Terra Firma

THE RISE OF STATE CAPITALISM

Emerging market states are undergoing a necessary maturation process. Today, political choices, not economic fundamentals, determine how (and how quickly) waking giants like China, India, Brazil, Russia, Mexico, Turkey and many others can grow. But as their political and market institutions develop, governments of these states will slowly, but irreversibly, withdraw from direct interference in their domestic markets. This is the narrative that, until recently, many Western investors and corporate decision-makers accepted as inevitable.

Two decades ago, faith in the power of the state to micromanage domestic economies and generate prosperity seemed all but dead. The dynamism and market power of the US, Japan and Western Europe – fueled by private wealth, private investment and private enterprise – appeared to have fully established the dominance of the liberal economic model. As these governments privatised businesses and pensions, heavyweights like Microsoft, Toyota and WalMart sketched out ambitious global expansion plans. Globalisation became a household word.

But the financial crisis and global recession have capsized these assumptions. Political factors now play a fast-growing role in economic policymaking – even in the world’s wealthiest countries. This trend is especially obvious in Washington, where debates over bank bailouts, new financial rules, and expensive government plans to reform health care and energy policies have created complicated sets of risks and rewards for investors.

But even before the global economic meltdown had undermined faith in free markets, the determination of a new generation of emerging-market heavyweights to fuel prosperity and safeguard their domestic political control ensured that public wealth, public investment and public enterprise would make a remarkable comeback. An era of state capitalism has dawned, one in which governments are again directing huge flows of capital – even across the borders of capitalist democracies – with substantial implications for free markets and international politics.

THE TOOLS OF STATE CAPITALISM

State capitalism is an economic system in which governments manipulate market outcomes for political purposes. They embrace this system, not because it is the most efficient means of generating prosperity, but because it serves political as well as economic purposes. It puts vast financial resources within the control of state officials, providing them with the cash they need to protect their domestic political capital and, in some cases, to maximise their leverage on the international stage.

Nowhere is the state’s growing role in the performance of markets more obvious than in energy trade. The world’s 13 largest oil companies, measured by the reserves they control, are now owned and operated by governments. Saudi Aramco, Gazprom (Russia), China National Petroleum Corporation (CNPC), National Iranian Oil Company (NIOC), Petróleos de Venezuela, Petróleo Brasileiro (Petrobras), and Petronas (Malaysia) are each larger than ExxonMobil and all other energy multinationals. State-owned companies now control more than 75 per cent of global crude oil reserves. Multinational oil companies produce just 10 per cent of the world’s oil and gas and hold about 3 per cent of its reserves.

But the story extends well beyond energy. China and Russia are leading the way in the deployment of state-owned enterprises across a broad range of economic sectors, and other governments are following their lead. In defence, power generation, telecoms, metals, minerals and aviation, a growing number of emerging market governments, not content with simply regulating markets, are moving to dominate them.

These projects are financed in part by the emergence of a new class of sovereign wealth funds. States with large holdings in the currencies of other countries are establishing ever larger risk-taking funds meant to maximise their return on investment and, in some cases, their political influence. With the global credit squeeze making capital harder to come by, sovereign wealth funds have become even more important for the financing of state capitalism.

STATE CAPITALISM’S THREAT

The state capitalist trend poses several threats. First, state-run companies and investment funds tend to carry the same bureaucracy, waste and political cronyism that burden the (often authoritarian) governments that control them. For example, state-owned oil companies now control such a large percentage of the world’s oil reserves that the mismanagement, corruption and inefficiency that plagues their operations will drive up the prices we all pay for energy.

Second, western multinationals continually find themselves at a disadvantage when faced with state-owned competitors that can count on home governments for generous subsidies and political muscle. They also often enjoy protections when competing at home against foreign rivals.

Third, some emerging market-based, state-owned companies and wealth funds are making risky foreign investment bets. An emerging market country (like China, Iran or Venezuela) is at much higher risk of political upheaval than a developed-world country (like the US, Germany or Japan). When an emerging market-based national oil company buys long-term access to oil and gas supplies inside another potentially unstable country, it exposes its government to risks of heavy financial losses if political turmoil inside the partner state destroys the value of its investment. Those losses can produce ripple effects through the still vulnerable economies of the state-owned companies.

Finally, the political leverage and extra cash that state-owned companies and sovereign wealth funds bring their governments can embolden states like energy-rich Iran to pursue high-risk, foreign policy gambles – like full-speed development of a nuclear programme – secure in the knowledge that threats to reduce energy exports will help the country shrug off international pressure to back down. A threat from Moscow or Caracas to turn off the taps gives these governments useful political and market leverage with their neighbours. Europe already depends on Gazprom, Russia’s natural gas monopoly, for 25 per cent of its gas. Over the next several years, that dependency will probably deepen and Russia’s political clout will increase.

There are times when governments should intervene to protect citizens from the worst effects of under-regulated markets. But over the longer term, there is no evidence that political officials are better able than market forces to regulate economic activity. When US policymakers temporarily seize responsibility for decisions on how an economy should value assets and allocate resources, they inject short-term waste, inefficiency and bureaucracy into US and global markets. But when officials in several of the world’s most dynamic emerging markets embrace this system as a long-term means of ensuring their political survival, they undermine the global economy’s power to generate sustainable growth.

STATE CAPITALISM’S VULNERABILITIES

Over the long term, state capitalism is unlikely to reverse globalisation’s progress. States like China, Russia, and even the very stable Persian Gulf monarchies will face tremendous pressures as internal contradictions in their development – the environmental price China continues to pay for its growth, Russia’s reliance on resource national is mat the expense of the development of independent governing institutions, and demographic challenges facing the Saudis and other Gulf states –put their economic resilience to the test. Unlike state capitalism, globalisation does not depend for its dynamism on the wisdom and foresight of political officials.

But the greatest danger that state capitalism poses for the governments that practise it comes from the heavy burdens they accept with responsibility for national economic performance – particularly when it comes to the protection of existing jobs and the creation of new ones. Economist Joseph Schumpeter coined the phrase “creative destruction” in his 1942 book “Capitalism, Socialism & Democracy” to describe the various ways in which dying ideas and materials fertilise new ones, providing capitalism with a self-regenerating charge. As part of this virtuous cycle, industries die because they have become obsolete, and new ones arise from the ashes of the old to produce the goods, services and ideas that people want, sustaining an ever-evolving economic ecosystem. This process is not the product of political whim. It is as natural as human evolution.

Those who administer state capitalism fear creative destruction for the same reason they fear all other forms of destruction: they cannot control its effects on the livelihoods of the workers and consumers for whom they have accepted responsibility. The process of creative destruction generates the kind of uncertainty and volatility that drives people into the streets to challenge authority. It ensures that industries that only produce things no one will pay for will eventually collapse. In a state capitalist society, lost jobs can be pinned directly on state officials. That is why the ultimate aim of Chinese foreign policy is to fuel a domestic economy that creates millions of new jobs each year and why Russian Prime Minister Vladimir Putin travels to shuttered factories and orders them reopened before quietly bailing out the owners. Of course, workers in a free market system blame politicians for closing factories and lost wages, as well. But when the state owns the company that owns the factory, its responsibility is both more direct and more obvious. Governments do not want responsibility for destruction – creative or otherwise.

But the financial crisis (and the blame the US receives for it) ensures that the state capitalist trend will intensify over the next several years, and the world will face a contest between competing forms of capitalism. How countries with elements of both systems – India, Brazil, Mexico and others – chart their economic courses will help determine the near-term future of free trade and foreign investment.