Stratfor’s George Friedman: Long Turkey, Short China

December 16, 2009

The founder of Stratfor Global Intelligence explains why investors should embrace Turkey, Mexico and Poland … and not
China
.

 

Exchange-traded funds have made everyone into a global investor. Today, with the click of a button, we can gain access to everything from China and Russia to Turkey, Poland, Mexico and
Vietnam
.

With this newfound ability, however, come new risks. Company and sector-based analyses only go so far when looking overseas, particularly into emerging markets. For today’s global investor, geopolitical-, social- and country-specific economic risks are as important as single-stock factors in their potential impact on a portfolio.

As a result, smart investors are expanding the types of sources they consult in their research. Many are turning to Stratfor, a global intelligence company sometimes referred to as the “Shadow CIA.” Founded by George Friedman, Stratfor has more than 500 employees scattered around the globe, who aim to provide political, economic and military intelligence long before you read about it in the Wall Street Journal. For risk-savvy global investors, Stratfor’s Web site and reports are a key part of its due diligence.

Friedman discussed several emerging market economies of particular interest to Stratfor during a recent conversation with Matt Hougan.

 

IndexUniverse.com (IU.com): You and I have discussed
Turkey
in the past as one of your favorite areas of the world for investment. Why is that, and is it still true?

George Friedman (Friedman):
Turkey is an island of stability in a region of chaos. To the northeast, you have the Caucasus, with Georgia and Armenia; to the northwest, you have Bulgaria; to the south, Iraq and Syria; and to the east,
Iran
. Of all these countries,
Turkey
has the largest economy. It is the 17th-largest economy in the world.

It also has by far the largest and most capable army in
Europe, possibly barring the British—and only possibly.
Turkey
has a substantial internal market and a substantial middle class. It has interesting wage differentials [against other nations], and a lot of American companies are looking at it as a place to go, not only to produce products, but to sell them. And of course, it is perfectly located strategically, with easy access to Europe, the Middle East and
Eurasia.

It has weaknesses, such as the political split between the Islamists and the secularists. But radical Islam is not a major issue there, despite occasional terrorism. The issues in the southeastern part of the country with the Kurds are quite serious, but they don’t threaten the broader security of the nation.

Visitors to
Istanbul will be stunned by the amount of economic activity. There is massive construction. And the banking industry is quite conservative, so it’s done well during the crisis. The Turks looked at some of the alleged sophistication in the banking system in
Europe, and they were not impressed, so they decided to keep things simple.

IU.com: It may be an island of stability, but it’s surrounded by a sea of trouble. Shouldn’t we be concerned about having neighbors like Iran or (more distantly)
Russia
?

Friedman:
Turkey
is so strong militarily that neither the Russians nor the Iranians would dream of messing with it. In fact, both countries are very solicitous of
Turkey and make sure they don’t alienate it. You’re really looking at the 600-lb. gorilla of the region.

IU.com: Then why is it overlooked by the investment media? You never hear about
Turkey
.

Friedman: The American media is not very good at covering the world. They operate out of stereotypes that are 20 years out of date. For the same reason that the financial media wasn’t very good at covering the financial crisis, they aren’t good at covering this.

IU.com: Let’s turn to a neighbor of Turkey that’s been much in the news:
Greece
. There have been extensive stories recently about the potential of a Greek default. Is this something investors should worry about?

Friedman:
Greece
cycles between periods of moderation and periods of problems. They’re in the problem phase right now.

The thing to remember about
Greece
is that it is a Balkan country. It has far more in common with Serbia and
Croatia
than it does with its own history. If you want to understand Greece, understand
Bulgaria
. Thirty years ago, Greece and
Turkey
were seen as equals; that’s no longer the case. Turkey looms over
Greece
.


Greece
should be seen as a leading Balkan country, and not really as a European one.

 

 

IU.com: Let’s turn north. What about
Russia? Is the Russian economic boom real, or will it eventually wither and die?

Friedman: Russia is
Russia
. It is a country that exists because it has a single functioning entity: the security service, meaning the KGB or now the FSB. This has been true since the 19th century.
Russia is so diverse and diffuse that it has to have the security service or it has nothing.

For investors, the thing to understand is that the security service is the economy. If you look at how a company like Gazprom exists, it exists because it is deeply integrated into the FSB, which is in turn deeply integrated into the oligarchs.

The Russians have corporations, but regarding them as Western corporations is a massive mistake. To do business in Russia, you have to grasp the … the stunning idea that
Russia
is different. Where Western investors get in trouble overseas is when they fail to understand that they are not investing at home.

In
Russia
, politics and investments are mixed. If you don’t want to get involved in politics, don’t get involved in Russian investments. If you do want to get involved, understand that you are getting involved in the politics of the security agencies.

When Russian business is done, making money is an issue. But it’s very rarely the only issue.

IU.com: But Russian stocks have been booming. Practically, what does the fact that the security service runs
Russia
mean for investors?

Friedman: [It means] economic growth is not
Russia
’s biggest concern. It will sometimes grow at a slower pace … to achieve political goals. If an investor goes in just wanting growth, he may find that his interests are not aligned with the government.

The Russians are playing a more complex game than, say, the Chinese, who just pursue growth. That complexity makes investing there more difficult. You always have to remember that the period that investors remember as the most exciting in Russian history—the 1990s—is regarded by the Russians as an unmitigated disaster, and a road map as to what never to do again.

IU.com: Speaking of China, you’re actually one of the few people who have expressed skepticism about the growth in
China
.

Friedman: There are many people expressing skepticism, but mostly they are domestic Chinese, and they do so by investing outside of
China
.

We are seeing a surge of public and private investment coming out of
China, filling many voids in the Western world. But ask yourself the old insider rule: If China were such a great investment, why would anyone in China be investing outside of
China
?

If you listen to the central committee and politburo, they’re deeply concerned about the economy. They’re particularly concerned about the rapid growth rate, because unlike in the West where growth tends to parallel profitability, it doesn’t in
China. The profit margins on their exports are extremely low and sometimes negative. An extremely rapid growth rate is sometimes suicidal. That’s why the government is always trying to slow down the growth rate. But they can’t slow it down too much because all of the indebtedness is driving companies to raise cash to pay back debt.

IU.com: So all that growth is not necessarily a good thing …

Friedman: That’s the micro problem. The macro problem is bigger. According to the Chinese government, there are 1.3 billion Chinese, and 600 million live in households whose income is below $1,000 per year. Another 440 million live in households earning between $1,000 and $2,000 per year. That means slightly more than 1 billion Chinese have a standard of living equivalent to sub-Saharan
Africa.

There are 60 million Chinese with household incomes over $20,000 per year, the global standard for the middle class. Out of 1.3 billion Chinese, the “surging” Chinese middle class is 60 million. That’s the size of France, which is impressive, but looking at the whole country,
China is extraordinarily poor.

The Chinese factories produce things that cannot be consumed in
China
. Therefore, they are completely hostage to the American and European markets. The possibility of them refloating the yuan is zero. China’s biggest customer is Wal-Mart, but Wal-Mart also has the option of buying in Pakistan or
Vietnam
.
China
doesn’t have another option of where to sell its products. Withdrawing their investment in American government paper would be an interesting way for the Chinese to cut their own throat.

If
China had a serious recession, it would be plunged into economic chaos. If you make $1,000 per year and you lose your job, it’s not your 401(k) you’re worried about. The Chinese government is desperately worried about unemployment because they are afraid of the alternative. And so, they keep their uneconomic factories going, despite the debt.

Aside from all that, the Chinese are in great shape.

 

 

IU.com: What is the end game here?

Friedman: We have had two similar events in
Asia in our generation. The first was in
Japan
, where you had the same debt-driven economy growing at an extremely high rate. The West assumed that they were going gangbusters. What followed was the collapse of the Japanese banking system. Then we had the 1997 crisis in
East Asia, preceded by high growth. The collapse was caused by the same factor. Combine a debt-driven economy and a very high growth rate, and you end up with a very sudden collapse.

The difference with China is that neither
Japan
nor the other Asian countries had massive pools of utterly impoverished people. The Japanese could slow down their growth rate, preserve employment as their primary goal and survive without massive social instability.

Chinese resources, relative to its social issues, are dwarfed. They are trying to solve the problem by surging exports, as Japan and
East Asia did, but in a recession, that means subsidizing exports to the point that they’re losing money.

Today, the response you’re getting from the Chinese government is increased repression dealing with increased social unrest. People say that if
China
is doing so great, why are they cutting off access to the Internet? Well, either they’re stupid or they know something you don’t know.

Investment bankers love
China because they focus on the 60 million people and because once the transaction is done, they’re gone. But the reality of
China is far more complex than landing in Pudong and taking a car to the Shangri-la.


China
has expanded for 30 years. Each year you expand, the likelihood that you will expand the next year declines. They’ve had extraordinary expansion, but they have significant problems, which are manifested by their reserves. The inability of the Chinese to reinvest in its own economy is a significant problem.

IU.com: Will we see a massive wave of bank defaults when these debts come due?

Friedman: You’re already seeing them. The Chinese government doesn’t allow defaults no matter how high the nonperforming loan rate is. They step in and buy the debt, using their reserves to stabilize industry. That’s why the government tries to limit lending. But in many cases, the banks are lending to cover bad loans so they don’t have to book them.

The government is caught between allowing bankruptcies and shutting down the system.

IU.com: Let’s turn to
Poland
, which you have discussed in the past as a potential power in the future. A new ETF (PLND) just launched on
Poland
, so I’d be interested in hearing about what you think of the country as an investment.

Friedman: It’s the 18th-largest economy in the world, and the 8th largest in
Europe. That’s a pretty stunning reality.
Poland
is another country that has emerged. Major American companies like Dell are leaving Ireland and moving to
Poland
. It still has favorable wage advantages over other European countries, and it has a very sophisticated workforce. Plus, it’s part of the EU.

Basically, it is a sophisticated European country with a great wage variable and it is rising very, very rapidly. My question always is, why would you be surprised when the 8th-largest economy in
Europe is cited as an interesting place to invest?

Forgetting what I think about it strategically,
Poland
has already achieved more than almost any other Eastern European or Soviet country. When a company like Dell decides to give up on the darling of Europe [Ireland] and shift to
Poland
, it’s pretty telling.

IU.com: Flipping to the other side of the world, what about
Brazil
? Is the Brazilian miracle real?

Friedman: Think of Brazil as
Australia
. It’s utterly isolated geographically. Most of the terrain around it is impassable. Overland, it can’t touch Venezuela, and it has a land bridge to
Uruguay
. Think of it as an island.

As an island it is an amazing story. It has a range of social issues, but it is the real thing. The only country in Latin America that parallels it is
Mexico
. Brazil is the 11th-largest economy in the world and
Mexico
is the 13th largest. We regard these two countries as extraordinary opportunities for the risk-tolerant investor. Both have tremendous economic opportunities, and you pick up social unrest as the flip side of that opportunity.

We don’t know how
Brazil
will behave in a recession. The real test is how it manages a downturn. We know how it behaves in an expansion. But those who believe the business cycle has been abolished in countries like
Brazil
, well, I’d be glad to take the other side of that bet.

 

 

IU.com: But if you take a country like Mexico and to some extent
Brazil
, it’s just racked with violence and drugs. Isn’t that a problem for investors?

Friedman: No, that’s beneficial.
Mexico
has $25 billion to $40 billion in cash pouring into the country each year. And narcotics isn’t like any other industry. The profit margins on drugs are about 90 percent. In the auto industry, $40 billion in revenues may translate into $3 billion in profits. In this industry, $40 billion translates into $35 billion in profits.

One of the huge advantages of
Mexico
is this massive inflow of American dollars at low cost. One of the prices they pay is instability of the borderland. But that problem doesn’t stretch into the heartland, and that’s what’s important.

As in every country in the early stage of investment, one of the things you expect is serious social instability. Western investors want a country with tremendous growth potential, low risks and tremendous social stability. Good luck.

The price you pay for getting into these countries is understanding the social risks and the political complexity and mastering them. If you only want to look at the balance sheet of corporations, don’t go here.

Investors have a real opportunity in these countries, but they have to find a way to mitigate risks that are not economic.
Mexico
is the perfect case in point. There are huge opportunities. You just have to know what street to walk down.

 

 

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