The convergence question
The idea of convergence is a powerful one for many emerging markets investors. But what is it? Why should it happen? What does history tell us about it?
Our full paper found at the foot of the page looks in depth at this topic, but here’s the bite-size summary:
Convergence: the theory
Convergence theory implies that if a poorer country receives access to technology from richer economies, there will be a gap between its old and new production capabilities. This enables higher levels of investment and hence growth.
Convergence: the facts
Emerging countries have a very patchy record of achieving convergence.
- Latin America:
By and large the region has made little progress. The periods of strong uptrends we’ve seen have largely been the consequence of business cycles.
Latin America stands in stark contrast to Asia, where – for example – Korea and Taiwan have converged significantly. In the early 1960s South Korea’s per capita GDP was only about 3% of that in the US. It now stands at 50%. More recently, China - after years of going backwards – has moved from under 2% of relative per capita GDP in the early 1990s to 15% today.
- Emerging Europe, Middle East and Africa (EMEA):
Again, there is not much sign of convergence among the main countries in this region.
It’s clear that countries do not naturally converge. Most emerging markets have made little progress towards US levels of GDP per capita. But there are two noticeable exceptions – South Korea and China. What is it about the economic model in these countries that has allowed convergence?
We can examine the theme through the example of the biggest convergence story of them all in the 1960s and 70s – Japan – and a country that hasn’t converged – Brazil.
- Japan: In 1960 Japanese people were only about a fifth as rich as their US counterparts, on average. At the height of the Japanese bubble in 1989 they were at parity and at the height of the yen spike in 1995, they were one-and-a-half times richer.
- Brazil: Not much progress towards convergence and a long history of underinvestment
Convergence: what Japan and Brazil show us
The contrasting fortunes of Japan and Brazil show us that governance and political structures matter. Also hidden in the history is a story of initial conditions. By definition, a less developed country lacks a capital base. To converge you must have a source of capital. Developing that capital internally is a slow process of steadily building up a consumer society in a cycle of investment, leading to a bigger wage base, leading to consumption and more savings, leading back to more investment.
To experience the sort of rapid growth that Japan (and Germany) saw after World War 2 and to secure the political structures, a large capital injection is very helpful. Japan got one via the Korean War and Europe benefited from the Marshall plan. Brazil had no such help.
What does this mean for investors?
Fortunately, emerging markets investing is about so much more than convergence. However, it can help us understand the backdrop and long-term trends that enable us to identify attractive companies.
In a rapidly-changing geopolitical, economic and demographic landscape, more and more world-beating companies are likely to spring up in the emerging world.
Navigating this complex opportunity set is not easy, but the rewards can be extremely attractive if investors are prepared to take a flexible approach to both country allocation and stock selection.
We look at these topics in greater detail in our full research paper, which is available below.