The global economic environment of cheap money in the past two decades has been an aberration, which has led to today’s “massive capacity destruction” of natural resources, says Pippa Malmgren, President and Co-founder of the financial services firms the Canonbury Group and Principalis Asset Management.
As a result, countries such as China are rushing to secure supplies of commodities, while economic stimulus packages implemented by governments to avert a global depression are heightening the risk of inflation, which could threaten social stability, argues Malmgren.
Speaking recently at INSEAD’s Asia campus in Singapore, Malmgren described how politics, policies and geopolitics influence business risks. A former economic adviser to former US President George W Bush and a former senior investment strategist at UBS Warburg and Bankers Trust, Malmgren believes that the end of the Cold War and the influx of billions of people into the world economy created an environment of low inflation and volatility, which she described as an “exceptional landscape”.
“A lot of people think what we had for the last 20, 25 years was normal. And in my view it was not normal,” says Malmgren.
“It was an aberration in history to have these exceptional circumstances and they are now beginning to subside. What we are coming into is an economic environment that is much more normal. It’s a return to what we have before this exceptional set of circumstances.”
Although it appears that the world economy is improving, bolstered by economic stimulus measures, while financial markets are rallying again amid rising asset values and declining volatility, Malmgren warns it would be dangerous to interpret these signals as a green light for people to increase their investment risks instead of reducing them.
With the boom years behind them, businesses are grappling with the pain of economic deleveraging by significantly reducing production capacity. Malmgren says business owners told her that “massive capacity destruction” of commodities production has occurred as a result.
For instance, Malmgren points out that worldwide production capacity of some metals has fallen by some 80 per cent, while farmers in the US are trimming their herds of dairy cows because it has become too expensive to maintain excess inventory.
So with commodities prices far outpacing equity markets, Malmgren believes these rising commodities prices will be a deflationary “margin crusher” for companies.
Casting her eye to China, Malmgren says the current economic downturn and the weak domestic IPO market are forcing manufacturers in China to raise prices, which means that China will no longer export disinflation to the world. Instead China will be a source of inflation, says Malmgren.
To be sure, inflation poses a serious threat to China, as it threatens social stability. Malmgren points out that the protests in Beijing’s Tiananmen Square 20 years ago occurred against a backdrop of high inflation, while the recent demonstrations in Tibet saw monks protesting in the streets because they were being “priced out of a bowl of rice”.
“So they (the Chinese authorities) are very petrified. Their view is that there is nothing that will rip apart the social fabric of a nation faster than inflation,” says Malmgren.
“We see that for the first time in history we have the United States, the United Kingdom, many of the Europeans, the Japanese and frankly us (China) included, blowing out all-known boundaries of monetary and fiscal stimulus, and doing it simultaneously for the first time in history.
“What do we think will happen? We think it will work. And if it works, we have no mechanism for checking our economy from inflation.”
“So now we want to have a conversation with you Americans, because we need you to stop doing this, for our sake of social stability.”
Towards that end, China’s plan is to accelerate its long-term strategy of exiting financial assets and investing in ‘hard assets’, says Malmgren. This includes building deepwater ports, bridges and roads in Latin America and Africa to secure access to commodities.
Back home, China is developing its air, sea and land infrastructure as part of this strategy, while hoarding the necessary resources, such as iron ore and steel. Malmgren adds that she wasn’t surprised that China arrested Rio Tinto’s lead negotiator in China on allegations of industrial espionage to stop Rio Tinto from effectively raising commodity prices, because the Chinese leadership was fearful of inflation.
Fear of inflation is also why China is unwilling to recycle its currency from its trade surplus with the US back into the US treasury market for fear that its investment would be diminished, says Malmgren.
Besides China, many other sovereign wealth funds are seeking to secure ‘hard assets’ in commodities-rich countries, including Islamic countries such as Indonesia and Malaysia, says Malmgren. With the influx of investment funds to these countries, foreign exchange rates will become more volatile, she adds.
“The amplitude of volatility is going to be a lot higher as a function of the macroeconomic environment,” says Malmgren.
From a broader economic perspective, the world economy may appear to be improving, but what has changed is the burden of debt that will create a new set of pressures on governments, argues Malmgren.
“The old growth trajectory was very steep, the new growth trajectory is very shallow.”
So governments will attempt to improve their cash flow by raising taxes. But as entrepreneurs create the most jobs, the greater the tax burden on them, the slower the job creation response will be, says Malmgren.
“The only thing that leads us to recovery effectively is entrepreneurial risk-taking.”
Dr Malmgren delivered a presentation titled ‘Politics, Policy and Geopolitics as Business Risks’ at INSEAD’s Asia campus in Singapore October 5, 2009.