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The return of geopolitical risk

What happened?

Since the fall of the Berlin Wall in 1989 and the collapse of the Soviet Union in 1991, the U.S. has been the undisputed global superpower. Ideologically, it seemed as if we reached the End of History (i.e. the belief that free-market capitalism and liberal democracies are the culmination in the history of man’s socio-political development) and the beginning of Pax Americana. This led to a decline of geopolitical risk premiums across the world, a period known as the Great Moderation. However, almost three decades later, the U.S. is in relative decline, with the economic balance of power shifting towards the East, and China in particular.

What does this mean?

Financial markets always play out against the background of more structural and longer-term political and cultural developments. The post-war period until 1973 was the period of the Bretton Woods system, with fixed exchange rates and capital controls, coupled with rapid nominal growth and active fiscal policy by governments in the background of a divided world by the Cold War. The problem of stagflation and the collapse of the fixed-currency system by the 1971 “Nixon shock” led to a new paradigm: that of neoliberal policies and an active role of monetary policy by central banks and the global dominance of the U.S. that pushed for globalization and democratization across the world. This system eventually led to the 2008 financial crisis. As a result, the current political (e.g. populism, globalization backlash) and socio-economic developments (e.g. ageing societies, weak productivity growth) could thus usher in a new economic paradigm, driven by the new geopolitical imperatives of the coming era of Great Power Competition.

What’s next?

As China is challenging U.S. hegemony, it will lead to a climate with heightened geopolitical risk. The trade war is just an omen of this, and is part of an upward trend in geopolitical risk since the 2010s, as measured by the Geopolitical Risk Index. Recent empirical studies show that increases in geopolitical risk are significantly correlated with stock market performance, company earnings and resource prices. As a result, the end of the “fourth hegemonic cycle” of U.S. hegemony will result in a more strategic perspective on the economy (e.g. decoupling or relocating strategic value and production chains, increasing soft and hard tariff barriers) and resources (e.g. the U.S. sanctioning the Nord Stream 2 project, countries trying to gain national autarky in strategic resources), that will require a more active stance of financial investors to pick out winners and losersof this era of Great Power Competition.

Could 2020 see the first VR killer app?

What happened?

As we enter 2020, virtual reality is still struggling to win over consumers. It is now widely expected that VR will mostly be used by businesses. It is the classic problem of adoption: as long as consumers do not buy VR headsets, developers will not produce content that consumers want. Simply put: The platform needs a “killer app”, an application that entices consumers to pay for the platform. The difference between a VR killer app and the historical killer apps of other technologies (e.g. electricity and the lamp, computers and the spreadsheet) is that at least one use of VR is already very clear: playing videogames. For this reason, it is interesting that next year will see the first full-size VR-exclusive videogame based on one of the most popular IPs with Half-Life: Alyx. Could this become VR’s killer app?

What does this mean?

What makes Half-Life: Alyx interesting is that a highly talented studio (Valve) is showing the level of commitment from which others have shied away: Half-Life is one of the most popular videogame IPs of all time and Valve has built the engine for Alyx specifically for VR. Moreover, with the announcement of Alyx, it seems that we have entered the next phase of consumer VR innovation, in which competition to produce content is heating up. A few days after Valve announced Alyx, Facebook (Oculus Rift) revealed its acquisition of Beat Studios, creator of the popular game Beat Saber.

What’s next?

Contrary to popular belief, a killer app will not necessarily boost sales for VR headsets among a wide audience. A killer app will first trigger the interest of a much larger group of (hardcore) videogame consumers. Consequently, developers and producers will want to invest much more in producing content for VR. In turn, that will boost the adoption rates of VR among a wide audience in the longer run. Indeed, Half-Life: Alyx could become the killer app that sets this process of VR adoption in motion.

Can Modi make India a superpower?

This year, Indian Prime Minister Modi won a landslide victory in the Indian elections, providing him and his Bharatiya Janata Party (BJP) with a large majority in Indian politics. Although this was initially conceived of as a market-positive outcome, problems have started to accumulate in India’s economy. As such, Modi has some tough challenges to overcome in his second term if he is to sustain the Modi Wave that characterized his political ascent.

 

Our observations

  • Growth in India slowed down to 4.5% in the July to September quarter, and fell for six consecutive quarters from around 8% in the first half of 2018. As a result, India has now again lost its title of fastest growing large emerging market to China. This is also a severe blow to Modi’s goal of making India a $5 trillion economy by 2025, hoping to overtake Japan as third largest economy behind the U.S. and China.
  • As India has insufficient labor-intensive industrial production, its unemployment rate was relatively high at 8.5% in October, a 3-year high (although leaked government documents put it at a 45-year high). India has severe difficulty creating enough jobs for the 12 million Indians that are yearly entering its labor market. This also makes India’s economy less exposed to the external environment, although a decline in manufacturing accounts for most of the current slowdown (especially car sales declined, by almost 25% in September).
  • Modi support is concentrated in the “Hindu Belt” across the Indo-Gangetic plains, whereas his support is much weaker in the Indian South. However, the south is the most vibrant part of India, with GDP per capita and socio-economic indicators (e.g. fertility rates, literacy rates) at middle-income levels (while northern India is comparable to African countries in those respects). We’ve called this the “two tales of India”. South India is most important to India’s economy, as it is where India’s IT sector and large trading hubs (e.g. Chennai, Mumbai, Hyderabad, Bangalore) are located, whereas the political and cultural center is located in the northern parts of India. This could lead to a deepening divide and diverging interests of both Indias.
  • India’s CPI is increasing because of supply-side disruptions in onions, which have caused political fallout before, as onions are a core ingredient in Indian cuisine. That puts the Reserve Bank of India in a bind between slowing growth and rising inflation. In response to a slowing economy, the new head of the RBI has used the monetary policy space to support growth and has cut its main policy rate by 135 basis points to 5.15% since December 2018 (although it upheld the benchmark repo rate of 5.15% in its latest December 2019 meeting). India’s government has been under pressure to increase fiscal spending after a $20 billion corporate tax cut in September this year, but has little room to maneuver as it is reaching its target of a fiscal deficit of 3.3% of GDP. As a result of these problems, Moody’s has downgraded India’s credit rating to negative (although S&P kept India’s rating at “stable” last week).
  • India’s economic problems are partly caused by troubles in India’s shadow-banking sector, beginning with last year’s collapse of major lender IL&FS , which had been part of an easy credit cycle that facilitated a consumer spending boom in previous years. Now, as credit (credit to the commercial sector has dropped 88% this year) has dried up, private consumer demand and business investments have slumped.
  • Last month, Delhi declared an “air pollution emergency” after pollution had spiked to “severe plus” levels, closing schools, stopping reconstruction and shutting down coal and other fuel-based factories. Two years ago, a Sri Lankan cricket player vomited on the pitch after playing in the heavily polluted Delhi air. India’s air pollution is far worse than China’s has ever been, and 15 of the 20 most polluted citiesare in India (Delhi ranks 11th). India also ranks 177th of the environmental performance index, of 180 countries. In response, India is betting big on renewable energy. It set up a “national solar power mission” in 2010 and launched the International Solar Alliance in 2015 to mobilize about $1 trillion in solar power investments around the world, focusing mostly on tropical countries that are “sun-rich but cash-poor”. India wants to accelerate its efforts due to the falling prices of solar panels, and hopes to generate about 100 GW solar energy by 2022.

 

Connecting the dots

In May 2019, Modi and his BJP won a landslide victory in the Indian general elections. When he rose to power in 2014, with a pledge of radical reform and taking on corruption, after decades of Congress-led governments, his governments implemented some important reforms. The most important were a long-awaited tax reform in 2017, a demonetization move in December 2016, and a new bankruptcy code to speed up the process of “creative destruction” in April 2018. As a result, India jumped from place 130 to 63 on the World Bank’s Ease of Doing Business Index and receiving record amounts of foreign direct investments during his first tenure. However, the balance of his first term became more controversial towards the end, as Modi increasingly brought his hardline Hindutva rhetoric to the fore while economic problems began to accumulate. Furthermore, as Modi has positioned a considerable number of allies in India’s most powerful institutions, such as ministries, judicial courts and local governments, and used many “grass-root cadres” to support his messages throughout India, this led to increased polarization of India’s society and population during Modi’s first term.

Since the sweeping economic reforms in the 1990s, India’s economic growth has accelerated but inequality increased as well. Furthermore, given that India is still a highly traditional society, scoring low on many socio-economic indicators and having low urbanization levels and a large rural agricultural economy, this has led to a divergence between opportunities and aspirations of India’s poor. This makes India a prime example in which the process of modernization does not linearly leads to more progressive values and democratization. This is reflected in Modi’s popular Hindutva ideology (i.e. the belief that India is the homeland of Hindus) and more than half of Indians now favoring autocratic leadership and even military rule. It shows that Modi’s campaign was able to tap into deep resentments in India’s society, both in 2014 and 2019, and his support cut through caste and ethnic boundaries across India’s diverse society, a long-term goal of Hindu nationalists. After the beginning of his second term, his administration began an ethnic and nationalist campaign consisting of measures such as stripping almost 2 million minorities of their citizenship in Assam, building a Hindu temple on a demolished mosque site, building detention camps for Muslims in India’s Eastern provinces and stripping Muslim-majority Kashmir of its autonomy. Playing this card paid off, as he campaigned with hardline rhetoric against Pakistan and other minorities in India. This fuels fears that his administration will prioritize cultural issues over economic reforms.

A possible bright side to Modi’s first term was his push for the emergence of an India Stack”. Founded on India’s Aadhaar (biometric identification) system, this has provided huge leapfrog potential for India. Since its introduction, coupled with other government plans to increase (digital) financial inclusion, it has caused India’s lower-middle income classes to see rapidly expanding possibilities brought by digital technologies (India now has the third-most unicorns in the world, and its fintech and gig economy is booming).

Nonetheless, India has important structural development objectives which cannot be easily attained by digitization, such as a low urbanization rate, weak manufacturing industry, low productivity (driven by bad education and healthcare), high levels of pollution, rampant inequality, corruption and bad governance (i.e. crony capitalism, and what is often called the “Raj system”, referring to the colonial rule of the British overSouth Asia). In our view, these are development priorities when it comes to increasing India’s long-term growth and structural projections. On the other hand, India’s structural, long-term outlook is favorable given its strong positioning in digital technology, favorable demographics (it will be the most populous country by 2027), high savings rate to boost domestic investments, a dynamic startup culture that could benefit from reallocation of global supply chains due to the U.S.-China trade war, and being a favorable geopolitical ally to many affluent powers (e.g. Japan, the U.S., Russia). India being a favorable geopolitical stems from its tradition of non-alignment; that it adopted during the Cold War, India led developing countries that neither sided with the Soviet Union nor the U.S. As a result, India has few enemies (besides Pakistan, and arguably China, which seeks similar spheres of influence), but also few strong allies (India has joined several initiatives of the U.S. but is dependenton Russian military imports). And it only opened and liberalized its economy and shed its focus on autarky as recently as 1991.

In all these cases, reforms could be pursued by Modi’s government. However, as state governments have the most political power in India’s political system, large-scale projects are hard to implement through the central government. However, Modi’s increased majority in the Lok Sabha (the lower House of India’s bicameral Parliament) and the New Democratic Alliance (the BJP right-wing coalition controlling many states in India) could make it easier to carry out reforms in the coming years, meaning that India could follow up on its prospect of becoming the new leader of global economic growth. The current economic downturn and pending crisis could become another critical juncture like India’s financial crisis in 1991 that led to India’s liberalization and opening-up, and usher in a period of reforms that would finally propel India’s great potential.

Implications

  • India is very protective of its domestic industries and willing to pursue protection of domestic firms in order to gain scale to compete at a global level (i.e. the infant-industry theory). It is increasingly doing so with its domestic tech sector, as it wants to exclude American and Chinese tech giants. This is also visible in India’s reluctance to participate in the Regional Economic Comprehensive Partnership, the world’s largest free-trade agreement in the Asia-Pacific region.
  • India’s rising economic power might come with the ambition to become a global superpower. It iscurrently building economic ties along a horizontal line between South Asia and the Middle East. Furthermore, an Indian maritime strategy is emerging as the country seeks to employ its power in the Indian Ocean, all the way from Southeast Asia to East Africa. This will put India at odds with China, which is seeking influence in the same countries. Furthermore, together with Japan, India is currently developing a trade and investment project: the Asia Africa Growth Corridor (“AAGC”) as an alternative to China’s BRI.

On democracy in China

What happened?

The protests in Hong Kong have reignited the debate about democracy in China. In Foreign Affairs, the Hong Kong-based professor of philosophy Jiwei Ci, for example, argues that China cannot reach its next stage of development without democracy. What’s more, in his most recent public visit to Shanghai, president Xi Jinping called for efforts to explore new forms of democracy in the city. To be sure, it is highly unlikely that China will implement major democratic reforms in the coming years. However, it is important to wonder how the Chinese political system could gradually become more open and transparentlike all countries that reached high-income status (except petro-states).

What does this mean?

The topic of democracy in China is of course nothing new. Up until a few years ago, the belief that all countries would eventually become democratic was still dominant. More recently, the idea that democracy is merely a western concept, and other cultures have their own distinct political systems, has taken root. However, both perspectives disregard the possibility that all countries will experience a unique path towards a more open, liberal and transparent political system. Indeed, there are fundamental (institutional) differences between the democracies of the U.S., Europe and India. That being the case, a Chinese version of “democracy” is likely to come to fruition, but it will be shaped by Chinese traditions.

What’s next?

If Chinese politics become more open and transparent, it is likely to retain its highly centralized bureaucracy whose authority cannot be questioned directly (as to prevent the possibility of a weak unstable center of government). Instead, Beijing would increasingly encourage democracy at the local level. The well-known 2011 protests in the southern Chinese village of Wukan display the roots of this Chinese political spirit: protestors were frustrated with corrupt local officials, but carried flags in support of the Communist Party based on the belief that the party would intervene. Indeed, Xi’s visit to Shanghai highlights the Chinese path to political liberalization: Beijing will carry the responsibility to make local administrators listen to the demands of the people, possibly by holding elections.