Not missing the forest for the trees

April 27, 2023

Bamboo forest in Kyoto, Japan.

At Global Alpha we are macro aware but don’t make macro calls. Being macro aware helps us evaluate investment opportunities through the lens of a country’s economic indicators, politics and regulatory landscape. It can also be an important risk management tool, especially in emerging markets.

Macro awareness also comes from understanding a country’s policy choices on its path to success or failure. An exceptionally interesting book called “How Asia Works” by Joe Studwell, provides unique insights into why North Asian countries (Japan, Korea, Taiwan and China) have managed to achieve sustained economic growth while South Asian countries (Thailand, Malaysia, Indonesia and the Philippines) seem to have stalled on their way to economic success. The book answers several questions including:

  • Why successful industrial brands like Haier, TSMC and Hyundai emerged from North Asia and not South Asia.
  • How the Philippines went from being twice as rich as Korea to 11 times poorer in half a century.
  • Lessons that other emerging markets can learn from ones that have experienced growth and success.

The last point is particularly useful to our investment process. If there was a common thread (or formula for success) across North Asian economies, it would be the following.

Step 1 – Small gardens beat large ranches (Land reforms)

This is the crucial initial step, yet also the stage at which most countries falter. Achieving sustained economic growth of 7% to 10% over a significant period requires making tough political decisions, such as redistributing land in a peaceful manner. Following WWII, many North Asian economies were poor and had a surplus of labour in rural areas. However, land ownership was concentrated in the hands of a few wealthy and connected landlords.

The key to unlocking growth in this situation was to peacefully redistribute land from these connected landlords to small rural farmers and peasants. This approach is counterintuitive to what neo-classical economists might recommend, which is to establish massive, mechanized farms to maximize profit per acre. Instead, an intensive gardening approach on a small plot can deliver maximum crop yield.

The effect of this type of reform is that it fully employs the abundant labour available in rural areas. Increased agricultural output leads to sharp increases in purchasing power, waves of consumption and the resources to pay for basic manufacturing technology. Another significant effect of this reform was the social and economic mobility that it enabled, which in turn led to the emergence of a new middle class and a new cohort of entrepreneurs. For instance, the founder of Hyundai (Chung Ju Yung) in Korea and the founder of Formosa Plastics (Wang Yung Ching) in Taiwan were both sons of farmers.

Step 2 – Export or die (Carrot and stick approach to manufacturing)

As agriculture begins to create a new generation of entrepreneurs, returns from agricultural reforms start to taper off after a decade. The challenge then lies in redirecting entrepreneurial energy towards export-oriented manufacturing instead of services. Manufacturing is preferable to services because significant productivity gains can be achieved with low-skilled workers, and manufactured goods are more freely traded across the world.

Where policy differs from the consensus neo-classical approach is in offering protection to domestic manufacturers in the early stages of a country’s development, in the form of subsidies, while keeping international competition out of the domestic market with high tariffs. In exchange for this protection, domestic firms are required to maintain strict “export discipline.” This means that the more a domestic business exports and competes in the international market, the more subsidies and financing it receives.

A positive side effect of this policy is that businesses in North Asia were compelled to rapidly climb the technology learning curve to produce high-quality products. Those that failed to be export competitive were cut off from cheap credit and subsidies and were forced by the government to shut down or merge with successful companies. Instead of picking winners, the government weeded out the losers.

For example, Korea’s government encouraged a dozen conglomerates, including Samsung, Daewoo and Shinjin, to master car manufacturing in a market that was just 30,000 units in size. Vehicle imports were prohibited until 1988 and the import of Japanese cars until 1998, allowing domestic manufacturers to compete for survival. As a result of this policy, a single world-beating colossus in the form of Hyundai-Kia remains.

In contrast, Malaysia decided to master car manufacturing with a single state-owned enterprise (Proton) instead of encouraging private enterprise. With no export discipline or internal development of technology, Proton has mostly found success in the domestic market. In 2022, Proton sold approximately 141,000 cars, while Hyundai Kia sold over 6.8 million.

Step 3 – Targeted finance (Saying no to short-term profits)

The final step is to ensure that domestic financial institutions are fully aligned with the agricultural and industrial policy goals outlined above. Banks are kept under government control via the central bank and “directed” to lend to industrial and agricultural projects that may not necessarily yield the highest short-term returns but have the potential to earn long-term profits by nurturing infant industries. Capital controls are implemented to ensure that citizens’ savings remain in the country to finance national development projects.

The key is to avoid premature deregulation of the financial sector as with what led to the 1997 Asian financial crisis. Deregulation and capital market development as promoted by the World Bank and International Monetary Fund came much later in the industrialization process in Taiwan and Korea. In South Asia, premature deregulation of the financial system led to the issuance of new bank licenses to a cozy group of entrepreneurs who financed their own business activities and short-term speculative investments, like luxury real estate, instead of projects of national importance.

This historic review of North Asian success may seem both contrarian and counterintuitive due to its prescription of financial repression, tariffs and political intervention. However, it helps us at Global Alpha identify countries or sectors that might be on an unconventional path to success. For example, when we were in Vietnam late last year, we couldn’t help but wonder if its combination of an export-driven model and capital controls resembles the Korea or Taiwan of 1970s and 1980s.

Similarly, when Korea announced in 2022 its plans to develop its carbon composite industry as its second steel industry, we saw parallels with how it mastered the art of steelmaking with POSCO, now one of the world’s most efficient steelmakers. In fact, we have exposure to the advanced materials space in Korea through Hansol Chemical (014680 KS), which plans to invest ₩85 billion in silicon anode production as a solution to increasing the energy density of EV batteries while reducing charging time. If history is any guide, we can expect plenty of support from the Korean government to nurture this industry of the future.

Macro awareness can help you succeed

The success of emerging markets isn’t just about individual companies, but also about the broader economic and political context in which they operate. Being macro aware and having a solid understanding of the broader context can help investors make better informed decisions, mitigate potential risks and maximize their returns.

Global Alpha Capital Management Ltd.
April 27th, 2023