Risk Latte - On the Great Convergence and Oil

On the Great Convergence and Oil

Aditya Rana
January 16, 2011

Martin Wolf wrote two fascinating columns in the FT over the last two weeks on the important topic of the "great global convergence" between the developed world and the emerging economies, and how this theme is likely to shape our world over the next several decades. The first part deals with converging incomes (based on the works by Angus Maddison and Prof Kenneth Pomeranz) while the second part deals with how this is transforming the world (based on the work by Professor Ian Morris). To summarise:

Part 1:

  • After centuries of economic domination by China and India, by 1820 UK output per head was 3 times Chinese levels (and the US was twice that of China).

  • This process accelerated subsequently, and by the middle of the 20th century real incomes per head in China and India were only 5 and 7 per cent of US levels.

  • This process is now rapidly reversing, with the Chinese output per head, from 1980 until 2008, rising from 6 to 22 per cent of the US while India’s rose from 5 to 10 per cent.

  • Japan led the way for Asia with its output per head rising from 20 per cent of the US after WWII to a high of almost 90 per cent in 1990 and then declining to around 75 per cent in 2008.

  • China's real per capita GDP is roughly where Japan was in the mid-60s and India's is where Japan was in the early 1950s –and if China were to follow Japan's pace of growth at a similar stage in its development, its economy would be 3 times the size as that of the US (in PPP terms) by 2030 and bigger than the US and European economies combined. India would be 80 per cent of the size of the US economy by 2030.

  • The great recession was calamitous for the developed world with its output growingby a meagre 5 per cent from 2005 until 2010, compared with 41 per cent growth for emerging economies.

  • What has changed this time compared to the previous rise of East Asian economies is the sheer scale; China and India have 37 per cent of the world population compared to only 11 per cent for the Western world- making this convergence an inevitable trend.

  • While emerging economies face many significant challenges ahead, and China and India may never surpass US output per head, the main point is that they are still far away today and getting even halfway there would, by itself, be a significantly transforming event with the periphery becoming the core.

Part 2:

  • The two poles of civilization – the western world which descended from the agricultural revolution in the "fertile crescent" of the Middle-East, and the eastern world whose origins lay in a similar revolution in a part of what is now China – have had fluctuating periods of economic dominance, with the west leading the way until the fall of the Roman empire, then giving way to the east until the 18th century, and then taking the lead once again.

  • The recurring theme of exploiting the "advantages of backwardness" by the east today makes a likely reversal of roles in the 21st century.

  • Social development is an amalgam of four factors: energy use, urbanisation, military capacity, and information technology.

  • Energy "capture" is a fundamental requirement for development; the industrial revolution was really an energy revolution –an exploitation of fossilised sunlight. Energy capture and social development go hand-in-hand and their growth has exploded over the last two centuries with the east now leading the charge.

  • The International Energy Agency forecast that energy demand could grow by 50% by 2035 and the OECD argues that the great convergence is rapidly changing the global balance of supply and demand for resources resulting in a sharp increase in real prices of metals and energy.

  • If the energy per head consumption equalises across the world, energy consumption would be 3 times the current levels.

  • The OECD highlights other implications of this convergence: a decline in the relative wages of low-skilled people in developed economies, huge gains to exporters of resources and consumers in the developed world who have benefitted from cheaper products from China and India. However, this has also led to an increase in global savings over investment with resulting lower levels of real interest rates.

  • While the convergence has led to greater prosperity and more opportunities, it also poses serious challenges in terms of the inevitable rebalancing of political power and a constraint on resources.

  • So the big question is whether human ingenuity will overcome the lack of resources to support global growth or what Prof Morris calls the "five horsemen of the apocalypse" –climate change, famine, state failure, migration and disease take control over events. Prof Morris’s view is that each age gets the idea which is needed to overcome the problems it faces.

A key part of the investment process, as I have noted in previous newsletters, is to develop a framework which identifies long term global trends in economics, markets, social development and politics, which should then be reflected in your strategic long term asset allocation. Martin Wolf highlights the “great convergence” as an "epoch-making transformation" in our world and I fully accept this view and it is therefore critical to develop an asset allocation strategy which deals with the possible implications. The "great convergence" is inevitable, and while there are likely to be serious bumps along the way, they should be viewed as attractive buying opportunities to increase exposure to emerging market equities and commodities. The developed world is likely to provide periodic opportunities to buy stocks but I would argue that a typical investment portfolio (particularly if you reside in the emerging world) should be more heavily weighted in EM equities and commodities than developed world equities.

I attach below a graph provided by the IEA which illustrates the imbalance between expected demand and supply of oil – oil demand is projected to increase by 1.2% per annum until 2035 (less than the prior growth rate of 2%) with 93% of the demand coming from non-OECD countries (mainly China and India) while oil production is expected to increase by only 0.5% per annum (half the historical rate). With conventionaloil productionpeaking in 2006, it assumes all oil gains from here forward will come from non-conventional sources and gas and coal-to-liquids programs! In addition, with China and India taking-up most of the increase in oil production, there is an implied assumption that the OECD countries will actually reduce oil consumption to make the numbers work! While this may all work out over time, the implications are that the trend in oil prices is up as reflected clearly in the graph below:

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