Markets Insight

April 10, 2013 10:54 am

Markets Insight: EMs must respond to US industrial revival

Shale gas ‘revolution’ already making the US more competitive

Where there was darkness only six years ago, North Dakota’s shale rigs now light up the night sky in America.

The “shale revolution” in the US is a remarkable story, but it is less remarkable to an economist than the manner in which the manufacturing renaissance it could help drive is likely to turn the US into a competitor for emerging market economies.

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The US has consumed the output of emerging market economies over the past five decades, so is a manufacturing renewal enough to turn it into a competitor for those economies?

What about the effect on competitiveness of a dollar rally if the US economy revives, or the lower energy prices worldwide due to the shale revolution? And doesn’t the US produce more sophisticated products than most emerging markets – where is the competition?

First, competitiveness derives from changes in the exchange rate adjusted for inflation or wages. The inflation-adjusted value of the US dollar has fallen 35 per cent over the past decade, a major driver of the reindustrialisation story. As long as wage growth in emerging markets exceeds US wage growth, the US dollar can rally and still not erode competitiveness.

Second, US shale gas exports are restricted at the moment. Even by 2015, exports licensing will regulate trade, so the shale revolution will continue to benefit the US but not necessarily the rest of the world.

Finally, the greater sophistication of the US will be not be a problem as US manufacturing is going to do something quite rare: move down the sophistication ladder to reclaim some of the manufacturing activities it lost in the 2000s. This is what will create friction with emerging economies, which need to become increasingly sophisticated in their manufacturing. The medium-term growth outperformance emerging economies have enjoyed has an established empirical link to increasing sophistication, making it a necessity rather than a luxury.

Apart from computers and electronics, most of the areas the US is likely to recapture (transport equipment, fabricated metals and machinery, energy-intensive production) are unsophisticated relative to its current output and are the ones emerging markets would like to monopolise production of. Thus, reindustrialisation in the US is consistent with a move down the sophistication ladder.

Malaysia, China, Thailand, Russia, Brazil and Chile are the economies most at risk from this clash of sophistication, but for different reasons.

The Asian economies have shown strong medium-term growth outperformance, due to the speed with which they have raised the sophistication of their exports and manufacturing. Malaysia is even more advanced than China, but it is China that stands out globally. The sophistication of its export basket resembles that of an economy with three times its per capita GDP.

However, to maintain such outperformance, all three Asian economies will have to keep raising the sophistication of their exports and manufacturing to keep pace with rapidly rising per capita GDP, which is where they will clash with the reindustrialisation of the less sophisticated segments of US manufacturing.

The commodity exporting economies of Russia, Brazil and Chile need manufacturing to drive growth if they are to rely less on commodities. However, wages in all three economies are quite high, which prevents them from manufacturing low-end goods. This means they will be competing in the middle market segment, bringing them into conflict with US manufacturing as well.

Korea and Taiwan are also at risk if the US revives its computer and electronics sector. However, unlike the other six economies, Korea and Taiwan would be competing as incumbents and would probably be harder to dislodge.

The only outright winner is Mexico, as it is adopting the two responses available to emerging markets: passively slotting into the US supply chain, and actively pursuing structural reforms. India is also pursuing the latter course. Structural reforms are really the only way emerging economies can raise trend growth and lower inflation, thereby mimicking the impact that the shale revolution will have on the US economy.

In summary, future emerging market growth is at risk because of US reindustrialisation. How quickly reindustrialisation occurs is not something emerging economies can control, but they can control their response to this prospective threat.

Not every economy will respond successfully, and markets will increasingly reward those that do, and punish the ones that do not.

Manoj Pradhan is global EM economist at Morgan Stanley

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