As is our custom, we close out the current year with our geopolitical outlook for the next one. This report is less a series of predictions as it is a list of potential geopolitical issues that we believe will dominate the international landscape in the upcoming year. It is not designed to be exhaustive, but rather it focuses on the “big picture” conditions that we believe will affect policy and markets going forward. They are listed in order of importance.
Issue #1: China
China is trying to navigate the transition from being a high growth/low cost nation to a normal developed one. Since the industrial revolution the world has seen a series of nations accomplish this transition. In this phase, the economy is dominated by investment; the nation has an industrial base to build and thus has to find funds to pay for this project.
There have been two models to fund this development. The first involves attracting foreign money to the economy to pay for the investment. The foreign investor risks malinvestment or expropriation at the hands of the developing nation in hopes of high return. At the same time, the developing nation can’t get the reputation of “stiffing” foreign investors, otherwise the terms of investment will become too onerous or the flows will simply stop.
The second model involves generating the funds internally by suppressing consumption. This suppression can be accomplished in a myriad of ways. The currency is usually undervalued to raise the price of imports to reduce consumption. Taxes are often placed on consumption as well. Household deposit rates are usually below the rate of inflation to force higher saving,1 and there are restrictions on the capital account to prevent funds from leaving the country. Under this model, it is also normal to have a modest, or non-existent, social safety net to further boost precautionary savings.
The weakness of the first model is that it is dependent on foreign investors. If foreign investors become jaded on investing in the high growth/low cost country, then the model fails. The weakness of the second model is that, at some point, the industrial capacity exceeds domestic demand. If the model is to be maintained, new sources of consumption must be found. In nearly all cases, that source is exports.
Britain’s development was mostly internally generated. The U.S. relied on foreign investors. Development in Germany and Japan, prior to WWII, was internally generated. Since WWII, all development has come through the second model because nations could rely on the U.S., the provider of the reserve currency, to play the role of importer of last resort. So, since WWII, Germany, Japan, the Asian tigers and China have all followed the internal model that relies on export promotion. The development model worked best so long as the U.S. fulfilled the role of importer of last resort.
No nation remains in the high growth/low cost stage indefinitely. At some point, internal costs rise and foreign nations push back against losing market share to the high growth/low cost nation. In fact, under a gold standard, the high growth/low cost nation, which tends to run trade surpluses, accumulates gold and faces rising inflation. The increase in inflation makes exports less competitive and undermines growth. Thus, under a gold standard, the high growth/low cost nation is almost “naturally” forced to adjust.