Thursday, February 12, 2009
Crisis and Opportunity*
The Financial Crisis
The private Western financial system is structurally broken. The extraordinary leveraging of capital, into hundreds of trillions of debt, created a bubble that had to burst. Capital assets have been decimated.
The excessive leveraging if credit was due to the failure to regulate the debt origination, structure and transaction of mortgage-backed securities, hedge funds, credit-default swaps, derivatives and other innovative capital instruments. Alan Greenspan has admitted his error. This admission is ominous because what he could not have imagined has no intrinsic limits. We have only seen the tip of the iceberg. After the housing bubble, we will see the collapse of consumer credit and auto loans. Defaults on credit cards have reached 7% and auto loans are beginning to unwind.
Government bail-outs throughout the world will not work because there are not enough reserve capital assets to absorb an astronomical scale of debt.
Financial institutions are being nationalized and the financial sector is reduced.
Remaining private capital will continue to seek protection in the safe haven of government bonds, which have virtually no yield, when factored for inflation, and the downward speculative arbitrage of currencies. Government financial intervention is a powder keg of inflation. There is no end in sight.
The West is in technical recession. Collapse of the financial service economy has caused massive layoffs. The next distressed sector will be retail, which is 70% of U.S. GDP. Retail growth is negative and will be devastated by credit suppression. Commercial real estate and brand equities will decline.
China, India and emerging economies will continue to grow at a lower rate, which distresses their need for higher growth to urbanize large rural populations. Seven percent growth for China looks good in the West, but it is not enough for China. Yet the East will be better able to manage reduced growth than the West, which wrestles with negative growth. The growth imbalance is between the East and West is likely to last for a long time
The West became a consumer, financial and technology society while the East has became an industrial economy. The greatest mistake of the U.S. was its refusal to sell advanced technology and weapons to every buyer (its only growth sector in the real economy) to balance its trade deficits. American foreign policy butt heads with real economy, and forced China to build its own advanced technology. The West produced and sold credit, while the East produces things and moves which move forward to added value.
Debt is only manageable as long as there is credit to recycle debt. Once Western credit became paralyzed, its debt had to be devalued. Industrial manufacture in the East can be managed by reducing variable costs. It is more flexible in tough times than finance.
There are no new economic growth drivers in the West. The hope of an alternative energy will be vitiated by falling oil prices. Equities will fall to the level of the real economy and it is very difficult to measure what the real economy is. U.S. agriculture is only three percent and manufacturing nine percent of the economy. Europe, traditionally with a higher manufacturing percentage of GDP, is rapidly declining, without a retail expansion offset. We will see soaring Western unemployment, political confusion, protectionism and social unrest. Wealth is shifting from West to East.
Marketing created a consumer society based on consumer credit.
So long as finance was regulated, the leveraging of this credit was limited. Deregulation took the cap off of leverage. Information and media technology vastly enriched the perceived value of brands. The dynamic interplay of brand enhancement, consumer credit and low cost offshore production created vast profits in brand equities. In recessions, brands, which are, after all, only perceived values, lose their perceived value as savings become a stronger value. Consumers turn to value and price only goods. While brand value declines in the West, it is gaining strength in the East. The manifest wealth of brand ownership masks real debt.
Marketing became vastly empowered by information technology, product innovation and management sophistication. On the B2C side, product marketing went too far in hyping demand with too many new and varying product models, distribution channels, aspiration and promotions. Financial credit marketing to consumers hyped demand with too many consumer credit instruments (redundant credit cards, interest only credit programs, excessive credit lines, sub-prime mortgages) and leveraged debt to users, who lacked the resources to handle this debt.
On the B2B side, financial marketing technology and management innovation, without regulatory restraint, created sophisticated and impenetrable financial instruments (Mortgage backed securities, credit defaults swaps, repos, and other instruments) and sold them to financial institutions, which were incentivized by bonuses to buy this stuff, rather than scrutinize it. This has been an explosive combination of B2C and B2B marketing to consumers and to financial institutions.
It is not enough to regulate financial institutions at a macro-level. Micro consumer credit has to be regulated as well, along with product marketing. Even with a tightening of credit, clever and ruthless lenders will devise and sell new products to desperate consumers to get them out of their mess. They will find ways to sell this paper to traders desperate to grow client accounts. These practices will make matters worse.
Governments will have to empower their retail trade authorities to monitor and restrain both demand and supply products and their advertising claims. Marketing has to be regulated. In desperate situations, criminal penalty is the only restraint on fraudulent invention. Voluntary restraint flies out the window. Branding will have to be compelled to become responsible. In a deep recession we will see a tremendous shift from brand to value marketing…a movement from perceived value to demonstrated value.
We will return to the basics.
Situation in the U.S.
The U.S. is in a recession and it will be prolonged. With the nationalization of financial institutions we are not dealing with a cyclic phenomenon but with structural change. Structural change takes a long time to regain stability and gain trust. In the meantime the bankruptcy of companies and households will lead to austerity instead of “life style”.
Unemployment in the U.S. has reached 7% and will probably jump to 9% by the time the October storm is reported. It will climb higher next year as companies adjust to a weak and almost invisible Christmas buying season. Christmas sales typically account for 30% of annual retail sales. Without a Christmas behind or ahead, companies will retrench in the domestic market. With retail at 70% of the U.S. the magnitude of this domestic retrenchment of employment will be enormous. We will likely see a Japanese style of stagnation for a decade. It happened there. It can happen in the U.S.
U.S. companies will continue to shift marketing investment to the East, where economies will continue to grow, albeit at a slower rate. The economy of large populations growing at a slower rate is much more attractive than smaller populations with no economic growth. U.S. dollar strength, backed by military power, will reduce export and political passions will insure protectionism is a futile attempt to recover domestic manufacture. The trend toward personal and household savings will not fuel a domestic renaissance of manufacture.
With falling exports, the U.S. will be compelled to do what it has resisted for years – sell advanced technology and weapons to everyone as the only basis of trade balance or surplus. This will require a strategic alliance with China – a repeat of 1972 Nixon/Kissinger secret diplomacy, but in a new context and a new deal. The deal will probably sacrifice Japan, as 1972 sacrificed Taiwan.
The U.S. population will grow through immigration, legal and illegal, to lower labor costs for the arduous effort to revive the manufacture of low cost goods and expand domestic consumer demand. Protectionism will assist this attempted renewal. Conservative capital will continue to seek the wealth safe haven of U.S. military-based security. Investment capital will fly to growth markets in the East, along with domestic management talent. Foreign currency reserves will finance the Eastern acquisition of Western assets. It is hard to say how the society will manage social unrest.
Situation in Europe
Europe is in a deeper pickle than the U.S. They will have a prolonged recession, political fragmentation, protectionism and a tortured lowering of their fabled life style. The Euro may reach parity with the dollar, or go lower. Indeed, it may disintegrate as a currency.
The failure to pass an EU constitution was fatal. If it could not pass in a prosperous time, it certainly cannot pass in a desperate time, when every nation will look out for its own survival and not trust any common accord to insure survival. There is too much disparity of national conditions in Europe for unity of action. Stronger countries cannot carry weaker countries on their back when they can hardly walk themselves.
There is too much embedded welfare in Europe to support capital formation. A serious unwinding of welfare in a continent of high unemployment will cause social unrest. The economy will be paralyzed, which is a step worse than stagnation. Stagnant societies can act; paralyzed societies cannot. Europe’s failure to create an independent military was always the Damoclean Sword of the Euro.
Situation in China
China will be affected by the global economic crisis. Growth is falling to 8% growth and will likely descend to 7%. But China still has $2 trillion of currency reserves, a stable budget and manageable debt. Remarkably, retail is up 30% and exports grew 28% in the last quarter. China’s established model for production of cheap goods is serving her well in these bad times when the whole world needs cheap goods.
China will manage a balance between its continuing export economy and the growth of its domestic economy. Chinese policy is smart enough and authoritative enough to induce or force savings into consumption for domestic expansion. Its trade policy and acumen is smart enough to find new niches for the export of cheap goods as well as new niches for value added export. This balance will be a wonder to behold in a messed up world.
Chinese currency reserves will support its enterprises to acquire bargain production, brand and distribution assets abroad for higher profit margins. High distribution margins through ownership can offset higher production costs. In-country production and distribution will off-set protectionism. The economy will have sufficient growth to manage internal harmony. China will augment its world power when technology investment produces competitive value added products and advanced technology. When China has a competitive technology based in its production system it will make the Rmb convertible. It will become a global reserve currency and, unlike Europe, will fortify this currency will increase military strength.
Prolonged global recession will require more cheap goods, i.e. that is price-only and value goods vs. premium brands. China is the master of cheap goods production through its State policy models of low cost labor, industrial operations, entrepreneurial culture and supply chain management.
The major threat of global protectionism must be pre-empted by the export of its production systems, not just products. China must have internal production and market access in foreign consumer markets so it can flood these recessionary markets with cheap goods. When factoring in high distribution margins, it can offset higher labor costs with distribution profits for a lower total cost than domestic competitors. Chinese production and distribution in foreign markets will be accommodated (grudgingly) for employment and local tax generation.
China can transplant the Shenzhen SEZ (Special Economic Zone) model to foreign markets. SEZ is an integration of public capital support, incentive policies, subsidies and private investment in development, production, logistics and marketing. China’s can develop Sino-U.S. and Sino-EU economic zones in the U.S. and Europe. China and its municipal and provincial governments can retain tax revenues by supporting its enterprises abroad. U.S. state governments, like Kentucky, and certain European countries will welcome this entry to alleviate unemployment and local tax stress. These zones will be partnerships with domestic companies, but Chinese enterprise will have joint control of production, brand, logistics and distribution.
Land costs are cheaper in many State of the U.S. than in Guangdong.
Chinese enterprise will use local management talent desperate for work.
These new zones will be very large and require intelligent planning, artful political negotiations and foreign legislative protection. Unlike current ad hoc Chinese enterprise acquisition in the U.S. and Europe that are scattered and fragmented, these SEZ zones will provide political protection for Chinese local assets. They will represent a new stage of Chinese globalization. Instead of the West penetrating the East during the period of good times, China will penetrate the West during the period of bad times.
President, Kotler Marketing Group
*This speech was presented to the Asian Economic Forum, Hong Kong. September, 2008. It was published in the China Business Review in December, 2008