains and heightened corporate earnings. For these reasons, investors might not even need to leave the US to invest in a breakout nation in the coming years.
In Europe, Germany and Ireland stand out as potential breakout nations. Germany, which was relatively delivered going into the 2008 financial crisis, can now bolster its strong export sector and its domestic markets while the rest of Europe recovers. Unlike Germany, Ireland was crushed by the 2008 crisis, but it has done a fantastic job bringing down labor costs to make its exports competitive, even without a large depreciation of the Euro.
Furthermore, Ireland’s government has committed to fiscal discipline, and the country is moving faster than any other nation in recovering from 2008 as a result. Moving forward, both these nations are in a great position to outpace their European peers, who continue to struggle to recover from 2008.
The world is entering a new era of emerging market growth that will be marked by sharp variance in the fortunes of individual countries. Some countries are poised to become breakout nations that outperform their current per capita income peers and continue climbing the economic ladder while others have unaddressed structural challenges that will hold them back.
Going forward, it will be a bad idea to apply acronyms like “BRIC” to emerging markets and treat them as a cohesive group. It is important to understand the factors that make each developing economy unique, and investors need to do some digging to get a sense of how each of these economies works to discern which nations will break out in the future and which will remain stuck in their current economic stratification.
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