The world as an emerging market
20 August 2019
It has been a turbulent couple of weeks in the global economy and markets. Global bond yields have slumped – and equity markets have been volatile – on concern about the outlook for the global economy, partly due to the ongoing trade tensions between the US and China. And the mass protests in Hong Kong are a source of economic and political risk across Asia and beyond, with concern growing about forceful Chinese intervention.
My reading is that the global economy is not weakening to the extent reflected in market pricing. But alongside the slowing global economy, there is concern at the underlying weakening in the strength of political institutions around the world. Many global risks are importantly political in nature, and there has been a re-pricing of this growing political risk.
Argentina provides a striking example. After the incumbent suffered a large Presidential primary loss last weekend, Argentina’s equity markets (down ~35% in one day) and currency (down ~20% against the USD) cratered on fears of a return to populist policies. Argentina has form in this regard. Argentina was one of the richest countries in the world in 1900. Its steady decline (from over 100% of US GDP per capita in the 1890s to around 35% today) has been a story of weak institutions: poor economic and political management, corruption and rent-seeking. It has been a serial defaulter on sovereign borrowing, has had numerous currency crises, and has deep structural problems.
There is growing evidence of institutional weakness elsewhere in the global economy. There is an emerging market feel in the governance of leading economies like the US, as well as in economies like Italy. The EIU grade the US as a ‘flawed democracy’; this has been an Administration of highly personalised decision-making, with the degrading of norms and institutions. The conduct of US trade policy under President Trump provides an example of low-quality decision-making, which is increasingly having an economic and market impact. And Brexit is another example of institutional decay in an advanced economy, with significant economic and market consequences.
In a more structural sense, the strong growth of emerging markets over the past few decades – emerging markets now account for about 60% of global GDP – means that a large share of world GDP has relatively weak political institutions. Global institutional strength (on a GDP-weighted basis) has been declining. Indeed, several G20 members rank poorly on measures of institutional strength, such as Argentina, Brazil, Saudi Arabia, and Turkey.
China also provides an example. Under President Xi, there has seen a weakening of its political institutions; notably the removal of term limits. The tensions between China’s increasingly authoritarian political system and others are playing out in Hong Kong at the moment. China’s scale makes this a systemic issue. The rise of China means that for the first time the world’s largest economy will not be close to the global per capita income frontier with the associated institutional properties. China will be quite a different leading power.
In a world with increasingly emerging markets-like national political institutions, we should expect greater economic and market volatility. Politics will matter increasingly for economic outcomes. The shift from institutional constraints and norms to the exercise of political discretion (of variable quality) will lead to heightened downside risks. A heightened recognition of the impact of these political risk realities has been an important part of the market turbulence over the past weeks. Central banks have limited ability to lean against these political dynamics.
But in this context there is a premium to high quality political institutions. And it turns out that small advanced economies dominate rankings of institutional quality, such as the World Bank’s effective governance measures, the corruption perceptions index, press freedom, democracy rankings, as well as measures of economic institutions (as described in Landfall Strategy Group’s annual state of the small advanced economies report released last week, see here for selected Exhibits).
This institutional strength has supported strong economic performance by small economies, enabling small economies to develop high quality policy that has positioned them to benefit disproportionately from intense globalisation – and to respond well to shocks. Looking forward, strong political institutions will be an increasingly important source of competitive advantage for small economies (and others), acting to offset the implications of weakening national and global political institutions for the functioning of the global economy.
One way of framing this is whether you would prefer to invest in a large economy with relatively poor institutions, such as the US or China (but with greater power to shape the external environment) or a small economy with good institutions, such as the Netherlands or Singapore (that can set high quality policy over time, but is exposed to poor decision-making by larger economies). [Or perhaps if you were Greenland, whether you would prefer the US or Denmark.]
My assessment is that it is the advantage lies with small economies with strong institutions even in an otherwise challenging global environment. Indeed, eight small economies have negative yielding 10 year government bonds despite relatively strong GDP growth rates – from Switzerland and Denmark to Ireland. This suggests that markets are treating these small economies as safe havens that provide a measure of resilience to an uncertain global economic outlook.
In sum, in a world with increasingly emerging market characteristics it is those (small) economies that maintain strong political institutions that are most likely to perform well and to be resilient to global economic and political risks.
Dr David Skilling
Director, Landfall Strategy Group