Key Trends in Globalisation

China’s economic growth has become a key factor not only for itself but for world markets. As the scale of China’s impact is still too frequently underestimated it should be noted that, measured in current dollars and at market exchange rates, i.e. in terms of actual effective demand, in the three years following the start of the international financial crisis China contributed 33.4 per cent of global market growth – more than four times as much as the US 8.1 per cent (Table 1). While final data for 2011 is not yet available, it is already clear from the first three quarters figures that China’s market last year expanded by over $1 trillion – approximately twice as much in dollars as the US, despite US growth having resumed. Table 1 makes clear no other economy has approached China in terms of market/global aggregate demand expansion.

It is therefore a key question whether China will continue essentially the same scale of market growth in 2012. The answer is ‘yes’  – but because of the issue’s importance the reasons should be clearly outlined. Interlinked with this is the decisive role played by developing economies in recovery from the financial crisis – the interlinking being that China is by far the largest developing economy, while the developing economies have become China’s largest trade partners.

In the three years covering the period from the beginning of the international financial crisis to the latest available annual data, i.e. in 2007-2010, developing economies accounted for 78.6 per cent of world market growth and developed economies for only 21.4 per cent. Considered from another angle, simply taking different classifications, either the BRIC economies (Brazil, Russia, India and China), or China plus Latin America, contributed the majority of world market/effective demand expansion – either of these groupings accounting for more than twice as much market expansion as the developed economies.

Table 1

Turning to more detailed trends, the first feature determining China’s continued dominant position in world market expansion, one the consequences of which are insufficiently frequently noted, is that as China’s economy becomes larger a similar percentage yearly growth necessarily turns into an increasingly large annual absolute market increase – in inflation adjusted terms, China’s economy expanded by 2.3 trillion RMB in 2008, 2.4 trillion RMB in 2009, and 3.1 trillion RMB in 2010.

But even frequently cited constant price growth figures underestimate the expansion of China’s position in the world market. Actual sales, and therefore changes in aggregate demand, use real money which is affected by exchange rate shifts and inflation – further figures in this article are therefore at current market exchange rates and prices unless otherwise stated. In 2009, when China froze the RMB’s exchange rate due to the international financial crisis, China’s economy grew by $469 billion – compared to a US contraction of $353 billion. In 2010, when China allowed the RMB exchange rate to rise, its annual economic expansion rose to $935 billion and the figure will be over $1 trillion in 2011 – roughly twice US market expansion.

Table 1 also makes clear the second reason China’s market will continue  its expansion. World growth is now dominated by developing economies and China is their most rapidly expanding trading partner.

Considering trends among developing economies, China accounting for 33.4 per cent of global market expansion. Latin America was second – constituting 17.3 per cent of world growth, with Brazil accounting for 58 per cent of this. China and Latin America together accounted for 50.7 per cent of world market growth..

Among other developing economic regions, South Asia contributed 8.0 per cent to world market growth, with India accounting for 84 per cent of this. Developing East Asian economies, excluding China, accounted for 7.0 per cent of world growth – Indonesia constituting 54 per cent of this. The Middle East and North Africa accounted for 6.1 per cent of world growth with no single dominant regional economy – the largest contributor, Egypt, constituted only 19.9 per cent of the total. Developing countries in Europe and Central Asia accounted for 4.5 per cent of world growth – of which 55 per cent was Russia. Sub-Saharan Africa grew rapidly, but due to its low starting point only contributed 2.1 per cent of world growth.

Turning to developed economies, Japan illustrates the importance of currency movements for shifts in markets measured in dollar terms. Due to the yen’s sharp exchange rate rise, Japan contributed 14.9 per cent of the dollar expansion of the world market despite Japan’s economy contracting in inflation adjusted terms. The US contributed 8.2 per cent to world market growth, despite the US not having grown in constant price terms, due to the dollar rising against other currencies,

The ‘disaster area’ for world markets was the developed European economies with a decline of $668 billion – equivalent to subtracting 9.2 cent from world growth.

It is already clear 2012 will show no fundamental change in this pattern. Developed European economies will again be the worst performing region – suffering a recession possibly magnified by a low Euro exchange rate. The US should expand, but slowly compared to previous upswings in US business cycle. Therefore if the world economy is to grow this will again have to be primarily due to developing  economies.

Fortunately, the large developing economies are slowing but still growing substantially more rapidly than developed ones. China, the dominant factor in the equation, even on pessimistic estimates is likely to grow by at least 7-8 per cent in real terms this year which, after increases in the exchange rate of the RMB and inflation is take into account, means an expansion of its market of probably 12-15 per cent in dollar terms. Minimum real growth estimates for India are at least seven per cent.

It is also clear from the pattern in Table 1 why BRIC economies will again dominate world growth – in 2007-2010 they contributed 52.5 per cent of world market expansion. Not only are the BRICs individually the largest developing economies but each is the centre of a major regional economic area. While Brazil has slowed, Russia’s economy has been accelerating, and it is in any case China and India which are the dominant dynamic BRIC economies.

This overall situation clearly interrelates with China as it already carries out the majority of its trade with developing economies – 54 per cent of total trade, 49 per cent of exports and 60 per cent of imports.

The implications for China’s markets are clear. China has not only the world’s most rapidly expanding domestic market, and declining inflation gives it extra room for domestic economic loosening/stimulus in 2012, but its biggest trading partners are the most rapidly growing regions of the world economy. It is this combination of domestic and international factors which determines that  China will continue to remain the world’s most rapidly expanding market/supplier of increased aggregate demand in 2012. Given the negative prospects in Europe, and slow growth in the US, it will then be the situation in the developing economies, which is increasingly related to the situation in China, which will necessarily determine the overall prospects for world growth in 2012.

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This is an expanded version of an article which originally appeared in Shanghai Daily.

In 2012 the world economy will continue to struggle with the international financial crisis. There will be recession in Europe, world trade was already declining in September and October, and international commodity prices are falling sharply – a sensitive indicator of the state of the world economy. The only unknown is the severity of the slowdown – in particular, will the US be pulled into recession or merely continue to grow slowly, and by how much will the large developing economies such as Brazil, India and Russia decelerate? China’s premier Wen Jiabao predicted, regarding that country’s perspectives, that next year’s international economic situation would be “complicated and tough.”

Entering such a situation, a major issue is to assess with the maximum possible accuracy the position of China in the global economy – this affects both the rest of the world economy and China. Well known statistics, such as that China’s is the world’s second largest economy, are insufficiently accurate to suffice for this. For reasons indicated below they underestimate the role of China in the world economy’s development and are not fine grained enough to accurately judge economic policy. Analysis shows China will play a pivotal role in the world economy in 2012 – Goldman Sachs’s Jim O’ Neill, coiner of the term BRIC, estimated in the Financial Times: “While the financial and business world continue to hang on every twist and turn in eurozone politics, I think the biggest issue for the world in 2012 will be…China.”

The first reason for this is that China’s high growth rate results in its contribution to world economic expansion being much greater than its percentage of world GDP. In 2007, the last year before the international financial crisis, China accounted for only 6.3 per cent of world GDP on World Bank statistics. But in the following three years the world economy expanded by $7.2 trillion while China’s economy grew by $2.4 trillion – i.e. China accounted for 33 per cent of world growth. In contrast, in 2007 the US accounted for 25.1 per cent of world GDP, but in the next three years the US economy grew by only $0.6 trillion. Therefore in the last three years China’s economy contributed four times as much to global growth as the US. The EU, to make a comparison, contracted by $0.7 trillion during the same period.

The second key factor is China’s financial role. The key feature of this is not, as is sometimes supposed, China’s $3 trillion foreign exchange reserves. These have been accumulated over a significant period and, because a large part is an emergency reserve, only a small amount can be utilized at any point. The key element is the finance China generates each year for investment – i.e. its total company, household and government saving. In 2007 US total finance generated for investment was $2 trillion and China’s was $1.8 trillion – that is, the US was slightly ahead of China. By 2010, under the impact of their economies, different responses to the crisis, total finance available for investment in the US was $1.6 trillion and in China $3.1 trillion – i.e. China’s finance available for investment is now almost twice that in the US, a dramatic change in three years.

Turning to international trade, US imports have still not regained pre-financial crisis levels. Taking a three-month average, to avoid distortion by purely short-term fluctuations, up to the latest available data, for October, US imports were an annualized $17 billion lower than the pre-financial crisis peak level in July 2008. Therefore in the last three years the US market for exports has contracted. In contrast, compared to the pre-crisis peak in July 2008, China’s imports from other countries have increased by an annualized $575 billion. China therefore now plays a much greater role as a market for increases in exports than the US.

Finally is the structural position China occupies in the changing pattern of the world economy. The Economist magazine recently emphasized that 2012 will see a fundamental change in the world economy: for the first time the majority of world imports will be by developing economies. In 2008-2010 low and middle income, i.e. developing, economies accounted for 78 per cent of world economic growth.

China already carries out a majority of its trade with developing countries. In the three months ending in October, 54 per cent of China’s trade was with developing economies – 49 per cent of exports and 60 per cent of imports.

The rate of increase of China’s trade with developing economies is also significantly stronger than with developed economies. Between July 2008 and October 2011 China’s exports to developed economies rose by an annualized $107 billion and its imports from them by $145 billion. With developing countries, China’s exports rose by an annualized $143 billion and its imports by $204 billion. China was the hub of a rapid expansion of trade by developing economies.

This trade situation is directly linked to the new technological position China occupies in the world economy. A number of developing economies have passed from being merely suppliers of raw materials to exporting more technologically developed products – India’s success in software and Brazil’s in regional range aircraft are examples. But no other developing country has such a wide technological range of internationally traded products as China. Such trade originated in low technology labour intensive industries, spread through a rapidly widening range of medium technology products such as excavators, domestic goods and personal computers, up to the higher technology telecommunications equipment of Huawei and other companies.

This capacity of China to export across a wider range of the technology spectrum than any other economy creates its increasingly key position in world trade. China exports low, medium and some high technology products to developed economies, while its exports are increasingly on a higher technology level from the point of view of developing economies. China’s financial resources make it able to follow this widening range of exports with direct investment.

It is the combination of these features – the single biggest contributor to the increase in world GDP, the largest source of finance, the biggest potential increase in export markets for other economies – which results in China’s impact on the world economy being much greater than its pure percentage of world GDP. To put it in technical economic terms, developments at the margin, that is contributions to change, must be considered as well as averages.

Concerning the issues that will dominate 2012, China’s economy by itself is not yet large enough to pull the developed economies out of recession – although it can play a potentially significant role in collaboration with others. But in relation not only to Asia but to a widening range of developing countries the growth of China’s economy is crucial. As developing economies now contribute more to world economic growth than developed economies, this means that the success, or otherwise, of China’s economy for the global economy will be pivotal in 2012.

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This is an edited version of an article originally published as an opinion piece by China Daily’s website.

The beginning of 2012 is a suitable moment to assess China’s economic prospects for the year and coming period. This overall perspective is clear – China will grow strongly, remaining the world’s fastest growing major economy, and will continue to substantially outperform Western pessimist predictions. This is the same fundamental analysis maintained by the author over the last two decade period. Factual results during these twenty years have confirmed such projections – as opposed to the opposite perspective. As accurate or inaccurate predictions do not depend on personal characteristics, but on different fundamental analyses, therefore what leads to repeatedly correct and incorrect projections regarding China’s economic growth?

The core issue is simple but difficult for the majority of non-Chinese analysts to admit, despite constant confirmation by economic facts and repeated falsification of predictions of China’s serious slowdown. This core issue is that statements by Chinese analysts that China has a stronger economic structure than the US and Europe, and that this therefore produces stronger economic performance, is not a boast but actually factually correct. As this stronger character of China’s economic structure is not understood by many Western analysts, they therefore systematically, and each year, underestimate China’s economic growth potential.

Nevertheless, a genuine difficulty for non-Chinese analysts is that explanations of this economic strength are frequently posed only in terms of specifically ‘Chinese characteristics’. It is therefore worth spelling out more generally why China has a stronger economic structure than the US and Europe, and how this relates to global economic issues that will be faced in 2012.

 A model performance [By Jiao Haiyang/China.org.cn]

China self-definition of its system is a ’socialist market economy’. This denotes it differs fundamentally from the economy, modeled on the former USSR, which existed prior to China’s 1978 economic reforms, in that economic policy is not run by administrative but by market means. China has a large and vibrant private sector – indeed the world’s most rapidly growing private sector. However China differs from the US or Europe in having a sufficiently large state sector, and a nationalised core banking system, that it can directly set the economy’s overall investment level – the state sector is too small in the US or Europe to achieve this. This combination of market system and a state sector sufficiently strong to determine the overall level of investment is what gives China its greater economic strength than the US or Europe – such a structure can be understood either from a Chinese ’socialist’ point of view or a Western ‘Keynesian’ one, and for present purposes it  is unimportant which is chosen. 

To illustrate this, consider a key contemporary economic problem – the current situation in the US. The Financial Times on December 15 accurately described the situation in the US economy. It noted that the share of wages in US GDP had fallen to the lowest level since records began and concluded: ‘The decline in the labor share, along with a shift of labor income towards higher earners, may be an important part of why the US economic recovery is so sluggish. Workers on lower wages consume much of their income, while higher wage earners and those with capital income are more likely to save. That will not affect total demand if savers lend to those who want to consume or invest in buildings and start-ups – but investment has been slow to recover in the wake of the recession.’

In short, the US economy is growing slowly not because there is a shortage of funds for investment, on the contrary profits are at a record high, but because investment is very low – indeed the entire decline in US GDP in the current ‘Great Recession’ is accounted for by the investment fall. The problem is that in the US there is no mechanism which ensures that the huge funds available for investment are actually invested.

In China no such problem exists. If funds are not directly invested by companies, then the state owned banking system and state sector can invest them. Therefore no shortfall of demand occurs of the type analysed by the Financial Times in the US. During the entire international financial crisis China, unlike the US, suffered no investment decline – on the contrary investment increased. The problem of accumulation of unused funds of the US type, that is in Keynesian terms a shortage of effective demand, does not arise in China. Equally if China’s economy is booming, and companies are utilizing all funds for investment, the state steps back and cuts its own investment – reducing it to cool overheating. That is why China’s macroeconomic policy is stronger than that in the US – the problems of either shortage of or excessive demand, which plague the US and European economies, are smoothed in China.

This evidently does not mean China escapes all macroeconomic issues. No policy maker can judge absolutely accurately how strongly the international economy will grow, what will be all the inflationary or deflationary pressures present, exactly how China’s own economy will respond to a given measure etc. Therefore there are always issues of overheating, undershooting, inflation, deflation etc. But these are qualitatively smaller fluctuations than in the US or Europe.

The period since the onset of the international financial crisis showed this strength of China’s economic structure clearly. Faced with the international financial crisis in 2008, China was able to launch a massive stimulus package which meant its economy did not suffer a recession at all. The recovery of the world economy in 2010-2011 combined with the aftermath of the stimulus package to create some economic overheating and 2011 was therefore mainly spent damping inflation. In 2012, with negative trends dominating the world economy, China will loosen policy.

The overall result is evident. In the four years to the latest economic data, for the 3rd quarter of 2011, the US grew by 0.5 percent, the EU shrank by 0.3 percent, and China grew by 42.2 percent. China’s economy therefore suffered some fluctuations on a strong growth path, whereas the US and Europe suffered overall economic stagnation. The stronger character of China’s economic system was shown by these facts – those predicting crisis for China, on the same scale as the US or Europe, made the wrong predictions because they failed to analyze that strength.

It is this superior strength of China’s economic structure that also makes it clearly possible to predict for 2012 that China’s economy will continue to grow strongly, that it will remain the fastest growing major economy in the world, and that it will outperform on the upside Western pessimists predictions – as in previous years the facts of 2012 will confirm that analysis. Not until they understand the greater structural strength of China’s economy will current critics be able to make persistently accurate predictions.

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 A shorter and edited version of this article originally appeared on China.org.cn.

One of the biggest questions for the global economy in 2012 will be whether the US follows Europe into recession – the other is whether the large developing economies will be able to repeat their strong growth performance during the previous wave of the financial crisis in 2008-2010 by ‘decoupling’ from the US and Europe.

A significant negative for US prospects came with the release of the latest S&P Case-Schiller house price index. This showed a larger than expected 3.4 per cent annual fall for the latest period for which data was available – October. But much more significant than one month’s figures is the overall trend.

As shown in Figure 1 US house prices reached their post-financial crisis low in May 2009 after falling 31.7 per cent from their peak. Recovery continued until May 2010 after which prices began falling again. By October 2011 US house prices were 33.0 per cent below their all-time peak – the worst level since the international financial crisis began.

As housing is, with shares and bonds, one of the three great US asset classes, a significant fell in this category will have an impact across the whole US economy. In particular:

• it will further negatively impact the balance sheets of US banks;
• it will have a dampening effect on US consumer spending

Figure 1

The overall view of this blog remains that the US will continue to have historically slow growth rather than re-entering a recession, and the latest US consumer confidence figures for December were the best for eight months. But the fact that the trend of US house prices has now been down for 17 months is a serious negative.

Whatever their immediate mood US consumers are constrained by objective financial factors. With unemployment not falling significantly and incomes not rising falling house prices will further constrain consumers. The recent increase in consumer purchasing in the US has been financed by a reduction in savings levels – which is unsustainable.

The house price data by itself does not lead to a view the US is entering recession, but it pushes US growth towards the ‘slower’ end of the ‘slow’ spectrum.

Commodity prices are a particularly sensitive indicator for the world economy due to their strong and pro-cyclical price fluctuations. These in turn are linked to supply inelasticities – the obstacles to and pronounced time delays in changing the supply of many commodities.

Agricultural commodities frequently require a minimum of a year to increase output due to seasonal factors, and many minerals require very heavy investment, needing time to implement, before output can be increased. Once such heavy fixed costs have been undertaken it is prohibitively expensive to reduce production. Therefore whereas in manufacturing and services a large part of fluctuations in supply and demand is absorbed by changes in volume, in commodities a much higher part has to be absorbed by changes in price – hence extreme price fluctuations.

In that light Figure 1 shows a sensitive indicator for the world economy – the daily Dow Jones-UBS spot commodity price index for the last 20 years. The story is clear. The first gradual and then rapid surge in commodity price inflation in 2000-2008 is evident, as is the price crash during the international financial crisis. Price recovery occurred during 2009 up to spring 2011, taking commodity prices to higher levels than in 2008. This lay behind the consumer price inflation in India, China and other developing economies.

The peak of commodity prices was reached on 29 April 2011 – the subsequent decline itself being an excellent indicator of a slowing world economy. The subsequent fall, of 17.7 per cent to 21 December, may be seen in Figure 1.

Figure 1

The year on year fluctuation in prices, which is what is reflected in the annual consumer price and producer price index figures, is even more violent. In 2011 the peak annual increase was reached at 46.6 per cent on 7 June and by 21 December it had fallen to minus 6.3 per cent. This largely explained the falling consumer price inflation in first China and now India. This inflation drop gives to gives room to loosen economic policy which is why China, for example, will not have a hard landing.

The present fall in commodity prices is clearly not yet nearly as severe as in 2008. Neither, however, has the decline halted. As they are available on a daily basis monitoring the course of commodity price indexes is a key early warning tool for gauging how severe the international economic slowdown will be.

The present rapid shifts in the international and Chinese economic situations, resulting from the second wave of the international financial crisis centred on the Eurozone, are a challenge both to policy makers and a major opportunity for those with an accurate analysis of China’s economy.

China speed [By Jiao Haiyang/China.org.cn]

The reasons for this are the same as those when I ran a consulting company and knew inaccurate media analysis was an opportunity to make a profit. Businesses need accurate information to take correct decisions. If a newspaper writes an economy is going to boom when actually it suffers recession, the paper doesn’t directly lose anything, but a company acting on the wrong analysis can lose a great deal of money. Economic and business writing therefore operates under an objective discipline which doesn’t necessarily exist elsewhere – companies rationally pay a great deal of money for accurate information.

The reason a similar opening exists in China at present is that attempts are being made to convince businesses that China faces an ‘economic crisis’ on the same scale as that hitting the European Union (EU) and the US. This view is factually nonsense, as any comparison of economic data shows. In the four years to the latest data the US economy grew by 0.5 per cent, the EU’s shrank by 0.3 per cent, and China’s economy grew by 42.2 per cent. Given such comparisons claims that China is suffering from ‘crisis’ is rather like saying the US has cholera, the EU has typhoid, and China has a cold and therefore they are basically in the same situation as ‘all are ill’. Such claims destroy rational scales of comparison and are therefore wholly misleading in predicting what will happen.

China’s economy naturally faces problems – all economies always face problems. It has had excessive house price increases, which are now gradually coming under control, and its consumer price index has been too high – although again it is now falling. Recession in the Eurozone will reduce orders to China’s exporters. But China’s economic year on year growth rate in the last quarter was 9.1 per cent compared to 1.5 per cent for the US and 1.4 per cent for the EU. If the US and EU were paralleling China’s growth far from claiming, this was a ‘crisis’ they would be calling it an unprecedented boom!

A typical example of such fairy stories regarding China’s ‘economic crisis’ was a recent article in the Wall Street Journal by Nouriel Roubini and Ian Bremmer president of the Eurasia Group – a risk analysis company. This was entitled ‘Whose economy has it worst?’ and was introduced: ‘With Europe, China and the US in crisis, the real question is which of them will stumble first.’ The data already given above show such statements are bombast – there is no crisis in China’s economy similar to the US or EU.

Why, therefore, are such economic fairy stories published, why are they are publicized, and how to profit, not purely monetarily, from them?

One reason they appear, of course, is simply that people make wrong analyses. But the reason they are publicized is different. Take for example Gordon C Chang. He wrote a book in 2001 entitled ‘The Coming Collapse of China’. This argued ‘A half-decade ago the leaders of the People’s Republic of China had real choices. Today they do not. They have no exit. They have run out of time.’

In the ten years since China’s economy more than doubled in size. After such radically wrong predictions you might expect that Chang would find it difficult to obtain coverage for his analysis. But instead he is regularly published by Forbes magazine with articles posing such questions as ‘Can Beijing rescue a stumbling economy’. Some ’stumbling’ with nine percent GDP growth! Such analyses have nothing to do with reality but fit the politics of Forbes – which specializes in analyzing the ultra-rich in the US and is hostile to China. 

Business people caught up in such political maneuvers can lose huge sums of money. For example, in a case rather similar to the one of China at present, those backing a particular political grouping in Russia in the 1990s persuaded US hedge fund manager George Soros to become involved in a takeover battle around a Russian telecommunications company Svyazinvest. I was retained as a consultant by others involved and concluded Svyazinvest was a terrible investment. Therefore Soros was being pulled in for reasons of political maneuvers and not serious financial analysis. Soros lost approximately a billion dollars.

Companies rightly analyzing that China’s economy will continue to grow, GE and Goldman Sachs immediately come to mind, are those most successful in business in China. Equally there are Western analysts who correctly predicted China’s growth over the last period – Goldman Sachs Jim O’Neill, who invented the term BRIC, and the specialized consultancy Dragonomics for example.

This gives a major opportunity to those with an accurate analysis of China’s economy. Businesses following the erroneous view that China’s economy is going to drastically slow or enter crisis will lose money. Those who rightly predict China’s economy will continue to grow rapidly will gain credibility. This requires accurate analysis and reporting - not pretending there are no problems in China’s economy but correctly contextualizing that these are far less than in the US and EU. The facts over the next year, as in previous years, will simply show that China’s economy continues to grow strongly, suffering no economic crisis qualitatively equivalent to that in the EU and US at present.

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This article originally appeared on China.org.cn. It has been amended to remove references only relevant to readers in China.    

Summary

The studies on the relation between per capita GDP growth and returns on shares persistently find that the two are negatively correlated – i.e. a higher rate of growth of per capita GDP is associated with a lower return on shares. Cardiff Garcia and Neil Hume, in the Financial Times, recently logically used this data to deal with the relatively narrow issue of questioning analyses that the high growth rates of emerging markets, for example China, will lead to them displaying superior share performance to developed markets. But the implications of the overall finding are much more widespread and fundamental for economic policy. Specifically the implications of a negative correlation of per capita GDP growth and returns on shares include:

• The population’s living standard, i.e its consumption, is on average positively determined by, and positively correlated with, growth of per capita GDP. However the return on shares is negatively correlated with per capita GDP growth. It follows that the interests of the population’s living standards and the interests of shareholders are counterposed – the population has an interest in higher per capita GDP growth whereas shareholders, in terms of return on shares, would benefit from lower per capita GDP growth.
• Governments targeting high rates of increase in per capita GDP, that is high increases in living standards, should expect lower returns on shares than those with low rates of increase of per capita GDP, that is living standards. Therefore, high rates of per capita GDP and living standards, and high rates of growth of share prices/total return on shares, are counterposed and not complimentary objectives.
• These issues are in addition to the points made in the Financial Times that over the long run the higher economic growth rates of emerging economies would produce lower growth of share prices and total return on shares – this clearly fits China which has the highest rate of growth of any major economy but an underperforming share market. 

It should be stressed that such processes operate ‘other things being equal’ and over long periods of time. But they provide a long term determinant of economic developments which underlays, and therefore inflects, more short term trends. 

Given the widespread implications of this issue the present article therefore outlines the data and examines in more detail some of the implications.

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Not just emerging but developed economies

The Beyond BRICs section of the Financial Times recently analysed a report by Deutsche Bank’s John-Paul Smith which argued that share prices in emerging markets will suffer negative trends due to these countries government policies. The article however failed to provide the essential context that a negative correlation exists between per capita GDP growth and share price growth and total return on shares not only in emerging but in developed economies. It therefore follows, other things being equal, that high per capita GDP growth in some emerging markets would be anticipated to be correlated with underperformance of their shares.

However, this clearly raises a more general issue. Given that the aim of economic policy is to increase sustainable GDP per capita, as this makes possible increased living standards, this goal necessarily means that governments in both emerging and developed economies have to target high GDP per capita growth even although this will be necessarily be associated with lower share price growth and lower return on shares. The opposite course, targeting higher share prices and higher return on shares at the expense of lower GDP per capita growth, and therefore lower living standards, would mean placing the interests of the population lower than that of shareholders – a goal which, if being pursued, should be explicitly stated and would be unlikely to command widespread support. 

More specifically John-Paul Smith criticised governments of emerging markets on the grounds that: ‘GEM (Global Emerging Markets) companies are increasingly seen as “facilitators” for the broader economy, on the Chinese model, across many GEM markets.’ Stefan Wagstyl of the Financial Times paraphrased Smith as arguing: ‘The state will drive the redistribution of resources away from shareholders and in favour of labour.’

However it is well established in the studies on the correlation between share price growth/total return on shares and per capita GDP growth – for example Siegel’s Stocks for the Long Run, Dimson, Marsh and Staunton’s Triumph of the Optimists and Ritter’s Economic Growth and Equity Returns – that a negative correlation between per capita GDP growth and share prices exists in both developed and developing economies. Such negative correlation is not due specifically to government policies in emerging markets but is an overall feature of economic growth.¹ 

The data

Turning first to the data establishing the negative correlation between GDP per capita growth and share prices, Siegel found: ‘Real GDP growth is negatively correlated with stock market returns. That is, higher economic growth in individual [developed] countries is associated with lower returns to equity investors. Similarly, the stock returns for the developing countries against their GDP growth are plotted in Figure 81-b Again… there is a negative relation between the returns in individual countries and the growth rates of their GDP.’ (Siegel p124) Siegel’s findings for developed economies are shown in Figure 1 and those for developing economies in Figure 2.

Figure 1

Figure 2

Dimson, Marsh and Staunton found, regarding the total real return on equities and GDP per capita growth: ‘statistically, the correlation is -0.27 for 1900-2000 and -0.03 for 1951-2000.’ (Dimson et al p156)

Regarding the correlation of GDP per capita growth and share price increases Ritter found: ‘My calculations for… 16 [developed] countries over the 1900-2002 period get a correlation of -0.37.’

In a recent survey Jain and Kranson’s ‘The Myth of GDP and Stock Market Returns’ noted: ‘The data shows clearly that, over long periods and when adjusted for inflation, stock market returns and GDP per capital growth are negatively correlated.’

Goldman Sachs private wealth group, in a review, recently noted that the overall negative correlation between GDP per capita growth and share price growth extended to different groups of economies when ranked by growth rate: ‘Dimson et al have shown that if one invested in the slowest growing quintile of countries during this hundred-year- plus period, the equity returns would have outperformed the fastest growing quintile by 3% a year… Our own analysis for emerging market countries since 1991 showed the equity markets of the slowest growing countries within emerging markets outperformed those of the fastest growing countries by nearly 5% a year.’

This relation found by Goldman Sachs is shown in Figure 3.

Figure 3

China

Goldman Sachs noted China as illustrating this general trend: ‘China probably provides one of the best examples of the lack of correlation between strong economic growth and equity returns… China’s economy has outgrown that of the US by about 8% a year since the end of 1992 (the inception date of the MSCI China equity market index). Its equity market, however, has lagged that of the US by about 8% a year. Over the last 15 years, earnings per share growth in China has been negative 0.9% while that of the S&P 500 companies has been 5.4% a year. Most recently, in 2010, China has outgrown the US by an estimated 7% but the MSCI China Index has returned just 4.8% (the local Shanghai Composite Index is actually down 12.8%). On the other hand, US equities have returned 15.1%. Since the peak of US and Chinese equities in October 2007, China has outgrown the US by an estimated 10% a year, but Chinese equities have lagged the US by 2.7% a year.’ This data is shown in Figure 4.

Figure 4

Goldman Sachs survey therefore concluded: ‘Whether it is 1 year, 3 years or 18 years, economic growth has not translated into better investment returns in China … The evidence shows that faster economic growth rates do not result in higher equity returns. In fact, if faster growth is priced into the equity markets, the equity markets are most likely going to lag those of slower growth economies.‘

In a recent update of their study, for the Credit Suisse Global Investment Returns Yearbook, Dimson, Marsh and Staunton concluded: ‘[Our] Figure 2 ranks the real equity return of the 19 Yearbook countries over the period 1900–2009, from lowest to highest…. [our] Figure 2 shows that the supposed association between long-run real growth in GDP per capita and real equity returns is simply not there (the correlation is –0.23).’ This is shown in Figure 5.

Figure 5

Dividends, share prices and growth

In their study Dimson, Marsh and Staunton however noted an extremely close correlation between share prices/return on shares and dividend payments: ‘there is a high correlation (0.87) between real equity returns and real dividend growth across the 19 countries.’ 

Such a close correlation between dividend payments and share prices is related to the negative correlation between share prices and economic growth: ‘the claim that real dividends grow at the same rate as real GDP is clearly incorrect. Real dividend growth has lagged behind real GDP per capita growth in all but one country, averaging just –0.1%, and the correlation between the two is -0.30.’ Higher economic growth is correlated with lower dividends and vice versa.

Conclusion

The clearly established negative correlation between economic growth and share price growth has a number of implications:

• It must be understood that correlation by itself does not establish causality – i.e. the negative correlation between share price growth and return on shares and GDP per capita growth does not establish whether rapid economic growth causes lower returns on shares, or higher returns on shares causes lower GDP growth, or some other factor(s) causes both. The negative correlation however does exclude that high share prices cause high GDP per capita growth, and therefore that economic policy should aim to have high share price growth in order to stimulate economic growth. The negative correlation shows that high returns on shares are either irrelevant (i.e. non-causal) for economic growth or if causal then higher returns on shares are negative for economic growth.
• Underperformance of shares in emerging economies with high growth rates would be expected to flow from the negative correlation between GDP per capital growth and share prices. Other things being equal, the more rapid the growth of GDP per capita the greater the underperformance of shares that would be anticipated – this clearly fits China.
• As the negative correlation of GDP per capita growth and share prices exists in both developed and developing economies pointing to underperformance of share prices in emerging markets does not justify the claim that underperformance of shares in such markets is due to government policy – except that such an underperformance would necessarily follow from the (desirable) policy of ensuring high GDP per capita growth.
• If share prices are negatively correlated with GDP per capita growth, but dividend payments are positively correlated with returns on shares, this again fits the case of China. China experiences high GDP per capita growth but low dividend payments due in substantial part to the large role played in the economy by State Owned Enterprises which pay extremely low, or zero, dividends to the state.
• Once again correlation does not establish causality, but the negative correlation of share price growth with per capita GDP growth, while dividend payments are positively correlated with share prices, means either that low dividend payments are beneficial for economic growth, that economic growth creates low dividend payments, or some other factor(s) causes both trends.
• Given the rate of growth of living standards is positively correlated with GDP per capita growth, whereas share prices are negatively correlated with GDP per capita growth, there is no reason to assume a positive correlation between rising living standards and rising share prices – i.e. that rising share prices will enhance living standards. Given that the aim is rising living standards there is therefore no reason for governments to target high share prices.

Taking the specific case of China, the negative correlation between share prices and GDP per capita growth is one reason this blog, which has a positive analysis of the growth of China’s economy, has a negative position as regards any major expectations for China’s share market.

Evidently the Financial Times and John-Paul Smith dealt primarily with short term trends in share prices which can can be affected by very different factors to the long term correlations outlined above. However:

• It is misleading to present underperformance of shares in emerging markets as being due to negative government policies when underperformance of shares in rapidly growing developing economies would be precisely expected to be correlated with their rapid growth.
• The implications of the negative correlation between GDP per capita growth and share prices, in both developed and developing economies, are far wider than those raised by John-Paul Smith and in the Financial Times article.

Notes & References

Notes

1. ‘Economic growth’ is used here in the sense of GDP per capita. Increase in GDP which does not involve any increase in GDP per capita, that is which is based purely on population increase, does not increase prosperity and is simply quantitative addition and not real economic development. The point is clearly put by Dimson, Marsh and Staunton: ‘While many European countries such as the UK, France, Belgium and Ireland, experienced modest (50%-60%) population growth between 1900 and 2009, the New World grew much faster. The US expanded by 308%, and the increase was even larger in Australia (479%), New Zealand (423%), Canada (524%), and South Africa (923%). In common with other researchers, when making long run economic comparisons, we therefore focus on GDP per capita. This controls for population growth thus providing a more direct measure of growth in prosperity.’

References

Dimson E, Marsh P, & Staunton M, Triumph of the Optimists; 101 Years of Global Investment Returns, Princeton University Press 2002

Garcia C, ‘GDP growth and equities: a match made in… nowhere?’ Financial Times 10 February 2011

Hume N, ‘Chasing the dragon’, Financial Times 12 Feb 2011

Jain R & Kranson D ‘The Myth of GDP and Stock Market Returns’ Virtus Mutual Funds 2009

Ritter J, ‘Economic growth and equity returns’, Pacific-Basin Finance Journal 2005

Siegel, J Stocks for the Long Run 4th edition McGraw Hill 2008

Wagstyl S, ‘Deutsche: ‘If you think 2011 was bad for EM equities, just wait for 2012,’ Financial Times 8 December 2011

For several years the Financial Times has been giving widespread publicity to an analysis, particularly promoted by its (rightly respected) chief economics commentator Martin Wolf, and US finance professor Michael Pettis, that China was pursuing a ‘mercantalist’ policy aimed at creating a large trade surplus. This blog has repeatedly pointed out that this is not the case and what China has aimed at is a high degree of openness of its economy, that is of both exports and imports in GDP. This does not necessarily imply a surplus at all. 

At last, confronted with the decline in China’s trade surplus, the message seems to be getting through more generally in the FT. Analysing the latest trade data, and a speech by China’s president Hu Jintao, Kathrin Hille and Simon Rabinovitch from the FT‘ in Beijing note:

‘China’s trade surplus is set to decline in 2011 for the third straight year and is on track to be about half the size of the record $298bn surplus in 2008. That would amount to less than 3 per cent of gross domestic product, suggesting that China’s trade relationship with the rest of the world is increasingly balanced.

‘Critics in the US continue to point to their country’s yawning trade deficit with China as evidence of Beijing’s unfair support for its exporters, especially through what they allege is an artificially cheap renminbi.

‘But the US deficit with China appears to be more the result of the global trade structure than Chinese policy distortions. As a major processing hub in the global supply chain, China runs large bilateral trade deficits with producers of raw materials and large bilateral surpluses with importers of finished products.’

This is entirely correct. Let us hope that the FT from now on will drop its wrong analysis.

The present author has consistently pointed out that China’s consumer price inflation (CPI) is primarily driven by international commodity prices and not, as some have argued, by monetary conditions in China – for a more extended recent analysis see ‘Key Trends in China’s Inflation’ which appeared in China Daily. This fact is strongly confirmed by China’s new CPI data, showing a fall to 4.2% from October’s 5,5% and a peak of 6.5% in July. To illustrate this Figure 1 shows both international commodity prices and China’s CPI. The tight correlation of the two is evident.

Figure 1

To deal with the argument that correlation is not necessarily causation, the direction of causation between international commodity price indexes and China’s CPI inflation is clear. China’s CPI is simply not a sufficiently large factor in the world economy to determine world commodity prices. In terms of causality, therefore, either world commodity prices cause the changes in China’s CPI or a third factor, for example international supply and demand, causes parallel changes in both. In either case examining international commodity prices allows trends in China’s CPI to be predicted.

This close correlation gives good news for future trends in China’s CPI and therefore for the ability of its government to stimulate the economy. Year on year changes in international commodity prices are currently falling rapidly. The year on year change in the daily Dow Jones-UBS international commodity index has dropped from a maximum of plus 52.8 per cent in March to minus 0.5 per cent on 7th December. Given the close correlation between China’s CPI and international commodity prices these sharp falls in commodity prices create good conditions for China’s fight with inflation.. This in turn increases the room for the government to stimulate the economy.

At present the international economy as a whole faces overall stagnation in the developed economies rather than a large 2008 style downturn – despite the recession in Europe. China does not require a full scale 2008 type stimulus package, but loosening of economic policy is clearly increasingly possible. This will ensure there is no large fall in China’s GDP growth.

China’s latest CPI data are therefore important in confirming:

• The real causes and therefore dynamic of China’s inflation.
• The slowdown in inflation gives China the economic room for manoeuvre to loosen economic policy and ensure a ’soft’ and not a ‘hard’ landing.