Senior Associate Dean Bhaskar Chakravorti interviews Professor Laurent Jacque, Walter B. Wriston Professor of International Finance and Banking.
Bhaskar Chakravorti: Forget BRICs. Are the U.S. & Eurozone tomorrow’s emerging markets?
Laurent Jacque: It depends whom you ask. On one hand, you have asset managers who will invest money for pension funds and hedge funds and the like, and will continuously appraise the attractiveness of different asset classes and different markets. And the second category of actors are business people, and their perspective is different. It's more about market growth, industry concentrations, and potential demand. For the first group, the answer is unclear. For the second group, the BRICs will continue to be much more interesting than the U.S. and the Eurozone.
BC: Let’s talk about the asset managers first.
LJ: From an asset manager’s perspective, the BRICs may have run their course, and the U.S. or the Eurozone could step in to fill the vacuum. If I'm an asset manager, what initially attracted me to emerging markets were a couple of things: Higher return, faster growth, but accompanied by more risk. So traditionally emerging capital markets had a much lower correlation vis à vis the bigger, developed markets, and the BRICs were very attractive. Thus by investing in BRICs you were, in fact, increasing return while reducing risk from an overall portfolio point of view. Today, BRICs have of course surged ahead in terms of growth rates, but they've also been the victim of quantitative easing – QE2.
BRICs were the victim of QE2 in the sense that the U.S. interest rate policy pushed a lot of hot money to these markets. And in some of those cases, it has pushed the exchange rate to an abnormally high level and those currencies have become grossly overvalued. Any asset manager looking at Brazil or South Africa or even Russia today would say, “Hey, there's still exciting opportunity in these markets, but is the currency going to crash?” So I think what we've seen with the spiking of BRICs, or emerging markets, is that in a number of cases the exchange rate has gone way too high much too fast, and there's a risk of a crash that may wipe out the higher return those markets bring. So for an asset manager, the BRIC proposition right now is a bit more questionable than maybe five years ago, or even two years ago.
BC: Does that mean we do a U-turn back to the U.S. and the Eurozone?
LJ: What you have in the U.S. and the Eurozone is very low, if any, economic growth. Recently, we've seen a wakeup call – no growth and correction in value. Does that mean another dip? Possibly. What we know we do have – and something that’s spooking investors – is the Euro zone in a financial crisis that is different from the U.S. subprime crisis, but may be just as nasty. It is not clear that growth is going to pick up any time soon.
Consider, first, the Eurozone. What would it mean if one or two or three members of the Euro were to drop out of the single currency? I think there it may not be as nasty as people think, because what may happen is that those countries – say Greece, Portugal or even Spain – if they're freed from the Euro shackle, in fact would for a short period of time go through a very nasty transition where the new currency or resurrected old currency would take a nosedive, and then come back up.
In the meantime, the Euro crisis that is being called a budgetary crisis is, in my book, more of a competitiveness crisis. And that one-time devaluation may in fact revive the fortune of Portugal and Greece, and perhaps one or two others by making their economy competitive again.
So the scenario in the next two to five years is no growth, and in some cases negative growth, in Europe. We're going to have to see a spiking of risk, which may lead to a dramatic restructuring of the Euro where we would have a handful of core countries staying in the Euro and three or four countries dropping out, and that would be traumatic initially for banks, but may resolve the competitiveness crisis that those countries have. Down the road, this may actually revive those economies and boost growth in Europe.
In the U.S., the picture is not as clear. I don't think we're facing a lot of risk, but we are facing high unemployment, we are facing low growth, and it's not clear where it's going to go. We've kind of exhausted monetary policy as a way of reviving growth.
BC: Seems as if there are arguments leading us away from both categories. Maybe, the answer lies in going one level lower, into specific markets for a deeper exploration of investment opportunities. For what it is worth, Barron’s (on August 20, 2011) suggested that it is time to buy stocks in emerging markets. But let us turn from the to the business perspective.
LJ: For businesses – both big and not so big – it's a different proposition. If you're thinking of introducing a new product in South Africa, Brazil or India, then depending on whether it's locally manufactured or imported, the equation is very traditional – looking at disposable income, demand, competitors. If you're a local manufacturer in a country with an overvalued exchange rate, it's less of an issue, except that it may bring unwelcome competitors because imports are subsidized through the exchange rate overvaluation. But your eyes are really on market growth and disposable income. If those countries continue to grow, and it seems that they will, then the BRICs are still very attractive. You're never going to have in France the kind of growth you may have in South Africa or in India where you have millions and millions of people all coming out of poverty and starting to enjoy a higher level of disposable income. Now for those companies, I think the BRIC is still a very strong option. And depending on what business you are, it’s not clear that the U.S. and the Eurozone are as exciting.
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- On the impact of political leadership
BC: You mentioned earlier – and you were referring to Europe primarily, but I suspect some of this also has implications with the United States – that it's actually a competitiveness crisis in this region. In addition to the competitiveness crisis, there is also political crisis – a crisis of leadership – in both the Eurozone and in the United States. How do you manage these regions without unified leadership? Another way to frame this question: if you could wave a magic wand and have the kind of political leadership that China has – or even Russia has, to some extent – would that fix the problems of the Eurozone and the U.S.? That is, could the answer be a very clear and extremely effective leadership, and very effective domestic and foreign policy that is extremely well orchestrated, and aligned with near term and long term strategic objectives?
LJ: In the case of the Eurozone and the EU, I've always felt that we were putting the cart before the horse. There was a lot of boring work to be done that was never done before launching the Single Currency in 1999. And things such as harmonizing tax systems, enhancing portability of pensions, reconciling of industrial standards, synchronizing of electoral calendars. These are very boring issues, but to have a large group of geographically contiguous countries which have historical heritage and strong national identities to start working together, you've got to put in place an infrastructure – regulatory, tax, social, political –before you attempt the big item.
The Euro was a big prize, and people got fixated on it. Absolutely, a single currency makes a lot of sense. The problem is that Europe was not ready for it. We rushed into something that is highly desirable, and if done right would have wonderful implications. But we did it too early, ill-prepared, without giving ourselves the means of making it a success. So in terms of political crisis, I would say they need to crank it down one level, and ask, “Where are the easier, more attainable benefits from the European Union?” Well it's working on all the boring stuff that makes the Eurozone a better integrated economic region.
I would downplay the political crisis element that is getting everybody worked up and go back to things we can do. I think we are driving ourselves into the ground with Greece. It's unnecessary. Greece is 2.5 percent of the Euro zone GDP. Two years ago, I would have said “Okay, clearly you joined the Euro two years late at an undervalued exchange rate. We’ve decimated Greek industry by driving it into a grossly overvalued and noncompetitive zone. Let's adjust. Let's be nimble about this. You're part of Europe, but you're going to take a leave. Get your house in order, and maybe in 10 years from now you'll rejoin the Euro.” And now let’s put our energy into things we can do, not into problems we cannot solve.
When it is a question of market versus government, governments always lose. I think we're going to put more money into it, we're going to scream more, and, ultimately, it is going to cost us more for a problem that is misdiagnosed. We can throw a trillion dollars at Greece. Unfortunately Greece five years from now with one trillion dollar would be worse off than it is today. And so is Portugal. Spain: maybe, maybe not. I would tend to say that it would have to go as well. I think Italy can make it.
Let’s be realistic. We're not going to have a European government anytime soon. None of the parliaments in Europe believes the electorate is ready to give a blank check and say, we're going to have a federal government that's going to take care of fiscal policies, tax collections, fiscal income redistribution. It's not going to happen. Like the Chinese do, we need to have a longer-term horizon of where we want to be in 2015, 2025, and be realistic of what we can deliver.
The U.S. is different. It feels that there's more than ideological divide. It has deepened over the last decades; maybe it was 9-11. It seems that the center left and the center right have a harder time working together because the right and the left are less likely to compromise. So the center, which has historically been this country and kept it very sturdy, and stable, is increasingly held hostage to minority groups.
- Are the US and Eurozone the next BRICs? Or the next Japan?
BC: Let me ask you the original question, which is: forget the BRICs, are the United States and the Euro zone, tomorrow's emerging markets. One way to interpret that question is that there is a plausible scenario in which these economies remain in a deep funk for a long time, but there are underlying factors that down the road will help them re-emerge. Imagine that the U.S. – and maybe even the Eurozone, for slightly different reasons – goes into a Japan-like stage for the next 20 years. And in the meantime, at least China and perhaps several others, overtake these economies. There's lots of trapped potential in these large markets, and sometime in the future they become the “emerging” regions with creative and innovative ideas that lead to renewal and fast growth. Isn’t that how China, India and Brazil used to be characterized before they got started down the path of rapid growth? In other words, the roles would be reversed – is this possible?
LJ: Let me address the issue of the comparison with Japan first. One of the things that does not make you optimistic about Japan is that it is a greying population. They made a strategic choice early on of barring immigration. For all practical purposes, Japan was closed. They never reversed course as the pyramid of age became top heavy. And that is draining the huge reservoir of savings that Japan has its disposal. And any way you look, it's hard to see a reversal of that course in Japan.
If the U.S. becomes moribund, it will be for somewhat different reasons. And I would say that, for the U.S., it might be easier to snap out of 20 years of no growth. And the reason are: first, it's a much younger population; second, it's a country which has a tradition of tremendous creativity and innovation in the realm of business, science, medicine, electronics, and the like. You can have zero growth and unemployment, but that's not going to go away. So then there's a question, the U.S., 20 years of no growth, high unemployment, very possible. But still, you have this vibrant creativity that manifest itself through labs and universities and startups; third, US universities are another major factor in its resilience. Demand for higher education is very price inelastic. It's a premium product that survives the cycle. Net, net, if I put my money down, I would bet on the U.S. first. Europe second. Japan third.
BC: Why isn't Europe more like Japan? What's the bubbling underneath the surface in this moribund scenario for you?
LJ: Because I think – and depending on the country – you continue to have research innovations. You go to a lab in Switzerland and they are doing nuclear physics. And you go to Sweden, and there are only 7 million Swedes, but they export airplanes and jet fighters on par with either the American or the French. And as they had two car companies until not so long ago. So you have this mix of entrepreneurial spirit, high intellectual potential, and that doesn't die away because you have no growth and high unemployment. Japan unfortunately is held back by its population decline. So, all three – the US, EU and Japan – may fall into the same trap, but I would think the U.S. would be the first to be the rising Phoenix, so to speak, ahead of Europe.