without faster growth,the world’s rich economies will be stuck

• What will tomorrow’s historians see as the defining economic trend of the early 21st century? There are plenty of potential candidates, from the remaking of finance in the wake of the crash of 2008 to the explosion of sovereign debt. But the list will almost certainly be topped by the dramatic shift in global economic heft.
• Ten years ago rich countries dominated the world economy, contributing around two-thirds of global GDP after allowing for differences in purchasing power. Since then that share has fallen to just over half. In another decade it could be down to 40%. The bulk of global output will be produced in the emerging world.
• The pace of the shift testifies to these countries’ success. Thanks to globalisation and good policies, virtually all developing countries are catching up with their richer peers. In 2002-08 more than 85% of developing economies grew faster than America’s, compared with less than a third between 1960 and 2000, and virtually none in the century before that.
• This “rise of the rest” is a remarkable achievement, bringing with it unprecedented improvements in living standards for the majority of people on the planet. But there is another, less happy, explanation for the rapid shift in the global centre of economic gravity: the lack of growth in the big rich economies of America, western Europe and Japan. That will be the focus of this special report.
• The next few years could be defined as much by the stagnation of the West as by the emergence of the rest, for three main reasons. The first is the sheer scale of the recession of 2008-09 and the weakness of the subsequent recovery. For the advanced economies as a whole, the slump that followed the global financial crisis was by far the deepest since the 1930s. It has left an unprecedented degree of unemployed workers and underused factories in its wake. Although output stopped shrinking in most countries a year ago, the recovery is proving too weak to put that idle capacity back to work quickly (see chart 1). The OECD, the Paris-based organisation that tracks advanced economies, does not expect this “output gap” to close until 2015.
• The second reason to worry about stagnation has to do with slowing supply. The level of demand determines whether economies run above or below their “trend” rate of growth, but that trend rate itself depends on the supply of workers and their productivity. That productivity in turn depends on the rate of capital investment and the pace of innovation. Across the rich world the supply of workers is about to slow as the number of pensioners rises. In western Europe the change will be especially marked. Over the coming decade the region’s working-age population, which until now has been rising slowly, will shrink by some 0.3% a year. In Japan, where the pool of potential workers is already shrinking, the pace of decline will more than double, to around 0.7% a year. America’s demography is far more favourable, but the growth in its working-age population, at some 0.3% a year over the coming two decades, will be less than a third of the post-war average.
• With millions of workers unemployed, an impending slowdown in the labour supply might not seem much of a problem. But these demographic shifts set the boundaries for rich countries’ medium-term future, including their ability to service their public debt. Unless more immigrants are allowed in, or a larger proportion of the working-age population joins the labour force, or people retire later, or their productivity accelerates, the ageing population will translate into permanently slower potential growth.
• Faster productivity growth could help to mitigate the slowdown, but it does not seem to be forthcoming. Before the financial crisis hit, the trend in productivity growth was flat or slowing in many rich countries even as it soared in the emerging world. Growth in output per worker in America, which had risen sharply in the late 1990s thanks to increased output of information technology, and again in the early part of this decade as the gains from IT spread throughout the economy, began to flag after 2004. It revived during the recession as firms slashed their labour force, but that boost may not last. Japan’s productivity slumped after its bubble burst in the early 1990s. Western Europe’s, overall, has also weakened since the mid-1990s.
• The third reason to fret about the rich world’s stagnation is that the hangover from the financial crisis and the feebleness of the recovery could themselves dent economies’ potential. Long periods of high unemployment tend to reduce rather than augment the pool of potential workers. The unemployed lose their skills, and disillusioned workers drop out of the workforce. The shrinking of banks’ balance-sheets that follows a financial bust makes credit more costly and harder to come by.
• Optimists point to America’s experience over the past century as evidence that recessions, even severe ones, need not do lasting damage. After every downturn the economy eventually bounced back so that for the period as a whole America’s underlying growth rate per person remained remarkably stable (see chart 2). Despite a lack of demand, America’s underlying productivity grew faster in the 1930s than in any other decade of the 20th century. Today’s high unemployment may also be preparing the ground for more efficient processes.
• Most economists, however, reckon that rich economies’ capacity has already sustained some damage, especially in countries where much of the growth came from bubble industries like construction, as in Spain, and finance, as in Britain. The OECD now reckons that the fallout from the financial crisis will, on average, knock some 3% off rich countries’ potential output. Most of that decline has already occurred.
• The longer that demand remains weak, the greater the damage is likely to be. Japan’s experience over the past two decades is a cautionary example, especially to fast-ageing European economies. The country’s financial crash in the early 1990s contributed to a slump in productivity growth. Soon afterwards the working-age population began to shrink. A series of policy mistakes caused the hangover from the financial crisis to linger. The economy failed to recover and deflation set in. The result was a persistent combination of weak demand and slowing supply.
• To avoid Japan’s fate, rich countries need to foster growth in two ways, by supporting short-term demand and by boosting long-term supply. Unfortunately, today’s policymakers often see these two strategies as alternatives rather than complements. Many of the Keynesian economists who fret about the lack of private demand think that concerns about economies’ medium-term potential are beside the point at the moment. They include Paul Krugman, a Nobel laureate and commentator in the New York Times, and many of President Barack Obama’s economic team.
• European economists put more emphasis on boosting medium-term growth, favouring reforms such as making labour markets more flexible. They tend to reject further fiscal stimulus to prop up demand. Jean-Claude Trichet, the president of the European Central Bank, is a strong advocate of structural reforms in Europe. But he is also one of the most ardent champions of the idea that cutting budget deficits will itself boost growth. All this has led to a passionate but narrow debate about fiscal stimulus versus austerity.
• This special report will argue that both sides are blinkered. Governments should think more coherently about how to support demand and boost supply at the same time. The exact priorities will differ from country to country, but there are several common themes. First, the Keynesians are right to observe that, for the rich world as a whole, there is a danger of overdoing the short-term budget austerity. Excessive budget-cutting poses a risk to the recovery, not least because it cannot easily be offset by looser monetary policy. Improvements to the structure of taxation and spending matter as much as the short-term deficits.
• Second, there is an equally big risk of ignoring threats to economies’ potential growth and of missing the opportunity for growth-enhancing microeconomic reforms. Most rich-country governments have learned one important lesson from previous financial crises: they have cleaned up their banking sectors reasonably quickly. But more competition and deregulation deserve higher billing, especially in services, which in all rich countries are likely to be the source of most future employment and productivity growth.
• Instead, too many governments are determined to boost innovation by reinventing industrial policy. Making the jobless more employable should be higher on the list, especially in America, where record levels of long-term unemployment suggest that labour markets may not be as flexible as many people believe.
• Faster growth is not a silver bullet. It will not eliminate the need to trim back unrealistic promises to pensioners; no rich country can simply grow its way out of looming pension and health-care commitments. Nor will it stop the relentless shift of economic gravity to the emerging world. Since developing economies are more populous than rich ones, they will inevitably come to dominate the world economy. But whether that shift takes place against a background of prosperity or stagnation depends on the pace of growth in the rich countries. For the moment, worryingly, too many of them seem to be headed for stagnation.

Brazil,absolutely the most attractive emerging market right now

• scene at the BM&FBOVESPA, Brazil’s main stockmarket, earlier this month encapsulated Brazil’s thriving alternative-investment industry. A champagne-sipping crowd milled around José Carlos Reis de Magalhães, the boss of Tarpon, a local private-equity firm, on the floor of Brazil’s slick, renovated exchange. They were toasting the successful initial public offering (IPO) of Arezzo, Brazil’s largest shoe retailer. Tarpon had bought a 25% stake in Arezzo for 76m reais ($43.8m) in 2007 and seen its investment nearly quintuple in value in three years. Tarpon’s own share price is up by 143% from a year ago. The firm counts big endowments, like Stanford University, among the investors in its $3.5 billion fund.
• Tarpon is not the only part of Brazil’s private-equity and hedge-fund industry to have attracted international attention. In September Blackstone, a private-equity giant, paid $200m to take a 40% stake in Pátria Investimentos, a local private-equity firm. In October JPMorgan Chase’s Highbridge hedge fund, the world’s largest, bought a majority stake in Gávea Investimentos, a $6 billion Brazilian fund. Brazil is “absolutely the most attractive emerging market right now,” says the boss of a big American private-equity firm. Other economies may be bigger but investments there are seen as politically riskier. The Brazilian government is less hostile in its attitudes toward private, and foreign, investment.
• Sceptics recall the last time people declared a golden age for private-equity investment in Brazil. Foreign firms and banks flocked there in the 1990s. When shocks from the Asian crisis pulsed through the country, and Brazil devalued the currency in 1999, plenty flocked out again. Some local firms survived the bloodshed: GP Investments, Brazil’s largest private-equity firm, is still going strong, as are a handful of others from that era. But most global firms left and didn’t come back until 2006, when investment activity started to rev up again.
• Brazil is returning to a bigger, more resilient economy. OECD countries saw their GDP decline by 2.7% over the course of 2008 and 2009; Brazilian GDP grew by 4.9% during that time, and by a further 7.5% last year. It is now the world’s eighth-largest economy and could overtake Britain, France and Italy to become the fifth-largest by the end of this decade. The commodities boom is one source of growth: Brazil is the largest exporter of sugar, coffee and meat, and second only to America in soyabeans. Consumer spending is vibrant. The country is the world’s second-largest market for cosmetics and the third-largest for mobile phones. Its hosting of the 2014 FIFA World Cup and 2016 Olympics will require at least $50 billion in infrastructure investments, many of them privately funded.
• Money is pouring in, as investors throng funds’ offices on bustling avenues like Faria Lima in São Paulo and Paiva de Ataulfo in Rio. Local hedge funds managed around $243 billion in assets at the end of 2010, up by 23% from 2009, according to the Brazilian Financial and Capital Markets Association, an industry group (see chart 1). Private-equity firms oversee $36 billion.
• There are several reasons for this explosive growth. One is the maturing of the country’s capital markets. Laws protecting minority shareholders’ rights, for example, have fostered confidence. Brazil’s exchange is now the fourth-largest in the world by market value. That is a boon for hedge funds, which need liquid instruments to trade, and for private-equity firms, which use IPOs to cash out their investments.
• Investors are freer to choose where to put their money, too. Brazil’s 400 or so pension funds, with assets of around $342 billion, have been allowed to place money more freely with alternative-investment firms since 2009. Pensions now account for around 22% of investments in private equity and venture capital, according to Claudio Furtado of Fundação Getulio Vargas, a university. Valia, the $6.8 billion pension fund of Vale, a miner, has increased its allocation to private equity from 1% of assets three years ago to 6% in 2011.
• The Brazilian government’s sunny view of hedge funds and private-equity firms also helps explain their growth over the past few years. In many countries governments treat private-equity firms and hedge funds with either loathing or teeth-grinding tolerance. Partly because bank loans are very short-term, the tone from Brazilian officials is different. “As a country and an economy, we need private equity and venture capitalists to invest and to help our entrepreneurs,” says Maria Helena Santana, who runs the CVM, Brazil’s equivalent of America’s Securities and Exchange Commission (SEC).

• When Brazil’s government raised the tax on foreign investment in fixed-income instruments last year from 2% to 6%, private-equity firms complained. The government promptly changed it back—but only for them. BNDES, Brazil’s development bank, has put $1.1 billion into private-equity funds, and is the industry’s top investor. Private equity accounted for a higher proportion of GDP in 2010 than in most other emerging markets (see chart 2).

• Another reason for the rise in alternatives is a decline in interest rates. The benchmark Selic rate stands at 11.25%, much lower than the 26.5% it was set at in 2003. The threat of rising inflation may have reversed that trend in the short term but rates are expected to keep falling in the long run. Brazilian investors can no longer reap extraordinary returns just from parking their money in risk-free bonds. Maurício Wanderley of Valia says he looks for returns of 25-30% on his private-equity investments, and so far they’ve been “above our expectations”. Brazilian hedge funds have posted annualised gains of 17% over the past three years, according to EurekaHedge, a research firm. (North American funds have managed 8.6% on an annualised basis in that time.)
• The buzz around Brazil will put those returns under pressure, however. Alvaro Gonçalves of Stratus, a Brazilian private-equity firm, appears dismayed at the speed with which “armies” of global investment firms are arriving. Rather than fly in for visits, they now want to set up offices and hire local deal-makers. The competition is causing salaries to rise. Jon Toscano of Trivèlla Investimentos, a private-equity firm, estimates that executive salaries have nearly tripled in as many years.
• Greater competition has less effect on the hedge-fund industry, since there are many trading opportunities. But for private-equity firms, where the number of deal opportunities is smaller, there are huge consequences. Prices for deals have already gone up in the past year—although most investors say that companies are still not as expensive as they are in China or India, where there is even more competition.
• The three largest private-equity deals in Brazil’s history took place in 2010, all of them carried out by foreign firms. Stakes in consumer-related companies are particularly prized. Carlyle Group, an American buy-out firm, did three deals in 2010, involving a lingerie company, a travel firm and a health-care company—all of them bets on Brazil’s middle class. Many local firms are ramping up their efforts to look for deals beyond São Paulo and Rio, where most of the foreign firms are based.
• Ballooning deal prices may also drive crafty local firms to invest more money abroad. 3G Capital bought Burger King, an American fast-food chain, for $4 billion last year because the management felt Brazil had become too expensive and that global firms were too busy chasing deals in emerging markets to notice the opportunities at home. “You can do a buy-out in the United States of a global brand, a well-known company, and really face no competition,” says Alexandre Behring of 3G.

• Back in Brazil, some worry that the new entrants’ preference for big leveraged buy-outs (LBOs) could damage the industry’s unusually wholesome reputation. In Brazil private-equity deals are mostly unleveraged, and often involve minority positions in medium-sized companies. That’s partly because high interest rates make debt crushingly expensive—the average rate for a commercial business loan is 29%. But even if credit becomes more readily available, Brazilian firms are nervous of it. Brazilian managers reel off the names of highly leveraged buy-outs that have tanked in the West. “I hope we can avoid the image that we are raiders and vultures,” says Mr Gonçalves. “This is the profile that these large LBO firms left in markets, and we don’t want them to do that here.”
• It is more likely that the foreigners will have to adapt to Brazil than the other way round. Unlike China and India but like many other emerging markets, Brazil has only a limited number of large firms to invest in. Private-equity investors won’t be able to swim in a sea of $500m and $1 billion deals. Given the scarcity of long-term financing, some are looking to lend instead. “A large part of our plan is to provide credit and growth-equity capital” in Brazil, says Glenn Dubin, the boss of Highbridge.
• Although Brazil’s equity markets are liquid, concentration remains a problem for hedge funds. Eight companies account for more than 50% of the market value of the BM&FBOVESPA. Shorting the shares of smaller firms is expensive because it is hard to find shares to borrow. Larger funds have to be patient when building up positions. Luis Stuhlberger of Credit Suisse Hedging-Griffo, Brazil’s largest hedge fund, says it is like being “an elephant in a bathroom. You have to move very slowly, otherwise you break everything.”
• Funds must also comply with strict requirements for transparency and liquidity. Brazilian hedge funds must report their net asset values daily and their positions on a monthly basis. These are then posted publicly on the website of the CVM for anyone to see. Thanks to the country’s long experience of volatility and inflation, most investors do not agree to long lockup periods for their money. As a result, many funds offer daily liquidity, which means they do not have much flexibility with their strategies and cannot take illiquid positions.
• Some managers complain that Brazil’s regulatory system costs them their edge, because others know what they are up to. But most don’t seem to mind too much. Transparency brings legitimacy to the industry and calms investors, many say. Frauds like Bernie Madoff’s, which have dented investor confidence in hedge funds in America and Europe, are less likely to go unnoticed in Brazil. “Madoff would never happen in Brazil,” says Eduardo Lopes of Ashmore, an emerging-markets fund.
• Indeed, other markets are moving closer to a Brazilian-style system of regulating alternative investments. Hedge funds and private-equity firms have been mostly unregulated in America and Europe, but that is set to change. Later this year, America will start to require funds to register with the SEC and disclose some of their holdings to regulators. In France hedge funds now have to report their short positions; it is possible that other countries in Europe will enact similar requirements. “The financial crisis showed that many of the choices we made before are good choices,” says Ms Santana of the CVM.
• There are still plenty of risks in emerging markets, of course. Inflation remains a worry, and Brazil’s battle to keep down the value of the real has led to other capital controls on top of the tax on foreign investment. The BOVESPA index has declined by 6% in the past month. But here too, Brazilian alternative-investment managers claim an edge because they have been through rocky markets many times before. “They’ve basically taken as much chemotherapy as you can take and survived it,” says a foreign fund manager.
• Many managers in China and other emerging markets are familiar only with good times, so some investors worry that they might not perform well if the economy stumbled. Arminio Fraga, a former central-bank governor who founded Gávea, thinks the volatile global economic environment will play to Brazilian managers’ strengths in the coming years: “There are a lot of things out there that look familiar to us, given Brazil’s history.”