The challenges of 2007

Citigroup explains why there could be problems ahead.

Looking ahead to 2007, we expect some dramatic changes. Our house view is that the global economy will slow, but that the US will achieve a soft landing, rather than a deep recession. Part of the cushion given to the US will come from falling energy prices, and part will be from continued productivity gains in industry. But the real challenges for the world economy will have little to do with how the US economy ultimately behaves.

Indeed, much of 2007 will be driven by socio-political events rather than strictly economic behaviour. Why? If 2005 and 2006 were the years of energy dominating global finance, 2007 is likely to be the year when demographic issues intersect with the path of reform. Since Deng Xiaoping began to push China down the path of market reform in 1978, many more leaders have chosen to become more serious about bringing about the legal and economic reforms needed to raise living standards and make their nations more competitive on a global scale. This set of changes began to accelerate in 1990 with a slowing of birth rates around the world and the emergence of a growing middle class, especially in developing nations. But that growth has brought about problems that have been shunted aside for the past decade or so, as nations have both absorbed and revelled in their extraordinary economic growth. In 2007, many of those problems will come to the fore, and emerging nations will be tested in their responses.

The problems fall into five basic categories that can be characterised as binary dichotomies: primary education versus secondary education; the needs of the young versus the needs of the old; the rights of women versus the growing problems of males; the shift from political right to the political left; and environmental disregard versus environmental consciousness. Depending on where a nation stands on the path of reform, these dichotomies will either be esolved in a salutary fashion, or strong divisions will emerge that could cause major problems. Making these problems more acute will be the growing current account reserves of many emerging nations, developed from some combination of exports, domestic savings and energy production.

In China, for example, all five binaries have already emerged and are the subject of concern by officials. As China continues to move up the economic ladder, it has to find an equitable way of dealing with what may be a shrinkage of manufacturing jobs in the face of rapidly rising urban wages. At the same time, there is a need to expand development to the centre and western parts of the nation, while continuing to strengthen the social safety net, improving health care and providing better retirement benefits for those who are being displaced by ChinaÆs transformation. Meanwhile, ChinaÆs leaders also want to improve the nationÆs environmental conditions, a tall order in a country racing ahead at a breakneck industrial pace. China, of course, has one edge that many nations do not. It has over $1 trillion in a combination of foreign exchange reserves, gold and a current account surplus.

On the other hand, nations such as Chile and Ireland have been immensely successful in solving some of these seemingly intractable social/demographic problems. Brazil has also made significant progress in bringing its poor into the larger economy, while reinforcing the national social safety net. India, which has been hurtling forward on a growth path as rapid as ChinaÆs, two years ago decided to take a slight step backward to reconsider the path it was taking. While some of IndiaÆs fast growth entrepreneurs and newly entitled rising middle class might resent the Indian governmentÆs decision to open more university seats to lower castes, and to place a luxury tax on private school education, these are steps that could do much to dampen social resentment as the nation moves forward.

In many respects, what is happening in emerging nations on the path of reform is not new. Back in 1960, Walt W Rostow, a University of Texas historian who later became an advisor to President Lyndon Johnson, wrote ôThe Stages of Economic Growth: A non-Communist manifestoö. Rostow described a ôrevolution of rising expectationsö that would take place in nations where entitlement was replaced by opportunity, and where populations and governments needed to make critical decisions about how to spend not only their economic capital, but their political capital as well.

Nations that have repressed their minority populations, such as the large Shiite minorities in many Arab nations, are now being confronted by those minorities, who are using the reforms in the states in which they live to press their case for more freedom, and for a greater share of the nationÆs wealth. This can create social tension that must be carefully managed, lest it turn into sectarian violence, as in Iraq. It is altogether possible that 2007 could be a year of social upheaval, as restive populations ratchet up their demands. Most nations will try to forestall a drift toward social chaos, because there is too much at risk. The run-up in emerging market equities between 2002 and mid-2006 was a signal by investors that they were willing to reward countries on the path of reform. Likewise, any perception of rising instability is likely to hurt the valuations of emerging markets.

If 2007 could be a year in which social needs begin to make renewed budgetary demands on nations, how will those nations respond? Will there be a widening gap between rich and poor that will cause nations to make painful choices. In a 2001 paper written by World Bank economist, Branko Milanovic, with data research by Shlomo Yitzhaki of the Hebrew University titled ôDoes The World Have A Middle Class?ö, the pair argued that income disparities have grown so large that with the exception of about a dozen nations, it is becoming impossible to argue that national populations are moving toward a middle class existence. Though they reach no conclusions about what growing income disparity means, history tells us that restive populations will press for change by any means.

We know that 2007 will be a critical year in managing the revolution of rising expectations because there is still an enormous amount of money sloshing around û the so-called wall of liquidity that needs to be put to work to generate jobs, to improve the social safety net of nations and to improve education and opportunity for the two billion people who have not yet risen above the poverty level. Oilproducing nations and the industrious economies of Asia have an opportunity to make investment decisions that will affect their destinies for decades to come û and which will drive foreign investments toward or away from these economies.

Clark B Winter Jnr is global chief investment strategist for Citigroup Global Wealth Management. This article first appeared in the Winter issue of Asian Private Capital.
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