Today your company is confronting forces that are powerful and unpredictable. They range from instabilities in the global financial system to technological upheaval and abrupt changes in government policy. At the same time, the rapid growth of the South offers big opportunities.
This chapter explains these forces and shows what they mean for you. It is necessarily long because there are many factors to take into account, but it is essential reading. The successful leaders I’ve observed in the North and the South have a broad and penetrating view of what is happening beyond the borders of their home country. They master the global external environment. They are attuned to the shifts in the economic power of various countries, to the various trends that are shaping and reshaping markets, society, and the composition of GDP, and to changing demographics that put pressure on resources.
Such mastery is the basis of the successes you will read about later in this book and the prerequisite for determining what strategic and organizational changes you need to make. If you are too impatient, intimidated, indifferent, or arrogant to build this competence, your leadership is at risk of being obsolete. I can’t say it too strongly: Whether you’re a CEO or on the front line interacting directly with customers, you simply cannot plan and operate without a solid grasp of the dynamics and rules emerging in the global external environment and causing the tilt. They are changing every facet of the world you do business in. You have to step back from the constraining details of your business and industry, view the world at large, and pick out the key trends or items that could upend the world you’re accustomed to and create once-in-a-lifetime opportunities.
In my view, the most important forces driving change are the global financial system; competition among countries playing by different rules; the expanding footprints of digitization and mobile communications and the wave of innovation they unleash; changing demographics; and the pressure on resources and their prices. Each alone is enough to disrupt your future, but you can’t just look at them singly, as discrete phenomena, because they all influence one another. If you don’t understand their interrelationships, they can sabotage your planning.
Your goal is to get to a higher altitude. It’s like the view from a plane, as opposed to the one from a car. From this perspective you can see the true character of external changes. Create a network of people you can trust, including peers in other industries and organizations, to pool observations and collectively analyze the fast-changing environment. You will want people who are diverse in their thinking, backgrounds, and appetites for risk. You can create scenarios, decide which you think is most likely, and watch closely to see if you’ve judged them correctly.
As you become more attuned to the external environment, you’ll get better at detecting not only unstoppable trends but also seemingly small hinge events—for example, the introduction of a groundbreaking product by a nontraditional competitor or new legislation—that challenge your assumptions and change the game. Your ability to see these complex shifts—either ahead of others or more accurately—will improve. You’ll get better at anticipating the actions and reactions of competitors and countries. And your psychology will shift from feeling overwhelmed and anxious to enjoying the confidence and self-assurance of a leader.
Let’s start with the global financial system. Nothing else keeps all the countries in the world so intricately connected or plays such an enormous role in driving the global economy. But the system is also the biggest cause of uncertainty and volatility in the real economy (the one of goods and services) because it has no central governing body and no set of enforceable rules.
There are four essential facts to keep in mind: It is huge. It has been growing with breathtaking speed. It is so interconnected, complex, and lacking in transparency that even experienced experts struggle to understand it; quite possibly nobody in the world does. And more than ever before, it is frighteningly unstable.
Start by considering how much it has grown since 2000. According to research from the McKinsey Global Institute, the total value of the world’s financial stock, comprising equity market capitalization and outstanding bonds and loans, more than doubled to $196 trillion in 2007. The financial crisis knocked that back to $175 trillion in 2008, but by the end of 2010 the total had risen to $212 trillion. Cross-border capital flows have yet to recover lost ground; they grew from $5.8 trillion in 2000 to $11.2 trillion in 2007; in 2010 they amounted to just $4.4 trillion.1
Many players direct those flows of money. Besides banks and traditional investors, private equity firms from the United States, London, and Europe have shifted their focus south. Despite frequent restrictions against the majority stakes they’re accustomed to in the North, they’ve been setting up special units to focus on investments in places such as China and India, providing the seed money for Southern companies to expand. Sovereign wealth adds to the firepower, especially when it teams up with private equity firms or hedge funds. Three-quarters of all such money is in the Middle East or Asia, much of it accumulated from the sale of natural resources like oil or, in the case of China, the result of its massive trade surplus, much of it with the United States. According to a report from the Sovereign Wealth Fund Institute, Bahrain, Kuwait, Oman, Qatar, Saudi Arabia, and the UAE had some $1.4 trillion assets under management in March 2010. The biggest sovereign wealth fund (SWF) of all is the Abu Dhabi Investment Authority (ADIA), which had some $650 billion in assets in the fall of 2011. Singapore, Norway, Venezuela, and China also have sizable funds. Many are managed by the world’s best financial advisers, such as BlackRock, which seek investment opportunities globally.
These sources can combine, for example, through partnerships, to create even bigger flows of money to fund investments of unprecedented scale, able to help turn a small competitor into a global powerhouse practically overnight. Or they can move in unison, wreaking havoc with exchange rates, the stock market, and a nation’s export-import balance. For example, when money managers begin to lose confidence in a nation, they can pull their funds out of it in a day—more rapidly than at any time in history—causing a devastating loss in liquidity and the attending panic. The flow of credit comes to a halt, precipitating a decline in the real economy, the situation in Greece and Spain as of this writing.
Mobile capital has driven growth around the world and in particular has fueled the tilt, expanding the economies of countries throughout the South. China is the showcase: Multinational companies from Hong Kong, the United States, Taiwan, Europe, and Japan began investing significantly there in the early 1990s, when China’s economy was small and its trade surplus minuscule. More than half of China’s exports at that point were from non-Chinese companies that took advantage of differences in labor costs and currencies—“arbitrage” is the economists’ word for seeking advantage from such differences. Even as labor costs and the value of its currency, the yuan, gradually rose, China’s huge markets and fast-developing manufacturing expertise continued to draw capital.
The speed and efficiency with which money moves around the world is a genuine marvel. But it has a dark side: volatility. Interest rate differences measured in fractions of a percentage point attract large inflows of foreign capital from one geography or asset class to another, in search of higher returns. In today’s digitized world, those who control capital can have access to much the same information instantaneously. Computerized algorithms steer much of the trading, so traders often move in tandem, creating asset bubbles and busts or sudden swings in local currencies or the prices of commodities.
Countries attempt to protect their economies from the damaging effects of such swings by controlling the flow of speculative capital. China exercises an enormous amount of control, including all inflows and outflows of capital. In addition, its roughly $3 trillion of reserves provides a strong negotiating weapon and buffer against disruption to its domestic economy. India’s government also carefully regulates foreign institutional investment (FII) and foreign direct investment (FDI), as do the nations burned by the 1997 “Asian Contagion,” when Thailand had to decouple the baht from the dollar because it didn’t have enough foreign-exchange reserves to support a fixed rate. The baht’s collapse set off a chain reaction of devaluations and financial losses in Southeast Asia and Japan. It took two years and a $40 billion IMF currency-stabilization program for the afflicted economies to begin recovering.
But it is practically impossible to confine the flow of capital or to isolate its effects completely. For example, when the Federal Reserve pumped $600 billion into the financial system in 2010 through quantitative easing (“QE2” in shorthand: the policy of buying up government bonds to increase the money supply), some of that money soon found its way to the higher interest rates of Hong Kong, where the Hang Seng Index surged and property values inflated. So much money poured into Brazil that its finance minister declared his country to be the victim of a “currency war.” As prices inflated and industrial output began to slow, Brazil imposed a 6 percent tax on bond inflows. Thailand took a similar tack to curb the inflow of money: a 15 percent tax on interest and capital gains from government and state-owned company bonds.
In October 2012, International Monetary Fund managing director Christine Lagarde warned that easy money from the central banks of the United States and other developing countries was creating a risk of “asset price bubbles” in emerging countries.2
Some forms of control—for example, manipulation to keep a currency artificially low in order to boost exports—are generally considered unfair trade practices. But recognizing the new reality, in 2011 the International Monetary Fund, which has long pushed for free flows of capital, set out guidelines legitimizing controls when a country is unable to use monetary or fiscal policy to shield itself from an onslaught. “ ‘Our policy advice clearly cannot exclude a whole swath of economic policies—still less an area where the benefits of getting it right are significant, the economic and financial risks of getting it wrong are large, and the potential global gains from internalizing multilateral considerations substantial,’ said [now former] IMF managing director Dominique Strauss-Kahn.”3
Meanwhile, capital investment in hard assets continues to flow. Mostly it runs south as Northern companies shift their investment in plants, warehouses, logistics chains, and retail outlets. Over the past decade much of the money went to Brazil, Russia, India, and China—the so-called BRIC nations. More recently, reflecting the continuing roster of nations emerging into developing status, the hot new targets include Colombia, Indonesia, Vietnam, Egypt, Turkey, and South Africa (CIVETS). Barring a global calamity, new countries will continue to join the party for decades to come.
Although North to South is the general trend, the picture is not that simple. Some capital flows against the tide as Southern companies seek access to the North’s huge markets and know-how. The flow from South to North is likely to increase as Southern companies search for bargain-priced companies lamed by the forces of the tilt. Capital can even flow both ways in the same industry, if two players with different strategies each see greener grass on the other side. In late 2011, for example, Gap announced that it planned to close a fifth of its stores in the United States and triple its stores in China. Even as Gap was pruning at home, its Japanese rival Uniqlo was building stores there—despite its relatively slow growth, the U.S. economy is still huge.
As companies of the South seek capital to grow, they often tap funding from multiple sources inside and outside their home countries. For example, in late 2011, India’s Reliance Power Limited received government approval to borrow $2.2 billion from U.S. and Chinese banks to partially fund a power project. Also, today globally connected providers of capital form partnerships and seek mega-opportunities in the South for investments. That’s why Bharti Airtel was able to buy Zain for an enterprise valuation of $10.7 billion; bankers who saw the growth potential were more than happy to fund the company’s global expansion.
Cross-border investment in financial assets—foreign institutional investment (FII)—is tilting to the South along with foreign direct investment (FDI, investment by corporations in hard assets). Stock exchanges have blossomed, and investors worldwide have been drawn there for the usual reason: the tremendous opportunities for growth. The heavy influx of money in recent years has driven up price-earnings ratios to the extent that some North-based companies list their subsidiaries in the South to benefit from the difference.
These movements of capital heavily influence which geographies and which sectors of the economy are going to grow and develop and which will be starved. A flood of money is not always a blessing, though, if the hunger for growth creates excessive risk taking or overcapacity. By destroying entry barriers, excess capital can ruin the rate of return on investment for an entire industry, as happened to the airline industry in America, Europe, and India. Foreign institutional investment also affects currency valuations, balance of payments, and geopolitical relationships. China’s immense sovereign-wealth investments in U.S. Treasury notes helped sustain the West’s appetite for consumption and suppressed the value of China’s yuan. Sovereign wealth from the Middle East rescued U.S. and British financial firms after the meltdown. Such relationships link the fates of the countries involved and change the power dynamic.
China’s trade surplus has steepened the tilt by channeling money directly into companies that compete against the North. The Chinese government owns majority stakes in some of the country’s largest companies. These state-owned enterprises (SOEs) represent some 30 percent of all industrial assets in China and are run by managers in tune with the central government’s goals and policies. Other countries have used their foreign earnings for the same purpose. In 1976 the government of Saudi Arabia created the Saudi Basic Industries Corporation (SABIC), taking a 70 percent stake. SABIC is now one of the world’s largest manufacturers of petroleum-based products and is aggressively expanding globally. It’s acquiring technology—it bought GE Plastics in 2007—and moving into growth markets, for example through joint ventures in China with Chinese company Sinopec.
There’s another way in which the South has better access to investment capital: Southern companies and their owners are more patient about getting their returns than are those in the North. “Short-termism”—an excessive focus on short-term results—is the driving force for U.S. institutional investors, which hold the lion’s share of all U.S. equities. Wall Street’s obsession with quarterly profits favors companies that basically divest their futures, even at the expense of the long-term health of the business and domestic economy. Judgment doesn’t play much of a role; proprietary econometric models (“black boxes”) direct money to or away from a sector, industry, or specific company. CEO pay incentives in most companies mainly reward leaders for meeting short-term performance goals, and those who don’t play to the tune of the capital-market dancing masters are often criticized and replaced. As long as the financial-services industry maintains its power over the real economies of the North, competitors from the South can build for the future while their Northern competitors are forced to forgo similar opportunities.
Once you see the interconnectedness of the global financial system and its importance to worldwide economic well-being, you can begin to understand why its instability is frightening. It’s a problem not just for financiers but also for Main Street corporations and individuals everywhere; and it has been compounded by the lack of political will of various government players to confront the forces that are causing uncertainty. The financial crisis that began in 2007 and reached its pinnacle in September 2008 revealed the instability and unmanageability of the system for all to see. Worse, it accelerated the tilt because it undermined Northern economies by vastly increasing government debt, raising unemployment, stifling consumption, and shrinking investment. It battered the confidence of the business community, which later became gun-shy about investing any cash it was holding. It exacerbated political turmoil in the North, drawing attention away from the South’s growing power, and in particular, the fact that the U.S. trade deficit was largely with one country: China. Indeed, I consider it an epochal transformative event, the effects of which will continue to create challenges for business and political leaders for years to come.
The crisis generated a flurry of follow-on activity in Washington, including the Dodd-Frank financial reform bill, efforts to sharpen the scrutiny of regulatory agencies, and, perhaps most important, continuing analysis and disclosures about what went wrong and what problems remain. (See the appendix “The Global Financial Crisis: Who Dealt This Mess?” at the end of this chapter for my analysis of what caused the crisis.) But realistically, a true fix is nowhere in sight. You have to prepare yourself for further problems.
The seeds of the crisis lay in the insatiable drive of Wall Street firms to maximize the shareholder value of their own firms, gaining the highest leverage permitted with novel techniques of securitization. A key player was the essentially unregulated so-called shadow banking system, which includes the $2.6 trillion U.S. money market industry. No one thought about how the unrestricted actions of individual players might combine to affect the entire system. Systemic thinking, in a nutshell, was (and still is) totally absent, so that—for example—no thought was given to the fact that some 80 percent of the risk of toxic financial instruments was flowing to one organization, AIG. It was like sludge seeping from multiple tributaries into the same narrow river, eventually clogging the flow. Compounding the problem was the philosophy of then-chairman of the Federal Reserve Alan Greenspan, who believed that markets would correct themselves. That point of view was shared by then-President George W. Bush.
The system that affects the lives of countless people around the world continues to be overseen by totally uncoordinated players. Governance of the global financial system largely lies with U.S. regulatory agencies, presidential administrations, and Congress. Its effectiveness suffers from several drawbacks. Oversight is split among multiple agencies; besides being uncoordinated, they are outsmarted by the much better-paid talent of the firms they are supposed to regulate. Moreover, there’s a constant shuffle of people between the financial-services industry and the regulatory agencies. A score of executives from Goldman Sachs alone have either taken jobs at the Federal Reserve, the Treasury Department, and other agencies or been hired by Goldman from these agencies during the past three administrations. Two of the most prominent include Clinton Treasury secretary Robert Rubin and Bush Treasury secretary Hank Paulson, who led the bailout program in 2008 and appointed former Goldman vice president Neel Kashkari to oversee the $700 billion TARP fund. While it’s important for the agencies to have expertise and intimate knowledge of the financial system, the revolving door between the big banks and the regulators does not make for the most objective or effective governance. Legislation is filtered through a number of congressional committees short on expertise and in thrall to special interests.
Even regulators striving to do the right thing, particularly the Federal Reserve, can be undercut by private players. They’re caught up in a cat-and-mouse game with the far more powerful market players. They must take these players into account when they make their decisions, because the players try to anticipate what the regulators, especially the central bank, will do so they can plan their next moves. Their next moves may nullify the banks’ efforts.
Several stakeholders outside the system itself and with no legal authority—most notably the financial ratings agencies such as Moody’s, Standard & Poor’s, and Fitch—have enormous influence on it. Their assessments of financial conditions affect the availability and cost of capital available to nations, industries, and companies. A ratings downgrade can cause a sharp drop in a company’s stock price or increase its borrowing costs. Yet there is no accountability when these firms make the wrong judgments, as they did when they gave junk securities a top triple-A rating before the financial crisis. Further, the global financial system is dangerously opaque. Trades of enormous magnitude are made outside public view through program trading and so-called dark pools—mostly algorithm-driven computerized block trades made outside central exchanges and thus not in public view and invisible to regulators—allowing concentrations of risk to accumulate under the radar. It’s one of the major reasons that markets cannot correct themselves; not all players are playing by the same rules of the game. Regulatory agencies’ back-office systems and technology are no match for state-of-the-art processors that trade in nanoseconds.
Finally, control of the financial markets is concentrated in a small number of extremely powerful firms. In Predator Nation, his account of the financial crisis, Charles H. Ferguson writes: “By the time the bubble started, American financial services were dominated by five independent investment banks, four huge financial conglomerates, three insurers, and three ratings agencies.”4 A number were so big that the collapse of any one could endanger the entire financial system. Moreover, Ferguson adds, “many individual markets were and remain even more concentrated than the whole industry. Five institutions control over 95 percent of all derivatives trading worldwide, and two—Goldman Sachs and JPMorgan Chase—control nearly half. A group of about a dozen banks controls the LIBOR—the rate used to set nearly all short-term interest rates.… The top five investment banks dominate the market for initial public offerings, frequently share portions of such offerings with each other, and charge exactly the same fee.”5
Some who are in the know tell me that the key decisions in the global financial system are made by a cozy group of fifty or fewer people from these firms. They move frequently from one company to another. Often one company poaches an entire team from another. Over time they have built informal social networks, not just among themselves but also with regulators, most of whom have been employees of these companies or will go to these companies once their short tenure in government is over.
Going forward, your understanding of how the global financial system works will help you navigate through the complexities and uncertainties using your own good judgment. You will be able to follow the trends in the availability of capital and the overall direction of its flow as well as watch for pockets of excess that might cause a break in the system. You may think, Best to leave that to the experts, but you’d be wrong. You are as well equipped as the experts to do this for three basic reasons.
First, the most respected experts, even those whose research and views are promulgated in the business press, are specialists. They look at the financial system through the lens of the narrow discipline in which they have been trained. Their insights are often tremendous and deep, but their interpretations are from the viewpoint of their area of expertise rather than the total system. Second, almost all of these specialists hold to a specific ideology. One is that markets will correct themselves, so the government shouldn’t intervene. The opposing ideology is that only regulation can prevent and correct problems. The specialists in both camps make assumptions based on their beliefs that get embedded in their mathematical models. The assumptions become opaque, and the models focus on narrow aspects of the financial system. Third, much of the information that rolls out from government and private sources is qualitative and ambiguous; the appearance of precision is often false. U.S. unemployment statistics, for example, are notoriously fickle. Almost all information from China is unreliable.
You are better off using the insight and information the experts provide to form your own view of the total system, seeing patterns at the highest level and crystallizing what really matters. Keep in mind that this is not your old environment, where you work with established, familiar norms and have developed an instinct for ferreting out the information that counts. You will need to sift through a ton of factors to select the crucial few. Go through permutations and combinations and connect them to get insight. Many people brainstorm with others to test their hypotheses; the key is to make judgments about whom can be trusted. With practice, you will hone your skills and derive your own meaning.
For example, suppose that you make automobiles in Brazil. What does it mean to you when large amounts of money flow into the country? The cars will become more expensive compared with imports, since the currency is being revalued. This could go on for a long time, ravaging your industry. What might you do to save your hide? Cutting costs won’t be enough, but maybe the government could help—not with bailouts or the like but with a policy change that would impose duties on the imports. Why would the government want to do this? You need to assemble a delegation of peers in the industry who can show what the consequences will be for the country if nothing is done.
How about an opportunity instead? You’re the CEO of an Indian company with half of its revenue in dollars and no debt, facing the same forces. If you are tracking the global financial system, you might see that you have a brilliant strategic option to go forward. With interest rates at or near all-time lows, you could raise funds through long-term borrowing in U.S. dollars and use the money to make a strategic acquisition that’s a once-in-a-lifetime chance to take your company to a new level.
Political scientist Ian Bremmer relates a telling story at the beginning of his book The End of the Free Market.6 The scene is a meeting in New York in 2009 between a group of economists and scholars and China’s vice foreign minister, He Yafei. Writes Bremmer: “The smiling vice minister began the meeting with a question: ‘Now that the free market has failed,” he asked, ‘what do you think is the proper role for the state in the economy?’ ”
As Mark Twain said about rumors of his death, the pronouncement is premature. Most countries continue to permit market forces to drive their economies. And those forces are always regulated and guided to some degree—the pure, utterly free markets imagined by economic romantics are nowhere to be found in reality. Even America, the free-market champion of the world, has some forms of protectionism, such as agricultural subsidies.
But outright protectionism is now commonplace and is going far beyond the economists’ classic examples of import tariffs and quotas to include such things as limits on equity stakes, requirements for local content, certification approvals that favor local businesses, restrictions on exports, currency manipulation, and, perhaps most insidious, massive government support for chosen businesses and industries. By comparison, previous efforts have been small potatoes. Mechanisms such as the World Trade Organization smoothed the occasionally ruffled feathers over claims of unfair subsidies and the like, and trade agreements eased the free flow of goods and services.
The extent of these controls reflects the political architecture of a nation, which ranges from the minimalist role of the U.S. government to the ironclad authoritarianism of Cuba and North Korea, modeled on Soviet-era communism. Generally speaking, a democratic architecture means less control, but not always. Singapore, for example, is a democracy, but its voters support a government that has substantial powers to shape and direct business activity.
As countries vie for advantage, businesses get caught in the crossfire. For example, in 2011 the Brazilian government used its stake in a mining company, Vale, to force a change in leadership and further its national economic development goals. Despite a successful ten-year tenure and support from investors, Vale CEO Roger Agnelli was pushed out of office because he was focusing on China rather than investing locally in job-creating industries such as steel, shipbuilding, and fertilizer. Nationalism won out over what appeared to be sound business practice.
Bremmer’s label for highly hands-on direction of an economy is “state capitalism.” If governments practicing state capitalism can execute, they can have one notable advantage in the global marketplace: decisiveness. Some countries can execute better than others. Democracies, with their need to balance conflicting views and demands, will move slowly in the face of domestic divisions. Indeed, they can become so indecisive as to be almost paralyzed, as in the cases of Japan and Italy, owing to their political architecture. Lately the United States has fallen into a similar gridlock because of its highly polarized politics. Democracies, it seems, act swiftly and decisively only when they face real or perceived national emergencies that draw their fractious constituents together.
No country practices state capitalism more skillfully and aggressively than China. Because it is destined to overtake the United States in GDP in the not-so-distant future, you should understand in some detail how the country operates. China’s approach marks the first time in modern history that a nation has the economic clout of a major trading partner yet relies on the competitive tactics of an upstart. Its version of state capitalism is particularly effective because it combines several elements: well-informed and pragmatic planning by world-class experts, including consultants from the North; a political architecture that coordinates governmental bodies and holds them accountable; an execution machine with rewards and punishments from central levels to the local level; and a hybrid form of business enterprise that blends business and government.
China defends its intense government involvement in building businesses by pleading necessity. Its goals are staggeringly ambitious: continuing the transformation of a nation with a current population of almost 1.4 billion people from poverty to prosperity, while at the same time expanding personal freedom in a controlled, incremental fashion. Its leaders are deeply—and not unrealistically—afraid of social unrest that could derail its phased transition into the modern economic world, and so they do all they can to keep jobs growing. These days, for instance, the increasing income gap between the rural and urban populations is driving a program to create new, smaller urban centers anchored around manufacturing.
But China’s actions also reflect broader global intentions: to make the yuan a reserve currency, build extraordinary financial reserves, secure natural resources from around the world—and be a world leader. Its immediate focus is on economic power. For example, through the building of roads, ports, and pipelines, it has shown its intent to funnel trade flows with the South into the Chinese heartland. With economic power comes political power.
Singapore was a valuable model for China. From Lee Kuan Yew, Singapore’s first premier, the Chinese learned the strategy of building an export-based economy: Bring manufacturing in with wage and currency arbitrage, then move up the value chain; be sure to put competent people in charge, with pay incentives linked to economic performance. But China far surpassed the master in guiding capitalism to the state’s advantage and also put into practice one additional piece of advice: Build foreign reserves that will shield you from the unpredictability and wild swings of democratic capitalist societies.
China makes its economic priorities explicit and targets specific industries to develop in its five-year plan, a comprehensive document that lays out everything the state hopes to achieve in the coming period in great detail. It is now executing its twelfth five-year plan. One of the stated goals is to develop seven “strategic emerging industries”: alternative energy, biotechnology, new-generation information technology, high-end equipment manufacturing, advanced materials, alternative-fuel cars, and energy-saving and environmental protection. (It has already become the world’s largest maker of wind turbines and solar panels.) “Five-year plan” conjures up memories of the old Soviet Union’s recurring central planning failures, but China’s plans have nothing in common with those fantasies. Instead they are pragmatic undertakings built on factual information, compiled and executed by highly educated experts working with rigorous analytics and methodologies—and held accountable for the outcome of their work.
As Kenneth G. Lieberthal of the Brookings Institution explains in his 2010 book Managing the China Challenge, a top-down appointment system ensures that every political and party leader is sensitive to the goals and concerns of the leaders directly above him or her. Lower-level leaders control the bureaucratic agencies in their own jurisdictions, the courts, and local bank branches. They can decide the outcomes of legal decisions of real concern to them and dictate which local bank branches will provide credit to which projects. They can promote the growth of favored enterprises in their local jurisdictions through such means as granting business licenses (and changing them) and making available land and below-market-rate credit.7 This arrangement gives a Chinese mayor considerable power over multinational companies that compete against indigenous companies.
Local control is tightly linked to China’s central plan. Chinese government officials retain or do not retain their jobs based on how well they contribute to the goals of the leaders above them. They are assessed in writing every year, and here’s what’s especially revealing: According to Lieberthal, about 60 percent of the metrics that have been used to measure performance have directly or indirectly reflected GDP growth over the previous year. The system isn’t perfect, but it has been effective.
The line between business and government disappears with China’s state-owned enterprises (SOEs). Unconstrained by the need to turn profits, they are primarily vehicles for advancing national self-interest, for example, by procuring raw materials abroad. Chinese SOEs spent more than $100 billion buying mining and energy companies over the past five years8 and more than $5 billion to secure copper from places like Afghanistan and Zambia. In 2011 a consortium of five state-owned companies bought a 15 percent stake in the world’s largest producer of niobium, a hard-to-come-by metal used to strengthen steel for such things as jet engine components and superconductor materials. In 2012, China National Offshore Oil Corporation (CNOOC) made a $15.1 billion offer to acquire Nexen, one of Canada’s largest energy producers, a company with capabilities at the frontier of energy extraction, including drilling for natural gas in shale rock and deep-sea drilling in the Gulf of Mexico.
Is China’s version of state capitalism a sustainable new model? Probably not.
Some of China’s huge trade surplus is due to labor arbitrage and low currency valuation, neither of which is sustainable. Already wages are on the rise in the industrial centers, and lower-cost players such as Vietnam and Bangladesh are capturing business that previously would have gone to China. This trend will inevitably continue. In some cases, production is trickling back to Northern nations. The basis of competition will increasingly shift to traditional levers, such as technological advantage and managerial prowess. While some private Chinese companies—Haier and Huawei, for example—have built muscle as global players, SOEs have yet to prove they have an edge over North-based companies in decision making, execution, resource allocation, and innovation.
The core problem is the classic flaw of any economy where government dictates investment policies: politics tends not to respect the efficient deployment of capital. Showering unearned money on enterprises is usually wasteful (a mistake the North makes too when government picks a favored “industry of the future” to subsidize). China’s system for allocating capital to SOEs has produced some winners, to be sure, but it’s also created spectacular losers. For example, as Bill Powell wrote in Fortune magazine: “China’s solar energy industry has become nothing less than a capital destruction machine, with some of its most prominent companies now desperately flailing for lifelines.” The same is true of most Northern solar companies, driven to the wall by China’s low-priced output. Powell cites research by the Sanford Bernstein securities firm to suggest that “solar is turning into the DRAM industry: a business which for decades was a capital intensive, low profit tong war, waged between Japanese competitors and, later, Korean companies, led by Samsung—which eventually emerged as the clear industry leader.”9
Of course, this could be another instance of the clash between a relatively quick payoff and the long-term rewards of patient capital. For example, Japan has now joined Germany in rejecting nuclear power, which will inevitably increase the demand for solar. In an energy market with as many uncertainties as this one, it could be a gamble that pays off eventually. But gamble would seem to be the key word.
China’s internal stresses—for example, growing income inequality and pressures for more democracy—could throw sand in the elaborate gears and compromise its ability to execute the twelfth five-year plan. “China 2030,” a World Bank report prepared in cooperation with China’s Ministry of Finance and Development Research Center of the State Council, issued in June 2012, stressed that structural reforms to create a market-based economy are critical to the country’s success. Among them are rebalancing growth toward domestic consumption and away from investment and exports, and—most notably—cutting back China’s state-owned enterprises and giving more support to private enterprise. However, until its domestic economy can absorb the prodigious output of its factories, China’s policies are unlikely to change much. Quelling social unrest will likely require expanding inter-party democracy, a delicate process in a system that permits little political input from its citizens. President Hu has been vocal about opening the nation to diverse voices, but so far experimentation has been strictly at the local level.
How China’s leaders deal with these issues could alter the speed and direction of the tilt from North to South. After some three decades of GDP growth averaging about 10 percent annually, the pace of China’s growth is generally expected to average 8 percent or less over the next several years.
As to the putative failure of the free market, the United States has a track record more than two centuries long, and has been a model for most of the world’s successful economies. It operates on the premise that freedom of choice and secure property rights are what enable individuals to create economic growth, and business leaders to exercise initiative and make their companies flourish through innovation, productivity gains, close attention to their markets, and new business models. New initiatives and new technologies can flourish because of highly sophisticated institutions that have the expertise and willingness to fund risky projects—and de-fund those that can’t earn their way.
While technologies can be bought or copied, their deep and institutionalized wellsprings are difficult if not impossible to duplicate. Silicon Valley, for instance, is an institution in itself, an intellectual community of unsurpassed talent and collaboration. In addition, these advantages are supported by the world’s most advanced educational institutions, a relatively mobile workforce, and the effective melding of diverse people from other nations. Just as important, the same institutions that fund risky projects are quick to de-fund those that don’t earn adequate returns on capital. Government-supported companies, by contrast, most often don’t have this check on their ambitions. They don’t have the same imperative to develop the muscles of productivity, innovation, and competitiveness. And they aren’t impelled to develop competent leadership.
Finally, keep in mind a quote generally attributed to Winston Churchill: “Attitude is a little thing that can make a big difference.” Americans have always understood that they live in a place where a nobody can still become a somebody.
America’s current challenge is its lack of a coherent plan for solving the trade and federal deficits and promoting its economic power through long-term investments in such essentials as infrastructure, education, and basic research. The division of powers inherent in the American political system has made democracy viable over the long haul. But bitter partisan battles have put it at a big disadvantage in comparison with the focus and effectiveness of China’s guided capitalism. Once the United States overcomes its political gridlock and arrives at consensus on a national economic agenda, its businesses will be better supported and trade imbalances will improve. And as it moves toward energy independence by developing its shale gas and “tight oil,” it will not only reap huge revenues and create vast numbers of jobs; it will also have more strategic leverage in the world.
Innovation, productivity improvement, new business creation, and individual and state initiatives are alive and well, as is the sine qua non of a democratic society, leadership from below. Many states stimulate their economies with focused programs that invite foreign direct investment that creates jobs. People in these states have elected politicians who moderate local laws and state expenditures to create an environment more conducive to building a business, thereby improving the employment picture, tax base, and overall frame of mind about the future. It will take just a small core of leaders from both the executive office and the legislature who bridge the gap at the level of national policy to change the trajectory. A workable consensus in the areas of taxes, infrastructure, innovation, education, immigration, and regulation—like the one reached during the financial crisis with passage of the Troubled Asset Relief Program (TARP)—will create the opportunity for America to pick up the pace and regain its economic and technological leadership in the eyes of the world.
Business, of course, has its own major role to play, by itself and in conjunction with government and academia. Useful advice comes from Harvard Business School’s Competitiveness Project, which has put together a multipoint plan for businesses to pursue, ranging from continued devotion to productivity to improving skills, upgrading supporting industries, and reining in self-interested behaviors that in the aggregate detract from economic performance.10
The tug-of-war will continue, especially in times of slow growth. Advantages will come and go. But the world is still growing. For all of the trouble and angst it causes Northern nations and businesses, China’s success is also creating huge opportunities and driving the other economies of the South closer to one another. For you as a business leader, long-term success in the tilt means staying alert to the tactics countries use to bolster their own economies while building a business strong enough to win customers now and in the future.
The changes flowing from digitization are so continual and fast that trying to grasp their overall impact is like trying to gauge weather patterns while standing in a hailstorm. Many of the details are familiar: digital technology lowers cost and shortens cycle time; it allows companies to reach high volumes and generate cash quickly without a lot of capital; it pinpoints market segments and individual customers; it disrupts traditional marketing and distribution channels and radically changes relationships between businesses and consumers … and the list goes on. But here’s the big picture: digitization is making opportunity more ubiquitous, allowing new forms of value creation, and changing the composition of the global economy. It will increasingly alter value chains, eliminating intermediary links and upending old notions about scale economies.
Many current assumptions are already under assault. Take, for example, commoditization, the fear that haunts almost every business. Digital technology has widened and accelerated the threat. Yet just now emerging is a new generation of digital technologies that portend the exact opposite: the de-commoditization of product lines. Versatile and flexible computer-driven machinery can produce ever smaller batches of product—all the way down to batches of one—at costs not much greater than those of large-scale production. For example, using so-called 3-D printing, or “additive” manufacturing technology, machines shape material into whatever configurations the computer code tells them to. Instead of retooling equipment for each change, manufacturers need only to reset computer codes to produce a different item. The impact promises to be profound. Businesses will increasingly be able to build products where the customers are, instead of in big plants hundreds or thousands of miles away. As it develops, this trend is likely to speed the innovation cycle, redefine supply chain and distribution logistics, drive costs down further, and make wider varieties of goods available to more people. And it may erode some of the South’s advantages. Almost needless to say, it will force businesses to rethink their operations and planning.
Another huge result of digitization is the ability to create an entire new global industry from scratch in just a few years. Companies including Google, Vonage, Skype, and Apple are moving into the flow of telecommunications and creating cross-industry disruption. They have already begun to capture voice and data portions of the growing industry revenue earned by telecom carriers, and there’s reason to think that their portion will grow. In addition to their cost advantage, they aren’t bound by any legacy mind-set—and unlike their competitors, they are unregulated.
Internet-based marketing is still rewriting established rules of selling. Amazon, which may be the most sophisticated Internet company in the world, has not only an impregnable cost structure and delivery method, but an unsurpassed ability to understand and target its customers with algorithms that track their buying habits. After shaking up the bricks-and-mortar bookstore business model, it is doing the same in consumer goods ranging from apparel to appliances, challenging retailers such as Best Buy and even Walmart; suddenly the onetime maverick in retailing is a traditional player under assault.
Add mobile technology to the picture. Consumers get information about where to buy, learning, for example, that as they walk toward Main Street there’s a shoe store just a block away. They can call up a variety of reviews, including those by fellow consumers, compare prices, and then go online to buy what they’ve seen—cheaper and with free delivery. These engagements create revenue-generating opportunities for some, destroy them for others, and squeeze a lot of capital investment out of the value and supply chains.
Social networking is another game-changer, though the game is still one of guessing. We know that it can spread new ideas and influence behaviors on a massive scale, in moments. It can do everything from creating instant new markets for consumer products to unseating governments (think Arab Spring). Facebook’s disappointing IPO in 2012 made clear that many questions remain about how powerful a marketing tool social networking can become. But its potential seems vast; businesses are only beginning to explore ways of using it to pinpoint and satisfy consumer desires—and, with mobile phone apps, in real time.
The ability to compile and manipulate increasingly large data sets—so-called big data—promises to dramatically reshape business activity. The McKinsey Global Institute calls it the next frontier for innovation, competition, and productivity, adding: “The use of big data will underpin new waves of productivity growth and consumer surplus.” For example, says McKinsey, “We estimate that a retailer using big data to the full has the potential to increase its operating margin by more than 60 percent.”11
The explosion of big data comes from the increasing volume and detail of information captured from multimedia, social media, businesses’ own operations, and the so-called Internet of Things—information from sensors embedded in physical objects ranging from pacemakers to roadways, to billboards in Japan that scan passersby to assess how they fit consumer profiles and instantly change displayed messages based on those assessments. McKinsey notes that capitalizing on this torrent of information will command the attention of not just data-oriented managers but leaders at all levels: “Organizations need not only to put the right talent and technology in place but also structure workflows and incentives to optimize the use of big data.”12
The most dramatic change of all may be the power of digital technology to create structural changes in the composition of national economies. For example, mobile communications networks are leapfrogging the time-consuming process of extending landlines to the far reaches of places such as India and Africa, disbursing information and even medical care and increasing people’s appetites for a better life.
But do those changes also portend job losses on a huge scale? Some digital-based industries can grow revenues exponentially in a very short time without creating many jobs. In their book Race Against the Machine, Erik Brynjolfsson and Andrew McAfee argue that “computers (hardware, software, and networks) are only going to get more powerful and capable in the future, and have an ever-bigger impact on jobs, skills, and the economy.”13 The worry arises from the growing capability of computers to replace human input in realms once considered beyond the machines’ capabilities. Take pattern recognition, essentially a machine version of the human ability to learn in real time and adapt to changing conditions. Pattern recognition is the basis of the algorithms that Amazon and a host of unknown companies use to worm their way into the lives of consumers, by aggregating information gleaned from Web activities into precisely targeted sales pitches. It’s noteworthy that Google, not Toyota or General Motors, modified a fleet of cars to drive thousands of miles on public roads without any human involvement. Another new humanlike computer power is complex communication—the ability to converse with human beings even in situations that are complicated, emotional, or ambiguous. Early in 2012 Citigroup announced that it was looking into uses for IBM’s Watson, the supercomputer that caught the public eye when it beat two of the best contestants of the game show Jeopardy! IBM has partnered with the health insurance plan provider WellPoint to put Watson to work helping medical professionals diagnose treatment options for complicated health issues. And Citi, citing Watson’s ability to analyze human language and process vast amounts of information, was expecting to give it a job in customer service.
From the early days of the industrial revolution onward, of course, critics of “automation” have constantly worried about the loss of jobs. Maybe this time they’re right. But consider the finding from a recent Booz Allen study called “Maximizing the Impact of Digitization.” Among other things, the authors measured that impact in 150 countries and came up with some striking information. “An increase in digitization of 10 percentage points triggered a 0.50 to 0.62 percent gain in per capita income,” they found. “The more advanced the country, the greater the impact of digitization appears to be, which establishes a virtuous feedback cycle; a country reinforces and accelerates its own progress as it moves along the line.” What about job losses? In fact, they found that digitization creates jobs: “A 10 percent increase in digitization reduces a nation’s unemployment rate by 0.84 percent. From 2009 to 2010, digitization added an estimated 19 million jobs to the global economy, up from the estimated 18 million jobs added from 2007 to 2008.”14
The one certainty today is that digitization will play an ever-expanding role in shaping economic activity. The old agenda items associated with digitization—product and process productivity and quality, portfolio adjustments to reduce capital—will be superseded. Almost all companies will need to center their strategies on innovation and the implication of digitization. It will change every ecosystem and supply chain.
Another characteristic of the new world economy will be invention of a type and scale never before seen. Major innovation in the latter part of the twentieth century was, for the most part, institutionalized: highly concentrated in large companies such as Intel, Motorola, Siemens, and Bell Labs and in universities such as MIT, Stanford, and Harvard, and created by a relatively small number of people, most of them experts in one discipline or another. More recently, American tech entrepreneurs have been changing the world. Prominent among them: Steve Jobs, Marc Andreessen (inventor of the browser and now Silicon Valley’s most influential venture capitalist), Jeff Bezos (Amazon), and Mark Zuckerberg (Facebook).
Now a whole new population of innovators is in sight. Vast swarms of people, especially knowledge workers—though also including some who may not even have gone to college—are innovating around the world. Their ability to do so singly and collectively comes largely from the increasing real-time openness and democratization of knowledge and availability of startup funds in a digitized world. The latest help comes from cellular communication. The world’s two and a half billion mobile phone users—a number that grows daily, along with the proportion of smartphones in the mix—are able to share information they could never before access. Much of this innovation is at the local level for the local market, and some will find its way from one country to another. Online contests and crowdfunding help small-scale entrepreneurs get the money they need to develop their ideas.
The new population of innovators will also include many who work in large corporations, according to Scott D. Anthony, managing director of Innosight Asia-Pacific and author of The Little Black Book of Innovation.15 “The revolution spurred by venture capitalists decades ago has created the conditions in which scale enables big companies to stop shackling innovation and start unleashing it,” he writes in Harvard Business Review.16 Taking a page from start-up strategy, he says, they “are embracing open innovation and less hierarchical management and are integrating entrepreneurial behaviors with their existing capabilities.… It’s early days still, but the evidence is compelling that we are entering a new era of innovation, in which entrepreneurial individuals, or ‘catalysts,’ within big companies are using those companies’ resources, scale, and growing agility to develop solutions to global challenges in ways that few others can.”
As the tilt expands the world’s human needs and capabilities, businesses surveying the boundless opportunities have their eyes particularly on the exploding middle class, with its millions of new consumers. But you need to be nuanced in how you think about the middle class—it’s really many different segments, and they change quickly. You will have to identify these segments and prepare for more frequent strategy changes if you hope to succeed in this diverse and constantly evolving marketplace.
Even defining “middle class” is a tricky undertaking. One respected set of estimates comes from the Brookings Institution, in a 2011 report by Homi Kharas and Geoffrey Gertz.17 They define the global middle as households with daily expenditures between ten dollars and one hundred dollars per person in purchasing-power parity terms. But the ten-dollar threshold implies that some countries have no middle classes at all. As the Economic Times of India noted, “Everyone spending that much is in the top 5 percent here.” Nancy Birdsall, an economist who founded the Center for Global Development in Washington, D.C., suggests a four-dollar lower limit to include what she calls a “catalyzing class” of people who are not poor but not quite middle class, with implicit opportunities for upward mobility.18
Using the ten-dollar figure, and drawing from available data for 145 countries accounting for 98 percent of the world’s population, Kharas and Gertz reach a strikingly optimistic conclusion: “Our scenario shows that over the coming twenty years the world evolves from being mostly poor to mostly middle class. 2022 marks the first year more people in the world are middle class than poor. By 2030, 5 billion people—nearly two thirds of the global population—could be middle class.”
The distribution of spending by that middle class will be significantly different from today’s. Asians will spend the most. The authors note that “by 2015, for the first time in a hundred years, the number of Asian middle class consumers will equal the number in Europe and North America. By 2021, on present trends, there could be more than 2 billion Asians in middle class households. In China alone, there could be over 670 million middle class consumers, compared with only perhaps 150 million today.”19 Yet as the chart shows, raw numbers alone don’t paint the complete picture: China has more people than India, but India’s middle class is younger than China’s and will account for a considerably larger share of global consumption by 2048. Kharas and Gertz estimate that by 2030 India will account for approximately 23 percent of global middle-class consumption, China 18 percent, the United States 7 percent, and Germany and France 2 percent each.
Consumer-goods companies from the North, such as Coca-Cola, Colgate, and Unilever, have long had a global presence, but now shoppers on every continent stream into retailers such as Wal-Mart, Uniqlo, and the Gap. Audis sell briskly in China and India, and KFC is a mainstay restaurant in places as far-flung as China and Nigeria. Local businesses in the South, both small and large, have also benefited. Indian consumer-goods company Marico has expanded its reach to several countries in Asia and the Middle East, giving its top line a 44 percent boost in five years. As these companies expand, so does the number of people on their payroll, and the middle class grows.
The tremendous demand for resources has accelerated the progress of countries that possess them. Among these are the chronically underdeveloped countries of Africa. In many, the inflow of money has combined with some degree of political reform to allow the emergence of a sizable middle class for the first time ever. Another beneficiary is Indonesia. Japanese bank Nomura estimates the middle class of Indonesia—a large exporter of oil and coal—at fifty million, larger than India’s.20
The great demographic shift makes a compelling case for any growth-seeking company to focus on the South. But don’t paint an entire hemisphere with the same brush. India, for example, is not one economy but many, with its states of Gujarat, Maharashtra, and Karnataka far more economically advanced and likely to grow much more than Orissa or Uttar Pradesh. Bharti Airtel has defined thirty-eight distinct geographic markets in India and 106 distinct microgeographical markets in Africa called Zones. China too has big internal disparities between its relatively well-off industrial centers and its vast countryside.
There are two other important things to note about the global middle class.
First, it will increasingly be urban. Across the South, as they did earlier in the North, people have been moving to cities in large numbers, generally to escape the desperate poverty and depleted farmlands of rural villages. According to WHO, 53 percent of the world’s people now live in cities. By 2050, that figure should rise to 75 percent.
From Mumbai to Shanghai to São Paulo the residents of those cities have been finding jobs linked with exports to Europe, Japan, and especially the United States, and are rising from satisfying basic needs to buying a wide range of products and branded goods. Expanding local economies draw more people to the cities and enlarge the middle class. Those lucky enough to have a formal education have begun to take positions as engineers, programmers, analysts, marketers, and managers in both domestic and foreign-owned companies.
Their spending creates all sorts of new businesses, many with expanding opportunities of their own. And it doesn’t take a degree to become a successful entrepreneur. A Wall Street Journal story datelined Lima, Peru, captured this chain of opportunity concisely:
Aquilino Flores was a ragged looking 13-year-old when he started his career hawking T-shirts in the barrios of this capital city. Today his company, Topitop, is Peru’s largest apparel maker, with a chain of stores extending nationwide.
Over the past decade, as Peru transformed into one of the world’s fastest growing economies, upwardly mobile consumers began snapping up Topitop polo shirts and cargo pants made of high-quality fabrics and marketed under exotic sounding labels.
With stores strategically located in long-ignored barrios and provincial towns, Topitop’s sales have expanded six-fold since 2001, earning it the nickname “the Andean Zara.”
Shopping at a Topitop mall store in Lima recently, David Caceres, who runs a tiny car repair business here, bought a dressy pullover from the company’s “New York” label and a star-emblazoned T-shirt from its edgier “Hawk” line. “I’ll still have money left for movie tickets,” he says.21
Second, the middle class will be relatively youthful. The average age in some of the largest countries of the South is considerably younger than in the North. Half the population of India is below the age of twenty-seven. Sub-Saharan Africa is younger still. China’s population is relatively mature, creating tension between its need to consume and its need to save. These differences combine with cultural ones to create many marketing segments and subsegments, the composition of which can change very fast. (Visit populationpyramid.net for instant graphic depictions of these age differences.)
Note that the future of these young people depends on rising prosperity. They need jobs, and they need to be educated and trained for them. A country’s GDP has to grow fast enough to absorb those coming of working age, and the education system has to keep pace. High unemployment among young people is a major source of social unrest. Consider the 20-plus percent unemployment rates across the Middle East and North Africa around the time of the Arab Spring.22 Shirish Sankhe of McKinsey’s Mumbai office explains that “India’s gross domestic product needs to grow by more than 10 percent a year just to keep pace with the growth of the workforce, which is expected to increase by about one-third over the next 20 years.”23 Sankhe goes on to say, “Close to 270 million people will be entering the workforce. Yet the real job creation will be closer to 120 million to 150 million. That means the rest of the people will have to stay in agriculture.”
A weak education system can put a crimp in a company’s expansion plans or at least make it more costly to operate. In many high-growth countries, the supply of people trained as managers, marketers, engineers, and financial analysts has not kept up, creating a fight for talent and driving up wages. Salaries of senior managers and engineers in Brazil often match or exceed those in the United States. Some companies try to fill the void by providing training, but scarcity also affects retention. Engineers in India are known to jump ship frequently in search of a salary increase. Salary increases of 15 percent a year are normal for some jobs in India.
For a company doing business around the world, the growth of a youthful middle class adds up to a marketplace of mind-bending diversity, with segments that constantly change and mutate. To take one example, people earning three thousand dollars a year now in China could be making six thousand in three or four years and traveling to Canada and the United States. Cross-border mobility in many regions will add to the complexity of segmentation. Companies will have to identify the needs of all these segments and work backward, rather than hoping to modify existing products. They will have to master fast changes in communications and channels to customers; they will have to pinpoint subsegments including, for example, ethnic and religious groups within a given segment, with many distinct values and tastes of their own. Mastery of the local demography and its evolution will be central to winning.
While most eyes are on the middle class, however, it is not the only large-scale game on the planet. The bifurcation of income distribution between the very wealthy and all the rest will only increase. This is an unstoppable trend: In absolute terms, the profits going to those in the upper reaches of giant organizations can only increase. They will become an ever-larger market for makers of luxury items, from clothing and homes to cars, yachts, and airplanes.
At the other end of the spectrum, companies are designing products at low price points in emerging markets. So-called frugal innovation is likely to effectively expand the middle class by increasing its purchasing power. It will also open new markets among the poor. Hindustan Unilever and Procter & Gamble, for example, have designed low-cost detergent products tailored to the needs and constraints of India’s impoverished rural sections. Tata Chemical’s Swach water purifier is aimed at the same market; it filters water through rice husk ash and can provide a family of five with safe water for thirty rupees (less than a dollar) a month.
The burgeoning population of new consumers strains the world’s resources, including food, water, fuel, and minerals. Human imagination and capital usually remedy imbalances between demand and supply, but they cannot always keep up in the great new spurt of prosperity. The magnitude and speed of the increases in demand, coupled with the time lag in increasing production or finding substitutes, make for a new insecurity in what used to be dependable supplies. Governments that limit exports to satisfy their own economic plans exacerbate the problem, as do increasingly large and powerful suppliers with greater control over prices. The resulting imbalances have the potential to slow seemingly unstoppable economic expansion in some places, and also to create tensions among trading partners. At the least, they sabotage strategic plans, both short- and long-term. Here again, business leaders must hone their thinking, particularly in analyzing government involvement or control that disrupts the natural market forces.
China has been the biggest disrupter as both a buyer and supplier of resources. The country’s unmet needs and long planning horizon ensure that its appetite, albeit somewhat curbed by a recent slowdown in economic growth, will continue. It gets oil not just through signing contracts with suppliers: it buys the source. It needs food, so it tries to secure agricultural land outside China and fertilizer to grow it. It sends armies of Chinese workers to build railroads and ports in Africa in exchange for future supplies of such things as cobalt. Its deep pockets and long-term focus make it a Goliath against even the largest corporations that vie for resources independently.
When China exercises its power as a supplier, it can rock entire industries. Despite being a member of the WTO, which explicitly forbids export quotas, in 2010 it tightened restrictions on the export of rare earth minerals, where it had a 95 percent share of global supply, causing a worldwide scramble for the many non-Chinese companies that depend on them. Efforts by individual companies to stretch supplies and find substitutes eased but didn’t eliminate concerns about China’s control. In March 2012, even as prices for rare earth minerals softened along with global economic growth, the United States, Europe, and Japan filed a case with the WTO for what they claimed were unfair quotas and tariffs. At this time that case is pending. What no one could dispute was that a single entity—the Chinese government—held the cards. Even as the trade barriers eased and mining companies raced to fire up production of known deposits in other countries, businesses reckoned with the potential for more of the same.
Increasingly large and powerful private-sector suppliers exacerbate the problems. Throughout the 2000s, mining companies Vale, Rio Tinto, and BHP Billiton absorbed competitors as they raced to expand their capacities and scale. With fewer players came greater pricing power. In 2008, with demand ahead of supply, the giants of iron-ore mining began to shift toward shorter-term contracts, first quarterly, then monthly; the uncertainty played havoc with buyers’ plans. In March 2010, European carmakers felt the pinch when iron-ore producers flexed their newfound muscles raising prices by more than 80 percent. Industry groups sought help from the European Commission in Brussels, claiming that the three biggest producers (Vale, Rio Tinto, and BHP Billiton accounted for 70 percent of the ore that is transported) had “the significant pricing power of an oligopoly.”24 The European Automobile Manufacturers’ Association said, “Such excessive and unpredictable pricing policy would affect the competitiveness of manufacturing in Europe, including the automotive industry.”25
To complicate things further for businesses heavily dependent on volatile resources, price hikes in times of shortage are not necessarily industry-wide; the playing field tilts depending on negotiations and relative power. And because efforts to secure them create a huge transfer of wealth to resource-rich countries and speeds their economic development, which in turn increases demand—the swings are wide with far-reaching impacts in both directions.
Another risk to key inputs comes from efforts to keep costs down: tight inventories in supply chains can create monumental disruptions if something happens to a critical component. “People aren’t willing to pay to have empty capacity there just in case, because there’s a cost to it,” says John Hoffecker, managing director at consulting firm Alix Partners LLC.26 That point hit home with the automotive industry in the spring of 2012 when a major supplier of a chemical crucial in automotive fuel and braking systems had a problem. Early in 2012 its plant in Marl, Germany, blew up, wiping out much of the world’s production of the chemical. Knowing how tight inventories were at every link in the supply chain, executives worried that shortages would cause them to stop their production lines—an utter disaster in an industry with such tight margins. At a hastily convened meeting in Detroit, automakers and suppliers gathered to explore their options. They headed off a crisis by expediting their parts-validation process so that they could more quickly replace the resin with alternatives. But the episode provides a useful warning to all businesses heavily dependent on a single source of a critical input.
In India, a unique congeries of factors has left the country badly short of coal supplies. Coal generates more than half of the country’s electricity, and is used for much of its aluminum production. About 12 percent of that coal is imported, of which 70 percent comes from Indonesia.27 To maximize the economic benefits of its reserves, Indonesia set new rules in 2009: metal producers have to refine the ore in Indonesia before it can be exported, and international mining companies have to sell 51 percent of their mines to local companies after ten years of production.28 In 2012, it imposed a 25 percent export tax on coal.29
The Indian government tries to help by negotiating for coal, but it suffers from gridlock, and there are endemic problems with distribution, partly the result of the government’s politically compromised allocation schemes. The resulting shortages have shut down aluminum and steel plants for days and weeks at a time, making it impossible for aspiring businesses to achieve world-class efficiency—and if the business is highly leveraged, putting the entire enterprise at risk or forcing it to issue new equity, thus diluting shareholder value. Some private companies try to secure sources of coal on their own, but most are not equipped to do so, nor did they factor it into their expansion plans five years ago.
Around the world, companies have been looking to secure supplies of key resources by acquiring the production. Vertical integration fell from fashion in recent decades because it is generally less efficient than sticking to the main business, but now it’s reviving as a defense mechanism. Borealis, a $9 billion European petrochemical company, linked up with Abu Dhabi National Oil Company to assure access to essential supplies of petroleum feedstock to allow them to grow together in the Asia Pacific region (see Chapter 7 for the full story). Arcelor Mittal, the world’s largest steel company (started in Indonesia by Indian-born Lakshmi Mittal and now headquartered in Luxembourg), secured access to iron ore by expanding into mining—a costly bet given that both steelmaking and mining are scale-driven, capital-intensive industries. One Indian power company CEO I know canceled plans to build a plant because his company could not secure a supply of coal. But another, who had moved aggressively into building power plants, simultaneously acquired a mine in Australia as his source of supply. Quoting Jack Welch, the CEO said, “Control your destiny or someone else will.”
Technology and talent are less-tangible resources, but they are real components of value creation and competitive advantage that companies often go to great lengths to secure. Again, India provides a clear example. Its engineering schools produce about 400,000 graduates a year. Of these the 125,000 best will be snapped up by the five big IT companies—Infosys, Tata Consultancy Services, Wipro, Satyam, and Cognizant—which have upped the ante in terms of salaries, in-house training programs, and perquisites like food courts. Smaller players in the software sector recruit a further 100,000. This leaves a shrunken pool for manufacturing and all other sectors of the economy. As with any critical input, shortage of talent gives rise to wage increases—for Indian software engineers—of between 10 and 15 percent a year for experienced and specialized professionals. And the quest for talent crosses industries and geographic boundaries. Mining companies from South Africa, Indonesia, Australia, and Brazil are luring Indian engineering grads, offering them three times more than Indian companies can pay.30 Companies improve their choice of candidates by building a reputation for great work conditions and fast-track careers, but the challenge is ongoing.
Water shortages are becoming serious in Asia, the Middle East, and North Africa. People with more money eat better; protein-rich foods like chicken and beef require much more water to produce than a similar quantity of grain. For example, China’s water supplies are increasingly constrained by overexploitation and pollution. Moreover, water from melting Himalayan glaciers flows through China, to Nepal, Bangladesh, and India via the Brahmaputra and Ganges rivers. Some two-thirds of it is used for agriculture in northern India, which feeds much of the rest of the country. But China has been building dams upstream, which can reduce that flow considerably. China is India’s largest trading partner, and India has a trade deficit with China to the tune of $40 billion with no reversal in sight. It doesn’t take a lot of imagination to consider how China’s economic power might spill into negotiations over water, hurting individuals, businesses, and India as a whole. Would smaller countries similarly affected, such as Vietnam and Cambodia and other members of the Association of Southeast Asian Nations, join together to gain influence? These possibilities should enter your mind as you look at the external environment.
I’ve defined the major shapers of the tilt from North to South as the global financial system, the new varieties of capitalism, demographics, and digitization. But how do these trends combine? What do they have in common and where might they push in opposite directions? What will change any one of them, and how might that affect the others? You will arrive at your own insights through asking and answering questions.
Start by asking yourself what the unstoppable trends might be. These are major ones that seem highly unlikely to reverse:
• the march toward economic parity of nations and the rise of the middle class
• intensifying competition among countries for jobs and resources
• continuing imbalances in trade and discrepancies in national growth rates
• a shortage of leadership talent and skills in high-growth countries
• continual interconnectedness and disequilibrium in the global financial system
Don’t think of this list as definitive. Some trends may be more or less important in your situation—or you may think of others. Choose your own, and tap the brains at your company to test them. One way to do so is to schedule an off-site meeting of your top team and have the group brainstorm what they’re observing in the world, and repeat the exercise every quarter. (Any business leader can do this; you don’t have to be a CEO.) This is a time for both gathering facts and exercising imagination. As you do, consider a time frame of ten or twenty years, beyond most companies’ planning horizons. This will help you break away from the usual assumptions and straight-line projections of the current industry and company plans.
Ask your team to look at what is happening in the world, in various countries, in the industry, and in other industries, and narrow it down to a handful of trends that the group agrees on, making sure there is some internal consistency or logic to them. In other words, what is the team’s point of view about where the world is going and why? Then try this: Break the teams into smaller groups and ask each group to consider one of the trends you’ve identified from the viewpoint of a particular country or region. Let’s say you’ve agreed that China’s economic growth will be tepid as smaller Asian countries take over low-cost manufacturing. One team might take the view of China, another of the United States, another of, say, Vietnam. What actions might that country take? What would they mean for your company? For the competition? What could accelerate or reverse that trend? Chances are that some people will gravitate toward the macro view, perhaps focusing on issues of international policy, while others focus on the nitty-gritty. The trick is knitting those things together. Policy issues are relevant to business for two basic reasons: first, because policy directly affects company decisions such as where to locate facilities, where to recruit talent, what markets to enter, and where to raise capital; and second, because businesses can influence policy, as some leaders in the South do through their social networks. CEOs face the choice of whether to accept the externals or try to change them.
Don’t stop at the obvious. Dig deeper and consider what chain reactions might get triggered and what might set them off. In forming a broad and long-term view of the externals, you might see that the center of gravity for some industries—possibly your own—is tilting as well, just as machine tools and automobiles shifted to Japan in earlier decades. The South could well dominate telecom ten or twenty years out (note Bharti Airtel’s expansion to Africa and China Telecom’s partnership with AT&T), and even some R&D-intensive industries such as pharmaceuticals, where India’s Ranbaxy is already a global player. (Japan’s Daiichi Sankyo bought a majority stake in Ranbaxy in 2009 to shore up its own R&D.) Many companies, even dominant ones, will find themselves on shaky ground as they recognize that their strategy has a limited shelf life or that key markets could shift faster than they’d planned or that their expansion plans bump up against harsh realities of limited resources or talent.
If you accept the trends I’ve identified, consider the implications not only for your company and your industry but also for the policy makers whose actions will increasingly affect your plans. For example, given the interconnectedness of the global financial system, what mechanisms might arise to coordinate it? In late November 2011, the central banks of the United States, Japan, Canada, the UK, and Switzerland made a coordinated move to ease Europe’s liquidity crunch—tacit acknowledgment that they all have a stake in the stability of the global financial system. Will backroom diplomacy give way to a more formal means of protecting the system? If Washington can’t rein in Wall Street, will outsiders create pressure for reform? Perhaps creditors of the United States will use foreign ambassadors or representatives to make strong demands.
The greatest risks to the global financial system come through mispricing (as when assets are not sufficiently discounted for risk), lack of liquidity, and concentration or the so-called herd effect. It’s possible for a layperson to spot these things at least some of the time—and important because of the connection between risk in the global financial system and the real economy. For example, the bursting of the U.S. housing bubble really should not have been a surprise. The toxic combination of easy money, lax lending standards, incentives for loan officers to crank out mortgages to buyers who couldn’t afford them, and the packaging of the resulting shaky loans into triple-A-rated securities was there for all to see. Anyone scrutinizing this combination knowledgeably and thoughtfully could have sketched a pretty good scenario of the outcome. Yet most of the business and financial communities failed to see it coming. The few who were able to lift their heads above the herd belief in growth without end came out of the financial crisis either unscathed or considerably richer.
What might be the signals for a trend that affects your business? Where are the flawed assumptions? What will be the breaking point? For example, are today’s imbalances between creditor and debtor nations—China and the United States being Exhibit A—a similar potential source of problems? Foreign institutional investment is usually ahead of the game, so a concentration in its flow can be a sign of trouble down the road. Acceleration can also be a warning sign, for example, when the price of something begins to increase at a faster clip.
Some questions about trends affect almost every global business: If growth continues at a fast pace in Africa, Asia, and Latin America, will the demand for capital outstrip availability? Might sovereign wealth funds become more nationalistic, allowing only domestic investment, giving those countries an advantage? That’s a question McKinsey Global Institute raised in its report “Farewell to Cheap Capital?”31
It’s often argued that inflation is inevitable as countries ease their money supply to spur growth. How will that affect borrowing costs, and what does that say about how much debt you should carry at what maturity? Many Indian and Brazilian companies borrowed in dollars in recent years, counting on steady appreciation of their domestic currencies. When the rupee failed to appreciate and the Brazilian real took an unexpected dip, a good many got in trouble. Such financial missteps can delay competitive moves, leaving ripe opportunities unpicked.
What might various countries do if trade imbalances continue? Could smaller ones such as Vietnam and Thailand form a coalition to counter China’s asymmetric power? Will nationalism rise or wane? Will currency wars subside or intensify? Will business behavior win out over political agendas, even in China? China has allowed U.S. companies to buy hundreds of small Chinese firms over the years. Then, in 2011, the government gave Caterpillar permission to acquire a major manufacturer of mining equipment. Is this a sign of change?
Most leaders tend to get absorbed in the volatility of trends, obsessing on their immediate effects on business. What makes a leader exceptional is the mental and psychological ability to cut through the gyrations and keep focused on the big picture.
Not everything will have a neat conclusion, but by thinking through external trends and their implications you’ll know what you don’t know and therefore what to track. That, in turn, will increase your confidence and decisiveness. Over time you’ll build your mental capacity and raise the odds that you’ll see what others don’t. But you can’t wait for all of the pieces to fall into place. While you need to see the big picture, you don’t want to miss the narrow window of time in which it’s possible to stake out strategic positions and critical resources for the long term. Even in the face of incomplete knowledge, you have to act.
You can start filling the gaps right now as you turn to the next chapter. I’m going to take you inside some tough competitors of the South, the trailblazers who are positioning themselves to become global leaders in their industries. You’ll see firsthand their best practices and managerial tools—not to mention the leadership psychology that drives them.
THE GLOBAL FINANCIAL CRISIS: WHO DEALT THIS MESS?
I’ve often looked for a short and easy-to-grasp explanation of the crisis’s causes, but have found none that do a thorough job. What follows is a concise description of the key factors and players that contributed to it, in the proper sequence. My purpose is to help you understand the workings of the system and its interconnectedness.
LET THE MONEY FLOW
As with many such crises, it began with a flood of easy money. In the aftermath of the dot-com crash in 2000 and the September 11 terrorist attack in 2001, U.S. fiscal and monetary spigots were opened wide to stave off recession. The government cut taxes and raised spending, which increased further when the country went to war. Federal Reserve chairman Alan Greenspan ratcheted down interest rates steadily; by July 2003 they were at 1 percent, the lowest in half a century.
As the markets overflowed with liquidity, Congress and both the Clinton and Bush administrations set out to widen home ownership by directing Fannie Mae (Federal National Mortgage Association) and Freddie Mac (Federal Home Loan Mortgage Corporation) to relax credit standards. The combination of low interest rates and easy loans drove an increase in housing construction and a surge in real estate prices. Private lenders were all too happy to leap on the bandwagon, issuing so-called subprime mortgages that reduced lending standards to the point of irrelevance. Housing became the main driver of the U.S. economy: “By the fall of 2005, Merrill Lynch estimated that half of all U.S. economic growth was related to housing—including new construction, home sales, furniture, and appliances.”32
Much of the borrowing was by homeowners who refinanced and spent the money on everything from cars and clothing to vacations, helping to sustain consumption in the face of falling real wages. Their urge to splurge was further underwritten by the rising stock market, which made many of them richer—on paper. Indeed, you could say that the housing bubble was one aspect of a much larger phenomenon—let’s call it a confidence bubble: Things were great and could only get better! Household debt roughly doubled from 2000 to 2008, to almost $14 trillion,33 helping to raise the U.S. trade deficit to a peak of $763.3 billion in 2006. The main beneficiaries of the spending: China and oil-exporting nations. Both acquired enormous foreign reserves.
The vast amounts of money pumped into the system helped drive a worldwide economic boom that pushed up the prices of natural resources and created housing bubbles in other countries. Oil prices, denominated in dollars, rose as the dollar weakened; they spiked to nearly $100 a barrel in 2008, their highest level ever. The Fed actually raised rates from 2004 through 2006, but to little effect: money came pouring in from overseas as investors from Berlin to Beijing lent their savings to credit-crazed Americans.
The circus that preceded the meltdown was made possible only by the erosion of regulations that had governed the financial markets for decades. (A high point was the repeal of the Glass-Steagall Act of 1933, which had created a firewall between commercial banks and investment banks.) Deregulation was spurred by a Congress responding to the urgings of the financial community, and it was blessed by Greenspan—an ardent champion of free markets—as a wellspring of healthy financial innovation.
One decision by the Securities and Exchange Commission was key; it allowed major Wall Street firms such as Goldman Sachs, Morgan Stanley, Lehman Brothers, Bear Stearns, and Merrill Lynch to exceed the long-standing limit on their debt-to-net-capital ratio of 12:1. The decision allowed them to up their leverage to as much as 40:1, raising stupendous amounts of high-risk money leveraged on short-term funds from banks and money-market funds. (It is no coincidence that three of the five firms are now history.) They invested much of it in collateralized debt obligations (CDOs) comprised of those shaky mortgages. The risk ended up far from its creators, in the hands of mostly uninformed customers looking for high returns. Executive compensation linked to the soaring stock prices of these firms inspired lenders to push homeowner borrowing still more, often with shoddy practices and to people who couldn’t afford the mortgages.
THEY CALL THEM SECURITIES?
Among other things, deregulation allowed the creation of exotic debt instruments, most notably CDOs and credit default swaps, which were to play a major role in the debacle. CDOs were highly complex securities—so complex that even those who created and sold them often did not understand them—through which lenders took loans off their balance sheets and sold them in bundles to investors. Credit default swaps were a form of insurance designed to protect institutional buyers against defaults.
The CDOs were based on proprietary mathematical models for trading, designed by a small number of PhDs whose specialties are mathematics and physics. The content of those black boxes was a mystery to others, including almost all the firms’ senior-level leadership and boards of directors. In the run-up to 2008, anybody who cared to know what was going on had to rely mostly on supervisors several levels below the CEO who oversaw the specialists and traders.
Among the clueless were S&P, Moody’s, and Fitch, the major ratings agencies. They continued to classify many potentially toxic securities as AAA. At the time, only twelve companies in the world carried this top rating—yet sixty-four thousand securitization packages received it.
No wonder Warren Buffett famously—and presciently—called those instruments “weapons of financial mass destruction.” The breakdown of the system was only a matter of time. Surprisingly, the decision to allow greater leverage was made when the SEC was under the chairmanship of Bill Donaldson, a cofounder of Donaldson, Lufkin & Jenrette (DLJ), whose expertise and experience should have given him the foundation for understanding the implications of such a move. That is, when a financial institution is on the ropes and confidence in it fades, leverage works faster and more effectively in reverse. The chain reaction can—and did—swiftly bring the system to a halt.
That’s what happened when Lehman Brothers went under. Lehman had huge and heavily leveraged investments in subprime mortgage securities, and investors were—at long last—starting to realize how insecure they were. Throughout 2008 Lehman’s holdings were deflating at an accelerated rate, and the firm was hemorrhaging money. It began frantically looking for a buyer, but couldn’t strike a deal, and the U.S. Treasury declined to bail it out.
When Lehman filed for bankruptcy on September 15, the already battered Dow Jones fell some 500 points, its largest single-day drop since the aftermath of 9/11. But that wasn’t the worst of the fallout. One of the oldest and biggest players in the $2.6 trillion money market fund industry, the Reserve Primary Fund, had invested some $785 million in Lehman debt securities. These became essentially worthless with the bankruptcy, and drove the Reserve Fund’s net asset value below the $1 per share that money market funds customarily maintained—an event called “breaking the buck.” Reserve was forced to suspend redemptions to investors—a cataclysmic breach of faith in an industry whose products were considered second only to banks in their safety.
Next to fall were the so-called monoline insurers that guaranteed payments on all manner of bonds, including municipals. They had insured trillions of dollars’ worth of CDOs (which not incidentally acquired the insurers’ AAA ratings as a result). Leveraged as they were, few were able to pay out when those securities suddenly lost a significant amount of their value. Some 80 percent of this business was concentrated in one firm, AIG, which dominated the market for credit default swaps.
It’s a simple but often forgotten fact that confidence is the underpinning of any financial system; without it, none of the players can function.
The ensuing destruction of confidence began in the United States but spread almost instantly through the highly interconnected world financial system. There was panic in some quarters, and emergency meetings around the globe. Worldwide financial collapse seemed a real possibility. Frightened investors pulled their money out of just about anything in sight. Stock markets plunged, and margin calls further squeezed liquidity as buyers disappeared. Falling stock prices demolished corporate debt ratings and ravaged retirement funds. Forced to pull cash out of operations, businesses contracted and economies fell into a fast downward spiral. The misery spread quickly to Main Street as hundreds of thousands of jobs vanished, and a growing number of people could no longer afford to pay their mortgages. Municipal bond markets dried up, depriving governments of the funding they needed to operate and build. Mortgage lenders hoping to salvage their loans—vainly, as it turned out—began massive and often brutal foreclosures.
It might have been the Great Depression redux had not U.S. policymakers pulled together the massive intervention that included the celebrated bailouts and TARP rescue fund. The fierce political controversy the programs generated should not be allowed to dim the magnitude of the accomplishments: Without those actions, it’s hard to imagine what could have prevented a global financial collapse. As it is, the United States and many other nations have been left suffering from high unemployment and weighed down by debt, and they are not expected to fully recover for years.