The global economy of tomorrow: Better, stronger, faster

By Richard Kelly, Senior Economist, TD Bank Financial Group

With emerging markets now accounting for a larger and growing share of global output, it is their growth rate that will dominate.

As we emerge from recession, it is easy to remain fixated on the near term, such as balance sheet repair and fiscal stabilization. The enormity of these hurdles has left many with a rather dour view of economic potential.

This view fails to recognize that the world is rapidly evolving. The growing pains of emerging markets (EMs) over the past 20 years have sown the seeds for a seismic shift in power, influence and dynamism that will mark the next 20 years of economic history.

Emerging markets come of age

There are four major trends that, in spite of a slowdown in mature markets, should cause the global economy to speed up to an average pace of around 4.5% over the next two decades.

1. Urbanization will drive economic growth in China. Since 1995, China’s urban population has grown by 4.2% per year, while its rural population has contracted by 1.3%.

This is crucial, because the urban Chinese consumer spends three times as much as a rural consumer and, over the past decade, urban consumer spending has grown two-and-a-half percentage points faster each year. And while Chinese consumer spending accounts for only 35% of nominal GDP — about one-half the ratio for most advanced nations — that is changing as the wealth and income of Chinese consumers grow.

China’s export penetration is reaching a mature phase that will make it difficult to replicate the 20% to 40% annual growth in exports going forward. Increasingly, capital investment is being directed into the poorer western areas of China so that workers need not move to urban areas. The existing rural areas are themselves becoming urban.

2. Commodity and credit multipliers will reinforce growth in emerging markets. There are two very important multiplier effects that will help spread economic growth, both across markets and within EM consumers. The first is the commodity cycle. The urbanization of China will require natural resources to create the infrastructure and meet the demands of those emerging from subsistence and/or poverty. China accounts for about half of the world’s demand for iron ore and coal; one-third of the world’s demand for steel, zinc, aluminum and copper; and a growing 10% share of the world’s oil.

As China demands commodities, commodity-rich EMs will benefit disproportionately. Among these countries, Iran, Nigeria and Saudi Arabia seem best placed to increase their GDP growth rate over the next two decades, while Sudan and some of the smaller Gulf nations will likely see it harder to improve on their past performance.

And not only that, but industrialization in EMs has itself become a driver of global oil demand. Oil consumption among OECD nations has fallen every year since 2006, while it has continued to grow strongly in emerging markets right up until the effects of the global recession interrupted demand in 2009.

The second multiplier is credit. For most EMs, the evolution of credit markets remains at a very early stage. This means the credit multiplier process will help to juice up the spending power of EM consumers, even while many consumers in advanced nations look to deleverage.

3. Emerging-market institutional factors will improve. For economists, institutions are things like the rule of law, the existence of private property rights and the ability to access the judicial system to defend those property rights when they are violated — factors we take for granted in advanced economies. Research over the past decade has shown that the lack of effective institutions has been the defining feature separating EMs that have succeeded from those that have fallen behind.

While it is difficult to measure these sorts of intangibles, we can take increasing expatriate investment in emerging markets — both in factories and residential investment — as a sign that foreigners feel more secure in their holdings. Moreover, as these investments grow in importance for EMs, the governments have growing incentives to ensure that these essential initial conditions are sustained.

4. Emerging markets will drive the global GDP growth figure. The last trend is simply the arithmetic that results from the previous three trends. Over the past 20 years, emerging markets averaged a 5.3% GDP growth rate per year, while advanced economies averaged 2.2%. As a result, the global economy averaged a 3.2% growth rate.

With EMs now accounting for a larger and growing share of global output, it is their growth rate that will dominate. So while advanced economies look likely to grow by less than 2% per year over the next two decades, EMs seem capable of sustaining an average growth rate just north of 6% per year. With those growth rates, EMs will come to account for two-thirds of the global economy within two decades and a two-thirds/one-third split would imply a global economic growth rate of around 4.5%.

Think big

Now, will this process be a straight line? Absolutely not. There will be recessions along the way. Will EMs avoid future crises just because they have accumulated vast foreign exchange reserves to defend against the crises of the past? Nope. These can defend against past crises, but an evolving structure for the global economy and global finance implies an evolving structure for crises. History suggests that economies have frequently seen some kind of hiccup when trying to make the transition from the accumulation phase of economic growth to one driven by productivity.

Perhaps the hardest part for investors will be coming to grips with the fact that the global economy has changed and people will increasingly need to differentiate markets. We will have to come to know the nuances of China, Peru, Indonesia, Vietnam and Dubai just as we do now with the U.S., Canada or Germany. We may even find we have underestimated how much a stronger crop of EMs could support GDP growth in commodity economies, like Canada and Australia, or exports from all advanced economies.

So somewhere between the discovery of costless cold fusion and the exhaustion of crude oil lies the path for the global economy. It may be hard to believe, having seen the global economy barely alive, but we can rebuild it. We have the technology: better, stronger, faster.

In this issue		February 2010
	The global economy of tomorrow: Better, stronger, faster		Save money and help the planet with eServices
	U.S. equities: Key themes for 2010