Is ‘state capitalism’ killing emerging markets?

BOSTON — The US economy is a rusty has-been. The future lies in nimble, dynamic emerging markets like China, Brazil and Russia.

That theme has dominated the conventional wisdom, and sold many books, since the financial crisis.

Lately, however, it appears misguided.

As Wall Street sets new earnings records the “miracle economies” have quickly lost their luster. Growth is slumping. Their stock markets have shed more than 20 percent since late 2007.

So what went wrong?

Some fault bureaucrats.

“The full blame for this meltdown, and then some, can be placed at the door of their state-owned companies,” writes Ruchir Sharma, in a recent Wall Street Journal op-ed titled "How Emerging Markets Lost Their Mojo."

Sharma is head of emerging markets for Morgan Stanley. He is the author of a brilliant book called Breakout Nations, which parses why some upstart countries prosper, while most others flounder.

Sharma writes “global markets don't buy the conventional wisdom of the post-crisis years when … books forecast 'The End of the Free Market.'"

That's a reference to a book by Ian Bremmer, author and president of the Eurasia Group, a leading political consultancy.

Reached by phone in London, Bremmer told GlobalPost that he disputes much of Sharma’s thesis. Here’s an edited and condensed interview.

GlobalPost: In the Wall Street Journal, Ruchir Sharma recently argued that the failure of state capitalism is responsible for meltdown in emerging market equities. Do you agree with that assessment?

Bremmer: No. I think there are a lot of things responsible for the meltdown in the emerging market equities.

The first is that the US looks a lot more attractive right now. Growth is picking up, and the energy revolution, of course, is a piece of that. Trade, immigration and the deficit are all part of that.

The Fed is now talking about tapering its bond buying program. That means interest rates are going up. That's going to be a problem for emerging markets in terms of borrowing.

A third piece, of course, is that emerging markets are less stable, because of their middle classes. Economists think of middle classes as good markets for consumer goods, with lots of demand. In contrast, political scientists think of middle classes as citizens who are more demanding of governments. That causes instability if the governments don't respond well.

So, there are many things that have caused emerging markets to take a hit. State capitalism would be quite low on my list.

What does the declining market value of state companies say about the success of state capitalism and the risks to Western capitalism that you outline in your book "The End of the Free Market"?

When I said the “end of the free market” I was not saying that I thought state capitalism was a better system.

Economists rightfully point out that state-owned enterprises are economically inefficient. Having said that, they are extremely politically efficient. They exist to ensure the stability and sustainability of the existing political system. The reason governments have doubled down on state enterprises, especially in China, is not because they don't understand that the private sector is more efficient. It's because that's not their only priority. To pretend it is, that's a mistake.

We used to have a global free market dominated by the West and its multinational corporations. That is no longer true, particularly with the growth of emerging markets, and specifically with China on its way to becoming the world's largest economy. China is becoming larger much faster than it is reforming its state-owned enterprises out of existence.

Why is China pursuing this tactic?

The Chinese still don't innovate very well, so they lift themselves up the value chain by leveraging the attractiveness of the Chinese labor market. Once foreign corporations have invested, China’s weak rule of law means state-owned enterprises can capitalize on the proprietary technology that foreigners have developed.

I should mention that this works for privately owned national champions as well. In a country like China, you don't need to be owned by the state to be state capitalist. You just need to be preferred by the state over Western multinational counterparts in the private sector.

Baidu versus Google would be a good example of this. Huawei, with its ties to the People’s Liberation Army, would be another good example. Neither of them are state-owned, but they act like it. That's really important to understand why the Chinese aren't likely to shift to another model. Until the Chinese have the kind of educational and political systems that allow them to innovate, using state capitalism will continue to be the most attractive way for them to continue to bring technology to their own companies.

Sharma characterizes government-owned companies as “slow-witted giants.” Do you agree with that?

I think I probably do. They tend to be very large and not very agile, but they benefit from being the preferred operators of very powerful governments that set their rules.

Let's be very clear, these state-owned enterprises would not be huge today — and China would not be the success that it is today — if they had abandoned state capitalism decades ago.

Western multinationals investing in China are not interested in keeping that profit in China. They're not interested in helping China climb the value chain. They're interested in doing things as cheaply as humanly possible and maximizing profits for their own shareholders.

In that environment, the Chinese are using the advantages they have — their legal system, their political system, their size and scale, and their industrial policy — to try to level that playing field in their favor. They've been quite effective, but there's no question they haven’t been nearly as efficient as private sector corporations.

Chinese President Xi Jinping knows this. What he's not going to do is reform state companies out of existence. He will try to use the market and restrict capital to make state enterprises more efficient and transparent.

One way that I disagree with Ruchir Sharma is that he seems to believe that since these aren't performing well that means that China is going to move away from state capitalism. I don't believe that. I think they'll try to make state capitalism more efficient, but I think they will double down on the system.

Sharma cites Prime Minister Li Keqiang’s statement that China needs a “self-imposed revolution” to reduce the government's power and promote mechanisms for growth. Yet China has long maintained a tight grip on the economy. It sounds like you disagree that China is likely to pursue such reform.

The most difficult reform in the US system is taking money out of politics. The most difficult reform in the Chinese system is to get the politics out of money.

It is fundamental to the survival and stability of an existing communist system. It's fundamental to the livelihoods of the leaders that run the Chinese Communist Party and the People’s Liberation Army.

I understand that people who support free-markets don't like that system. We'd like them to do something different. But, that's very different from saying that they're going to do it.

As people get wealthier and as consumption drives more of their economy, it will be harder for Beijing to maintain state capitalism, there’s no question about that. But under current leaders Xi Jinping and Li Keqiang I don't see a fundamental change in the system.

Let's talk about other emerging nations. Sharma calls on emerging markets to “return to the path of reform including privatization and reduced government control over the economy.” Is this the right approach and are the countries in question likely to divest from their public holdings?

I think that some will. This is a complicated question. It's certainly true in a lower growth environment that most governments do not have power and they don't have the leverage to get away with the advantages of state capitalism that China does.

If you're Brazil, for example, and your markets start going down, your tendency is going to be toward more market reform. I think that that's sound advice and that's probably true for India too.

Russia is a little bit tougher. We just saw [President Vladimir] Putin in the St. Petersburg International Economic Forum basically doubling down on stimulus from oil reserves. Putin is not a guy who is going to open up and reform the economy in a meaningful way, even though he probably should.

Another interesting question is how much these countries will be influenced by China. While the Chinese state capitalist system is not a model for other economies, China will become a dominant economic influence in many emerging markets.

And, as China does, they will develop very strong relationships with state-owned enterprises in those countries. That, politically, will make it harder for those countries to create the kind of reform that Ruchir is talking about.

Let's talk about how this affects the US economy. Your book argues that the rise of China and other state-dominated emerging markets marks a trend under which much of the world will no longer abide by the Western playbook. Instead, these countries will seek power with less regard for the rule of law. Do you still think of this as a defining trend of our era or have things changed?

State capitalism has become a stronger trend of our era, what I call the “G-Zero.”

Increasingly, multinationals are operating in an environment where they have to pay much more attention to politics, and they can't invest on the basis of where the markets may be attractive.

Look at what happened with the [National Security Agency] NSA and Mr. Snowden recently, and what that means for US firms in the IT and telecoms space, Google and Facebook and the rest. Basically, it said that US firms operate under certain kinds of rules in connection with the US government and the military industrial complex. If you are a foreign IT company, if you're a foreign government and you’re looking at that you're suddenly thinking much more politically about that sector.

I see that happening in India with the retail, consumer and pharmaceutical sectors. The Indian government wants pharmaceuticals to be cheap, so they're willing to not renew patents for Western firms and give patents to local firms and let them charge a tiny fraction of what the Western firms do.

I think that as some of the emerging markets get wealthier they'll move to more reform and transparency. But, the growth of the emerging markets is happening much faster than the reform process. This is a real shift in the way the world economy is run.

It's away from the dominance of Washington consensus and the American free-market model to a much more hybridized model. The US recognizes that.

If you look at what the US is doing on trade we're not trying to do a Doha round anymore, we're not doing universalist trade. Instead, we're pursuing the Trans-Pacific Partnership and Transatlantic Trade and Investment Partnership, which are very important multilateral groups, but they're coalitions of the willing.

They're saying we can't get everyone on board, so we're going to do sub-global with countries that agree with us. That's a very smart strategy, but it's not a very global strategy. It's what you do when you've reached the end of a global free market.

So state capitalism continues to reshape the global playing field.

One thing I'd like to say is that I do believe that because state capitalism is a less efficient system, in the long-term if the US and the West continue to stick to their guns and stick with the kinds of arguments Ruchir is making, then ultimately things will move in our direction.

But, the fact is, it's going to get a lot harder before it gets easier. It's going to get harder most importantly because when China becomes the world's largest economy they will still be completely committed to state capitalism — no matter what they tell us publicly — and that's a real challenge for us. We shouldn't pretend otherwise. 

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