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T h e w o r l d e c o n o m ySeptember 24th 2011

A game of catch-up

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A game of catchup

QUARRY BANK MILL is a handsome �vestorey brick building set in thevalley of the river Bollin at Styal, a small English village a few miles southof Manchester. It was built in 1784 by Samuel Greg, a merchant, whofound pro�t in supplying cotton thread to Lancashire’s weavers. The rawcotton shipped from America’s slave plantations was processed on thelatest machinery, Richard Arkwright’s water frame. Later Greg extendedthe factory and installed coal�red steam engines to add to the waterpower from the Bollin. All this gave a huge boost to productivity. In 1700 aspinster with a pedaldriven spinning wheel might take 200 hours to produce a pound of yarn. By the 1820s it would take her around an hour.

Greg’s mill was part of a revolution in industry that would profoundly alter the world’s pecking order. The new technologies�laboursaving inventions, factory production, engines powered by fossil fuels�spread to other parts of western Europe and later to America. The earlyindustrialisers (along with a few late developers, such as Japan) wereable to lock in and build on their lead in technology and living standards.

The �great divergence� between the West and the rest lasted for twocenturies. The mill at Styal, once one of the world’s largest, has become amuseum. A few looms, powered by the mill’s water wheel, still producetea towels for the gift shop, but cotton production has long since movedabroad in search of low wages. Now another historic change is shakingup the global hierarchy. A �great convergence� in living standards is under way as poorer countries speedily adopt the technology, knowhowand policies that made the West rich. China and India are the biggest andfastestgrowing of the catchup countries, but the emergingmarketboom has spread to embrace Latin America and Africa, too.

And the pace of convergence is increasing. Debtridden rich countries such as America have seen scant growth since the �nancial crisis.The emerging economies, having escaped the carnage with only a fewcuts and grazes, have spent much of the past year trying to check theireconomic booms. The IMF forecasts that emerging economies as a wholewill grow by around four percentage points more than the rich world

The shift in economic power from West to East is accelerating, says

John O’Sullivan. The rich world will lose some of its privileges

The Economist September 24th 2011 1

SPECIAL REPORTTHE WORLD ECONOMY

1

A C K N O W L E D G M E N T S

C O N T E N T S

In addition to those named inthe text, the author wouldlike to thank the following fortheir generous help: MarceloCarvalho, Robert Ellison,Stephen King, Guilherme daNóbrega, Eswar Prasad,Kenneth Rogo�, Mary Roseand Alan Taylor.

A list of sources is at

Economist.com/specialreports

An audio interview with

the author is at

Economist.com/audiovideo/specialreports

3 Becoming number oneWhen will China’seconomy overtakeAmerica’s?

5 Converging economiesOnetrack bind

8 Reserve currenciesGreenback mountain

12 CommoditiesCrowded out

13 Exporting jobsGurgaon grief

15 Southnorth FDIRole reversal

16 Beefed upBrazil’s meat giant

17 The path aheadCottoning on

0 20 40 60 80 100

Official foreign-exchange reserves, Q2 2011

Rich world$3.2trn

Emerging world

$6.5trn

Breakdown by currency Allocated reserves, Q2 2011, %

$ ¥¤ £ Other

1.8

1.1

1.32.0

10.68.0

4.9

5.8

4.3

6.8

4.6

3.9

3.1

5.5

2.2

4.7

0.6

Population2010, bn

Canada0.03

United States0.31

Mexico0.11

Brazil0.20

Britain0.06

Japan0.13

India1.23

China1.34

Russia0.14

Sub-SaharanAfrica0.80

CIS*0.14

Central &E. Europe0.18

Euro area0.33

Indonesia0.24

Australia0.02

Middle East& N. Africa0.42

Latin America& Caribbean0.28

GDP growth, 2001-11, %2011 forecast

0

1

5

10

GDP per person, 2010, PPP $'000

RICH WORLDEMERGING WORLD

>4035-4010-165-10<5 30-35

*Commonwealth of Independent States

Sources: IMF; UN; The Economist

both this year and next. If the fund is proved right, by 2013 emerging markets (on the IMF’s de�nition) will produce more than halfof global output, measured at purchasingpower parity (PPP).

One sign of a shift in economic power is that investors expect trouble in rich countries but seem con�dent that crises inemerging markets will not recur. Many see the rich world as old,debtridden and out of ideas compared with the young, zestfuland highsaving emerging markets. The truth is more complex.One reason why emergingmarket companies are keen for a toehold in rich countries is that the business climate there is farfriendlier than at home. But the recent succession of �nancialblowups in the rich world makes it seem more crisisprone.

The American subprime mess that turned into a �nancialdisaster had the hallmarks of a developingworld crisis: largecapital in�ows channelled by poorly regulated banks to marginal borrowers to �nance a property boom. The speed at whichbond investors turned on Greece, Ireland and then Portugal wasreminiscent of a run on an overborrowed emerging economy.

Because there is as yet no reliable and liquid bond marketin the emerging world to �ee to, scared investors put their moneyinto US Treasury bonds and a few other richcountry havens instead. So few are the options that even a ratings downgrade ofAmerican government debt in August spurred buying of the derided Treasuries. Indeed the thirst in emerging markets for suchsafe and liquid securities is one of the deeper causes of the series

of crises that has a�icted the rich world. Developing countriesbought richworld government bonds (stored as currency reserves) as insurance against future crises. Those purchasespushed down longterm interest rates, helping to stoke a boomin private and public credit.

Today’s faltering GDP growth is a hangover from that boomand adds to the sense of malaise in the rich world. Many households in America, Britain and elsewhere have taken to savinghard to reduce their debts. Those with spare cash, including companies, are clinging on to it as a hedge against an uncertain future. A new breed of emergingmarket multinational �rms, usedto a tough business climate at home, seem keener to invest in therich world than most Western �rms, which have lost their mojo.

Grandeur and decline

People who grew up in America and western Europe havebecome used to the idea that the West dominates the worldeconomy. In fact it is anomalous that a group of 30odd countrieswith a small fraction of the world’s population should be callingthe shots. For most of human history economic power has beendetermined by demography. In 1700 the world’s biggest economy (and leading cotton producer) was India, with a populationof 165m, followed by China, with 138m. Britain’s 8.6m peopleproduced less than 3% of the world’s output. Even in 1820, as theindustrial revolution in Britain was gathering pace, the two

2 The Economist September 24th 2011

THE WORLD ECONOMY

SPECIAL REPORT

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Asian giants still accounted for half theworld’s GDP.

The spread of purposebuilt manufactories like Quarry Bank Mill separatedeconomic power and population, increasingly so as the West got richer. Being ableto make a lot more stu� with fewer workers meant that even a small country couldbe a giant economic power. By 1870 the average income in Britain was six times larger than in India or China. But by the eve ofthe �rst world war Britain’s income perhead had been overtaken by that ofAmerica, the 20th century’s great power.

America remains the world’s biggesteconomy, but that status is under threatfrom a resurgent China. With hindsight, itschange in fortune can be traced to 1976, theyear of America’s bicentennial and thedeath of Mao Zedong. By then income perperson in China had shrunk to just 5% ofthat in America, in part because of Mao’sextreme industrial and social policies.

The average Indian was scarcelyricher than the average Chinese. Both China and India had turned inward, cuttingthemselves o� from the �ow of ideas andgoods that had made Japan and other lesspopulous Asian economies richer. India’seconomy, like China’s, was largely closed.Huge swathes of industry were protectedfrom foreign competition by high importtari�s, leaving them moribund.

China was �rst to reverse course. In1978 Deng Xiaoping won approval for aset of economic reforms that opened China to foreign trade, technology and investment. India’s big liberalisation came a little later, in 1991. The GDP of China andIndia is many times bigger now than itwas in the mid1970s. In both economiesannual growth of 8% or more is considered normal. Average living standards inChina are still only a sixth and in India afourteenth of those in America at PPP exchange rates, but the gap is already muchsmaller than it was and is closing fast.

Moreover, the great convergence hasspread beyond India and China. Threequarters of biggish nonoilproducing poor countries enjoyedfaster growth in income per person than America in 200007,says Arvind Subramanian, of the Peterson Institute for International Economics, in his new book, �Eclipse: Living in the Shadow of China’s Economic Dominance�. This compares with 29%of such countries in 19602000. And those economies are catching up at a faster rate: average growth in GDP per person was 3.3percentage points faster than America’s growth rate in 200007,more than twice the di�erence in the previous four decades.

If emerging markets keep on growing three percentagepoints a year faster than America (a conservative estimate), theywill account for twothirds of the world’s output by 2030, reckons Mr Subramanian. Today’s four most populous emergingmarkets�China, India, Indonesia and Brazil�will make up two�fths of global GDP, measured at PPP. The combined weight inthe world economy of America and the European Union will

shrink from more than a third to less than a quarter. Economic catchup is accelerating. Britain’s economy dou

bled in size in the 32 years from 1830 to 1862 as increased productivity spread from cotton to other industries. America’s GDP

doubled in only 17 years as it overtook Britain in the 1870s. Theeconomies of China and India have doubled within a decade.

This is cause for optimism. An Indian with a basic collegeeducation has access to worldclass goods that his parents (whomight have saved for decades for a sputtering scooter) could onlyhave dreamed of buying. The recent leap in incomes is visible inChinese cities, where the cars are new but the bicycles look ancient, and in the futuristic skyline of Shanghai’s �nancial district.

China is still a fairly poor country but, by dint of its largepopulation, it is already the world’s secondlargest economymeasured in current dollars. It may overtake America as theworld’s leading economy within a decade (see box), a prospect

IN 2010 CHINA shot past Japan to becomethe world’s secondlargest economy (basedon current market prices). But when mightit supplant America at number one? Theanswer depends on how the exchange ratesare calculated. The IMF’s forecasts and thelongrun tables of GDP compiled by the lateAngus Maddison, an economic historian,are based on purchasingpower parity(PPP), which makes allowances for the lowerprices of nontraded services in poorercountries. On that basis, the size of China’seconomy is already close to America’s and islikely to overtake it by 2016.

China is further behind when itseconomy is measured in current dollars(and much further in terms of GDP perperson). America’s GDP in 2010 was $14.5trillion at current market prices; China’swas $5.9 trillion. How quickly the gap isclosed depends on three things: the relativespeed of real GDP growth in China and America respectively; the in�ation gap betweenthe two economies; and the rate at whichthe yuan rises or falls against the dollar.

The Economist has crunched thenumbers and found that, based on reasonable assumptions about these three variables, China could overtake America in thenext decade. Its economy has grown by anaverage of more than 10% a year over thepast ten years. As the country gets richerand its workingage population starts toshrink, that growth rate is likely to tail o�to perhaps 8% soon. For the Americaneconomy the calculation assumed an average annual growth rate of 2.5%.

In�ation tends to be higher in fastgrowing emerging economies than inslowgrowing rich ones. This is because of

Becoming number one

China’s economy could overtake America’s within a decade

the BalassaSamuelson e�ect, named forthe two economists who �rst explained it.Fast productivity growth in export industries raises average wage costs acrossthe economy, including in nontradedservices where productivity is sluggish. Thatin turn pushes up average in�ation. Ourprojection assumes a 4% in�ation rate inChina compared with 2% in America.

The third factor is the exchange rate.To sustain its catchup with America, Chinaneeds to rebalance its economy away fromexports towards consumer spending, whichwill require a rise in its real exchange rate.Some of this will come from having a higherin�ation rate than its trading partners. ButChina’s large currentaccount surplus andAmerica’s big de�cit also suggest that theyuan will have to become much strongerand the dollar much weaker. We have allowed for an extra 3% annual rise in theyuan against the dollar on top of the in�ation gap of two percentage points.That implies a slight slowdown inthe yuan’s recent appreciation.

If all this comes to pass,China’s economy will bebigger than America’s by2020. On a di�erent set ofassumptions�a Chinesegrowth rate of 6%, an Americanone of 3% and an appreciation ofthe yuan of 2% a year�the dateslips to 2024. Or you can makeyour own predictions, using theinteractive chart on The Econo

mist’s website, by going tohttp://www.economist.com/blogs/dailychart/2010/12/save_date.

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THE WORLD ECONOMY

SPECIAL REPORT

2 that has given rise to many concerns in that country. More generally, there are worries about what the ascendancy of emergingmarkets would mean for jobs, pay and borrowing costs in therich world.

The �rst worry is about direct competition for things thatare in more or less �xed supply: geopolitical supremacy, theworld’s oil and raw materials, the status and perks that comewith being the issuer of a trusted international currency. Formost people, most of the time, their country’s ranking in terms ofmilitary power is not a big issue. The emerging world’s hungerfor natural resources, on the other hand, has made richworldconsumers palpably worse o� by pushing up the prices of oiland other commodities. The yuan’s increased use beyond China’s borders is a (still distant) threat to the dollar’s central role intrade and international �nance, but if the dollar were eventuallyshoved aside, it would make Americans poorer and raise the costof their borrowing.

A second set of anxieties relates to job security and pay.Ever stronger trade links between rich and wouldbe rich countries will mean a reshu�e in the division of labour around theworld, creating new jobs and destroying or displacing existingones. Lowskilled manufacturing and middleskilled servicejobs that can be delivered electronically have been outsourced tocheaper suppliers in China, India and elsewhere (indeed, Chinais now rich enough to be vulnerable to losing jobs to Vietnamand Indonesia). The threat of outsourcing puts downward pressure on pay, though most American studies suggest that trade accounts for only a small part of the increase in wage inequality.

A third concern, which is at odds with the �rst two, is thatthe emerging markets are prone to crises that can cause a stillfragile world economy to stumble. Sluggish GDP growth in therich world means developing countries have to fall back on internal spending, which in the past they have not managed well. Itraises the risks of the overspending, excessive credit and in�ationthat have spurred past emergingmarket crises. Even if crises areavoided, emerging markets are prone to sudden slowdowns asthey become richer and the trick of shifting underemployed rural migrants to urban jobs becomes harder to repeat. The rapidgrowth rates of the recent past are unlikely to be sustained.

Status anxiety

Few forecasters expect America to be a poorer place in tenor 20 years’ time than it is now. The present may be grim, buteventually the hangover from the �nancial crisis will fade andunemployment will fall. What rich Western countries face is arelative economic decline, not an absolute fall in average livingstandards (though a few of their citizens may become worse o�).That matters politically, because most people measure their wellbeing by how they are doing in relation to others rather than bytheir absolute level of income.

The e�ect of the loss of topdog status on the wellbeing ofthe average American is unlikely to be trivial. Britain felt similarangst at the beginning of the 20th century, noting the rise of Germany, a military rival. It seemed stuck with old industries, suchas textiles and iron, whereas Germany had advanced into �eldssuch as electricals and chemicals. That Britain was still well o� inabsolute terms was scant consolation. The national mood contrasted starkly with the triumphalism of the mid19th century,says Nicholas Crafts of Warwick University. A wave of protectionist sentiment challenged the freetrade consensus that hadprevailed since 1846. It was seen o�, but not before it had split theTory party, which lost the 1906 election to the Liberals.

No country, or group of countries, stays on top forever. History and economic theory suggest that sooner or later others willcatch up. But this special report will caution against relying on

linear extrapolation from recent growth rates. Instead, it will suggest that the transfer of economic power from rich countries toemerging markets is likely to take longer than generally expected. Rich countries will be cursed indeed if they cannot put on anoccasional growth spurt. China, for its part, will be lucky toavoid a bad stumble in the next decade or two. Emergingmarketcrises have been too quickly forgotten, which only makes themmore likely to recur.

Education and social security will have to adapt to a worldin which jobs continue to be created and displaced at a rapidrate. The cost of oil and other commodities will continue to risefaster than prices in general, shifting the terms of trade in favourof resourcerich countries and away from big consumers such asAmerica. The yuan will eventually become an international currency and rival to the dollar. The longer that takes, the less pressure America will feel to control its public �nances and the likelier it is that the dollar’s eclipse will be abrupt and messy.

The force of economic convergence depends on the income gap between developing and developed countries. Goingfrom poor to less poor is the easy part. The trickier bit is makingthe jump from middleincome to reasonably rich. Can Chinaand others manage it? 7

1

WITH A MAXIMUM speed of 430kph (267mph), theShanghai magneticlevitation (or maglev) train is as much

fairground ride as vital cog in the city’s transport system. Astretch of the 30km track from Longyang Road to Pudong International Airport runs alongside a motorway. The speeding carsleft behind are a guide to how fast the train is moving. For passengers who like to quantify their thrills, a digital speedometerin each carriage counts up the train’s acceleration to its top speedbefore the numbers tumble again as the train slows towards theairport terminal.

The Shanghai maglev is a powerful symbol of China’s modernity�even if the technology was developed in the 1960s inslowcoach Britain and the kit was made by Siemens, a Germanengineering �rm. But the venture is not a moneyspinner. On amidsummer afternoon, the train is halfempty and many of itsoccupants are tourists travelling just for fun. That is because, forall its impressive speed, the maglev is not a great way to get to orfrom the airport. Tickets are too pricey for all but rich businessfolk and foreign tourists, and those customers �nd the line inconvenient. Once they alight at Longyang Road they are still someway from the �nancial district and the best hotels.

Sceptics about China’s economic miracle see the Shanghaishuttle as an example of how badly statedirected banks allocatecapital. China invests some 50% of its GDP, more than double theaverage in rich countries. The big capital projects of stateownedenterprises, such as railways, receive funding on easy terms, butinterest rates paid on bank deposits are capped. A system that favours certain borrowers over ordinary savers or bank shareholders is bound to back illjudged projects and run up baddebts, argue the bears. A collision between two highspeedtrains in China on July 23rd, which killed 40 and left 191 injured,seemed only to con�rm those suspicions.

Let’s leapfrog

But there is a kinder interpretation of China’s appetite forprestige projects such as highspeed rail. Its leaders must knowthat as an economy develops it cannot rely inde�nitely on copying the machinery and knowhow of richer countries. The bettero� a country becomes, the closer its technology is to bestpractice and the fewer of its workers are left in lowproductivityjobs such as farming. The easy catchup gains are exhausted andthe economy slows or gets stuck. One way out of this �middleincome trap� is by trying to leapfrog the technology leaders.

China’s recent growth has been so impressive that it seemschurlish to question whether it can continue. Yet the country will�nd it more di�cult to grow quickly as it becomes richer, as willIndia and Brazil. All three big emerging markets need to �ndways to avoid the in�ation that has bedevilled developing countries in the past, and to strike a good balance between consumption and investment, foreign and domestic demand.

China’s reliance on exports and on investment that supports export industries has reached its limits. The country nowneeds to shift the balance towards domestic demand, which requires capital to be redirected toward the smaller enterprisesthat serve consumers. Brazil is almost the mirror image of China.

It has a thriving consumer economy which it is �nding hard tokeep in check. Its high interest rates discourage the investmentspending it needs to improve its poor productivity record. And itneeds to make sure that the strong currency that comes with abooming commodity sector does not leave it with too narrow anindustrial base. India, like Brazil, is prone to overheating and hasa currentaccount de�cit, though thanks to its high investmentrate its productivity record is closer to China’s.

The problems of middleaged development will soon af�ict China and others, according to research by Barry Eichengreen of the University of California, Berkeley, Donghyun Parkof the Asian Development Bank and Kwanho Shin of Korea University. They examined middleincome countries (with earningsper person of at least $10,000 in 2005 prices) which in the pasthalfcentury had enjoyed average GDP growth of at least 3.5% forseveral years but whose growth rate had subsequently fallen byat least two percentage points. The research con�rmed theirhunch that the loss of momentum is mostly due to economicmaturity rather than a shortage of workers or a slackening in investment. The workforce grew at the same rate after the slowdown as before it, and its quality kept improving: indeed the average worker acquired skills at a slightly faster rate after theeconomy had slowed. The increase in physical capital (factories,o�ces, roads, machines and so on) tailed o�, but this accounted

for only a small fraction of thedrop in GDP growth.

Instead, most of that dropwas caused by a slump in �totalfactor productivity��the e�ciency with which workers andcapital are used. �Growth slowdowns, in a nutshell, are productivitygrowth slowdowns,�write Mr Eichengreen and hiscolleagues. A decline in totalfactor productivity is what youwould expect when the �easy�phase of economic development comes to a close. Movingunderemployed villagers intourban jobs in factories and of�ces with imported equipment

Converging economies

Onetrack bind

To become rich, the emerging markets must spring

the middleincome trap

Great fall of China

Source: CEIC

Chinese householdconsumption as % of GDP

0

20

40

60

80

1952 70 80 90 2000 10

1



2

1

raises productivity. But as rural slack is used up there are no moresuch gains to be had.

According to the three economists, this sort of slowdown ismost likely to happen when average income reaches around$16,000 in 2005 prices; when income per person rises to 58% ofthat in the world’s leading economy; or when the share of employment in manufacturing gets to 23%. Those three thresholds�of which the absolute level of income is the most important�will not necessarily all be reached at the same time. Chinamay already have hit the manufacturing target, and if its economy sustains a growth rate of around 9%, the average incomethreshold will soon be breached. But the relative income threshold remains far o�. In 2010 China’s income per person was 16% ofAmerica’s, according to the IMF.

The research shows that economies such as China’s, withan undervalued currency and a low rate of consumer spending,are more likely to su�er such a growth slowdown. These milestones are based on averages of many countries that livedthrough sudden slowdowns, and their experiences varied widely, cautions Mr Eichengreen. These are not iron laws. Even so, itseems certain that a slowdown will follow once the easier partof the catching up has been done. The question is whether Chinacan mitigate this by changing its growth model.

Last year’s model

That model has proved successful in other parts of Asia. It isexportled, so demand has been mainly from abroad. To meet it,China has mobilised its vast reserves of cheap labour, to which ithas added a fastgrowing stock of physical capital, much of it imported but �nanced from the country’s own savings. Because ofChina’s capitalintensive growth model, consumer spending hasan unusually small share of GDP: in 2010 it fell to only 34% (seechart 1, previous page). This only adds to the reliance on exports.

China’s �nancial setup reinforces this model. The �ow ofcapital across its borders is heavily policed. China has curbed therise in its currency, and kept its exports competitive, by buyinghuge quantities of dollars and other foreign currencies, amassing $3.2 trillion of foreignexchange reserves, worth 54% of China’s 2010 GDP.

The banking system is closely managed by the state. Foreign banks account for barely 2% of total bank assets. The cashcreated to keep the yuan down is mopped up by forcing China’sbanks to buy lowyielding �sterilisation� bonds or to hold morecash in reserve. Interest rates are set in favour of stateownedcompanies (often monopoly suppliers to exporters) but o�er little reward for householders. Credit for consumers is still scarce.

China’s growing weight in the world economy means itcannot rely inde�nitely on other countries’ spending. The debtoverhang in parts of the rich world means that China’s foreigncustomers are hardpressed. And the country is a drain on demand from the rest of the world: its currentaccount surplus (ameasure of its excess saving) rose above 10% of GDP in 2007,though it has since halved. This is a source of tension: the Americans complain that China’s exchangerate policy provides its exporters with an unfair subsidy at the expense of their own workers. The exportled strategy is also beginning to lose its potency.Each rural migrant set to work on machinery to serve China’s foreign customers is harder to �nd than the last.

If China is to avoid the middleincome trap, it needs to develop its domestic market. It must switch from indiscriminatelyamassing factories, ports and other �xed assets to a more �nelygraded allocation of capital and workers that allows small service �rms to �ourish. That transition will be helped along by twofactors. As the working population starts to shrink around 2015,the household saving rate should fall because countries with

fewer earners and a larger proportion of dependents tend tospend more. And China already devotes a bigger share of its GDP

to research and development than do other countries with similar income levels. That gives it a better chance of sustaining productivity growth when the gains from adopting existing technologies run out. But other facets of China’s economy militateagainst change. For example, the World Bank ranks China 65thout of 183 countries for giving companies access to credit, behindIndia (in 32nd place).

The obstacles are formidable. Shifting to an economy thatconcentrates on consumers will mean dislocating entire industries. Higher wages in China, which are needed for this sort of rebalancing, are already driving some textile jobs to Vietnam andCambodia. Removing implicit subsidies to rents and interestrates would cut many �rms’ pro�ts and stir opposition. Banksused to dishing out capital at the government’s sayso wouldneed to make �ner judgments, withholding money from industries with low returns and moving it to promising new ventures.But will they be able to tell the di�erence between the two?

Brazil is the textbook example of a fastgrowing countrythat hit a wall (though it is not covered in the study by Mr Eichengreen and his colleagues). Its economy grew by an average of almost 7% a year between 1945 and 1980. GDP per person rose fromjust 12% of America’s to 28%, according to the Maddison statistics.

But then convergence went into reverse.The debts accumulated to pay for imported machinery became crippling as interest rates shot up. Industries that hadserved a protected home market were revealed as ine�cient. A weak currencyand wage indexation fed �rst in�ationand then hyperin�ation.

A series of monetary and �scal reforms in the 1990s tamed in�ation and arrested the decline in relative income. Brazil’s income per person is now above 20%of America’s level. But the economy suffers from frailties that are the mirrorimage of China’s. Investment is 19% of GDP,well below China’s and quite low evenby richworld standards. That is one reason why productivity is feeble, thoughBrazil’s woeful education system and decrepit infrastructure are also to blame.The economy tends to grow at around 4%a year, faster than most rich countries butmore slowly than Brazil’s emergingmarket peers.

Weak investment re�ects low domestic saving. Brazil still habitually runs acurrentaccount de�cit. This reliance onforeign capital has left it vulnerable to periodic balanceofpayments crises, thoughit has piled up $344 billion of foreigncurrency reserves to fend them o� in future.Brazil’s net foreign liabilities (private andpublic) amount to $700 billion, comparedwith China’s net assets of £1.8 trillion.

The �ip side of Brazil’s low saving isstrong consumer spending, at 61% of GDP

last year. The business of providing loansto householders is booming. This is inpart because BNDES, the stateowned development bank, provides subsidisedloans to Brazil’s big statedirected compa

China’sgrowingweight inthe worldeconomymeans itcannot relyinde�nitelyon othercountries’spending


THE WORLD ECONOMY

SPECIAL REPORT



nies and to some other �rms. That limits opportunities for business lending, so private banks must look elsewhere.

Brazil’s economy has two great strengths. Its population ofworking age is growing quickly, and it is rich in natural resourcesat a time when emerging markets are industrialising at an unprecedented rate. Brazil vies with Australia as the world’s largestexporter of iron ore, much of it to China.Its plentiful arable land is astonishingly fecund (in some places three harvests a yearare possible), thanks to an ample supplyof sun and fresh water. The �subsalt� reservoirs o� Brazil’s southeastern shorecontain at least 13 billion barrels of oil.

The commodities boom and the oil�nds have freed Brazil from its traditionalbalanceofpayments constraints. Foreign money is �ooding in,lured by Brazil’s high interest rates and the expected earningsonce the oil starts to �ow. But that creates a new problem: astrong currency that hurts the country’s exporters outside the resource industries.

The textbook remedy for this sort of �Dutch disease� is toraise productivity or lower costs in tradable industries that donot bene�t from the resource boom. In August the governmentsaid it would abolish payroll taxes in four labourintensive industries: footwear, clothing, furniture and software. There is ample scope to further lower the �Brazil cost��local shorthand for arange of handicaps including ramshackle roads, high interestrates, jobs levies, taxes and bureaucracy.

Brazil is one of the most onerous countries to do businessin, coming 127th out of 183 in the World Bank’s ranking. Hiringand �ring is costly and closing a business can take years. The taxsystem is complex and bedevilled by rules that often con�ict. �Ifyou’re honest and want to comply with the tax code, you needan accountant and a tax lawyer for life,� laments one São Paulobased economist.

Real interest rates in Brazil are among the highest in theworld. The central bank’s benchmark rate is 12% and may need torise again to tame in�ation, which is well above the target of4.5%. High rates are in part a legacy of past in�ation that punished saving and rewarded borrowing. A culture of saving hasyet to take �rm root, so demand for credit outstrips supply. Fiscallaxity has also played a part. The economy is running at or beyond full capacity. The jobless rate is 6%; it has rarely been lower.Brazil’s budget ought to be in surplus. Government debt is rolledover every three years and crowds out other borrowing. But amarket for longerterm debt would require a commitment tokeeping publicsector payrolls and state pensions in check.

Brazil hopes that the oil discoveries will be exploited in away that helps other industries rather than harming them. Thegovernment has insisted that Petrobras, the statecontrolled oilgiant with sole operating rights in the subsalt �eld, must buymost of its supplies in Brazil.

Eike Batista, a colourful magnate with interests in mining,oil exploration and logistics, is building a port complete withshipyard (in tandem with Hyundai, a South Korean �rm) to comply with the localcontent rules. �The demand from Petrobrascould �ll two shipyards,� he says. A modern port will encourageforeign manufacturers to build factories along Brazil’s coast andserve the domestic market. �Brazil will not be trapped in commodities,� he insists. But others worry that Brazil is �irting with astatein�uenced and inwardfacing model of industrialisationthat has failed before.

Brazil and China need to make di�erent sorts of transitionsif they are to sustain their development. Brazil has to save and invest more; China needs to consume more. Brazil is rich in re

There is ample scope tolower the �Brazilcost��local shorthand fora range of handicaps

1

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THE WORLD ECONOMY

SPECIAL REPORT

sources; China is hungry for them. Brazil is short of good roadsand railways; some of China’s will attract too little tra�c. Brazil isyoung; China is ageing. �Perhaps they should merge,� is the wrysuggestion of Arminio Fraga, a former centralbank governor ofBrazil who now runs Gávea Investments in Rio de Janeiro.

India’s bumpy road

India’s main challenges are a mix of those facing Brazil andChina. Like China, India has enjoyed a recent growth rate abovethe emergingmarket norm, at around 8% a year. It ought to be doing better still: after all, it is poorer than China, so the scope forcatching up is greater. Investment is a healthy 38% of GDP. Muchof India’s investment is �nanced out of companies’ own pockets,a symptom of an immature �nancial system. Most �rms cannotrely on external funding, though giant Indian conglomerates,such as Tata, are able to tap into international capital markets.

Like Brazil, India is in desperate need of better roads to linkits far�ung internal markets. It is a young country, with its workingage population set to grow at 1.7% a year until 2015, a fasterrate even than Brazil’s. But too many of its people are educatedbadly, if at all. As in Brazil, companies often have to provide remedial education to bring recruits up to scratch. Arcane lawsstand in the way of a wellfunctioning jobs market. Corruption isa blight on infrastructure projects. The economy is prone to overheating and has a currentaccount de�cit.

This speaks of a deeper weakness in emerging markets. Inthe past they have not been good at managing internal demand.Relying on exports allowed them to grow and save at the sametime. Now that the rich world’s economies are struggling, thathas become harder, raising the prospect of the sort of ills that ledto emergingmarket crises in the past: excess government spending, rapid credit growth and in�ation. The transition from middleincome to rich economy relies on sound monetary, �scal andregulatory policies, says Raghuram Rajan, a former IMF chiefeconomist now at Chicago’s Booth School of Business.

The fear of renewed trouble in the debtladen richworldeconomies has meant that Brazil and India have been slow tostop local in�ationary pressures from building. China passed its�rst big test �lling in for richworld demand when it increasedbank credit by an astonishing onethird during 2009. It was awelcome stimulus to the local and global economy, but there aregrowing doubts about the wisdom of many of those loans. Thedebts run up by local authorities to �nance infrastructure are ofparticular concern.

China bulls argue that the expenditure was essential to thecountry’s rebalancing. Better transport links between the richcoastal cities and poorer western regions were needed to develop China’s internal market. Sceptics see roads with no cars,trains with few passengers and empty buildings. Some reportssay 2 trillion yuan of localauthority loans have gone sour. Worryingly, some of the foreign investors who had rushed to takestakes in Chinese banks are slinking away. Bank of America,which has problems in its home market, has sold half its stake inChina Construction Bank.

Even so, stabilising aggregate demand may prove easierthan settling the social con�icts or tackling the industrial stasisthat entrap middleincome countries. This depends not only ona welltuned economic engine; it also relies on how fairly thepain of adjustment is shared, says Harvard University’s Dani Rodrik. Societies torn by class or other rivalries are often set back byeconomic change. Democracies with rules and procedures forsettling disputes and compensating losers tend to do better.

Mr Rodrik contrasts South Korea’s bounceback from theEast Asian crisis in 1998 (as well as from earlier troubles) with theslump endured by Brazil and other Latin American countries in

the 1980s. South Korean industry had been tested in export markets so it could build a recovery on its industrial strength. Brazilhad lacked that strength. But South Korea was also able to recover more quickly because each interest group agreed to absorbsome of the pain from the downturn. The government said itwould do its best to help the country get over the crisis but �rmsshould do their bit by avoiding layo�s and unions should moderate their wage demands. In Brazil, by contrast, everyone triedto shift the pain of lower living standards onto others. In�ationtook o� and Brazil’s GDP per person stagnated for 15 years.

China may have the stronger economy, says Mr Rodrik, butBrazil and India are likely to be better at handling the social mobility that comes with being a middleincome country. All threeof these emergingmarket giants will have to work hard to avoidthe middleincome trap. Their recent economic performance isgood but experience suggests that there will be setbacks. Yet asthe rich world stumbles from crisis to crisis, the prosperity gap isclosing fast. America’s claim to economic leadership looks increasingly threadbare, and one of its longheld privileges�having the world’s main reserve currency�is under threat. 7

AT THE FLAGSHIP store of Yue Hwa Chinese Products inHong Kong customers can �nd exotic and everyday items

from mainland China without having to cross the border. The offerings include silk brocades, sandalwood carvings, Sichuanpeppers and traditional Chinese remedies such as ribbed antelope horns. Horn shavings, boiled in water, are said to quietenthe liver and quell fevers.

Feverish visitors from the mainland can even pay for theirshavings in their own currency, the yuan. The store charges2,660 yuan ($416) for a whole horn, at an exchange rate of 1.1Hong Kong dollar per yuan. Nearby moneychangers o�er a better rate, but some Chinese visitors prefer the convenience of using their own money. That way they can still get a latenightsnack at the 7Eleven after the moneychangers have closed.

That is how, not long ago, the yuan set out on its career as aninternational currency. It crept into Hong Kong in the wallets ofmainland visitors. The trickle across China’s borders quickenedlast year when the government allowed a broader range of Chinese �rms to settle imports and exports in yuan. In the same yearit set these o�shore yuan free. Outside the mainland, the yuancould be transferred between banks, borrowed, lent and invested, just like any other currency.

This o�shore experiment is, for many forecasters, a �rst tentative step towards making the yuan a fully �edged reserve currency to rival the dollar and the euro. But China’s policymakersare in two minds, as they tend to be when it comes to freeing �nance. Restricting the �ow of money into and out of China protects the country’s immature banking system. When Japan sanctioned the international use of the yen in the 1980s it set the stagefor a damaging property bubble.

On the other hand China hates having to rely on the dollar.O�cials are troubled by the Federal Reserve’s notably loose

Reserve currencies

Climbing greenbackmountain

The yuan is still a long way from being a reserve

currency, but its rise is overdue

2

1



2

1

monetary policy and by America’s rapidly rising public debt.They fear that stimulus measures put in place to revive America’s�agging economy will sooner or later generate a burst of high in�ation and weaken the dollar. That would hurt holders of US

government bonds, including China. Around $2 trillion of itscurrency reserves of $3.2 trillion are in dollars, mostly in bonds.On August 5th America lost its tripleA credit rating from Standard & Poor’s because it had failed to come up with a credibleplan to cap its public debt. China’s o�cial news agency, Xinhua,immediately called for a new reserve currency.

Such calls have been made before, during bouts of dollarweakness in the late 1970s and mid1990s, but the dollar stillholds the privileged position in the world’s monetary system ithas occupied since the second world war. It faces no immediatechallenge to its status, notwithstanding the debt downgrade, because there are few good alternatives. Despite a long and steadydecline in its value against other currencies, it still accounts for60.7% of the world’s $9.7 trillion of currency reserves. That isaround three times America’s weight in the world economy asmeasured by GDP. The dollar’s closest rival, the euro, accountsfor 26.6% of the world’s reserves.

How does one currency maintain such dominance? Textbook economics says domestic money has three uses: as a unitof account against which the value of goods is measured; as amedium of exchange; and as a store of value used to conservespending power for a rainy day.

The won ful�ls these roles in South Korea; the yuan doesthe job in China; and the dollar provides these services in international markets as well as in America. It is the unit of accountfor commodities such as crude oil that are traded globally. Mosttrade that is invoiced in a currency other than those of the trading partners is quoted in dollars. And because the dollar is the benchmark forworld prices and is used to settle crossborder trades, it makes sense for countriesto keep stores of dollar reserves, both as a�oat and to bolster con�dence in theirown currencies.

The demand for reserve currenciesis a boon to their issuers. Around $500 billion of America’s currency is used outsidethe country’s borders. Some of this cash isused to lubricate dollarbased international trade. But much of it greases thewheels of crossborder crime such asdrug tra�cking: crooks need a unit of account, a medium of exchange and a storeof value just like legitimate businesspeople.

Indeed, a reserve currency might almost be de�ned by itsappeal to criminals. Of the ¤900 billionworth of euro notes incirculation, a third by value comes in the form of the pink andpurple ¤500 note. Cynics say it was issued to capture a share ofthe international black market from the dollar, for which the largest denomination is $100. An illegal stash of ¤500 bills would belighter, easier to conceal and easier to count. The ¤500 note waswithdrawn by banks in Britain after police said its main use wasin organised crime. That is a compliment of sorts to the euro.When Somali pirates or Russian gangsters demand payment inyuan, it will be the surest sign that economic power has shiftedto China.

The cost of printing $500 billionworth of notes is negligible compared with the value of the goods and services they cancommand. In order for those notes to circulate outside America,they must �rst have been exchanged for $500 billionworth ofgoods and services. They represent a cost in real resources. The

gap between the printing cost of banknotes and their face valueis called seigniorage. Governments that print reserve currenciesbene�t from extending seigniorage beyond their own borders.

Issuers of international currencies also enjoy protectionfrom currency volatility. A Vietnamese exporter selling to Chinais exposed to exchangerate risk: he pays his workforce in dong,the local currency, but receives payment in dollars. If the dollarfalls, so do his earnings, but his labour costs are unchanged.American exporters do not have to worry about currency mismatch because both their domestic costs and their export earnings are in dollars.

Nor has America had much need to acquire costly reservesof its own. Under the Bretton Woods system of �xed exchangerates that governed richcountry trade until 1971, members wereconstantly at risk of running short of dollars if their exports became uncompetitive, whereas America could always print moredollars. This was an �exorbitant privilege�, grumbled France’s �nance minister at the time, Valéry Giscard d’Estaing.

Exorbitant privilege v original sin

The privileges of reservecurrency status were not con�nedto the dollar, though it enjoyed the lion’s share. They include being able to borrow cheaply. The dollars and euros (and, to a lesserextent, the pounds, Swiss francs and yen) that other centralbanks keep in reserve are mostly in the form of governmentbonds. The extra demand weighs on bond yields and sets a lower threshold for the cost of credit for businesses and consumers.

This part of the exorbitant privilege contrasts with theemerging world’s �original sin�, a term coined by Barry Eichengreen of the University of California, Berkeley, and RicardoHausmann of Harvard University for some countries’ inabilityto borrow in their own currencies. Borrowing in foreign currencies (as Brazil and other Latin American countries had done before the 1980s debt crisis) leaves original sinners at risk of defaultif their currency loses value. Troubleprone countries have oftenhad to keep interest rates high, even in a recession, to supporttheir currencies and stave o� default on foreigncurrency debts.Hungary is a recent example of a country in this sort of trap. TheFederal Reserve has never had to worry about such things.

The divide between the exorbitantly privileged and the

original sinners was especially deep after the East Asian crisis of199798. The lesson from that crisis was never to be short of reserves. The investment rate in emerging Asia fell, the saving ratestayed high and the excess saving was sent abroad. It marked thestart of an unprecedented buildup of foreign exchange to insureagainst future balanceofpayments problems. The world’s currency reserves increased from $1.9 trillion in 2000 to $9.3 trillionin 2010. Much of the increase was in China.

The surge in demand for safe and liquid assets in dollars,euros and pounds pushed down longterm borrowing costs. Thesavings of the emerging world allowed the rich world to spendtoo freely, one of the deeper causes of the wave of crises that hasa�icted the rich world since 2007. America’s �nancial marketsmet the global demand for �safe� dollar assets by repackagingthe mortgages of marginal borrowers as bonds, which turnedsour. But the resulting �nancial crisis hit mainly the rich worldrather than the emerging markets.

Richworld banks and investors seeking higher returns

China hates having to rely on the dollar. O� icials aretroubled by the Federal Reserve’s loose monetary policyand by America’s rapidly rising public debt


THE WORLD ECONOMY

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2

1

when interest rates were low had bought a lot of the ropy mortgage securities. That made room for reserve managers in emerging markets to buy more bonds backed by governments or issued directly by them. Investors were so anxious for yield thatthey barely distinguished between good and bad credits. Countries with large public debts, such as Greece and Italy, could borrow as cheaply as countries with sound public �nances such asGermany. Windfall tax revenue from housing booms fuelled bycheap foreign credit made the public �nances of Ireland andSpain look sound until recession (and, in Ireland’s case, the terrifying cost of bank bailouts) caused public debt to explode.

Some believe the exorbitant privilege is really a curse thatlures the reservecurrency country into too much borrowing orprinting too much money. Over time this saps the economic andpolitical strength that was the source of the privilege. This paradox was �rst noted in 1947 in a Federal Reserve paper written byRobert Tri�n, a Belgianborn economist.

Under the Bretton Woods arrangement currencies werepegged to the dollar at �xed exchange rates. The dollar in turnwas tied to gold at a �xed price. Tri�n spotted a dilemma. A rising stock of dollars was needed to �nance world trade. The moredollars were supplied, the more the currency’s link to goldwould be questioned since America’s gold stocks would supportan everlarger pile of banknotes. This came to a head in August1971 when heavy selling forced President Nixon to suspend the

conversion of dollars into gold. The Tri�n dilemma is echoed in contemporary worries

about the rich world’s public debts and its currencies. Easy accessto credit lured the euro zone’s periphery into overborrowing.Greece is insolvent, Ireland and Portugal are not far o�. For reserve currencies, what is safe is in con�ict with what is convenient, argues Stephen Jen of SLJ Macro Partners, a hedge fund,adding that �the euro is e�cient but it’s not safe.� Reliable and liquid repositories for rainyday saving are scarce, which is why reserve managers and bond investors continue to push money intothe Treasury market. But this tempts America to overextend itself,amassing debts it may one day struggle to service.

As America’s weight in the global economy drops, supplying the world with most of its reserve currency needs may become too big a job for the country. In his recent book, �ExorbitantPrivilege�, Mr Eichengreen argues that a reservecurrency systemwill emerge in which the dollar, the euro and the yuan share theprivileges and the responsibilities. That would make the world asafer place, he reckons, because each issuer would nudge the others towards �nancial and �scal discipline.

It is not obvious that one currency needs to play a preeminent part. In its heyday, sterling was rarely as dominant as the dollar has been since it took over. On the eve of the �rst world warthe pound accounted for only around half of all reserves: most ofthe rest was in French francs and German marks. By 1924 more re



serves were held in dollars than in sterling.The dollar is �awed, but so are the candidates to displace it.

The euro has no single �scal authority standing behind it. Nor isthere a single issuer of sovereign debt to match the size and liquidity of the market for US Treasuries�although the bonds issued by the European Financial Stability Facility (EFSF), the euroarea’s emergency bailout fund, may foreshadow a single eurobond backed by all its members. For all its shortcomings, theeuro still accounts for a quarter of the world’s reserves. Even asthe region’s sovereigndebt crisis has deepened over the pastyear, its currency has gained groundagainst the greenback.

The speed at which the dollar rose toprominence suggests that the yuan mightbe an international currency as soon as2020, says Mr Eichengreen. The greenbackovertook sterling in reserves barely a decade after the founding of the Federal Reserve in 1913 as the backstop of dollar liquidity. The Fed pushed the dollar by fostering aliquid market for trade acceptances, the credit notes used to fundshipments. By the mid1920s more trade was carried out in dollars than pounds and more international bonds were issued inNew York than in London.

However, the obstacles to the yuan becoming a reserve currency are bigger than those faced by the dollar in 1913. At that timeAmerica was already a trusted storehouse for capital, a democracy where the rule of law was �rmly established. China’s recenthistory is less reassuring, so it will take a while before foreignersfeel secure keeping their savings in yuan. The currency wouldhave to be fully convertible so that investors could park theiryuan reserves in assets of their choosing and redeem themwhen needed.

This in turn would require China to allow capital to movefreely across its borders, which it has been reluctant to do. In recent years it has eased restrictions on residents taking capital outof the country; for example, more foreign takeovers by big Chinese �rms have been allowed to go ahead. But foreigners faceformidable barriers to bringing money into China because thegovernment is reluctant to cede control of the yuan’s value or ofdomestic bond yields to the ebb and �ow of foreign capital.

China has taken some baby steps toward setting the yuanfree. It has allowed trade in goods to be invoiced and paid inyuan. The proceeds can be put to work in a �edgling o�shoreyuan market in Hong Kong with restricted links to the mainland.Trade settlement in yuan has grown rapidly, reaching 600 billionin the second quarter of 2011 (around 10% of total trade), according to the People’s Bank of China.

So far such trade settlement has been a rather onesided affair: most has been for imports (ie, Chinese �rms paying foreigners in yuan for supplies). Few of China’s exporters are willing orable to demand yuan from foreign customers, though those customers should not �nd it hard to get hold of the currency. China’scentral bank has set up swap agreements with the central banksof many of its emergingmarket trading partners, ranging fromSingapore to Kazakhstan, allowing foreign banks to supply yuanto their customers.

By the end of July yuan deposits in Hong Kong had swollento 572 billion. The IMF said in July that 155 billion of yuandenominated bonds (socalled �dim sum� bonds) had been issuedin Hong Kong since the market was set up, many by branches ofmainland banks. Issues by non�nancial foreign companies areless common, in part because �rms still need permission to bringthe cash raised into China. There have been some highpro�ledeals, though the bonds have short duration. McDonald’s sold athreeyear bond last year. Caterpillar, an American maker of

earthmoving equipment, has issued a couple of twoyear bondsso far. A recent sale in Hong Kong of 20 billion yuan of government debt was heavily oversubscribed.

The o�shore yuan market has quickly come up from nowhere and China’s central bank has continued to strike bilateralswap deals to keep it growing. But it is a big leap from being a currency in which a chunk of your own trade is settled to being afully �edged international currency, and a further jump to reservecurrency status. Only a small fraction of the world’s $4 trillion in foreignexchange deals each day are for trade settlement.

The bulk of currency dealing is for hedging or related to tradingin stocks, bonds and other assets. The dollar is one side of 85% ofall currency trades, according to the Bank for International Settlements (see chart 2). The yuan accounts for just 0.3% of turnover.

Yet the exorbitant curse will catch up with the dollar oneday and the yuan is its most likely replacement. China’s economy is second only to America’s in size and is likely to overtake itsoon. It is already the world’s largest exporter. And it has net foreign assets of $1.8 trillion, whereas America owes a net $2.5 trillion to foreigners. Only Japan is in a stronger position.

A global yuan?

Reservecurrency status depends on these three gauges ofeconomic dominance�size of economy, exports and net foreignassets�says the Peterson Institute’s Arvind Subramanian. By 1918America had the world’s biggest economy and would soon be itslargest creditor and exporter; within a few years the dollar alsohad the lion’s share of the world’s foreignexchange reserves. Ifthat precedent is anything to go by, the yuan should soon become the main global reserve currency, and not merely a junioralternative to the dollar or the euro.

The rewards to China of opening up fully to foreign capitaltrump the risks, reckons Mr Subramanian. Turning the yuan intoa reserve currency o�ers China a way out of its mercantilistgrowth model, which has run its course. Demand for yuan reserves would push up the exchange rate, discourage exports andgive China’s consumers greater purchasing power. A push for re

serve status for the yuanwould go hand in hand withthe development of China’s �nancial system�a necessarystep to support the small andmediumsize businesses itneeds to serve its domesticmarket, and for many otherreasons. For China to escapethe middleincome trap, it willhave to let go of the yuan.

The rich world’s monopoly on reservecurrency privileges has given it �rst call onthe world’s precautionarysavings. For now, it is clingingon to its privileges. But rivalryfrom developing countries inthe markets for oil and commodities is already exacting aprice from the West. 7

It is a big leap from being a currency in which your owntrade is settled to being a fully �edged internationalcurrency, and a further jump to reservecurrency status

Passing the buck

Source: Bankfor InternationalSettlements

Currency share of average dailyforeign-exchange turnoverApril 2011, %

2

0 20 40 60 80 100

$

¤

¥

£

E-w* other

R-w† other

A$

Swiss franc

C$

Yuan

*Emerging-world†Rich-world

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THE WORLD ECONOMY

SPECIAL REPORT

1

LOOK OUT ON any day from Pier Two at the Tubarão Portcomplex in Brazil and you will see at least half a dozen

ships on the horizon. The queue of waiting vessels allows theport’s loading manager, Leonardo Barone, to keep its three piersin constant use. Tubarão is owned by Vale, the world’s largestironore company. A record 104m tonnes of ore was shippedfrom here last year.

Back from the water’s edge a phalanx of huge dumpers unload iron ore from the trains arriving from Vale’s mines in MinasGerais. The 905km railroad carries 40% of Brazil’s rail freight onjust 3% of its track. A standard freight train on this line has 252 carriages and three locomotives. Around 4,000 carriages are emptied in Tubarão each day.

The unloaded ore is blended and stockpiled in a vast yardenclosed by �nemesh screens to stop the dust from blowing towards the nearby city of Vitória. Then it is scooped by giant rotating buckets onto a moving belt and conveyed to a long chute atthe pier where it is poured into the hold of a waiting vessel.

The port’s construction in the mid1960s was sponsored bysteelmakers from Japan. Today Brazil’s main customer is China,which takes 15% of its exports (mostly iron ore, soyabeans andoil), up from almost nothing ten years ago. The cargo that theships are queuing up for at Tubarão has become far more valuable. Iron ore now fetches $178 a tonne, compared with $13 atonne in 2001.

Broader measures of rawmaterial costs have jumped aswell. The Economist’s index of nonoil commodity prices has trebled in the past decade. The recent surge has reversed a downward trend that had lasted a century. Industrial rawmaterialprices fell by around 80% in real terms between 1845, when The

Economist began collecting data, and their low point in 2002 (seechart 3). But much of the ground lost over 150 years has been recovered in the space of just a decade.

This has raised the incomes of commodityrich countriessuch as Brazil and Australia as well as parts of Africa. It has alsocaused even sober analysts to speak of a �new paradigm� in

commodity markets. Even though GDP has slowed to a nearstandstill in many parts of the rich world, the price of crude oil isclose to $100 a barrel�as high in real terms as after the oil shocksof the 1970s (see chart 4 on next page).

What accounts for this turnaround? The price spikes overthe past century were linked to interruptions in supply, notablyduring the �rst world war. But recent price rises have been toobroadbased and longlasting to be adequately explained byfrost or bad harvests. Nor is it obvious that producers are hoarding supplies. At Tubarão everybody is straining to get the oreonto the ships more quickly. Valuable time is lost in docking andin starting the loading.

There is a more straightforward explanation for the scarcity: the surge in commodity prices is simply the result of exploding demand and sluggish supply. The demand side has beenboosted by industrial development unprecedented in its size,speed and breadth, led by China but not con�ned to it. Growth in

emerging markets is both rapid and resourceintensive. The IMF estimates thatin a middleincome country a 1% rise inGDP increases demand for energy by thesame percentage. Rich economies are farless energyhungry: the oil intensity ofOECD countries has steadily fallen in recent years.

China’s appetite for raw materials isparticularly voracious because of thecountry’s size and its high investmentrate. Though it accounts for only aboutoneeighth of global output, China usesup between a third and half of theworld’s annual production of iron ore,aluminium, lead and other nonpreciousmetals (see chart 5 on page 16). Most of theenergy for Chinese industry comes fromcoal�a dirty fuel that contributes to China’s poor air quality. Its consumption ofoil roughly tallies with the economy’s sizebut is likely to grow faster than GDP as

China gets richer and buys more cars. Supply has struggled to keep pace with this burgeoning de

mand. The world’s ironore production has doubled over thepast decade but prices have risen 13fold. The metal content ofcopper ore has been falling since the mid1990s as existing minesare depleted. This mismatch between demand and supply is anageold problem in commodity markets. It takes years to �nd anddevelop new mines and oil reservoirs and to build the infrastruc

Commodities

Crowded out

Chinese demand had ended a century of steadily

falling rawmaterial costs for richworld consumers

Metal detector

Sources: The Economist; Thomson Reuters *Adjusted by US GDP deflator

The Economist industrial commodity-price index, real* $ terms, 1845-50=100

0

20

40

60

80

100

120

140

1845-50

1860 1870 1880 1890 1900 1910 1920 1930 1940 1950 1960 1970 1980 1990 2000 2011

3

Optimistsbet onhumaningenuity tospring theMalthusiantrap, as ithas done sooften before



2 ture (rigs, pipelines, railways, ports) to bring the commodities tomarket. Supply responds slowly to price increases and delay often leads to excessive investment which then depresses prices.

The extractive industries had only just recovered from sucha binge when prices began to rise again. By the start of the millennium a long bear market in commodities had purged the excesses of the 1970s, says Dylan Grice at Société Générale. The sector was poised for contraction but instead faced the biggest andfastest industrialisation in history.

The supply of commodities is again slowly catching up.The big reserves are mainly in remote and sparsely populated areas. That is in part why the economies of Australia, Canada, Brazil and subSaharan Africa have been growing quickly. Brazil isblessed with timber, exceptionally fertile land, metal ores andnow oil reserves�though the biggest of these are in hardtoreach places, far o� the coast and in deep water beneath a layerof salt. There is now a shortage of geologists who can help withthe search for oil. OGX, an oil �rm founded by Eike Batista, a Brazilian magnate, has tempted some retired ones back to work.

Brazil’s o�shore oil will be expensive and di�cult to recover. If this is what the world is relying on, say the pessimists, theshortage of oil is truly critical. They argue that the resource limitsto growth �rst noted by Thomas Malthus in the late 18th centurystill apply. Optimists bet on human ingenuity to spring the Malthusian trap, as it has done so often before.

Why it matters

The imbalance in commodity markets is likely to persist atleast until resourcehungry countries become richer and newsupplies come on stream. In the meantime the surge in emergingmarket demand will continue to hurt the advanced economies. The rise in oil and commodity prices has pushed up in�ation in rich countries and acted like a tax on consumers.

The IMF reckons that a 10% rise in oil prices knocks 0.20.3%o� global GDP growth in the �rst year, but the impact on a big oilconsumer like America is twice as large. The sluggish growth inAmerica’s economy in the �rst half of this year was due in part tohigher oil prices, which in turn were caused partly by strong GDP

growth in China (though supply disruptions also played a role). The commodities boom has also made monetary policy

more complicated. In�ation targets allowed governments andcentral banks to argue that price stability and full employmentwere complementary goals. If too many workers were idle, thatwould bear down on prices and allow central banks to keep interest rates low to boost spending and jobs and to guard againstde�ation. For a decade after 1997 China’s e�ect on world priceshad made life easier for the rich world’s central banks. Imports of

cheap goods from China brought down prices in America andelsewhere, keeping in�ation low. But now that Chinese wagesare rising, the e�ect of the country’s rapid industrialisation onworld commodity prices is pushing up richworld in�ation.

Because of the persistent rise in commodity prices, in�ation has not come down even though there is lots of slack in mostadvanced economies. The textbook response to commodityledin�ation is to regard it as temporary and ignore it. But that becomes harder if it persists and raises expectations of future in�ation. In Britain, for instance, in�ation has been above the Bank ofEngland’s 2% target for most of the past four years, yet interestrates have been close to zero. Some complain that the in�ationtarget has simply been abandoned.

Commodity prices are acting as regulators of globalgrowth. The emerging markets are �rst in the queue for suppliesbecause they are often able to use each extra barrel of oil or shipload of ore more gainfully. Their demand raises prices and lowers real incomes in the rich world, which gets crowded out. Richcountries had become used to unlimited access to cheap raw materials: prices had been falling for a century or more. Now there iscompetition for primary resources. Producers are bene�ting andrichworld consumers are su�ering, at precisely the time whenthey are also increasingly anxious about job security as Chinaand India rise and rise. 7

Crude awakening

Sources: The Economist; Thomson Reuters *West Texas Intermediate

Oil price*, $ per barrel at 2011 prices

1970 80 90 2000 110

20

40

60

80

100

120

140

4

AS THE DELHI metro snakes its way out of the crowdedsouth of the city the scene turns more rural, with the occa

sional water bu�alo, schoolgirls playing hopscotch outside a village school and crudely built brick houses. But by the time thetrain draws up to the suburb of Gurgaon, the cacophony of urban India is heard once again.

Twenty years ago Gurgaon was farmland. Now it is a sea ofvillas, shopping malls, o�ce blocks and apartment buildingswith names like Beverly Park and Oakwood Estate. The metrohoardings advertise the best places to buy o�cewear or theLovely Professional University’s record for getting people intojobs. On a busy Friday the roads are crammed with honking TataSumos, the local sportsutility vehicle. Many drivers are on theirway home after a night working the American shift.

Gurgaon is a global centre for outsourcing backo�ce services. Here and in other such hubs around India, routine o�cework and data analysis are carried out for a variety of corporatecustomers, many from rich countries (so their tasks have beeno�shored as well as outsourced). The work can be sophisticated:crunching the pro�tandloss numbers of listed companies forWall Street analysts, or teasing spending patterns from the datagathered by supermarket tills.

Wages in Gurgaon are a small fraction of those of a backof�ce clerk in Newcastle or New York. That lowers costs for consumers. But it also raises anxiety among workers about low payand a drain of jobs to cheaper locations. The range of tasks thatcan be outsourced and o�shored is constantly expanding.

The notion that trade kills jobs is based on the false premisethat there is a �xed amount of work to do. The world’s leading

Exporting jobs

Gurgaon grief

Now for the next shakeup in the global labour market

1


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larger than in the past. A quarter of American jobs in 1970 were inmanufacturing and hence potentially o�shorable. Many didmove o�shore but were replaced by jobs in service industries.

A lot also depends on what happens in emerging markets.If China can successfully switch from exportled growth to domestic sources of demand it will create more opportunities forAmerican exports. As China and India become better o� thewage gap with the rich world will narrow and the pace of o�shoring will slow. And as technology opens up more sorts ofwork to crossborder trade it will create openings for richworldeconomies whose comparative advantage is in services.

If services become more tradable that will be good forAmerica’s workers. But it might also exacerbate the growingwage divide within its own labour market. Economic theory suggests that trade with emerging markets creates a wage premiumfor the skilled workers in rich countries. The world’s division oflabour is determined by the relative abundance of skilled andunskilled workers. Rich countries have more of the former, sospecialise in traded goods with a high skill content. Poor countries have more of the latter, so concentrate on lowskilled work.Skilled workers in rich countries bene�t from trade, but thewages of the less skilled su�er from foreign competition.

Most studies so far have found that trade explains only asmall part of the increase in income inequality in America sincethe 1980s. The decline of tradeunion power and belowin�ationincreases in the minimum wage also played a role. But most ofthe growing inequality is probably due to technological changewhich makes a college education more valuable�in much thesame way that trade does, in fact. It is possible that the e�ect oftrade on wages is more signi�cant than those studies have found.Much of the stu� that China makes is no longer produced in therich world, so it is di�cult to establish a direct link.

That may also be because the data are not detailed enoughto capture the e�ects on relative wages within industries, saysJosh Bivens of the Economic Policy Institute, a thinktank inWashington, DC. Only those with a fouryear college degree(perhaps a quarter of America’s workforce) are clear winners

economies have been ceding jobs to lowincome rivals since theindustrial revolution. The cotton industry in Britain was in thevanguard of that transformation but soon faced competition��rst from New England, then from America’s South. The millshave largely disappeared and the spinning and weaving jobs replaced by betterpaid ones. As the division of global labour becomes ever more �negrained, small tasks rather than whole industries move abroad. Trading partners share the e�ciencygains. The world is better o�, even if some individuals lose out.

Many more to go

This sort of gradual restructuring is not new, and neither isthe job insecurity that stems from it. But anxiety about o�shoring has risen, for three reasons. First, jobs are already scarce because the hangover from recessions caused by �nancial criseslasts longer than that from other sorts of downturns. Second,China and India between them have around 2.5 billion people,so the potential for further o�shoring from the rich world is immense. Third, advances in computing and communications allow for a wider range of jobs to be shifted across borders.

These last two factors mean that o�shoring will be a hugelydisruptive force, says Alan Blinder, a professor at Princeton University. A recent study carried out in America with a Princetoncolleague, Alan Krueger, found that a quarter of the workers interviewed considered their work potentially �o�shorable�.This �gure includes all manufacturing jobs, as goods are readilytraded across borders. But it also covers many occupations thatused to be thought safe from foreign competition.

Any service job that can be delivered down a wire withoutany diminution in quality is o�shorable, reasons Mr Blinder.That means highpaying jobs in accountancy, �nancial analysisor computer programming are at risk. Jobs that involve facetoface contact or require the worker to be present are safer: think oftaxi drivers, plumbers, police o�cers or janitors. Mr Blindermakes a distinction between personal and impersonal services.Only the latter are o�shorable. A contract lawyer or radiologist isvulnerable to o�shoring; a divorce lawyer or family doctor isn’t.

Yet not all the jobs that can be o�shored will be. Even inmanufacturing the savings on labour from o�shoring are oftenoutweighed by other cost considerations. Lowvalue bulkygoods, such as bricks or bottles, tend to be made close to wherethey are consumed because transporting them is expensive. Carsare also mostly made in the countries where they are sold.

Hightech manufacturing relies on a skilled labour forceworking closely with designteams. There is little cost advantage to o�shoring for smallbatches of goods or where fastdelivery to local customers isimportant. Economies of scalemean industries are �sticky�:Britain’s cotton industry, for instance, did not go into seriousdecline until the 1960s eventhough wages were high.

The alarm over the threatto jobs from India and Chinaechoes the anxiety about Japan’s rise in the 1970s and1980s. America’s economy hassurvived the shakeup of itssteel, electronics and car industries, as have other rich countries. The scale of the challengeis large but may not be so much

Wok, stock and barrel

Sources: BP StatisticalReview; IMF; ThomsonReuters; World Bureauof Metal Statistics

*Purchasing-power parity

China’s share of worldcommodity consumption2010, %

0 20 40 60

Iron ore

Coal

Lead

Zinc

Aluminium

Copper

Nickel

GDP at PPP*

Oil

5

2 from growing trade, reckons Mr Bivens.The most striking feature of rising wage dispersion is not

the wider gap between the skilled and unskilled but the biggerslice that goes to a tiny elite. The share of income claimed by thetop 0.1% of earners increased from 2% in 1970 to 8% by 2007, according to research by Emmanuel Saez of the University of California, Berkeley, and Thomas Piketty of the Paris School of Economics. Much of this trend, says Harvard University’s RichardFreeman, is explained by stock options, which are counted aspart of pay. �This goes back to something we have thought of asoldfashioned: capital versus labour,� says Mr Freeman.

Waiting for intelligent robots

There are dangers in extrapolation. The recent rapid growthrates in emerging markets are unlikely to be sustained. And perhaps the wage premium paid to workers with a college degreewill shrink again, for reasons unrelated to trade. Scarce and expensive skilled labour is often a spur to invention. Before the industrial revolution the handspinning of raw cotton into threadwas the main bottleneck in the production of cloth. It took sixspinsters to feed each handloom used to weave thread into cloth.The introduction of mechanised spinning (of the sort carried outat Quarry Bank Mill) changed that, creating a dearth of handweavers. Then power looms destroyed the wage premium forhandweaving, so the Luddites destroyed some of the looms inresponse. It is conceivable that advances in arti�cial intelligencemight spell the end of the wage premium for skilled workers, too.

But for the immediate future skilled workers in the richworld still seem to have the best prospects. Collegeeducatedworkers are more likely to be able to switch jobs in response tooutsourcing than those with little education. And the rewardsfor those with jobs that compete in the global market for tradableservices are likely to be higher than for those in lowskill personal services�though the risks of losing their jobs are also greater.

The anxiety about o�shoring has obscured another changein the economic landscape that will bring jobs to rich countries:the rise of the emergingmarket multinational. 7

THE HALEWOOD CAR plant near Liverpool was once notorious for strife. In the 1970s its bolshie workforce fre

quently clashed with tetchy managers. In the peaceful interludesthe plant turned out �eets of Ford Escorts, a popular family car.

The plant is now part of Jaguar Land Rover (JLR), owned byTata Motors, the car division of an Indian conglomerate. Thesedays it is a cheerful and contented place. At one end of the plantworkers examine the body parts shaped by one of ten giant metal presses. At the other end, in the paint shop, a sprayer dressed ina protective suit squirts a mist of colour inside the back door of acar shell. Forklift buggies, owned by DHL, a logistics �rm withan onsite operation, distribute parts from outside suppliersaround the factory.

The reason for the activity and the good humour is that production has recently started on the new Land Rover Evoque, amini sportsutility vehicle. Before the car had appeared in theshowrooms, JLR had taken 18,000 orders for it and it was alreadyfor sale on eBay. Thanks to the contract for the Evoque, Halewood’s workforce has doubled to 3,000 in the past year. Local

suppliers will also bene�t. Two centuries ago the rise

of the cotton trade in the millsaround Manchester and theport of Liverpool spelled doomfor India’s textile industry. Today Indian �rms own largechunks of Britain’s old industrial northwest. The Stanlow oilre�nery close to Halewoodwas bought earlier this year byEssar, an Indian conglomerate.Brunner Mond, a chemicals�rm started in 1873 just a fewmiles from Quarry Bank Mill,was bought by Tata Chemicalsin 2006. Blackburn Rovers, afounder member of England’sprofessional football league in1888, is owned by VH Group, anIndian poultry �rm.

These Indian outposts arepart of a broader shoppingspree by emergingmarket�rms. Their share of crossborder mergers and acquisitions(M&A) rose to 17% in the sevenyears to 2010, up from just 4% inthe previous seven years, according to a recent report by theWorld Bank. They are thesource of more than a third offoreign direct investment (FDI)in other emerging markets.Typically this sort of FDI is �or

Southnorth FDI

Role reversal

Emergingmarket �rms are increasingly buying up

richworld ones

Uphill rushCross-border M&A deals fromemerging world to rich world 2000-10

Source:World Bank

*Middle East & North Africaexcluding United Arab

Emirates (UAE)

By source

By destination

6

0 50 100 150

China

ME & NA*

UAE

Singapore

Brazil

India

Russia

Other Asia

Mexico

Sub-SaharanAfrica

Other

0 40 80 120 160 200

UnitedStatesOther

Britain

Canada

Australia

Italy

Germany

1



ganic�, which involves setting up a localfactory or branch o�ce. By contrast, directinvestment by emergingmarket �rms inrich countries (socalled southnorth FDI)tends to be �acquisitive�, which meansone company buying another.

The bulk of the emergingmarkets’M&A in rich countries comes from �vecountries, led by China but also includingIndia. America is the rich world’s main recipient, with Britain not far behind, eventhough its economy is only around onesixth America’s size. Other big targets arecommodityrich Canada and Australia(see chart 6 on previous page).

Firms from America and Europe arefalling over themselves to invest in fastgrowing emerging markets like China andIndia to escape sluggish economies athome. But why are emergingmarket�rms rushing in the other direction? Themain reason is that, like richworld multinationals, they seek access to new customers. �As a company you don’t want tobe con�ned to local growth,� says Mansoor Dailami, one of the authors of theWorld Bank report. �You want to have theglobal economy as your market.�

An acquisition is often the quickest(and sometimes the only) way to gain afoothold in a country. JBS Friboi, a bigmeat company based in Brazil, had nopresence in the American market until itbought Swift, a struggling American rival,in 2007 (see box). Tata’s purchase in 2000of Tetley, a British tea �rm, gave it instantaccess to consumers in North America, aswell as in Britain.

Slow but steady

Emergingmarket �rms may alsowant to limit their exposure to their livelybut often brittle home market. Growth inthe rich world may be slow but the investment climate is often warmer. There arebetter regulations; the tax laws are easierto live with; the courts are less capricious.

Brands are a consideration too. Ratan Tata, the chairman of the Tata group,said the chance to own the Jaguar brandwas �irresistible�. Building a brand cantake years and pots of money; buying anestablished one is often cheaper. Acquiring a richworld company can also be aquick way to get hold of technology aswell as the tacit knowhow that comes with operating a �rm inmature markets.

Moreover, a corporate presence in the rich world o�ers access to cheaper and more reliable �nancing. The World Bankstudy found that around twothirds of emergingmarket �rmswhich were active in crossborder M&A had used some form ofinternational �nancing to do so�a bank syndicate, a bond issuein foreign currency or a stockmarket listing in a rich country. Corporate bond markets in places like China and India are still underdeveloped, so a big, globally �nanced M&A deal paves the

way for future capitalraising. A deeper macroeconomic force behind southnorth FDI is

the need to put emergingmarket savings to work. The three largest emergingmarket buyers of richworld �rms, China, the United Arab Emirates and Singapore, all run large currentaccountsurpluses and so acquire claims on foreigners. (Acquisitions by�rms in Brazil and India are part of a more even twoway �ow ofcapital with the rich world.) By contrast, America funds its currentaccount de�cit by selling assets to foreigners. Much of theimbalance in savings between the rich world and the emerging

purchased Pilgrim’s Pride, a Texan chickenproducer. The deals were in part opportunistic: both companies were in �nancialtrouble and JBS was able to raise moneyquickly, some of it in Brazil’s equity market.But they also gave JBS a presence in andaccess to the American market. That in turnallowed it to export to Japan and otherAsian markets from which it had previouslybeen shut out.

Like other emergingmarket �rms,JBS found it cheaper to buy brands than tobuild them. A �eet of small vans sportingthe Swift logo sells fresh meat in the areaaround the Lins factory. The �rm is alsolaunching a branded range of highqualitysteaks. JBS already sells fresh beef fromBrazil to the European Union under theHilton quota scheme, which cuts importtari�s on meat produced to a high standard. JBS buys 2,500 Hiltongrade cattleeach year from Edson Crochiquia’s SantaIzabel farm, an hour or so from Lins. It is hisonly customer and sends inspectors to thefarm four times a year to monitor the cattle’s food and board.

Because freshness is vital to highquality food, jobs at foodprocessing �rmscannot easily be shifted to wherever labourcosts are lowest. �You have to be where thecows are,� says Wesley Batista, one of thefounder’s sons, who runs the �rm. As ithappens, the cost advantage is shiftingtowards the �rm’s richworld operations.The strong real makes it more expensive toexport from Brazil and the weak dollar is aboon to the American arm. America hasother advantages, too. Taxes are simplerand the jobs market is much slacker than inBrazil. �There are more people availablewho have the right skills and are welleducated,� says Mr Batista. Moreover, it isnow easier to persuade senior sta� to movefrom Colorado to Brazil than the other wayaround�another sign of a world turnedupside down.

Beefed upThe world’s largest meat company is Brazilian, but mostly operates abroad


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JBS STARTED IN 1953 as a butchers founded by José Batista Sobrinho in Anápolis, acity in Brazil’s central state of Goiás. The�rm expanded initially thanks to a fastgrowing Brazilian economy and morerecently by acquiring other companies. Itis now the world’s largest meat producer.In 2010 it had revenues of 55 billion reais($31 billion), only a third of which werefrom its operation in Brazil.

The JBS plant at Lins, 450km fromSão Paulo, is one of the �rm’s largest andemploys 5,000 people, working two eighthour shifts. Inside teams of butchers �lletand trim the carcasses that arrive on aconveyor belt, tossing the cut meat intoplasticlined trolleys. Much of the raw beefis cooked and canned at the plant. It is�rst ground into mince and then steamedand rotated in an oven angled like a cement mixer so that the juices run o�. Fat,salt, sugar and colouring are added to thehalfcooked mix before it is canned. Thecooking is completed at high temperaturesin the cans which are then dried andlabelled. The market for this sort of processed meat is global: the plant suppliescanned meat for Princes, a British �rm, aswell as beef toppings for pizza parlours in

Belgium and Holland. Fresh meat is a

di�erent matter. Brazilian companies like

JBS are bannedfrom exporting itto America forfear of footandmouth disease.

This is one reasonwhy in 2007 JBS

bought Swift,then America’sbiggest beef processor, based inColorado. Twoyears later it

markets is made up by the sale of government bonds. But emerging markets such as China already have their �ll of lowyieldingTreasuries and want to acquire assets with better prospective returns, including richworld companies.

The pattern of developedcountry de�cits and emergingmarket surpluses is likely to continue. Except for China, the developing world is mostly young, which means that its savingstend to be higher than those of the ageing rich world. If the commodities boom continues, it will leave the oilrich Middle Eastwith bulging trade surpluses. The upandcoming economiesmay seek to emulate China’s model, which relies on others to dothe spending. The resulting balance of global saving will meanthat emergingmarket �rms will spread themselves around therich world and employ a growing share of its workforce.

Emergingmarket buyers usually o�er cash and tend tooverpay. A study by OleKristian Hope and DushyantkumarVyas, of the University of Toronto, and Wayne Thomas, of theUniversity of Oklahoma, found that �rms from developingcountries generally bid higher than richworld rivals to buy companies in developed markets, often for patriotic, social or political reasons. Tata’s 2007 acquisition of Corus, an AngloDutchsteel �rm, is a case in point. Yet although Tata may have paid overthe odds, it got a big con�dence boost out of it, as did India as awhole. �The psychological and cultural dimensions of the dealwere enormous,� says Shamik Dhar, who covers Asian economies for Aviva Investors, a Londonbased fund manager.

Apart from a good price, the targets of such acquisitionsalso get a welcome infusion of animal spirits and an appetite forinvestment that are frequently missing from richworld boardrooms. Developingcountry bidders have created a more vibrantmarket for the control of richworld companies that keeps managers on their toes.

They often gain speedier access to emerging markets too.China is JLR’s fastestgrowing market and might soon be its biggest one. A few of the cars made at Halewood are shipped in kitform to India for assembly. That makes the cars cheaper for Indian consumers, as there is less import duty to pay. Carworkers atHalewood seem happy to be working for an emergingmarketmultinational. Above all, they are happy to be working. 7



2

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IT IS A crisp Friday morning in Santa Isabel, a small Brazilian town 60km northeast of São Paulo. Gabriel de Matos,

technology director at Paramount Textiles, is taking delivery ofthe latest machine for dyeing the wool yarn that is made here. Itwon’t look out of place: most of the equipment is less than tenyears old. The machines for spinning yarn are 40% faster thanthe ones they replaced. The new kit has allowed Paramount tosupply �nergrade wools for the men’s suits its customers make.

The factory re�t and the move upmarket was a response tocompetitive pressures that have driven many local rivals out ofbusiness. The global market for woollens has halved since themid1990s. Consumers these days prefer casual clothes, but Brazil is now too rich to compete with cotton producers in Vietnamor Indonesia. �We need a premium product like wool to coverour costs,� says Mr de Matos. China also produces wool and itsland, labour and capital are often cheaper. �Thank goodness weare so far away,� he says. �Time is money and that gives us somebreathing space.�

Paramount is copying the tricks long used by richworldbusinesses to fend o� lowcost rivals from emerging markets:better designs, newer machinery, shorter production runs (togive rarity value to each line) and faster delivery to local markets.

Britain bounded ahead in textile production two centuriesago, and established �rms have been looking over their shoulderever since. An early challenge came from the textile industry inNew England, where countless townships called Manchesterwere founded (of which one survives). That cluster soon facedcompetition from factories in the lowwage American South.

The cotton industry has carried on travelling: its technology moves easily to wherever labour costs are low. The patternhas been repeated for other sorts of ventures. More complextechnologies are harder to copy, so their di�usion has been slower. But technology eventually spreads. It is what drives economicconvergence, making large parts of the developing world bettero� year by year.

Demography is destiny again

For much of the past two centuries the knowhow that determines productivity and living standards has been concentrated in the West. That is true of hard engineering technology aswell as the tacit knowledge of how best to organise production,support markets and manage aggregate demand. Because largeproductivity gains were con�ned to the West, the populous partsof the world stayed poor.

That was anomalous. Population has determined economic power for most of human history. Now demography andproductivity are pushing in the same direction. America and Europe are demographic minnows compared with the developingworld’s two giants, China and India. And the rich world’s �nancial crisis and its aftermath is accelerating the shift of economicpower eastwards. Just as the catchup in emerging markets isspeeding up and broadening out, the rich world’s economiesseem to be grinding to a halt. If China can avoid a blowup in thenext decade, it is likely to become the world’s biggest economy�

The path ahead

Cottoning on

The West’s relative decline is inevitable but the East’s

rise will still be troublesome


THE WORLD ECONOMY

SPECIAL REPORT


though its citizens would still be poor by American standards.The big question for the global economy is whether the rap

id growth in emerging markets can continue. The broad economic logic suggests more of the world economy’s gains shouldcome from convergence by emerging markets than from the richworld pushing ahead. Each innovation adds less to richworldprosperity than the adoption of an established technology doesto a poor country. At the start of the industrial revolution the cotton industry alone could make Britain’s productivity jump. Butnow that the frontier is wider, there is less scope for leading economies to surge ahead. More of the world’s growth ought to comefrom catching up.

But contrary to some excited forecasts, the growth ofemerging economies is unlikely to continue at the same pace, orin a straight line. Economic convergence is a powerful force butcannot knock over every obstacle. And the barriers to growth become bigger as economies enter the di�cult middleincomephase of development.

Moving capital and workers from dying to rising ventures istrickier than transplanting poor rural migrants to cities in the early phase of catchup. As economies become richer they can relyless and less on the brute force of additional machine power todrive their prosperity. They have greater need of a skilled workforce and a �nancial system that is attuned to where the best returns are likely to be made. Countries thathave relied on exports to fuel their growthneed to shift to internal sources of spending, with all the associated headaches formonetary and �scal policy. In the pastmany middleincome economies haverun aground because they have failed tomeet such challenges.

Careful what you wish for

The biggest emerging markets, withtheir huge foreignexchange reserves, appear to be almost crisisproof (at least outside eastern Europe) in contrast to theseemingly crisisprone rich world. But setbacks in making the shift from poor to richare inevitable. Indeed a lesson of recenteconomic history is that countries and regions that ride out a crisis well are all themore vulnerable to the next one. Hubrisleads to policy mistakes, as the developedworld has proved so devastatingly. Sothick is the gloom pervading the richworld that the onceregular emergingmarket crises have almost been forgotten.But this makes it even likelier that theywill one day return.

Those anxious that the rich world’s economic power isebbing might welcome a few emergingmarket slipups. A lessfrantic rate of growth in the developing world would also slowthe relative decline of the West and allow it to cling on to some ofits privileges for longer. The dollar and the euro could maintain areservecurrency duopoly for longer; commodityprice pressures on businesses and consumers would ease; and the impactof developing economies on relative wages and jobs turnovermight be less jarring.

Yet the emerging markets are the best hope for globalgrowth�for the next few years at least. Japan’s economy is in afunk; the euro zone is in danger of imploding; and much of therest of the rich world is hungover from a giant credit boom.America, Britain and others took on debts that now look steep

compared with incomes andthe value of the homes againstwhich much of the money wasborrowed. They are saving hardto �ll the gap. Those with cash(including a chunk of the corporate world and not a fewhouseholds that gained fromthe housing boom) are clingingon to it because of uncertaintyabout future demand, job prospects, taxes, the supply of creditand much else.

That is the main reasonwhy a fast rate of catchup bythe emerging markets would bebetter for the West than a faltering one. A richer and more consumerled China would be likelier to buy more of the servicesin which developed countrieshave a comparative advantage.

It would be healthy, too, ifthe developing world couldbreak the rich world’s monopoly on international �nance. Theemerging markets account foralmost half of global GDP buthave no reserve currency oftheir own. For now there seemslittle alternative to the dollar asa �nancial lodestar and the main storehouse for the world’s precautionary saving. The yuan is the likeliest candidate to supplant it but has so far taken only baby steps to becoming international. The longer it takes for the yuan to emerge, the more riskythe global �nancial setup will become. The worry is that strongdemand for Treasuries as reserves might tempt America to overstretch itself. The wreckage from the rich world’s housing bustshows the dangers of money that is too cheap.

In other ways, too, it might be better for the rich world ifChina and others caught up with it sooner rather than later. Faster catchup would narrow the wage gap between emerging andrich countries and help to relieve the downward pressure on un

skilled wages. A mature Chinese economy would waste fewernatural resources on hardtojustify investments. Many in therich world fear the loss of economic dominance that will be theeventual outcome of convergence. But perhaps losing it is worsethan having lost it.

And perhaps the pessimism about America and Europe isas overdone as the optimism about emerging markets. The richworld is an enticing place when viewed from the developingworld. For all its troubles, America’s economy is a source of envy.Europe’s highend industries and luxury goods are not easilymimicked. Emergingmarket �rms �nd it easier to do business, toraise �nance and to �nd skilled workers in the rich world. Suchattributes are hard to replicate. If it were easy, the emerging economies would already be rich. 7

The growth of emerging economies will not continue at thesame pace, or in a straight line. Setbacks in making theshift from poor to rich are inevitable

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