Remarks to the Emerging Markets Private Equity Association
We live in turbulent times. In Europe, in America, and in parts of Asia there is an elemental unease about what is to come. The rule-bound order that the Western victors of World War II created is disintegrating. International law no longer protects the weak. Bluster, bullying, and bombing appear to be superseding diplomacy, comity, and the peaceful resolution of disputes between nations. Digital demagoguery dominates the news and the stench of fascism is in the air.
Some people blame all this on Donald Trump. Traditionally, the United States sought to keep the world stable and boring. But President Trump delights in chaos and unpredictability. He has described himself as “a very stable genius.” Others charge that he is an erratic ignoramus. President Trump is likely both the most closely watched and the most ridiculed man on the planet – viewed abroad as the Inspector Clouseau of American politics, and by many at home as a combination of P. T. Barnum, Charles Ponzi, and Warren G. Harding.
About two-fifths of Americans think Donald Trump is God. But God and Donald Trump are quite different. God does not imagine he is Donald Trump.
Throughout his life, Mr. Trump has had a way of sticking his name on things. We live in what must be called the Time of Trump. But what is happening is not all his fault.
Risks are reallocating themselves for reasons that are structural – influenced but neither caused nor exemplified by one man’s behavior. Two centuries of economic theory are being set aside in favor of what I call “troglonomics” – knuckle-dragging mercantilism that emphasizes bilateral trade balances above all else. The future of institutions once central to global governance is uncertain. Less and less can be taken for granted internationally. Long-agreed legal principles may – or may not – regulate transactions. Now you need to nail that down.
Due process is the key concept of the rule of law. In the past, if a process for producing a decision was fair, that was enough to legitimize the outcome. But outcomes now legitimate processes rather than the other way around. The turn to troglonomics is part of this broad shift in moral philosophy. Rather than emphasizing fair processes for resolving international differences, it seeks to dictate outcomes. To this end, it relies on government-managed trade.
Managed trade engages the government not just in setting the parameters for trade and investment but in regulating specific transactions through tariffs, quotas, and review by national security agencies. This substitutes political judgments for both market forces and the business judgments of the parties to transactions. It displaces the predictability of market economics with the uncertainties of politics. As such, it is a businessman’s nightmare and a politician’s delight.
Troglonomics allows office-seekers to grandstand on national security issues at the expense of entrepreneurs, companies, and investors. It makes deals far more vulnerable to changes in the political weather and the whims of ambitious office-holders than was the case when open markets, monitored but not directed by governments, were the norm. It increases the need for investors to kow-tow to government and creates new opportunities and incentives for corruption. Under managed trade and investment regimes, political risk analysts, lobbyists, vested interests, and politicians make out like bandits. No one else can be sure they will.
The new thinking embraces the concept that the ends justify the means. This affects foreign policy and commercial dispute resolution alike. It facilitates brazen efforts to overthrow foreign governments, support rebellions against them, bomb their territory, and kill their citizens without reference to their ostensible sovereignty. It has also led to the partial suspension of sovereign immunity for foreign nations and their instrumentalities by courts in some developed country jurisdictions . This enables interested parties to seek damages from foreign states for their public policy decisions and to undo settlements of investment disputes that have been agreed among stakeholders.
These changes in the international political economy are creating an environment of heightened legal unpredictability. They raise risks. This makes due diligence and the contractual arrangements more tedious, time-consuming, and subject to the caprices of government officials.
Such hazards are exacerbated by the new American animus against multilateral institutions. The United States is not just acting outside WTO [World Trade Organization] rules and practices as it ramps up trade wars with major trading partners, it is actively seeking to strangle the dispute resolution procedures and erase the case law the WTO has created. To these ends, Washington is blocking the appointment of new judges to the WTO’s Appellate Body as the terms of incumbents expire. The WTO was created to facilitate free trade, lower tariffs, and eliminate quotas. U.S. Secretary of Commerce Wilbur Ross has declared that nations wishing to trade with the United States must now choose between subjecting their exports to tariffs or to quotas.
Will the WTO go quietly into oblivion? We better hope not. Its demise could cause world trade to enter a free-for-all. Some estimate that the result of a WTO collapse could be 30 percent tariffs in the United States, 36 percent in the E.U., and 39.5 percent in China. That’s about a tenfold increase from current tariffs of around 3 to 4 percent. This would invalidate much of the calculus on which investments in emerging markets have been built. It would hurt the poorest countries most.
Washington's de facto withdrawal from existing multilateral bodies and de-activation of its role in global governance have forced China and others to seek alternatives to the rule-making organizations created after World War II. New banks and funds like the Asian Infrastructure Investment Bank (AIIB), the “BRICS” bank, and various funds associated with China’s “Belt and Road Initiative” are now a reality. These institutions meet important needs in global and regional finance but represent a fracturing of the global order that has the potential to complicate transnational business operations.
What rules, standards, and dispute resolution mechanisms will apply within the new Eurasian space created by the “Belt and Road Initiative?” Will some version of the existing rules carry on, despite whatever happens to the legacy order in world trade? How will the trade and investment regime in Eurasia differ from practices in Africa or the Americas? No one yet knows.
The notion that de-globalization can repatriate lost jobs to developed economies creates still more unwelcome risks. It misunderstands the interactions between automation and globalization. Globalization is synonymous with production and supply chains. These are the transnational equivalent of assembly lines. They divide work into segments and invite those who can produce each segment most efficiently to do so. This leverages comparative advantage to bring prices down while assuring quality. It also spreads wealth transnationally. Inclusion in production chains has been key to economic growth and improved living standards in low and high-income countries alike. The United States now proposes to replace the low tariffs that make production and supply chains possible with punitive tariffs or quotas.
There are two predictions out there about what the U.S. smashing of production chains involving China and others will accomplish: one by 99.99 percent of the world’s economists and the other by Peter Navarro, the high priest of troglonomics. He is the author of “Death by China,” an inflammatory tract that won him renown among white nationalists and endeared him to Donald Trump. As our president is fond of saying, we will see what happens. I don’t think it’s going to be anything good.
Limiting Chinese imports by imposing tariffs or quotas may make China less competitive in the U.S. market but it will not make the United States a more efficient producer of anything. Tariffs and quotas will raise U.S. consumer prices unless American companies switch to others abroad who can produce as efficiently as their current Chinese suppliers can. Tariffs and quotas will push up the price of imports and generate inflation. By making Chinese components of U.S. manufactures more expensive, tariffs and quotas will raise prices for domestic purchasers of US-manufactured products, make some U.S. producers uncompetitive, depress U.S. exports, shift outsourcing to foreign suppliers other than China, and erase many more jobs in the United States than they create.
We are talking about the possibility of an unprecedented disruption of established patterns of economic intercourse amounting to 40 percent of the global economy. Trade and investment are how wealth is spread. When they are disrupted, some lose as others gain. Some of you must already be thinking about how you might make money shifting Chinese production chains to other locations in Africa, the Americas, or Asia, finding new suppliers for U.S. buyers, and outsourcing more of the production of suddenly unprofitable U.S. manufacturers. The application of troglonomics to U.S. trade and investment offers salvage opportunities that make Brexit’s market disruption potential look inconsequential.
But don’t count your profits from this disruption until it happens. It’s always possible that the trade wars the United States has just launched will be called off. And, if they aren’t, it will take a while for the direction of change to become fully apparent. A lot will depend on what major trading nations blindsided by “America Firsters” do.
Major economies committed to free trade and global integration seem likely to reject domination by American mercantilism. Though resource nationalism is on the rise, most seem very much to want markets, not politics, to remain in command of trade and investment flows across borders. China, the E.U., India, Japan, south Korea, the United Kingdom and other major trading economies have yet to show any receptivity at all to Trumpism or troglonomics. None appears to believe that bilateralism can produce or sustain as just and prosperous a world as multilateralism has. The rest of the world could just decide to create its own multilateral trade regimes to parallel the WTO, like the AIIB and New Bank parallel the Asian Development Bank (ADB) and World Bank.
Confidence in the unique capacity of markets to adapt to change is buttressed by what’s happening in the energy sector – the very foundation of global economic health. The fracking revolution began in North America but it is now rapidly spreading. The introduction of fracked access to tight oil and shale gas has enabled unprecedentedly rapid responses to imbalances in global energy markets. This has damped down price volatility. Shifts in prices are now almost exclusively the result of changes in political and politico-military risks – you see them in significant market reactions to Trump’s appointment of John Bolton as his national security advisor, the opening round of trade war with China, plans to end the nuclear deal with Iran, possible sanctions on Venezuela, and Houthi threats to bomb Saudi Aramco.
This is a reminder that military-industrial complexes run on fumes from foreign threats. There are plenty of such fumes in the air at present, and not just in Syria and the Persian Gulf. They smell like plutonium, cordite, and solid fuel for missiles. And they have the potential to explode.
South and north Korea have decided that the prerequisite for the denuclearization of the peninsula is peace and reconciliation between them. They have taken charge of the issue. But Kim Jong-un and Donald J. Trump have yet to meet each other. The crisis in Korea could still flare up at any time.
U.S. relations with Russia have never been less cordial. Given Russia’s relative weakness in conventional military terms, any U.S. confrontation with Russia in Ukraine or the Levant could immediately escalate to the nuclear level.
The United States and China are in an apparent transition from rivalry through adversarial relations to enmity. The Taiwan issue is back as an increasingly credible casus belli.
The Iran nuclear deal may or may not survive U.S. repudiation of it. There is again talk of a strike on Iran by Israel, Saudi Arabia, the United Arab Emirates, and the United States.
There are quite a few wars and lots of arms races going on. If you’re into dual-use technology, you’re likely happy. Arms manufacturers face a sure bull market.
The world is changing in perplexing ways. Some changes are for the better; some for the worse. But most changes reapportion wealth. And, speaking of the redistribution of income, the famous American bank robber, Willy Sutton, had it right. When asked why he picked on banks, he replied “because that’s where the money is.” Queried about why he carried a submachine gun when he plied his profession, he observed that “you can’t rob a bank on charm and personality alone.” I’m not sure that’s the case in private equity, but ... well, I’ll leave that where it is.
So, where’s the money? Where’s it likely to go? And where and how will it be managed? How do you pry it loose? What should it be applied to?
Well, the money isn’t up the road at the World Bank or U.S.A.I.D. anymore. Washington’s belated agreement to minor capital increases for the World Bank and IFC1 is certainly welcome, but official development assistance, pioneered by the United States, is now decidedly on the wane. In the future, development is going to depend on private capital and the crafting of local policies calculated to attract it. The United States has a savings rate that’s below zero and a plan for fiscal redemption that relies on an infinite number of credit rollovers.
So far, other people have been happy to fill the American savings gap with the dollars they earn by selling more than they buy in the U.S. market. Money comes from other developed countries and from places with high savings rates, like China and the countries of the Persian Gulf. The innovations that put these savings to their most profitable use are currently here in the United States and in France, Germany, India, Japan, south Korea, Scandinavia, Switzerland, and the U.K, among other places, which now include China. The countries to which money tends to flow are those with low cost, industrious workers and relatively open economies, like Bangladesh, China, Colombia, Côte d’Ivoire, Ethiopia, Ghana, Mexico, Panama, Peru, the Philippines, Vietnam, and a lengthening list of others. (You know who you are!). The people here in this hall have broken the code of private equity investment in places previously considered exotic where government-friendly investors are now welcome.
Meanwhile, the locus of basic scientific research is shifting from the United States and Europe to Asia. National security restrictions now threaten to close American universities and research institutions to foreign nationals from countries that Washington views as potential threats to the United States, like China. A lot of lab, research, and development work is about to migrate to other places, including neighboring, but less paranoid, Canada.
Populations in industrialized countries, including newly industrialized countries like China, are rapidly aging. Labor shortages are being met by robotics. This may preclude the previously anticipated relocation of tens of millions of light industrial jobs to low income countries in Africa and South Asia. Tempted as such countries may be to import “socialism with Chinese characteristics,” they lack the “Chinese characteristics” needed to make that system work.
Most of these shifts in the global allocations of investment and growth are not the product of government initiatives. The exception is China’s “Belt and Road Initiative.” The projects this will finance represent big development opportunities for the countries and companies participating in them. The major limitation those cooperating in them face is their capacity to carry debt. Not even China offers free lunches. But more and more countries are creating significant regional capital markets. A case in point is the Saudi Tadawul, assuming that a Saudi Aramco IPO [Initial Public Offering] there goes through. There are ever more alternative routes to profitable exit from investments. In 2017, 36 percent of the world’s IPOs were Chinese, with 15 percent taking place in Europe, and 10 percent in the United States. That means that almost 40 percent of IPOs took place in less well-known markets, not a few of them in emerging market countries. This diversification of markets seems destined to broaden and continue.
Change, especially major structural change, is inherently disturbing. But it is also an opportunity for the agile and alert – the sort of people in this room. EMPEA members have nurtured professional competence and a reputation for probity that inspire confidence in investors and the companies in which they seek to invest. Meetings like this one are unique venues for the exchange of information and the development of relationships with colleagues. In the volatile days ahead, this adds essential value.
I wish this meeting success!
And, as the turbulence unfolds, may the Force be with you!
1 International Finance Corporation