The Next Frontier

It’s been years since the farmers left the farmhouses of Delhi, which are now weekend retreats for the upper class, playgrounds on the fringes of the city where unmapped dirt lanes suddenly open onto lavish mansions with sprawling gardens and water features. This is the Hamptons of India, where event planners will re-create Oscar night, Las Vegas, even a Punjabi village for the homesick, complete with waiters in ethnic garb. At one such extravaganza, I managed to chat over the pounding techno music with a 20-something scion of the farmhouse demimonde. He was a classic of the type–working for Dad’s export business, wearing a tight black shirt, hair spiky with gel. After determining that I was a New York City investor in town looking for opportunities, he shrugged, saying, “Well, of course. Where else will the money go?”

That comment sums up the overconfidence in the big emerging markets after a decade of unprecedented success. The amount of private money pouring into emerging markets has quintupled, to nearly $1 trillion, much of it in funds that make no distinction between China and Chile. And yet the latest headlines indicate that emerging markets are headed for a slowdown. Annual growth rates have fallen in Russia from boom highs of 8% in the early 2000s to 4% today, in India from about 8.5% to under 7% in that period and in Brazil from about 4% to just 2.7%. In China, which grew at better than 8% for 14 years, Premier Wen Jiabao lowered the official target to 7.5% in March. At that rate, China–which overtook the U.S. as the leading contributor to global growth in 2007–will hand back that title this year. This is part of a fundamental change in the dynamics driving the rise of poor nations. The laws of economic gravity are catching up with the BRICs (Brazil, Russia, India, China). As the age of easy money ends, the growth rate in emerging markets will slow to the 1950s and ’60s average of about 5%, punctuated by recessions and leaving more losers than winners.

As recently as 2002, emerging markets were seen as the problem children of the financial world, but in 2003 they took off on the fastest, broadest boom in history. Fueled by easy money pouring out of the U.S., the average growth rate in emerging markets doubled to 7.2%, and the number of nations growing at faster than 5% more than doubled, to 114. At the 2007 peak, all but three of the 183 nations grew as recessions disappeared. Many observers came to see this boom as the new baseline and to believe that all emerging nations were destined for decades of rapid growth as if they were all new Chinas.

It has become fashionable for pundits to look to the 17th century, when China and India accounted for about half the world economy, as evidence that these nations will re-emerge as dominant powers in 2050, as if 17th century performance offered some guarantee of future results. The lesson of history is different. Economic development is like a game of Chutes and Ladders: nations are much more likely to fall back than to keep climbing.

That’s partly because the bigger an economy gets, the harder it is to grow fast. China recently surpassed per capita income of $5,000, the same level (in current dollars) at which all previous Asian-miracle economies began to slow dramatically. Japan in the 1970s, Taiwan in the 1980s and South Korea in the 1990s–all continued to catch up to the U.S., but slower, with growth rates falling about 4 points, to 5%. In China, a 4-point slowdown would lower growth to 6%, wiping out hundreds of billions of dollars in China plays. Those include some direct investments in the nation and in commodity economies like Brazil and Russia that feed oil and sugar to the Chinese export machine.

It is a common mistake of bearish forecasters to assume that economic story lines will end in collapse rather than a new chapter. The slowdown of the BRICs will transform the global economic scene, clearing the stage for a new group of breakout nations: emerging markets that beat the expectations and rivals in their income class. That includes the manufacturing juggernaut of South Korea; the European pillars of financial responsibility, Poland and the Czech Republic; the Asian comeback story, the Philippines; the world’s best-run big commodity economy, Indonesia; and the new model of Muslim economic management, Turkey. In fact, the next two members of the club of trillion-dollar economies are likely to be Indonesia and Turkey, both large, market-oriented Muslim democracies that will serve as inspirations to struggling Muslim nations and as a lesson to Westerners who think Muslim modernity is an oxymoron.

The slowdown of the BRIC nations also sets the stage for a revival in the U.S., which looks likely to exceed its low expectations. In February, Gallup polls asked Americans to identify the world’s leading economy; 53% said China, where average incomes are still about a tenth of America’s. In coming years, China’s image will shrink to realistic dimensions, reducing pressure on Washington to raise trade barriers and to cast China as a threat. Western fears of the BRICs’ forming a political bloc will fade: China has growing trade links with Brazil, Russia, India and South Africa, but those four don’t trade much with one another. They will be hard pressed to find a common agenda.

Meanwhile, the competitive position of the U.S. is growing stronger. In the past decade, China accounted for half the growth in demand for oil and other commodities–the key factor in spiking prices–but China’s slowdown will break this commodity supercycle, with great benefits for the U.S. The currencies of many major emerging markets are rising against the dollar, which is near its lowest inflation-adjusted level since the early 1970s, producing an American manufacturing revival. The U.S. share of global exports had been falling for years, but it bottomed out at 8% in 2008 and is inching higher. Basic American strengths like rapid innovation, a relatively young population and openness to skilled immigrants are extending its lead in technology. Once again all the hot new things, from cloud computing to social networking, seem to be emerging from Silicon Valley.

The idea that the big emerging nations are taking over the world economy will cease to be the market mania of our day. The related manias for China and commodities will break. Investors betting big on emerging markets’ rising as a class will start treating them as individual stories. No nation can hope to hitch a free ride on the tailwinds of easy money and market optimism, as so many did in the past decade. They will have to propel themselves, and the new breakout nations will take the advice of a Latin proverb: “If there is no wind, row.”

Adapted from Sharma’s new book, Breakout Nations: In Pursuit of the Next Economic Miracles. The author is the head of emerging markets and global macro at Morgan Stanley Investment Management